VC funding
Image source: http://www.constructionexec.com/article/navigating-renewable-energy-project-agreements

This article has been written by Sugandha Nagriya, pursuing a  Diploma in M&A Institutional Finance and Investment laws (PE and VC transactions) from LawSIkho.

Introduction 

Investing in Renewable energy helps in powering a cleaner future. While fossil fuels will still be a massive source of power, the growth in renewables will still be impressive, and that impressive growth could be worthy of a portfolio position for VC investors. 

The scope of the renewable energy sector includes large-scale infrastructure projects as well as innovative technologies, which require huge investments at every stage. The most common source of financing for the early stage in renewable energy projects is the VC funds. Thus, in this article, we’ll look into whether venture capital is well-positioned in India for the rapid commercialization of renewable energy projects.

What is VC funding? 

Venture Capital funding is a type of investment that is done in start-ups, companies, and projects during their initial stage to help your venture grow. The people who make such investments are called Venture capitalists. They generally look for startups that are small but have huge potential to grow and their main work is to provide funds and guide to use those funds in the venture. 

VCs are more comfortable investing in less capital-intensive industries and focus on the early stage of the firm’s life cycle where the capital needs are comparatively smaller, to provide a lower overall investment in the firm, while still maintaining a significant share of the equity. They also “exit” their investment, either through a sale to existing companies in the field or through the public equity markets.

What are renewable energy projects?

Renewable energy is generated from sources that naturally replenish themselves and never run out, the most common sources are solar, wind, hydro, geothermal, and biomass. Over 80% of the total energy consumed by a human is derived from fossil fuel, however, renewables are the fastest-growing source of energy in the world. 

How is renewable energy created? 

The answer to this question is renewable energy projects. Renewable energy projects help to derive energy from these natural sources by setting up power plants. These power plants help to produce energy from natural sources for example India has the 5th largest wind power plant with a capacity of 3595 MW. Thus to produce renewable energy, power plants are installed under renewable energy projects. To set up the power plants, renewable energy projects require huge funds which are mainly administered through the Ministry of New and Renewable sources of energy (MNRE). The Indian Renewable Energy Development Agency (IREDA) comes under MNRE which works as a non-banking financial institution for providing loans for renewable energy projects. The government allows financial relaxations to renewable energy projects in the form of tax incentives. Soft loans are also available for renewable energy manufacturing enterprises. 

Distinguishing features of VC investments

We’ll start by describing the characteristics that venture capital firms have created that make them particularly suited to help fund renewable energy projects.

  1. A major distinction between venture capital (VC) and other forms of financing is that VC companies prefer to concentrate on high-risk investments. Furthermore, the risk is not overcome until the VCs have made substantial investments in the project, which ensures that large amounts of money will already be spent until the project fails. It’s worth mentioning that all of their investments had the potential to generate outstanding returns at the time of their initial investment.  Given the high risk of failure, VCs will not invest in ventures that do not have a chance of succeeding. They have no idea which of their investments will turn out to be winners and which will fail. As a result, a large number of investments in the portfolio is a significant aspect of the venture capitalists’ investment process, increasing the chances of a favorable “tail outcome” in the portfolio.

2. The skills needed to run a startup are very different from those needed to run a large company. The collection of skills and connections that VC investors bring to bear on their investments is thus a second significant feature of venture capital. VCs minimize the project’s operational risk by ensuring that it is progressing as planned and assisting in the removal of roadblocks related to the operational risk of the project and increase its chances of success. The governance provided by VC investors is thus an important feature of venture capital compared to other sources of finance. In fact, one of the most valuable assets of successful venture capitalists is their stable network of management expertise, which can be brought in to help an opportunity that is beyond the current management’s reach.

VC funding for renewable energy projects

According to Venture Intelligence Data. In the quarter ended March 2020, private equity-venture capital (PE-VC) companies spent $5.9 billion across 164 transactions, down 37% from $9.4 billion across 227 transactions in the same timeframe last year.

In the most recent quarter, 14 PE-VC investments worth $100 million or more were made, down from 20 in the same timeframe last year. The $567 million acquisition of power generation company Rattan India Power by Goldman Sachs and Varde Partners was the largest PE-VC investment revealed in the first quarter of 2020.

In the first quarter of 2020, $1.6 billion was spent across six transactions in the energy sector. Apart from the RattanIndia agreement, Singapore-based Temasek and Sweden-based EQT Group established O2 Power, a $500 million renewable energy platform focused on India. Actis’ $415 million purchase of solar energy assets from Acme Cleantech solutions was the third-largest energy transaction in the first quarter of 2020.

While VC investors in India seemed to have shrugged off the chilly winds emerging from the US (owing to the WeWork IPO fiasco and Uber stock price slide of late 2019), the Coronavirus contagion infected the ecosystem sharply starting mid-March,” remarked Arun Natarajan, founder of Venture Intelligence. “We can expect VC investors to be highly selective when it comes to making new investments in the months ahead and to be focused more on helping existing portfolio companies survive the downturn”, he added.

Despite growing interest in the field, the number of venture capital firms dedicated to renewable energy is still limited. Also in energy-related ventures, venture capitalists are increasingly focusing on part manufacturers rather than full-scale energy producers, the reasons which we will see in the section below. 

 

Problems faced by VCs

The following are the problems faced by VCs while investing in a renewable energy project. 

Financing

VC funds are not designed for financing projects: it’s more for building companies.  One of the most important aspects of energy production projects is that they are too risky. The risk for energy production companies lasts much longer than it does for other VC-backed companies. It also implies that risk capital is needed not only in the early stages of a company’s existence but also to demonstrate that the project is viable on a large scale. Demonstration and first commercial plants for energy production are very capital intensive and thus if the VC makes less investment to what is required it makes their portfolio much riskier. While many projects face the risk of not receiving enough early-stage capital to advance beyond the pre-commercial stage, energy production projects, in particular, face a massive funding gap between the demonstration and first commercial stages of the project. The funding gap which arises at the commercialization stage has been referred to as the “valley of death”.

Managerial skills

While much of the focus of investors has been on the challenges of financing, it is essential to mention that energy production ventures face more than just a capital gap. Large oil companies or utilities are often the sources of potential entrepreneurs with experience in the energy sector. Their experience is in leading big, well-established businesses that aren’t subject to much competition and have a lot of cash on hand. As a result, they make good CEOs when the startup or project is more developed, but they make poor entrepreneurs when cash is scarce and must be raised constantly, the business model is unclear, and decisions must be taken quickly with minimal knowledge.

Many with a background in VC-backed entrepreneurship, on the other hand, maybe good at operating small IT, biotech, or semiconductor startups, but they are ill-equipped to handle and expand energy production companies with various business models and challenges. Since VCs require entrepreneurs to play a central role in fundraising for the large amounts of money required for commercial due diligence of the project, in addition to managing large production facilities, international commodity pricing, and anticipating the changing government policies, the skill set required of such CEOs is in short supply.

Exit mechanism 

Most VCs face the risk that they may not be able to raise follow‐on funding or to achieve an exit, as they mostly do in other sectors. The reason for not achieving the exit is that most of the incumbent firms are unwilling to buy these projects at pre‐commercial stages, and thus, the time to exit for the typical project is much longer than the three to five-year timeline that VCs typically target (the time to build power plants and factories is much longer than a software sales cycle and can even take longer than the life of a VC fund). 

This causes venture capitalists to withdraw from sectors where they may have assisted with pre-commercial financing, and leave them with sectors where they are unsure if they will be able to finance the project through the first commercial plant, or whether they will be able to exit their investment at that stage.

Government policies

Policy changes and uncertainty are major factors hindering the potential investment by private sector players across the clean energy investment landscape. This is particularly true when the periodicity of the regulatory cycle is smaller than the investment cycle required for demonstrating commercial viability. In such an event, no one is willing to invest in the first commercial plant if they do not know what the regulatory environment is going to be by the time success has been demonstrated.  

Possible solutions to the problems 

  1. Finance

The majority of venture capital investors in clean energy projects do not have dedicated funds for this sector and may need to rely on much more syndication or predetermined partnerships among VCs to maintain the level of investment needed by this sector. The difficulty of raising this amount of money is based on the fact that energy development investments would necessitate longer-term funds so that VCs can nurture projects by commercial demonstration and thus avoid the valley of death. As a result, limited partners who invest in VC companies would have to commit greater amounts of money over longer periods of time.

Given the gap in human capital required to grow and run energy production projects in the short‐to‐medium term, VCs will need to spend significantly longer with individual portfolio companies to ensure that they continue to be successful.

2. Government support

  • The first area in which the government can make a major contribution is through policy interventions that are consistent, predictable, and long-term in nature and aimed at increasing demand for renewable energy. Thus, Eliminating policy uncertainty decreases policy risk and makes it easier for private capital markets to schedule their investments accordingly.
  • Second, the government can directly encourage M&A activity either through the regulatory system or through corporate incentives so that projects can get more advanced technology for the projects. The government should also provide incentives to existing businesses to be early adopters of emerging technology. This can effectively assist in bridging the “valley of death,” attracting more early-stage funding, and ensuring that a sufficient number of projects expand.

Finally, the government can create more public‐private partnership funds like in 2018, a municipal entity aggregates projects for third-party distributed PV developers via a public-private partnership and enables them to overcome barriers to accessing debt capital markets. These partnership funds can help them, either with first commercial diligence or as mechanisms that effectively compete with the incumbents. 

Conclusion

Venture capital has been the source behind the widespread innovation in India over the last several decades. But the COVID-19 pandemic has turned the economy upside down, and the renewable energy sector is no exception. It has led to delay in construction timetables, disruption to operations, reduction in orders, and damage to the investment climate. We may hope that the situation may become stable in the coming year, until then the Governments should revisit deadlines for renewable energy projects that face contractual obligations for near-term delivery and the Venture capitalists should invest in a partnership to help the renewable energy projects grow in this time of distress.  

References


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