E&Y: Challenges Present Opportunities in Water Investing

The U.S. faces major water challenges in the coming years, including water scarcity, aging infrastructure, climate change, water-quality issues and water-related energy risks. To address some of these issues for investors and water-related industries, Ernst & Young produced a white paper outlining some of the challenges and opportunities regarding investing in water sustainability and infrastructure efficiencies.

E&Y’s cleantech team put forth an action agenda, which recommends developing data and transparency practices to establish pricing models that reflect the true value of water; establishing common terminology, standards and metrics for water footprinting; bringing new capital and efficiencies to the water sector through private equity; developing public-private and public-public partnerships to help close the water funding gap; strengthening industry frameworks and regulations for assessing, adopting, and procuring new technologies; and considering long-term capital expenditure needs in formulating water utility bond ratings.

Water investing has recently been gaining traction as an alternative asset class with institutional investors, due to the fact that its returns are not correlated to the broad market.

Private equity is an important potential source of capital for the water sector, according to the paper. It can help drive consolidation, new efficiencies, and fresh inflows of cash into technology and infrastructure innovations and modernizations.

E&Y argues that water sector investments offer private equity funds potential benefits, including capital preservation through defensive holding, upside through technology innovation, value creation through consolidation and break-out companies focused on the water demand-supply imbalance.

That said, E&Y acknowledges that U.S. private equity investment in water has been limited because of the local nature of the water business, which can require customization that reduces profits and scale.  The sector’s high fixed costs, major project financing requirements, long investment periods, inelastic demand, and restricted margins have also bound private equity involvement.

Still, privatization and deregulation in some markets show that benefits are available. In Brazil, private equity investors now have opportunities to “buy and build out” strategic water companies.

Private equity investors have recently become important players in some U.S. deals. Rialto, California, granted a 30-year concession for the operation of its municipal water and sewer systems in return for an initial payment of $35 million and $41 million in private equity capital for infrastructure upgrades. These kinds of deals may become more common if the regulatory climate improves.

Venture capital investment in the U.S. water sector has increased in recent years too, although it’s small compared to the overall market size.  About $120 million in venture capital was invested in water companies in 2012, but that’s just 0.4% of total U.S. venture capital investment.

VC firms investing in water include Element Partners, Emerald Technology Ventures, Energy Technology Ventures, Liberation Capital, Meidlinger Partners, Draper Fisher Jurvetson and Chrysalix Energy Venture Capital as well as a number of angel investor groups.

Several corporate venture funds and corporate development units of large corporations, like GE, have also taken strategic positions in water, which focus primarily on technology and service opportunities. Most water-dedicated funds are relatively small in terms of assets under management and their activities are spread across multiple water markets, which diminish impact.

The factors restraining venture capital investment include the fact that highly regulated industries like water often refrain from assuming innovation risk. As a consequence, startups must persevere through months-long installation trials and reviews. This long road to return on investment requires a lot of capital.

The low level of interest in new water enterprises, narrow set of attractive opportunities and limited scope of exit options propel start-up entrepreneurs to focus on specific market needs, such as cost-cutting technologies that increase efficiency or solve defined problems that local authorities pinpoint.

Compared to biotech, tech or energy start-ups, there is no “customary” broad participatory process to qualify and finance companies from seed stage to initial public offering (IPO) in the water sector.

Historically, R&D and engineering efforts have rarely yielded groundbreaking disruptive water technologies. That doesn’t mean they never will.  The small number of firms focusing on water means less competition among new investors.  The field is wide open for agile entrepreneurs to come up with water efficiencies that solve the coming water challenges – which means there are also opportunities for investments in start-ups and small tech firms willing to take on the challenges inherent in working with the water business.

To read the full report, click here

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