IFC Advisory Services in Sustainable Business Public Privatequity Partnerships: Accelerating the Growth of Climate Related Private Equity Investment Issue Brief In partnership with Private Equity – Uniquely suited to finance Figure 1: Number of Climate Friendly Deals Closed by PE/VC climate friendly projects funds between 2000 and 2010 by Geography Mitigating climate change requires vast investment. The World Bank estimates “the volume of financing needed to meet the additional costs by the international community for climate change-related development at between $180 billion and $250 billion per year. However, this sum represents only the additional or incremental costs: it would need to leverage nearly 20 times that amount—or up to as much as $4.6 trillion—from underlying investment finance from other public or private sources.” These investment needs are diverse, and catalyzing the necessary finance to address the challenge of climate change will require interventions across all asset classes. Among the various types of Source: ICF International and the Payne Firm. capital, Private Equity/Venture Capital (PE/VC) is uniquely suited to financing climate friendly investments that are risky, innovative, While the market has grown there is considerable opportunity to and relatively small. PE/VC funds will certainly not provide more accelerate the deployment of PE/VC capital in emerging markets. than a fraction of the $4.6 trillion investment needed—but they fill a As can be seen in Figure 1, most deals are occurring in developed key niche. In particular PE funds can: countries, with more than 50 percent of activity in the United States and United Kingdom. Less than 10 percent of climate • Make risky investments: PE/VC funds provide firms and friendly deals are in emerging economies, and of these more than projects with a form of financing that is more patient and flexible 80 percent have occurred in India and China. As a result, less than than debt. PE/VC funds are among the only investors willing 2 percent of PE/VC fund activities spread across all the emerging to provide cash to medium sized companies to burn while they markets outside of India and China, despite these countries develop into profitability making up 20 percent of the world’s economy. Further, most • Provide cornerstone finance: PE/VC funds are able to provide investment in emerging markets has been made by international equity finance to earlier stage companies that cannot access debt firms investing from overseas. There is still a very limited number financing (cash flows too risky and too few tangible assets) and of locally developed climate friendly private equity funds in are too small to access securities markets, but too large to rely Emerging Markets. on friends and family. The equity financing provided by PE/VC funds allows the companies to invest and access other forms of financing such as debt Climate Related Private Equity constrained • Help companies do business better: PE/VC funds help the by capital market barriers companies in which they invest to build up their governance, managerial and technical capacity. This provides much needed A number of barriers stand in the way of PE/VC being available support, especially in developing countries where such capacity is to climate friendly projects in the desired quantities. New fund often lacking management teams will have to form. The new managers need to • Identify and develop business opportunities: PE/VC funds raise funds from limited partners. The funds need to be deployed take an active role in developing the pipeline of projects and into profitable investments. As fund managers deploy capital companies in which they can invest. This often means helping profitably, they can raise more capital from the limited partner companies in which they wish to invest to build up the systems community, in a virtuous circle. This should be a virtuous circle of (such as governance, accounting and personnel) needed to absorb market development. outside financing, systems which are often lacking in companies in developing countries. Unfortunately, the virtuous circle is slowed by four underlying factors: information asymmetries, agency problems, newness, and coordination problems (these are shown in Figure 2). These in turn Over the last decade there has been a significant growth in climate create specific challenges for the private equity industry creating friendly investment by PE and VC firms. From very few deals in 2000 barriers to: the market has grown to US$ 20 billion per year in 2010. 2 Public Privatequity Partnerships: Accelerating the Growth of Climate Related Private Equity Investment Figure 2: Development dynamics of the PE/VC market the barriers holding back the PE/VC market. To assist with the formation of funds and raising capital, public sector financial Long fund-raising institutions can: periods deter new Fu r m teams Fund n d at Fo management team forms Anchor new funds: IFIs can identify promising new fund io Potential n management teams lack capital management teams and commit capital to them. Anchoring includes letting teams with potential know where they need to strengthen Repeats Fund managers lack track records their offering (for example, by bringing additional skills), helping the Pioneering a market Raises capital has high costs from LPs fund with structuring and documentation, and introducing the fund New investment Difficult to Deploy areas lack a history of returns to other potential investors. The advice and introductions are made capture all returns capital, then from pioneering exit credible by the IFI committing capital to the fund. Anchoring has investments New investments are perceived to be risky successfully kick-started PE/VC investing in areas as diverse as early Benefits of Carbon Abatement not easily stage climate friendly infrastructure in Asia, plantation forestry in monetized Impede Africa, and clean technology in China. To help develop emerging Development of Cycle of Success fund managers, IFC invests a substantial proportion of its funds with Information Asymmetries Agency Problems Newness Co-ordination Problems new fund managers. During the early 2000s, IFC supported many first time PE/VC funds in nascent markets with little previous PE/ VC fund activity. As shown in Figure 3 IFC’s investments in these first time funds were relatively successful. IFC’s investments in first • Fund manager formation: New investment areas need new time funds outperformed global benchmarks, and also outperformed fund managers. However, putting together a new fund is risky, IFC’s investments in follow on funds in more established markets. costly, and time-consuming. Few professionals with the right IFC believes the differentiating factor in fund returns is the manager’s skills have the appetite to do it. Unfortunately, a shortage of skill set, not whether this is a first time fund. good fund managers slows the rate at which the entire market can develop. • Raising capital: Mitigating climate change requires investments Figure 3: IFC’s Returns from Investing in First Time PE/VC in new sectors, using novel business models and technologies. Funds Outperform Follow on Funds and Industry Benchmarks These investment types often have no track record of historic (2000-2010) returns. The fund management teams who have the skills to 30% tackle these areas are often new too, with no track record. Yet typical investors in PE/VC funds rely on track records of teams 25% Internal rate of return and sectors in deciding where to place their capital. This leads 20% to a chicken and egg problem. A fund or sector needs a track 15% record of returns to attract capital, but without a track record of returns it is unable to raise financing and so cannot invest and 10% build a track record. 5% • Deploying capital: Small, innovative climate friendly projects 0% may impose high management expenses on PE/VC funds, IFC: returns on Emerging markets: which are uneconomic within the industry-standard two percent investments in upper quartile management fees. Such pioneering investing can benefit the first time of PE/VC development of a whole industry, since it produces models for PE/VC funds fund returns others to follow, but it is often hard for the pioneers to capture Source: IFC and Cambridge Associates emerging markets benchmarks. this aspect of the benefits they produce. Further, PE/VC funds— like any other investor in climate friendly projects—suffer from difficulties in capturing the positive externalities from carbon • Finance new fund development: Public institutions can emissions reductions in a form that can attract finance. provide capital to new management teams to help them finance the costs of setting up a new fund and getting commitments to the fund from investors. The capital provided could be a quasi- Public capital can be deployed to equity investment in the fund manager, which would return accelerate private sector investment capital to donors from returns on the fund if it is successful. IFC does not do this now, but its experience with first time funds The public sector—particularly the International Financial suggests that this approach could be commercially successful, as Institutions (IFIs) and bilateral donors—can help to overcome well as developmentally positive. Public Privatequity Partnerships: Accelerating the Growth of Climate Related Private Equity Investment 3 • Invest in a new fund on a concessional basis through a Figure 4: Growth of PE Assets under Management in Yozma waterfall structure: In a classic fund structure, all investors, Scheme including any public institutions, participate pari passu —that is, they share equally in profits and losses. Public institutions have an opportunity to offer a ‘waterfall structure’, which $10,000 subordinates their returns to the returns of private investors in Fund size in millions of US$ certain circumstances. The waterfall can be designed to attract $8,000 private investors by dampening their losses if the fund does $6,000 badly or leveraging upside if the fund succeeds. This approach Government's contributed to the development of the Venture Capital (VC) initial investment +$7 $4,000 billion sector in Israel. In Israel, the Yozma fund deployed US$100 was $100 million in 1993 and million of government capital in 1993 into select VC funds using $2,000 ended in 1997 a waterfall structure. This helped catalyze the development +$2.6 billion of an industry which had US$9.6 billion under management $0 1993 2001 by 2001. In other words, as shown in Figure 4 for every dollar invested by the Israeli government in 1993 by 2001 US$96 had Public investment Private investment Private investment in Yozma funds in Yozma funds in non-Yozma funds been invested by the private sector. To help overcome the barriers to deploying capital profitably, public sector institutions can: Removing these barriers to the development of the PE/VC market could create a virtuous cycle. Easier fund raising would encourage more • Support pioneer investments: Grants can be provided for fund managers to form. More funds would mean more investment, pioneering activities such as feasibility studies and regulatory building up track records, and investment history. The benefits of approvals for new types of investment. Given the scale of the early pioneering would come through in lower costs going forward. pioneering needed, there is potential for governments to increase Perceptions of risk would fall. Improved carbon payment mechanisms the level of support provided and to proactively route it through would make more climate friendly projects profitable, further improving the PE/VC funds. In order to mitigate potential moral hazards investor perceptions of the sector, and increasing capital flows. As and to increase the alignment of interest between public and this process unfolds, more and more climate friendly investments in private capital support could be provided through a loan facility emerging markets would be able to access PE/VC funding. This would that is repaid out of the fund manager’s future earnings. This be a significant boost for the myriad of companies with climate-friendly facility could help cover the upfront costs enabling PE funds projects that need equity to finance start-up costs or to accept the risk to provide business and market development services as part of of volatile and risky cash flows, but are too large to rely on finance from their investment strategy. family and friends. Clean technology development, energy efficiency • Improved carbon payment mechanism: Bilateral donors have investments, renewable generation projects, efficient transport an opportunity to create a carbon payment mechanism which infrastructure and land use and forestry projects all can benefit from could offer guaranteed minimum prices for future carbon sales. the specific characteristics of PE/VC financing. This would greatly help with project financing, while the cost could be quite low. Channeling the carbon payment mechanism through suitable PE/VC funds would help ensure that the funds reached their targets, and also aid with financing, given the cornerstone role that PE/VC funds play in many financial structures. PublicPrivatequity Partnerships: Accelerating the Growth of Climate Related Private Equity Investment full report: http://www.ifc.org/sustainableinvesting Photocredit: © Curt Carnemark/World Bank The findings, interpretations, views and conclusions expressed herein are those of the authors and do not necessarily reflect the view of the Executive Directors of the International Finance Corporation or of the International Bank for Reconstruction and Development (the World Bank) or the governments they represent. The material in this publication is copyrighted. IFC encourages dissemination of the content for educational purposes. Content from this publication may be used without prior permission, provided that clear attribution is given to IFC and is not used for commercial purposes. International Finance Corporation • 2121 Pennsylvania Avenue NW • Washington, DC 20433 USA Tel. 1-202-473-3800 • Email: asksustainability@ifc.org • www.ifc.org/sustainableinvesting 4 Public Privatequity Partnerships: Accelerating the Growth of Climate Related Private Equity Investment