Tuesday, December 06, 2005

HBS Cyberposium reactions, venture capital, clean energy, and clean water

Based on all of the reporting that's come out of the HBS Cyberposium (see the column here and one reaction here), it's caught some attention. It appears to have been a very good conference with a lot of thoughtful discussion. Despite not having been able to attend (an impending family arrival keeps me local right now), the discussion definitely deserves some reactions.

"In the future, I see a median rate of return of zero or less"

"We're in the lottery business"

Is venture capital really nothing better than playing the lottery? Taken out of context, that quote would imply that there is no skill involved. And it also implies another potential point of view about the traditional venture investing areas -- that they may be over-invested, so that the expected return to an average investor has been capitalized down to zero (which would clearly be even worse than other investment classes), as Professor Sahlman postulated. Under that kind of scenario, and in a "hits-driven" industry, the idea would be to simply place your bets in the right market, and hope for the unlikely best.

Venture capital and other forms of private equity are all about imperfect information. If the public equities markets are "perfect" markets, where close-to-perfect information means that all assets are predominantly fairly priced (as some argue), then private equity is the opposite: It is supposed to be the opportunity to get into areas that are less-understood, with less liquidity, so that superior knowledge matched with some patience and targeted assistance can yield strong returns. There's still a lot of risk and volatility involved, of course. But the returns shouldn't be zero. In fact, it should be the opposite -- given the riskiness of the investment class, even under a "it's nothing more than a dartboard" mindset venture capital should still outperform public equities overall, since LPs will need higher returns on average over time to compensate for higher risk. Even compensating for the fact that Professor Sahlman's statement was carefully about median and not mean returns (leaving open the possibility that a few "star performers" could float overall industry returns while the predominant body of investors achieve around zero returns), his statement should have been seen as unrealistically pessimistic versus other investment classes.

So for investors to seriously think that venture capital returns will be zero at the median, and not skill-driven, is a scary thought -- it means that on average it is probably WORSE than throwing darts. How could that be true, unless investors are consistently and knowingly over-investing in certain areas, hoping to get lucky. Just like the lottery, it wouldn't make economic sense unless you are an incredibly risk-seeking investor.

I would argue that most venture capital investors would disagree with the idea that venture investing is nothing more than a lottery with an expected return of zero. Many VCs are experts in their specific areas of investment, and even those who aren't subject-matter experts are often terrific at pattern-recognition and have other valuable experience to draw upon. There's a lot of skill involved in figuring out which fledgling companies and technologies have a strong chance for dramatic growth, and which seem like too much of a risk compared with the opportunity and price. Furthermore, VCs can improve the odds of their bets by being value-add investors, taking an active supporting role with their portfolio companies, providing key business contacts and access to top external resources, and leaning on their previous experience and connections. Backing the right horse, based upon such skill and intentions, shouldn't be a complete crap-shoot. It should be a very educated guess for an investor with strong knowledge and experience in a carefully-chosen space (or at least unique access to such knowledge and experience), and it shouldn't be a passive action. But the fact that such pessimistic sentiments are nevertheless being taken seriously, and even agreed with, suggests that smart venture investors should be looking more into the areas where the main body of investors aren't looking.

Which of course is where the next quotes of note come in:

"Clean energy is big on the west coast... Venture capitalists haven't traditionally invested in [healthcare, education and the environment], but given the amount of money that's in the business, somebody is going to try, and somebody will be right."

"Those spaces [healthcare, education and the environment] don't fit the venture profile for timeframe and liquidity. They require a ten year, $100M investment. With that said, the profile around energy, particularly solar, is starting to look more standardized."

Clearly, clean energy is being seen in these quotes as an area that is seeing increased liquidity and shorter investment timeframes, and an area where investors are increasingly turning. It would appear that such investors would agree with the analysis above which suggested turning to relatively underinvested areas.

It's no coincidence as well that solar is particularly highlighted in the above quote, since that's the clean energy investment area that's been getting the most attention lately from non-specialized investors, as the spate of recent major fundings shows. Ironically, in an effort to move in new directions, a lot of mainstream VCs seem to be commonly looking for deals in solar right now... Thus, other clean energy investment areas are undoubtedly going to gain the attention of such investors next, as they gain comfort in the industry and move deeper into the space to try to stay ahead of the curve.

Those who regularly visit this site, of course, know that the opportunities for attractive returns in "standard" liquidity timeframes already stretch far beyond simply investing in solar, and further into other clean technologies besides clean energy.

Will water be next?

I had the pleasure of participating on a local Wall Street Transcripts panel on water investing last week, along with Ira Ehrenpreis of Technology Partners, Warren Weiss of Foundation Capital, Marty Lagod of Firelake Capital, and Rod Parsley of The Water Fund and Terrapin Partners, a pretty impressive group. All are actively investing in private equity opportunities in water (the first three plus my own firm focused on venture-stage investments).

There was a lot of optimism about the water space as an emerging area for venture investment.
  • Large markets with a lot of unmet needs (billions more dollars need to be spent on upgrading water distribution infrastructure in the U.S. alone),
  • Significant opportunities for the application of successful technologies from more mature investment areas (sensors, telecommunications, distributed computing), and
  • Large acquisitive players to provide liquidity and strong exit potential.

Some significant obstacles remain, however. The panelists cited such challenges as:
  • Capital-intensive, often more applicable to project financing than venture capital
  • Not all unmet needs will be met via proprietary technological solutions, in fact much of the expected multi-billion dollar investments in water infrastructure over the next decade-plus will be in non-technology spending
  • There aren't enough proven entrepreneurs entering the space (although there are definitely some), more backable management teams are needed
  • Slow-adopting customers for technology means a long sales cycle and slow market penetration rates
  • Water remains a low-priced commodity where pricing is not very clear to the end user
Nevertheless, as one panelist noted, the venture investors on the panel probably represented a significant portion of all active investors in the space, suggesting that the space is not getting a lot of attention. As noted, there are significant challenges to investors looking to get into the water space. But given the magnitude of the opportunity, and the increasing innovation and increased entrepreneurial attention in the space, it probably deserves more venture investor attention. As I noted on the panel, water is a critical resource, just as critical if not more critical than energy, with significant shortages and resource constraints looming. There's an important role for innovation in solving these challenges, and larger industry providers and technology incumbents are increasingly reaching out to venture investors to help them identify and cultivate such innovation. Energy may be an increasingly hot area for venture investors... But water may be next.


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