US corn prices are skyrocketing and construction costs for new ethanol projects are on the rise, and getting new facilities financed is becoming increasingly difficult. Tightening margins have made equity investors think twice about putting money into new capacity, and have caused them to turn instead to strong ethanol stocks to get exposure. On the financing side, the market has dwindled to a few big project banks and the agricultural lenders that have been there from the start. New entrants are few and far between and a number of the deals that have been announced over the past year have yet to see the light of day.

Sponsors are unable to cost-effectively hedge the commodity risk associated with new ethanol plants, says one CEO of a private equity firm active in the market. "It makes it much more difficult to finance transactions in the current market," he says. "So our perspective is with a combination of the backward-dated ethanol market – with forward prices declining – and a heavy carry in the corn market, it is making it more difficult to attract banks and equity finance to projects." He notes that his group's own plans have been put on hold, to some extent. "We are continuing to monitor several projects but we are on hold until we see how the market develops."

Peter Gray, managing director at KPMG Corporate Finance, adds: "Projects without ready access to corn will see tightening margins and will have a tougher time accessing the markets." The best-placed developers, in the current environment, are the farmers that created an ethanol market and are the primary beneficiaries of the US subsidy regime. The losers in an environment of high per-bushel corn prices are all the other users, everyone from independent ethanol producers to corn tortilla makers.

Expensive and large

According to one lawyer who has advised on several recent ethanol deals, commodities have a certain effect on the financing process, but the real issue relates to increasing construction and EPC costs. "For a long time you could build a plant for not a lot of money, but now it is very expensive to do that. Before they were saying they would finance as much as 60% of a deal on debt, but now they are saying they will cap that at a dollar amount per gallon," he explains. "Now lenders want to be exposed less to projects and it requires a lot more equity for developers to get a deal done."

Gray says that the trend toward increasing scale and size in ethanol projects has brought in the bigger banks. "The big banks have greater scrutiny on deals than traditional agricultural lenders and regional banks. They take a completely different approach than large project finance banks," he says. Larger projects have been the cause of supply that is beginning to outstrip demand, and will affect investors' appetite for risk. "This will lead to fundamentally tightening margins and could mean further increasing of corn prices."

One market participant says that equity investors are asking themselves whether it is worth it to invest in a new plant right now or whether they should rather invest in publicly traded stocks to get their ethanol exposure. "Right now they are indifferent. The premium to invest in a new facility is probably the same or not as good as just buying the stock."

There is certainly more risk with the equity piece, but equity also has everything to gain if the industry does well. "The lending market has not shut down," says another banker. "It makes us more conservative but ethanol is still an attractive value proposition."

Those investors that are willing to put in equity are companies and investors with a long-term perspective and deep pockets. "The real winners," says one equity investor, "are likely to be equity owners that have paid down debt and so are not subject to this volatility, and the equity owners that can operate through the volatility in the market."

Ag banks back on top

Although diminishing margins affect equity raising, they do not have the same impact on the lending community, according to one banker at a large European institution. "The industry has tightened and analysts are projecting diminishing crush margins. Although this affects equity interest, it does not have the same effect on the lending community. There is still strong appetite to invest in these types of projects, so long as we structure them with enough equity underneath to maintain a conservative profile."

But the universe of interested lenders has nonetheless changed. After the rash of deals financed in the B loan space in the last several years, rising corn prices and increasing construction costs have led to a turnover in the ranks of arrangers on new deals. Banks with a more conservative portfolio of debt, and more robust project exposures, are better placed to get through the current volatile period without losses. The farm credit banks, for instance, have been relatively conservative in their credit analysis, and have stood aside while the more aggressive debt providers financed the entrance of private equity players into the ethanol market.

Gray says that given current market conditions, the agricultural lenders have an advantage in terms of their degree of market sophistication and understanding of the sector. "They have been involved in ethanol financing for a longer period of time," he says. "They have more experience in commodities hedging for feed and corn prices, and they have a better ability to analyse and accept risk for the biofuels industry."

According to the active ethanol lawyer the number and type of projects that will get financing is narrowing. "Now, really, the New York banks are only financing people with a proven track record and strong management team. New entrants are having difficulty getting traction in the financing world." The institutional loan market, which has dominated ethanol finance in the last several months, has shrunk dramatically. Lenders in the B loan market, once thought to be much less sensitive to commodity risk than project lenders,  are a much-reduced presence.

The pipeline gets congested

For the broader market, some of the weaker projects may be weeded out. In fact, a number of transactions that were announced in the past year have not made their way to market yet. For example, Cargill, the privately held giant of US agribusiness, has put forward a deal for 400 million gallons of new capacity in the Midwest through its Emerald Renewable Energy subsidiary. Debt financing was mandated to BNP Paribas in February, with Santander and Standard Chartered as co-leads, but no news has come out on when the deal will launch.

According to one banker, this deal had been touted to come out since last December. "Their biggest difficulty, the same with a number of other projects, including Ethanex, is securing equity," he says. "With the fall of margins it scares the equity guys away."

The Ethanex Energy deal, with Morgan Stanley and WestLB as lead arrangers, involves the financing for three new ethanol plants with a total capacity of 500 million gallons in Illinois, Kansas and Missouri. Says an industry source: "Currently Ethanex is in the market to raise equity and all of the equity needs to be in place before the debt can be raised. The launch is said to be late fall of 2007." The three plants are expected to cost $400 million to complete.

Another deal that has yet to hit the market is Cilion Ethanol's $200 million portfolio financing, which it announced in December. CoBank, Farm Credit Services of America and MetLife are mandated lead arrangers on the transaction. Given the sponsors behind the venture, and the media interest they generated, its slow progress is all the more curious.

The company was put together last year by Khosla Ventures and Western Milling, with equity investments from Richard Branson's new Virgin Fuels group, private equity group the Yucaipa Companies and VC group Advanced Equities. Says one banker familiar with the market: "We have heard they were trying to get credit from the ag banks but the deal struggled. It has not closed yet but we don't know if they are planning to or not."

In the current market, the surest way to get a deal off the ground is to send a project to banks with existing cashflows. One such is Illinois River Energy, which is close to completing a $140 million debt facility with WestLB by including an existing operating facility in the portfolio that it put up for financing. Illinois owns a 50 million gallons-per-year plant located in Rochelle, Illinois. The sponsor wants to refinance the project's existing debt and increase the size of the debt to finance a new 50 million gallon plant alongside. WestLB is likely to need to approach both agricultural and commercial lenders in syndication.

On 7 February, US BioEnergy closed a $427 million loan through farm credit provider AgStar Financal. The deal dwarfs the other financings coming to market, and finances five plants with a total of 450 million gallons of capacity. US BioEnergy has done everything that a developer should do in the current environment. It contributed some operating assets, worked closely with corn suppliers and, crucially, Fagen, the largest, strongest and most experienced plant contractor, is a shareholder.

But newer entrants will need to wait for suitable financing conditions to come together. For instance, the $300 million transaction announced in November 2006 for Spanish conglomerate Abengoa will come to market in July, according to Ralph Cho at WestLB. WestLB and Banco Santander are joint underwriters on the deal, which will finance the construction of two 88 million gallon plants in Indiana and Kansas.

Ethanol has become the quickest way for the US to talk up its determination to use less imported oil, and the market has suffered from the attention. Gray at KPMG says that the market has been too focused on the ethanol space. "The degree of support has been fairly focused on one area of the biofuels arena, and that has had significant ramifications. We are seeing it already in increased corn prices and increasing construction costs. And the big oil companies are not really getting behind this, aside from Marathon," he notes. "The next period will be one of consolidation. At the end of that we will see ethanol come through as a much more viable industry."