The Money Identity, the Bond Supremacy, the Washington Ultimatum: Biofuels and loan guarantees

February 16, 2011 |

Bourne out of desperation, the biofuels industry spies financing ops in the Bond market. Smileys all round. What happened? What’s next?

This month, the biofuels industry cheered as loan guarantees came through from the USDA for projects by Coskata, Enerkem and INEOS Bio in Alabama, Mississippi and Florida – all producing cellulosic ethanol. What was notably absent were the banks.

Essentially, despite rising banking sector profits and good results from stress tests, the bank financing market has not returned for biofuels – the financing source for whom the USDA loan guarantee was developed in the first place. Instead, via a hybrid financing concept developed at Stern Brothers, Mintz Levin and Kreig DeVault, the biofuels industry has pivoted towards the bond market where, from all reports, scale-up financing is available, and increasingly interested in biofuels projects.

Tinker, Tailor: Industry and government analyze, fix the loan guarantee structure

And, in a scenario more common to science fiction novels set in alternative universes, industry presented its analysis of the problems with the loan guarantee program to the USDA, and the Department fixed it (in the recent revised rules, though still subject to a comments period). Without running to Congress for legislative cover, without the multi-year bureaucratic delays that we are used to. Well, maybe not as fast as hoped, but there was a turnaround.

“When you are trying to get a rule change, you usually have to beat people over the head. But USDA listened. They were serious,” commented Mintz Levin partner Mark Riedy, who with Stern Brothers MD John May and Kreig DeVault partner John Kirkwood, has been organizing victory on the bond financing opportunity. “They admitted that they saw a problem too – no one was accessing the loan guarantee program. We wrote our comments based on what the industry needed, and in their rule they adopted almost everything. Then they had to negotiate with OMB and they warned us they thought they would only get 75 percent of what was asked for, but we got that and more.”

The program in question is from Section 9003 of the Farm Bill – the USDA’s enhanced loan guarantee program, aimed at moving advanced biofuels towards commercialization – and specifically, at absorbing technology and offtake risk that was deemed too tough for the traditional project finance markets – much less the battered markets of the past few years.

When we talk about advanced biofuels in the Digest, we tend to see readership spikes when we have news on transformative technologies, not new financing mechanisms. But readers, this is where the rubber meets the road – the global energy system needs transformation, transformation requires scale, scale requires finance, finance requires a mechanism, and the mechanism was broken.

The Name is Bond

“We knew we could get things done,” remarked Stern Brothers managing director John May, “if we could allow the LG to apply to bonds and institutional debt. This is the only market interested in lending to these projects. They have the liquidity, and the ability to assess and price the risk. Banks just don’t have it. Banks look at projects that are at, or close to, investment quality . These are single or double B projects, not investment grade, with a set of offtake and feedstock agreements that are just not bankable in that traditional sense. The
USDA really got it. Secretary Vilsack was really responsive to the industry, because they understood that they could not provide that rural economic opportunity unless they could transform the financing.”

Reidy added, “We took the time to work with [the USDA] on their own terms, and took them through how and why the credit markets had changed. We made the argument that if the programs are going to be a good tool, the USDA was going to have to enter into a true partnership with industry, and share the risk. Certainly the incentives were there and the vision to redevelop rural america. But we needed a financial rationale for that and I think we supplied that. When we first started the typical bureaucratic resistance to change – there were all these anachronistic provisions. But we explain how to change the provisions and not increase the risk to the USDA. That there was no particular risk in a combination of bank and bond financing, that was risk that they didn’t already had. At that point, the line of communication opened up, and it was authentic communication, in real time.”

Sufficient ammo? Sure. In the nick of time? Well, maybe.

Let’s pivot back to the parlous state of the government’s own finances. We have heard, for example, that the Biomass Crop Assistance Program, BCAP, proving transitional incentive payments to small farmers to get them into the biomass-growing business, is on the chopping block, before it really even got out the door for advanced biofuels.

We also note that the UK government, also taking austerity moves, cancelled funding for the UK Carbon Trust’s algal biofuels project and is eliminating up to 40 jobs in the process.

So, now that the USDA can issue loan guarantees for projects financed by bonds and institutional debt, will there be loan guarantee money at all?

The USDA and DOE loan guarantee well: dry as a martini?

What we hear is: sort of. At the Digest we hear that there will be up to $300 million available for the USDA’s next round of loan guarantees – representing money held back from 2009 and 2010. At this point, there is no statutory minimum amount for 2011, nor is there any in 2012, and so additional loan guarantee money has to be appropriated, and that may not happen now that the Obama administration has fallen in love with electric cars and reportedly put all its eggs in that basket, with a marquee program announced in the State of the Union address to put one million electric cars on the road by 2015.

Ultimately the money will come from the Congress, and what we hear is that as much as $400 million in new loan guarantee money could come through for 2011. But we are betting, in these nefarious times for government budgets, that $300 million is what will be available.

Meanwhile, we hear that the DOE is getting totally nailed in the discussions on the hill in terms of its loan guarantee program. We hear that the program may be reduced in its total guarantee authority by as much as 25 billion – which essentially zeroes out the DOE’s remaining credit subsidy funding (the mechanism which makes the loan guarantees work), and zeroes out the program. There is a ton of negotiation left to do, but the message to the industry is clear. This is not the hour to leave your lobbying to amateurs. Washington is going to be playing fiscal musical chairs this year, and getting thyself to the Hill with a very good story about why advanced biofuels loan guarantees are one program that is working, and deserves support – well, the time is nigh.

On the side of happy, there’s the Obama proposal to eliminate $40 billion in oil and gas subsidies, and moving those into renewable energy. Hmmm, great idea, we’ll see about that.

Non-guaranteed finance for scale-up: not quite mission impossible.

So, back to the finance markets – are they getting more healthy? What about the possibilities for non-guaranteed finance, as advanced biofuels moves forward.

John May told us, “we remain very confident that the bond market will be a great source of debt for these sorts of projects. The guaranteed debt is easy to sell. There is interest in non-guaranteed debt, even, the BB or B projects that are well below the bottom of investment grade. It’s not a question of whether the bonds can be sold, but what’s the interest rate.

“Our approach is to combine the guaranteed and the unguaranteed – to come up with a blended interest. If 60 to 80 percent of the debt sold at a 4 or 5 percent rate, because of the guarantee, then there is 20-40 percent unguaranteed, that might have to be sold at 12 or even 14 percent. But the blended rate is still 7, 8 or 9 percent, still great for a valley of death project. The key is the ability to live with high rates on the unguaranteed portion, so companies that have equity great strategic partners that can inject more equity if needed – even in a tough bond market – that is going to get projects done.

“It’s better than all equity, hands down. That kind of money requires 20+ percent or 30+ percent returns. It’s an extremely expensive form of money – if we come up with a blended solution that is below 10, even if some is at the 12-14 or higher, that’s still way less expensive.”

Projects of interest: who’s the beautiful Bond girl?

What kind of projects are going to receive the most grace and favor from the USDA going forward. We noted that all three of the new loans were for Southeastern US locations, and were for cellulosic ethanol, and featured low-cost or negative cost feedstock. Sign of things to come?

Reidy added, “The first four were waste to cellulosic ethanol project types, but they are looking at new things – biobased chemicals, biojet. Vilsack very much in favor of getting those fuels out, and the USDA signed MOUS with CAAFI and FAA, but no one is producing those jet fuels at scale. So we expect that drop in fuels will score high on the next round, though the sizes of projects may be smaller so get more out the door.”

John May agrees. “The cellulosic ethanol space is staring to crowd up a bit. Other areas have to be of interest to USDA. Vilsack desires to look at geographic diversity, so that’s a factor. With feedstock, any time you can get negative cost feedstocks that helps with the risk, and the interest rate. As far as size, there’s sort of a natural cap at around $400 million for any project in the USDA program because the cap on senior debt is $250 million, and given that mezz debt and tax credit debt is hard to come by, there’s a ceiling there. They will be bigger than the  B&I and REAP size, which is caps out at $40-50 million, and but not more than that 300-400 million horizon.

“Moneypenny, let me tell you the secret of the world”

So there we have it, pilgrims. The industry was shaken, the USDA was stirred, and bonds came to the rescue.

Will there be additional loan guarantee financing? Well, see your local Congress member, today. And tomorrow. The day after is a good idea too. In the meantime, the bond market is tough, but it is open, and there is some appetite for unguaranteed debt – so sharpen thy pencil.

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