Piecing Project Financing Together

Obtaining financing for ethanol projects is much easier today than it was in the industry's early days. But there are still hurdles to clear, especially with so many project developers clamoring for funding. Developers can increase their chances of getting the necessary financing by making sure certain crucial components are in place.
By Holly Jessen | October 26, 2006
The ethanol industry's building blitz has attracted a host of developers interested in a piece of the action. Newly proposed projects are announced regularly, with some developers expressing interest in pursuing multiple projects at the same time.

The zeal with which the industry is being embraced is a welcome change from the early days, when ethanol pioneers struggled in their attempts to persuade people to accept and appreciate the renewable fuel. However, the race to build plants can, and has, strayed into irrational territory in recent times. "The exuberance of this industry has caused a lot of projects to get in a queue that will never get built," says Jeff Kistner, vice president of project finance for BBI International.

Attracting the attention of investors and lenders is an essential component in moving a project from the idea stage to reality. To distinguish a project from others out there, it's important to have a solid business plan, and form relationships with a skilled project management team and trusted design/build companies. "They all have their challenges, but good projects will get financed, both with debt and equity," Kistner says.

Project Homework
The No. 1 hurdle that project developers must clear before attempting to gather financial support is the permitting process, according to Todd Alexander, a partner with Chadbourne & Parke LLP. Securing the services of a capable construction contractor is also a crucial step in the process, one that could prove to be difficult in light of the current building frenzy. Once those pivotal elements are in place, developers can move toward obtaining equity and then debt needed to get the project moving.

Properly structuring a project via a feasibility study improves the chances of success, according to Mike Masterovsky, director of the renewable energy division for SJH & Co. A feasibility study looks at components such as proper location, grain sourcing strategy, and pricing of both feedstocks and products produced at an ethanol plant.

Not all feasibility studies are created equal, however. Financiers want to know that a feasibility study has been completed by an objective source, one that is not involved in the project, Masterovsky says.

Being able to produce ethanol is only one part of the project equation. Having contracts in place to sell both ethanol and distillers grains is another. "Lenders now are looking to see that you have those offtake contracts," Masterovsky says.

Selecting a proven management team can enhance a project's ability to obtain financing, according to Mark Yancey, vice president of project development for BBI. "The services of an experienced project development firm will effectively eliminate the learning curve associated with developing an ethanol project, allowing the project to achieve its goals in an efficient and expeditious way," Yancey says.

It's also important to have a business plan that is realistic. Some developers have unrealistic expectations of the industry, Kistner says. One group he talked to wanted to make $4.50 per gallon ethanol a part of its business plan.

With so many new companies interested in joining the ethanol industry, some project developers may have experience in building business in other sectors, but it doesn't always directly translate for the ethanol industry. "As long as you stay within the fundamentals of the ethanol industry, you should have a good project," Yancey tells EPM. "When you try to bring different business fundamentals to this industry, you may have some problems."

Experienced ethanol project developers will steer plants clear of areas that don't have adequate feedstock nearby or the infrastructure required to economically deliver feedstock.

Not building enough equity into a project could also cause problems. "Having more equity gives you the cushion to weather adverse effects from the commodity [price] swings," Kistner says. What works for the ethanol industry is a ratio of about 40 percent equity to 60 percent debt. Other projects go higher on the equity side, with 50/50 splits, he says.

Today, some developers are looking at 20 percent equity. While that might work in other businesses, it can cause potential problems down the road because of ethanol's commodity-to-commodity risk, Kistner says.

Yancey agrees, adding that many projects today are undercapitalized. Lenders are starting to look at the amount of equity, or capital, an ethanol project is able to secure to help determine what projects they want to service. "Lenders have few metrics that can be used to differentiate between projects, and this [40/60 split] has emerged as a crucial component," he says.

Design/Build Factor
Securing the services of a proven ethanol design/build team is another major hurdle that must be cleared in order to attract prospective investors and lenders, Yancey says. Working with an engineering firm and general contractor that have consistently demonstrated success will make the financing process much easier.

"Less experienced firms, or those with a blemished record, will be seen as adding risk and make financing more difficult," Yancey says.

Established companies that enter into secured engineering, procurement and construction contracts (EPC), where the design/build company signs a performance guarantee, give lenders a tool to evaluate potential. "If there's not an EPC in place, that makes the lenders nervous," Masterovsky says.

Although new design/build companies have cropped up in the ethanol business, contracting with a company that doesn't have direct ethanol experience can cause complications with financing. "The lenders really look at them with a fine-tooth comb," Masterovsky says.

Coverage for liquidated damages (LD) is another risk-reduction factor that lenders take into account. While some experienced companies are now getting waivers for this requirement from lenders, LD coverage is required for unproven or emerging companies, Yancey says. Still, there are a number of general contractors that are required to have LD coverage and are "eminently qualified and financially bankable," Yancey says.

LD coverage offers protection if the schedule is not met or the process should prove faulty. It's typically capped at 10 percent to 20 percent of the project cost. "A performance bond can be required, but the bottom line is the LD requirements must ultimately be borne by the design/build team, through either the firms' financial reserves or an insurance vehicle," Yancey says.

Working with the big names in ethanol process design and building definitely improves the chances of financial closure. However, because of the rapid growth of the ethanol industry, the established firms are "saturated" with projects and are booked a year or two in advance, Yancey says.

The construction flurry has also created a bottleneck in the equipment delivery system that can drag construction time out from about a year to as long as 18 to 20 months. "Delivery times for virtually all key pieces of equipment are increasing due to demand for equipment and supply of raw materials," Yancey says.

On top of that, costs for stainless steel for certain equipment are rising 20 cents a pound. That increases fabrication costs significantly, he says.

Riding the Waves
Despite recent complications caused by the ethanol project boom, raising equity is much easier today than it was in the early years of the industry, Alexander says. Businesses and private investors have stepped up with money in hand as they've grown more comfortable with the technology. It's fairly easy to raise the needed financing for good, solid ethanol projects on both the debt and equity side, Kistner says. Today, there are between five and 10 "solid" lenders with histories of participating in the ethanol industry. Projects that can get two, or perhaps three, term sheets should be pleased, he says.

Investors have also gravitated toward ethanol projects because of the spread between the price of ethanol, which tracks the price of oil, and the price of cornbringing very healthy returns to equity providers.

On the other hand, it would be a misconception to say that any bank out there will provide a loan to an ethanol project. "Is this industry a lendingtree.com? No," Kistner says.

In fact, during September or perhaps starting in August, there was a change in the equity market, Alexander says. Equity providers remained more cautious at press time, he says. Part of that can be attributed to the impact of declining oil prices, and subsequently, ethanol prices. As the industry continues its fast growth pace, the potential for overcapacity is also something investors are watching. Finally, with more and more ethanol plants coming on line all the time, investors wonder how that will affect prices for corn and distillers grains. "We're seeing a very rapid build-out of the industry," Alexander says.

When Hawkeye Holdings announced in mid-September that it was delaying its initial public offering, investors sat up and took notice. The company, which was purchased by Thomas H. Lee Partners for $1 billion, owns two ethanol plants in Iowa. "People were concerned before that, but when Hawkeye had to pull its public offering, that got people nervous," Alexander says.

Of course, the nature of markets being what they are, that doesn't mean the floodgates won't reopen, he says, adding that the market changes on a weekly and even daily basis. The market's expectations of oil prices, positive action by the federal government, breakthroughs in cellulose-to-ethanol technology or sugar prices are all things that could recharge interest in the ethanol industry.

On the other hand, Kistner says raising equity has been a problem when working with private investors. It was retail equity, or the managed equity funds from Wall Street, that tightened up. "Personally, I don't think the money was ever there for the majority of the projects like people said it was," he says.

While there were projects built with Wall Street money, those projects fall into the minority. About 60 percent of ethanol projects today are owned by rural development groups, while the other 40 percent are owned by businesses or corporations. "That 40 percent was what attracted Wall Street," Kistner says.

Holly Jessen is an Ethanol Producer Magazine staff writer. Reach her at hjessen@bbibiofuels.com or (701) 746-8385.