Venture capital funds flow into cleantech small and medium-sized enterprises

Following the trend toward green technology, venture capital firms see “cleantech” SME start-ups as a good bet for a big return on their investments

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Peter Mitchell/London

Chemicals isn’t normally a sector you’d associate with risky start-ups, except for biotechnology. But the craze for so-called “cleantech” companies – those that develop environmentally friendly technologies of one type or another – has turned that on its head.

Not that the cleantech sector is as tightly defined as it might be. Like biotech, it consists of a battery of distinct segments, including solar, wind, and geothermal energy generation biofuels energy storage technologies – especially batteries based on new materials and new technologies for pollution abatement, recycling, clean coal, and water conservation. Even nuclear energy is sometimes included.

The sector has grown phenomenally in importance. While cleantech represented only 2% of total venture investment in 2004, by 2007, it had captured 7.4%. Venture capitalists pumped a total of $2.2bn (€3.5bn) into more than 200 US cleantech companies in 2007 – almost 50% up on the 2006 figure, according to statistics from the US National Venture Capital Association (NVCA).

In the same period, the number of VC firms investing in the clean technology sector more than doubled. The sector accounted for 97 start-up and early-stage venture-backed fundings, or about 25% of all the US’s VC investment in 2007.

In 2006, there were only 52 deals, representing 18% of total US investment. Almost entirely as a result of the cleantech boom, the industrial/energy sector has risen to become the fourth-largest destination for VC investments.

THE CURRENT HOT SECTORS

Most of the favored companies are in the advanced specialty chemical, material, energy and agriculture segments, with the bulk of the investment ($368m in 22 deals) going into the energy field. Next-generation biofuels and energy storage are now the vogue areas, with investors expecting to see a further boost from additional government funding and renewable energy policies, such as carbon taxes or emission trading.

Moreover, despite the US financial crisis, investment in the sector has persisted into the first quarter of 2008 – unlike the formerly favored biotech sector. According to statistics from US business information provider Dow Jones, companies in the cleantech sector secured 34 deals and more than $500m of US investment in the first quarter, which is comparable with the same quarter in 2007. As always, it depends how you count it, and how you define cleantech. The NVCA’s figures say that US investment in the sector went up by 50% from the previous year’s first quarter. In fact, the sector bagged four of the 10 largest deals during the first quarter of 2008, including the first quarter’s biggest financing of $130m.

This was against a credit crunch background, in which general VC investing fell by 7%. And there was an even sharper tumble in biopharmaceutical funding, formerly the darling of technology VC firms. US investing in that sector slumped by 60% in the first quarter, with only 59 financings worth a total of $771m compared with the $1.89bn in the same period last year.

Nor is the cleantech investment boom just a US-centered phenomenon. According to consultancy Deloitte Touche Tohmatsu, European countries are emerging as leaders in clean technology, with the UK and Germany in particular rapidly gaining investor support.

In Deloitte’s survey of nearly 400 venture capitalists worldwide, 43% of respondents regarded Germany as having the most cleantech expertise, just behind the US. Germany’s position is probably due to its government’s long-term policy of support for alternative energy technologies, combined with its strong technology base. This has helped it become a leader in photovoltaic technology. Japan and Brazil are also catching up, says Deloitte.

John Cheesmond, managing director of private equity investors SBV Chemlife in Basel, Switzerland, confirms this. “VC investing in chemicals, including cleantech, is just as active in Europe as in the US,” he says.

BYE BYE BIOTECH?

So it looks as if there has been a change of sentiment in the VC community, with cleantech taking over from biotech as the goose that everyone hopes will lay golden eggs – the “latest hot idea,” as Kate Bingham, managing partner of London-based venture capital fund SV Life Sciences Advisers calls it.

But is it a bubble? “Lots of money has been tossed into the sector, especially in the US. Our investors think it’s gone way over the top,” says Bingham. It’s not so much a mimic of the biotech phenomenon of the late 1990s, but as a new and potentially dangerous repeat of the dot-com bubble, she warns. “Just look at the amount of funds that these companies are raising on the back of minimal track records,” she says. “There is such a resemblance to the dot-com boom that it has to be a worry.”

This also means exits for cleantech investors are not going to be as easy as they used to be for biotechs. Given the cycle of investing in cleantech, significant exit activity through initial public offerings (IPOs) should start in 2009 and accelerate throughout 2010, according to global consultancy PricewaterhouseCoopers. But so far, VC-backed cleantech exits have been limited, with only five IPOs listed on the US-based NASDAQ index since 2005, raising an average of $77m.

This isn’t going to get easier any time soon either, with the current nervousness in the financial markets. In January, the US-based VC-backed biodiesel producer Imperium Renewables had to shelve a $345m IPO. Market conditions doubtless played a part, but another significant factor contributing to the wariness of the public markets is that the cleantech sector is very much a newcomer with no track record of producing returns.

Cheesmond believes that, though biotech will continue to dominate VC investing in the chemical sector, cleantech will soon establish itself. At the moment, though, government intervention has muddied the waters so much it’s impossible for investors to assess cleantech companies’ chances accurately, he says.

“A lot of the available information on environmental investments has been obscured by government subsidies and grants,” he says. “Several companies in the biofuels sector tell me that without the government subsidies, they couldn’t continue, and that is extremely difficult to take into account when making investment decisions.”

Moreover, he says, the dramatic movements in raw material prices has dented investors’ confidence. “If chemical companies can’t pass on the raw material price increases, it makes the predictability of their cash flows much more difficult,” he says. This saps the enthusiasm of both private equity companies and of the public markets to finance the sector – which in turn makes VC investors wary about putting up the seed capital, not knowing how long it will be before they get their exit. The likely outcome is that VC investment will shift to later stage companies, as VCs have to sustain their companies longer than they expected. That will create a shortage of financing for fledgling firms. “It is going to get very difficult to raise capital on the VC early-stage side,” Cheesmond predicts.

VC EYES ASIA

However, Cheesmond points to China and India as the sites of growing chemical VC investment, not only in cleantech but in smaller entrepreneurial activities such as biocides. Here, the driving force for investors is the ability of these countries to undercut the European companies’ established products, because production costs are lower.

Cheesmond is not the only one with faith in India. The Cleantech Group, a US-based organization of cleantech investors and companies with more than $3 trillion of assets, recently announced the formation of an Indian investment arm. Vinod Khosla, founder of US-based Khosla Ventures, which has financed several cleantech firms, will chair the enterprise. Khosla says VC and private equity investment in Indian cleantech companies increased by nearly 60% from 2006 to 2007, with $190m invested in the fourth quarter of 2007 alone – a 171% jump on the same quarter a year earlier.

Cleantech Group chairman Nicholas Parker says the Indian cleantech market and investment opportunities are “primed for substantial growth, especially within the clean energy and water sectors.”

Times may be getting difficult in Europe and the US, but as always, the West’s problems are Asia’s opportunities.

For the macroeconomic view, see our Chemicals & the Economy Blog