The Green ETF
“Greed is Green” - Gordon Gekko, probably
As cryptocurrencies and NFTs continue to multiply, everyone is looking for the next great wealth-creation opportunity. One of the core beliefs at Coral Carbon is that climate tech, done with scientific rigor and operational excellence, is that opportunity. We believe this is possible both on the small scale for individuals working in the sector, but also on the largest possible stage of institutional finance.
Background
The S&P 500, the returns of which are generally considered the standard of excellence for money management, generated an annualized average return of 7.3% for its shareholders, adjusted for inflation, over the last 30 years. 7.3% is low - really, really low.
The current global GDP was approximately $80tn at the end of 2022 per the IMF. One Bloomberg analysis of the potential market capitalization of nuclear fusion technology, which we’ve examined in our last few posts, suggests an aggregate valuation of $40tn over the next few decades. There is clearly an opportunity in climate and green technology. However there are two key obstacles to driving adoption of green investing as a marketing-beating, available-to-all strategy:
Correct apportioning of risk
Evaluating climate businesses is hard and, well, the task of money managers is to… manage money. Few even in professional cohorts have the hard science background or knowledge to pick winners, so meeting the needs of hedge fund managers serving university endowments will be almost impossible from a risk-management perspective. We need to enable investors to own small slices of many businesses instead of betting the farm on a large segment.
Market liquidity
EFTs and Mutual Funds purchase fractional ownership in businesses in the hope of amortizing returns across a portfolio of bets. This process is vastly simplified through focus on publicly-traded businesses (i.e. the companies that are already winners). There are thousands of EFTs and Mutual Funds out there made up of thousands of different equities. In contrast, there are less than a dozen equities traded on major stock exchanges that describe themselves as climate-focused, with the majority of these having occurred via SPAC in the past three years. It’s therefore impossible for even a scaled ETF provider to optimize a new fund based on the climate sector.
Existing Solutions?...
Has anyone tried to create a climate ETF?
Yes! The world’s preeminent operators of indices, Vanguard, Fidelity, iShares, and Schwabs, all offer ESG funds. The issue is these funds are complete shit. We can all agree that the purpose of these funds is to invest in companies that either lower the rate of temperature damage or remove carbon from the atmosphere. The top equities in Vanguard’s US Stock ESG Fun are: Apple, Microsoft, Amazon, and two classes of Alphabet shares. These are great companies from the shareholder perspective, but deeply complex in lowering global temperature. ESG has, to date, been a marketing ploy more than a global change-management strategy, with providers focused on avoiding the allocation of capital to the worst offenders (think oil and tobacco companies) rather than effecting positive change.
Our Solution
What does the better way look like?
Going back to the two obstacles (apportioning risk and market liquidity), we need a two part capital stack to leverage retail investment in the fight against climate change.
Micro-Private Equity
While the lack of industry liquidity in climate tech presents an issue for traditional institutional capital, it represents an opportunity for the next generation of finance entrepreneurs. We see a wave of PE funds between $5-25m AUM, with specific vertical focuses seeking 3-5x return in 5 years. We recommend seeking investment from operator and scientist LPs who can provide value-add advisory services and occasionally take on full-time operational roles. While these amounts are too small to attract interest from traditional fun LPs, twenty accomplished professionals investing $250k each creates a viable mini-fund that can distribute bets widely enough to be confident in returns.
Climate companies have historically run leaner headcounts than their traditional tech peers by 30-50%, per an analysis of Pitchbook data on the 25 highest funded climate companies. With this in mind, a $10m micro-fund can likely lead up to 20 seed rounds (assuming $250k checks), with the balance of the funds reserved for follow-on investments into 5-10 later identified winners. We recommend further segmenting investments by category; climate-focused SaaS (ex. Pachama), IoT (ex. Stormsensor), existing tech decarbonization (ex. Droneseed), and moonshots (ex. Helion, Zap Energy). The first two categories can be evaluated using existing and well understood metrics and generate traditional returns, the third will require strong operational understanding of supply chains, unit economics, and process engineering at scale determine early performance, and the fourth category will generate outperformance if carefully selected based on scientific expertise and business rigor.
Climate is everyone’s problem, and we anticipate and encourage networked cooperations between the micro-PE funds. Aligned geographic and/or vertical focuses prevent competitive issues between providers which allows for sharing playbooks, creating network effects among portfolio company executives, and pooling funds for follow-on investments; this can significantly accelerate the time to market for winning companies.
Green ETF
At twenty investments per five year fund, we see an opportunity for a true Green ETF once a critical mass of 50 successful PE firms is obtained. Success here would be each PE firm is on at least their second fund and have demonstrated 3-5x returns on their first fund. The implied AUM of our micro-PE funds is $500m. This provides an investment opportunity for up to 1000 seed rounds with follow-on funds for the winners.
While early stage financing is a business of outliers, exceptions, and creative thinking, we don’t believe that the nascent sector of climate PE will be attractive to institutional capital absent a track record of success. For those funds that survive and beat the first fund performance metrics, we see the ETF provider simply doubling their fund sizes, by matching the amount of capital committed by the initial operator-LP base. Climate investment continues to have an image and perception issue, and providing assurance of skin in the game will be a necessary reassurance.
With the additional capital the micro-PE funds can fund additional seed rounds and inject more capital with follow-on investments. This not only diversifies and mitigates risk for these institutional investments, but it also creates more opportunities for climate tech companies to join the Apple, Microsoft, and Amazon of the world as publicly traded companies.
Creating the Green ETF at least 15-20 years away. However, we are hopeful up-in-coming finance entrepreneurs act quickly to bring together operator and scientist LPs to start this process. As always Coral Carbon would be excited to connect with allocators to help them identify the next set of climate changing companies.