IFC Advisory Services in Sustainable Business 66763 Public Privatequity Partnerships: Accelerating the Growth of Climate Related Private Equity Investment In partnership with: Table of Contents Executive Summary.................................................................................................................1 1 Introduction......................................................................................................................3 2 The Distinctive Combination of Private Equity and Venture Capital to Mitigating Climate Change.............................................................................................5 2.1 The Role for PE/VC in Emerging Market Climate Finance....................................6 2.1.1 Clean Technology Development...................................................................7 2.1.2 Clean Power Infrastructure...........................................................................8 2.1.3 Energy Efficiency............................................................................................9 2.1.4 Land Use and Forestry...................................................................................9 2.1.5 Transport Infrastructure...............................................................................10 2.2 How PE/VC Investing Adds Value..........................................................................10 2.2.1 Funding Risky New Technologies and Business Models...........................12 2.2.2 Identifying and Developing Investment Opportunities...........................13 2.2.3 Help Companies Do Business Better...........................................................13 2.2.4 Being the Cornerstone Investor..................................................................14 3 Barriers to Development of PE/VC Market in Climate Friendly Investing................17 3.1 Barriers that Slow Fund Manager Formation......................................................19 3.1.1 Long-Fund Raising Periods Deter Potential Management Teams...........19 3.1.2 Potential Management Teams Lack Capital..............................................19 3.2 Barriers that Slow Capital Raising.........................................................................20 3.2.1 Fund Managers Lack Track Records............................................................20 3.2.2 New Investment Areas Lack a History of Returns.....................................20 3.2.3 New Investment are Perceived to be Risky................................................20 3.3 Barriers to Deploying Capital in Climate Friendly Investments..........................22 3.3.1 Pioneering a Market has High Costs...........................................................22 3.3.2 Difficulties in Capturing all the Returns from Pioneering Investments....22 3.3.3 The Benefits of Carbon Abatement are Not Easily Monetized...............23 4 Mechanisms to Facilitate Private Equity Fund Investing...........................................25 4.1 Anchoring................................................................................................................26 4.2 Financing Fund Development................................................................................28 4.3 Public Capital in the Waterfall...............................................................................30 4.4 Supporting Pioneering Investments......................................................................34 4.5 Improved Carbon Payments...................................................................................37 5 Conclusion.......................................................................................................................39 i Appendices Appendix A: The Basics of PE/VC Funds..............................................................................41 Appendix B: Funds Reviewed...............................................................................................44 Tables Table B.1: Background on the Funds.................................................................................44 Table B.2: Success and Failure of the Funds Reviewed...................................................44 Figures Figure 2.1: Number of Climate Friendly Deals Closed by PE/VC funds between 2000 and 2010 by Geography............................................................5 Figure 2.2: Deal History in the Climate Friendly Investment Market, by Primary Industry.............................................................................................5 Figure 2.3: Examples of Sectors that Mitigate Climate Change........................................6 Figure 2.4: Some Climate-Friendly Investments that Need PE/VC..................................11 Figure 2.5: PE/VC Funds Financing of Projects by Independent Developers.................15 Figure 3.1: Development Dynamics of the PE/VC Market.................................................17 Figure 3.2: Why Does a Private Equity Investment Not Occur in a Market with the Potential for Healthy Returns..............................................21 Figure 4.1: Interventions to Overcome Barriers to PE/VC Fund Investment...................25 Figure 4.2: IFC’s Returns from Investing in First Time PE/VC Funds Outperform Follow on Funds and Industry Benchmarks (2000-2010).........26 A Waterfall Structure that Increases Upside Leverage Relative Figure 4.3:  to a Pari Passu Structure....................................................................................32 Figure 4.4: A Waterfall Structure that Dampens Downside.............................................32 Figure 5.1: Generic Structure of a PE/VC Fund....................................................................41 Figure 5.2: Life Cycle of a PE/VC Fund.................................................................................42 ii Boxes Box 2.1: Solar Lamps: An Industry Accesses PE/VC Fund Financing to Expand..........7 Box 2.2: Energy Efficiency Business Models...................................................................9 Box 2.3 The Role of Private Equity in Financing Geothermal Projects......................12 Box 3.1: Other Barriers to Investment...........................................................................18 Box 4.1: The IFC’s Experience Investing in First Time Funds.......................................27 Box 4.2: Northern Lights Capital Group—Commercial Seed Investment..................28 Box 4.3: Avoiding Moral Hazard.....................................................................................29 Box 4.4: The Yozma Fund: A Successful Waterfall Structure.......................................31 Box 4.5: Public Capital in Waterfall Structure: Lessons from International Experience...........................................................33 Box 4.6: E+Co’s Support for Bio2Watt Leads to the Introduction of Environmentally Friendly Technology to South Africa.................................35 Box 4.7: Examples of Approaches to Supporting Pioneer Investments....................36 Box 5.1: The Difference Between Debt and Equity......................................................41 iii Public PrivatEquity Partnerships: Accelerating the Growth of Climate Related Private Equity Investment Acronyms and Abbreviations ADB Asian Development Bank CCGT Combined-Cycle Gas Turbine CDM Clean Development Mechanism CER Certified Emission Reduction COP15 15th Conference of the Parties CSR Corporate Social Responsibility CW Carbon Warehouse Defra  The Department of Environment, Food, and Rural Affairs DFID Department for International Development EE Energy Efficiency EBRD  European Bank for Reconstruction and Development EU-ETS  European Union Emissions Trading Scheme ERPA Emissions Reduction Purchase Agreement ERUs Emission Reduction Units ESCO Energy Service Company GHG Green House Gasses FIs Financial Institutions GP General Partner IFC International Finance Corporation IFI International Financial Institution LP Limited Partner IPO Initial Public Offering KFW Kreditanstalt für Wiederaufbau MAC Marginal Abatement Cost MACC Marginal Abatement Cost Curve MCCF Multilateral Carbon Credit Fund PE Private Equity PE/VC Private Equity and Venture Capital NASDAQ National Association of Securities Dealers Automated Quotation System PEF Private Equity Funds PSPEF Publicly Supported Private Equity Fund PPP Public Private Partnerships SPC Shadow Price for Carbon UK United Kingdom of Great Britain and Northern Ireland UNFCCC United Nations Framework Convention on Climate Change US United States of America US$ United States Dollar VC Venture Capital VCF Venture Capital Funds WACC Weighted Average Cost of Capital iv Executive Summary M itigating climate change by reducing greenhouse capacity. This provides much needed support, especially in gas emissions in developing countries will require developing countries where such capacity is often lacking considerable investments—estimated by the World Bank’s 2010 World Development Report to be as much as $4.6 Identify and develop business opportunities: PE/VC funds ••  trillion to keep global average temperature rise within 2 degrees take an active role in developing the pipeline of projects Celsius by the end of the century. Most of this investment will need and companies in which they can invest. This often means to come from private businesses. Many of the investments will helping companies in which they wish to invest to build require risk taking and innovation, involving new technologies up the systems (such as governance, accounting and per- and new business models. Many investments will be small and sonnel) needed to absorb outside financing, systems which face uncertain cash flows. Climate friendly projects with just these are often lacking in companies in developing countries. characteristics—small size, risky and requiring innovation—will need sources of capital able to deal with the level and types of The ability of PE/VC funds to provide both expertise and risk involved. They also need investors able to add value through capital means that they are uniquely positioned to initiate improved governance and mentoring of management. investments in nascent climate industries. Not all sources of capital are able to respond to this challenge. The PE/VC market faces barriers that slow Far from being fungible, capital tends to fall into specific investing in climate friendly projects in categories. Equity—the at risk capital which claims profits from emerging markets the business—is clearly different from debt, which comes with a much lower risk appetite and an expectation of fixed returns. There are both capital market and carbon market barriers that hinder the development of the PE/VC market for climate Among the various types of capital, Private Equity/Venture friendly investing in emerging markets: Capital (PE/VC) is uniquely suited to financing climate friendly investments that are risky, innovative, and relatively small. PE/ Fund manager formation: New investment areas need ••  VC funds will certainly not provide more than a fraction of the new fund managers. However, putting together a new $4.6 trillion investment needed—but they fill a key niche. fund is risky, costly, and time-consuming. Few pro- fessionals with the right skills have the appetite to do it. Unfortunately, a shortage of good fund managers PE/VC funds fill an important niche slows the rate at which the entire market can develop. PE/VC funds: •• R aising capital: Mitigating climate change requires invest- ments in new sectors, technologies and business models. Make risky investments: PE/VC funds provide firms ••  These investment types often have no track record of his- and projects with a form of financing that is more pa- toric returns. The fund management teams who have the tient and flexible than debt. PE/VC funds are among the skills to tackle these areas are often new too, with no track only investors willing to provide cash to medium sized record. Yet typical investors in PE/VC funds rely on track companies to burn while they develop into profitability records of teams and sectors in deciding where to place their capital. This leads to a chicken and egg problem. A fund Provide cornerstone finance: PE/VC funds are able to ••  or sector needs a track record of returns to attract capital, provide equity finance to earlier stage companies that can- but without a track record of returns it is unable to raise not access debt financing (cash flows too risky and too few financing and so cannot invest and build a track record. tangible assets) and are too small to access securities mar- kets, but too large to rely on friends and family. The equity •• Deploying capital: Small, innovative climate friendly financing provided by PE/VC funds allows the companies projects may impose high management expenses on PE/ to invest and access other forms of financing such as debt VC funds, which are uneconomic within the industry- standard two percent management fees. Such pioneer- Help companies do business better: PE/VC funds ••  ing investing can benefit the development of a whole in- help the companies in which they invest to build dustry, since it produces models for others to follow, but it up their governance, managerial and technical is often hard for the pioneers to capture this aspect of the 1 Public PrivatEquity Partnerships: Accelerating the Growth of Climate Related Private Equity Investment benefits they produce. Further, PE/VC funds—like any is, they share equally in profits and losses. Public institu- other investor in climate friendly projects—suffer from dif- tions have an opportunity to offer a ‘waterfall structure’, ficulties in capturing the positive externalities from carbon which subordinates their returns to the returns of private emissions reductions in a form that can attract finance. investors in certain circumstances. The waterfall can be de- signed to attract private investors by dampening their losses if the fund does badly or leveraging upside if the fund suc- Role of the Public Sector ceeds. This approach contributed to the development of the Venture Capital (VC) sector in Israel. In Israel, the Yozma The public sector—particularly the International Financial fund deployed US$100 million of government capital in Institutions (IFIs) and bilateral donors—can help to overcome 1993 into select VC funds using a waterfall structure. This the barriers holding back the PE/VC market. To assist with the helped catalyze the development of an industry which had formation of funds and raising capital, public sector financial US$9.6 billion under management by 2001. In other words institutions can: for every dollar invested by the Israeli government in 1993 by 2001 US$96 had been invested by the private sector. A nchor new funds: IFIs can identify promising new fund ••  management teams and commit capital to them. Anchoring To help overcome the barriers to deploying capital profitably, includes letting teams with potential know where they public sector institutions can: need to strengthen their offering (for example, by bring- ing additional skills), helping the fund with structuring •• Support pioneer investments: Grants can be provided for and documentation, and introducing the fund to other pioneering activities such as feasibility studies and regulatory potential investors. The advice and introductions are approvals for new types of investment. Given the scale of the made credible by the IFI committing capital to the fund. pioneering needed, there is potential for governments to in- Anchoring has successfully kick-started PE/VC invest- crease the level of support provided and to proactively route ing in areas as diverse as early stage climate friendly infra- it through the PE/VC funds. In order to mitigate potential structure in Asia, plantation forestry in Africa, and clean moral hazards and to increase the alignment of interest be- technology in China. Anchoring can be a commercially tween public and private capital, support could be provided successful strategy. IFC’s return on first time private eq- through a loan facility that is repaid out of the fund man- uity fund teams between 2000 and 2010 was higher than ager’s future earnings. This facility could help cover the up- the top quartile benchmark of emerging market funds. front costs enabling PE funds to provide business and mar- ket development services as part of their investment strategy. Finance new fund development: Public institutions can ••  provide capital to new management teams to help them fi- •• Provide improved carbon payments: Public sector institu- nance the costs of setting up a new fund and getting com- tions have an opportunity to create a new kind of carbon mitments to the fund from investors. Firms currently do payment mechanism that will provide revenue certainty for this on a commercial basis but largely in developed PE/ carbon emissions reducing projects. While this mechanism VC markets. IFIs and donors could do this in emerging could in the long term provide an additional revenue stream markets. The capital provided could be a quasi-equity in- in the short term it can be used as collateral against which vestment in the fund manager, which would return capi- projects can raise more debt. Such a new carbon payment tal to donors from returns on the fund if it is successful. mechanism would be particularly helpful in catalyzing IFC does not do this now, but its experience with first further private equity investment as the increased lever- time funds suggests that this approach could be com- age would help to shift the equity returns on many climate mercially successful, as well developmentally positive. friendly projects from marginal to commercially attractive. •• Invest in a new fund on a concessional basis through a wa- Through a combination of the above five interventions, public terfall structure: In a classic fund structure, all investors, in- sector institutions could greatly accelerate the development of the cluding any public institutions, participate pari passu —that PE/VC market in climate friendly investing in emerging markets. 2 1 Introduction Public sector institutions around the world are working on ways •• Public sector institutions have a range of interventions they to bring more private finance into investments in emerging can use to overcome those barriers and so increase PE/VC markets that mitigate climate change. This paper argues that finance of climate friendly investments in emerging markets there is an important role for Private Equity and Venture (Chapter 4). Capital (PE/VC) funds. IFC has been actively investing in climate friendly private equity funds and is interested in The audience for this report is policy makers and others understanding how public private partnerships could be interested in the role that public support for PE/VC funds can developed to scale the market. To that end, IFC contracted play in supporting climate friendly investments. It is intended Castalia Ltd (www.castalia-advisors.com), to prepare this to help shape conversations about how public capital can report. This paper suggests that: effectively be deployed to leverage private finance to stimulate the growth of climate friendly private equity investment in •• PE/VC funds have unique role to play facilitating climate emerging markets. friendly investments (Chapter 2) •• These funds face important barriers that limit the flow of PE/VC into climate friendly investments (Chapter 3) 3 2 The Distinctive Combination of Private Equity and Venture Capital to Mitigating Climate Change Mitigating climate change requires vast investment. The interventions across all asset classes. Among the various types World Bank estimates “the volume of financing needed to of capital, Private Equity/Venture Capital (PE/VC) is uniquely meet the additional costs by the international community for suited to financing climate friendly investments that are risky, climate change-related development at between $180 billion innovative, and relatively small – and thus likely to have the and $250 billion per year. However, this sum represents most transformational impact. PE/VC funds will certainly not only the additional or incremental costs: it would need to provide more than a fraction of the $4.6 trillion investment leverage nearly 20 times that amount—or up to as much as needed—but they fill a key niche. $4.6 trillion—from underlying investment finance from other public or private sources.”1 Indeed over the last decade there has been a significant growth in climate friendly investment by PE and VC firms. From very These investment needs are diverse, and catalyzing the necessary few deals in 2000 the market has grown to US$ 20 billion per finance to address the challenge of climate change will require year in 2010. While the market has grown there is Figure 2.1: Number of Climate Friendly Deals Closed by PE/VC considerable opportunity to accelerate funds between 2000 and 2010 by Geography the deployment of PE/VC capital in emerging markets. As can be seen in Figure 2.1, most deals are occurring in developed countries, with more than 50 percent of activity in the United States and United Kingdom. Less than 10 percent of climate friendly deals are in emerging economies, and of these more than 80 percent have occurred in India and China. As a result, less than 2 percent of PE/VC fund activity is spread across all the emerging markets outside of India and China, despite these countries making up 20 percent Source : ICF International and the Payne Firm. of the world’s economy. Further most investment in emerging markets has been made by international firms Figure 2.2: Deal History in the Climate Friendly Investment investing from overseas. There is still a Market, by Primary Industry very limited number of locally developed climate friendly private equity funds in emerging markets. 70,000 2500 Deal Value Deal Value (Millions $) 60,000 Number of Deals 2000 Investments have to date also targeted Number of Deals 50,000 a common niche with 3,334 deals, or 40,000 1500 80% of the total number of climate 30,000 1000 friendly deals focusing on technology 20,000 500 development, particularly in energy 10,000 generation, as shown in Figure 2.2. 0 0 Energy Generation Energy Efficiency Energy Storage Recycling & Waste Energy Infrastructure Transportation Air & Environment Manufacturing /Industrial Agriculture Water & Wastewater Materials Other Source : ICF International and the Payne Firm. 1 This investment is required to keep global average temperature rise within 2 degrees Celsius. Page 2 World Bank, 2010 “Beyond the sum of its parts, combining financial instruments to support low-carbon development” The International Bank for Reconstruction and Development. 5 Public PrivatEquity Partnerships: Accelerating the Growth of Climate Related Private Equity Investment 2.1 The Role for PE/VC in Emerging Market Climate Finance Clean Energy and in other sectors including energy efficiency, As shown in Figure 2.3 in emerging markets there is an land use and forestry, and climate-friendly transportation. untapped potential for private equity and venture capital Opportunities also exist along the supply chains in these to support technology deployment and business growth in industries, both upstream and downstream. Figure 2.3 Examples of Sectors that Mitigate Climate Change Areas where investment Sectors in which PE/VC funds invest that Companies that need is needed and the relative mitigate climate change PE/VC financing size of investment needed Converting agricultural Biogas wasted into electricity (i) Independent developers not Heat from underground affiliated with larger is used to generate Geothermal utilities or large listed electricity companies, investing in small scale projects, Clean power Wind energy is used to typically less than infrastructure, 33% Wind farms generate power 35MW, and (ii) start- ups introducing Biological waste from and/or manufacturing Biowaste factories is used to new technologies cogeneration produce energy Solar radiation is con- Solar verted into electricity Photovoltaic Companies whose Independent ESCOs business model is based companies, not on saving clients energy afiliated with a utility Energy efficient These devices replace Start-ups not linked to devices and Solar lamps carbon emitting established electronics processes, 43% kerosene lamps companies These devices reduce Small to medium size, carbon emissions from domestic companies Cookstoves cooking Land use Plantations sequester Unlisted plantation (forestry and Agriculture carbon companies agriculture), 10% investments Infrastructure investments Mass transit systems PPPs that reduces the need for Mass reduce carbon-emmitting energy, 14% transit personal transportation Source : Todd Johnson, Claudio Alatorre, Zayra Romo, and Feng Liu, 2009 “Low-Carbon Development for Mexico”, The International Bank for Reconstruction and Development, The World Bank. Percentages refer to the share of investments expected in Mexico.2 2 These percentages are different for countries other than Mexico. For instance in Indonesia there is substantial potential to reduce emissions from changing land use. In Indonesia the two largest sources of GHG emissions are peatlands (which makes up 38 percent of GHG emissions in 2005) and the degradation of natural forests (which contribute around 40 percent of emissions). Dewan Nasional Perubahan Iklim, 2010 “Indonesia’s greenhouse gas abatement cost curve” August 2010 6 The Distinctive Combination of Private Equity and Venture Capital to Mitigating Climate Change 2.1.1 Clean technology development times as many patents per dollar of R&D expenditure than Mitigating climate change requires that consumers and companies other firms’ spending on R&D. Smaller firms often need PE/ use energy more efficiently, and that energy is generated from VC funds to provide them with capital because they cannot new, renewable resources. This requires innovative new devices access finance from banks or security markets. They are also and processes. able to earn the returns that PE/VC funds expect from their ability to achieve fast top line growth. Innovations in energy efficiency and renewable energy technology are likely to come disproportionately from smaller The disruptive and innovative role of start-up companies can companies that are supported by, or need support from, PE/VC be seen in the climate mitigation investment area. Box 2.1 funds. Large investments have already been made by Venture shows how VC funds have contributed to the development Capital (VC) funds in this space. In the United States alone, of solar lantern technologies. Solar lanterns replace kerosene VC funds invested more than $1 billion on clean technology in lamps which emit carbon dioxide. Castalia’s research suggests the first three months of 20113 Kortum and Lerner4 find that that 100 million households who rely on kerosene lamps could companies supported by Venture Capital Funds produce five afford to buy a solar lamp. If solar lantern companies achieve Box 2.1: Solar Lamps: an Industry Accesses PE/VC Fund Financing to Expand Large, well established, electronics companies were slow to supply solar lamps to poorer consumers. The market was not thought to be particularly large, and designing solar lamps for consumers at the bottom of the pyramid was difficult for multinational companies used to selling products to wealthier consumers. A number of start-up companies filled the gap, introducing innovative products and business models. The table below shows that leading solar lamp companies relied on PE/VC fund financing to expand (d.light and Duron), or are actively seeking PE/VC fund investors to grow (Barefoot Power and Greenlight Planet). Example of device Name Investment and Financing Barefoot • Equity and loan support from Oikocredit Power • €1 million grant from EIB (Australia) Seeking $5 million from other finance providers including PE/VC funds. •  d.light  aised start-up capital by winning business plan competitions • R (United States) $6 million Series A financing from PE/VC fund investors •  $5.5 million Series B financing by the initial investors and Omidyar Net- •  work. Greenlight • Grant funding Planet (India) • Initial funding from an angel investor Currently looking to social impact funds to grow its business. •  Duron • Raised start-up capital through grants Seed Capital from Angel Investors (Idealab, Quercus Trust, Solgenix). •  3 Tiffany Hsu, 2011 “Clean-tech venture capital jumps 54% in first quarter 2011” LA Times, May 2, 2011 (http://latimesblogs.latimes.com/greenspace/2011/05/cleantech- venture-capital-jumps-54-q1.html). 4 Samuel Kortum and Josh Lerner, 2000 “Assessing the contribution of venture capital to innovation” RAND Journal of Economics, Vol. 31, No. 4, Winter 2000, pp. 674–692. 7 Public PrivatEquity Partnerships: Accelerating the Growth of Climate Related Private Equity Investment their objective to serve all these consumers, annual carbon These segments have growth characteristics that offer dioxide emissions from kerosene lamps would fall by 8 million opportunities for smaller applications. Additionally, many tons.5 Yet companies in this space typically have almost no of the clean power technologies are new, for instance wind assets, and negative cash flow, so banks will not lend to them. and biomass generation use rapidly developing technology. Innovative geothermal plants are being developed as well. Take d.light as an example. d.light is pioneering the sale of solar lamps to poor consumers in India, Africa, and the Pacific Given the scale and the relative novelty of the technologies, Islands. The firm was initially unable to obtain debt finance. smaller developers can be expected to play an important role. It had few tangible assets because its business model required Innovation will be crucial to supporting the development substantial investment in the development and marketing of the industry as it helps to lower the costs of technology of innovative products. In its early years d.light relied on enabling scale up by larger utilities. Innovation will also be financing from PE/VC funds such as the Acumen Fund, required to develop new business models for the deployment Gray Matters Capital, Nexus Venture Partners, Draper Fisher of clean energy solutions. Small scale enterprises will need to Jurveston, and Garage. This financing enabled d.light to sell be backed with capital and expertise if they are to get through more than 250,000 lamps by 2010 and the company hopes to their start up phases and into full production. provide lighting to 50 million people by 2015.6 There is already considerable investment in clean energy by PE/VC funds are also supporting “better place”, a company private equity funds.9 For instance, Berkeley Capital has raised that is pioneering the roll out of battery service stations where $74.12 million for its Renewable Energy Asia Fund (REAF). electric vehicles can swap drained batteries for a recharged The fund will focus on investing in small hydro, wind, solar battery in much the same way that a car fills up with gasoline. power, and biomass in India and other developing countries This infrastructure allows electric vehicles to achieve the in Asia.10 same range and convenience as conventional fossil fuel powered vehicles.7 Another beneficiary of PE/VC financing is Still, the investment need is greater than the current private Changelight, a Chinese company that researches and produces equity activity. Project developers report that an absence of LED chips and high efficiency solar cells.8 Investment is third party financing is holding back investment. An example therefore happening but it is still at a very nascent stage with a is asiaBIOGAS, a developer with experience developing a limited number of investors actively looking for opportunities. range of biogas technologies in South East Asia. Despite its experience and technical credentials, it has found that an 2.1.2 Clean power infrastructure absence of third party equity financing has constrained its ability to develop projects. Opportunities also exist to utilize To meet GHG emissions reductions targets, substantial telecom towers, which are not connected to the grid, as investment is needed in biogas, geothermal, wind farms, and foundation customers providing power to them with a high other renewable energy generation. Investment will be needed renewable energy content. While there is a very significant in grid connected installations, mini grids and in devices such market and demand for such an approach, the key aspect of as solar lamps. In many cases these technologies often use it is that the power company needs to have the appropriate relatively small, decentralized power plants. These plants are balance sheet in order to assume the risk that comes from the often developed by smaller companies with limited resources demand of the mobile operators or tower companies. Private which need cornerstone investors such as PE/VC funds. equity funds could supply the crucial cornerstone equity for such ventures. 5 Castalia research on the potential market for products and services that extend access to energy 6 David Wolman, 2010 “Want to Help Developing Countries? Sell Them Good Stuff — Cheap” Wired October 2010 (http://www.wired.com/magazine/2010/09/st_essay_pennies/). 7 Israeli Cleantech Partners supported better place, better place is described on its website ((http://www.betterplace.com) and Israeli Cleantech Partners is described here: (http://www.israelcleantech.com). 8 Changelight received financing from Sequoia Capital (http://www.http://www.sequoiacap.com/china/changelight). 9 Asieh Monsour, Stella Yun Xu and Mark Fulton, 2009 “Infrastructure Investments in Renewable Energy” RREEF (http://www.dbadvisors.com/content/_media/1175_ InfrastructureInvestmentsInRenewableEnergy.pdf). 10 VCC, 2009 “Berkeley Energy Raises $74M Cleantech Fund To Invest In India, Asia” VCCIRCLE (http://www.vccircle.com/500/news/berkeley-energy-raises-74m-cleantech-fund-to-invest-in-india-asia). 8 The Distinctive Combination of Private Equity and Venture Capital to Mitigating Climate Change 2.1.3 Energy efficiency Box 2.2: Energy Efficiency Business Models As much as half of the total abatement in Green House Gases There are two major business models based on improving (GHG) needed globally is expected to come from increased energy efficiency (EE). The first is to profit from producing energy efficiency.11 Analysis of abatement costs consistently more energy efficient equipment. This includes sellers of show energy efficiency investments as among the lowest cost industrial equipment as well as consumer appliances such approaches, often generating financial and economic returns as washing machines and light bulbs. that should more than justify the investment, even before The second is the Energy Service Company (ESCO) the benefits of GHG abatement are taken into account. Yet model. These companies install equipment, or redesign the potential for energy efficiency gains in private companies buildings and industrial systems and processes, to reduce and government facilities remains largely unexploited. This is their customers’ energy usage. The customer does not pay often because the managers of those companies and facilities for this service. Rather, the ESCO bears the up-front cost do not have the expertise, focus, or incentive to pursue energy and then makes back its investment by receiving a share efficiency. Other barriers include agency problems, in which of the resulting energy savings. In this way the ESCO energy efficient investment would be a cost to the landlord, but provides service (reduced energy consumption) and the benefit would go to the tenant in lower utility bills. People finance by bearing the up-front cost and only receiving buying buildings and equipment often cannot easily assess the its return over time. difference in lifetime energy costs between different options, and so may choose not to pay more for more efficient options, One of the earliest examples of an ESCO was Time even when doing so would be in their own interest. Energy from Texas. In the 1970s it started selling a device to automate the switching off and on of lights and Energy Service Companies (ESCOs) are a solution to some other equipment to save on energy costs. Many potential of these problems. As described in Box 2.2, ESCOs are users doubted that significant savings would result from companies that specialize in increasing energy efficiency for installing the devices, and so sales were slow. To overcome large energy users in the private and public sectors. They install these doubts the company decided to install the devices devices, and implement processes, which reduce companies’ up-front and ask for a percentage of any savings that and governments’ energy usage. The ESCO provides the resulted. This approach led to a large increase in sales. capital, focus, and expertise needed to make energy efficiency This model has been widely adopted since then.12 happen, and typically is rewarded with a share of the savings in energy costs. Because ESCOs invest in energy efficient equipment and its 2.1.4 Land use and forestry installation, and then are paid from a share of the energy savings, they need capital. Without significant collateral ESCOs can PE/VC funds also have an important role to play investing in find raising debt challenging and are generally able to leverage plantation forestry. Expansion in plantation forestry has the their assets less that other companies. ESCOs therefore need potential to sequester large amounts of carbon dioxide. Take substantial quantities of equity—more than can be provided East Africa for example. The World Agroforestry Centre13 from friends and family and retained earnings. However, they estimates that in Kenya, Zambia, and Uganda there is potential are generally too small to raise equity on a stock exchange. for 30 million hectares of plantations. In a scenario where this As a result, a lack of private equity constrains their ability to land would otherwise be grassland, these plantations would grow. An example is Gestión Integral Energética SA (GIE), a sequester enough carbon emissions to offset the emissions that Columbian ESCO. GIE provides services to smaller clients eighty 500MW coal powered stations make over 20 years. that the ESCOs associated with large utilities in Columbia don’t consider worth serving. However, GIE and other similar Reaching even a fraction of this potential will be difficult ESCOs struggle to access equity financing. They report that without access to private equity. Large scale expansion in there are many companies that they could profitably serve if greenfield plantations are difficult to finance using debt they had access to additional equity financing. because plantations can take more than seven years to start 11 IEA, 2009 “World Energy Outlook 2009 Fact Sheet, Why is our current energy pathway unsustainable?” (http://www.iea.org/weo/docs/weo2009/fact_sheets_WEO_2009.pdf) Bullock, Cary, and George Caraghaiur. 2001 “Guide to Energy Services Companies” The Fairmont P, Inc., 2001. 10 Mar. 2008 12. Figures for Kenya, Uganda and Zambia are taken from Jonathan Hasket, “Potential for Land Use Carbon in Africa: Forest and Agroforestry Carbon” World 13. Agroforestry Centre (www.africaclimatesolution.org/.../Potential_for_Land_Use_Carbon_in_Africa_06042009.pps). 9 Public PrivatEquity Partnerships: Accelerating the Growth of Climate Related Private Equity Investment generating revenue, meaning that the investment cannot cover 2.2 How PE/VC Investing debt payments from cash flows for seven years or more. It is Adds Value difficult to raise finance for plantations through public equity offerings because integrated forestry companies (of the kind Many climate-friendly projects and companies are small, typical in East Africa) have had difficulties achieving fair innovative, and face unfamiliar risks. These projects and value in public equity markets—which makes listed forestry companies need capital that is able to deal with the risk and companies wary of investing in plantation assets.14 uncertainty involved and as a result securing debt finance can be problematic without sufficient collateral. Equally smaller As a result, PE/VC funds are behind a number of the businesses are often caught between having the necessary companies pioneering investment in plantations in East scale to access the public markets but requiring too much Africa. For instance, Green Resources, one of the continent’s capital to be funded through friends and family. Climate largest plantation companies, received financing from Phaunos related businesses in new sectors also in many cases require Timber Fund.15 Another leading player in the region is New investors who can provide additional support and services Forests Company which received financing from HSBC’s helping to improve governance, management capacity and Principal Investments fund.16 These companies, and others, business processes, as they undergo rapid expansion. As Figure have financed large increases of the land under plantation in 2.4 illustrates Private Equity and Venture Capital Investors the region using PE/VC fund investment. provide a mix of capital and expertise that can support fast growing climate friendly businesses in some of the key growth 2.1.5 Transport Infrastructure sectors that were identified above. Since around 20 percent of anthropogenic GHG emissions come However private equity is among the most expensive sources of from transport, efficient transportation infrastructure is clearly capital. Twenty percent plus returns on capital are a common important in abating emissions.17 This will mean new investment target. In addition, the costs of the fund manager—the in efficient urban transit systems such as metro rail and bus rapid management fee and the carry—must ultimately come out of transit, as well as multi-modal freight terminals and efficient ports the returns on the investment. Clearly then, PE/VC funding and rail networks for the transport of heavy cargo. Efficient toll for a company only makes sense when other types of funding roads can also reduce emissions if they provide more direct routes, are not suitable or available, or when the fund manager is able less stop-start driving, and cut time idling in traffic. to add significant value to the investment. PE/VC funds are an important source of finance for ports, rail, PE/VC funds use four main techniques to achieve their desired and for Public Private Partnerships (PPPs) which enable many returns: public transportation projects. The rehabilitation of London’s underground was financed by private equity, as was Sydney’s • Revenue growth: Higher sales, coupled with constant or airport rail link. Private equity is also investing in port assets declining unit costs, increase the total value of profits and globally. In India for example, private equity is backing thus the value of the company. For example, a supplier of the expansion of Karaikal Port in Tamil Nadu.18 A PE firm energy efficient appliances could expand its distribution managed by Warburg Pincus has invested in the development network, increasing sales and profits proportionately of Gangavaram Port in Andrha Pradesh—the deepest port in the country.19 Infrastructure funds have made large scale • Margin expansion: Prices can be raised or costs cut thus investments in public transport infrastructure in developing increasing the firm’s profitability and thus the price at countries. IDFC Private Equity has invested in public which it can be sold. For example, a solar PV company could infrastructure in India and 3i Infrastructure has raised a $1.2 improve its procurement of solar panels, thus pushing down billion fund to invest in transport infrastructure in India.20 input prices 14. Neilson suggests that integrated plantation forest companies are not “able to realize the true value of their planted and managed native forest holdings in the companies’ share prices” and so these companies have a large incentive to disinvest from plantation holdings and a corresponding absence of incentive to invest in plantations. D Neilson, 2007 “Corporate Private Sector dimensions in planted forest investments”. Food and Agriculture Organizations of the United Nations. 15. Capitaleritrea, 2009 “Phaunos Timber Fund Raises Stake in East African Forester Green Resources” (http://www.capitaleritrea.com/region/phaunos-timber-fund-raises-stake-in-east-african-forester-green-resources/). 16. HSBC, “Principal Investments, Africa” (http://www.hsbcnet.com/pi/africa). 17. Roger Gorham, 2002 “Air Pollution from ground transport an assessment of causes, strategies and tactics, and proposed actions for the international community” The Global Initiative on Transport Emissions, A Partnership of the United Nations and the World Bank, Division for Sustainable Development, Department of Economic and Social Affairs, United Nations (http://www.un.org/esa/gite/csd/gorham.pdf). 18. http://www.avcj.com/avcj/news/2103237/ascent-capital-commits-usd45m-karaikal-port-expansion. 19. http://www.gangavaram.com ; http://www.business-standard.com/india/news/gangavaram-port-hopes-to-break-even-in-3-yrs/447560/. 20. http://www.3i-infrastructure.com/3i-india-infrastructure-fund.html. 10 The Distinctive Combination of Private Equity and Venture Capital to Mitigating Climate Change Figure 2.4: Some Climate-Friendly Investments that Need PE/VC Type of Ability to Volatility and Ability to Benefit from Need for company provide Risk of Cash access managerial private equity collateral Flow securities advice financing market Indepenent Developers have In early to late Developers are Advice on Clean power infrastructure developers few tangible stages projects too small to access contractural risks, 3 assets until project have high securities markets structuring Biogas is financed likelihood contractural of failure arrangements, Geothermal regulatory risks and risk Solar Photovoltaic management techniques Wind farms Small-scale projects Same as above Equity needed in Projects are too small financing to absorb to access securites Biowaste any volatility in markets cash flow, even congeneration though cash flow relatively stable Companies not Banks sometimes don’t Risk of non-payment Too small Potenital to Energy efficiency affiliated with accept contracts with by firms facilitate transfer of ESCOs a utility clients as collateral technology and 3 pratices Clean technology Start-up companies Companies have High risk and volatility Too small Strategic and managerial advice development few tangible assets in start up phase have increased Solar lamps value 3 Cook stoves Independent Value from bringing Land use and forestry developers Plantations are a Plantations produce Limited in the best practice 3 source of collateral little on-going cash management of Plantations flows to service debt plantations PPPs Transport Infrastructure Collateral depends Risk of non-payment Only particularly PPPs do not benefit on the nature by government large PPPs can from management 3 PPPs of the PPP access securities advice markets • Multiple expansion: The Price to Earnings ratio (or similar In emerging markets, these techniques can be less easy to valuation metric) at which investors value a company deploy and PE/VC funds must focus largely on revenue increases. In essence, a new buyer is willing to pay a higher growth and margin expansion. While debt is harder to raise price per dollar of expected future earnings than the PE/ PE/VC funds do still provide a crucial source of capital against VC fund paid for it. This is generally achieved by decreasing which further finance can be leveraged. For climate related risk levels (for example, taking a renewable energy project investments PE and VC funds look to achieve returns by: from permitting to operations). It can also be achieved by increasing the prospects for growth, for example, pioneering • Funding risky new technologies and business models which the entry of the investee company into a new market creates value by allowing the firm to achieve revenue growth • Increased leverage: The amount of debt taken on can be • Identifying and developing promising companies, through increased thus reducing the firm’s cost of capital and thus significant due diligence and pipeline development PE funds increasing its value. For example, a biogas company can take actively seek and create new investment opportunities and on more debt as it becomes more established. This would will often spend considerable time supporting businesses allow equity to be taken out of the company, and increase prior to an investment. the return on the equity that remained. • Helping companies do business better through improved In developed country markets, leverage and multiple expansion governance, strategies (including a shift to lower carbon are the techniques commonly associated with PE funds.21 These operations), and systems which facilitate equity investments techniques—buying a company, loading it with debt, and then and helps firms to achieve higher revenue growth and selling it at a higher price to someone else—can be controversial. margins. This approach can also expand multiples, since with better management and governance systems, risk is reduced. 21 VC Funds in contrast focus more on Growth. They are looking for firms with low sales but great potential, such as new technology companies. 11 Public PrivatEquity Partnerships: Accelerating the Growth of Climate Related Private Equity Investment • Being the cornerstone investor in a growing company, and This ability to take risk is in complete contrast to banks. so bringing in other, lower-cost debt capital that would not Typically, banks demand that borrowers have steady positive otherwise be available thus increasing the firm’s leverage cash flows that can pay interest on the debt, and tangible assets that can be used as collateral. These requirements work The following section lays out in greater detail how private for companies investing in real estate or machinery, but firms equity funds have the potential to support the growth and investing in intellectual property or new business models development of climate related businesses by providing struggle to get bank finance. a combination of growth capital and expertise. A fuller description of the basics of how Private Equity and Venture Geothermal energy is a renewable technology that absolutely Capital investing works can be found in Appendix A. requires risk capital. Geothermal energy is one of the few renewable resources that provides reliable power 24 hours a day, 2.2.1 Funding risky new technologies and 365 days of the year, at prices which can be competitive with business models fossil fuels. Unfortunately, early stage geothermal development is much riskier than conventional power plant development. VC investors in particular often seek to finance highly risky The only way to tell if the geothermal resource will generate technology companies, knowing that many will fail, but power is to drill a well. But drilling the well costs millions of counting on those that succeed to do so well that they more dollars—often a substantial portion of the total geothermal than offset the losses. For this approach to make sufficient development cost. Few investors are ready to put up millions returns to warrant the risks, the firms that succeed need to of dollars, knowing that it could all be lost if the well is not achieve dramatic revenue growth. successful. Box 2.3 describes how private equity investors have been willing to take on this risk. Box 2.3: The Role of Private Equity in Financing Geothermal Projects Broadly speaking, the development of a geothermal plant as large amount needed to drill each hole makes it difficult to shown below occurs in two stages, (i) finding the geothermal raise financing from friends and family. Early wells therefore source and drilling wells to establish the source’s potential are often financed through third party equity, with Private and (ii), construction of the plant.22 The first stage is Equity funds such as ArcLight, USRGs, and Denham Capital completed with the drilling of production wells. This is a providing the needed financing. This financing allows the risky exercise, as drilling does not always lead to a productive project’s geothermal potential to be demonstrated. Once well. Each well, productive or not, is very expensive at US$3 the well has been proved, the remainder of the development million–US$6 million each, depending on various factors. costs, consisting of negotiating contracts and constructing The high risk of failure precludes debt financing and the the plant, can largely be financed using debt financing. Drilling Build and operate 100% Percentage of Capital Costs 80% 60% 40% 20% 0% Project Timeline Internal Equity Private Equity Debt Source : Adapted from Todd Bright, 2010 “Geothermal Power–Private Equity Perspectives” Denham Capital. 22 This discussion relies on two reports (a) John McIlveen, 2011 “A Geothermal Incentive Design” GRC AGM San Diego and (b), John McIlveen, Mark Vernest and Khurram Malik, 2008 “A Geothermal Primer” Jacob Securities. The numbers referred to in the text do not necessarily map directly to the numbers implied by the graph. 12 The Distinctive Combination of Private Equity and Venture Capital to Mitigating Climate Change 2.2.2 Identifying and developing of the companies that they provide finance to. Through their investment opportunities carried equity interests in the companies in which they invest, the fund managers benefit from any increase in the companies’ PE/VC funds invest heavily in finding companies that are in value from increased growth, improved efficiency, multiple need of their capital and assistance. Fund managers then work expansion or leverage. with promising companies to refine their strategies, business plans, and management teams to turn “diamonds in the rough” IFC has found that providing advice and support also helps into true gems. PE/VC is almost unique in this regard. Banks safeguard the investments PE/VC funds make. PE/VC funds and stock exchanges tend to be more passive, waiting for firms in typically buy minority stakes in the companies in which they need of capital to come to them, and expecting the companies to invest. In emerging markets the legal protections for minority develop sound plans on their own before they will invest. shareholders are often quite weak. Providing advice and support helps the PE/VC funds to be seen as real partners to A typical infrastructure PE fund, for example, will need to the majority shareholders and so increases the likelihood that identify a pipeline of potential investments from the fund the majority shareholders will respect their legal rights.25 raising stage. A renewable generation fund therefore will seek out developers with promising projects, and offer to provide An example of a PE/VC fund providing advice that helped a them with capital. Throughout the investing phase of a funds company improve its performance is Tsinghau Venture Capital life the management team is using industry networks to seek (THVC) whose Clean Energy Fund purchased a 37 percent out new opportunities. stake in PowerU, an energy services company in China. THVC acted as a sounding board for PowerU’s management Many times, PE/VC funds come into contact with companies and helped the company appoint a financial officer.26 Before and entrepreneurs who have part of what they need to be THVC invested in PowerU, the fund manager helped the successful, but not the complete package. The strategy to company improve its financial and accountings systems and commercialize a technology might need to be rethought, or skills, paving the way for THVC’s equity investment. Similarly, the firm’s management team strengthened. The fund will work GEF’s Africa Sustainable Forestry Fund has been able to with the company to figure out how to turn its idea into an increase the value of its investments in forestry companies investable business proposition. by facilitating the introduction of modern management techniques, increasing the productivity and thus the value of Aloe Capital did this when it worked with Indian entrepreneurs the companies in which it has invested.27 Arul Chalamalasetty and Mahesh Koli to create Greenko. Greenko buys, builds, and runs clean technology power Infrastructure funds investing in early-to-late stage renewable plants in India. The company began by purchasing distressed energy projects often provide developers with substantial advice biomass plants across the country and rehabilitating them. It and support. PE/VC funds help to mitigate development and then began to build its own biomass power plants and its own contractual risks; for instance, by structuring and securing run-of-the-river hydro plants. Today Greenko directly employs appropriate contractual arrangements and terms with suppliers, 600 people (1,300 including contractors) and reduces carbon development and operating partners. They also apply risk emissions by 1,448,909 tons a year.23 management techniques such as risk transfer to subcontractors and suppliers through performance bonds, guarantees, and 2.2.3 Help companies do business better warranties. PE/VC funds increase the value of the companies in which they E+Co’s support for Bio2Watt illustrates the value an experienced invest in a number of ways. Besides providing needed capital, investor can bring to an entrepreneur. Bio2Watt is a South they replace and recruit senior management, provide technical African company introducing ‘animal waste to energy’ plants in advice, contribute to strategic decisions, and facilitate access South Africa. These plants reduce methane emissions,28 produce to debt and equity financing from other finance providers.24 electricity, and improve the management and disposal of animal PE/VC funds have a particular incentive to increase the value waste. Through its capital, expertise and networks E+Co assisted 23 Venture Intelligence, 2010 “Private Equity Pulse on Cleantech” July 2010 (http://www.ventureintelligence.in/pepulse-ct-2010.pdf). 24 Hannu Jungman, 2003 “The Value Adding Role of V2C - Searching Evidence from the value-added provided by Private Equity investors” Frontiers of E-Business Research 2003. 25 Udayan Gupta, 2011 “Institutional Investor International Finance Corp’s Private Equity Gamble Pays Off” September 23, 2011 26 David Blanchard, 2005 “Equity capital investment in China’s Energy Efficiency Sector” http://3countryee.org/public/EquityInvestmentEEChina.pdf. 27 Castalia market intelligence. 28 Methane is a powerful greenhouse gas 13 Public PrivatEquity Partnerships: Accelerating the Growth of Climate Related Private Equity Investment Bio2Watt to develop its pioneering projects in South Africa. the value of the companies they invest in by increasing the E+Co helped the entrepreneur select the right technology, leverage of investee companies. Their connections with develop environmental impact assessments and negotiate lenders allows the companies they invest in to take on more Power Purchase Agreements (PPAs). E+Co used its extensive debt thus increasing their leverage and the return PE/VC international network to facilitate investments in the company funds make on their investments by international investors and assisted Bio2Watt to secure grant funding (see Box 4.6 for more details on the investment). • PE/VC funds strengthen businesses, and so improve access to capital. By making businesses better at what they 2.2.4 Being the cornerstone investor do—for example, by strengthening the senior management team, and making sure management information and The unique characteristics of PE/VC funds enable them to accounting systems are in place, PE/VC firms naturally become cornerstone investors. A cornerstone investor helps to make their portfolio companies more attractive to other attract the rest of the capital that a company needs to grow. investors. This process culminates when the PE/VC fund exits. A fund’s exit from an investment generally involves • PE/VC provides a risk-bearing cushion that allows banks sale to a larger company, or listing on a stock exchange. The to lend. For example, Global Green Power, a bio-energy new owners are generally much more able to raise capital company in the Philippines, needed $60 million to establish than the entrepreneurs originally were, assuring a supply of biomass power plants. Banks were willing to lend $44 capital for continued investment. Because the new owners million. However, banks would only lend if the company can more easily raise capital they are able to pay a higher could raise $16 million in equity.29 Until Global Green price for the earnings the firm generates (as measured by Power attracts this outside equity investment, its innovative, the ratio between the price per share and the earnings per carbon-mitigating plan cannot be implemented. This risk share). This allows the PE/VC fund to earn a return on their bearing cushion is particularly important in developing investment from the resulting “multiple growth” as they pay countries. For example, in developed markets, banks are a lower price for the firm’s earnings and sell their investment often willing to finance wind farms with a debt-equity for a higher price. ratio of 90:10 (nine parts debt finance to one part equity). In developing countries the comparable figure is often far The crucial role PE funds can play as cornerstone investors lower. For example, in Vietnam banks typically will only is apparent in the development cycle of renewable power finance on a debt-equity ratio of 50:50 (one part debt projects. Many innovative renewable projects are developed finance to one part equity), and in some other countries a by independent project developers—individuals and small debt-equity ratio of 70:30 is the norm30 firms who specialize in spotting new project opportunities. As Figure 2.5 illustrates, these independent developers are able to • PE/VC firms have strong connections with other finance the early stage of projects, but struggle to finance mid- financiers, facilitating information flow and trust. stage to late-stage project development. Entrepreneurs often do not know what banks need to see to persuade them to lend. Entrepreneurs also may not know Lenders (both mezzanine and senior debt providers) are which financiers are interested in their type of company. PE/ generally willing to finance much of the construction costs, VC firms are in touch with other financiers because the PE/ once all permits and contracts have been finalized. However, VC funds are repeatedly seeking capital for their portfolio it can cost millions of dollars to get through the late stage companies. This means the PE/VC firms know what banks development process of getting all the approvals to use the and other financiers are looking for, and so can provide an site and the renewable resources, and negotiating a long term efficient bridge between their investee companies and other contract to sell the power. financiers. Just as importantly, because PE/VC firms are playing a repeated game, they have an incentive to only seek Some PE funds—such as InfraCo Asia—are willing to take loans for companies that will be able to repay. This reduces on this risk, and thus get the renewable projects across the the risk the lenders face in evaluating the investment, and line and into the stage where more conventional capital will so make it more likely that a company backed by a PE/ flow to finance the project.31 Therefore, they play a key role VC fund will be able to raise debt finance. This provides a in developing a pipeline of new energy infrastructure projects. channel through which PE/VC funds are able to increase 29 This equity would essentially absorb the first $16 million losses if the business plan did not work as expected. 30 Interviews with market participants. 31 Infraco Asia is supported by the PIDG group of donors. Additional information on Infraco Asia can be found at http://www.infracoasia.com/. 14 The Distinctive Combination of Private Equity and Venture Capital to Mitigating Climate Change Figure 2.5: PE/VC Funds Financing of Projects by Independent Developers Early-stage Mid-stage Late-stage Development Financing Construction Operation PE/VC fund finance needed to raise debt PE/VC necessary to Financial Close and mezzanine finance develop projects Debt Finance (Project Finance) Sponsor/ Developer Mezzanine Capital Private Equity and Infrastructure Funds Early Stage Project Late Stage Project Construction Development Activity Development Activity Finance Approx. 1% of Approx. 4% of Approx. 95% of Total Project Cost Total Project Cost Total Project Cost Establish Feasibility CASH FLOW Financial Close Source : SDCL and UNEP Note : Sustainable Development Capital (http://www.sdcapital.co.uk/) and Duncan Ritchie and Eric Usher, 2011 “Mind the Gap, Addressing the lack of early stage financing for low-carbon infrastructure in developing countries” UNEP. 15 3 Barriers to Development of PE/VC Market in Climate Friendly Investing The previous chapter has noted that PE/VC can play an important Information asymmetries32 and agency problems33 plague role in financing and supporting the growth of new dynamic low capital markets generally. Investors are looking for returns at carbon enterprises. It has also highlighted that while PE and VC least commensurate with the risks involved. Firms seeking funds are active in the market there are significant opportunities investment generally have better information about their likely to scale up and accelerate climate friendly investment. However future performance and risk than the investors. But firms also a number of barriers stand in the way of PE/VC being available have incentives to overstate likely performance, and understate to climate friendly projects in the desired quantities. Figure 3.1 risks. The investor is left in the unfortunate position of illustrates the development dynamics of the PE/VC market. New knowing that the firm has the best information (an information fund management teams will have to form. The new managers asymmetry), but also not feeling fully able to trust what the need to raise funds from limited partners. The funds need to be firm says (an agency problem). deployed into profitable investments. As fund managers deploy capital profitably, they can raise more capital from the limited The problems are worse for LPs placing funds with a fund partner community, in a virtuous circle. This should be a virtuous manager. The LP wants a fund manager with the expertise to circle of market development. make high returns. Many would-be fund managers will say they are experts and can generate high returns. The LP finds it Unfortunately, the virtuous circle is slowed by four underlying difficult to validate the would-be manager’s claims of expertise factors: information asymmetries, agency problems, newness, (an information asymmetry), but is not able to simply take the and coordination problems (these are shown in brown in claims at face value (because of the agency problem). Figure 3.1). Figure 3.1: Development dynamics of the PE/VC market Long fund-raising periods Fu at Fo deter new teams Fund n d io n rm management Potential management team forms teams lack capital Repeats Fund managers lack track records Pioneering a market has Raises capital high costs from LPs New investment areas Deploy lack a history of returns Difficult to capture all returns from pioneering capital, then investments exit New investments are perceived to be risky Benefits of Carbon Abatement not easily monetized Impede Development of Cycle of Success Information Co-ordination Agency Problems Newness Asymmetries Problems Information asymmetries arise from asymmetric information, which is defined as “a situation where economic agents do not all have the same information”, this 32  concept is closely related to the issue of agency problems discussed in footnote 33 ( John Black, 2003 “A Dictionary of Economics” Oxford University Press, USA. September 18, 2003). A gency problems arise from the principal agent problem which is defined as “The problem of how person A can motivate person B to act for A’s benefit rather than 33  following self-interest. The principal, A, may be an employer and the agent, B, an employee, or the principal may be a shareholder and the agent a director of a company. The problem is how to devise incentives which lead agents to report truthfully to the principal on the facts they face and the actions they take, and to act for the principal’s benefit. Incentives include rewards such as bonuses or promotion for success, and penalties such as demotion or dismissal for failure to act in the principal’s interests.”(John Black, 2003 “A Dictionary of Economics” Oxford University Press, USA. September 18, 2003). 17 Public PrivatEquity Partnerships: Accelerating the Growth of Climate Related Private Equity Investment To offset information asymmetries and agency problems, provide a guide as to how value can be divided between the investors use information on track records of managers. parties, reducing time-wasted in zero-sum negotiations. New They also look at past investment returns. Reputations for investment areas have none of these advantages. The first private competence and integrity are important. By definition, in a equity fund investing in biomass generation in Bangladesh will new area, track records and history are lacking. Reputations not find lenders accustomed to financing biomass plants. The and networks are being newly made. As a result, in a new area legal precedents governing the respective rights of senior and like climate friendly investing in emerging markets, where junior lenders in ESCOs in the Philippines do not yet exist. managers lacks track records, LPs can find it almost impossible to tell who to invest with. Rather than risk placing money with The underlying factors of information asymmetry, agency someone who “talks the talk but cannot walk the walk”, LPs problems, newness, and coordination problems give rise to at least may not invest in such a sector at all. eight specific barriers (shown in blue in Figure 3.1). These barriers: Coordination problems, too, put grit in the cogs of market •• Slow the rate at which competent people coalesce into fund development. To get deals done, many actors need to come management teams together. Project developers need to bring in outside equity. Debt finance needs to be forthcoming. The equity investors, •• Slow the rate at which fund managers can raise capital for the lenders, the project developer, and entrepreneurs all need to the fund know how to find each other, and work together. •• Diminish the ability of the fund to deploy capital profitably. In well developed markets, each niche in the investment eco-system is filled. Information and social networks allow These barriers interact. If deployment was easier, LPs would be the players to find each other. Precedents and competition quicker to commit capital to funds. If fund-raising was quicker, Box 3.1: Other Barriers to Investment There are barriers which affect all climate friendly investing, whether carried out by PE/VCs or not. In addition, there are barriers which affect all PE/VC investing, whether climate friendly or not. This box mentions some of the main barriers in each of these categories. Barriers to all climate friendly investing – Regulation: in many cases government regulatory (whether PE/VC or not) regimes can deter investment (for example, • L  ack of carbon payments, or other mechanism to when power prices are held below cost) or fail translate the environmental benefit of greenhouse gas to provide the enabling environment needed (for emissions reductions into financial rewards. This is a example, when there is no legal regime to facilitate particular obstacle for many green power infrastructure commercial forestry). and land use projects Barriers to all PE/VC investing • Government actions, which may inadvertently make (whether climate friendly or not) economically viable investments unprofitable, or simply  nadequate rule of law: PE/VC funds tend to prefer • I impossible. Three important areas where government investing in countries with fast judicial processes and imposes barriers are: strong, fair, and efficient enforcement of business law. A – Ownership: government owns many of the entities lack of effectively enforced laws governing the rights and where investment is needed and so private sector obligations of limited and general partners deter PE/VC investment can only go ahead if government investment establishes a Public Private Partnership  ax regimes: Corporate tax levels, and in particular the • T –  Taxes and subsidies: these often distort treatment of capital gains and the repatriation of profits investments in favor of GHG producing processes. by foreign investors, are important for PE/VC funds. For example, subsidies of fossil fuels are common. Where countries do not have investor PE/VC friendly tax regimes, PE/VC investment will be slowed. 18 Barriers to Development of PE/VC Market in Climate Friendly Investing more teams would set out to become fund managers. For now, 3.1.1 Long-fund raising periods deter potential these factors together combine to limit development of the management teams market to below its potential. Of course there are other barriers that affect investments in climate-friendly sectors in emerging Raising a fund takes at least a year, and often several years. markets generally, or that affect general PE/VC investment in Even after years of effort, success is far from guaranteed. emerging markets. Some such barriers are summarized in Box Understandably, this deters potential fund management teams 3.1. These barriers should not be discounted. However, they from the attempt. have been well canvassed elsewhere, so this paper concentrates on the barriers specific to climate friendly PE/VC investing in People who are already working in private equity in a more emerging markets. established area may decide to stay in the area they know. The risks are lower, the rewards perhaps as high. When E+Co worked to raise a PE/VC fund to make climate friendly 3.1 Barriers that Slow Fund investments in South East Asia, it found it very difficult to find Manager Formation qualified fund managers and those it did find were difficult to recruit because they had more promising options that were less New investment areas need new fund managers—existing risky. The same is true for project developers or consultants PE/VC fund managers generally lack experience in climate- who may stick with what they know. A risky leap into a long friendly investing in emerging markets. There is a niche for period without earnings, in the hope of eventual private equity new fund management teams that bring together individuals success, can be daunting. with relevant sector experience. A successful new fund manager might combine individuals with previous private equity It must be pointed out that creating new fund management investing in mainstream energy projects with individuals who teams is difficult in any area of private equity investing. But have gained a deep knowledge of clean energy through work as in areas already well-served by fund managers, the time a project developers or consultants. new fund manager takes to get established does not impede the development of an entire market segment, since there are Indeed, new fund managers are forming. Examples include already enough fund managers with track records operating. Inspired Evolution Investment Management, which launched the Evolution One fund to invest in clean technology in In contrast, in climate-friendly investing in emerging markets, Southern Africa.34 Another example is MAP Capital which if managers are not attracted to the sector, the process of seeks to invest in clean energy projects in Asia, with a focus on wearing down the other barriers—such as lack of data on sector Indonesia and Southeast Asia.35 returns—cannot begin. Despite this, many skilled people who could form fund 3.1.2 Potential management teams lack management teams are deterred by the costs and risk involved. capital Paradoxically, while the need for new fund managers is greatest in new areas, new areas may also be the hardest for managers to Long periods fund raising mean long periods without earning. establish themselves in. Fund raising cycles may be even longer Typically, significant travel is needed and this is expensive. than in other parts of the PE/VC market. MAP Capital has Investment pipelines need to be developed. Potential investors been fund-raising for more than four years, despite having an demand face to face meetings. All this is only possible if the experienced team, and a commitment from OPIC.36 Many new would-be management team has enough capital to pay living teams may be capital constrained. Therefore it will be difficult expenses and outgoings. Most people with skills and expertise for them to sustain the expenses, and the long periods without to be fund managers do not have the capital to do without income, that raising a fund entails. income for a year or two, let alone to fund other expenses on top of that. 34 http://www.inspiredevolution.co.za. 35 A DB, 2008 “Proposed Equity Investment in Asian Clean Energy Private Equity Funds, Report and Recommendation of the President to the Board of Directors” Project Number: 41922, March 2008 (http://www.adb.org/Documents/RRPs/REG/41922-REG-RRP.pdf). 36 http://www.opic.gov/investment-funds/full-list accessed 9 October 2011. 19 Public PrivatEquity Partnerships: Accelerating the Growth of Climate Related Private Equity Investment Again, this problem may be worse for climate-friendly PE/ THVC shows how good new teams can struggle to raise VC investing in emerging markets than it is in many other funds. THVC was a first time management team that wanted areas. Travel costs are higher when building funds that to invest in clean technology in China in 2002. It would link (typically developed country-based) investors with be the first fund to do this. THVC was struggling to raise developing country projects. Additionally, because the area is funds in light of the limited history of returns that the fund nascent, there are fewer people in the sector who have already managers (as well as the sector) had. Initially THVC raised a earned the sort of wealth that allows them to strike out on relatively small fund of around $25 million.37 This was only a their own as fund managers. quarter of the minimum size needed for a sustainable fund— the management team had to meet their expenses from the management fee, which by industry tradition is set at around 3.2 Barriers that Slow Capital 2 percent of assets under management. Therefore, with a small Raising fund, the management fee was not enough to cover proper fund management expenses. Despite this, THVC pressed Limited partners (LPs) investing in funds prefer fund managers ahead with investing the money that had been committed. with a proven track record, investing in sectors that generate This allowed the firm to build up a history of returns. On the profits more than commensurate with their risks. In a new area, back of this, THVC has now been able to raise $300 million fund managers do not have track records; return histories are in funds, and has been a leading investor in a large number of lacking, and risk perceptions high. pioneering clean technology companies in China. 3.2.1 Fund managers lack track records 3.2.2 New investment areas lack a history of returns Those talented people who do persevere and form fund management teams face a chicken and egg problem. Almost all Limited partners make choices about which sectors to invest limited partners want to invest with fund management teams in. Clearly in making a judgment on where to allocate capital, with track records of having successfully managed private investors like to know the past history of returns in different equity funds before. The traditional approach to selecting sectors.38 managers places track record at the center of the investment process. Indeed many institutional investors have written or This creates another chicken and egg problem. Until private unwritten rules against placing funds with managers who equity has been investing in an area, there will be no history have not previously operated a fund. There are a number of of returns. But without a history of returns, limited partners explanations used to justify this approach. One reason is are reluctant to come in—even when underlying investments that investors need to conduct more careful due diligence in the area actually have the potential to earn good returns. on a new fund management team which is costly. Another reason is that large investors such as pension funds outsource 3.2.3 New investment areas are perceived to decision making to investment agents who need to explain to be risky the pension funds why they have made the investments they have. Reference to the track record of a fund manager provides A related problem to the lack of return history is high perceived an easier (and seemingly more objective) justification than risk. Fear of the unknown is a commonly observed trait of defending a personal judgment of a new manager’s ability to the human psyche. Studies suggest that this fear also operates invest effectively. Clearly, without some way to break through, in investors’ minds.39 In other words, just because an area is progress of PE/VC finance in a new area, such as climate unknown, there is a human tendency to assume that risks in change, will be slow. that area are higher than they really are. As a result investors tend to invest in that which they find familiar.40 According to Blanchard (2001) the THVC’s fund had at least US$25 million committed, its follow on fund aimed to raise US$30 million. 37  The need to demonstrate that investing will be profitable in comparatively little known markets is thought to be an important inhibitor of Foreign Direct Investment 38  (FDI). For instance, see DeCoster, Gregory P. and William C. Strange (1993), “Spurious Agglomeration”, Journal of Urban Economics, Vol. 33, pp. 273-304. Note that this effect is different from the simple lack of information problem of the previous heading. Lack of information removes the (apparently) objective basis on 39  which investors would like to justify their capital allocation decisions. It does not suggest that the new area is worse than areas with returns history, just that there is no information to justify a decision to invest. In contrast, fear of the unknown leads to the conclusion that an unknown area is actually a worse investment destination than a known area, because it is riskier. Huberman, Gur, 2001, “Familiarity breeds investment”, Review of Financial Studies 14, 659-680; and Kalok Chan, Vicentiu Covrig, and Lilian NG, 2005 “What 40  Determines the Domestic Bias and Foreign Bias? Evidence from Mutual Fund Equity Allocations Worldwide”. The Journal of Finance, Vol. LX, No. 3, June 2005. 20 Barriers to Development of PE/VC Market in Climate Friendly Investing Figure 3.2: Why Does a Private Equity Investment Not Occur in a Market with the Potential for Healthy Returns ROE required for attracting As a PE/VC fund market matures required investors into PE returns fall with a decrease in uncertainty funds in a new (as a track record is established) and investment area transaction costs fall (as experience is built up doing deals). As a result, the market reaches a point where returns in (actual and required) the market place are sufficient to attract funds into the market and the private equity gap is closed. ROE Number of PE Key: Projects/Companies investments made in Required ROE ( ) actual ROE a mature market Actual ROE ( ) Number of PE/VC investments made in the market Source : Castalia This tendency to fear the unknown creates yet another chicken investors. The returns the company expects to achieve would and egg problem, as Figure 3.2 illustrates. be high enough to attract PE/VC investment in a company that already had a track record in the Philippines. However, In an unfamiliar area like climate-friendly investing in due to the lack of an operating track record and the perceived developing countries, perceived risk may be above what risk risk of investing in the Philippines investors are unwilling to perceptions would be in a more mature market. Underlying commit equity. investments in the sector may offer returns above what would be required in a more mature private equity market. However, Investors report that once a single plant is up and running if these underlying returns are below the return investors profitably, required returns would drop to a level that Global require given the high risk perceptions in an immature market, Green Power projects can comfortably achieve. Thus if Global it may be that no investment takes place. If, however, some Green Power could successfully finance the first plant it could initial investment does occur, then perceived risk and hence attract financing for the other three plants that are in the required returns drop and, when they drop below the actual advanced stages of planning. From the investors’ point of view levels being achieved, significant amounts of investment can though, not knowing if a firm can deliver on its promises, or if flow. As investment increases, the best opportunities are taken the feedstock can be secured, or how the regulatory regime will up first, and so in time actual returns are forced down. evolve, is a genuine barrier to early investment. Biomass generation in the Philippines may be a sector trapped Another example is the experience of commercial plantation at a stage where high perceived risks prevent investments being forestry in Africa. The sector has strong profit potential, and made, if the story told by Global Green Power is anything to strong potential to mitigate climate change. Despite this, go by. Global Green Power aims to develop, finance, build, it has been difficult to get investors to consider the market. and operate biomass power plants in the Philippines. These As a result, the CDC (the Fund of Funds owned by the UK biomass plants work well elsewhere in the world, but are new government), the IFC, and others supported the establishment to the Philippines. The company is seeking PE/VC investment of the GEF Africa Sustainable Forestry Fund (GASFF) by the to build the plants. However, it has been unable to attract Global Environment Fund. GASFF has achieved a first close of 21 Public PrivatEquity Partnerships: Accelerating the Growth of Climate Related Private Equity Investment $84 million on the “first private equity fund to focus solely on 3.3.2 Difficulties in capturing all the returns sustainable forestry in Southern Africa”.41 Early indications are from pioneering investments that GASFF is likely to earn healthy returns in the market.42 Worsening the high costs of pioneering a market are the difficulties of capturing the benefits. It might be argued that 3.3 Barriers to Deploying Capital the additional costs of pioneering a market should be more than in Climate Friendly Investments offset by additional returns. Indeed in some cases, early movers can seize the best opportunities, or gain such a commanding Fund managers that have been successful in raising their lead on the market, that their initial cost and risk bearing is more fund then face a number of barriers to deploying capital into than rewarded. In climate change markets this is not always true. areas that, at first sight, seem as if they should be profitable. Sometimes the returns for “first movers” are not much higher Pioneering investments are more costly to complete, while than those for firms that follow. For instance, in many markets the benefits of the pioneering efforts can be hard to capture. prices are often fixed (for instance through Power Purchase Additionally, there is the problem that the environmental Agreements) or the first mover’s cost of production is no lower benefits of carbon abatement are still not easily monetized. than those that follow. As a result, the market’s development can be delayed as companies in the industry are not willing 3.3.1 Pioneering a market has high costs to invest while they wait for another company to demonstrate that investing is indeed profitable. Once a company invests and In a new area—such as investing in new technologies and demonstrates the technologies’ profitability, they are willing to business models in emerging markets—deal structures, follow as the risk of investing falls. As a result there is potential documents, business models, everything, needs to be developed for a market failure as the companies wait for someone else to for the first time. invest so that they can free ride on the information generated by the first mover’s investment. The result is that investment takes Consider a PE/VC firm interested in backing Energy Service longer to occur than it should.43 Companies (ESCOs) in a market such as the Philippines, where they are not yet widespread. The business case seems clear. Bio-gas production from agri-processing plants is a recent ESCOs solve a well-recognized problem—that commercial example of an industry where good commercial returns are and industrial companies often lack the management focus possible, but this potential could not be unlocked until an early and knowledge to invest in energy efficiency. ESCOs’ value mover demonstrated the technologies’ commercial viability. In proposition is that they will make the energy efficiency Thailand in the late 1990s, it became clear that the use of the investments, provide the capital and expertise required, and effluent from cassava processing plants for biogas production get paid out of a share of the savings produced. The model has had the potential to generate substantial returns and reduce proved to work in the United States, Colombia, and elsewhere. carbon emissions. However, the owners of cassava processing Energy audits in the Philippines indicate that high returns from plants, and other plants with similar effluent, were wary of energy efficiency investments are likely. investing given that the technology had not been proven to be profitable in Thailand. This barrier was overcome when E+Co, Pioneering this market may involve large costs—costs that are an impact investor, invested in KWTE in order to enable it hard to estimate in advance. Few firms or individuals in the to create a plant to produce methane from SWI, a cassava- Philippines know how to operate the ESCO business model, processing factory.44 The plant was successful and profitable. A while foreign ESCOs will not be at home in Philippines number of owners of similar plants in the area saw this success business culture. Since the concept is new, pioneering ESCOs and also invested in the technology. Within five years, KWTE will have to educate a skeptical market about how the model was sold. E+Co’s annualized investment return was healthy, works. ESCO contracts that work under Philippines law will based in part on the sale of carbon credits. need to be drafted. Banks will need to be persuaded to provide debt finance, something they will be initially reluctant to do, since ESCOs have few realizable fixed assets. The first investors, then, must shoulder the burden of creating the entire market. Tom Minney, 2010 “GEF Africa sustainable forestry fund” Africa Capital Markets News (http://www.africancapitalmarketsnews.com/551/gef-africa-sustainable- 41  forestry-fund/). Castalia market intelligence. 42  Th is market failure is discussed in detail in Ricardo Hausmann & Dani Rodrik, 2002. “Economic Development as Self-Discovery,” NBER Working Papers 8952, 43  National Bureau of Economic Research, Inc. Interviews with E+Co. 44  22 Barriers to Development of PE/VC Market in Climate Friendly Investing 3.3.3 The benefits of carbon abatement are not easily monetized In well-functioning markets, prices that business are paid reflect the social benefits they create. However, where businesses generate externalities this equation between social benefit and revenue breaks down. Clearly this is a major problem for climate friendly investing. Carbon emissions are considered to be a global negative externality, but are not generally priced. The failure to earn revenue from emissions reductions can make the difference between earning a commercial return and not. Thus where there is no financial reward for reducing carbon emissions, private equity funds will not be able to deploy capital into some climate friendly projects, because the returns will be too low. The Clean Development Mechanism (CDM) does provide payments and these do reward companies for reducing GHG emissions. However, it is difficult for companies to raise debt or equity financing against the payments from the CDM. There are a number of reasons for this. An important one is that financiers are uncertain about the price at which the credits will be sold—most notably due to uncertainty about whether there will be an extension (or replacement) of the Kyoto protocol. For this reason, debt and equity providers do not take into account expected CDM payments when providing finance.45 Some emerging markets provide financial support to renewables. For instance, Jamaica offers a 15 percent premium on the power price to renewable energy when setting bulk purchase tariffs for electricity. The Philippines is planning feed-in tariffs with a similar aim. In general though, many carbon abatement projects find it difficult to capture the value of their abatement effects. Interviews with a wide range of investors and developers suggest that few (if any) financiers incorporate carbon payments into debt or equity financing decisions. 45  23 4 Mechanisms to Facilitate Private Equity Fund Investing Given the global benefits of increased PE/VC in climate •• Anchoring: Selecting, improving, and validating a new fund change, the global community has an interest in overcoming so that other investors also commit capital the barriers to it. The public sector, including multi-lateral agencies and governments, can leverage private capital into •• Financing fund development: Provide capital and funding climate friendly investments. to help new funds get through the costly fund raising stage The public sector has a long history of leveraging private capital •• Public capital in the waterfall: Putting public money into a into PE/VC fund markets. Public sector initiatives played a new fund on terms that either protect the downside or lever- pivotal role in the development of the PE/VC fund markets age the upside for private LPs, encouraging them to invest. in the United States and United Kingdom, the countries that today have the most active PE/VC fund markets across Deploying capital can also be challenging in climate friendly the board and specifically for climate friendly investments.46 investing in emerging markets, These investments break new The white text boxes in Figure 4.1 illustrate a number of ground—which is always costly and risky. Moreover, the key interventions that use public capital to leverage PE/VC fund benefit of carbon emission reduction often does not translate development. These interventions aim to accelerate market into secure revenue. Public sector institutions should consider: development by boosting fund formation, and by overcoming barriers to profitable deployment of PE/VC capital in climate •• Supporting pioneering investments: Concessional finance friendly investments in emerging markets. for operational activities can help offset the costs of pioneer- ing, and reflect the information value of these activities Fund formation is particularly difficult in a new area because a new area needs new management teams. New teams do not •• Improved carbon payments: There is scope for an alternative have track records, so LPs are reluctant to invest with them. The approaches to carbon payments that could lower transaction three main interventions public sector financial institutions can costs and make it easier to raise debt finance. bring to bear here are: Figure 4.1: Interventions to Overcome Barriers to PE/VC Fund Investment Finance fund development Anchoring Public capital in waterfall Support pioneering investments Improved carbon payments L erner suggests that the federal government’s Small Business Investment Companies (SBIC) programs played an important role in the development of the United 46  States Venture Capital industry in the 1960s and that the United Kingdom government supported Industrial Development Finance Corporation (ICFC) played a key role in the development of the United Kingdom venture capital market. Page 37-41 of Lerner, 2009 “Boulevard of Broken Dreams” Princeton University Press. 25 Public PrivatEquity Partnerships: Accelerating the Growth of Climate Related Private Equity Investment 4.1 Anchoring Public sector financial institutions can anchor PE/VC funds Figure 4.2: IFC’s Returns from Investing in First by taking the lead on finding, and investing with, good new Time PE/VC Funds Outperform Follow on Funds fund managers. Given other commercial opportunities, private and Industry Benchmarks (2000-2010) investors may not be interested in putting sufficient effort into doing due diligence and investigating the fund manager’s investment thesis in the climate friendly area. By contrast, 30% public financial institutions have the ability to take the lead. IFC has played this role successfully in developing new 25% Internal rate of return emerging market PE/VC funds, as Box 4.1 describes. 20% To help develop emerging fund managers, the IFC invests a 15% substantial proportion of its funds with new fund managers. During the early 2000s, the IFC supported many first time PE/ 10% VC funds in nascent markets with little previous PE/VC fund 5% activity. As shown in Figure 4.2 the IFC’s investments in these first time funds were relatively successful. The IFC’s investments 0% in first time funds outperformed global benchmarks, and also IFC: returns on Emerging markets: outperformed IFC’s investments in follow on funds in more investments in upper quartile established markets. These returns are high because these funds first time of PE/VC are often entering markets where few PE/VC funds are active, PE/VC funds fund returns so they face little competition when investing in companies. This enables them to spend time on due diligence, invest on Source : IFC and Cambridge Associates emerging markets benchmarks. more favorable terms, and so generate higher returns.47 IFC believes the differentiating factor in fund returns is the In climate friendly investing, Berkeley Capital shows the value manager’s skill set, not whether this is a first time fund.48 of CDC50 as an anchor investor. Berkeley Capital is a private This thinking is starting to gain traction elsewhere. A survey equity fund focused on the development of new renewable conducted by the consultancy firm Green Peak Partners and energy infrastructure assets in Asia. CDC was Berkeley Capital’s the investment manager of Capricorn Investment Group, found first investor. Berkeley Capital states that CDC played a: LPs are now placing more emphasis on the qualities of a fund’s management team than on a firm’s historical track record.49 critical role in the successful launch of the Fund”. Examples of the activities that CDC engaged in Another good example of anchoring in fund formation is the way included “introductions to other potential LPs, [making EIB backed the Dutch Infrastructure Fund (DIF) by providing themselves] available to speak with other potential LPs the first capital commitment. The EIB’s due diligence of the about CDC[’s] due diligence process and [its] investment company, and structuring the legal documentation to best market decision, an understanding approach to fundraising standards, gave comfort to private sector investors. This helped delays, and….[n]egotiat[ing] the Fund’s documentation DIF raise further funding, including from financial investors who to provide additional comfort to potential LPs51 had not previously invested in PE funds in this sector. These investments made up a substantial proportion of the IFC’s investment. The institution placed over 40% percent of its PE/VC fund portfolio with first time 47  funds. This amounts to a commitment of more than US$600 million across 50 funds. The results are unaudited and taken from internal analysis of the IFC portfolio of Private Equity Funds. David Wilton, 2010 “A Comparison Of Performance Between First Time Fund Managers & Established Managers Moving Into A New Market. 48  How Important Is Track Record?” Chief Investment Officer, Private Equity, IFC. http://www.ifc.org/ifcext/cfn.nsf/AttachmentsByTitle/ PerformanceComparisonFirstTimeFMandEstablishedManagersMovingtoaNewMarket/$FILE/Comparison+of+Performance+Between+First+Time+Fund+Managers+ and+Estableshed+Managers+Moving+to+a+New+Market.pdf. “First-time managers can hold their own” Private Equity Fund Manager via Factiva 3 September 2011. 49  CDC is a Development Finance Institution within the government of the United Kingdom (www.cdcgroup.com). 50  51 Berkeley Energy, 2010 “Written evidence submitted by Berkeley Energy to the International Development Committee” United Kingdom Parliament (http://www. publications.parliament.uk/pa/cm201011/cmselect/cmintdev/605/605vw04.htm). 26 Mechanisms to Facilitate Private Equity Fund Investing Box 4.1: IFC’s Experience Investing in First Time Funds As shown in Figure 4.2 IFC earned healthy returns from In identifying new fund management teams the IFC generally investing in first time funds during the 2000s. At the beginning avoids issuing calls for fund managers in the formalized tender of the decade, when the IFC’s staff first thought through how type process that public sector institutions tend to favor. to make investments in PE/VC funds, they thought they Rather the IFC tries to be always ‘in the market’. This gives it would make these decisions based on the returns the funds opportunities to work with good fund management teams as had generated in their previous iterations. This is the standard they arise. It also reduces the problem of selecting teams that approach that institutional investors use when investing in PE/ are skilled in public procurement processes, but who lack real VC funds. What become clear was that this approach would sector or investing experience. not work in the areas where IFC wanted to invest countries More often than not, fund management teams approaching with little PE/VC fund activity. These countries had few IFC may be strong in some areas, but lack a key component for funds with any type of track record. As a result, IFC needed to success. Sometimes the team knows the sector well but does not establish new metrics that identified good fund management have anyone who can structure equity investments. Sometime teams where no team had a track record. Two key metrics the fund’s investment thesis needs development. Where the fund turned out to be: is promising in other respects, the IFC gives the team feedback • Skill set: IFC has found that the main drivers of returns on what needs to change before IFC will fund them. This advice for PE/VC funds in emerging markets are growth, is especially valuable since it is difficult to find elsewhere. It and efficiency improvements in the firms invested in. is credible, since IFC actually will back fund managers to fill People with the skills needed for this type of investment the gaps identified. The IFC also provides advice to teams on typically have experience in senior management or structuring and legal documents. Again, this kind of advice consulting in the target sectors and countries. The need is hard to get elsewhere, and puts funds in a better position to for these skills is in contrast to developed markets where attract investment from other LPs. leverage and multiple expansion are more commonly The IFC introduces new fund managers to other LPs that the drivers of value creation. As a result in developed may be interested in investing. The IFC’s recommendations markets PE/VC funds place more emphasis on ensuring are respected because the IFC’s approach has achieved high that they have skills commonly found in investment returns (as Figure 4.2 demonstrates) and because the IFC banks itself is investing in the fund and so is putting its own money • T  eam cohesion: a PE/VC fund is a partnership that behind the recommendations it is making. must work together over ten years or more. It must make difficult, irreversible investment decisions, often under time pressure. The resulting pressures can pull PE/VC fund partners apart and lead the funds to fail. To avoid these problems the IFC has had to become attuned to the team dynamics of nascent fund management partnerships to ensure that they invest with those that are likely to retain their cohesiveness over the life of the fund and beyond. Source : Interviews with David Wilton and other IFC staff 27 Public PrivatEquity Partnerships: Accelerating the Growth of Climate Related Private Equity Investment Funding from IFIs and bilateral donors can also reduce political risk for climate-friendly funds. National governments, Box 4.2: Northern Lights Capital Group— in general, are wary of mistreating companies or funds in which Commercial Seed Investment International Financial Institutions or bilateral donors have Northern Lights Capital Group illustrates how a business an ownership stake. For this reason, private limited partners model to support nascent fund management teams can consider that the political risk of investing in emerging markets work to facilitate climate friendly investments. Northern is lower when they co-invest with a donor or IFI. Lights is a firm that invests in new or early stage fund managers. The company invests equity in promising fund In summary, by being an early investor in a fund, an IFI managers to cover operating costs during the formation of becomes an “anchor” for private investors. The key benefits the firm. Northern Lights also provides strategic guidance private investors see from this anchoring are: evidence of a and business support to help find limited partners and thorough due diligence on the fund manager; a seal of approval raise capital. In return, they share in the management fee on the fund documentation; likely assistance to the fund in and carry of the fund manager. developing key relationships, including with other investors; In 2010, Northern Lights invested in Nereus Capital, and mitigation of the political risk inherent in investing in a private equity firm targeting renewable energy emerging markets. investments in India, providing capital to get the firm off the ground. Northern Lights is currently helping the firm to raise capital and plans to become an LP in their first 4.2 Financing Fund Development fund. Nereus expects to make investments in renewable power projects of US$5 million to US$35 in size. New teams with the potential to manage funds face difficulty paying the bills while they raise capital. In other markets, Source: Discussion with Northern Lights Capital Group; Bloomberg Business Week (http://www.businessweek.com/news/2010-12-15/northern-lights- investors have seen a profit opportunity in providing financial invests-in-nereus-to-target-india.html). backing to new fund management teams. There may be a role for public sector institutions to play a similar role in climate friendly investing. This support could be offered on purely commercial terms as an equity investment in the fund manager, or on a more concessional basis. In either case, IFC’s experience suggests that backing first time funds it will be critical to guard against moral hazard in making financially could offer good returns. IFC does not typically funding decisions. seek a share of the fund managers it invests with. Were it to do so, the average returns, coupled with the economics that Equity Seed Capital for Fund Managers would likely have been available in exchange for an anchoring role and some working capital investment, would probably have In other markets, investors have seen a profit opportunity in generated a strong return on investment. This suggests that providing financial backing to new fund management teams. public sector entities could provide capital for this approach on These investors identify promising new or early-stage fund a fully commercial basis. managers and provide seed capital to launch private equity firms. An example is the Northern Lights Capital Group as Concessional investment support to fund formation described in Box 4.2. In return for their investment, Northern Lights Capital Group receives a share of the returns of the fund If the public sector wished to prioritize the development of management team. Given the double risk of this investing new fund managers, more concessional seed capital structures strategy—first that the fund manager will in fact succeed in would be possible. Funding could be provided to nascent raising a fund, and then that that fund will make money— teams as a reimbursable grant which would be repaid as a investors will seek high returns on their investment. percentage share of the fund manager’s earnings (carry) in the event that the team was successful. The share of the carry There may be both the opportunity and the need to develop could be negotiated on a case by case basis and would need something similar to provide financial backing to new fund to ensure that sufficient incentive was left for the team but managers in emerging markets climate friendly investing. that public capital was equally able to participate and share in The barriers to fund raising in the sector are more severe than any future upside. By decreasing its return expectations the in many other sectors. Worsening this, fund managers in facility would be providing operating capital at concessional developing countries may have less personal capital to sustain rates. However, by sharing in the economics, public capital their fund raising efforts. would be reimbursed for its risk while creating a potentially 28 Mechanisms to Facilitate Private Equity Fund Investing evergreen facility. Established as a multi donor trust fund this facility could be ring fenced from IFIs investment operations Box 4.3: Avoiding Moral Hazard in order to prevent any conflicts of interest or institutional Once the public sector starts subsidizing PE/VC funds capture of new teams. development expenses or providing capital on terms more favorable to the market there is the risk that the money Clearly, funding new managers has significant risks. One will be spent wastefully. While moral hazard is always particular risk is moral hazard—the likelihood that some a concern when providing concessional finance or grant managers will use the funding to pay themselves, without funding there are ways to mitigate it. achieving the intended objectives. Design features that could An example of a funding arrangement that could lead mitigate the moral hazard risk include: to moral hazard is to provide grants to PE/VC funds to evaluate different types of technology for use in a •• Financing of this sort should only be committed by those renewable energy infrastructure project. A concern arises public entities with an ability to judge a team’s drive and like- because the PE/VC fund may use the money wastefully. lihood of success This is clearly a problem if the manner in which the money is spent is not monitored carefully. In this case the PE/ •• Financing should only cover part of the costs, so that the VC fund may well just use it to improve their profitability members of the fund management team still commit a sub- or pay themselves higher salaries. However, even if the stantial share of their personal wealth to fund development provider of the grant carefully monitors the fund’s expenditure it may be difficult to stop less obvious forms •• Funding could be largely or entirely limited to third-party of waste. For instance, the PE/VC fund could spend the costs, such as travel expenses and lawyers, reducing the temp- money investigating technologies that are highly unlikely tation to consume the financing in salaries for the would-be to succeed in the context in which they are considering managers. investing. •• Funding should be provided in tranches once key milestones Moral hazard can be mitigated. An example discussed had been delivered. in the text is to require the PE/VC fund to pay back the “grants” if the fund it operates is successful (thus Initial capital commitment to allow investment during fund converting the grant into a type of concessional loan). raising This helps mitigate moral hazard because PE/VC funds will spend the money more carefully if they expect to pay An additional option for speeding fund formation would be for it back. This type of scheme can mitigate moral hazard a public sector institution to invest an initial commitment with but not eliminate it in all circumstances. For instance, a a fund manager to allow it to start investing in projects, while fund that does not expect to succeed, and so won’t expect it continues raising capital from other investors. This would to pay back the grants, will feel far less reason to use the allow the fund manager to build track record faster, and take money carefully. advantage of projects in its pipeline that it might otherwise be Given how difficult it is to mitigate moral hazard entirely, too late to invest in. Such a commitment could also allow the there is always the chance that PE/VC funds (or any fund manager to start earning a management fee, helping to recipient of grant or concessional finance) will use money cover some of the costs of the team while fund raising continues. wastefully. In light of this difficulty, the public sector needs The chance of being able to start investing more quickly could to consider whether the likely benefits from catalyzing the encourage more fund management teams to form. market outweigh the potential for waste that arises from the resulting moral hazard. Some investors appreciate the value of backing a fund manager without requiring investment from other LPs. In fact, this is Note: Moral hazard: “the danger that if a contract promises people done quite often. Guy Hands (a leading British private equity payments on certain conditions, they will change their conduct so as to make these conditions more likely to occur. For example, moral hazard fund manager who now runs Terra Firma) got his start when suggests that if possessions are fully insured, their owners are likely to take Nomura agreed to back him with the capital he needed, creating less good care of them than if they were uninsured, or even to connive at their theft or destruction.” The Oxford Dictionary of Economics Nomura Principle Finance Group. The first LP to invest (http://www.enotes.com/econ-encyclopedia/moral-hazard). in Valiance Capital, Generali, allowed for Valiance to start investing before other LPs invested.52 An example of an IFI Interviews with market participants. 52  29 Public PrivatEquity Partnerships: Accelerating the Growth of Climate Related Private Equity Investment doing something similar is the IFC SME Ventures program.53 4.3 Public Capital The program provides risk capital to small businesses in selected in the Waterfall IDA countries through independent investment funds selected on a competitive basis. Public sector institutions can also create a “waterfall structure” that changes the risk-return relationship for other investors and That said, IFC and most other IFIs do not generally allow an thus encourages them to commit to a fund. investor to start investing their money54 until at least three LPs in total are committed to the fund. Most are unwilling to be the Generally, all investors in a fund invest on an equal footing majority investor in any fund or project. There are good reasons or “pari passu”. In a pari passu structure, all investors benefit limited partners will not commit funds until others commit. from any profits or suffer from any losses in proportion to their Chief among these is that each investor wants to benefit from investment, on an equal basis. A public sector institution has the others’ due diligence. Committing funds to a fund manager the option to make a fund more attractive to private investors is a risky decision. Each investor wants the reassurance that by agreeing to take more risk, or lower returns, than the private other investors also think it is a good decision. investors. This can be achieved by moving away from the pari passu principle and using a “waterfall’ structure”. Box 4.4 If a public sector institution were to allow fund managers describes the success of public capital in a waterfall structure in to start investing with only one LP committed, additional catalyzing the Israeli VC market. safeguards would be needed to overcome risk and moral hazard. This could include closer than usual supervision of the fund Waterfall structures can either dampen the losses that the manager. The public sector institution would also encourage private sector experiences if the fund loses money (downside the fund manager to go on to raise funds from other LPs, to protection), or leverage the returns they receive if the fund does ensure that the fund appeared to the market as a normal PE/ well, providing “upside leverage”. (It is also possible to design a VC fund, and not the captive instrument of a single public structure that does both). sector institution—this would be important for the catalytic function to be achieved. The provision of downside protection or upside leverage is in principle similar to tools that are in standard use by governments trying to increase investment in particular areas or sectors. Leveraging upside is akin to providing tax breaks that increase returns for those investments that are successful. Providing downside protection is similar to the provision of guarantees to mitigate the losses to investors whose investments fail. In either case, the underlying intent is identical to that described here. The government is trying to increase the returns to private sector investors in a particular sector and thus increase investment there. How the waterfall works “Leveraging upside” and “dampening downside” increase returns for private sector investors by transferring the fund’s returns from one group (the public sector) to another (private investors). When the upside is leveraged, this transfer occurs if the fund succeeds. The public sector takes a return smaller than its proportionate share of the profits, and consequently “ramps up” the private sector’s returns. With downside protection the transfer occurs if the fund fails to reach a certain return. The public sector then takes on a greater than proportionate share of the losses, which reduces the private sector’s losses. 53 http://www.ifc.org/ifcext/media.nsf/AttachmentsByTitle/AM08_SME_Ventures/$FILE/AM08_SME_Ventures_IssueBrief.pdf. Sometimes referred to as “reaching a first close”. 54  30 Mechanisms to Facilitate Private Equity Fund Investing Box 4.4: The Yozma Fund: A Successful Waterfall Structure Israel’s Yozma Investment fund provides a useful illustration of how public The Yozma fund co-invested with 10 funds from outside Israel. The sector intervention mechanisms help catalyze private investment into the funds that Yozma invested in were so successful that the public sector PE/VC sector. Yozma was a government supported $100 million “fund of was bought out of eight of the ten funds by the private sector investors funds” that successfully catalyzed the Israeli VC industry during the early or LPs. The funds no longer needed government support as they were 1990s. Through Yozma, the Israeli government provided matching funds able to raise their funding from the private sector for subsequent of up to $8 million to foreign investors that set up VC funds in Israel. The funding rounds. Most of them were able to expand over time. The government provided these funds as equity. However, the other investors enormous returns achieved attracted other funds into the market. (or LPs) in these funds had the option to buy out the Israeli government’s Many of these funds were invested with Israelis who had worked original investment after a few years. Effectively they would pay the Israeli on the original ten funds and who could now raise funding given government a nominal interest rate on the money the Israeli government their impressive track records. By the end of the 1990s there were 100 had invested, thus providing upside leverage to investors. Buying out Israeli VC funds. As shown in the figure over the page these funds had the government would only be attractive if the fund was successful. In $7 billion under management by 2001. The original Yozma funds had addition to the financial incentives, “the project adopted a legal structure $2 billion under management by 2001 up from $200 million in 1993 for the venture funds that foreign investors would be comfortable with. (including public and private investments). In total, the overall market Included were features such as a ten-year fund life, limited partnerships was $10 billion by 2001 compared to around $30 million in 1992. modeled on those standard in the United States.”(a) The VC industry in Tel Aviv is now the second largest center for VC finance after Silicon Valley, larger than Boston’s and, as a percentage $10,000 of GDP, Israel now has the largest VC industry in the world. Fund size in millions of US$ $8,000 Some ascribe the success of the Yozma fund to the internet bubble on the NASDAQ and other exchanges. However, this does not appear to $6,000 be the case. Yozma was well on the way to successfully establishing an Government's Israeli VC industry by 1995 when the bubble was only just starting to initial investment +$7 $4,000 billion develop in the United States. The Israeli early stage VC industry has was $100 million in 1993 and continued to be successful into the 2000s after the bubble burst in the $2,000 ended in 1997 +$2.6 early 2000s.(b) billion $0 1993 2001 It appears that the industry has led to substantial benefits for the Public investment Private investment Private investment Israeli economy. The increased availability of finance for technology in Yozma funds in Yozma funds in non-Yozma funds start-ups should have made investing in civilian R&D more attractive and so should have increased the number of projects available to be financed. In line with this, civilian R&D increased from 2 percent to 4 percent of GDP over the period of the Israeli VC industry’s growth.(c) 100 Israeli VC firms • invest US$5 billion Little direct • involvement by US Source: Yigdal Erlich, “the Yozma Group–Policy Success Yozma exits (1997) and other foreign Factors” http://www.insme.org/documenti/Yozma_ VC firms • Yozma enters and presentation.pdf (accessed December 10 2010) and Senor and subsidizes entry (total Profitability • Market established Singer (1999). investment $100 demonstrated and Notes: (a) Page 156-157 Josh Lerner, 2009 “Boulevard of Broken (2000) million) learning occurs Dreams” Princeton University Press. • Foreign (mainly US) VC I sraeli and US funds • Gil Avnimelech and Morris Teabal, 2004 “Targeting (b)  invest firms invest in 10 funds venture capital: lessons from Israel’s Yozma program” Chapter 5 in Anthony Bartzokas and Sunil Yozma starts investing (1994) Mani (eds), 2004 “Financial Systems, Corporate Investment in Innovation, and Venture Capital” Edward Elgar Publishing. Civilian R&D (c) Markku Maula and Gordon Murray, 2003 “Finnish went from 2% Industry Investment Ltd: An International Evaluation” Ministry to 4% of GDP of Trade and Industry. 31 Public PrivatEquity Partnerships: Accelerating the Growth of Climate Related Private Equity Investment The way that leveraging upside and dampening downside percent of the returns flow to the private LPs, increasing their increase returns for private investors (LPs) is shown in Figure returns from 20 percent to 36 percent if the fund succeeds. The 4.3 and Figure 4.4. For illustrative purposes a $100 million donor LP funds this by accepting a smaller share of any profits fund with a one year life is assumed (footnote 55 highlights a generated ($2 million rather than $10 million). number of further simplifying assumptions).55 Figure 4.4 does the same comparison for downside protection. Figure 4.3 compares a waterfall structure that leverages upside As downside protection only helps if the fund loses money, (the right hand graph) to a straight pari passu investment (the Figure 4.4 shows a scenario in which the fund has experienced left hand graph). Upside leverage only “kicks in” if the fund $20 million in losses. In the pari passu structure (left hand generates a profit, otherwise losses are shared equally. Therefore, graph) these losses flow equally to the donor and private LPs Figure 4.3 shows a scenario in which the fund has generated (50 percent to each). In contrast in the waterfall structure, these $20 million in profit. In the pari passu structure (left hand losses fall disproportionately on the donor LPs, increasing their graph) these returns flow equally to the donor and private LPs losses from 20 percent to 36 percent. This reduces the private (50 percent to each). In contrast, in the waterfall structure 90 LP’s losses from $10 million to $2 million. Figure 4.3: A Waterfall Structure that Increases Upside Leverage Relative to a Pari Passu Structure Returns Pari Passu Upside Leverage reduced by 80% Returns Fund profit Fund profit $25 increased $20m => 20% $20m => 20% Public LPs Profit on funds invested in millions return $2m => 4% by 80% return $20 Public LPs return $10m => 20% Private LPs $15 return $18m => 36% return $10 Private LPs $10m => 20% $5 return $0 Fund Public sector LPs Private sector LPs Fund Public sector LPs Private sector LPs Figure 4.4: A Waterfall Structure that Dampens Downside $25Passu Pari Downside Protection Fund Public sector LPs Private sector LPs Fund Public sector LPs Private sector LPs $20 $0 Profit on funds invested in millions Private LPs Private LPs $15$-5 -$10m => -20% -$2m => -4% return return Losses $-10 $10 dampened by 80% Public LPs Public LPs $-15 $5 -$10m => -20% -$18m => -36% return return $-20 Losses $0 Fund loss Public sector LPs Private sector LPs increased Fund Fund loss $-25 -$20m => -20% return by 80% -$20m => -20% return To make the numbers easier to follow the public and private sector LPs have equal stakes (which is not necessarily the case). It is assumed to have a one year life (whereas a 55  fund would typically have life of 10 years), there is no inflation, and risk free investments offer zero return. The fund is assumed to either “succeed” and earn a 20 percent return or “fail” and lose 20 percent of the funds invested, and if it’s assumed to have a 50 percent chance of succeeding and a 50 percent chance of failing, the value of the subsidy is the same with either. That is, with either structure (used alone), the public sector LPs can expect (on average) to lose $4m and the private sector LP can expect to earn $4m. Thus either approaches to providing the subsidy increases the private sector’s return from an expected value of $0 to $4m. This assumes away any tax issues. $0 32 $-5 Mechanisms to Facilitate Private Equity Fund Investing Box 4.5: Public Capital in Waterfall Structure: Lessons from International Experience An analysis of the experience of successful and unsuccessful of PE/VC funds have been created by states in the United funds (presented in Appendix B) suggests that the public sector States which were as small as $10 million. As a result, they should (a) “seed fertile ground”, that its total contribution should had hardly any effect. At the same time there is a risk in be set at (b) the “golden mean” (not too small or large), and that being too large. A Canadian program granted generous tax (c) the funds must have a commercial investment focus. incentives to invest in trade union managed PE/VC funds. Seed fertile ground It appears that there was far more money in these funds than could be usefully invested and so fund returns were The Israeli Yozma fund, a very successful government supported poor. In addition, it appears that these funds crowded out “fund of funds”, was extremely effective at capitalizing the the private sector, and so private VC activity fell as a result.a Israeli PE/VC industry during the 1990s largely because it was launched in a “project rich environment”. Israel had a long Create and run the fund on a commercial basis and strong history of developing new civilian and military The basis for a successful market catalyzation by a publicly technologies. As a result, when the VC funds started looking supported fund is that it paves the way for other funds to for technology start-ups to invest in, there were many viable follow. It is less likely to do this if the private sector investors candidates and they could quite easily find firms that had or LPs in the fund don’t have a commercial rationale significant growth and profit potential. for investing or if the fund is run on non-commercial An interesting contrast to the Yozma experience is that of grounds. For example, the members of the German fund the New Zealand Venture Investment Fund (NZVIF). called the Deutsche Wagnisfinanzierungsgesellschaft New Zealand tried to replicate the Yozma experience and so (WFG) that was created in the 1970s to invest directly structured its fund in a very similar way. Despite the similarities in new companies, had been pressured by the government between the two funds, NZVIF has been less successful so to invest in the fund to help catalyze the market for far and it is taking far longer to find projects to invest in. A technology focused VC funds in Germany. As a result, plausible reason for this is that New Zealand does not yet have the banks saw this as an exercise in Corporate Social the pipeline of start-ups with promising new technologies for Responsibility (CSR) and thus pressured the managers to the VC funds to invest in. dampen the fund’s returns by making socially conscious investments. Consequently, the WFG failed to effectively Choose the golden mean fund size catalyze Germany’s PE/VC industry.b A fund needs to be large enough to cover the minimum costs of running it effectively. This puts a floor on how small a single publicly supported PE/VC fund can be. A number  osh Lerner, 2009 “Boulevard of Broken Dreams” Princeton University Press Sources: a. J  e information on the WFG comes from (a) Caroline Fohlin 2006 “Venture Capital Revolutions Germany and the United States in the Post-War b. Th Era” (http://www.econ2.jhu.edu/people/fohlin/FohlinPUB-PRIV-VCrev-w-tabs10-29-06.pdf) and (b) Ralf Becker and Thomas Hellman, 2002 “The Genesis of Venture Capital Lessons from the German Experience” CESifo Working Paper Series number 883., 15 November 2002. This example has been set up so the two different waterfall by the fund. The two approaches also differ in terms of the structures increase the expected returns for the private LPs by incentives they give investors. the same magnitude. In this example, with either approach the expected value of the incentive to the private investors Choosing the waterfall design is identical (making numerous simplifying assumptions described in footnote 55 including assuming away taxes). Providing investors with upside leverage has better incentive properties than providing them with downside protection. Nevertheless, the two approaches appear quite different after Examples of programs that provide upside leverage include the fact. With downside protection, the funds transferred to the Yozma Fund (as discussed in Box 4.4) and the NZVIF (as the private LPs come out of the donor LPs principal, and hence discussed in Box 4.5). The advantages of leveraging investors’ has the appearance of a grant. In contrast, with the upside upside returns are twofold: leverage the transfer is funded out of the profits generated 33 Public PrivatEquity Partnerships: Accelerating the Growth of Climate Related Private Equity Investment •• Attracting the right kind of investors (overcoming ad- Another justification is based on risk perception. If it is true verse selection): leveraging firms’ upside will only be at- that perception of risk is excessive in a new area, then the tractive to those investors who believe the fund has the returns demanded by private investors will be above the levels potential to do well. Thus, when the upside is leveraged that in a sense “should” be demanded. This suggests that the this ensures that private sector investors’ decision to in- public sector might in fact be able to achieve a reasonable risk- vest can be taken as something of a vote of confidence adjusted return on investment, even though the return is below in the fund’s prospects. In contrast, if investors’ down- what private investors receive initially. side is sufficiently protected they may invest even if they have little confidence in the fund’s investment mandate Finally, there may be a justification driven by taxation issues. If public and private sector LP investors are pari passu, and the fund •• Giving fund managers the right incentives (overcom- generates a return (net of fees and carried interest) to its investors ing moral hazard): leveraging upside for the fund man- of 15 percent, the public sector investor receives a 15 percent gross ager gives it a stronger incentive to achieve higher returns. and net return as an LP as it pays no tax on its profits. However, a Leveraging investors’ upside gives them a strong incentive to private sector investor will receive a 15 percent gross return and a pressure the fund manager to achieve returns. In contrast, if 10 percent net return assuming a 33 percent tax rate on its profits. the subsidy is used to dampen returns the investors have less Therefore, as an LP investor in the Fund, the public sector investor incentive to pressure the fund manager to achieve returns. receives a higher net return than does the private sector investor. An example of this is the WFG where the investors had so In this sense, a subsidy in a waterfall structure may be thought of little incentive to achieve returns that they are reported to as bringing public sector returns more into line with private sector have resisted efforts by the fund manager to increase returns. returns, but doing so in a way that provides developmentally- positive incentives to private investors. While the ideal mechanism for providing a subsidy is to leverage the upside, some investors may only be attracted to a PE/VC fund if downside protection is provided. For 4.4 Supporting instance, as discussed in Box 4.5, the WFG needed to Pioneering Investments provide downside protection to attract conservative, risk averse banks, to the structure. Pioneering new markets and investment structures has costs which are higher than investing in mature markets. The The subsidy question benefits of the pioneering may, at a social level, outweigh the costs. However, for a private investor, the pioneering may not Waterfall structures do amount to a public sector subsidy to be worthwhile, because the costs are born by the first investor, the private investors in the firm. By agreeing to take lower while the benefits are often reaped by others. The public sector returns for the same risk level, the public or IFI investor must may have a role to play helping investors meet the costs of expect to transfer resources from the public to private sector. pioneering new climate-friendly investment areas. This is most clearly true when the public sector losses some of the value of the principle invested, but it is also true when E+Co’s experience illustrates the point. E+Co is an impact- the public investor misses out on some or the profits from a oriented debt fund now moving into PE/VC investing. As successful investment. Given that these waterfall structures discussed for the example of Bio2Watt in Box 4.6, E+Co incurs do involve a resource transfer, or at least an opportunity cost, pioneering costs in: compared to pari passu investing, the question arises how this can be justified. •• Explaining the equity product: clean energy entrepreneurs such as improved cookstove manufacturers in Africa are not The obvious justification is that by increasing investment in familiar with the concept of outside equity investment. E+Co PE/VC funds targeting low emissions projects, the public sector needs to explain to entrepreneurs why it may make sense to give contribution achieves the global good of increasing greenhouse up a share of profits and control in exchange for growth capital gas abatement. While more indirect and risky than, for example, subsidizing a wind farm directly, PE/VC waterfalls •• Enterprise development services: E+Co needs to provide have the potential to achieve much larger abatement levels per what are essentially technical assistance services to potential dollar of public subsidy. The reason is the development of PE/ investee companies, putting in place governance structures, VC market has the potential to take-off in a virtuous circle, in financial reporting systems, and the other infrastructure of the way Yozma led to a take-off of the Israeli PE/VC sector (and a successful business. This is needed not only to help com- hence the high tech economy in Israel). panies to grow, but to make them investable in the first place 34 Mechanisms to Facilitate Private Equity Fund Investing Box 4.6: E+Co’s Support for Bio2Watt Leads to the Introduction of Environmentally Friendly Technology to South Africa Bio2Watt (PTY) Ltd is a pioneering company introducing Selecting the appropriate technology—Mr. Thomas first technology to South Africa that converts agricultural waste looked to German technology due to Germany’s large to energy. In playing this role it has faced a number of waste to energy industry. But this technology was not challenges. The support and finance E+Co has provided has economically viable in South African conditions. E+Co used been critical to the company’s success so far. its network to introduce Mr. Thomas to Waste Solutions, a In 2006 the founder of Bio2Watt, Mr. Thomas, left his New Zealand producer, with experience in waste to energy stable job at a large corporation in South Africa to develop systems in South East Asia (a). These systems were more a renewable energy development business, fulfilling a dream suited to South African conditions and were able to produce he had for several years. He set out to identify large sources of power at a lower cost, far closer, to that charged by South waste that could be collected easily for conversion to energy. Africa’s monopoly power producer, Eskom. He focused on manure which is relatively easy to collect Satisfying regulatory requirements —the plant needed compared to other forms of agricultural waste. He found to submit an Environmental Impact Assessment. Because a potential source for the manure at Beefcor farm which this was the first plant of its kind in South Africa, the is half an hour drive from Johannesburg, near the town of Department of Environmental Affairs was cautious and Bronkhorstspruit. The farm had 20,000 head of cattle and requested a number of additional studies. In the end the a million chickens. The farm was struggling to manage the Environmental Impact Assessment cost twice as much as vast quantities of waste these animals produce on a daily expected. basis and so was receptive to Mr. Thomas’s proposal to take Supporting the business’s development—E+Co helped the waste away for use in power generation. The farm’s waste Bio2Watt to engage the legal firm Edward Nathan had the potential to power a 3MW plant while reducing Sonnenbergs (ENS) which provided legal services for the greenhouse gas emissions. To turn this potential into reality sixteen contracts required to get the plant up and running. he had to find the appropriate waste to energy technology for Examples of the contracts included supply agreements South African conditions, pass numerous regulatory hurdles, and power purchasing agreements. E+Co has also helped develop the business and find financing. E+Co helped him Bio2Watt establish proper governance processes and overcome each of these challenges. participated as B2W’s partner in all of its important negotiations and meetings. Finding finance and funding —Mr. Thomas used up his savings during the early stages of businesses development and so finding additional funding was crucial. E+Co assisted Bio2Watt to secure grants from the Dutch government to support the project development costs. E+Co itself provided debt and equity, and helped Bio2Watt to raise equity from investors in E+Co’s international network. Once Bio2Watt has successfully launched its first plant in South Africa it plans to launch similar plants in the rest of South Africa and throughout Sub-Saharan Africa. Source: E+Co (http://eandco.net/) and Bio2Watt (http://www.bio2watt.com). Note: (a) Waste Solutions (http://www.wastesolutions.co.nz/ •• Management of a small fund with small individual invest- However, the transaction costs do not reduce in proportion to ments: many climate friendly companies in emerging markets the smallness of the investments and funds, meaning that the are small, meaning that smaller funds, with smaller bite-sizes fund management costs per dollar of assets under management per investment make sense. This is natural in a pioneering area. exceed the two percent that is standard in the PE/VC world.56 Interview with Christine Eibs Singer CEO of E+Co. 56  35 Public PrivatEquity Partnerships: Accelerating the Growth of Climate Related Private Equity Investment Box 4.7: Examples of Approaches to supporting Pioneer Investments EC ASEAN Cogen Programe  nterprise Development Support: This line of support • E This program promotes the implementation of biomass, coal, is an annual grant to fund managers to develop a and gas cogeneration projects in ASEAN countries. It does pipeline of early stage investment opportunities by this by providing a grant of 15 percent of the cost of EU made providing services to early stage companies or projects. equipment for projects that demonstrate the technical and These services include training and coaching of financial viability of these technologies in ASEAN countries. clean energy entrepreneurs or project developers and The Cogen program also provided technical assistance to feasibility studies for potential projects companies implementing co generation technologies.  eed Capital Support: Seed capital support is designed • S UNEP’s Seed Capital Assistance Facility (SCAF) to provide support for covering the higher costs of early stage companies or projects. The additional costs can UNEP, the African Development Bank, and the Asian include technical assessments, contract negotiations, Development Bank launched the Seed Capital Assistance environmental impact assessments, and permitting. Facility which is designed to facilitate energy investment The support is a grant that is provided on a project funds to provide seed financing to early stage clean energy to project basis and typically in the range of 10 to 20 enterprises and projects in developing countries. SCAF offers percent of the investment. two main “support lines” to fund managers targeting the clean energy investments through a SCAF agreement: In addition to the two support lines, SCAF has also provided seed capital of US$150,000 to fund managers interested in investing in clean energy opportunities to cover the initial operating costs of starting a fund. To date, SCAF has supported five fund managers with seed capital, and are targeting five more in the coming year. Discussion with Eric Usher with UNEP, SCAF website Source:  (http://www.scaf-energy.org/about/introduction.html) and for the EC Cogen Programe (http://www.cogen3.net/aboutcogen.html). In addition, a number of climate friendly business models •• Grants for training and enterprise development services to are new—examples include renewable energy IPPs in investee companies. many countries and ESCOs. Business partners, banks, and regulators all need to be educated. New deal structures and As noted earlier, developing new investment opportunities legal documents need to be developed. and supporting and mentoring companies post investment are crucial to the success of a private equity fund. Consequently, To unlock climate friendly investments and start the virtuous public capital that is deployed to support such efforts needs to cycle of PE/VC market development, the public sector may ensure that it does not distort the existing commercial incentives consider covering some of the pioneering costs. A number of of the fund manager, does not create excessive transaction public sector institutions provide grants which cover part of the costs and that it uses structures that reduce moral hazard. cost of developing climate friendly projects. These are intended One option could be to offer fund managers loans rather than to offset the pioneering costs of new, often small projects. They grants to develop the critical resources necessary to effectively typically cover such things as the costs of pre-feasibility studies, deploy capital. These loans could be used to supplement the market studies, and tests of the technical feasibility of the idea. management fee of undersized funds; contribute towards due diligence and other transaction expenses in innovative deals Generally speaking, the public sector may support market and will enable managers to deploy additional resources to pioneering through: directly support and grow their investee companies. •• Grants to assist with pipeline development The loan could be structured such that it only becomes payable if the PE/VC fund earns a return above its hurdle rate. If the •• Grants to cover part of the cost of feasibility studies hurdle rate is not reached, the loan would become a grant. This mechanism provides the fund with equity-like capital but at 36 Mechanisms to Facilitate Private Equity Fund Investing debt rates of return. Such concessionality would help to offset an option mechanism, governments could commit to purchase the increased costs of pioneering. Under this structure the fund a specified quantity of emissions reductions, at a period in the manager is given an incentive to use the money appropriately future, at a “strike price” which would be set when the contract but is not left with a debt burden if the fund fails to exceed was signed. For example, the contract might allow a wind farm its hurdle rate. Further, securing the return against the entire to sell up to 0.8 tons of carbon emissions reduction, at $20 per performance of the fund (and not to a specific investment) ton, each year for the next 15 years, if it displaces electricity helps to spread the risk and increase the likelihood of return generated with coal. To make this work, governments would reducing the burden to the public sector. The advantages of create a fund to offer carbon options. The fund would need to this approach include: have the financial backing to pay the agreed strike price when the emissions reductions are achieved. •• Incentives are aligned: The GP has an incentive to use the money carefully because the GP will pay back the money if Such a mechanism is particularly well suited to help increase the hurdle rate is exceeded the level of PE/VC investment. Crucial to this structure is the ability of projects to use the mechanism to help raise more •• The cost of the subsidy is minimized: A subsidy is only in- debt. By being able to increase leverage equity returns that curred if the fund fails to meet its targets. This reduces the were marginal become commercially attractive. cost of the donor support because the loan is repaid if the fund succeeds To understand how such an agreement could work, a hypothetical example is presented that is in line with the •• The returns to the LPs are not affected. An advantage of experience of Global Green Power (as discussed in 3.2.3, providing concessional finance in this way is that the LPs Global Green Power has well developed plans to build low can invest in the fund on a standard commercial basis emissions biomass power plants in the Philippines). A biomass power plant is expected to generate carbon credits during •• Transaction costs are reduced. Standard industry practices operations, and a price floor on the carbon price would ensure can be used to call capital from the loan for pre agreed eli- that the revenues of a biomass plant would increase by at least gible expenses. 10 percent over the life of the project. Carbon revenues would allow the project to: i) directly increase the dividends paid to equity investors, ii) borrow against these revenues (increasing 4.5 Improved Carbon Payments leverage), or iii) a combination of i and ii. If 100 percent of the carbon revenues are directed towards paying more dividends Many climate friendly projects are only financially viable to equity investors, the return on equity will increase by 5 if they receive revenue for the value of the carbon emissions percentage points—from 22 to 27 percent. reductions they cause. The Clean Development Mechanism (CDM) was created to provide such revenue. In practice, the If 60 percent of the carbon revenues are used to increase debt CDM has not worked as well as hoped. The transaction costs (from 60 to 70 percent of capital costs), and 40 percent directed of getting the carbon revenues are high. Recent collapses in towards paying more dividends to equity investors, the return prices and trading volumes means the revenues are lower than on equity increases by 8 percentage points—from 22 to 30 expected. Without a fixed price structure carbon payments percent. Six percentage points of this increase are explained can’t be used to leverage investment. by the increase in leverage. This suggests that using carbon revenues to increase leverage could increase returns to equity Public sector institutions have an opportunity to create a new investors more than if exclusively used to increase dividend kind of carbon payment mechanism that will provide revenue payments to equity investors. The 8 percentage point increase certainty for carbon emissions reducing projects. Such a would be enough to put returns to a level at which many PE/ mechanism would allow carbon revenues to be used to raise VC funds would be willing to invest in what is an untested debt, and would increase equity returns on projects. technology. Further by catalyzing the first investment a track record is demonstrated reducing the risk and transaction costs Development of a new bilateral based for subsequent investors. carbon payment mechanism Crucial to attracting the additional debt is the certainty of the Governments could overcome some of the shortcomings of carbon revenue. Currently, there are two key risks that any the CDM by offering contracts to purchase carbon emissions financier relying on carbon revenue faces. The first is the price reductions in the future, at prices which are fixed now. Using at which carbon emissions reductions can be sold in the future. 37 Public PrivatEquity Partnerships: Accelerating the Growth of Climate Related Private Equity Investment The second is whether the project will actually deliver the carbon reductions. The carbon put option will remove the price risk. The other risk—delivery of the emissions reductions—will remain. However, for many projects this risk is one that banks can get comfortable with. Take the example of a renewable energy project. Banks are happy to lend against future power sales, because through the quality of the technology and the operator involved they can get comfortable that power will be generated. For a renewable generator, carbon emissions reductions are simply a by-product of power production, suggesting that lenders will be comfortable lending against future carbon revenues for many projects, provided the price risk can be removed. Beyond the financial incentives that accrue specifically to equity investors, the advantage of using PE/VC funds as routes to market for carbon payments include: •• They are already in touch with climate friendly projects seeking finance, so costs of originating deal flow for the car- bon payment would be low •• They are already putting together financing packages for these projects, reducing transactions costs for investors (since all the financing can be arranged at one time, work- ing with a limited number of entities). 38 5 Conclusion There is an opportunity for the public sector to use public •• Seed fertile ground: The Israeli Yozma fund was success- resources to unlock a virtuous circle of climate-friendly PE/ ful because it was launched in a “project rich environment”. VC investing in developing countries. PE/VC demands high Similarly structured initiatives in places that lacked the un- returns, but has unique characteristics that enable it to back derlying investment opportunities have not done as well innovative, risky ventures and technologies, finance energy efficiency projects, and boost development of renewable •• Choose the golden mean fund size: The fund size must be generation and efficient transport infrastructure. Unlocking related to the size of the potential market opportunity. Too this potential requires the removal of barriers that now slow the small, and it can fail to catalyze the market. On the other development of the PE/VC market. hand, public sector support that is too large crowds out pri- vate capital and depress returns, as too much money chases Removing barriers to fund formation too few investments Potential PE/VC fund managers are deterred from trying to Create and run the fund on a commercial basis: Private in- •• create climate friendly PE/VC funds targeting emerging markets vestors are attracted to funds with fully commercial objec- because of the high costs and risks. Many potential fund managers tives. Anything else will depress returns and send mixed mes- lack the capital needed to sustain a one or two year capital raising sages, possibly retarding the development of private investor process, with no income and no guarantee of success. A lack of interest in the sector. well-qualified fund managers with clear skills and experience in climate-friendly investing in emerging markets in turn limits Remove barriers to investing the capital that can be raised for this sector. These difficulties are accentuated because investors consider climate friendly Many climate friendly projects earn lower returns than in a investing in emerging markets to be highly risky and there is no sense they “should”, either because carbon abatement benefits history of returns. These problems can be overcome with time. are not easily monetized, or because of the costs of pioneering As investments are made, track records and investment histories new sectors. IFIs and donors can help overcome these problems will follow. In all likelihood, greater familiarity with the sector, in the following ways: its technologies, business models, and countries of operation will reduce the perceived risk. However, the public sector has an •• Fund the costs of pioneering: National and international opportunity to accelerate this process. public sector institutions can help offset the costs of pioneer- ing new business structures and educating markets. These The challenge is to overcome the current chicken and egg costs are significant barriers to the first mover PE/VC funds. situation, in which a lack of past investment in the sector limits To offset the cost, public sector institutions can provide grants the flow of capital in, and so perpetuates the lack of data and and loans at concessional rates track records that deter fund investors. The public sector can co-invest in funds and attract private capital into those funds •• Improved carbon payment mechanism: Bilateral donors through the use of the following three techniques: have an opportunity to create a carbon payment mechanism which could offer guaranteed minimum prices for future •• Anchor new funds: Invest in new funds, provide them with carbon sales. This would greatly help with project financing, advice on how to improve their team and structure and intro- while the cost could be quite low. Channeling the carbon pay- duce them to other potential investors ment mechanism through suitable PE/VC funds would help ensure that the funds reached their targets, and also aid with •• Finance new fund development: Provide new management financing, given the cornerstone role that PE/VC funds play teams with financial support to get them through the costly in many financial structures. fund raising stage The potential for market development •• Public capital in the waterfall: Invest in funds on terms that encourage private investors to invest in the fund by dampen- Removing these barriers to the development of the PE/ ing their downside or leveraging their upside. VC market could create a virtuous cycle. Easier fund raising would encourage more fund managers to form. More funds While co-investing approaches have had clear successes, there would mean more investment, building up track records, and have also been failures, in which the public sector money was investment history. The benefits of early pioneering would come lost, or the development objective not achieved. Key lessons through in lower costs going forward. Perceptions of risk would from previous experience include: fall. Improved carbon payment mechanisms would make more 39 Public PrivatEquity Partnerships: Accelerating the Growth of Climate Related Private Equity Investment climate friendly projects profitable, further improving investor perceptions of the sector, and increasing capital flows. As this process unfolds, more and more climate friendly investments in emerging markets would be able to access PE/VC funding. This would be a significant boost for the myriad of companies with climate-friendly projects that need equity to finance start- up costs or to accept the risk of volatile and risky cash flows, but are too large to rely on finance from family and friends. Clean technology development, energy efficiency investments, renewable generation projects, efficient transport infrastructure and land use and forestry projects all can benefit from the specific characteristics of PE/VC financing. In all of these areas of climate friendly investing, PE/VC finance can make a distinctive contribution by: •• Funding risky new technologies and business models •• Identifying and developing investment opportunities •• Helping companies do business better through improved, governance, strategies, and systems •• Being the cornerstone investor in a growing company, and so bringing in other, lower-cost capital that would not otherwise be available. In this way, donor and IFI action to boost the development of PE/VC funds can allow PE/VC capital to play an appropriate part in financing the $4.6 trillion in climate-friendly investment estimated to be needed annually.57 57 Page 2 World Bank, 2010 “Beyond the sum of its parts, combining financial instruments to support low-carbon development” The International Bank for Reconstruction and Development. 40 Appendix A: The Basics of PE/VC Funds It is common to speak generally of capital as if all sources of Box 5.1: The Difference Between capital are equally available under all circumstances, and can Debt and Equity be used for the same purposes. In fact, capital tends to fall into specific categories, and is not easily fungible between them. For Typically, firms need finance when they don’t have sufficient example, equity—the at-risk capital which claims profits from funds on hand to make an investment. When financiers the business—is clearly different from debt, which comes with provide these funds to enable businesses or projects to a much lower risk appetite and an expectation of fixed returns. invest, they receive a claim on the recipients’ future income (debt) or a claim on their future profits (equity). Equally importantly, different providers of capital tend to A provider of debt financing provides funds in exchange follow well-defined and predictable procedures and investment for a claim on a pre-determined amount of the borrower’s strategies, and are suited to projects and companies whose income. An example is a mortgage where the bank characteristics are aligned with the risk perceptions and modes finances the purchase of the house in exchange for a pre- of risk management adopted by these providers. For example, determined set of payments from the borrower. These banks typically require collateral for lending. Stock markets cover interest, various fees, and the principal borrowed. provide risk capital, but involve high transactions costs and In contrast, a provider of equity financing does so in are generally only suited to larger undertakings able to explain exchange for a claim on a proportion of the firm’s profits. their business and the risks involved to the general public. A common form of equity financing is the issuance of shares on securities markets. The investor provides funds Private Equity and Venture Capital fund managers raise money to the firm in exchange for a share of the firm’s profits from institutions such as pension funds, insurance companies, paid through dividends. and sovereign wealth funds. The investors are generally referred to as “limited partners”(LP).58 High net worth individuals, In practice the “debt-equity dichotomy does not do justice family offices, and foundations can also be limited partners. to the richness of claims encountered” with many sources of financing falling between the two. The PE/VC fund unites fund managers, who have expertise and Source: Jean Tirole, 2006 “The Theory of Corporate Finance” Princeton no money to invest, with limited partners who have the money University Press. Figure 5.1: Generic Structure of a PE/VC Fund Fund Manager Limited Partners Also known as General Partner Private Equity/Venture Capital Fund Also known as the Limited Partnership Make investments in the underlying companies Investment A Investment B Investment C Th is is because private equity funds are typically structured as partnerships. The investors are “limited partners” because their liability is limited to the amount they 58  invest. The fund manager typically is also the “general partner” in the fund, and takes management responsibility. 41 Public PrivatEquity Partnerships: Accelerating the Growth of Climate Related Private Equity Investment to invest but lack investing expertise in an area. The typical PE/ The life cycle of a fund VC structure aims to create an alignment of interests between the limited partners and the fund manager. The fund manager Private equity funds go through several distinct stages, which charges the limited partner a management fee, usually around may be summarized as: 2 percent of the value of the assets invested. This fee is to pay salaries and expenses. The fund managers also get a “carried Formation of fund management team •• interest”—essentially a share of the returns they create for the limited partners. In a typical set-up the fund manager gets 20 Raising capital from LPs •• percent of the returns the fund earns. Finding and selecting investments •• This so-called “2 and 20” structure is what achieves the alignment of interests. The 2 percent management fee provides Structuring the Investment •• the fund managers with the money to live on and run the fund while returns are being generated, while the 20 percent •• Management “carry” can be a powerful reward for generating returns. For example, the fund manager of a $100 million fund would Exit. •• have $2 million a year to pay salaries and expenses for a small management team. If the manager turns the $100 million into These are illustrated in Figure 5.2. While every fund is unique, $300 million, then the team could get 20 percent of the $200 it is not uncommon for the fund management team to spend million profit, or $40 million. Clearly this is highly motivating two years fund-raising; that is, persuading limited partners to to the fund managers, allowing them to earn investment invest in the fund. Successful fund raising requires convincing rewards from the expertise, even though they do not have their limited partners that the fund managers have: own capital to invest. A well-justified investment philosophy, allowing them to •• In recent years variants on the “2 and 20” model have been select good projects and companies in which to invest developed. Often the “carry” is only earned on returns above a certain hurdle level, for example 8 percent. Limited partners A track record of successful investments •• have been reducing management fees below 2 percent for some funds, and fund managers have been proposing innovative The skills required to identify good investment opportuni- •• ways of structuring the carry. However, the basic idea of the ties, structure investments and manage them.59 team being paid a fee to cover salaries and expenses, and then being rewarded with a share of the upside, remains the same. Figure 5.2: Life Cycle of a PE/VC Fund 1 2 3 Fund Raises capital Deploys capital and then exits management from LPs team forms Finding and Structuring Management Exit from selecting investments of investments investments investments 59 http://www.ifc.org/ifcext/cfn.nsf/AttachmentsByTitle/PerformanceComparisonFirstTimeFMandEstablishedManagersMovingtoaNewMarket/$FILE/Comparison+of +Performance+Between+First+Time+Fund+Managers+and+Estableshed+Managers+Moving+to+a+New+Market.pdf. 42 Appendix A: The Basics of PE/VC Funds Once the target level of funding is reached, the fund is said to Silicon Valley and has backed many successful technology “close”. At this point, it can start investing. companies, including Google. The VC model assumes that most of the investments will fail, but the ones that succeed The money in the fund cannot earn returns until it is invested, will make it big. VC funds are now backing companies de- so fund managers want to deploy the fund capital quickly. veloping new, climate friendly technologies. An example is However, managers need to scrutinize a large number of Draper Fisher Jurvetson’s investment in d.light, a company opportunities, rejecting most of them, in order to select those pioneering the sale of solar lamps to low income consumers 60 with the best prospects for superior returns. This process of origination and due diligence means that the investment phase Growth equity funds or expansion funds: funds that look ••  can take around three years before the entire fund is committed. for businesses that are already operating, have positive op- erating cash flows, and unrealized growth potential. Many Once a fund is committed, the fund manager’s focus turns to growth funds invest in small and medium enterprises which increasing the value of the investee company. The fund will are light in fixed assets (and therefore cannot easily raise generally have a representative on the board. The fund may debt finance), but too small to list on the stock exchange to suggest new business strategies, help to arrange additional raise equity. Climate Change Capital, a PE fund, invested finance, bring in new members of the senior management team, in Power Plus Communications AG (PPC). This invest- and generally use connections and skills to add value to the ment allowed PPC to expand its business selling communi- investment. cation technology systems used in smart grid applications61 The last phase of the fund’s life is exit—this is where the fund •• Infrastructure funds: these provide capital for econom- sells all the investments it has made. Over the life of the fund— ic infrastructure (for example, wind farms, waste water typically ten years—all returns will be realized in cash. While treatment plants), and public private partnerships such as the need to sell out all investments within a defined period limits mass transit projects. For instance, Macquarie Mexican the strategies that can be pursued, the overwhelming advantage Infrastructure Fund has invested in wind farms in Mexico62 is that it removes any argument about the returns earned. Returns are simply the difference between the cash put in, and Timber management organizations (TIMOs) and forestry •• the cash paid out at the end. The fund manager gets paid its funds: these invest in plantations and plantation companies. carry out of the increase in cash over this period. While funds Forestry funds are conventional PE/VC funds that invest in are opportunistic, willing to sell when they see an opportunity forestry companies. An example is Phaunos Timber Fund to maximize returns, the ten year life of a typical fund means which invested in Green Resources, a forestry company in- that seven years after close, most funds are concentrating on a vesting in greenfield plantations in East Africa.63 TIMOs, program of selling, or “exiting from”, their investments. on the other hand, are funds that purchase and manage forest land (typically plantations) on behalf of investors. Type of PE/VC investing Missing from this list are Leveraged Buy Out (LBO) Funds. Within the general type of investment approach described From a developed country perspective this is odd because these above there are four broad types, with four different investment are the predominant category of PE/VC funds in these markets. philosophies, that are worth highlighting: These funds purchase established companies by raising debt against the companies own cash flows. However, LBO Funds Venture Capital (VC) funds: funds that look for the next ••  are not particularly important in climate friendly investments big thing by investing in start-up companies that are of- and play a relatively small role in emerging markets. For these ten pre-profit or even pre-revenues. This model started in reasons LBOs are not a focus of this paper. 60 http://www.dlightdesign.com/about_investors.php. 61 http://www.climatechangecapital.com/private-equity/investments.aspx. 62 New Energy World, 2011 “Macquarie Mexican Infrastructure Fund, FEMSA buy Mexican wind project” http://www.newenergyworldnetwork.com/renewable-energy- news/by-technology/wind/macquarie-mexican-infrastructure-fund-femsa-buy-mexican-wind-project.html. 63 http://www.phaunostimber.com/. 43 Public PrivatEquity Partnerships: Accelerating the Growth of Climate Related Private Equity Investment Appendix B: Funds Reviewed Table B.1: Background on the Funds Name Country or Objectives Market or government Period of the funds Size of of Fund Multilateral failure targeted operation (start/end) the Fund Deutsche Germany Government aimed Failures in the financial market The fund began in 1975, Initially the fund had Wagnis –finanzie to increase the inhibit promising technologies government involvement capital of DM 50 million -rungsgesellschaft commercialization of new from attracting finance ended in 198465 (or Euro 25.56 million) (WFG)64 technologies Finnish Industry Finland Accelerate the availability Improve conditions for firms The fund began in 1995 100 percent government Investment Ltd. of risk capital for start-up (SMEs particularly) by making and is on-going owned, initial investment (FII) 66 companies in a manner that equity investments in VC of 53.8 million Euro. Over is profitable organizations period 1995-2001, more than 200 million invested Global Energy EC, Germany, GEEREF aims to cut GHG The externality caused by GHG First investment appears The target funding size Efficiency and Denmark, and emissions, increase access to and financial market imperfections to have been made in for GEEREF is €200-250 Renewable Energy Norway 67 energy service and support lead to too little investment (it will 200969 million and as of September Fund (GEEREF) financial sustainability 68 catalyze private and public capital) 2009, GEEREF has secured a total €108 million70 Yozma Venture Israel Facilitate the growth and Financial markets lead to failure to 1993 to 1997. New Yozma is fully owned by Capital Ltd. development of technology provide capital to new technology Yozma funds are still the government, the initial companies in Israel companies on-going investment was $100 million71 New Zealand New Zealand To accelerate the Information asymmetries and lack Since 2002 $160 million NZD Venture Investment development of the VC of skilled people lead to under- $40 million NZD for the Fund (NZVIF) industry and increase the development of the VC industry seed co-investment fund. commercialization of research Table B.2: Success and Failure of the Funds Reviewed Name Extent of of Fund success or failure Deutsche Wagnis –finanzie The WFG experienced significant losses (returns less than -25 percent) and did not induce the development of a market -rungsgesellschaft (WFG)72 Finnish Industry Investment Coinciding with the introduction of the FII the VC market boomed in Finland. It is not thought that the FII was crucial to Ltd. (FII) 73 this growth. The FII has failed to increase investing in early stage firms Global Energy Efficiency GEREEF has made number of investments but it is too early in the fund’s life to tell whether they will be successful and Renewable Energy Fund (GEEREF) Yozma Venture Capital Ltd. The Yozma group contributed to the development of a $10 billion VC industry (the largest in the world as a ratio of GDP)74 New Zealand Venture NZVIF has invested $80 million NZD matched by $400 million NZD from the private sector. Since NZVIF was Investment Fund (NZVIF) established six venture funds have been created. Before this there were no funds exclusively operating as VC funds The information on the WFG comes from (a) Caroline Fohlin 2006 “Venture Capital Revolutions Germany and the United States in the Post-War Era” and (b) Ralf 64  Becker and Thomas Hellman, 200 “The Genesis of Venture Capital Lessons from the German Experience” 15 November 2002. 65 The fund was intended to run for 15 years. Th is section is largely taken from MarkkuMaula and Gordon Murray, 2003 “Finnish Industry Investment Ltd: An International Evaluation” Ministry of Trade and 66  Industry. 67 http://geeref.com/posts/display/1. European Commission, 2006 “Mobilising public and private finance towards global access to climate friendly, affordable and secure energy services: The Global Energy 68  Efficiency and Renewable Energy Fund” Communication from the Commission to the Council and the European Parliament. GEEREF, 2009 “GEEREF Pumps E12.5 million in Renewable Energy In Asia” December 11, 2009 http://geeref.com/posts/display/18. 69  70 http://geeref.com/posts/display/1. 71 Page 156 Josh Lerner, 2009 “Boulevard of Broken Dreams” Princeton University Press. The information on the WFG comes from (a) Caroline Fohlin 2006 “Venture Capital Revolutions Germany and the United States in the Post-War Era” (http://www. 72  econ2.jhu.edu/people/fohlin/FohlinPUB-PRIV-VCrev-w-tabs10-29-06.pdf) and (b) Ralf Becker and Thomas Hellman, 2002 “The Genesis of Venture Capital Lessons from the German Experience” CESifo Working Paper Series number 883., 15 November 2002. Th is section is largely taken from Markku Maula and Gordon Murray, 2003 “Finnish Industry Investment Ltd: An International Evaluation” Ministry of Trade and 73  Industry. 74 Page 157 Josh Lerner, 2009 “Boulevard of Broken Dreams” Princeton University Press. 44 Photocredit: (front cover) ©Curt Carnemark / Worldbank, (page 30) ©Arne Hoel / World Bank Copyright 2011 International Finance Corporation (IFC). All rights reserved. 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