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New Issues Arise as the Size of Ethanol Plants Increase

By Todd Alexander and Marissa Leigh Alcala | April 01, 2006
During the past 24 months, the average size of new ethanol facilities in the United States has increased significantly. As of March (according to Ethanol Producer Magazine), there are currently five ethanol plants under construction with capacities of 100 MMgy or greater. In addition, Aventine Renewable Energy in Pekin, Ill., is undergoing an expansion that will put its total capacity at 160 MMgy, and 16 more new ethanol facilities are under construction with capacities between 50 MMgy and 100 MMgy. Later this year, it is expected that groundbreakings will occur for additional ethanol plants under development with expected capacities upwards of 100 MMgy. It is no coincidence that this increase in the number of large-scale projects under development has coincided with an increase in the number of money-center banks lending to ethanol developers, as well as an increase in the number of private equity firms investing in ethanol companies.

The changing landscape of the players in ethanol financing is altering the traditional structure of ethanol development for these larger projects from a relationship-based approach to a more highly negotiated and formal contract-based business.
Ethanol development in the United States has its origins in the farming communities of the Corn Belt, where for years farmers and farming co-ops have constructed, operated and maintained small and medium ethanol production facilities as a means of hedging against fluctuations in the price of corn. Financing for the development of such projects was traditionally provided by farmers and other local residents investing through a co-op equity structure, together with small-scale financing provided by local relationship banks.

While many new and proposed ethanol projects plan to capitalize on the significant economies of scale available to larger facilities, the cost of constructing such facilities is well beyond the size of traditional ethanol debt and equity structures. To fund the construction of larger facilities, developers are increasingly looking to partners outside farming communities, including private equity funds and money-center banks. With limited, if any, exposure to the ethanol industry, these new partners are looking to their standard set of risk management tools in structuring their returns on project investment. By way of example, these tools can include greater controls over project operations and the terms of project-related contracts than those used by more traditional sources of financing for ethanol plants. This shift in financing partners requires a reevaluation of certain traditional elements of ethanol project structure. While this meeting of different cultures necessitates adjustments and compromises from all sides, there is real potential for success as evidenced by the recent closings of private equity investments and money-center bank financings for numerous ethanol projects including those sponsored by Abengoa Bioenergy Corp., ASA Biofuels, Aventine Renewable Energy, Hawkeye Renewables, Pacific Ethanol Inc. and VeraSun Energy.

THE PARTIES

Developers

Local farmers and other local businesspeople continue to be the primary developers of new ethanol facilities. These developers put together a project from the ground up—locating a site; identifying strategic partners including construction contractors, technology providers, suppliers and off-takers; and managing the day-to-day business of the project company throughout the development stage. Developers invest a substantial amount of "sweat equity" into each project and tend to stick with a project long after the construction financing is paid off. Local developers also tend to be involved in community relationships. Developers themselves, or their friends and family members, may be employed as senior management or executives for a newly formed ethanol company and value the relationship of their company as a significant employer of construction workers and plant operators in the local community. In addition to sustainable community relationships, developers are looking for real financial returns on their investment.

Equity investors

Private or institutional equity investors are focused directly on the financial return of a project, as well as the liquidity of their investments. Private and other institutional equity investors are often seeking returns in excess of 20 percent, and based on equity fund rules, are often required to exit a project within five to seven years. Because equity funds traditionally have less experience in the ethanol industry, they are looking for projects with strong management teams in addition to significant short-term returns. Equity funds tend to get involved with large projects where economies of scale lead to a higher projected return per dollar invested, and their access to large pools of capital are highly valued. Some equity funds will also look to provide subordinated debt to new ethanol development projects as a way to achieve a preferred return and minimize their exposure to the vagaries of the ethanol business.

Money-center banks

With bank debt for large-scale ethanol construction projects commonly reaching more than $100 million, the funding for these loans oftentimes can no longer be provided by a syndicate of relationship banks. Developers of large-scale ethanol facilities are increasingly looking to money-center banks to lead syndicated financings for these projects. Money-center banks have a relative lack of experience with ethanol financings—although this is changing—and may not have long-term relationships with the developers. As a result of these and other factors, the documentation for money-center bank deals is more heavily negotiated. Developers should expect the financing documentation from money-center banks to be replete with covenants (both affirmative and negative) controlling critical aspects of the way a project company can run its business and pay its bills. This is usually coupled with significant regular reporting requirements to keep the syndicate of senior lenders fully informed regarding the project's status.

Because money-center bank loans tend to be syndicated outside of the local market, the lead arranger for such financings will insist upon industry-standard provisions in order to sell the deal to potential syndicate participants. These institutions tend to put more value on written contractual commitments than relationship banks. That being said, relationship banks continue to remain involved in money-center bank financings as members of the financing syndicate. In fact, syndicate participants with less exposure to the ethanol industry may view the inclusion of a local bank with significant ethanol experience as validation that the proposed project is fundamentally sound.

Money-center banks will often apply a higher level of scrutiny to project contracts and to project-related risk management than local relationship lenders. The required senior lender cure rights for project company breaches of project-related contracts may be beyond the requests that ethanol construction contractors, suppliers and off-takers are accustomed to seeing with local bank financings.


THE CHALLENGES

While the inclusion of these diverse parties requires creative solutions to address their divergent interests, it also allows the project risk to be allocated based on a particular institution's appetite.

Equity issues

With multiple sources of equity including the project developer, private or institutional equity funds, as well as continued involvement of additional local partners, divergent interests will need to be reconciled with respect to the rate of return on equity investments, and the allocation of voting rights with respect to management of the project company. With numerous equity investors, a common approach is to divide the equity into classes, with each class having a different rate of return on its equity investment and/or different voting rights. Voting rights may be further divided into the right to appoint members to the project company's board of directors, which may be expressly allocated to designated equity investors, and the weighting of the votes of each class of equity on different types of management decisions. Certain management decisions might be taken with the vote of less than all classes of equity interests, while other decisions might require the vote of all classes.

The rate of return on investment for different equity investors may also change over time, with equity funds often looking to recoup their initial investment before developers or local investors become eligible for equivalent distributions. Developers should appreciate that bonuses for private equity fund managers are often contingent on fund investors receiving a return of all their initial investment plus an additional nominal rate of return. As a result, private equity tends to favor a sharing of distributions that allows them a higher percentage of the initial project profits with such percentage reducing dramatically after the amount of their initial investment has been returned and, in many cases, a nominal return on that investment has also been achieved.

Project contract issues

Money-center banks review project contracts with a critical eye, looking not only to ensure that the project will be constructed, operated and managed effectively, but also to ensure that in the event of a project company default, the senior lenders can keep the project running. This translates into requests for cure rights and extended cure periods for the senior lender group. Often, it also translates into the construction contractor being asked to assume certain risks that it has not customarily assumed—such as increased exposure for liquidated damages and higher limits on overall contractor liability—even though the contractor may have a great deal of experience with ethanol projects.

Inter-creditor issues

Where a project will be funded by multiple debt sources (for example, a combination of subordinated and senior debt, or a pairing of senior money-center bank financing and senior local bonds), the terms of the inter-creditor arrangements will be critical to each debt provider. Senior debt providers will be looking for the upper hand and expect to control the flow of project revenues that can be applied to repay subordinated debt. Senior lenders will likely insist on the right to stop all flow of funds to subordinated lenders in the event of a default under the senior debt financing. Where subordinated debt is provided by institutional investors or funds looking for a healthy return on their investment (rather than deeply subordinated loans made by long-term equity investors who consider such debt a placeholder for a portion of their equity investment), the subordinated debt providers may start off with an expectation of rights and remedies beyond those that senior lenders would accept. Subordinated lenders may look to higher returns as compensation for their relative lack of control over their investment.

While overcoming the hurdles of successfully financing a large-scale ethanol development project are not insignificant, the industry has shown that developers, equity funds and money-center banks can work together successfully to finance important new construction of these plants.

Todd Alexander and Marissa Leigh Alcala represent the law firm of Chadbourne & Parke LLP. Reach Alexander at talexander@chadbourne.com or (713) 571-5900. Reach Alcala at malcala@chadbourne.com or (202) 974-5609.
 

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