Elusive Equity

Tight margins for ethanol producers in the latter half of 2007 forced project developers to take a more calculated approach to raising money. EPM talks with financial analysts to discover what trends can be expected heading into 2008.
By Bryan Sims | November 13, 2007
High corn and low ethanol prices combined with elevated construction costs caused the ethanol industry to pause in the midst of a frenzied build out that began in 2006. Not surprisingly, unfavorable market conditions have made it more difficult for developers to raise equity for new construction, begging the question: Have the fundamental strategies of raising equity in years past become obsolete? If so, what new strategies could be implemented heading into 2008?

The industry has certainly seen low ethanol prices in years past, however, corn was cheaper. "Those considerations combined make fundraising in the traditional private equity markets difficult because you have to find someone who understands long-term commodity cycles and the lack of correlation between corn and ethanol," says Christian Dobrauc, with First National Investment Banking, a subidiary of First National of Nebraska Inc. "Institutional investors who wanted to get in [the ethanol industry] for quick returns in 2006 are passing on many new ethanol projects today just because of the commodity risk. All considerations aside, good deals are still getting done and the mergers and acquisitions market is alive, with strong interest from both the buy and sell side of the equation. We have seen a material up-tick in both the number and size of assets actively exploring strategic alternatives, a move we think is positive for the industry."

One of the major contributors to investment apprehension in equity fundraising is the perceived oversupply of ethanol in today's marketplace. The United States has the capacity to produce 6.9 billion gallons of ethanol with an additional 6.5 billion gallons under construction, according to figures generated by the Renewable Fuels Association (RFA). "Based on the rate of growth, this is not an uncommon reaction to capacity," Dobrauc says. "It's cyclical just like the underlying commodities, but one has to get a better understanding of the long-term demand for ethanol." Government intervention such as initiating a national E15 or E20 blending requirement, expanding the national renewable fuels standard (RFS), an increase in discretionary blending or a revised Farm Bill could sway investors to pool money in ethanol once again as they did in 2006 if corn prices decrease and ethanol prices rise, allowing producers to see positive margins.

According to Jeff Kistner, project manager and vice president of project finance for BBI International, the high price of corn is the primary culprit deterring ethanol plant developers and private equity investors. "The only reason this is a different cycle than what we've gone through in the past 10 years is high corn prices," Kistner says. "I think the shake out we're going through is really going to shake out which projects are going to be viably competitive in the market compared with the ones that aren't."

One example of how difficult it is to raise private equity in today's market occurred in Minnesota, which has experienced substantial ethanol growth in the past three years. Crookston, Minn.-based Agassiz Energy LLC was in the process of raising equity for the better part of 2007 to build an ethanol plant near Erskine, Minn. That equity drive was suspended due to "current market conditions," said Don Sargeant, Agassiz Energy chairman and chief executive officer. The low price of ethanol, coupled with the high price of corn was making it harder for the developers to prove that the project would be profitable. "The price of corn hasn't changed a whole lot in the past few months, but the price of ethanol has changed dramatically," Sargeant says. "The break-even spreadsheet started to have a different look when the price of ethanol dropped to that $1.60 to $1.70 (per gallon) range." Agassiz Energy intends to revisit its equity drive in six to nine months, he says. "We're continuing because we believe that in the long term there will be good solutions out there for a stronger demand for ethanol," Sargeant says. "We feel at this point in time we need to wait until this bottleneck or crisis is addressed and then assess the parameters [heading into next year]. Hopefully by then, Congress will have a new Farm Bill and Energy Bill and some new ways of doing things."

As the industry continues through its maturation process, experts believe that this "shake out" may determine what makes a particular project able to sustain growth and be profitable in an inherently volatile industry. It may require developers to take a different approach to raising equity. To get a better idea of what type of investment approach to take, one must understand the different investment philosophies that have been conducted this year. The two primary approaches are the private equity model, or what Kistner coins the "main street" approach, and the public equity model, or "Wall Street" tactic. The main street model is geared to stimulate rural economic vitality whereas the Wall Street model is driven by returns, he says. According to Kistner, in the United States investors have poured $6 billion to $8 billion into equity for ethanol projects. On average, about $2 billion to $3 billion has come from rural communities in the past six months.

In 2006, a good deal of venture capital funds filtered into the developing ethanol industry, but it was Wall Street investors who prevailed with larger investments. In 2007, however, Wall Street investors pulled back and private equity funding increased as margins receded into line with historical averages and more ethanol supplies came on line, according to Kyle Althoff, BBI International project analyst. "[Private equity investors] are still committed to the projects because of the benefits they provide not only economically to the community in terms of jobs and benefits, but it also improves the basis in the local area and diversifies returns for farmers," he says.

In the past, the typical debt-to-equity ratio to build an ethanol plant was 40 percent equity and 60 percent debt. Today, the equity split is usually 50-50, depending on how comfortable the lender is with commodity risk. That, of course, varies from lender to lender, he adds. "It would be interesting to see how it plays out, if ethanol prices remain low for a long period of time, and which groups are still able to move forward and how they emphasize the competitiveness of their project over another," he says.

As the industry has demanded more equity, analysts have wondered if there would be a re-emergence from one branch of the main street modelthe farmer-owned co-op. According to the RFA, there were 49 farmer-owned ethanol plants in the United States in mid-October with a total of 1,948 MMgy of capacity compared with 1,677 MMgy in 2006. Althoff observes that there have been fewer farmer co-ops starting up mainly due to high capital costs and lack of working capital to apply toward a projecta measure of a company's efficiency and short-term financial health. A few years ago, an ethanol plant developer could build a 100 MMgy plant for $100 million, today a 100 MMgy plant costs $200 million.

Although the industry was predominantly established using the farmer-owned co-op strategy, Dobrauc thinks that the industry will see increased growth in the corporate model. "In the co-op model, they are now looking at ways to form holding companies with multiple assets, so the number of companies isn't growing as fast, but they're still adding aggregate capacity," he says. "Some of the top ethanol producers are farmer-owned co-ops and they have evolved by leveraging attributes from the corporate model."

No matter which model would-be producers follow they will have to prove that their projects are going to be competitive in a volatile market. "Institutional investors are seeking projects that have unique competitive attributes, serving to diversify the top-line or lower the cost structure," Dobrauc says. "Diversifying feedstock input, co-product output and optimizing natural gas utilization are key components as well."

As project developers sharpen their pencils in preparation for tougher equity drives, existing producers are looking for ways to tighten their belts until market conditions improve. The strategy of obtaining liquiditythe degree to which assets can be bought or soldis attracting the attention of some producers as a way to optimize their debt to equity balance. One way to restructure a company's debt and equity blend to optimize the capital structure is by recapitalization strategies or "recap." The driver behind a recap strategy is that the values of the enterprise change based on margins. The value of the equity follows suit, but equally important depends on the underlying capital structure, according to Dobrauc."What happens in a recapitalization is that you can sometimes use a new layer of debt for a mature plant to repurchase shares, so you allow partial liquidity for a portion of your shareholders using a prudent amount of debt while essentially not having to sell to someone else," he says.

As ethanol producer margins narrowed in late 2007, there seemed to be an increase in merger and acquisition activity where several pure-play ethanol producers acquired existing plants and projects under construction. In 2008, in addition to mergers and acquisitions, the industry will focus on asset optimization, cash flow diversification and investment in ethanol infrastructure, Dobrauc says.

Bryan Sims is an Ethanol Producer Magazine staff writer. Reach him at bsims@bbibiofuels.com or (701) 746-8385.