A Return to Rationalism?

The investment surge that infiltrated the ethanol industry 18 months ago brought with it an expanded repertoire of chic finance options. As the smoke from that intense period clears, however, it's evident that Midwest farm banks didn't forfeit their power position in U.S. ethanol plant finance.
By Ron Kotrba | March 06, 2007
No sooner did the largest ethanol investment rally in history cool off when a war-weary President George W. Bush faced the nation and a Democrat-led Congress for his seventh State of the Union address. The president strategically opened with domestic issues before making his protracted pitch on salvaging war efforts in Iraq. Then, he urged legislators and the public to embrace a five-fold increase in domestic biofuels production and use by 2017—a 35 billion-gallon initiative that would dwarf the current 7.5 billion-gallon renewable fuels standard (RFS). The Renewable Fuels Association (RFA) held a press conference the next morning, during which RFA Chairman Ron Miller said new demand for renewable fuels would ensure "continued investment by Americans in all walks of life, from Wall Street to Main Street—from stockbrokers to school teachers." At the same press conference RFA President and CEO Bob Dinneen offered his own comments. "As new capital has come into this industry—and new intellectual capital—I'm confident we'll see cellulosic ethanol … far sooner than most people think," he said. "[The current RFS] sent a strong signal to the marketplace and financial community that this is a secure place for people to invest." Imagine the swell of investment with five times the security.

Even so, there remains throughout the industrial and developing world a pervasive recognition: Unremitting demands on construction materials and prefabricated equipment have steepened capital requirements to build virtually anything, anywhere. For the U.S. ethanol industry, financiers stress the importance of understanding how the upward cost of materials and equipment—and an increasing demand on labor, design and engineering services—affect individual project financing and the future build-out of this industry.

The Great Equalizer
"We strongly support President Bush's initiative," says Tom Reich, vice president of structured finance with Noble Americas Corp. "However, it will not necessarily be the 'tipping point' in [the bankers] broadly approving projects—they will still require strong commercial fundamentals with strong equity sponsors."

A 100 MMgy plant today costs about $200 million, or $2 per gallon for construction, according to Paul Ho, director of global energy at the worldwide investment banking firm Credit Suisse. Less than a year ago, EPM spoke with John Urbanchuk, director of LEGC LLC, about the cost per gallon for constructing an ethanol plant. In early 2006, Urbanchuk said a 100 MMgy dry-grind plant cost $1.35 per gallon; 65 cents less than what Ho suggests is required today. Elevated construction costs are, in turn, driving up the amount of money that equity project groups must acquire before lenders will close their deals. Plus, leading industry builders say project estimates are now only good for approximately 60 to 90 days, making capital requirements somewhat of a moving target.

"The demand for construction and engineering firms, and materials has increased the dollars-per-gallon costs and, along with it, the equity portion of the equity-to-debt ratio," says Mark Schmidt, senior financial services executive with AgStar Financial Services. "When costs go up, something needs to absorb it."

AgStar has a strong monetary presence in the ethanol business, managing $1.5 billion of ethanol project debt and holding $250 million of it directly. The remainder is picked up by a group of select participant lenders. "As lead lender, our role is to negotiate the term sheets, go to the marketplace and present the terms in book form to a potential group of commercial lenders waiting to participate, and sell them on the fact that this is a doable deal," Schmidt tells EPM.

Higher plant costs and equity requirements don't have to be obstacles to new projects, Reich says. "Rising ethanol plant construction costs directly related to volatile component costs have proven troublesome, and senior lenders are pushing back on simply accepting this trend," he says. "Maybe with strong project sponsors—and above-market equity levels—senior lenders will consider 'cost-plus' financings and not always require lump-sum turnkey ethanol plant construction contracts, which should reduce the overall cost of projects."

Debt levels have risen too, but money-smiths in the finance world say the increase has been disproportionately outpaced by equity. "This also means there is a lower return to equity holders," Ho explains. The perception of lowered returns may make it difficult for many projects to awaken high levels of investor interest. This is especially true for projects with less attractive locales—where corn is less abundant and therefore priced higher, or where water is scarce. "Location is one common denominator for all projects to which we consider lending," Schmidt says. "It's the primary consideration and has been so for years. We always do our due diligence on all aspects of a project even though some areas are expedited because of the design-build firm's experience, for example. But we'll still consider the merits of a project based on location first."

Another factor affecting investment and financing of new ethanol projects is that margins for existing producers have gotten thin. Low crude oil and gasoline prices have sunk ethanol's retail value, and corn prices in the cash and futures markets have ticked steadily upward. While AgStar underwrites debt proposals using historical average prices for ethanol and corn, it also conducts a series of sensitivity analyses on current ethanol economics in order to get the complete view of the risk, Schmidt says.

Expanded Options
In the traditional finance model, an ethanol project group holds equity drives to raise capital. Typically, a Midwest farm bank would then close the deal with a 10-year loan arrangement, and the borrowers would pay the principal down each year to lower the financial risk. AgStar rewards the customer as principal is reduced and the overall financial condition of the borrower improves. "Lenders need to build incentives into loan documents, like better interest rates and lower costs," Schmidt says. "With incentives, the borrower has additional motivation to improve their financial situation, lower their costs and build equity. All of these factors decrease risk and increase their ability to survive an economic downturn."

A couple of years ago, Wall Street investors jumped onto the U.S. ethanol bandwagon because of the attractive terms, Ho says. Then, 18 months ago, a metamorphosing rally in ethanol investments took off. As a result, general non-investment-grade financing was hot on the institutional syndicated loan side—B loans—for greenfield ethanol projects. Wall Street senior loan arrangers offer B loan (sometimes in the form of high-yield bond financing) investment opportunities to private-sector investors or syndicators who are willing to take on a higher risk in return for a larger, faster reward.

Wall Street money has debt and equity components. Reich says the debt side of Wall Street is made up of senior loan arrangers and syndicators: the bank market has its "club" or loan syndication group; and the institutional market has "term B" loans or industrial revenue bonds, he says. Wall Street equity includes privately and publicly traded equity funds, in addition to bankers assisting with initial public offerings and reverse-merger shells. "In between the traditional debt and equity players, you have the subordinated debt—mezzanine—lenders and the preferred equity investors that have 'shades-of-gray' levels of difference between them," Reich says. A mezzanine loan might best be described as a hybrid form of capital that is treated as equity, according to Ho. Therefore, from a senior lender's standpoint, they take an equity risk and treat it like a return.

The flurry of Wall Street activity in the ethanol sector is reportedly diminishing as ethanol production steamrolls closer to surpassing the 2012 RFS target four years early. As a result, ethanol project developers have returned to the more traditional funding sources. As Reich points out, farm-bank lenders have nurtured this industry from its humble beginnings, and they're holding strong. "They'll continue to positively shape this industry," he says. "However, investor groups looking to line up big-ticket multi-facility financings will find more loan capacity from Wall Street senior loan arrangers and syndicators who reach out to a broader base of loan participants."
Because of current market conditions, Wall Street investors are more cautious. "Wall Street money, especially that from high-yield bond investors, is more readily available for existing companies that have the balance sheets—an ongoing company with track records," Ho says. "It's more difficult for companies with no existing production."

The increased investment options over the past two years have really added liquidity to the ethanol sector "in the form of additional equity investors and senior lenders," Reich says. "We [at Noble Americas] Corp. were particularly fortunate to have drawn upon our global bank relations and brought incremental loan capacity to our equity investment projects and, by extension, to the market."

Prudence Pays
Ho says most project leaders and developers—except those hired for their financial prowess—don't overly concern themselves with the details of project finance, nor should they. "Be prudent, yes, but don't put the cart in front of the horse—commercial issues should take precedence over financing issues most of the time," Ho tells EPM. "Some get really involved, and others delegate that responsibility out to their finance team. This type of involvement doesn't impact operations much on a day-to-day basis, so long as margins are decent." As margins get squeezed, project owners need to think about how to manage commodity risk and to determine what margins will protect them over time, so long as they don't run into problems with the lenders, Ho says. A rational undertaking for the average project developer might be to reduce the myriad of available finance options down to financial arrangements that give the company greater benefits, and to define the capital risks associated with each tier.

Overall, fewer greenfield ethanol projects will get financed this year, Reich predicts. "Good projects with strong and strategic project sponsors will get done this year, but in general, we see fewer greenfield projects closing this year than last," he tells EPM. "Instead, look for more expansions and related refinancings from currently operating companies with proven management teams. Also, I expect we'll see more hybrid debt financings with senior loans being complemented with industrial revenue bonds as part of the [new] capital structure."

The five-fold RFS up-sell that the president pitched in his State of the Union address could reinvigorate madness in the ethanol market coming down from its previous investment high, but ultimately the current marketplace is one in which calculated managers of risk are gainfully employed, customary Midwest farm banks are still king and Wall Street is selectively interested in the right project with sound balance sheets. So long as corn supplies can absorb the demand and cellulose research remains demonstratively fruitful, lenders are ready to provide the capital resources to make it happen.

Ron Kotrba is an Ethanol Producer Magazine staff writer. Reach him at rkotrba@bbibiofuels.com or (701) 746-8385.