Game Plan for Capital Project Financing Discussions with Lenders
As the ethanol industry has matured and paid off significant amounts of debt in the past few years, it is becoming more common for plant managers to consider expansions or upgrades to enhance efficiency. Many consider new technologies for processing alternative, value-added products from corn. Some older plants simply need to reinvest in the plant, bringing it up to state-of-the-art.
The lender’s point of view of such projects is not all that different from the evaluation by the management team and board of directors. It starts with projected return on investment (ROI). What are the costs? What are the potential returns and how might additional gallons affect the local corn basis? Unlike the investor, the lender generally only has downside risk to the stated interest rate on the loan and no upside in the form of greater returns, thus the lender’s tolerance for risk is generally not as great as equity investors.
When discussing a capital infrastructure project with a lender, be prepared to discuss the short- and long-term benefits and risks. Prepare a three- to five-year projection with the key assumptions used in the analysis. Consider stress testing those assumptions, as the lender definitely will be doing so in its evaluation. Consider the ROI under different scenarios and how it makes the plant more competitive in the long run.
The goal of most projects is to drive down costs to be more competitive or to capture higher-margin revenue products. Thus, understanding the plant’s performance drivers and how the facility ranks on the performance curve are important, typically stated as EBITDA (earnings before income taxes, depreciation and amortization) per gallon. History has shown that the most efficient gallons will have less volatility to earnings during down cycles.
When considering a new technology with new market opportunities, expect pushback for expenditures with the serial number “001.” While we have seen great successes, such as corn oil extraction, not all projects experience universal success, nor does one size fit all. For instance, there may be geographical differences that impact success. Another example: Cellulosic production is still an evolving path. Often, it’s better to be patient and ride out the infancy phase of new technology, so initial bugs can be corrected and performance data accumulated.
As with all commodity-related industries, the project’s impact on the business’s working capital will be a key discussion point, especially in an expansion where more working capital may be required. Working capital in the 15- to 20-cents-per-gallon range generally is considered healthy. Higher working capital levels, however, can mitigate the additional risk a capital investment project may bring. Expect your lender to have covenants around this financial metric. Striking the right balance among asset investment, a strong working capital position and distributions back to investors is the biggest challenge as new projects are discussed.
While the historic and projected financials of the plant are central to a lender’s credit decision, equally important is the strength of a management team. Strong economic periods can hide management deficiencies, but good performance during challenging times highlights strong management teams. Not all adverse factors can be controlled, but strong management positions the facility to better navigate them.
An ethanol plant’s debt level is usually a combination of historic and projected cash flows, working capital and management strength. The level of debt generally ranges between 50 and 65 cents per gallon, depending on the project. As it relates to expansion, there is always the discussion on whether the industry needs more gallons. This is no different from many other commodity-based businesses and is a function of supply and demand. A business expansion must include plans on how to survive an oversupplied market. This correlates with being an efficient producer with working capital to absorb acceptable losses and a strong management team that can adapt to changes to the market.
Having a good lender relationship establishes management’s credibility and generally creates a more open dialog as capital projects are discussed. Lenders do not like surprises, so keep them informed and let them know what the business sees as potential risks and why the business is comfortable with the risk. Cultivating this relationship on an ongoing basis will position you for a more productive, honest and beneficial discussion when the time comes for project financing.
Author: Jason Johnson
Vice President, Team Leader, AgStar Financial Services