It’s been a banner year for energy transition-focused fundraising, but the financing gap for the energy transition still sits in the trillions of dollars. However, private markets have a lot of work to do before they’re able to step up to the plate and fill that gap.
For instance, much of this funding gap exists between asset classes – the “missing middle” of the energy transition, according to The Missing Middle: Capital Imbalances in the Energy Transition, a report released in September by S2G Ventures.
According to the report, the US and Europe saw $270 billion in energy transition-focused private capital raised between 2017 and 2022. That is a record high, with nearly $120 billion being focused in early and mid-stage venture capital, $55 billion in late-stage venture and growth equity, and $100 billion in infrastructure and private equity.
The report’s analysis found that there is too much capital in the earlier-stage venture space and there is a meaningful deficit of capital available in the in the growth-equity space, with the infrastructure/low-risk private equity stage being balanced – though one of the report’s authors disputes this interpretation.
“A more prospective interpretation of that would be to say that there actually isn’t adequate infrastructure capital available, because if we de-bottleneck the growth stage, we unlock more demand for the subsequent infrastructure stage,” explained Frank O’Sullivan, a managing director at S2G Ventures and the former director of research for the MIT Energy Initiative.
It’s tempting to say that the solution is to ramp up the amount of capital available to growth-stage companies – and fast. But that is easier said than done. When it comes to fundraising, GPs seeking institutional investments are often forced to scale back their mandates to fit within the allocation buckets that LPs oftentimes legally must abide by.
While some more established GPs like KKR have been getting creative with their climate mandates, hoping to educate LPs to think outside of their typical “silos”, it remains to be seen how successful they can be. And ultimately, there is an upper limit to how many GPs can play that game without LPs restructuring their allocation system altogether.
But even if the flexibility mindset is dealt with at an LP-level, there are other, more common private-market issues to consider, such as valuations. Over the years, surges in institutional demand for renewable energy exposure have played their part in pushing up prices. Sellers, of course, are also incentivised to raise the value of their asset to the greatest extent possible at the time of exit, to boost returns. All of that has translated into chunky EBITDA multiples being paid in certain sectors. Whether or not these high prices will result in diminished returns – or write-downs – now that the macro winds have changed remains to be seen.
In any other market, that would be the worst consequence investors could face for overpaying. But when it comes to the energy transition, it’s not just LPs’ portfolios that are on the line. Every dollar raised for the transition counts, and money spent unwisely in one place could be used to further good projects with real impact. Worse: bad deals can have a chilling effect on investment in a sector that can ill-afford it.
Equity has a big role to play in the energy transition – it’s up to GPs and LPs alike to ensure that investment mandates are flexible and valuations are as diligent as they can be in this most crucial of sectors.