When asked to identify the principal uncertainty affecting the future of ethanol plant financing, CoBank Vice President Tom Houser says matter-of-factly, "You've just asked the $64,000 question: Is capacity going to outpace market growth, and if so, to what extent?"

Even with California and New York ushering in ethanol on the coasts, the industry's senior lenders say the next three years of ethanol plant financing will carry relatively high risk. Ethanol plants are, indeed, good performers, consistently paying investment returns above 12 percent, but the industry's well-known market volatility has limited the size of its lending pool. The industry needs more capital—and more lenders—Houser told EPM, but only if the availability of new capital is balanced with the growth and stability of markets for ethanol and distillers grains.

"It's a fine line … a very fine line," he said, referring to the challenge of guaranteeing a consistent supply of ethanol to the nation without drastically overbuilding.

How much hinges on RFS?
The outcome of the pending U.S. energy bill—with its five billion gallon per year renewable fuels standard—weighs only modestly on the lending community.
Passage of an energy bill would certainly reduce the amount of political uncertainty that has shrouded the growth of the industry for the last two years, but lenders say it wouldn't change ethanol plant underwriting practices or near-term lending standards.

Long term, however, the RFS becomes more significant.

"If the energy bill passes, it would be more of a 'feel good' type of reinforcement for us," Houser said. "It would help ease concerns about certain aspects of the industry's future, but it wouldn't necessarily change the way projects are financed. The RFS would not immediately reduce risk and volatility in the ethanol industry. Long term, it would be beneficial."

Mark Schmidt of AgStar Financial Services said passage of an energy bill, and an RFS, has the potential to boost lender confidence instantly.

"Uncertainty equals risk, and having a clearer picture of the future would prove positive for the ethanol industry," he said.

Last month at the National Ethanol Symposium for Lenders in Chicago, Schmidt said, "Obviously there are a lot of political issues involved with the ethanol industry and these political issues can sometimes pose a risk. So the sooner [the energy bill] is settled the better."

Brian Thome, of First National Bank of Omaha, said passage of the RFS might unlock new markets and improve the ethanol industry's supply and demand scenario.

"Uncertainty is not a good word in the banking world," he told EPM. "Without coming to some conclusion on the politics of the energy bill, there is no sound way to project the future supply and demand of ethanol."

And a clearer picture is what new lenders might be waiting for.

More lenders, more ability
Currently, there are less than five senior, or lead, lenders financing ethanol plant debt. Senior lenders "source the deals" and negotiate the terms and conditions of loans. Participant lenders "buy" a portion of the senior debt.

"The amount of debt that each lender carries, or holds, is relative to their capital position," Schmidt said. "It also depends on how much of the bank's total loan portfolio they choose to make available to the ethanol sector."

Senior lenders will sometimes take a secondary role and act as a participant in another bank's project.

CoBank, AgStar Financial Services and First National Bank of Omaha have each been involved in ethanol projects as participant lenders but are typically considered senior lenders. CoBank, for example, has been involved with the financing of at least 20 ethanol plants, taking the lead on all but four. Likewise, First National Bank of Omaha has been a senior lender on most of the 18 ethanol plants it has been involved with.

"The difference between a senior lender and a participant lender is sometimes purely a matter of which bank is managing the loan and which banks are simply buying chunks of it," Houser said.

Most senior lenders will carry $10 million to $20 million, leaving the lion's share of the debt to be divvied up among four or five participant lenders.

Capital market in 'good' condition
The ethanol industry's "capital market" is often defined as a "pool of debt" associated with ethanol plants ranging from 20 mmgy to 100 mmgy.

The health of an industry's capital market is reflected by the balance of low and high equity projects in the collective portfolio of its lending community.

"The ethanol industry's total pool should be a blend of older and newer plants, distributing the risk in terms of age and equity," Schmidt told EPM. "As the industry grows, there's a tendency for risk to increase because the debt of newer plants outpaces equity growth from older plants."

If the portfolio falls off balance, participants in the debt pool—both senior and participant lenders—will throttle down growth in order to maintain an acceptable level of equity.

That said, the ethanol industry is in relatively good financial health.

"Based upon the number of plants built in the last two years, combined with plants that were on the books the previous two to four years, the ethanol capital market should be in good condition with acceptable risk," Schmidt told EPM.

On the flip side, the ethanol industry's capital market has become tighter in the last 12 months.

"There are a number of banks interested in participating in loans with experienced lead lenders, but the political climate has been a bit too unsettling for most of them," Thome said. "Banks habitually look for the greatest risk in any type of credit, and the most significant risk in lending to ethanol is determining the future of the supply and demand for ethanol. Many of the banks we talk to find that single question to be a deal-stopper when they make a final decision about entering ethanol lending."

Characteristics of successful projects
The simple truth is, most proposed ethanol projects never achieve financing.

Thome, for example, said First National Bank of Omaha usually receives between six and eight new project contacts a month. Of those, the bank will usually obtain just two or three actual prospectuses, which it reviews.

"The success rate is around one in 10 (for total projects pitched)," Thome said. "However, of the projects upon which First National Bank of Omaha performs an in-depth review, the success rate is much higher, probably 50 percent."

Another lender estimated that less than 25 percent of the total projects reviewed are actually built.

From a risk management view, Thome told EPM, lenders are generally creating more formal policies of project acceptance than in the past. Of course, it's unlikely that a proposed ethanol project would ever be financed without first presenting a feasibility study and a business plan.

"The business plan and feasibility study are the foundation documents that justify reasons for the plant's existence," Schmidt said. "This is the only place to start."

Houser agreed, saying, "If those two things aren't in place, there's really not much to talk about."

Most successful business plans and feasibility studies are extremely detail specific. According to Schmidt, the size and location of the proposed plant will tell you a lot about the viability of the project.

"Location dictates the availability and cost of the feedstock supply," Schmidt said. "While the availability and cost of transportation—both rail and truck—partly determine the cost of inputs entering the plant and the value of finished goods leaving the plant."

The availability and cost of utilities is relative to location, too, Schmidt explained. The size of the facility dictates the cost of construction and establishes production economies.

Thome said First National Bank of Omaha, as with its participant lenders, looks at feasibility studies in great depth. The bank reviews access to feedstocks, energy supply and availability, transportation and water.

The character and determination of the people involved with the project is important, too.

"The final key ingredient is the people with which the bank is doing business," Thome told EPM. "Ownership and management will make or break a company in any industry."

What about state incentives?
State incentives, either in the form of excise tax exemptions or direct producer payments, often provide the impetus for the grass-roots organization of ethanol projects. But lenders don't rely heavily on state appropriations.

"State incentive programs are not a primary factor in our decision-making process," Houser said. "For that to be a primary factor, we would have to always assume that the state is going to follow through on its funding obligation. History has shown that to not always be the case."

Although the nation's economy is showing strong signs of rebounding, lenders say both the federal government and state government are suffering from the same problem: not enough income and too many expenses. The effects of state deficit problems on ethanol incentive programs have been well documented in several states.

"Being able to honor future financial commitments that depend on future payments is precarious today," Schmidt told EPM. "The best state economic incentive would be up front, otherwise our underwriting does not put 100 percent of the value on them."

That said, most lenders agree that if two identical ethanol projects were being proposed on separate sides of a state line, the state with the better incentive program would probably win out.

Furthermore, state incentives, along with the USDA's Commodity Credit Corporation program, curtail some of the cash flow risk associated with start-up.

"Any outside funding that provides cash flow to a project on an annual basis helps to smooth out the severe cyclicality that can occur in production-agricultural lending," Thome said. "However, a producer never knows if the state funding will be reduced or disappear, such as happened in Minnesota, so it must be certain of its own abilities to meet its cash obligations. Having said all of that, cash is cash, and a company in a state with cash incentives will certainly be a leg up on one without."

Experience diminishes technology risk
For good reason, experienced design/build firms simply have more credibility with banks. The design/build team is not only important to the overall cost of the project, but the long-term costs of production.

Does that mean new engineering firms face a losing battle breaking into the ethanol industry?

"I would not classify it is a losing battle, but it's a steep uphill climb," Houser said. "If you go back to the mid-1990s, we had to deal with market risk—which we still do—and technology risks, which have all but disappeared with the leading design/build companies. So if a group comes to me with an unknown builder, I'm not going to immediately say 'no,' but it's another element of risk that must be considered."

In fact, Houser said, a project that signs an unknown builder might require performance bonding and other types of insurance that help compensate for the technology risk being taken by the lender.

In general, lenders say new construction or engineering companies must undergo a healthy introduction to the industry and undergo a period of due diligence if they want their projects to be financed by one of the experienced lead lenders.

"Nominally, the barriers to entry for companies wishing to design or build ethanol plants are no worse than in any other industry," Thome said. "The real barrier comes from the financial side of the industry. With limited banking capital at work in any industry, the banks will always gravitate to the projects or companies that are deemed to have the least amount of risk. That means there is one more hurdle for a prospective plant to overcome if it is using an unknown engineering or construction company. That hurdle is not insurmountable, but a group should realize that it needs to be prepared to answer that question in depth when it comes time to meet with the banks."

Equity requirements have risen
The cost of building an ethanol plant, including working capital, is determined by the size of the facility. The economics of scale make larger ethanol plants less expensive to build, per gallon of capacity.

Plants financed by AgStar and CoBank typically fall between $1.25 to $1.50 per gallon, working capital included.

A 40-mmgy plant will typically require total capital of somewhere between $55 million and $65 million.

A $65 million plant would require about 12 percent to 15 percent working capital, equaling about $5 million to $6 million.

"A lot of these plants are grossly under-funded to begin with, in terms of liquidity, and they end up seeking emergency loans, which we won't do," one lender said.

"Due to the risks associated with a rapidly growing industry, and an unknown political climate, the equity requirements for ethanol projects have increased since the late 1990s," Schmidt said. To mitigate risk, future producers have to be willing these days to put more equity on the balance sheet.

Houser said most ethanol plants built in the early 1990s were "50/50"—50 percent equity, 50 percent debt. Then projects went down to around 40 percent equity, 60 percent debt.

"Now we're back up around 45 to 50 percent equity, 55 to 50 percent debt. We've just returned to where we should be, given the overall risk profile of the industry," he said.

Along with equity requirement, interest rates may also be on the rise. It has been suggested that more lenders would be involved with the ethanol industry if interest rates were higher.

"Generally, a startup industry needs more equity to offset the added risk of uncertainty in addition to the normal risks associated with the investment," Schmidt said. "When an industry has some operating experience, and perhaps has matured, then equity requirements may decrease. If an industry grows rapidly in response to demand, then there's an anticipated risk of production exceeding demand and the equity requirements increase again."

However, ethanol producers might argue, the technology risk associated with production has been drastically reduced, in turn reducing the financial risk of lending into the industry.

"Improvements in ethanol plant efficiency and reliability are great and help mitigate the risk in the lack of a cost/price relationship," Schmidt said. "Experience in process and production has reduced the risk today from where it was several years ago."

So far, the financial institutions involved in the ethanol industry have treated ethanol similarly to how they treat many other agricultural commodity businesses. However, the large "money-center" banks—the banks the ethanol industry is trying to attract—view ethanol lending as strict project finance, which entails a different set of rules, complete with higher costs such as interest rates and fees.

As Thome explained, the current set of lead lenders in the ethanol industry are more interested in "relationship lending"—a need to know exactly who is running the plant and making decisions on a day-to-day basis.

"[We] can be more flexible in meeting the needs of our borrowers, which usually does not fit the mould of project financing," he said.

Giant dry mills require more capital, more lendersThe growing size of new dry mill ethanol plants has only compounded the need for more capital.

"With these larger plants, we need more lenders in the ethanol industry to carry a portion of the debt," Houser said. "Most banks are only willing to carry so much per project."

With the advent of larger ethanol dry mills, ranging from 80 mmgy to 100 mmgy, lenders are keenly interested in not only the technological efficiencies of the plant, but also economies of scale.

"We have found that the larger the project, the more likely there will be cost and production efficiencies," one lender said.

Another said, "During the most volatile periods, the larger plants in my portfolio did better than the smaller ones."

However, the economics of the project in terms of its effect on area corn prices, has been questioned.

"These huge plants have very real efficiencies but they also have a potential—from pulling so much corn from one area—to inflate the price of the plant's feedstock," Houser said.

VeraSun Energy, a 100-mmgy plant under construction in Aurora, S.D., is trying to mitigate this problem with a plan to rail in corn from outside the region, carefully calculating the increased transportation costs.

While some lenders still question the economics of these giant dry mills, it's clear to them that the industry is moving toward larger plants with greater production efficiencies.

"From this point forward, we expect to see nothing less than 40 million gallon plants going up. That's basically the minimum," Houser told EPM.

A feel for the market
Ethanol plant lending practices can be heavily affected by supply and demand. That's why lenders often rely on marketers for information about where the market may be heading.

"There's always a policy risk—markets can change in a hurry," Thome told EPM. "So it's important to know these people, to understand the marketers and understand the idea of cyclical swings."

Of course, lenders never get too cozy with ethanol marketers.

"We appreciate our relationships with vendors and marketers but we do not depend upon these relationships for our market analysis," Schmidt said. "We attempt to find as much of an unbiased market assessment as possible."

Most banks require future producers to have marketers in place before financing takes place. As with design-build firms, lenders are looking for experience and long-term commitment to the ethanol industry from marketers.

"We would prefer to see producers work with marketers that are not only moving the product but developing markets for the product and investing in the long-term future of those markets, rather than just being a broker," Houser said.

Distillers grains takes a front seat in the underwriting process, too.

"Distillers grains can make or break the plant's ability to operate with positive cash flow," Thome said. "Among other underwriting criteria, First National Bank of Omaha spends time visiting with marketers for all of the coproducts of an ethanol plant. It is through the conversations with the distillers grains marketers that the bank gains an understanding of the current market factors and the potential gains to be made for the products."

Paying down debt
Lenders want ethanol producers to heavily pay down debt in the early years after financing. The ethanol industry is considered "debt sensitive" because the amount of debt, and the rate, can affect the bottom line.

"The balance sheet is the ultimate risk mitigator," Schmidt said. "To rapidly pay down debt will improve your ability to withstand operating risk, and the resulting equity and working capital from debt pay-down will give you staying power in tough times."

The cost of plant expansions and technology advancements reinforce the need to get debt paid down early.

"Paying debt down and building working capital will allow for investment in technology and will mitigate future operating risks," Schmidt told EPM. "Paying down debt and building working capital creates cash for technology, equipment and inputs."

In closing, it is extremely important for an ethanol plant to reduce its debt when it has the opportunities to do so.

"Some investors dislike that the banks require significant debt reduction early in the loans, especially when the plant is receiving incentive payments," Thome said. "Investors must understand, however, that a bank's return on its investment is limited to the net interest income it receives from the loan for a certain period of time. There is no upside potential to the risk associated with the loan. An investor, however, has the opportunity to see significant benefits from production in the long run, especially when the bank is paid off entirely." EP