Sustainable Finance – the trigger for change across capital markets:
Conscious investing is on the rise. And conscious action is always propelled by two forces:
- The draw or pull of something desirable
- The push to act created by a level of pain
This simple analogy holds true for our investment decisions, be it for individuals or those running multi-billion dollar asset portfolios.
The New Normal
Without a doubt, 2020 will be a year of huge change for the global investment community. A looming global depression combined with the consequences of climate change will force investors to look at their responsibilities in enabling micro and macro economies, as well as the ongoing impact of their capital in a sustained and dedicated manner.
Change will be powered by a combination of these basic push/pull forces. On the one side, a desire to truly affect change and derive ‘new/alternative’ forms of alpha. On the other, the need to act or fear alienating clients and co-investors as well as face regulatory scrutiny for not doing enough or worse, causing harm.
EU’s Green Deal
The regulatory clarity provided by the EU Parliament’s adoption of taxonomy regulation on 18th June, to promote a ‘Green Deal’ to boost private sector investment in sustainable projects, is significant as it enacts both push/pull drivers.
This breakthrough will allow for a ‘common’ language on how sustainable projects are classified. Regulation naturally implies enforceable criteria. But this legislation aims to encourage capital flow by providing much needed clarity on how capital can be allocated and how it needs to evolve to best service the planet and people while enhancing performance (and profit).
Private Market’s Role in Sustainable Investing
Private market investments (private equity and venture capital (VC)) have always had a key role in providing much needed funding for growth and emerging businesses.
In theory, VC should be the most ‘impactful’ capital available. The reasons are simple. VC:
- Invests in young emerging businesses where the intent is for returns to outweigh risk.
- Increases economic productivity by using underutilised resources and – capital. Applying this to untested business ideas can increase productivity, employment and returns.
- Offers better choice: Innovation to meet the needs of society more effectively, and more affordably drives greater wellbeing and improvement to lives.
- Improves market resilience: A lack of competition can cause markets to become lazy and uncompetitive. Greater market diversity also reduces risk, by ensuring there is no single point of failure when macro factors change.
Venture Capital’s Failed Promises
From the outset, it is important to say these observations are a blend of my own learnings from working in ‘venture’ for the last decade – either building ventures, advising corporate ventures or working with co-investors; and they are common themes across the global VC industry.
For the most part, success has been associated with financial performance but the value of impact is much broader.
Venture structures offer tight economic models where the rules of the game focus on scoring home runs. The entire portfolio return is what matters vs the performance of individual investee companies. This is an accepted and reinforced model for investors into VC funds (aka, Limited Partners or LPs) where annual fees are tight and allow for limited capacity to serve portfolio companies. VCs are incentivised to drive for the ‘unicorn’ or a 10x revenue multiple of an investee company within the portfolio and bias resources to those with a greater probability of success.
In addition VCs are herd investors. They tend to always co-invest forming predictable cohorts. This can often create confirmation bias. Piling into the same companies often creates a concentration of investment and actually increases the risk for LPs.
Many argue the VC industry lacks discipline, by seeking disruption and market share dominance without a clear path to profitability. VC-fueled startups aren’t held to the same standards as existing publicly traded competitors. These businesses must answer to investors worried about cash flows and operating earnings every three months.
This becomes a very unhelpful self-perpetuating cycle. A lack of liquidity options for investors in VC structures means LPs place high expectations for return on their investment allocation. The incentive for the VC is to reach its hurdle target. How that is achieved is through a ‘black-box’ and cannot be tampered with.
Investee companies, so often desperate for investment, trade high stakes in their businesses with no guarantees of broader support unless they are at top of the pile in financial return potential. Over capitalization is as much a disservice and under investment for an investee company. There are many examples of the woes of over-valued companies – think We Works, Theranos, Uber, BOX and lately the UK’s Monzo having to ensure a downround, raising only half of its anticipated investment requirement.
Venture Capital reimagined
Sustainable venture capital (SVC) is what we at Redsand Ventures are aiming to play a part in shaping and executing against.
Long-term investing has never been more important than today. The capital needed to transition key transformative industries – transportation, health, real estate, education – and infuse that with new markets players – needs to resist easy solutions. Rather, a thesis needs to factor in time, money and knowledge capital to bring incremental value to the investee company.
Just as with other forms of impact investing, VC needs to create greater optionality for founder and funder by adopting a knowledge network and patient capital framework which:
- Incentivises funder (LP) and founder with the same structure: Investability needs to take a long-term view. Investors need to do this with capital allocation, and view repeatable investments vs a focus on the earliest possible exit.
- Supplements technical understanding: a deep understanding of the issues and structures underpinning any societal and environment challenges an investee project is set to solve.
- Fosters relationships and commitment: forge deep, long-term relationships with the people and organisations they are invested in.
- Optimises financial return: weighing the returns (both financial and impact), relatively high risk and illiquidity as all key considerations of a longer or blended return cycle for investors.
The models to achieve this are all available. Combining liquidity optionality can be derived through applying a combination of equity ‘products’ over a time period to serve the lifecycle needs of investee companies but, at the same time, provide investors choice through more liquidity events.
The schema below plots the likely lifecycle of an investee by stage of maturity and the kinds of layered optionality as it matures to limit dilution but still incentivize investors. The combination of equity and debt applied to the life of a single investee company provides an investor optionality at various stages of investee growth:
Without restricting this analysis to a debate on the most suitable ticket size, this model will only succeed if a venture investor has the ability to flex its terms to layer debt and equity with complimentary mechanisms such as warrants capable of incentivizing both founder and funder. Time is a lever in the mix. The incentive is to ‘stick’ with the investee company so an investor and its LPs can enjoy variability in return from the same portfolio company.
And the determinant of longevity for an investee company is knowledge capital/network. Or as many like to say – ‘smart capital’.
In summary, SVC is nothing esoteric. The mechanisms for return are all standard. What’s important is how these investment approaches are combined over time. And how the venture capitalist retains the investee company beyond an equity round.
For LPs, this approach can offer greater overall return, but much more transparency and flexibility.
The ask is that LPs adjust their risk/return over time expectations so it can be the catalyst for venture capital to prove its sustainability.
If this change comes from ‘the top’, SVC will come into its own.