Over the last months, the investment environment has been facing a rapidly changing landscape due to several factors that have been spreading doubts and uncertainty about what the future may hold.
The 11-year-long bull market (stock prices continually rising) seems to have come to an end. A flourishing macro-economic environment and a relatively smooth ride through COVID-19 driven by generous government stimuli are stalling.
This is evident in recent changes to key economic indicators, worrying both investors and consumers around the globe. The most evident effect has been the rising inflation, which recently hit a 40-year high. There is no single cause for this, but rather a mix of coincidental and historical events.
One aspect of this rise comes from supply chain issues being experienced on a global scale as a result of continued COVID-19 lockdowns and the war in Ukraine — having caused on top of a humanitarian crisis, a rise in prices of primary resources like wheat and oil.
These issues lead to supply facing restrictions, which in turn causes vendors to increase the prices of goods to remain profitable despite the higher price of resources.
The second effect, which is rather a consequence of inflation, is the various interest rate hikes that we’ve seen around the world (e.g. US, UK and Switzerland) over the last weeks. The European Central Bank (ECB) also recently raised interest rates for the first time in more than 11 years.*
These factors feed a vicious cycle that increases uncertainty about what could happen in the coming months and years. The landscape is constantly evolving, and no one fully knows which scenario(s) will come to life.
That said, there have already been visible effects on the investment landscape.
The rising cost of debt and higher uncertainty in the market have decreased investor appetite for higher-risk investments. This is evidenced by a steep drop in public stocks, with the S&P 500 down over 20% and the NASDAQ down 30% at the halfway point of this year.*
The public sentiment is steadily worsening, and many people think that a recession might hit the economy towards the end of the year.
What is the sentiment in the private markets?
Private markets have been growing and are well positioned to weather the storm
Despite the uncertainty that surrounds the majority of the macro-economic environment, there are reasons to believe that private markets, and more specifically private climate funds within the space, are well equipped to outperform public markets.
Historical returns show that, over the long term, Private Equity (PE), and more specifically Venture Capital (VC), has been able to consistently offer higher returns compared to public market returns.*
Figure 1. Vintage years’ internal rate of return of >100M $ funds Global VC (Preqin, 2022)
Looking even more closely, one can see how returns in PE are typically lower for funds that started in the years before a downturn or financial crisis (this can be observed in Figure 1, where returns are displayed by the year in which money was invested).
PE funds that started between 2004 and 2005 had an annual return of between 4-6%. Funds that started during the downturn performed quite well — VC funds beginning between 2007 and 2009 had a return of 10-15% or higher on average globally, despite the Great Recession hitting in those years.
Note: These returns are on average — top-performing VC funds have been shown to outperform these averages significantly.
The explanation for this: adverse conditions impacting the years when capital is invested have little impact on returns compared to the conditions of the year(s) when the funds divest (considering a holding period of 3-7 years, and hence vintages like 2004 and 2005 attempting to achieve exits during the crisis).
Note: A holding period is the amount of time the investment is held by an investor — the period between the purchase and sale.
Figure 2. Dry powder of the Global VC industry
A second reason to believe that private markets are in a good position in the current environment is the all-time high level of dry powder (capital that has been raised but not deployed yet) currently available within PE.
Due to this, fund managers are expected to continue to invest, leveraging the new economic environment as fertile ground for new investments.
Climate tech has been growing even faster
Within the Private Equity space, climate tech is one of the segments that has been gaining the most attention, thanks to:
Large corporates committing to net-zero by 2030 already
Governments consistently increasing investments into the space
More climate tech companies have proven business models, attracting even late-stage investors
Over the last few years the space has grown substantially (with 14% of VC investments currently going into climate tech)*, with investment volume reaching over $39.2B in 2021, and the number of climate tech unicorns steadily increasing (19 new ones just in 2021).*
Next to the size and positive trends taking place in climate tech, the kind of returns that climate tech investors achieved have started to outperform the broader private equity and venture capital market.
Figure 3. Returns of Climate Tech compared to generalist PE & VC
Similar to the PE/VC market as a whole, funds focused on climate tech also have extensive dry powder at their disposal ready to be deployed — a reason to believe that climate tech is well equipped to last through a potential “winter”.
The amount of dry powder currently available in climate tech currently stands at over $20B.*
This means that substantial capital has already been committed to be invested into climate tech, even though the benefits are not visible yet in terms of actual funding rounds. For climate tech, this is particularly beneficial, given that some breakthrough technologies and projects require more time and capital to develop than, for example, the average SaaS business.
But in what ways could the climate tech investment space be impacted?
How might climate tech be affected?
Despite the strong tailwinds for the space over the last decade, climate tech will likely not be immune to many of the factors that are hampering the overall private market space. Rising interest rates will play a particularly relevant role in its development.
The development, production and distribution of core infrastructure needs within the energy transition (e.g. solar and wind), new technological developments and industrial projects (e.g pilot plants) are all “capital intensive” — meaning they rely on large loans and investments.
In times of rising interest rates and uncertain outlooks, loans become expensive and less readily available, making it harder to build a positive business case for projects (i.e. factories) that require a lot of capital.
Additionally, the high inflation will lead to higher costs of resources, transportation and energy, adding more challenges for companies that have to make large investments.
The rapidly changing geopolitical environment could also potentially affect climate tech more than other sectors, given the effect a recession and rising energy prices have on elections in industrial countries.
Let’s look at the “green premium”, for example.
The “green premium” refers to the additional costs that consumers face when choosing a clean alternative over a product that is responsible for more greenhouse gas (GHG) emissions. The cost of this premium is often softened through government intervention — either introducing policies that make carbon-intensive alternatives expensive or through subsidies that allow greener options to be more cost competitive.
The geopolitical trend seems to be going two ways: in the short-term, we see increased investments in and activity of fossil fuel plants, while at the same time we see increased commitment to renewable power from governments.
The E.U. has set up joint European action for more affordable, secure and sustainable energy to make Europe independent from Russian fossil fuels well before 2030. This will include, amongst other actions, boosting energy efficiency, increasing renewables and electrification, and addressing infrastructure bottlenecks.*
The U.S. made a significant step forward in its commitment to tackling climate change with its Inflation Reduction Act. Within this legislation, there is a total of $369B available for climate and clean energy investments.*
There’s also been a continued willingness from investors, next to governments, to continue to invest in this space.
The current environment has led to fewer dollars but continued momentum in climate tech funding. In the first half of 2022, climate tech startups raised $18.6B. While this figure is 21% lower than the white-hot second half of 2021 (23B), it still outpaces H1’22 climate tech investments (16B). Plus, the number of deals is actually growing, with more climate companies receiving Seed and Series A funding than ever before in Q2 2022.*
Climate tech is (really) different from clean tech
When it comes to climate tech, some investors might mention that the sector already went through a downturn, and (partially) failed.
The predecessor of the current climate tech environment, then referred to as clean tech, was an industry mainly represented by energy companies, mostly active within the renewable energy space. Clean tech took off in the early 2000s.
After attracting considerable attention and capital, the 2008 Great Recession hit and forced everyone to face the harsh reality: most clean technologies were not able to survive yet without the help of subsidies.
The clean energy tech was just not cost competitive when compared to carbon-intensive resources such as oil. Plus, the fundamentals of the business model of many technologies did not have pure profits in sight, making it almost impossible for these companies to survive.
Since then, there have been major evolutions in the way climate tech functions and the kind of companies that operate in the space.
Figure 4. Industry focus and size of clean tech and climate tech
The investment volume flowing into the industry has increased exponentially (also considering that drop in funding following the peak in 2009-10). From a heavy focus on the renewable energy sector, many different sub-verticals have gained traction and are focusing on addressing the entire range of GHG emissions (Fig. 4).
Even more importantly, the degree to which technologies within the energy sector (but also overall) are cost competitive compared to GHG incumbents has changed dramatically. The price of solar and onshore wind energy has declined 89% and 70% respectively (Fig. 5), making renewable energy the cheapest form of energy available.*
Figure 5. Change in price of major energy sources (in $/MWh)
Together, these new attributes of the climate tech industry put the space in a much better position compared to the clean tech investment opportunity available during the last financial crisis.
Is now a good time to invest?
Risks but also opportunities
There is no certainty about what the outcome of the recent developments will be. How deep will a downturn be or how long it will continue to influence the space is not yet known, but we do understand how expert fund managers deploy capital wisely in a less favorable environment.
Especially during a downturn, top-performing PE/VC fund managers can carefully select good companies and promising technologies, which means that picking from the top quartile ensures relatively strong returns compared to other asset classes.
Other than being selective, it’s becoming increasingly evident how fund managers that are more active and better performing on the operational level are often the ones achieving better returns. This means that focusing on operational improvements and supporting portfolio companies will be even more important.
Lastly, given the increasing cost of capital, and generally less flourishing environment that investors will likely be facing during the next period, fund managers are likely to be focused on companies that are either profitable or at least have profitability in sight within their business plan.
The era of companies growing fast at all costs is likely to be put on hold for a while, and the preference seems to be moving toward the ones with sound business models.
What opportunities does this present to investors?
There are a handful of opportunities that investors will be presented with. Private markets offer an environment that is not dependent on or largely influenced by public sentiment, which represents a huge advantage when compared to the kind of volatility that public market investors face, especially during times of recession.
To fully leverage this opportunity, the importance of investing over the full market cycle to minimize risk has to be fully understood.
As highlighted in the first paragraph, returns are dependent on the economic conditions of the exit years, rather than the years over which the capital is committed (or vintages). As trying to time the market has been repeatedly shown to not be a wise investment strategy, investing continuously throughout the years allows diversification in terms of when your money is committed — hence balancing risks and opportunities.
Another opportunity for investors is the mix of dry powder and valuations cooling down. This combination is a good way for fund managers (and investors) to enter good companies at reasonable prices, which would have positive implications for returns and exits being made in a better-looking scenario.
This content is for informational purposes only. Carbon Equity does not provide investment advice. You should not construe any information or other material provided as legal, tax, investment, financial or other advice. If you are unsure about anything, you should seek financial advice from an authorized advisor. Past performance is not a reliable guide to future returns. Your capital is at riskA
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