How gas supply and price disruptions now outweigh Big earnings potential plus an energy-related focus are prerequisites when AEP and Cinergy sort through investment projects.
Power companies fast are becoming in the venture capital (VC) community. A scan of utility press releases reveals that utilities are investing in emerging companies at an alarming rate. Indeed, many electric utility companies aggressively are pursuing ventures with high growth potential in an effort to spur earnings, diversify their investment portfolios, and capitalize on their corporate strengths. As the days of rate base regulation slip away, power companies are gearing up to shift investment focus, at least to some degree, away from the traditional business of generation, transmission, and distribution. Finding new, profit-boosting investments is a full-time endeavor for a new breed of utility managerthe venture capitalist.
Above all, utilities are driven by the potential earnings offered by venture capital investments, which are especially attractive compared to the uninspiring regulated rates of return utilities historically earn. One way to make Wall Street take notice is to grow earnings with a portfolio of strategically and soundly placed venture capital investments. Of course, companies also must protect investors from excessive risk by remaining focused on energy-related ventures. Typical utility price-to-earnings ratios, or P/Es, are in the low teens, reflecting the regulated, relatively low-risk/low-reward returns. By creating earnings through successful ventures, the utility can break out of that mold; in fact, combined growth in earnings and P/E ratio may lead to potentially explosive stock price appreciation.
Even the most aggressive venture-focused utilities tend to seek business opportunities that are related to their core business. In theory and in practice, the utilities described in this article emphasize the need for their venture capital to flow to energy-related companies. Through their VC investments, these utilities aim to better serve their own changing markets with the resulting new technologies and energy products.
Two potential growth markets are emerging for energy-related projects (and, therefore, venture capital investments):
- power quality, and
- emissions control.
During the last decade, computer-related energy usage has risen substantially. For most commercial computer applications, reliability is critical to the bottom lineindeed, individual outages can cost Internet and communications firms millions of dollars in lost revenues and liability. For that reason, many high-tech commercial energy consumers are willing to pay a premium for ultra-high reliability service. The power control market, also known as the "nines" market, named for the labeling of the electric service reliability metric, comprises products and services to meet this need.
The "nines" represent the number of nines to the right of the decimal point, in excess of 99 percent, in the measure of reliability. For example, one would pay a "two nines" price for 99.99 percent reliability, and a "three nines" price for 99.999 percent reliability. More "nines" cost more money, naturally, so price points for each nine will be set by a load-serving entity. Clearly, a number of ventures and existing products already are attacking the reliability market, including those related to backup power, distributed generation, and protection equipment. The consensus is that this market, poised for hyper-growth, will continue to foster an active venture capital interest in these technologies.
The emissions control market is fostered by regulations such as the U.S. Environmental Protection Agency's NOx SIP Call (the call for state implementation plans to reduce emissions of nitrogen oxide), which places strict limits on NOx emissions in the Eastern United States by 2003. Fossil generators are anxious for new, cheaper alternatives to existing control equipment choices in order to meet the new requirements. A number of small technology-oriented companies are working hard to meet these needs, and several have been graced with utility-based VC.
The recent attention to power quality and emissions control highlights just two of the many issues shaping the utility industry. As markets continue to change, the demand for emerging technologiesand the venture capital to spawn themwill continue to grow.
Finding a Project: What Makes a Good Match?
AEP is one of the power industry's venture-focused companies, formally entering the VC arena as an extension of its long and successful energy R&D program. The company remains active in R&D, but now is dedicating more effort toward commercializing promising products. AEP brings much more to a potential partner company than just cash, including the technical and commercial experience of its R&D program, laboratory access, management guidance, and a strong brand. The utility can offer these strengths to give growing companies a better chance of long-term success, and reap the rewards of boosted earnings through the target company's performance.
According to Warren Walborn, AEPÕs director of investment, an investment opportunity must meet three criteria before it enters AEPÕs portfolio. First and foremost, the investments . This enables the company to maintain a focus on its holdings, while capitalizing on the company's expertise and strengths in the energy industry. Second, the investments must add to the company. Walborn sees these investments as not only placing AEP in a favorable long-term position in the power industry, but also assisting the corporation's overall returns and perception by the capital markets. Finally, each investment must show the potential for "very high" return on investment. Without disclosing actual targets set by the company, Walborn says that throughout his career, he has seen venture capital as an asset class returning at least 25 percent. In many cases, especially for early-stage products, he sees targets well in excess of 100 percent. He predicts that these same levels will apply to utility-oriented venture capital.
Walborn prefers to find companies that are in the "expansion stage," needing capital and guidance with existing products. Earlier-stage opportunities may offer higher potential rewards, but AEP tries to avoid taking on projects with that level of risk. Each opportunity is considered on a case-by-case basis, however. Expansion-stage technologies are most likely to flourish with AEP's finishing touches, which include market experience and exposure, distribution support, and management guidance. The latter is critical to success, according to Walborn, and AEP typically maintains a presence on the target company's board of directors to watch over its investment and lend high-level guidance and resources.
One recent investment headed by Walborn is a stake in PHPK, a Columbus, Ohio-based cryogenics company. AEP saw PHPK as a key player in the support of superconductivity applicationsa rapidly growing industry niche in a market hungry for innovative technologies. After establishing that PHPK met its three primary criteria, AEP bit. In the six months since the utility's investment, PHPK has nearly doubled its business. Walborn attributes much of that growth to the AEP name; indeed, buy-in by a large and respected corporation is an instant endorsement of PHPK's technology and capabilities. The partnership has helped open up new business opportunities for PHPK that already have brought measurable results.
Just as companies like AEP are looking for the next home run, the reverse is happening as well. Small, energy-related technology companies are finding that utilities are flush with cash and other attractive qualities that make them preferred investors. Thermal Energy International Inc. of Ottawa, Canada, is a prime example. A provider of heat recovery and emissions control systems, the company recently earned a U.S. patent for its NOx control technology, THERMALONOx. Thermal has a portfolio of developing products and ideas for electric generators, but has not fully commercialized their potential. (It would be categorized as an expansion-stage company, according to Walborn's definition).
Executives at Thermal realize that the United States is a prime market for its technology, which, they say, will be substantially cheaper than competing technologies. Initial interest in the company's products has been high, but given the long sales cycle for its multimillion-dollar systems, marketing is costly. To successfully approach the U.S. market and overcome associated costs, Thermal is seeking capital from a number of sources, including offering various risk-and-reward opportunities to utilities and independent power producers interested in being early adopters of THERMALONOx. These could be attractive opportunities given current compliance pressure and questions about the ability of suppliers of existing technologies to meet demand for NOx compliance solutions.
Thermal Energy president and CEO Tom Hinke emphasizes his preference that the benefactor be a utility in the United States, the company's primary market. In addition to the cash that Thermal needs for its expansion, there is great potential value in the right partner's guidance, experience, and U.S. market savvy, he realizes. Additionally, Hinke points out that the new investor likely would be a key customer itself.
What Hinke offers in many ways is what U.S. utility venture capitalists are looking for: innovative technologies to serve the power markets, strong market potential, and the potential for off-the-chart earnings. According to Hinke, Thermal is in the process of negotiating with several U.S. companies for the expansion capital it needs.
The E-Business Venture: A Booming Niche
Certainly, the potential of the e-business frontier is not lost on the utility players. Utility B2B e-commerce will account for 17 percent of the industry's transactions, growing from $30 billion in 2000 to over $266 billion in 2004 (Source: Forrester Research Inc.). One company poised to take advantage of that e-business potential in the energy sector is Cinergy Corp. Kevin Kushman and Brian Stallman are managing directors of Cinergy Ventures LLP, a wholly owned subsidiary of Cinergy. Their unit is divided into two divisionsventure investing and e-business developmentand business is booming on both fronts.
Going into 2000, Cinergy held roughly $40 million in venture capital investments. Since formalizing its approach through the creation of Cinergy Ventures earlier this year, that amount has risen to $100 million. The company expects returns of at least 30 percent on its venture capital investments.
Cinergy Ventures considers a variety of investment opportunities but one rule applies: each must be energy-related. Deals come from many places. In addition to uncovering opportunities internally, Cinergy sometimes receives pitches for deals. In other cases, the utility's venture capital partners help identify and assess new opportunities. In order to increase the likelihood of success with these companies, Cinergy plays the role of a strategic partnernot just a financial partner. The cash Cinergy invests is a key ingredient to a venture's success, but the company sees its role in providing strategic guidance and access to operational R&D resources as just as important. By offering both cash and other support, Cinergy says, it gives its seedlings the best chance for success.
Like Walborn at AEPand most other VC playersKushman breaks VC opportunities into three categories: (1) commercialized companies with ready products or products that will be marketed within three months; (2) refinement-stage companies with proof of concept for marketable products within one year; and (3) drawing board companies with solid concepts, but without proven technologies or imminently marketable products. Cinergy expects to have about 30 percent of its investments in opportunities in the commercialized stage, 60 percent to 65 percent in the refinement stage, and 5 percent to 10 percent on the drawing board. The earlier in development an investment is, the more that is expected in long-term ROI in order to account for the risk involved.
Cinergy Ventures considers a number of standard criteria in choosing projects for its portfolio. The potential opportunity must have a strong, rapidly growing market, a defendable business plan, and manageable capital requirements. Another critical component is Cinergy's comfort with the target company's management team. They must be a solid, growth-oriented group of managers that, ultimately, will be complemented by the addition of Cinergy membership on the board of directors.
One of Cinergy's venture investments was in the Convergent Group, an Internet enabler that, among other things, helps utility local distribution companies Web-enable their operations. Shortly after Cinergy's investment, Convergent was purchased by Schlumberger Ltd. In this case, Cinergy was able to turn a quick "multi-hundred percent" profit in a short period of time, and re-invest in the new Schlumberger-owned entity in the pre-IPO stage. Convergent benefits from Schlumberger's worldwide presence and management support. Kushman doesn't expect most of Cinergy's deals to be so financially successful in such short timeframes, but he is confident that attractive deals will continue to develop.
Competition for Projects: Stymied by Affiliate Rules?
While playing the role of venture capitalist is exciting and potentially rewarding, it has its potential headaches and pitfalls. In addition to the risks associated with any new business venture, utilities also face possible legal and regulatory problems. For one, rules impose a number of constraints on utilities that most other organizations do not face. This issue is particularly important if the utility will be a trade partner of the new affiliate, as opposed to just a "hands off" investor. State regulators are wary of affiliate transactions that may pose risk for retail electric customers.
Two affiliate issues affect the way utilities deal with their affiliates. The more general of the two is defined by developed by the state regulatory agency. These rules may limit the degree of utility ownership allowed and other organizational and communications issues that arise between the company and its affiliate. The second issue is specific to of the products and services that utilities and their affiliates trade. Not all venture capital investments involve the latter issue, because the affiliate may not be a trade partner with the utility but rather a true investment play.
Ken Costello of the National Regulatory Research Institute agrees that affiliate rules may play an important part of the utility-affiliate relationship. For utilities that trade goods and services with their affiliates, many state regulators have adopted transfer pricing rules to circumvent potential cost-shifting and cross-subsidization that may harm the utility's ratepayers. A rule of thumb is that the utility pays the of market price or cost for goods and services purchased from the affiliate, leaving the affiliate to bear the of market price or cost when paying the utility for goods and services. This rule keeps ratepayers from unfairly subsidizing the venture, but can be a serious burden for startup companies with partial utility ownership.
Cinergy's Kushman has not yet run into any problems with affiliate interest codes of conduct, but he says that they could put his utility at a disadvantage. He explains, Cinergy Ventures was established as a non-regulated unit and invests in minority equity stakes in order to avoid the constraints that affiliate rules place on utilities. "When implementing the technology of a portfolio company, Cinergy Ventures understands the prohibitive nature of market price/cost transfer pricing policies in some states. Tactically, their investments are structured such that portfolio companies' business models will not be restricted by these affiliate rules, while protecting the strategic value derived by having a progressive utility partner."
Despite the potential regulatory and business risks associated with venture capital investing, the outlook for both the quantity and quality of deals is encouraging. Armed with corporate resources and support, the utility venture capitalists are geared up to enhance their portfolios while adding strategic value to their parent companies. The ultimate results will be known after successful integration of the new investments within the organization, and after overall returns for the venture capital portfolios are calculated. After that, the impact on the utility stock price is up to the Wall Street expertsperhaps resulting in re-classification of several key power company players in a more risk-and-reward-oriented sector. Only time will tell, but then, that is the mantra of the venture capitalist.
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