The US-India Joint Clean Energy Research and Development Centre has recently announced a U.S.D. 100 million fund for funding private and public sector “cleantech” research. The fund will advance amounts to U.S. and Indian joint research groups in the bio-fuels, energy efficiency, and solar energy sectors.
After the Silicon Valley bonanza, “cleantech” was touted to be the next big thing for venture capital (“VC”). The reality has been different. The market has seen significant private equity in the larger power groups, but early stage equity funding (before the commercial operation date of a project) has been relatively rare. The trend has been to invest in holding companies or developer groups (and not projects). In India, VC and private equity funds invested USD 816 million in thirty-two green firms in 2010-2011 (compared to USD 828 million in thirty-two firms in 2009-2010). Whilst this seems like a large number, it is actually a drop in the ocean compared to VC funding across the world. Further, two to three investments made up around ninety per cent of the deal value (including Blackstone’s USD 290 million investment in Moser Baer, which is already an established company with diversified business and a strong balance sheet).
Even the greater availability of funds, because of the several funds focused on clean energy that have been set up, and which are themselves funded by a variety of multilateral and development funds, has done little to change this scenario.
Venture capital funding is essentially high-risk funding which is provided at the early stages of a company. VCs identify companies that are usually developing an innovative technology or have a unique business plan, and make investments that have potential for explosive growth, at a point where the valuation is extremely low. The expectation is that they would receive high returns when the company succeeds. VCs also typically require bankruptcy and valuation protection and typically look at promoter-backed exit options.
Reasons for the lack of VC funding
One of the major reasons that VC funding for “cleantech” has not been as prevalent in India as it has been in some of the other countries is the fact that in India, most of the renewable development is focused of generation, rather than development of innovative technology. VC generally looks for something in excess of a successful project. They look at organisations that can yield high returns. Generation is capital intensive and therefore developers look for long-term power purchase agreements (“PPAs”) to offset their project risk. Further, it is extremely difficult to sell renewable power on a merchant basis or private basis and PPAs are usually the only source of income. Unfortunately the tariff receivable under the PPAs are regulated (that is, they require the approval of the electricity regulator who, while ensuring a fair return for the generator, needs to ensure that consumers are not overburdened) and IRR returns get pegged in the nine to ten per cent category, which is not enough incentive for private funds (accustomed as they are to IRRs in excess of twenty per cent).
The competitive bidding regime (under the Jawaharlal Nehru National Solar Mission, (“the JNSSM”)) is another major deterrent. In has increased the uncertainty in relation to the price that a developer will be able to obtain and developers have been forced to intentionally quote lower prices to be able to qualify for the JNNSM. It does not help that there is no certainty that the project will be able to find a purchaser to buy power at all.
The third important factor has been the lack of project finance and expensive domestic debt. VCs look for business plans that provide for adequate levels of debt availability to scale up the operations of the developer. Given the uncertainty of project debt in India and the consequent insistence on promoter guarantees and similar support, VCs sometimes end up having to take more risks.
VCs also look at well-defined exit options (either by way of put options or through a public listing of the company) so that they are able to exit the investee company with a certain guaranteed return. In India, the feasibility and enforceability of these options have been under some doubt. Project lenders are also uncomfortable with a promoter entity receiving a return on investment (or exiting) prior to the debt being repaid.
Sophisticated entrepreneur-led firms, which can convince early-stage investors, have also been relatively rare. VCs have reportedly found it extremely difficult to source investments where they are comfortable with the promoters. Many funds suffered from excesses in 2008-2009 when investments were made in high-risk at exorbitant valuations. Investors lost money in these deals and are understandably more careful now.
An uncertain regulatory regime, with respect to land allotment and allocation procedures in particular, and inconsistency in the implementation of electricity law policies, coupled with the very Indian indifference to regulatory requirements have been issues that VCs have found difficult to reconcile themselves with.
Finally, most of the activity in India has concentrated on the generation of electricity. There is relatively less work being done in some of the other areas where VCs are active, for example, energy efficiency projects, sustainable buildings, and lighting systems.
I have written previously (here and here) about the fact that the Government is determined to push renewable energy and a consequence of this is the fact that the regulatory regime (which was once notoriously unreliable) is becoming increasingly favourable for renewable energy (including, for example, the introduction of the renewable energy certificates trading mechanism). Further the focus is also diversifying with emphasis not only on generation, but also on other aspects such as development of indigenous technology, and rural electrification.
Changes in the foreign investment law have made it easier to raise capital and ensure exit for early stage and VC funders. For some time, there was a structural problem with compulsorily convertible preference shares (CCPS), (which is the preferred investment instrument for VC and private equity funds). India’s foreign direct investment regulations (“FDI Regulations”) required that parties were required to specify the conversion price up-front. There has been a welcome amendment to this in the recent Press Note 1 of 2011, which now requires that only the formula for conversion (and not the definitive price) needs to be specified up-front. Further, the minimum pricing norms apply on the date of the issue and therefore allow the investor to participate in the upside. This makes it much easier for VCs to determine returns and ensure exits.
Another welcome development is the Securities and Exchange Board of India (“SEBI”) allowing the listing of small and medium enterprises (“SMEs”) either through a separate exchange or a separate platform. Companies with net-worth in the region of ten crore rupees, who would have found it impossible to consider an Initial Public Offer, can now look to access public markets to raise funds.
There is a growing interest in research and development and an increasing portfolio of companies are looking at innovations in technology and business models, particularly the vast potential that is represented by India’s massive, untapped rural sector (the potential market for off-grid rural level solar is estimated to be in excess of USD 2.11 billion per year). Key objectives for these companies are the rationalising of costs and the development of products that will work in India, rather than imposing western technological solutions. The JNSSM requirement that companies should use panels made in India would also boost these enterprises. Clearly, VCs, if they can reconcile themselves to some of the compromises that are inevitable in doing business in India, will play a larger and larger role in the growth of the rural sector.
[Published in mylaw.net, May 23, 2011]