Doing something different

Surprisingly for an industry which helps drive virtually every other type of human activity, business or otherwise, energy is among the least popular destinations for private equity investors. Energy is the world's biggest industry sector, worth around $2 trillion annually, but only a few private equity investors outside the US have entered, despite global energy use being predicted to double by 2020, according to the Basel Agency for Sustainable Energy.

?There has been an historical bias against investment in the sector because you are dealing with a commodity with a high level of price volatility,? says Sean Carney, until recently a London-based partner at Warburg Pincus, which has a large energy franchise. ?Energy investments are extremely capital intensive and require a steep learning-curve,? which is a key reason why few of the large private equity managers dominate energy-related investment activity, and why potential newcomers have been slow to enter. According to EVCA, European energy investment by private equity firms between 1997 and 2001 totalled €1.4bn, just 1.3 per cent of the overall total.

Part of what's keeping those energy-focused private equity firms that exist busy is channelling investment into areas that the world's giant energy companies do not themselves reach into ? but where these giants have obvious needs and interest. They may be customers and they may turn into your trade buyer. Warburg Pincus has invested over $700m of its $10bn under management in four key energy areas: oil and gas, oilfield services, power generation and energy infrastructure. It has also invested in several alternative energy technologies globally since the late 1980s. ?It's a huge sector with lots of opportunity to earn attractive returns,? explains Carney part of the attraction.

In 2002, the firm committed $100m to Insight Energy, a US company set up by four senior management figures from Rolls-Royce Power Ventures to make small to medium-size power plant acquisitions of between $10m and $100m in North America and Western Europe. ?With Insight, we're looking to acquire power generating assets below the radar screen of the big [corporate] players, which we define as 150 megawatts and smaller. It's difficult to outbid the strategics. We're looking to do something different.?

In Europe, 3i is among the most active participants in energy investing, having completed more than 30 investments with a combined value of over $400m. Other big investors include Bridgepoint Capital, Aberdeen Murray Johnstone and niche investors including Norsk Hydro. 3i targets interests in service companies, businesses involved in exploration, drilling and completion, as well as production companies. ?The European energy sector is pretty buoyant at present and has produced some spicy returns,? says Graeme Sword, who heads the firm's oil and gas team in Aberdeen.

The firm has led the way in North Sea oil and gas exploration since the likes of Shell and BP cut back their interests in these fields. ?We're interested in developing the fields that no longer appeal to big players where we can be more focused and keep costs low,? says Sword.

The VC role
Specialist know-how is also a significant barrier to entry in energy-related early-stage investment, which so far has left this market to a small number of venture firms investing in alternative and renewable energy companies. Active venture capitalists might either invest in companies that generate the energy or back developers of technologies that these companies use to make it happen. ?There is a great opportunity in backing companies which are offering technologies to increase the efficiency of existing, traditional energy sources,? says Bruno Derungs, a principal at Swiss-based Sustainable Asset Management's (SAM) private equity group.

Improving energy efficiency has to be a key objective, according to Albert Fischer, partner at Netherlands-based Planet Capital, alongside the development of viable renewable energy resources and cleaning-up the use of fossil fuels. ?The driver in the market is the simple fact that we need a new energy supply.? Europe's energy sector venture capitalists are aiming to help nourish this mission.

In addition to the ever-decreasing reserves of fossil fuel, there are other factors that make a strong argument for alternative sources, not least the need to establish greater reliability of supply and the almost insatiable increase in demand from a growing global population. Additional supply is likely to come from a combination of wind, solar, geothermal and biomass generated energy. In addition, future energy use is likely to be more focused on decentralised generation systems such as micro-turbines, energy storage technologies and fuel cells. Venture capital can play a major role in these sectors where low current valuations can provide firms with considerable opportunities.

That it is possible to make profitable investments in European alternative energy has already been evidenced. Planet Capital for example, which is currently raising a €50m fund, achieved its first exit in April from its debut investment, Indec. Indec, which operates a pilot plant for the production of components for solid oxide fuel cells in the Netherlands, was sold to Bayer unit HC Starck, providing Planet Capital, which did not disclose the size of its investment, with an exit valuing the company in excess of €10m.

The Indec transaction can be seen as exemplary of the opportunity that exists in the sector. The company was founded in 1999 by the Energy Research Centre of the Netherlands (ECN), with which Planet Capital has an exclusive dealflow arrangement. ECN describes itself as an independent research foundation involved in the development of sustainable energy supply. It looks for partners who have the necessary marketing and sales infrastructure for the commercialisation of promising intellectual property it has developed.

?In the 1970s and 1980s government and research organisations have subsidised R&D up to the creation of a prototype,? says Planet's Fischer. ?In order for such developments to come to market, the government ends its investment. This provides VC firms with the opportunity to bridge the equity gap for these technologies, often at very low valuations.?

Difficult fundraising
A number of specialist European VC players have emerged over the past ten years, several of which are currently raising capital. Firms currently on the fundraising trail include 4D Global Energy, backed by Société Générale Asset Management, which held a first close for a $150m fund on $60m in February. The fund is targeting profitable mid-market companies across all energy sectors primarily in Europe, although it will not invest in speculative exploration, trading or technology risks. Also in the running is Denmark-based Conduit Ventures, backed by Shell Hydrogen, Mitsubishi Corporation and Johnson Matthey. Conduit is currently raising a $100m fund for fuel cells and related hydrogen technologies investment. In 2002, P/S BI New Energy Solutions, a fund set up by BankInvest Group, raised just over €30m for a fund focused on European companies developing new energy technologies.

Switzerland-based Sustainable Asset Management is about to embark on a €100m fundraising programme. ?At the moment, the fundraising environment is black and white,? says Derungs. ?Investors are either very or not at all interested in the sector. We need to educate the market and show that it is a lucrative sector, and not the not-for-profit sector that it is sometimes perceived as being.? And Fischer at Planet Capital observes: ?[The industry] appeals to anticyclical people, people not into typical VC at the moment.?

Fortunes could in part hinge on the political climate over the next ten years. The European Union has signalled its intent to encourage the reduction of greenhouse emissions, while the US government has been less keen to support developments, as witnessed by its decision not to ratify the Kyoto protocol. The European Union has set targets for an increase in primary energy production from renewable sources by 2010. In 1999, six per cent of energy in Europe was generated from renewable sources. The EU expects this figure to have doubled by 2010. In terms of electricity production, 14 per cent of the region's requirements were met by renewable and alternative production in 1999. The EU has specified that this should increase to 22 per cent by 2010.

One newly established European private equity firm hoping to benefit from this agenda is Englefield Capital, run by former Warburg Pincus executive Dominic Shorthouse, which recently closed a €660m buyout fund. Englefield will look to make equity investments of €20m to €50m in mid-market companies with enterprise values of €50m to €400m. ?Renewable energy has a following wind, in terms of subsidies and consumer support across the board,? says Shorthouse. ?We want to back businesses with proven technologies across Western Europe. It is a sector of considerable complexity, but we quite like complicated opportunities.?

3i, in addition to its interest in the more traditional energy sectors, has also been a significant investor in the renewable sector for the past six years, although primarily on a reactive basis: much of 3i's renewable investment activity is the result of its links to oil and gas. Nonetheless, the firm has completed twelve deals in the sector since 1997. ?Renewable energy has been slower to develop than had been expected, with companies taking longer to achieve critical mass.? 3i's Sword levels some of the blame for this at the door of governmental institutions. ?There has been less government support than people expected, and no dialogue with the private equity industry. But private equity definitely has a role to play in the sector's growth.?

Some VC practitioners talk about the difficulty of predicting future trends in the market, and describe it as a sector that has gone quiet. This is as much the result of the broader VC downturn as it is the level of uncertainty in what is still an emerging industry. As Carney puts it, ?in Europe in particular, the alternatives sector is relatively undercovered.? And as one institutional investor observes: ?Alternative energy still needs more involvement from mainstream players. The market is still dominated by niche players. I hope this will change.?

On the oil and gas front, Carney is clear on what is required of private equity managers. ?You have to be willing to take a risk. You can't simply buy proved, producing properties at market rates and achieve venture returns.? Until fairly recently, it would have been unusual for private equity players in energy sector to unashamedly position themselves as risk-takers, investing fairly sizeable sums in oil and gas exploration buy-and-build strategies.

Conversely, the venture capital sector currently seems to be the more cautious about its traditional role as leaders of innovation in an emerging sector. It is not a lack of dealflow that is slowing investment in alternatives. ?We see as many as 700 deals annually and this figure is increasing,? says Derungs. It is simply that the climate, both economically and politically, would seem to favour investors in the traditional energy sectors, for the time being at least.