Ethanol is finally being taken seriously as an alternative fuel – even President Bush has woken up to its existence. But private investment and lending into ethanol is difficult because the product is at the mercy of two commodity cycles. Consequently, US ethanol project lending has traditionally been dominated by the farm bank loan market.

However, in February 2005, Credit Suisse First Boston closed the first project financing of an ethanol facility – the $242 million Hawkeye Renewables Project. The key to the deal was the flexibility achieved through a B loan financing. CSFB devised a repayment schedule that mitigated price volatility by making it responsive to market conditions. A system of cash sweeps is designed to ensure that amortisation is more rapid during bullish periods and less so in lean times.

Hawkeye Renewables is 53% owned by Whitney & Co, a mid-tier private equity company. Management hold 17% of the project and the remaining 25% is owned by other investors.

The project comprises two facilities in Iowa: a greenfield site at Fairbank and an existing plant at Iowa Falls, which currently produces 40 million gallons of ethanol per year. The new plant will produce 100 million gallons of ethanol per year, making it one of the largest facilities in the US, while Iowa Falls' output will be doubled to 80 million.

The financing features $185 million debt in the form of a seven-year B loan, and $57 million equity. A portion of the equity was already in place from the financing of the existing Iowa Falls plant, which closed in June 2004, and also featured loans from Hudson Capital totalling $45 million, which the Hawkeye project refinanced.

Traditionally, ethanol producers in the US have either been agri-business majors, such as Archer Daniels Midland and Cargill, or smaller corn farmers' co-operatives. The price of ethanol is linked to gasoline, while the production process is also dependent on the price of corn inputs. The risk of a low price for ethanol coupled with high corn prices has in the past limited interest from elsewhere.

But the ethanol has recently attracted the attention of private equity firms, such as Whitney & Co, which recognise the industry's growth potential and are taking advantage of its low barriers to entry.

It is easy to see why private equity firms are getting excited by ethanol. Oil refiners get a 51-cents-per-gallon federal excise tax credit for mixing ethanol into gasoline, and many states supplement this with further subsidies. Add to this the fact that its main rival as a fuel additive, MTBE, has been banned by many states for supposed carcinogenic qualities, and an environment has been created in which ethanol producers should be able to prosper.

Despite the benign conditions, several risk variables remained that were considered by the rating agencies when assessing the project; S&P gave the debt a B rating, with a recovery rating of 3 (50-80% recovery of principal in the event of a default), while Moody's assigned Hawkeye a B2 rating.

One of the major risks was overbuild. US ethanol capacity is growing by 20% to 25% per year, with capacity currently at 4 billion barrels per year and another 1 billion under construction. Despite the healthy prognosis for the industry's long-term future, the danger is that supply exceeds demand in the medium term. If such a scenario were to materialise, however, it is likely the Hawkeye plants would be among those to survive, owing to their large size, which gives them economies of scale.

Another concern is the risk that the 51-cent federal subsidy for ethanol will not be renewed when it expires in 2010 – without it the entire viability of the ethanol industry would be put in doubt. However, some form of federal government subsidy has been in place for ethanol for two decades, and it seems unlikely, given the current political climate, that the tax credit will not be extended beyond 2010.

But the biggest concern relates to commodity price volatility. Hawkeye tries to circumvent this through its flexible repayment mechanism.

The transaction is structured so that once interest payments are met the debt can be amortised at as little as 1% of principal each year. However, a cash-sweep mechanism also requires the project to use at least 40% of excess cash flow each year to pay down senior debt. In addition to this, a debt repayment schedule is in place, with between $20 million and $25 million having to be repaid annually. If the cumulative targets are not met the sweep increases to 100% of excess cash flow.

There is also a one-year debt service reserve and a covenanted minimum DSCR of 1.2x.

Although this arrangement tries to accommodate the commodity cycle, an element of risk remains: back testing by the rating agencies indicated that in 1996, when corn prices were high, the project would have needed to dip into the debt service reserve. However, in all other years revenues would be sufficient to cover costs and debt service.

The capital market's receptiveness to Hawkeye was evidenced by its wide distribution to over 60 investors. The deal was four times oversubscribed, allowing CSFB to flex down the pricing from an initial 350bp over Libor to 287.5bp.

Although the deal depended on the ability of Fagen, the EPC contractor, to deliver the facilities on time, the construction risk was considered minor by the rating agencies. Ethanol facilities are relatively simple to build and Fagen, which delivered the original Iowa Falls project on time, is one of the leading EPC contractors for the industry.

Hawkeye Renewables
Status: Closed February 2005
Size: $242 million
Location: Iowa
Description: Financing and refinancing of two ethanol plants, one as an extension and one as a new project, with a total of 180 million gallons' capacity
Sponsor: Whitney & Co, management, private investors
Debt: $185 million
Arranger: CSFB
Lender counsel: Skadden Arps
Borrower counsel: Gibson Dunn & Crutcher

Independent engineer: Harris Group