By Christoph Lueneburger

cat·a·lyst (k t l- st) n. A substance that initiates or accelerates the speed of a reaction between other agents without changing itself in the process.

Introduction
I recently discovered an emerging product targeted at industrial, agricultural and domestic applications. Demand is global, elastic and growing. The product is under-priced and there are no substitutes, and if you have read this far, you may expect me to sell you some land.

I am talking about water, of course and I admit I have not just recently discovered it—I am an obsessive user. Water has been around for quite a while and like oil, it is essential to industrial processes. Unlike oil, however, it is equally essential to virtually all other processes on the planet, from any organic reaction to the drilling and processing of oil, yet it is not, itself, consumed as it is used. Water may become polluted, it may transition phases, but it can always return to a state of liquid purity—it is the ultimate catalyst of evolution, whether biological or industrial.

This article argues that significant opportunities for value creation await the strategic private equity investor throughout this enormous industry. One path to success begins with assembling full-service solutions tailored to specific demand segments by concentrating on competencies that are currently not cohesively integrated.

Water stock
Perhaps it is because the evaporation-condensation-precipitation cycle has been impressively reliable for eons that we have only recently begun to think of water as a precious commodity. Much has been written about the influx of investments into private and public equities in the water industry. The July 2005 issue of the Global Water Intelligence Report speaks eloquently of the hoards of explorers waiting at the gate. And indeed, a look at a basket of two dozen stocks1 of companies in the broader water business reflects the fundamental strength of this sector. Figure 1 compares the water basket to the Dow Jones Industrial Index over the past 15 years and illustrates that the mean daily gain of the water basket is not only greater than that of the Dow, but its volatility (measured here in terms of standard deviation) is also less. Compared to the Dow, in other words, a small-er number of stocks generated a greater return with lower volatility. That is true both over the entire 15 years and during the relatively calm five-year period starting in 1992. Given that the fundamentals of this industry are continuously intensifying, it is no wonder that investors are taking notice as the long-term growth of the water basket is certain to continue unabated. Alas, I don’t have the world’s land to sell you—think bigger.

Among the candidates for thinking bigger about contributing to the creation of value in this industry is the private equity investor. Because the water industry has evolved based on local supply and demand over decades (and centuries), it is a highly fragmented industry with many competitors concentrating on niche segments. And even though large players such as Siemens and GE are cultivating increasingly imperial water portfolios, the space is far too immense to allow a comprehensive wheelhouse of goods and services for all thirsts.

Nor is universality a requirement for success in this vast industry. The process of building a presence in the broadest range of competencies can as easily diffuse a company’s competitive position as it can substantiate it.

Identifying sectors
One approach from the private equity perspective is to focus on specific families of applications. Compartmentalizing the water industry as illustrated in Figure 2, we can both place existing companies and envisioned services in a competitive space along transportation, information and process dimensions.

Neil Berlant, a gray (but vibrant) eminence of the water industry for two decades, recently suggested over lunch that in order to understand what a real water solution looks like, one should spend a month on the loading dock of any plant that requires water for its cooling, processing or injection applications and record all deliveries that relate to water, be it filters or chemicals, hardware or software. A true solution bundles the set of equipment and services that unfailingly meets the facility’s demand for water at the right purity, pressure, temperature and price.

Keep in mind that the majority of industrial applications that rely on water do not yield goods that contain water. Water, in most of these industries, is a critical part of the process, but not of the product. Therefore, most manufacturers do not think of themselves as being in the water business—yet more often than not they are responsible for managing their water solution.

Thus, the challenge for the discerning private equity investor is to find specific segments where financial and strategic resources enable the creation of sustainable value beyond the growth inherent in the fundamentals of the water industry as a whole. Successful build-up strategies will pick and stick to particular solutions, bundling all elements supporting the customer’s water needs.

Determining which competencies are usually least integrated in today’s water market is one potential method of establishing starting points for a build-up. The correlation matrix in Figure 3 delineates the business activities of each of the competitors of the water basket in Figure 1 into 20 industry competencies analogous to those of Figure 2. Since these public competitors tend to be the largest in their fields, their suite of services is likely to be the most expansive, revealing the dominant service bundles offered today.

As we can see, some competencies are positively correlated: virtually all companies that provide maintenance also offer billing. The more interesting question, however, concerns itself with negative correlations, shown in increasing shades of blue in Figure 3. Companies in chemical processing, for example, tend not to be in design and logistics, while Infrastructure players are generally weak in purification and filtration. Summing up all correlations for each competence, we find contamination detection to be the most insular among those represented in the water basket.

To further illustrate one process leading to the articulation of a private equity investment strategy, let’s consider contamination detection as a competence that has yet to be broadly integrated into complete solutions tailored to specific demands. How could a strategic private equity investor help unlock value in coalescing a one-stop service platform? Rather than diving into the massive industrial arena, let’s start closer to home: the residential market.

Vulnerability versus detection
We can survive one month without food, three days without water and four minutes without air. Virtually every food product we buy in the grocery store—including water—features an expiration date and nutritional information; many U.S. homes have a carbon monoxide detector to ensure we are breathing good air. But there appears to be little concern about contaminants in the tap water we use to not only wash and prepare our foods but also (in lots of households) drink. And while many people have resorted to drinking bottled water, the coffee I am drinking was certainly not screened for the presence of inorganic toxins that can endure boiling water.

Considering the vulnerability of our water supply to accidental and willful pollution as reflected by the spectrum of toxins, from E. coli to lead, that are routinely found in tap water, it is a staggering fact that water is not tested a single time after leaving the treatment plant. In a world of both weakening metropolitan water infrastructure and rising terrorism, how much value is waiting to be unlocked in integrated point of use contamination detection alone? You are no longer getting just a water bill, but a report documenting the health of your water relative to U.S. EPA standards and alerting you to any trends of interest.

More importantly, you are getting real-time security: as you draw a glass of water from your tap at 2:00 a.m. you receive an instant automated call informing you of traces of benzene in your incoming water. You also learn that your filtration system removed the benzene, that the water in your glass is safe for drinking and that a digital alert has been sent to your municipal water utility, which will follow up within 24 hours. What would a full-service offer guaranteeing not only water quantity but also quality delivered to our homes be worth to us? What would it be worth to a food processing factory, a cosmetics plant, or a pharmaceutical manufacturer?

Integrating the transportation, process and information needs of specific demand segments, we can conceive of similar solutions for other low-correlation competencies in Figure 3, such as corrosion resistance, metering and controls. Each of these areas allows the formulation of turnkey services tailored to the needs of established markets, whether domestic, industrial or agricultural. Without a doubt, there is great potential for value creation outside particular technological vogues such as membranes and desal.

Having selected paths toward long-term growth, the investor will also contemplate potential exit scenarios five to ten years hence. Half of the public companies sampled in this article have price-earnings ratios between 21x and 28×2. Although these PE ratios do not increase with revenues in the overall industry, they are on average relatively greater in companies offering more competencies that are highly correlated3, per Figure 3. The relevance of the competence correlation is further substantiated by the fact that sheer number of competencies alone has not incited price appreciation in these companies beyond the basket average since 1990.

One implication for private equity investors is that while the drive toward integrated water solutions is only beginning, attractive exit scenarios via public markets will mature for well-assembled small- and mid-cap (rather than simply hefty) water companies. Established, large players in this market will present additional exit options as they continue to build their water portfolios.

Conclusion
Industrial and population growth drivers along with population shifting and concentration will continue to clash with treatment efficiency limits as well as pollution effects. Coupled with regulatory constraints and the capital expenditure intensity characteristic of the water industry, this conflict is certain to effect change. Successful responses to that change will bundle competencies into cohesively integrated services tailored to a clearly defined demand. Private equity players who want to participate in the creation of value in the water industry therefore must be more than financial investors. We have to be enduringly committed and strategically align ourselves with specific segments in this vast industry. We have to be willing to add value to our portfolio companies in partnering with management teams to cultivate not only operational excellence but also strategies that are both turnkey and value-adding. If we can do that, we will discover in water a metacatalyst for long-term investment success.

About the author
Christoph Lueneburger, P.E., became managing partner of Rigger+Stern Capital Management in 2002 after working for Bertelsmann Capital Ventures in New York. Leveraging his graduate background in fluid dynamics as well as his operational experience, Lueneburger is currently establishing an investment focus on the water sector at private equity house Stonehenge Partners in Columbus, Ohio. He can be reached at (877) 298-4409 or at clueneburger@stonehengepartners.com.

1 Because no exchange-traded fund for water exists today, the ad-hoc basket used herein contains tickers AMN, AWR, BMI, CCC, CLC, CLX, CWT, DHR, DNEX, FELE, FLS, GLK, INSU, LNN, MIL, MSEX, PNR, RBN, SWWC, TMO, URS, VMI, WTR and WTS. All of these have been listed at least since Q2-1990.

 

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