With this installment, we turn to an article written by Todd E. Alexander and Marissa Alcala, partners in our project finance group. It was first published in the November 2006 issue of the Project Finance NewsWire.
The ethanol market showed signs of cooling this fall because of falling oil prices and fears about overcapacity, but interest in new biodiesel plants remains hot.
Larger and larger biodiesel plants are being brought to market for financing. The projects are both new builds and expansion of existing facilities. Potential demand for biodiesel is also growing.
The distillate fuels market in the United States is currently 62 billion gallons a year, with potential for various blends of biodiesel throughout that market. The National Biodiesel Board reports that the maximum annual production capacity for US biodiesel plants in operation was 37.5 million gallons per year as of early September 2006. Of 86 plants in operation, only 20 have capacities of 10 million gallons a year or more. Thirteen of these existing facilities are adding additional capacity; the additions are currently under construction. The board said 65 new biodiesel plants were under construction in early September. Three of the new plants will have capacities of 80 million gallons a year or more. The largest has a capacity of 100 million gallons. Thirty two of the plants under construction have capacities between 10 and 80 million gallons.
As the demand for biodiesel increases, developers are turning to bigger projects in an effort to benefit from economies of scale. Banks and private equity funds are helping the construction boom by providing funding for ever larger projects.
Any developer seeking financing should secure a strategically located site and negotiate a solid technology and construction contract before approaching potential lenders and equity investors.
Because the operating costs for biodiesel plants tend to be fairly comparable regardless of the technology employed, one way a developer can stand out from the pack is site logistics. The key to a strategic site is to find one that reduces costs and increases flexibility.
Site location can have a significant impact on costs. For example, putting a plant close to a reliable source of feedstock will decrease transportation costs on the supply side. Siting a plant close to a committed offtaker or sizable blending market will help reduce transportation costs for offtake and delivery. A site near an active port or other water- way will reduce overall transportation costs because of the comparatively low cost of barge and other water-based trans- port (particularly when compared to transport by rail or road). The greater the number of destinations that a plant can access easily, the greater the ability a developer will have to manage feedstock supply and offtake to maximize profit at any point in time. Direct access to water also means direct access to the export market, making a facility less reliant on industry growth within the United States.
Developers often enter into turnkey construction contracts with a fixed price, guaranteed construction schedule and guaranteed performance level upon completion in an effort to reduce construction risk. Lenders usually require such a turnkey contract as a condition to funding. A project will cost more to build under a turnkey contract; the contractor will charge more in exchange for taking on more risk. The contractor usually agrees to cover the developer’s fixed costs if there is a delay in construction. It also agrees to compensate the developer for lost value if the completed plant does not meet guaranteed performance levels. In a project finance transaction, these guarantee payments will be used to pay interest during a construction delay or, in the event that performance guarantees are not met at completion, to buy down the debt.
The number of contractors who will sign turnkey contracts to build biodiesel plants in the United States is small. These contractors include Lurgi PSI, Fagen, REG and Safer Energy. Because most of these contractors also build ethanol plants, they should be familiar with the standard turnkey provisions that lenders require. However, given the small pool of potential contractors, delays are to be expected in getting on a contractor’s master schedule, and the actual schedules, once a project is listed, are elongated. Contractors are also using the high demand for their services to charge premium fees.
A non-turnkey contract can be used if the equity investors are comfortable taking construction risk. The project would have to be financed either with all equity or with debt backed by significant sponsor-completion support. The developer could arrange for a single contractor to build the facility without any performance guarantees, or arrange for various components to be provided by multiple contractors. The latter approach, often referred to as an owner-construct process, places an additional burden on the developer of managing the construction timeline and supervising multiple contractors. In exchange for this additional responsibility, the developer may be able to build the plant at a lower cost.
Developers also need to obtain rights to the process technology that will be used in the plant. In a turnkey arrangement, a technology license is incorporated into the construction contract or provided in an accompanying license agreement. In an owner-construct structure, the developer must sign a license directly with a biodiesel process technology provider.
Biodiesel developers usually use one of two approaches to raise equity. The first is to do a private placement of shares or other equity interests in the project company. The second is to solicit proposals from a limited number of private equity firms, and select an investor through a competitive bid process.
Factors to consider in a bid process include timing, what, if any, preferred return the private equity investor will require, the carried interest to the developer, the degree of control the equity investor will insist on over the project and advisory or ancillary services. In some cases, a private equity firm might offer to provide both equity and subordinated debt. Such subordinated debt is typically priced in the range of 12% to 18% and might also include warrants in favor of the subordinated lenders for conversion to equity.
All equity investors look for strong projects with projected rates of return around 25%. Solid supply and offtake contracts with competitive pricing and dependable, experienced counterparties will help make a project more attractive. Equity investors may also be interested in multi-plant opportunities with the same developer.
A private placement would be expected to attract a larger number of small investors, and would draw investment based on expected returns with the developer’s management team running the project. The carried interest to the developer would be determined in advance by the developer and identified in the placement memorandum. A developer using this approach usually retains more control over the project, but ends up with a smaller carried interest than in a private equity scenario. A private placement typically takes more time to execute than an auction involving just a few private equity houses.
It is usually faster to raise money from just a few private equity funds. Private equity management teams often bring valuable expertise and contacts to the table that may be of particular benefit to developers with less business experience. This can lessen the day-to-day burdens on the developer team. A developer may need to engage a financial adviser to make introductions and facilitate the review of proposals. Such financial advisers typically charge a finder’s fee of between 4% and 7% of the equity raised from their efforts.
Private equity investors tend to have a shorter investment horizon than investors who buy equity offered through a private placement. Private equity firms usually want to hold an investment only for a few years before exiting. A private equity investor might sell its interest in a biodiesel facility to another private equity fund, to an interested company or, less frequently, to the original developer or company management. Another exit strategy that can be attractive to both private equity and other investors is to take the biodiesel company public eventually through an initial public offering. Many private equity firms would be interested in “master limited partnership” structures where a biodiesel company has units that are traded on a stock exchange or over-the- counter market. This would provide liquidity and make for an easy exit. It would also bring down the cost of equity to developers. Such structures have been slow to develop.
Regardless of approach, equity can always be split into different classes with various rates or priorities of return, as well as varied levels of voting or management rights. The right structure for each project will depend in part on timing and on the preferences of the developer and initial project sponsors. Developers can generally expect to maintain a carried interest in the range of 15% to 20%, with higher numbers in some exceptional cases.
To date, most financing for biodiesel plants has come from Midwestern banks in Minnesota and Iowa. However, lenders with experience with ethanol are showing a growing interest in biodiesel projects. With the significant growth in biodiesel production anticipated in the next few years, money-center banks are also expected to enter the market.
Because the biodiesel lending market is still relatively immature, developers should expect biodiesel financing terms to be more conservative than current ethanol financing terms. In particular, developers should expect lower debt-to- equity ratios (i.e. more equity and less debt). Midwestern banks are usually lending to biodiesel projects at a 1:1 debt-to- equity ratio. As is the case with ethanol financings, developers should also expect significant cash sweeps that protect the lenders against downside risk. While a 7- to 10-year term for biodiesel financing is common, lenders typically size cash sweeps that, if realized, would reduce the total life of the debt by two years or more.
Lenders evaluating biodiesel projects obviously focus on the expected returns and health of the project while the loan will be outstanding, but they also want the project to look healthy for a few years after the loan is expected to be repaid to provide a cushion in the event of delays or other complications. Lenders focus in particular on the supply of feedstock. There is a limited number of crushing facilities in operation currently, and ownership of them is concentrated in the hands of only a few companies. Lenders will insist that a project have a significant amount of working capital. There are long lead times between payment for feedstock from a crushing facility or importer and when the feedstock is delivered. Working capital could be borrowed as part of the debt principal, addressed through longer or more flexible payment terms, or provided by a strategic partner or separate lender. Banks usually offer working capital equal to 50% to 80% of the accounts receivable and inventory of the project.
Lenders also expect developers to have a commodity hedging strategy to shield the project from volatility in biodiesel and feedstock prices. In addition to traditional hedging arrangements, developers can also control prices by entering into long-term fixed price contracts or by entering into tolling agreements where the biodiesel producer is paid a flat fee for turning feedstock into biodiesel. Some producers have also been able to secure offtake contracts with prices indexed to heating oil or ultra-low- sulfur diesel.
Other mitigants that help attract lenders to the biodiesel industry include the use of equipment in biodiesel plants that lets the producer switch among various feedstocks depending on which is the most economic at any given time. This flexibility puts biodiesel in a unique position to weather fluctuations in feedstock pricing and availability (particularly compared to ethanol plants that usually require major plant or process modifications in order to switch feedstocks). As an export market develops for US biodiesel, this will also help make lenders more comfortable because of the flexibility it affords for dealing with changes in the US market. Use of biodiesel as a replacement for fuel oil in power plants would open a new segment in the offtake market; plans are underway to test the viability of biodiesel in power plants in the northeastern United States.
Just like in any project, there are risks that must be managed and monitored.
The US government offers a tax credit to blenders as an incentive for using biodiesel. Blenders can get a credit of $1 per gallon for blending agri-biodiesel (diesel fuel made from virgin oils derived from farm commodities and animal fats) or 50¢ per gallon for other biodiesel made directly from agricultural products and animal fats (sometimes called brown and yellow grease). Some market observers believe biodiesel consumption in the US depends on this blender’s credit, at least outside states where biodiesel blending is required by law. The credit expires at the end of 2008. While there is risk that the blender credit will not be extended by Congress, most in the biodiesel industry are confident that it will be continued beyond 2008 in some form. Selling into a healthy export market may help to mitigate part of this risk.
Biodiesel prices fluctuate. Most biodiesel facilities are uneconomic to operate if wholesale prices for petro- diesel drop below $1.20 per gallon. The price for petro- diesel is a factor in what can be charged for biodiesel. However, there is no correlation between petro-diesel prices and prices for feedstock used to make biodiesel. This leaves plants exposed to being whipsawed if biodiesel prices drop at the same time that feedstock prices remain high. Use of one or more of the hedging strategies discussed earlier, together with the opportunity to switch feedstocks to get the best market price, is the best way to mitigate this risk.
Another risk is the potential harm caused by poor quality biodiesel making it to market. When the 2% biodiesel blending requirement first went into effect in Minnesota, unanticipated quality problems slowed acceptance of biodiesel and required that temporary waivers of the blending requirement be granted. The industry must ensure that biodiesel meets required production and performance standards, including cold flow properties, to succeed. To help address quality concerns, the National Biodiesel Board started a BQ-9000 accreditation program for producers and marketers of biodiesel. This is similar to the steps that wineries have taken with appellation controlee laws to guarantee quality. Many expect biodiesel eventually to become unmarketable without BQ-9000 accreditation.
The biodiesel market is still evolving, with rapid growth now being led by many of the large ethanol producers such as ADM and Cargill. Individual projects are getting larger. More banks are crowding into the market as potential lenders. This helps borrowers, but at the same time, the trend is also toward increasing complexity in loan arrangements.