Feature – The Utilities Economy: The Next Big Thing –

Venture capitalists are starting to seize opportunities in technology and services companies in the utilities sector as the government breaks down its traditionally monopolistic walls and opens the industry up to competition.

While many firms make opportunistic investments in the utilities space, three firms usually come to mind when energy deals are mentioned: EnerTech Capital Partners L.P., Nth Power Technologies Inc. and Kinetic Ventures.

“We’re seeing today probably close to 15 to 20 transactions a week,” says David Lincoln, a managing director at the Wayne, Pa.-based EnerTech. That number has doubled over the last two to three years, he says, because of EnerTech becoming a key player in energy investing and the popularity of the electric, water and gas marketplace. EnerTech, which is currently raising a $150 million-targeted second fund, invested its first $50 million vehicle in 14 companies, Lincoln says.

Nth Power’s first fund already is invested in 13 energy-related companies and will back two to four more deals before its $65 million are completely invested or committed, says Nancy Floyd, a managing director at the firm (story page 23). San Francisco-based Nth Power backs early-stage companies in the United States and Europe that are poised to capitalize on the newly-deregulated energy industry and is currently raising its second vehicle targeted between $75 million and $100 million, Floyd said.

Electric companies gearing up for the competition are desperate for technologies and services that will distinguish their commodity from others. And that’s where venture capital firms investing in the “New Energy Economy” are busy placing their bets: on companies that create technologies and services designed to set them apart from others.

To attract clients, utility companies will be forced to offer competitive prices, become customer-oriented and supply electricity from a variety of sources to satisfy their customers’ various needs. An environmentally conscious homeowner, for example, might be willing to pay an added cost for “green electricity,” power that comes from an environmentally-friendly plant, whereas a consumer simply looking to save dollars on utility costs will sign up with the lowest-priced supplier.

We are “going to see a lot of companies [in the utility-related space] that are currently private going public within the next couple years,” says Robert Chewning, a vice president of research at Morgan Stanley Dean Witter. “We definitely think it is one area that will be big.”

Although the Public Utility Holding Company Act of 1935 sought to prevent electric companies from owning electric transmission wires in non-contiguous states, electric companies serving a group of contiguous states or a single state continued to operate monopolistically.

California, however, began a state-by-state restructuring trend of the utilities market in 1998, and as of September, 18 other states had followed, says Hugh Holman a senior research analyst at BancBoston Robertson Stephens. Additionally, Michigan, New York and Vermont issued regulatory orders to accomplish similar goals and almost all the remaining states have legislation pending or research being conducted to move in the same direction. Within the next three to five years, about 90% of the states will be deregulated, he says.

Thinking Outside the Grid

Venture capitalists investing in this space typically back companies that establish three types of products: software that creates a competitive billing environment or enhances consumer relations; Internet sites that sell energy; and products that adjust energy quality and reliability.

Robert Shaw , a pioneer in the space and founder of Arete Corp., founded in 1983 as one of the original venture firms dedicated to energy investing, stresses the potential of on-site generators. He points to Capstone Turbine Corp., a company backed by both Arete and Nth Power that sells generators offering energy providers and commercial businesses a private source of power. This energy appliance is being marketed to businesses like Wal-Mart, for example, to ensure power quality. Eventually, Shaw predicts, on-site generators will become standard appliances in private homes.

While generators are poised to greatly affect the market, other technologies are competing for attention. Electric Lighting Inc., for example, also in the Nth Power portfolio, produces a controlled lighting system capable of providing energy-efficient dimmable fluorescent lighting systems that can adjust light output based on need.

Maurice Gunderson and Floyd, the founders of Nth Power, along with other investors and analysts in the space, compare the path of energy deregulation to that of the telecommunications industry. Energy deals received about $141 million of venture capital in 1998, just below where telecommunications investments were in 1981. In 1998, the telecom industry received $599 million in venture funding. The situation is not identical, but similarities do exist, the founders assert, indicating that energy deals could be the next big thing.

“We see the power technology sector as a sector that will become increasingly important and attractive to investors,” says Morgan Stanley’s Chewning. Over the past 10 years, just short of 400 deals have been completed in the energy sector, 78 of which were closed in 1998, according to Venture Economics Investor Services, a sister company to VCJ. Complete 1999 figures were not available at press time.

Kinetic’s $90 million Utility Competitive Advantage Fund, which closed in December 1998, backed 14 companies and will invest in another three before it is completely invested (VCJ, December 1999, page18). One of Kinetic’s portfolio companies, Peace Software International Ltd., is an example of a software provider set to capitalize on the deregulated industry. The company’s Energy Consumer Information System product provides a competitive advantage to its clients – gas, electric and water utilities – by delivering customer-driven information, as well as flexible rates and contract structures.

“It’s a very opportunistic time for companies like Nth Power because there’s such a strong market for technology that differentiates one energy supplier, energy service provider from another,” says James Newcomb, a senior advisor at E-Source Inc., a Colorado-based company that provides analysis on retail energy markets.

Enermetrix.com, an Internet site dedicated to connecting energy buyers and sellers, received a third round of financing in excess of $20 million in December. Essential.com, another Internet site selling electricity, along with Internet access, local and long distance telephone and wireless services, is also in the process of raising a third round of financing, says Basil Pallone, the company’s director of finance. He would not reveal the deal’s target amount, but said the first round closed at $3 million in April and the second at $12 million in July. “Deregulation is creating a lot of opportunity, and I think that is what is attracting the VCs to us now,” Pallone says.

InSight Capital Partners, a New York-based firm founded in 1995, started investing in the utilities sector in 1998 with the hire of Venture Partner John Blend who focuses attention in the utilities space, says Jeffrey Horing, a partner at the firm. At press time, InSight led five utility deals, including CES International Inc., Convergent Solutions Inc., iMedeon Inc., Peace Software and Enermetrics.com, and was evaluating another two or three. The firm is expecting some of these investments to exit through public offerings in the next four months, followed by a couple more by the end of the summer, Horing says.

The electronic power industry has been typically slow to develop new products because innovation in this space has never been rewarded, Holman says, adding that in a free market, “people want and need to be innovative to win customers or to keep customers they’ve got.” In a regulated industry, there are different incentives than in a free market, and regulators and executives become risk averse, he says.

Despite high enthusiasm for the energy sector, there are no guarantees that such deals will reap high returns. Considering that we are not living through an energy crisis, customers are not itching to save on their electric bills, says Barry Abramson, a senior utilities analyst at PaineWebber Inc. “Unless the new entrant has something that is a dramatic technological advance,” he says, investing in utility-related companies “could be too much of a risk.”

All In The Timing

“Probably the most critical element in all this is to understand the timing of this market. Lincoln, who prefers to invest in companies that serve markets including, but not exclusively limited to the utilities industry, says “companies making a sole bet on rapid changes in the utility industry may be holding their breath.”

The market is slowly unfolding and will gradually peak in the next five years, many predict. “If you are an investor,” BancBoston analyst Holman says, referring to Essential.com and other companies that sell electricity online, “you have to invest now.” But his advice varies from company to company within the utilities sector. A venture capitalist investing in an air pollution control company, for example, might be better off waiting three or four years until that market is regulated, he says.

“We’re probably not to the peak yet in terms of opportunity, but far enough along that it is not speculative to anticipate unfolding of competitive markets,” Newcomb says.