Research Note: September 2011

The Cleantech World, according to European LPs

European LP Advisory Group Members Introduction

Richard Youngman Managing Director, Europe & Asia The Cleantech Group +44 (0) 20 7164 2197 richard.youngman@cleantech.com L. Warren Pimm Partner Sustainable Development Capital LLP +44 (0)20) 7478 8930 warren.pimm@sdcl-ib.com

The Cleantech Group, in collaboration with Sustainable Development Capital Ltd (SDCL), has established a European LP Advisory Group made up of many of Europes leading institutional investors within private equity and infrastructure markets. Earlier this year, the Advisory Group was brought together in Amsterdam to meet and discuss the key issues facing the cleantech and sustainability markets specifically within the venture capital, private equity and infrastructure sectors. This research note summarizes, on an anonymized basis, some of the insights discussed by the group. Executive Summary It was widely acknowledged by the Advisory Group members that the wider capital market volatility experienced over the past 18-24 months has created further reluctance by institutional investors in committing to longer-term investments. However, against the muted general appetite for longer term private equity and infrastructure focused investments, the sub-sectors within clean technology, clean energy, and sustainability remains of interest to most active investors. For many, the market continues to suffer from an image problem, exacerbated by weak lines of communication between GPs and investors. However, these considerations are improving, as reflected through the increased interest in, and understanding of, sustainability as a driver of long term investment returns and as a mitigatant of risk in long term private equity and infrastructure focused investments. Underlying fundamentals and macro drivers are growing in their intensity and the market continues to show positive signs of maturing, with several high-profile investment exits. Continued market development and expansion seems certain, with greater scope for communication exists between LPs and GPs supporting that growth.

Cleantech/sustainability investing still has an image problem

Capital flows in private equity generally have slowed over the past 18 months, driven by the denominator effect where the collapse of public markets and the price of liquid assets has reduced the value of the overall portfolios, leaving investors with large over-allocations in more resiliently valued alternatives. Following this challenging period, investors are also trending toward a more cautious and risk-averse strategy in the post crisis environment, resulting in continued investment in established sectors of the market such as standard buyouts.
Source: 3P Capital Advisors

However, there is still a wide dispersion of investor appetite. There is, in the eyes of one member of the European LP Working Group, insufficient appreciation of the extent of the growth in flows of investment and trade between the emerging markets, in which the developed markets, and most European and North American LPs, simply not in that flow. The result of which is that of the two base investment theses: i) low risk/low return; and ii) high risk/high return the latter tends to be ignored: Views on investment are very much framed and formed in the context of the low growth/low risk/low return mode of the West. Another member of the group pointed out that in emerging markets, sustainability is already integral to LPs and is not necessarily regarded as a separate investment class or discipline. Image The consensus of the LP group was that cleantech/sustainability continues to have an image problem. Still regarded by many as a niche area of investment, it is closely associated with climate change over the equally powerful driver of energy security. It also suffers with being viewed as highly politicized, unlike conventional sources of power, despite the fact that both oil and nuclear power receive a far greater proportion of tax benefits and subsidies in comparison to alternative energy.

Its the end of the beginning, not the beginning of the end...
Although it is evident that there is still work to do in enhancing both the image and profile of cleantech/sustainability, it is important to understand how much progress has already been made. This point was emphasized by LPs who had been active in the area the longest. There is a growing body of opinion, that cleantech and sustainability have now achieved more acceptance as part of mainstream investment programmes and will prove an essential element in strategic asset allocation going forward, with a new range of risks identified and mitigants applied to appropriately address them. Underlying fundamentals Whilst LPs may have reduced additional commitments to cleantech and sustainability in 2009-10 (in line with the rest of their PE portfolios), the macro factors driving the opportunities within the sectors certainly have continued to develop. Energy and resource security, twinned with high commodity prices from population expansion and urbanization show no signs of slowing. And the emphasis has now expanded to food and water supply issues as well. Due to the time-critical nature of the issues, the pressure on the requirement for investment is even greater. Consider what Jeremy Grantham of GMO had to say in his April 2011 newsletter: The prices of all important commodities except oil declined for 100 years until 2002, by an average of 70%. From 2002 until now, this entire decline was erased by a bigger price surge than occurred during World War II. Statistically, most commodities are now so far away from their former downward trend that it makes it very probable that the old trend has changed that there is in fact a Paradigm Shift perhaps the most important economic event since the Industrial Revolution.

Whilst institutionals may be sitting on the sidelines, corporates are not.

Market development Although LP investment in 2009-2010 was generally down relative to historical pace, GPs have been actively deploying capital. 2007-10, saw more than $30bn of investment in private cleantech companies, the largest investment area in venture capital. If innovation capital represents about 1-3 % of all cleantech and sustainability investment (as it typically does in other fields), then annual cleantech and sustainability investment across all asset classes, might be running in excess of $300bn, the Cleantech Group reasons. This estimate is supported by Bloomberg New Energy Finances estimation that in 2010 $243bn was invested in the narrower band of clean energy investment.

Corporate engagement Corporate entities have emerged as a vital source of investment in the market. Governments and institutional investors may be hesitant; however multi-national corporations cannot afford to be so. The macro drivers identified earlier require mitigation, with a key solution to this being through investment in cleantech and sustainability.

Source: Cleantech Group

Corporates are evident in direct venture deals, as well as investing in new and follow-on funds. The number of corporate investors active in cleantech venture deals has increased from 49 in 2007 to 85 in 2010. Corporate investors clearly view cleantech and sustainability as integral elements of future growth and expansion. Corporate executives recognize that this wave of change respects none of the large, existing industries and that the cleantech and sustainability part is the high growth part. For example, lighting exists but LED is the high growth area. Energy infrastructure exists however renewables and smart grid are the high growth themes. Similarly in Transportation, electrification has given the industry a new lease of life. Put this way, cleantech and sustainability are neither separate nor niche. In the past, deals which would have been financed through external debt are now being financed by large-scale corporates. For example Centrica, Siemens and Dong Energy, are using balance sheet capital and commercial debt in the UKs 270MW Lincolnshire offshore wind project. Market maturity Resilience in the face of challenging market conditions is evident through strong exit activity and continued momentum in fundraising efforts. 2010 saw $16bn of cleantech IPOs and $35bn of M&A representing an estimated 6-8% of the global total. 2011 to date has seen some large, high-profile transactions, such as Schneider-Telvent ($2bn), Total-SunPower ($1.4bn) and Toshiba-Landis+Gyr ($2.3bn), along with the smaller, but significant, BASF-Inge and ABB-Epyon deals.

At the same time as the market is maturing, it is also consolidating and rationalizing. Follow-on fundraising for poorly performing managers is proving challenging. The fading of weaker fund managers and companies will usher in a smaller, but arguably higher quality marketplace. With exit activity increasing and markets showing more maturity, private equity interest has been growing, with clear evidence of a number of non-venture funds looking to put larger amounts of capital to work. In 2010-2011, it was noticeable that venture backed companies Sic Processing and Agri.capital were both taken over by mid-market fund managers: Nordic Capital and Alinda Partners, with an investment remit of taking these companies to the next level of development. Institutional European investors in the popular mid-market buyout segment continue to increase their exposure to cleantech/sustainability investments. Governments investment in the market, especially in Europe and North America, will reduce considerably in the short-term, with disbursement of funding under government stimulus packages coming to an end. However, the effect may still be to come. We cannot be sure what these programs have seeded and stimulated yet; in the same way we never knew at the time of investment, the spin-off effects for technological innovation in civil society that would result from defence spending and space programs. As we call time on the end of the beginning phase, we can reasonably look back and summarize the key achievements in the development of the market as follows: larger numbers of established companies and proven, or semiproven, innovations in the global portfolio; greater corporate market engagement, providing validation, capital and scalability; greater level of market experience for the fund managers that survive the cull; some venture stage investments are now successfully being taken to the next level; the drivers and pricing pressures, underpinning this general cleantech/sustainability investment theme, are increasing in their intensity, if not in a straight line

The old world is not coming back. New strategies, new approaches, new processes are needed
Looking ahead It would appear that there can be a bright future for potential cleantech and sustainability investors, however further work is still required to adapt to the practicalities of investment in the theme. GPs point toward the rigidity of LPs investment strategies for the limited amount of capital they are able to deploy in different sectors. This is countered by the argument from LPs that they do not see
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enough distinctive investment strategies and that too much capital is already chasing insufficient deal-flow. This hints at a situation whereby GPs and LPs could usefully communicate more to mutual benefit. Some LPs have yet to reach a sufficient level of investment diversification whereby they have individual allocations to some of the underlying investment sub-themes. Areas for future discussion Some key questions were posed within the group, which were not addressed in the time available. They are recorded below for general interest and to solicit opinion. These included: Has the 2% and 20% management fee and carry hurdle model run its course? Do generalists with specific cleantech/sustainability sector exposures outperform investors with a pure play commitment to the theme, as one LP contended? What is the correct course of action? Is simply mitigating risk enough? (The recent Mercer report, Climate Change Scenarios implications for strategic asset allocation, argues not). So what new approaches and initiatives are needed?

Summary There is still room for private equity to do much more in these markets. In the first three quarters of 2011, capital flows continued into clean energy, environmental technologies, into key infrastructure sectors including water, waste, transportation, and also into real assets within the timberland and agriculture sectors. The world is a complicated one right now for private equity LPs: from choosing which developed or developing economies to focus on, to picking quality managers and finding the right strategies. The commitment to the asset class, however, remains firm and the opportunity for new and differentiated investment strategies wide open, as illustrated below in the final thoughts section.

Final thoughts - so what could, or should, institutional investors be doing?

Some specific perspectives from the LP group A last area of discussion developed around ideas and themes which the group believes could shape successful and distinctive investment strategies of the future. These were recorded, as follows: The increased collaboration and resultant investment and trade flows between developing, emerging economies, bypassing the older more industrialized world, must be acknowledged. We are out of the flow. Acknowledge the lion-share of current and future growth stage opportunities are in China. Their cheaper operating costs and increasing experience anchors the trend. There is an increased adoption of cleantech in Asia, not just China and India. Smaller countries with more stability are increasingly investable In Brazil, resources need to get to the ports and distribution centers on the coast, as well as to their final destination in more modern and sustainable ways. A transportation infrastructure investment opportunity results. Watch Japan - $1trillion to be invested in more sustainable infrastructure over the next 10 years Cleantech and Climate Change are viewed with skepticism. Either avoid the use of these terms in investment dialogue and focus on returns, or educate stakeholders. Corporates do not seem to be overly concerned by the definition. It is only investors that are getting hung up on it Focus on business models, management teams and the hard business fundamentals in place of technology and engineering. Look elsewhere for inspiration on how things could be done differently in the future e.g. the military. Think as much about resilience as efficiency. The Japan experience concentrates the mind on the need for diversification and decentralization to be secure. Acknowledge that partnerships are on the rise, which has implications for investors, and how and to whom economic rent derives.

Acknowledgements On behalf of the Cleantech Group and Sustainable Development Capital LLP, we wish to thank and acknowledge each of the attending European LP Advisory Group Members. The insights provided and reported on are collective insights, many of which will be built on in future discussions with the European LP Advisory Group going forward. European LP Advisory Group Members
Cleantech Group LLC Richard Youngman, Managing Director, Europe & Asia Sustainable Development Capital LLP Warren Pimm, Partner Adveq Management Dr. Rainer Ender, Managing Director Gaia Arnaboldi, Investment Manager, Real Assets AlpInvest Alison Klein Esselink, Investment Manager Capital Dynamics Rory Quinlan, Managing Director Caisse des Depots Patricia Jeanjean, Head of Alternatives Nadim El Khazen, Direction des Finances Citigroup Private Banking Kay Blackwell, Managing Director Consensus Business Group Wayne Keast, CEO New Energy and Environment Investments Credit Suisse Private Banking Sven-Christian Kindt, Director Private Banking & Private Equity Eliane Gentinetta, Director Credit Suisse CFIG Roger Ammoun, Director, Investments European Investment Fund Patric Gresko, Director Hermes GPE Magnus Goodlad, Investment Manager Investec Mark Henderson, Director Macquarie Funds Group Ingo Marten, Head of Cleantech Funds Pantheon Ventures Dushy Sivanithy, Investment Manager SAM Private Equity AG Roland Pfeuti, Head of Private Equity Keimpe Keuning, Director Siemens Asset Management Ralph Schnell, CEO, Siemens Venture Capital Transport for London Padmesh Shukla, Investment Manager Unigestion Paul Newsome, Executive Director, Head of Investments Private Equity Robert Collan, Director, Private Equity