During the last six months, the appetite of private equity funds for investing in ethanol deals has gone from euphoric to cautious. The change is understandable given the rapid reversal in the “crush spread,”or the difference between the price of corn and ethanol.Corn prices rose during the past six months from the low $2 range in June to the high $3 range in December while ethanol prices fell from the $4 range in June to just above $2. The effect of these commodity swings has also taken its toll on the public markets, as evidenced by the decision by Hawkeye Holdings to defer its initial public offering and the overall performance of the other publicly-traded ethanol companies, such as Aventine Renewable Energy,VeraSun Energy and Pacific Ethanol. Given these conditions, developers who are still seeking funding for new plants have to ask themselves: what are the prospects for raising equity? And how should one approach the task? The short answer to these questions is that the prospects for raising equity have diminished at least for the moment, but money remains available for deals that are properly structured and able to differentiate themselves.The following is a discussion of ways many projects do just that.

Stand Apart
Many of the fundamentals that led the equity markets to embrace the ethanol industry early last year remain in place. First, there are more than 100 plants in commercial operation that continue to service their debt even with poor crush margins. Second, the market was receptive to an initial public offering by US BioEnergy of $140 million on December 14, 2006. Third, Congress recently extended a tariff of 54¢ a gallon on imported ethanol through 2008 that will continue to provide the industry with a buffer against low-cost imports from Brazil and elsewhere. Fourth, the Democraticallycontrolled Congress is likely to provide the industry with at least as much support as the current Congress. Nonetheless, there is no disputing that the equity markets have become more selective. As a result, it is essential for developers to take to heart the importance of differentiating their business plans from those of their competitors in one or more of the ways discussed below.

Offtake Agreements
One of the more exciting trends in the ethanol industry during the past year has been the acceptance of ethanol as a fuel additive by the oil industry. Examples of this include a joint venture that Marathon Oil announced with the Andersons to own ethanol facilities jointly, as well as agreements by several oil companies to enter into long-term offtake agreements directly with ethanol producers. Sponsors of ethanol facilities can benefit from this change in direction by entering into synthetic and actual tolling agreements that shift the price risk of corn and ethanol to the offtaker in exchange for offering a discounted product. For instance, we have seen synthetic tolling agreements signed in which the offtaker agrees to pay a price for ethanol equal to the price of corn plus price of natural gas plus a processing fee.We have also seen actual tolling agreements offered where a large agricultural concern has agreed to pay an owner a processing fee for the right to have its corn and natural gas processed by a plant. Both of these options can be extremely attractive to private equity, provided that the returns afforded by the processing fee are adequate. First, this type of offtake agreement assures the owners that there will be a market for their product. Second, the agreement either eliminates or greatly reduces the risk that declining crush spreads will squeeze profits from a project below the internal hurdle rate if the supply of ethanol temporarily exceeds demand or corn prices remain at elevated levels. Third, the agreement may allow a project to increase the amount of debt thereby reducing the amount of equity required. Sponsors entering into these types of contracts need to concern themselves not only with the tolling fee, but also with other essential terms and conditions. For instance, what liability do the owners have if the project is completed late? Who takes the risk of force majeure and other unplanned maintenance events? What recourse does each party have after a breach by the other, given the tremendous potential exposure that each party has to the other in these types of arrangements? In addition to the use of offtake agreements, at least two plants took advantage in 2006 of the derivatives markets to lock in margins for corn, natural gas and ethanol, thereby using the financial markets to create a proxy for a tolling agreement. Of course, this strategy is much more difficult to implement under the current pricing environment, but may still be possible for plants that are nearing completion or that have sponsors willing to provide credit to support their obligations.

Construction Costs
Construction costs in the ethanol industry increased significantly in the past year. It is now common for owners to pay more than $1.75 a gallon for turnkey projects. In addition, the lead times for critical-path items like field-constructed tanks have increased dramatically and the liquidated damages offered to support the schedule and performance have also declined. As a result, owners have begun to explore costand time-saving alternatives. The most common costsaving device is the use of a limited notice to proceed. Under the terms of a limited notice proceed, the owner agrees to provide the contractor with enough money to begin the initial drawings for the site and to make equipment deposits on those items that have either long delivery times or are experiencing price escalation. The benefit of this approach is to shave off of the schedule the 45 to 60 days of engineering work commonly associated with the construction process before the contractor begins to break ground and to allow the contractor to lock in the prices of those pieces of equipment that have been driving construction prices toward $2 a gallon. Sponsors using a limited notice to proceed should be careful to integrate the contractor’s performance under the limited notice with its performance under the more general construction contract. For instance, the warranties, the performance guarantees and the schedule in the final construction contract need to be coordinated so as not to disadvantage the owner for having given the contractor an early start. In addition, the price escalation provisions should be designed in such a way as to minimize the owner’s loss of leverage with the contractor. Another approach that is receiving increasing consideration is where the owner builds the project itself.Under this approach, rather than entering into a turnkey contract with a contractor, the owner in effect agrees to act as its own general contractor. This has the benefit of avoiding much of the mark-up associated with hiring a general contractor, but it does leave the owner without a third party to absorb the risk of construction delays and cost overruns. Although these risks can be reduced by properly structuring the subcontracts to provide for a pass through of certain rights, such as schedule and warranty work, this approach is most practical where the owner has a combination of construction experience and the ability to finance cost overruns.

Energy Costs
Many in the investing community have accepted the idea that we have entered an era of higher natural gas prices. Accordingly, investors are now more receptive to financing the additional up-front capital costs needed for infrastructure to avoid use of natural gas. We saw several approaches used in 2006. One is the use of coal as the direct energy source for steam requirements. This approach is now in use at several plants and is under consideration by several more. Another is to derive methane from manure as has been proposed by Panda for its plant currently under construction in Hereford,Texas, as well as for other plants that Panda has under development. A third approach is to burn the distiller’s grains that are a co-product of the ethanol production process to create steam. This approach is under consideration by several plants as well and is claimed by some to have a payback period of less than four years under current pricing conditions. Each of these alternatives holds out the allure of lowering steam costs. However, sponsors should be aware that each of these alternatives has yet to be fully accepted by the financial community and, as a result, requires either a contractor to guarantee their performance to a degree or another creditworthy party to provide completion support.

Value Added Co-Products
Many plants in the future are likely to squeeze more value out of the corn they consume to make ethanol. For instance, VeraSun announced in 2006 that it would be producing biodiesel from oil extracted from its distiller’s grains using a process developed by Crown Iron Works. Separately,GS CleanTech offers its own corn oil extraction technology from the syrup produced by ethanol facilities. Another approach taken by Ethanex, among others, is corn fractionation, which removes nonfermentable components of the corn from those that are fermentable. Although more capital-intensive, fractionation has the advertised benefits of allowing increased output of ethanol from the same plant, reduced enzyme requirements and higher-value distiller’s grains, and it creates its own source of corn oil for sale. Fractionation raises the same issues as use of innovative technologies to reduce natural gas consumption. Use of any non-traditional process to create value-added co-products can create structuring issues if sponsors are asking lenders to finance a portion of these costs.

Management Team
Until recently, most ethanol plants were built by farmer coops. In the last two years, there have been moves toward larger plants, multi-plant platforms and heightened merger activity. Private equity funds and the capital markets are increasingly focused on management structures.They want managers with flexibility and experience to achieve the highest risk-adjusted returns on investment. Sponsors should address the management structure and offer a seasoned management team in their business plans to handle these concerns before seeking debt and equity.We have seen several well-structured transactions fail to gain traction in the equity markets because of their failures to propose a team that was perceived as responsive to these concerns. In the current market, it is essential to distinguish a project from the competition. Successful projects have done this by adopting one or more of the techniques described in this article.