By Chris Groobey

Venture capital investments in the energy sector are on a dramatic upswing.

Independent analysts recorded energy-related investments of $218 million in 1999 and $450 million in 2000, and they project that more than $1 billion will flow into energy-related technologies by the end of 2001. This amounted to just 0.47% of the $46 billion in total venture investments in 1999 and 0.52% of the $87 billion in venture capital investments in 2000, but 2.5% of total venture capital investment of $40 billion projected for this year.

Early and seed-stage investors — who, by definition, are always looking for the “new new thing”— are banking that deregulation, increased energy costs and uncertain fuel supplies will create expanding markets for everything from customer relationship management, or “CRM,” software to energy management systems to new power generation and energy storage technologies. Upheaval in the $300 billion US utility industry will, these investors hope, generate opportunities and financial returns that will offset fading opportunities in the information technology and life sciences areas.

Investing in the energy sector — especially at the seed and early stages — will require a different skill set than most information technology-focused venture firms have currently. To profit from deregulation, investors must first understand the existing regulatory environment and then predict what will happen as it is dismantled. They must evaluate new power generation technologies against existing — and still formidable — technologies and with an experienced eye toward the future pricing and availability of fuels. For these and other reasons, energy venture investing is not dominated by Kleiner Perkins, New Enterprise Associates and the other household names of the new economy, but rather by a relatively small number of established and new partnerships led by energy veterans and often backed by larger energy firms.

The Venture Capitalists

One example of these newly prominent venture capital firms is Kinetic Ventures, which is currently raising a $100+ million fund, its eighth, to invest in e-commerce, customer service and communications technologies useful to utilities competing in the new, deregulated environment. Kinetic has invested more than $290 million from its previous seven funds over the past 15 years, with the majority of the funds’ limited partners being domestic and international utility companies.

Todd Klein, managing director of Kinetic Ventures, believes that his firm’s unique value proposition comes from the principals’ utility-industry experience, the firm’s utility investor base and — perhaps most important — the firm’s semiannual gatherings of investors and portfolio companies, which have resulted in joint ventures, sales opportunities and direct equity investments. Kinetic summarizes this strategy as “maximizing investor relationships to provide unprecedented access to the utility industry.”

Klein reports that Kinetic’s deal flow is at an all-time high. He believes this is the result of three key trends: 1) entrepreneurs adapting existing software and technologies to the relatively untapped energy market, 2) a resurgence in fuel cell, powerline carrier and superconductivity research and development and 3) an increasing focus among the utility companies on the value of customer relationships and the need to draw ever-increasing revenue from relatively mature markets. Kinetic’s investments include APX (an internet exchange for the buying and selling of electricity), Peace Software (customer care and billing systems) and SmartSynch (wireless-enabled metering).

Toucan Capital is another, younger venture capital firm founded in 1998 by power-industry veterans Robert Hemphill — a former executive vice president and current board member of The AES Corporation — and Linda Powers — a former senior vice president for global finance of Enron Corporation. Toucan is currently investing its second, $120 million fund in life sciences and information technology companies.

According to Hemphill, Toucan is especially interested in small-scale fuel cells and energy storage technologies, primarily for portable and vehicular applications. Toucan has declined to invest in other, large-scale generation technologies, partly due to an aversion to business plans that rely on significant capital expenditures or government subsidies to survive and also because, as Hemphill puts it, “nothing beats the GE Frame 7 turbine. It presents a very high barrier to entry” for new generation technologies due to its high efficiency and low cost of operation.

Other energy-oriented venture capital firms include Nth Power Technologies ($200 million under management, 20 portfolio companies), EnerTech Capital Partners ($285 million, 18 companies), Prospect Street Ventures ($216 million, 30 companies), GFI Energy Ventures ($454 million, 30 companies) and Altira Group ($100 million, 10 companies). Later-stage investors include prominent private equity firms Thayer Capital Partners, The Carlyle Group and JPMorgan Partners, each of which manages more than $1 billion. Finally, many large energy firms are making direct strategic investments in promising companies, including Cinergy, Exelon, PG&E and Enron.

Investment Philosophy

Venture capital firms typically expect that between one and four of every 10 investments will achieve a “liquidity event,” be it an acquisition or an IPO. Therefore, to be worth investing in, a new technology must be capable of capturing a reasonable share of a large market and present a plausible exit strategy. In the utility sector, most investors are focusing on technologies that make energy more reliable and efficient — which translates into increased earnings from the same revenue — or that give one company a competitive edge over another in the fight for the most profitable customers — which translates into revenues at the expense of one’s competitors.

AES Intricity is one of the new breed of energy companies that believes proprietary, unique technologies will help it to acquire customers. According to Rob Morgan, AES Intricity’s general manager, direct investment in new energy technologies by established energy companies has often followed — and suffered from — the pattern of “if you build it, they will come.” Products were built first, marketed second — often at great expense — but actually sold to customers and used last, if at all. Morgan argues that the smarter path is to build products based on specific needs of existing customers, then market them beyond the initial group of users.

AES put this philosophy into practice through its July 1999 acquisition of New Energy Ventures — now called AES New Energy — and the subsequent spin-off of a new company called AES Intricity. AES Intricity includes the information technology support, billing and back-office groups of AES New Energy and the people and technology of Energy Tracking Inc. and OhmTech Labs, which AES acquired in December 2000.

AES purchased Energy Tracking Inc. and OhmTech, and those companies’ technologies relating to the measurement of energy consumption and analysis of customer consumption patterns, in response to customer demands for real-time, internet-capable metering devices. In opting for the “buy” side of the build-versus-buy decision, AES purchased an already-mature product line that has since been rolled out to customers in 11 states, far faster than if AES had developed the technology itself.

The bottom line, according to Morgan, is that deregulation is offering customers choices for energy that correspond to actual consumption patterns, not statistical load profiles. With its newly acquired technology, AES Intricity is able to provide to its customers information that allows them to monitor usage across their own facilities, and then to compare that usage to usage by other companies in the same industry. AES believes that customers using this technology will be able to lower their costs and better manage their processes.

Conclusion

Venture capitalists and established companies alike hope that the energy sector will experience the same growth and create as much wealth as did the telecom sector in the first years following its deregulation. The venture capital community is currently holding approximately $40 billion in uncommitted funds. A significant portion of these funds, and of the billions in funds yet to be raised, will be invested in energy-related technologies. The challenge will be for the players in the now-hot energy sector to avoid the losses and business failures that have recently befallen the telecom sector.