Avoiding the hype

From renewable energy to materials recycling and green transport, cleantech’s allure is simple: it offers the potential for profitable, transformative growth while helping the fight against climate change, delivering energy efficiency and resource security, handling the by-products of consumption and creating  jobs.

This golden halo makes the cleantech theme a hot ticket. There are now four times as many private equity funds focused purely on cleantech as there were in 2005 with an estimated $12 billion to invest. Since pure funds make just 30 percent of overall cleantech investments, the total sum poised to enter the sector is clearly vast.

This poses a challenging set of questions for an investor: which of cleantech’s many sectors do I support?  How do I identify the companies that will deliver good returns?  And where should I sit on the complex risk/reward spectrum?

Recent years have yielded few clues, with frozen financial markets making it hard for even mature cleantech businesses to complete IPOs and trade sales. But two major – albeit very different – cleantech exits in 2010 have shed fresh light on the cleantech cycle: Tesla Motors, an IPO in the US, and SiC Processing, a sale in Europe.

A SPARKLING IPO

Electric car company Tesla was created in 2003 by chief executive Elon Musk, whose track record includes co-founding PayPal. Musk describes Tesla as a “freaking technology velociraptor” that’s poised to revolutionise the way Americans buy and drive cars.

Tesla’s revolutionary promise and captivating products certainly found favour in June 2010, when its IPO raised $226 million. The shares, which had an initial target of $14 to $16, briefly hit $30, pushing the company’s value towards $3 billion.

But this exuberance masks some difficult financial and technical facts. Tesla has a small client base and has never made a profit. Indeed, it readily accepts that it will lose money and eat cash until the 2012 launch of its “mass-market” Model S. And electric cars face many well-known challenges, such as batteries, range and infrastructure, that may take a decade or more to address.

All of this makes Tesla a vibrant but uncertain technology investment. While some early investors are reported to have realised profits, others may remain locked in for some time to come.

THE SIC STORY

SiC Processing is a later-stage example of a cleantech business that has realised returns for its investors.
In June 2010, SiC was acquired from a group of growth capital investors, including Frog Capital, by Scandinavian private equity firm Nordic Capital. Börsen-Zeitung described the sale as “the largest private equity transaction of the year in Germany” and estimated SiC’s price tag at close to €500 million.

Established in 2000, SiC has become a large and profitable provider of high-end recycling services to manufacturers of the photovoltaic wafers used in solar cells. The process recycles materials and reduces the overall cost of solar energy.  In the fiercely competitive wafer market, SiC’s ability to cut clients’ costs led to rapid adoption, with facilities across Europe, Asia and North America.

In recent years, the market for solar cells has seen both phenomenal growth and a sharp slowdown, but SiC has continued to expand throughout. Sales have grown at a compounded annual rate of 54 percent over the last three years. EBITDA has grown at a compounded annual rate of 69 percent in the same period. It has secured long-term customer contracts and has increased penetration in China, home to many of the world’s leading solar cell manufacturers.

TOO MUCH TOO SOON

Because cleantech contributes to transformational change, it can be prone to inspirational rhetoric and even, at times, a bubble mentality. No one currently knows which direction some cleantech investments will ultimately take but the last 10 years have provided some salutary examples of the perils of expecting too much too soon.

An obvious comparison is telecoms and internet in 1999, when online businesses were valued out of all proportion to revenues, infrastructure was ramped up and the mobile web hovered seductively on the horizon. Many investors lost money and only now, a decade on, are the promises of 1999 starting to become reality.

More recently, the cleantech arena has seen its own example of this. From 1990 to 2008, US ethanol production rose ten-fold, on the basis of the biofuel’s ability to supplement and – possibly – to replace fossil fuels. But the shine has worn off due to doubts about ethanol’s emissions performance, ethical concerns about land use, a fall in the price of petrol and rampant overcapacity.

Transformational technology doesn’t always deliver on early promise and, when it does, it may take longer than expected.

Tesla and SiC are just two points in a cleantech spectrum that offers a wealth of risk/reward opportunities. Each investor will make their own choice about where to sit and there is no right position or easy choice. At all points, technological and regulatory risks feature and the path to market can be long and hard.

DUE DILIGENCE

Of the many areas of due diligence, timing is a key consideration. An investment in a proven technology or service that has market traction and that offers quantifiable benefits provides more clarity on how new capital can create shareholder value. It pays to be sceptical about how quickly a new technology or service might transform a well-established market.

Analysing the dynamics that drive a market leads to much better decisions about where in the value chain to invest. A fast-growing segment that attracts plenty of capital may not be the best place to invest. In terms of products, while a technical advantage is always important, a commercial lead is a better competitive tool.

Select a market in which demand is based on a critical market needs rather than discretionary spending and a recurring service offering rather than a product offering. This leads to more secure contracts, more predictable cash flows, and less risky investment.

In cleantech it is hard totally to escape the positive or negative influence of regulations or subsidies, but 2nd or 3rd level exposure and geographic diversity provides some de-risking.

In terms of financial due diligence, proven financial performance, long-term contracts, recurring revenues and predictable cash flow underpin access to growth capital, be that equity or debt.

Most investors in today’s funds need some certainty that GPs can exit with a reasonable return in 2013/14. This inevitably means a single-minded focus on the basics.

Put simply, it’s time to be wary when valuations reflect speculation rather than income, and the rhetoric is only “this will change the world” without “this will also deliver solid financial results”. 

Iyad Omari is a partner at London-based Frog Capital