This year’s New York Climate Week (NYCW) was way over-subscribed.
First of all, that’s amazing to see. No matter what’s going on with the economy, the election, geopolitical tensions, etc., the amount of interest in climate opportunities among investors, entrepreneurs and policymakers is unstoppable.
Secondly, from here forward the NYCW folks really need to find another week to hold their events other than the same week of the UN General Assembly — hotels were really hard to come by. And simply getting around Manhattan was difficult at times given all the security measures.
But third and more importantly, the “missing middle” was very obviously on display as one of the most talked-about topics at many of the events. However, despite its wide application at NYCW, the term was being used in different ways by different people, confusingly so.
Speaking generally, what everyone is recognizing is that there is a capital gap, the “missing middle”, between technology and business model innovation stages (mostly venture capital funded) in climate solutions, and when mainstream infrastructure capital (with its billions upon billions in dry powder) is willing to step into rolling out those solutions at scale. Way too often over the past two decades, promising solutions have “graduated” from the venture capital stage, only to languish without scaling up after that. Venture capital investors focus on getting to the first of something. Mainstream infrastructure investors, on the other hand, want to be the first to fund the tenth of something.
CREO, a large community of family offices and affiliated investors, recently put out a report covering this topic.
There are basically three aspects of this same missing middle. One is simply growth equity. The CREO report shows that there has been a dearth of such corporate investments at this stage over the past few years. Some of this may be a result of underwhelming performance among those growth equity investors who have ventured into this sector. There are a number of potential reasons for this underperformance — one explanation that I personally favor is that “growth” investors in climate have historically been pulled into earlier stage opportunities and more capital intensity than they would typically want to see, with predictably underwhelming results.
One reason I am actually optimistic about this being the reason for this aspect of the capital gap is that I see relatively newer efforts at firms like Activate Capital and their peers with very sector-experienced investment teams who are walking into growth stages now eyes wide open. If that historical underperformance is the main reason for the current capital gap in growth stage investments, to see smart people with battle scars now stepping in is actually encouraging.
Another version of this missing middle is “First-Of-A-Kind” project capital. Every innovation needs its first fully-commercial-scale implementation. Some of these are small enough to be done by the startup itself on balance sheet. But some of these are necessarily huge and expensive (for just one such example, think about the size of a hypothetical sustainable aviation fuel refinery). These “FOAKs” are not a good fit for even the most adventuresome infrastructure investors. At least as a standalone project investment. The first implementation of any new idea quite often takes more time and money than expected to build and optimize. And yet at the same time, there’s only so much financial return that can be expected off of any such project. So the risks quite often outweigh the rewards for project finance investors, at least when looking in a focused way on just that single FOAK project as an investment opportunity. And yet (again, depending upon how big they are) they’re also often too big to be wisely invested into via venture capital.
This, at NYCW and in a lot of other conversations right now, is increasingly a widely-recognized problem. Behind the scenes we are seeing some investors trying to build new strategies specifically to target FOAKs. Over the past decade-plus, we’ve also seen some successful efforts to bring in the necessary capital and expertise to build a FOAK via a corporate partnership or joint venture. And there are a couple of philanthropic efforts like Breakthrough Energy Catalyst that are doing some limited but still valuable work on FOAKs. Nevertheless, it remains an unresolved challenge. My personal belief is that if the FOAK is small enough it should be done on balance sheet by a startup, and if it’s too big then it should still be done by someone who is bringing not only the off balance sheet project capital, but also has a significant stake in the startup itself. Because a FOAK is more valuable strategically than as a standalone project investment, always.
The third and least recognized version of the missing middle is what happens after the FOAK. Because any FOAK will be a unique snowflake. It may work, but it probably (because of inevitable cost and time overruns, as noted above) looks unattractive in retrospect as a financial investment. Heck, it may well be held together with duct tape, bailing wire and chewing gum. It proved an important point — this solution can be built, and works. But it’s not usually the kind of easily replicable, obviously financially attractive project that mainstream infrastructure is already excited to put hundreds of millions of dollars of investment into replicating.
This “projects 2 to 10” problem is just as much an obstacle as the FOAK, and it’s as much about a talent and cultural shift for the startup as it is a capital gap. The startup team that has been told by venture capitalists “move fast and break things!” suddenly has to build something that absolutely DOES NOT BREAK. The lingo is different, the disciplines are different, the attitude is different, the needed skillsets are different, and the capital structures are different. (Full disclosure: this is, of course, the version of the missing middle that my own firm focuses on solving)
So for investors, it’s important to realize that this “missing middle” everyone is suddenly talking about has these different versions and aspects. It’s not sufficient to solve just one. Ideally, we see more smart growth equity investors enter the space, while we see innovative FOAK financing structures that work, while we see more firms like mine focusing on what happens after that (but before mainstream infrastructure finally steps in). We need more of all three solutions.
I feel more encouraged than ever after this year’s NYCW that a lot of people now recognize this issue and are working on it. So that’s good. But for the broader investor universe, whenever you see news coverage of a promising new climate innovation or startup, you need to ask yourself:
“How will this innovation actually get funded to get to scale, even after it’s shown to work?”
Because what we’ve all learned by now is that because of financial structure challenges, and risk/reward limitations, and simply knowledge gaps, just building a better “climate solution mousetrap” won’t mean the world will actually beat a path to your door.
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