The search at US project lenders for new assets has taken a slightly surreal turn. The last two months have seen projects come to market fueled by milk, corn, and turkey droppings. The three projects – Southwest Cheese, FibroMinn and Hawkeye Renewables – all draw for their inputs on the US agricultural sector, and reflect profound changes in farming. The changes, which involve modernisation, realignment, and new capital, offer what some lenders say could be a shower of new project finance business.

Cheesy pleasy

The purest sign of what agriculture could present is the Southwest Cheese financing. Southwest Cheese, a $136 million deal for UK's Glanbia, Dairy Farmers of America and Select Milk Producers, and led by Citigroup, is the first of what Citi believes could be a slew of financings for intermediaries – processors that establish themselves between producers of raw commodities, and the distributors of processed foods. Southwest is located in Clovis, New Mexico, and will process 2.4 billion pounds of milk, produce over 250 million pounds of cheese and 16.5 million pounds of high value-added whey proteins.

The background to the project is the need for food producers such as Kraft to handle ever-larger blocks of cheese – as their production techniques become ever more industrial, so do their requirements of their suppliers. A facility capable of producing large blocks of cheese lies outside of the capabilities of the dairy co-operatives that traditionally produce cheese, and is not a segment that interests the distributors. "Tying up large amounts of capital in production facilities is not an efficient use of their shareholders capital," says Bob Dewing, managing director at Citigroup's energy and infrastructure group.

In the instance of the cheese industry, there already exists a dedicated processor, Glanbia, a British producer of cheese and dairy products. Glanbia has a consumer products division, but it prefers to market to other producers than establish a large and expensive retail operation. In the US, it has a liquid commodity-like market for its output, since cheese is traded on the Chicago Mercantile Exchange.

But, and this is where project lenders come in, its price has a floor set by the department of agriculture, designed to ensure a certain revenue for farmers, but also to ensure a certain margin for an intermediate producer. It enabled Citi to bring in Rabobank, Farm Credit Services of America, Farm Credit Bank of Texas, Metlife, CoBank, ING, and Wells Fargo in syndication. The bank list indicates a mixture of agricultural bank and commercial bank interest in the plant, a mix that could skew more towards the commercial banks if borrowing requirements get bigger.

This is, according to Dewing, who worked on smaller cheese factory financings in Australia, a trend that looks set to spread to other industries. "We could see further deals for cheese factories, although there is no reason why this structure could not be used for other food makers. In the breakfast cereal business, many brands would rather contract with a dedicated cereal processor and concentrate on marketing and distribution. This is what the soft drink makers realised decades ago. They ship concentrate to the bottling companies, and then market the product."

Given that the market has a degree of experience of such facilities as PET factories, and pulp and paper mills, and has sometimes even made money on them, moving into the space will be a natural progression, but there is an existing network of agricultural lenders, with CoBank at its apex. And CoBank has plenty of experience in project finance, and can compete on price with commercial and institutional lenders.

Where there's muck...

But while such bespoke assets offer a tempting promise of future dealflow, biomass and ethanol projects offer more immediate prospects. Leading the pack, perhaps surprisingly, are biomass projects fueled by animal waste. The main, probably the dominant, developer, is Fibrowatt, again originally from the UK.
Fibrowatt has developed a number of plants – 12.7MW Eye, 38.5MW Thetford, and 13.5MW Glanford – in the UK under the old non-fossil fuel obligation contracts, which made it possible to project finance such an emerging technology. Thetford is still the largest biomass project in Europe, and the largest chicken litter-fuelled plant in the world. It was financed with a £$57 million ($109 million at today's rates) loan from WestLB and RBS that closed in 1996.

Its founder, Simon Fraser, decided to exploit the high calorific content of poultry litter for the small-scale projects, before selling Fibrowatt to EPRL, originally part of Kelda. Fibrowatt USA is Fraser's attempt to replicate the experience with the much larger US poultry growers as clients. And as with cheese, so with Turkeys. Farmers produce turkeys in ever greater numbers, on concentrated sites, and sell them to a smaller number of processors. But they are now producing at such large sites that there is no way to practically and cheaply dispose of the waste as fertilizer.

While Fibrowatt does not have a lock on biomass technology (other players such as Catamount have a sizeable presence), it is a natural developer, and operator, and has the means to bring in equity from both EPRL, which kicked in 70%, and Homeland Renewable Energy, a group of private investors that includes Fraser and the other founders.

And while the UK, which has a market-based renewable obligation certificate regime, is no longer so friendly to high capital cost developers with constrained balance sheets, the US is. Renewable portfolio standards, which encourage utilities to contract with renewable producers for a certain proportion of their power, allow developers to benefit from a richly-priced power purchase agreement that can approximate the length of institutional debt.

But the troubles of the US poultry growers, much more than the market for renewable power, drive the economics of a poultry litter-fired project. As facilities get larger, they produce more waste, more waste than can be spread over nearby fields at a low cost. A biomass facility thus becomes and essential means of disposing of this waste, and will thus be able to sign fuel supply agreements with the several farmers in the vicinity of a plant.

Benson: poultry-fired capital

FibroMinn is a 55MW project located in Benson, Minnesota, that closed a $202 million private placement in December. The project required lobbying to create an acceptable biomass mandate in the state, and thus compel local utility Xcel Energy to sign the necessary power purchase agreement. While the local poultry growers were supportive, several groups opposed the incentive package, and others content that the plants cause unacceptable emissions of dangerous metals. While this opposition is as yet muted, permitting issues could well derail the substantial slate of projects that Fibrowatt USA has in development. It is actively developing a 40MW facility in Mendenhall, Mississippi, and a 38.5MW plant in Eastern Shore, Maryland.

FibroMinn was structured as a leveraged lease using institutional debt, with a lessor, PowerMinn, owned by private investor Norton Herrick, and a lessee, FibroMinn, raising the debt from a group of institutions led by John Hancock and Prudential Capital. The placement agents, HH Media and McDonald Investments, brought in Met Life, Nationwide Life, Ohio National Life, Ohio National Assurance, Beneficial Life Insurance Company and Manufacturers Life. The plant has such a long contract that the use of institutional debt is possible, although developers, notably those in the footprint of utilities less well versed in renewables than Xcel, might find it hard to match these terms.

While Fibrowatt USA crosses the south persuading producers to sign agreements to supply waste, and utilities to buy power, other producers are wondering whether biomass plants are potential solutions, in particular beef producers, which already concentrate cattle in feedlots the size of cities. Their waste problems, as well as the problem of methane from cow digestive systems, are beginning to receive attention from biomass developers, which believe that cattle growers in enclosed spaces, for instance the Californian feedlots, might be suitable candidates for a gas-fired unit. But such projects will not likely be commercial scale, and are not yet far advanced.

Ethanol: ready to blow or too mature?

By far the most advanced intrusion of project finance into agriculture has been the private development of ethanol plants. The main reason for the interest is a mixture of simple proven technology and a generous incentive package. Ethanol plants are essentially distilleries, turning corn into ethanol, feed and yeast byproducts. There is little in the way of proprietary technology, except for some plants, which produce a higher proportion of feed. Ethanol plants have in the past consisted of smaller facilities that have been used by farmers as a hedge against higher energy prices, and lower corn prices. They have traditionally been not much larger than roughly 20 million gallons per year, and have been financed with a mixture of equity from farmers and agricultural bank loans.

The reason why ethanol, which does not really make economic sense as a standalone commodity, is so attractive is a volumetric ethanol excise tax credit of 51 cents per gallon. This is partly a recognition of the political clout of corn growers in the US, but also a recognition of ethanol's use as a fuel additive. Ethanol production, which stood at 2.8 billion gallons per year in 2003, could grow to 5.5 billion by 2012.

When leaded gasoline declined in popularity, refiners usually added MTBE, a derivative of methanol, to fuel to make it burn more cleanly. MTBE has been associated with groundwater pollution, and states, beginning with California and now across the Northeast and Midwest, have moved to ban it. The US Clean air Act mandates the use of oxygenates such as ethanol as additives at some times of year.

Ethanol even cropped up in the negotiations and ultimate collapse of a comprehensive energy bill. Since the price of a continuation of a break for ethanol became dependent on a waiver of liability for MTBE producers. Despite some lingering concerns over the effects upon emissions, ethanol demand is booming, although, rather like synfuel projects, and their tax credits, many participants like to keep their involvement low key.

But the projects attract interest because they produce a potentially lucrative, but often volatile commodity. Ethanol's price is a derivative of the price of gasoline, and is set on a spot market while corn prices determine supply costs. Long-term contracts are not available, and while feed has a fixed margin (both input and output are linked to corn prices), this element, on average 20% of revenues, is rarely enough to sustain the capital cost of an ethanol plant.

The ethanol industry has expanded thus far by contractor/developers – the likes of Fagen and ICM – working with multiple corn growers on ever-larger facilities, backed by agricultural banks. There was never a large market for independent operators, and ethanol now seems poised to attract the attention of large and aggressive private equity firms.

This is a trajectory immediately familiar to power sponsors, one that bedevils every attempt by project lenders to mark out new territory. As one lender puts it "the developers might be able to put together a deal we'd look at, but they get too greedy."

Private equity firms are greedy in the sense that they are more than happy to embrace commodity risk, and want to see distributions as soon as possible. While there are few ironclad ways of hedging the mismatch between corn and gasoline prices, there are expensive ways to put in place structures that would increase lender comfort, either ancillary debt facilities or some form of contingent equity. But few private equity sponsors are willing to accept this drag on their returns.

Aventine's advent

In this respect the two most recent public financings to date do not augur well. The first deal, for Aventine Renewables, closed in December 2004, a $160 million, seven-year deal led by Morgan Stanley and JP Morgan. According to sources familiar with the transaction, the keenly priced floating rate deal, understood to have a margin of around 200bp over Libor, sold strongly.

It was more akin to a leveraged buyout than a project financing, although $62.5 million of the proceeds were to go towards the expansion of an ethanol plant in Pekin, Illinois. The deal will maintain Aventine's position among larger players such as Archer-Daniels-Midland and Cargill.

Morgan Stanley Capital Partners bought Aventine, the second largest ethanol producer in the country from the Williams Companies in February 2003 for $75 million. Aventine currently produces 140 million gallons of ethanol per year, and wants to increase its capacity by 66.5 million, of which 55.5 million will be at the Pekin plant and another 10 million will be at a Nebraska facility in which it owns a 75% stake.

The financing, which does have restrictions on the use of some of the funds, largely pays back, and handsomely, the purchase price. Morgan Stanley has turned over the management off the investment to Metalmark, a group of former Morgan Stanley bankers. Aventine is run and financed as a standalone business, and its offering circular stresses the marketing and trading capabilities that the new operation will embrace.

Hawkeye's debut

The second financing, for Hawkeye Renewable Energy, shows that what project financing opportunities as do exist will be on a small scale, and that by the time they gain sufficient size to be of interest to a large-scale lender, they often approach a different market.

Hawkeye, formed by mid-tier private equity player Whitney & Company, financed a 40 million gallons per year plant using loans for Hudson United Capital, a niche renewables finance unit, led by former Chrysler Capital principals, of Hudson United Bank. Hudson lent roughly $21 million in senior construction loans and $24 million in senior term loans to the project. The construction loans were first made available in June 2004 and converted to term loans in early February 2005.

But Hawkeye, which wanted to raise capital at a faster rate to fund other projects, turned to the B loan market to refinance the debt and borrow additional funds. It has closed a $185 million loan, arranged by Credit Suisse First Boston, which is due 2012 and is priced at 287.5bp over Libor.
The debt sold on to mutual funds, loan funds, fewer hedge funds than normal, and several commercial banks, despite gaining a B2 rating from Moody's. CSFB was able to flex the pricing downwards from an initial level of 350bp in the face of strong demand.

The fact that plants often have a finite level of firm cashflow to support senior debt encourages developers to utilise mezzanine finance to support their ventures. Whitney provided a $40 million mezzanine facility to Hawkeye, rather than more equity (it put in $17 million). TCW's power funds, as well as the remaining captives, are other players in mezzanine capital.

Persistent roadblocks

Hawkeye's financing (for more details, see the deal analysis, this issue) is not likely to be the last – market players suggest that up to $1 billion in business is possible this year, in a mixture of bond, bank, and B loan financings. Lenders will want to move quickly – some 755 million gallons of capacity is currently under construction, and it is possible that by 2006 the industry will have moved to a position of excess capacity.
The excise credit is up for review in 2010, and may not be extended, although it still represents an incentives package that any wind farm developer would envy. The US department of Agriculture's Commodity Credit Corporation also extends credits, often as much as 20 cents per gallon, for new production capacity, but these payments are more marginal to plant economics, and more vulnerable to being withdrawn.

And even with the most solid fundamentals, projects can take time to come to market. AgriTech, a 100 million gallon per year plant to be located in Great Falls, Iowa, shows some of the enhancements that might be available to borrowers. AgriTech mandated CSFB to structure a deal, but the deal migrated to WestLB with the move of key bankers, before ultimately collapsing.

Nevertheless, the deal looked intriguing. The plant would have benefited from a marketing and distribution agreement with Noble Group, and Noble's sister company, Noble Trade Finance, would have provided a revolving, working capital facility to finance the project's wheat and barley inventories, work in progress, and ethanol receivables.

Such tweaks will be essential for tightly-structured deals, and as one participant has already noted, there will be a lot of hot money chasing ethanol deals in coming months. Only the most disciplined developers will be able to resist the lure of ready capital. But America's farmers may well benefit.