The Curious Case of Water Innovation
Water is unlike any other investment
Water does not play by the usual rules — it simply does not behave like any other resource or any other commodity. Not oil, not carbon. Water is unique.
Water is not priced in the global marketplace. When water is priced locally, it is priced irrationally with locations in dire water stress often pricing lower than locations with water abundance. Water is necessary to survive. Yet too much water can cause catastrophic damage.
And like water, investing in water technology does not follow conventional rules.
2015 — An Extraordinary Year for Water
For those of us who pay attention to water, 2015 was an extraordinary year. Much was done to move water and water stewardship to the fore of the public consciousness. The California drought occupied headlines for most of the year only to be eclipsed by the Flint lead crisis in November and December. Then water had a central role in the Paris climate change talks.
Organizations like CDP, Ceres and The Alliance for Water Stewardship made enormous strides toward integrating water risk management into the lexicon of business decision making. CDP queried 1,073 of the world’s largest publicly traded companies about their water risks. A record 405 companies responded.
Throughout the year, the CFA Institute published information and held webinars about their new research paper “Environmental Markets: A New Asset Class”. The paper contains an excellent overview of the broad set of opportunities in water and water infrastructure.
Because of these efforts, asset owners are now pushing their asset managers to account for water, water risk and water sustainability, and those managers are in turn demanding that companies disclose water risk in their own operations and in their supply chain.
The tragic case of Flint has highlighted the massive need for investment in our country’s water infrastructure. Writing in the Nov/Dec 2015 issue of the CFA Institute Magazine, Sherree DeCovny cites estimates from the American Water Works Association that $1 trillion will be needed to rehabilitate US water infrastructure in the next 25 years. DeCovny suggests that there will be significant opportunities for asset owners in the muni markets in the coming decades because of these infrastructure demands.
In November, The Water Technical Working Group released proposed eligibility criteria for Water Climate Bonds. The Climate Bonds Standards Board is expected to finalize the Standard in 2016.
If you accept the argument that capital follows opportunity, you might think that funding for water tech companies, and especially start-ups, must be in good shape. The space should meet the criteria VCs look for in markets:
- Large Total Addressable Market
- Growing markets
- Opportunities to expand into international markets.
Well, maybe not
For all of the movement focusing on engaging institutional investors and asset owners in solving water issues, there is a shocking lack of angel/venture capital in the water technology.
To put the size of the water tech community in perspective, it may be helpful to look at the broader startup ecosystem. 500 Startups is completing its 15th cohort and has invested in over 1500 companies. Founded in 2006, Techstars has invested in 762 companies and deployed $2.04 billion to those companies. YCombinator deployed $12.8 million to its Summer 2015 class alone!
According to Mattermark, almost $60 billion in venture capital was deployed in 2015, with the average A round coming in at $10.4 million. The Cleantech Group tracked 430 clean tech deals in 2015 totaling slightly over $2.0 billion.
According to data from PitchBook, there were 39 water start-up/early stage VC deals in 2015 totaling a mere $44.17 million in deal flow. Here is the breakdown:
- Accelerator / Incubator — 12 deals
- Angel — 15 deals
- Seed — 3 deals
- Early Stage VC — 9 deals
That’s only 2.2% of the clean tech funding market and 0.07% of the broader startup market.
Does Funding = Innovation
Many investors, technologists and researchers believe that the amount of funding in an industry is a proxy for the amount of innovation in that industry. When you consider the lack of funding in water tech, you might assume there is no innovation in the industry. But you would be wrong. There is considerable innovation in water.
I am lucky enough to be in position to see a significant innovation emerging in water tech. I can assure you there are hundreds of fundable companies in the water tech space.
If venture will not fund innovation in water technology, who will?
What about Corporate Venture?
Dow, SUEZ Environnement NA, GE, Virgin, Unilever and Danaher all have corporate venturing funds. But, for a start-up to be an attractive investment by one of these large corporate venture groups, the technology and the market must be de-risked. Very few of these corporate venture teams will look at a Seed or A round.
If past behavior of corporate investors is any indicator of future behavior, it is safe to assume that corporate venture units will only bet on execution risk — which means they can help bring a technology to scale, but they will not play in early stage deals. This leaves early innovators without funding.
Veolia is one company that seems to be trying to break the mold. While Veolia does not have a corporate venture team, their open innovation team is active in many clean tech accelerators in the US, like GreenTown Labs. Veolia has recently launched a corporate accelerator with The Water Council. Because of this, Veolia is positioning itself to see very early stage technology and potentially bring it into their portfolio.
Can the Feds solve the problem?
While many are quick to cry that “the government shouldn’t pick winners and losers”, I am unaware of any other investor that has, since the early 1980s, actively participated in early stage markets to the extent the Federal government has. The 11 Federal Agencies that participate in the Small Business Innovation Research (SBIR) program have collectively deployed over $40 billion to early stage companies.
Few investors will take on technology risk that the SBIR program does. SBIR program is specifically designed remove technology risk in emerging companies. We should embrace this and build upon it.
In the President’s Budget for FY 2017, $88 Million is allocated to the National Science Fdn for funding basic research on water technology. Assuming the budget is passed and further assuming that 25% of the allocation is assigned to the SBIR program and that $17.6 million was allocated in $225,000 chunks (max SBIR Phase I amount), 78 companies could be funded. This would make the National Science Foundation the largest investor in the water space. In fact, their investment alone would double the number of companies funded.
What about Impact Investors?
There was significant excitement 2015 about the IRS guidance on Mission Related Investments, Program Related Investments and subsequent DOL guidance on the permissibility of endowments and pension plans investing in alignment with their missions. The guidance should, in theory, allow foundations and pension plans to put the corpus of their assets to work alongside their grant making activities. Many had hoped that this would unleash a wave of new money.
Shortly after the ruling, the Kresge Foundation announced a shift of $350 million to their impact investment portfolio.
The McKnight Foundation took a bold stance on aligning their $200 million impact investment portfolio to focus on climate initiatives. McKnight appears to be taking a hybrid approach by making both direct investments and placing assets in public markets.
Sarah Kearney and her colleagues at the PRIME Coalition offer an interesting solution for carbon sensitive investors. PRIME Coalition calls itself an aligned intermediary — a two-sided marketplace, connecting philanthropists that want solutions for climate change on one side to promising companies and projects on the other. In November, The White House announced that letters of intent to commit in excess of $1 billion had been signed between 4 institutional asset owners and PRIME. PRIME must now source $1 billion of private company deal flow. While that much deal flow may not be an issue in the energy/carbon space, it clearly is in water.
Unfortunately though, few asset owners have the resources to do direct deals and fewer yet have the capacity to monitor a portfolio of the hundreds of investments that would be necessary to deploy these sums of capital in seed deals. Most asset owners have minimum check sizes in place and most peg that number around $10 million.
While the rulings by the IRS and DOL are major shifts, the investment community still does not have the infrastructure in place to increase the amount of capital going to early stage impact technologies.
Is Water Technology even an Impact Investment?
Beyond the mechanics of breaking up large pools of funds into digestible chunks, there is the nagging question of whether water technology even is an impact investment? I recently hosted an investor conference at North America’s largest water technology trade show. One of the conference panelists is the head of a major US bank’s impact investing program. He said to me on several occasions, “I don’t get why I’m here.” Even inside the impact investing industry, there is reluctance to see water technology as an impact investment.
The Global Impact Investing Network (GIIN) defines impact investing as “Investments made into companies, organizations, and funds with the intention to generate social and environmental impact alongside a financial return.” Given that definition how could water technology not be impactful?
So, who is going to own this?
The World Economic Forum recognized water risk as a growing global problem. Water ranks as the 9th most likely global crisis in 2016 on the WEF Global Risk Report — and the 3rd most impactful if it occurs.
27% of respondents to the CDP Water Report indicated that water risk had manifest itself as a detrimental impact to their business in 2015.
Water is a very big deal — both economically and socially. It won’t take much to radically alter the water technology investment universe. There was only $44 million deployed in the sector in 2015, compared to the $60 billion deployed to broader venture markets. Only 39 start-ups received funding last year.
Sim Simeonov’s presentation on “Patterns of Successful Angel Investing” argues that the closer a portfolio has to 100 investments, the higher the probability of outsized returns.
My hypothesis is that if we can deploy $25 million and construct a portfolio of 100 water tech companies we both change the water tech industry and produce venture comparable returns.
That’s a win for everyone. The industry can deploy new technologies to deal with aging infrastructure, to keep our drinking water safe and clean, to enhance our agricultural production and to provide clean water for industrial use.
If venture-like returns can be produced, the asset class will become attractive to venture. If venture deploys capital, more companies can be funded. If more companies are funded, more positive technology can be brought to the market.
It’s a virtuous cycle.
But, it is going to take someone with a checkbook who is willing to be first. Will it be you?