Breathing easier
By Vyvyan Tenorio

February 6, 2004

Pundits have long postulated a brave, new future world of solar-powered homes and space-age smart cars. But it wasn't until Geoffrey Ballard, an eccentric visionary, took his hydrogen-fuel-cell maker, Ballard Power Systems Inc., public in the early '90s that investors began thinking that there may be more to the vision than, well, hot air.

Alternative-energy companies have since come and gone, in some cases unable to weather either the loss of regulatory and tax incentives; in others, the victim of a cyclical drop in fossil fuel prices. A few survivors lasted long enough to catch technology's roller-coaster ride up, only to come crashing back to earth with other tech stocks.

But now energy technology is back on the front burner for VCs. Solar energy, wind power and other nontraditional sources such as hydrogen fuel cells are attracting investments, drawing the spotlight once again to the sector.

In addition to renewable energy sources, companies developing clean-energy technology — including gas purification, energy storage and energy efficiency tools — are being funded.

And this time, it's not just specialized energy funds and strategic investors writing the checks. Mainstream venture capital firms now seek out these companies as The Next Big Thing.

The premise behind these investments is essentially sound, analysts say. There will be fundamental changes in the way energy is produced, distributed and used 10 years from now. For the first time in many years, industry executives say, it is in the interest of business to pursue alternative and clean-energy sources, thanks to a combination of factors: weaknesses in the electricity grid, political instability in the Middle East and rising fossil fuel prices.

Still, clean energy bets are fraught with risks. And, to date, the sector has not yielded the blockbuster returns to offset the risks in the same way that, say, the information technology industry has.

“This isn't an area of superior performance,” says Albert Sherman, vice president of investments for Gas Technology Institute of Des Plaines, Ill., a not-for-profit independent technology company focused on energy research and development.

“If we gathered up all the performance data, I expect it wouldn't knock anyone's socks off. There have been some gains, but I don't expect performance to have been in the high double-digit returns.”

But the money is definitely flowing in — enough that young energy tech companies no longer seem like poor cousins of IT startups.

Clean energy gets a tiny fraction of total venture capital. Even when combined with clean technology of other sorts — anything from water purification and materials recovery and recycling to environmental IT — it accounted for only 7.4% of the $4.3 billion invested overall in North America last year, according to Cleantech Venture Network, a resource and consulting firm based in Ann Arbor, Mich., that tracks private companies in the sector.

“Clean energy is one of the most promising and visible parts of clean technology as a subset, but it's only about 50% of the total,” says Nicholas Parker, chairman of Cleantech Venture.

Part of the problem is that the biggest potential customers, utilities, historically have not had much appetite for innovation. They have focused heavily on reliability, which has led them to build excess capacity. And as heavily regulated virtual monopolies, they had little incentive to invest in innovative equipment or technologies.

August's paralyzing blackout in the Northeast could prove to be a turning point. It made the vulnerability of the region's electricity grid all too obvious. Although the blackout itself had very little to do with clean energy, it stimulated interest in reliable energy sources.

“The things that caused the blackout are some of the fundamental drivers that pushed us to invest in the sector a while ago,” says David Berkowitz, who oversees the energy portfolio at Toronto's Ventures West Management Inc. “One blackout doesn't get customers to change their buying habits overnight; it's just a wakeup call.”

Other factors have contributed to the interest: The Iraq war further pushed up oil prices, and now the Northeast is suffering through a second unusually cold winter.

While clean energy has slowly ascended over the past few years, venture investing in the sector bounced back in the last quarter of 2003 with venture capital spending more generally. “It's an evolving sector, though still a very small part of venture,” says Neil Suslak, managing director of Braemar Energy Ventures of New York, which is raising its maiden fund.

“We see it as a long-term trend, although you have some variability coming in above or below that trend,” says Tucker Twitmyer, a principal at Ener Tech Capital Partners of Wayne, Pa.

Only a handful of funds, including Aret? Corp. of Center Harbor, N.H.; Chrysalix Energy Management Inc. of Vancouver, British Columbia; London's Conduit Ventures Ltd.; GFI Energy Ventures LLC of Los Angeles; and Nth Power of San Francisco, are pure-play energy investors. Most investors, such as EnerTech, Ventures West, Advent International Corp. of Boston, Kinetic Ventures of Chevy Chase, Md., and RockPort Capital Partners LP of Boston, invest in other areas as well.

Now more generalist VCs have made forays into the sector or are on the lookout for opportunities there. These include Alta Partners, Benchmark Capital, Draper Fisher Jurvetson, Kleiner Perkins Caufield & Byers, Mayfield, J.P. Morgan Partners LLC, Technology Partners, Rustic Canyon Partners and U.S. Venture Partners. (Rustic Canyon is an investor in The Deal LLC.)

Government entities are also jumping in. The U.S. Army is investing in portable power and alternative-energy technologies to lighten soldiers' loads and to develop alternatives to hazardous power sources. Battelle Ventures LP has set up a $150 million early-stage technology fund to commercialize technologies in energy and other fields from Battelle Memorial Institute of Columbus, Ohio. And the state of Michigan is funding a $150 million initiative, similar to those in neighboring states, that will invest in alternative-energy technologies, among other areas.

The venture affiliates of large energy companies, such as E.ON Venture Partners GmbH, Hydro-Québec CapiTech Inc. and Shell Internet Ventures BV, are also poking around, hoping to get a window on emerging technologies.

Gas Technology Institute is an investor in Ener Tech's second, $234 million fund, raised in 1999. GTI's Sherman says it's too early to predict fund performance.

“It's about a year away from cash returns, but what I can say is that it's been a very good strategic fit for us, particularly in our fuel cell R&D,” he says. But he concurs that the technology has not led to the home runs that VCs look for.

A critical issue with clean-energy investments is the long lead time for profitability. “With alternative energy, you have to be pretty patient,” Ventures West's Berkowitz says. “It's not a quick-flip kind of sector, where you invest and flip it 12 months later.”

Indeed, the more established energy VCs, and even the new specialist Braemar Energy, have diversified to improve returns and mitigate the risks that flow from investing in companies that, in some cases, are waiting for markets to materialize.

Ventures West, for one, has been investing in energy companies, though not exclusively. In 1987, it led the first institutional round in fuel cell pioneer Ballard Power, based in Burnaby, British Columbia. Ballard faced an array of hurdles, not the least of which was then-cheap oil. In its 1993 IPO, the company raised a measly $15 million, priced at $8. It took several years for momentum to build, but its stock eventually rose to $121 a share in 1998.

Ventures West managed to get “tremendous returns” from Ballard Power, says Berkowitz, whose firm recently held a $120 million first close on its eighth fund, the largest one raised in Canada last year. “But we were there for 11 years from start to finish. It's venture capital the way it used to be done.”

Ballard's performance has not been as stellar of late because the clean-air regulations that have prompted carmakers' interest in fuel cells keep being modified to push the deadlines further and further out.

“Now it's really 2010 and beyond” for adoption, Berkowitz says.

One portfolio company, QuestAir Technologies Inc., also of Burnaby, initially focused on automotive fuel cells. It signed a partnership with Ballard Power, and for a while, Berkowitz recounts, things were going to the moon. But as the timetable stretched, investors balked at funding the company. So Quest shifted strategies and began marketing its hydrogen purification technology to existing markets.

“Although it's not as sexy as the original proposition, its focus on building highly profitable business in real markets today will keep the company growing until that big market opens up,” Berkowitz says.

Berkowitz won't talk about Ventures West's energy duds, but like other firms, it has had its share. “Companies that are agile and good at containing cash burns are doing well in this sector,” is all he'll say, “while those sticking with the original strategy come hell or high water will disappear.”

Braemar Energy is focusing on technology for energy businesses, including stationary and portable power, as well as for transportation and fuel applications. As Suslak says, “We're unlikely to be doing fuel cell investments.”

Braemar held a $35 million first close in December 2002 and expects a final close this year at $50 million to $70 million. It aims to find companies that offer attractive solutions to large energy companies.

In August it invested in Solicore Inc., a Lakeland, Fla., developer of a new battery for smart credit cards and consumer electronics products. The $13 million round drew several financial backers, led by Draper Fisher. Air Products and Chemicals Inc. threw in $2 million. That strategic participation “portends well for the company,” Suslak says.

EnerTech takes views opportunities more broadly. The firm's first fund, a $55 million vehicle raised in 1996, invested in Capstone Turbine Corp., a Chatsworth, Calif., maker of microturbine technology designed to provide highly efficient, low-emission power systems.

Capstone rode the technology boom and went public in 2000. Despite a subsequent fall in Capstone's stock, EnerTech still made a “substantial return” on its $4.5 million investment, says Michael DeRosa, an EnerTech principal.

His firm doesn't expect utilities to buy its clean-energy technologies, however. It targets power equipment systems that can be sold to companies such as ABB Ltd., Caterpillar Inc., General Electric Co. or Siemens AG. Of course, it may also be possible to exit some investments through IPOs, executives say.

While it looks at a variety of technologies, EnerTech prefers companies with technology that works today, DeRosa says. A case in point is Clean Air Power Inc., a San Diego-based developer of emission reduction systems for diesel engines that has had considerable success selling products in Europe, Asia and South America.

“The drivers are different in different places, but essentially, it's emissions reductions and cost savings,” De Rosa says. With a “very robust pipeline” of orders, some supported by grants in the U.K., the company expects to be profitable in 2004, he adds.

DeRosa is suspicious of the hype around environmentally friendly technologies such as hydrogen fuel cells and photovoltaic cells, but EnerTech has nonetheless invested in long-term research programs. For instance, it backed Franklin Fuel Cells Inc., a Wayne, Pa.-based early-stage company trying to commercialize a solid oxide fuel cell technology developed at the University of Pennsylvania that promises high energy efficiency and low emissions with existing fuels.

“Something like Franklin would take some amount of time, but if you get there, the type of company you could be building and the type of barriers [to entry by competitors] you would have would be extremely significant,” DeRosa says.

Fresh air funds
Clean and alternative energy companies caught the attention of VCs last year
2003 Company
Investors Round Transaction ($mill.)
Dec. Enviromental Energy Resources Ltd.
low-level nuclear waste remediation technology
Tokyo Financial Group 2 $5.0
Oct. Solicore Inc.
solid plastic battery maker
Draper Fisher Jurvetson
Braemar Power and Communications Partners LP
Firelake Capital Management
OPG Ventures Inc.
Hydro-Quebec CapiTech Inc.
2 15.0*
Oct. Comverge Inc.
load management software maker
Nth Power
Ridgewood Capital Management LLC
Norsk Hydro Technology Ventures
EnerTech Capital Partners
E.ON Venture Partners GmbH
Shell Internet Ventures
Data Systems & Software Inc.
2 18.6
Sept. Encelium Technologies Inc.
energy management systems
VentureLink Brighter Futures Equity Fund
Blue Hill Partners
1 0.8
Sept. Avista Labs Inc.
fuel cell systems developer
Enterprise Partners Venture Capital
Buerk Craig Victor LLC
Chrysalix Energy LP
Wall Street Technology Partners LP
2 12.5*
Sept. Prevalent Power Inc.
developer of clean energy generation projects
Angel investors 1 N/A
Aug. Powerspan Corp.**
pollution control technology
Beacon Group
FirstEnergy Corp.
Zero Stage Capital
NGEN Partners LLC
Aquilex Services Corp.
Calvert World Values International Equity Fund
N/A 20.0
July EnerNOC
control systems for backup power generation
Draper Fisher Jurvetson
Braemar Power and Communications Partners LP
1 2.5
June NanoSolar Inc.
developer of low-cost solar cells
Benchmark Capital
U.S. Venture Partners
Stanford University
1 6.5
June QuestAir Technologies Inc.
gas purification technology
Government of Canada N/A 7.4
May Metallic Power Inc.
recyclable, zinc-based fuel cells
Arete Corp.
Beacon Group
Cinergy Ventures LLC
Teck Cominco Ltd.
Hydro-Quebec CapiTech
MP Investments
Nth Power LLC
Perseus LLC
4 13.5
May Evergreen Solar Inc.***
photovoltaic systems
Perseus LLC
RockPort Capital Partners
N/A 29.0
March Clean Air Partners Inc.
clean technology to diesel-powered generators
CIBC Capital Partners
Emerson Electrics Co.
EnerTech Capital
Exelon Capital Partners' Nth Power
RBC Capital Partners
2 8.6

* Two tranches
** First close
*** PIPE (private investment in public entity)
N/A = Not Available

Source: The Deal