While my wife was shivering in Chicago, I was enjoying a nice sushi lunch in LA, speaking with Jim McDermott, managing director of US Renewables Group and Rusheen Capital.
Jim began his alternative energy investment business in 2003 after he had taken Stamps.com public (an idea from a business school project…), raising a $100 million fund, sponsored by a single, large West Coast investor.
Rather than trying to craft a literary masterpiece, I’ll simply relate my take-aways from my conversation with Jim. I hope you find these meeting notes interesting and informative about how a professional Private Equity and Venture Capital investor thinks about risk control.
How did you survive during the CleanTech blow-up in the late aughts?
Most VC and PE funds keep some cash in reserve, let’s say 1.75 : 1.00. We were lucky in our second fund that we had reserved much more cash – on the order of 3.0-4.0 : 1.0. We had our share of blow-outs, but because we had the extra cash, we were able to soldier through.
Also, we have had a few investments that worked out very quickly, so that helped us on the liquidity side and investor relations side as well.
[N.B. In option terms, this is exactly how one would reduce the leverage of an otherwise high-leverage investment like an OTM call option. By keeping plenty of excess cash, Jim’s investment company was essentially lowering the leverage of their investment substantially. I just did a mini-course about Leverage where we discuss this dynamic]
Why did so many of the smart VC funds have such trouble with Clean Tech?
A lot had to do with the model that they were using and the fact that they were accustomed to investing in software companies. The model for a software company is to go really fast, release a product, and try to create a network effect / market share advantage that you can monetize later.
But software is different from energy infrastructure in a few really important ways. First, it is capital intensive, and the Silicon Valley teams were not used to capital intensive firms. Second, they completely underestimated the importance of regulatory issues and made mistakes on that side as well.
What did you do well?
We, on the other hand, started slow. We talked first to entrepreneurs and if they had good ideas, we started calling around to large oil companies to talk to them about what the entrepreneur was planning and to see if the oil companies would be interested in that and if not, what similar offering would be interesting to them. After we got a firm sign of interest from a big, conservative company like Exxon, we started talking to the regulators – especially to the regulators in California. We explained the idea to them and tried to see how they might view that from a regulatory standpoint. We sometimes had to work to convince them that the particular projects we were working on should be granted some special regulatory or tax status.
Once we were sure that we were headed in the right direction on the regulatory side, we hired good engineering firms to start working on the technical details and generating detailed cost estimates.
At each stage in the process we invested a little capital, but we gated our investment. If a company couldn’t make it through a certain gate, we would just walk away from it. I have $80 million invested in one of my companies, but half of that was allocated just within the last year (after the company had brought on some big, influential industry partners).
Because of this gating, even for investments that I’ve been in for a long time – 11 years, for instance – my weighted average investing period is only about 4 years.
When the founder of Carbon Engineering and I started talking, I told him that there was no way I could invest in him at that stage, but that he should find a billionaire to invest in him. He found two! (Bill Gates and Murray Edwards). After he was up and running, we walked slowly through each of these gates, making sure that we had a good handle on the cash flows.
When I joined the board, the first thing I told them was that they had to produce fuel with the Air-to-Fuel technology. It was okay if they only produced one milk carton of it, but they had to produce some fuel that could actually be put into an engine that would run something.
What is the environment like right now?
I am getting so many ideas crossing my desk that I can hardly keep up with them. These are not only Carbon-to-Value (i.e., sequestering CO2 and turning it into a product like jet fuel or concrete or whatever) plays but all sorts of deals that involve clever ways to conserve resources, purify water, and the like.
My guess is that the California wildfires last year really started to wake people up; that and other disasters that are occurring more and more often now. I’ve got friend with whom I went to business school who bought $10 million mansions in Florida that are completely uninsurable now. Sure, they could sell them for $3 million to somebody, but those assets are essentially stranded now.
My guess is that there will be some catalyst, not necessarily a huge disaster, but some change in attitude, and all of a sudden, people are going to start asking “Does anybody make a machine that pulls CO2 out of the air?” At that point, I’m just going to stand up with my flag and become a billionaire overnight because we’ll (Carbon Engineering) will be one of the only companies in that field.
I’ve seen this over and over again and that is how I have made all of my money. I can see something is going to happen clearly, but I just can’t see when. If I can stay invested in it long enough, I get this beautiful convexity of returns – that’s what happened with Stamps.com. Of course STMP crashed with all the other Internet 1.0 companies, but it is a real business and is now again worth about $6 billion.
At the end of our conversation, Jim asked me about my fund idea…
I explained to him that I had realized that the kind of leverage layering that I had been thinking and writing about for a long time and working on putting into practice in the public markets had a real parallel to Climate Change investing.
The leverage layering assumes that we create a single investment structure using instruments with varying leverage. Layering unlevered stock positions with unlevered short put positions with moderately levered ITM call positions with highly levered OTM call positions with zero-leverage cash positions.
With human response to climate change, I realized there really was only one asset – human civilization and industrial production – and that one could look at companies at different stages in their commercialization from the standpoint of leverage.
Public companies that hold dormant assets (I brought up German LED manufacturer Osram) that were commercializing what I call Evolutionary Applications, could be held to increase investor liquidity and decrease downside risk. Eventually the dormant assets would come into demand and we would own a call option that no one had recognized or valued properly before. Those positions could be held in relatively high concentrations (e.g., three firms might make up 40% of the portfolio weight).
Small cap and private companies that hold emergent assets (I brought up vertical farms) using what I call Novel Adaptation technologies, would represent a moderately levered portion of the portfolio and would not be as highly concentrated (e.g., seven firms might make up 40% of the portfolio).
Companies with nascent assets, attempting to commercialize what I call Revolutionary Development technologies (this is what Jim likes) would be held in relatively smaller position sizes so would be relatively less concentrated (e.g., five firms and cash might make up 20% of the portfolio).
I also told him that I was looking to set up an operating company – for instance a vertical farming franchise – in a tax-advantaged geographical area and overcapitalize it so that the excess capital could be invested as a fund. (This idea relates to the Opportunity Zones that were established in the 2017 tax Act.). Doing this, we might be able to offer huge tax advantages to investors – capital gains generated from OZ businesses are tax-advantaged – and also align our incentives with the investors.
Jim’s comments…
- “This idea of combining public and private investments is really interesting and is something I’d never thought about. I want to talk it over with a few people I know and ask them what they think, but it seems like a really good idea.”
- “You should look at whether you could set up the operating company as an MLP (Master Limited Partnership) or as a BDC (Business Development Company) so that you could have a legal structure in which you could combine ongoing (i.e., public) and discrete (i.e., project / private) investments int0 a single firm. Essentially, you would become a listed venture fund.”
- “To sell this idea, you should probably just pull together a model portfolio so investors can see what their risk at each leverage level is. If you can show investors that out of a $100 million fund, that only $20 million is going to be spent on moonshots and that $40 million is going into a couple listed firms they can trade on Charles Schwab if they have to, they’ll probably be a lot more willing to consider the idea.”