Caught between hopes that biofuels could be a lasting substitute for petroleum and fears over labour and environmental standards, as well as food price inflation, reactions to biofuels are typically schizophrenic. That poses dangers for investors. And yet they are coming in droves.

Ethanol in Brazil was traditionally based round small-scale sugar cane farming, where producers used the option to make ethanol as a government alternative fuel programme got underway. Since then, the picture has grown more complex. Larger businesses have emerged and absorbed smaller farms and mills, professionalizing what was once a cottage industry. Since then, a host of new players have come in. Firms that have a less obvious connection to energy are using ethanol as a diversifier and to mop up cash flow and agribusiness firms are keen to have another market for their output.

More surprisingly, cautious multilateral development banks have become involved despite – or perhaps because of – the bad headlines, as they seek to promote a fuel that, at least in Brazil, can be produced efficiently and on degraded pastureland. But most unusual are the combinations of private equity, hedge fund and institutional investors. They are all navigating a highly complex industry, making big bets on the best model for this long-term, volatile business.

Brazil has taken the lead in efficient ethanol thanks to a sub-tropical climate, its large landmass and a biofuel program that dates from the 1970s. The domestic market for ethanol is growing fast. Consumption grew by 54.8% in the first five months of the year to 5 billion litres.

Brazil's population of close to 200 million, increasing car ownership and the conversion to flex cars (ones that can use any combination of ethanol and petrol) mean that process has years to run. While 90% of new cars sold today are flex, only 18% of Brazil's total fleet is, says Paulo Batista, planning manager at biofuel start-up BRENCO. Ethanol consumption should grow, provided petrol does not become competitive on price, he says.

Slow fuelled

In spite of very high petrol prices, governments are moving slowly on ethanol because of a thicket of prickly issues surrounding its production. Three issues in particular could create bad publicity for institutions looking to finance the industry and curtail its growth.

Labour conditions, particularly for cane cutters, remain poor. Farms are necessarily a long way from towns and workers tend to be housed in drab, cramped accommodation, at best. Arduous working conditions, poor food and extreme heat are the norm and many cases of active maltreatment are reported. This is made more complicated for new entrants, which need to hire thousands of workers and comply with complex local labour legislation. The solution will likely be mechanization, which Brazil's states are starting to mandate, albeit at very different speeds.

Two other conjoined issues also need careful handling. Global fears over Amazon deforestation and the possibility that biofuels are causing food price inflation are inter-twined. The Amazon is increasingly being used to grow crops and raise cattle, though the Amazon's climate is not well suited to sugar and land is still plentiful in Brazil, say ethanol's supporters. A recent government survey showed that Brazil has about 7 million hectares of land under sugarcane and 200 million hectares of pasture.

Strategic players yield to financial ones

But despite these concerns, investors are still drawn to ethanol's use as a petrol substitute. And while oil and gas producers grapple with higher exploration, development and production costs, the potential for productivity gains in ethanol are huge, says Paulo Batista, planning and coordination manager at ethanol producer BRENCO. Mechanisation and genetically modified cane are just arriving and the fermentation process is becoming more efficient, he notes.

That said, until recently the sector had changed little in the last 30 years. The traditional model of the family farm with a mill or two is still extremely common in Brazil. The sector remains highly fragmented, with leader Cosan managing a market share of only about 8%, says João Pesciotto, a vice-president at biofuel producer Comanche Clean Energy. There are 360 plants in Brazil, split between 280 groups and 90% of the mills were built in the late 70s and early 80s, he adds. And the sector has been through lots of ups and downs, which has led to little investment in new machinery until recently.

In this under-developed market, investors are taking a variety of tacks. Energy companies, such as BP, are testing out new sources with a geographically diverse, global strategy. BP is investing in jatropha, an oleaginous plant that is good in poor soils and arid areas. Agribusiness players including Bunge, Cargil and Louis Dreyfus have also been moving into ethanol. Dreyfus is already one of the largest producers in Brazil and Bunge recently announced investments of R$1 billion in the country's northern state of Tocantins.

Investments are also coming from firms that have a more indirect link to energy. Odebrecht, best known for civil construction, has funded ETH Bioenergia as a venture with Japanese trading conglomerate Sojitz Corporation, which has taken a 33% stake in the business, says Eduardo Pereira de Carvalho, director.

Odebrecht wanted to put its cash flow from other business lines to productive use, and contributed a generous 40% slug of equity to the new business, he says, explaining that as the ethanol business is a new one for Odebrecht the firm wanted to minimize risks. Debt financing for all these projects will come mostly from official sources, the bulk from Brazilian development bank BNDES, which offers long-term interest rates of 6.25%, says Pereira de Carvalho.

Indeed, BNDES remains highly dominant in lending for project financing, thanks to low long-term rates – in a country with one of the highest real interest rates on the planet – which shut out most alternative domestic debt sources. "With a long-term rate less than half the commercial banks, project sponsors try and get as much as they can out of BNDES and the smaller regional development banks, such as the Banco do Nordeste," notes Miguel Noronha, executive director, at AG Angra Investimentos, a firm established as general partner of AG Angra Infra-Estrutura Fundo de Investimento em Participações, a private equity fund and an investor in the sector. "Finding long-term, reasonably priced debt outside BNDES is extremely hard," he notes.

That reliance on the development bank is being exacerbated by a monetary policy tightening cycle that started in April. Short-term rates stood at 13% in August and are widely predicted to increase. So those sponsors that can afford to do so will hold off on getting funding for projects, predicts João Zani, a director at Bradesco, Brazil's largest private sector bank.

According to Zani, Bradesco is funding three projects in the sugar and ethanol sector, with total debt of R$1 billion and average tenors of 10 years. The projects are also seeking BNDES financing or a combination of sources with BNDES as a key lender, he says. Greenfield projects are likely to have debt/equity ratios of 70/30 or 75/25, he notes, adding that BNDES imposes a maximum debt/equity of 75:25.

There are signs of stress at the development bank. Noronha is concerned that it is over-stretched, thanks to its commitments to Brazil's growth acceleration scheme (PAC). The PAC is designed to boost infrastructure spending by roughly R$500 billion in a four-year period that ends in 2010, and there is a danger that BNDES could run out of resources. Furthermore, timetable for approvals and restrictive directives on environmental criteria as well as legal requirements on tendering make the BNDES less efficient than the private sector, he argues.

That should give scope for multilaterals, particularly the Inter-American Development Bank to step in. The IDB is working on a number of small scale projects, and in July it said it will provide a $269 million A loan and mobilise a $379 million BNP Paribas-led B loan for three new ethanol plants, all in Brazil. But the IDB, like other multilaterals, has to be very circumspect about its involvement with biofuels. To this end, it has launched a biofuels sustainability scorecard, which it says will make sure that projects adequately address concerns about ethanol production.

New and old debt

A new breed of developers, firms like BRENCO and Comanche, plan to tap other sources of funding. BRENCO, for instance, is planning to invest R$5 billion to build 10 units, and wants to become the prime investment vehicle in Brazil for biofuels, explains Batista, an ex-investment banker from Goldman Sachs. Investors include ex-World Banker James Wolfensohn, Steve Case, founder of America Online, and US retailer and investor Ronald Burkle.

Since it had no track record, the founders used relationships such as those with Tarpon Ventures to raise funds Batista says. The firm carried out a private placement in March last year that raised $200 million for initial equity, with $50 million from founding sponsors and $150 million from institutional investors. They include an emerging markets fund manager with substantial energy interests, Ashmore; Goldman Sachs' proprietary equity group; Amber Capital, a hedge fund that is building a Latin portfolio and Ontario Teachers, he says.

But if the new breed of producers is looking to financial players to line up equity, they are still looking to more traditonal sources of debt. In August BRENCO lined up R$1.2 billion in loans from BNDES to fund part of the construction of one of its first facilities, Alto Taquari-Mineiros, which is slated to produce 220MW of electricity and 370 million gallons of ethanol per year.

Comanche, a rival firm, has investors that overlap with those of BRENCO, and has won backing from a mix of hedge funds and banks that includes Deutsche Bank; Whitebox Advisors; and Deephaven of Minneapolis, says João Pesciotto, its vice-president for operations. It has also pursued debt financing from cross-border sources. In March, 2007, it issued $60 million in equity and convertibles. In June of the same year, it issued a further $20 million in equity and convertibles.

After making acquisitions, it tapped its investor base again in December last year for one-year bridge debt and equity. "Each round was at a higher valuation," says Pesciotto. Comanche then reached out to new investors to take out the short-term fund raising of December. In June of this year, it issued securities to 13 new investors and one existing investor, including senior secured notes due 2013; shares; and two classes of five-year warrants, raising $67.5 million (for more information, search "Comanche" at projectfinancemagazine.com).

"We originally did approach private equity funds and were surprised that we caught the attention of hedge funds more," admits Pesciotto. At that time, better terms were available from hedge funds: "private equity companies were just too greedy," he says. The firm raised funds abroad to build a bridge as alternative to investors that were not necessarily able to trade in emerging markets, he says.

Both these firms insist that the eclectic nature of their investor base does not lead to conflicts in the business plans or friction over the timing of an exit. "It's obviously a long-term investment and the money raised is more like venture capital money," says Batista. He says that the funding comes from relatively small allocations from each investor that can look for illiquid, long-term projects. That said, BRENCO plans an initial public offering as early as 2009-10, depending on market conditions, says Batista. That should raise $300-400 million. "We are funded to build five mills. Beyond that we will depend on further equity, either through the IPO or private rounds," he says. Likewise, Comanche intends to do an IPO when the market has improved, says Pesciotto.

Others argue that having this investor base does not have the patience to watch a new business grow in an industry that experiences severe volatility, and whose fundamentals are as much a product of the sugar industry as the energy industry. These investors are not ready to take long-term risk in what is a long-term business, said one industry insider. It takes four to six years to bring investments to fruition, too short for a time cycle for the hedge fund industry, he believes.

Exit the laggards

The chequered history of equity offerings in Brazilian biofuel producers suggests that an inflexible IPO plan may not be a great idea. In 2006 and 2007, three local IPOs took place, none of which has yet provided attractive returns.

Cosan, the largest, and the first of the three to list, saw its share price plunge in 2007, although its performance has improved markedly this year. In 2007, the share price dropped by over 50%, as sugar prices dived and a massive expansion of foreign investor interest drove up the prices of assets, and made it difficult for Cosan to compete for assets and pursue its consolidation strategy. Shares of smaller São Martinho and Guaraní have also suffered, partly because small, illiquid stocks are out of favour in current market conditions.

Other early-stage movers that raised money overseas did not fare much better. The share price of Clean Energy Brazil, which is listed on London's AIM, has been very volatile. Clean Energy also found competition for producing assets to be iintense. Lots of foreign investors arrived pushing up prices, while export opportunities remained limited, depressing investment in logistics, says Marcelo Junqueira, Clean Energy's chief executive officer.

Some producers believe that equity investors were quick to panic, and slow to appreciate the market's fundamentals "[Cosan] share price increases didn't reflect reality. Investors didn't know the sector, they were not familiar with the business," said Cosan's chief financial officer, Paulo Diniz. Share prices of ethanol producers have continued to track pure sugar producers closely and with a glut of sugar production from India last year, ethanol shares slumped.
One of the main difficulties for investors is that the vagaries of sugar prices dictate the price of share prices of ethanol companies, and many investors in the sector are not sure whether to treat ethanol as an energy or a commodity play. The market is still looking at sugar prices, admits Batista, insisting that BRENCO is an energy company. Investor jitteriness is stoking further volatility. "We need to differentiate our story from sugar," he admits.