In the late 1950’s and early 1960’s, the modern technology sector began its life. Unfortunately, the innovation was there, but the capital market funding wasn’t. So, in 1961, Arthur Rock raised $3.5 million from 25 limited partners and formed a venture capital fund. The rest is history.
The firm of Davis and Rock backed dozens of companies, such as Intel and Apple Computer, and the venture capital industry was born. Over the following decades, the venture capital industry generated hundreds and hundreds of billions of dollars in shareholder value as it launched a generation of cutting-edge enterprises.
Now flash forward to the late 1970’s and early 1980’s. Corporate America was very inefficient. Entrenched management teams built big and bloated conglomerates that weren’t creating shareholder value. And shareholders couldn’t change things because they had no way of raising capital to take over companies or challenge management teams. Then Michael Milken created the junk bond market, which enabled small, well-run companies to take over larger, inefficient companies. There were a lot of things wrong with the junk bond market, but it fostered efficiency and innovation, and it provided lesser-rated companies with access to much-needed capital.
Venture capital and junk bonds each filled a financial void, and they’ve since gone on to become driving forces in the way we build companies, industries and economies.
A similar void and opportunity exists today in the world of project finance. To put it simply: there’s very little financing available for projects that employ new technology in the fast-moving and fast-growing renewable energy sector. It’s true that the government is helping to fund projects in this area, but public-sector money, on its own, is hardly a long-term solution. To supplement and solidify these efforts, I believe we need to create the equivalent of a junk bond or venture capital market for renewable energy project finance.
What would this look like?
Well, from my perspective, the new “sweet spot” for project finance revolves around renewable energy deals that primarily range in size from $100 million to $500 million. And, even though the project finance market is currently uneasy – and even closed – when it comes to transactions that involve new or unproven technology, this is where the reward clearly overrides the risk.
Balancing Risk and Reward
I envision several solutions that could help spawn a new and lucrative market for renewable energy project finance. First, we could create an instrument that delivers quasi-equity returns. Second, we could adjust the risk profile of these investments to make them more palatable to traditional project finance investors. Or third, we could employ a hybrid, or combination, of the two approaches mentioned above.
We can create quasi-equity returns by slicing project finance for renewable energy into tranches. The most secure tranche would have first claim on the assets; the next secure tranche would have second claim; and the third trache would have last claim. Obviously, the rates of return would be based on the amount of risk each tranche incurred.
We could also inject equity into the parent company as part of the project returns. Many renewable energy companies have valuable technology that is currently being developed, but perfecting this innovation will take a few projects. If we provided ownership in the parent company (and the ongoing business opportunity that represents), we could help compensate project financiers for taking a risk.
Adjusting the risk profile for renewable energy project finance investments could be accomplished by creating a fund that would invest in multiple projects across a variety of technologies. The diversified fund would consist of limited partners who would be investing in a broad-based new energy economy project portfolio with many avenues for potential success.
Attracting New Investors
The concepts discussed above are not new. They are tried and true, and have been used in finance for a long time. But I believe they should now be applied to expanded project finance markets that include the renewable energy sector. By moving in this direction, the project finance market will start attracting new investors who favor asset categories such as convertible bonds and junk bonds. The one caveat here, though, is that project developers are going to have to realize that they will need to pay a rate of return that is above project finance returns for their first few projects.
The net results could be exceedingly beneficial, however. The project finance market will grow, investors will be able to balance risk and reward, and the renewable energy sector will have the capital to fulfill its innovative 21st century potential.
Michael Butler is Chairman and CEO of Seattle-based Cascadia Capital, LLC, a national investment banking firm that is financing the future for a wide range of companies in a variety of key sectors.