Drop in the bucket

Biofuels and solar power get all the attention. But if they’re looking for investments tied to a critical commodity and a long history of public market profits, cleantech VCs would have sound reason to consider the water business.

Over the past five years, a staid index of U.S. water utility stocks produced a return of more than triple that of the Nasdaq Composite. And with population growth, climate change and industrial pollution threatening to diminish global freshwater supplies, industry analysts expect rising demand for new technologies to provide potable water for drinking and irrigation.

Combine the long-term outlook with a summer of record-breaking droughts and a bevy of new cleantech funds, and you’d think there would be a deluge of H2O-related investments. But you’d be wrong: Water-related deals account for a comparative droplet of VC investments.

Low tide

Since last year, U.S. venture funds have invested in more than a dozen water technology-related startups, with a particular focus on purification and filtration (see table). Those companies have cumulatively raised close to $150 million, according to Thomson Financial (Publisher of VCJ). While that’s a significant sum, it’s a far cry from the $740 million VCs invested in biofuels last year, or the $590 million that went to solar deals.

“It’s remarkable there is not more activity in this sector to develop new technologies,” says Steven Parry, a partner at NGEN Partners in Santa Barbara, a venture firm that invests in materials science and clean technology startups. “You would think it would be otherwise with the shortages that are occurring in the developing world.”

For its part, NGEN “made a conscious decision” nearly four years ago to make water a significant part of the fund’s portfolio, Parry says. To date, the firm has made three investments in that area: Pionetics, which purifies water using electricity, EnviroTower, which develops water treatment technology for cooling towers, and Sensicore, which makes a sensor for monitoring water quality. In most cases, funding rounds were oversubscribed.

Part of the problem VCs confront is that water, like power, is principally a utility business, driven by century-old companies that are slow to innovate. Pricing models also make it difficult to implement water-conserving technologies. Because most U.S. consumers pay a fixed amount for their monthly water bill, there’s little financial incentive to cut back consumption, says Greg Sullivan, managing director at Chrysalix Energy, a cleantech venture firm based in Vancouver.

The outlook is changing as U.S. venture funds target investments toward developing countries, where shortages of potable water rank among nations’ most pressing concerns. Cleantech private equity fund XPV Capital lists water as its foremost area of interest, citing international aid agency data estimating that more than 1 billion people do not have direct access to fresh water.

In China, government officials forecast that $22 billion will have to be spent on wastewater treatment alone by 2015, according to XPV. In areas blighted by industrial pollution, including places in China, Parry says, water is so acidic that “not only is it hazardous to drink, it’s hazardous to touch.” Companies with advanced approaches to water decontamination, therefore, will find ready demand for their technologies.

Sullivan also sees U.S. municipalities’ largely hands-off approach to water consumption evolving to a more conservation-oriented mindset, particularly in drought-ridden Western states. Many districts already provide incentives for installing things like smart watering systems or low-flush toilets and low-spray showerheads. At the state level, California recently enacted a bill that will require smart meters to monitor landscape watering. VCs are also keen on funding more sophisticated water-saving technologies.

Make it easy

“We’re trying to look for solutions where it doesn’t require a significant behavioral change,” says Sullivan, pointing to portfolio investments like HydroPoint Data Systems. The Petaluma, Calif.-based company makes an irrigation system that uses satellite weather data to control how much water is dispensed, for example, on a residential lawn. Chrysalix also invested in Novazone, a Livermore, Calif. company that develops ozone based technology for disinfecting produce that consumes much less water than chlorine-based systems.

Heightened investor activity in the water industry follows years of outsized returns for public investors, says John Dickerson, CEO of Summit Global Management, which invests in public companies in the sector. Between 2001 and 2006, investments in water utility stocks generated average annual returns of 15.4%, according to Summit.

“Now, on the private equity side, water has become sort of the next big thing,” he says. “Managers are coming out of the woodwork.”

Players include TWF Management, which is operated by Terrapin Partners, the Pictet Global Water Fund, run by Pictet Asset Management in Geneva, and Aqua International, the water investment arm of Texas Pacific Group. New exchange-traded funds have also recently debuted, such as Claymore S&P Global Water (Ticker: CGW) and PowerShares Water Resources (Ticker: PHO).

The sector also appeals to globally-minded investors, as water filtration and purification business represents one of the rare sectors where goods are exported to developing countries. New products—such as the purification systems marketed by Pionetics—are commonly made mostly in developed countries like the United States and Canada and sold to China and other emerging markets.

“It’s one of these areas where we can affect the balance of trade in the opposite direction,” says Parry.

Low flow

To date, few venture capital firms have reaped returns from investments in water-related business, but that is largely a result of so few VC investments having been made. One exception is Basin Water, which went public on Nasdaq in May 2006. It had previously secured a $5 million bridge from Cross Atlantic Capital Partners of Radnor, Penn. At the time of the IPO, Cross Atlantic owned a 5% percent stake in Basin, which currently has a market cap of about $200 million.

There has been no shortage of acquisitions of non-VC-backed water technology companies. General Electric acquired Zenon Environmental, a publicly traded developer of membranes for water purification and wastewater treatment, for $656 million last year. In 2004, GE bought Ionics, another developer of filtration and wastewater treatment systems, for $1.1 billion.

Siemens Water Technologies, meanwhile, announced in January that it has taken over four U.S. companies: Envirotrol, CEC, Ultrapure Solutions and Sunlight Systems. The companies, which have total sales of $25 million, develop technologies for activated carbon water treatment, deionization, and disinfection.

Parry predicts more venture-backed companies will end up in acquirers hands over the next couple of years and that the exit pace will accelerate. “To date, venture exits in the water sector have not been that exciting,” he says. “We’re just at the early phases of what we think will be a big boom.”