[bradleyland]

That's true, but there are hard limits to the heat conversion efficiency of an otto-cycle internal combustion engine [1].

Given two engines, both optimally designed to approach those limits, air-cooling is not as practical or as efficient as water-cooling. This means that for a given displacement, you'll hit the boundaries of air-cooling before you will water-cooling. If you want to continue to increase your power for a given displacement, you have to find a way to dissipate the wasted heat energy. That leads you to water-cooling.

It's not that water cooling is that much more efficient, but that it scales more easily. With air-cooling, you have limited space around the cylinders for cooling fins. The head is particularly problematic because of the valve gear. With water-cooling, you can increase the dimensions of the radiator in three dimensions to improve heat dissipation capabilities.

1: http://physics.stackexchange.com/questions/98966/maximum-the...