Crazy. Sexy. Risk.

December 24, 2016 |

bd-ts-122616-risk-cover-smOn any list of 10 Colossal Failures of the Finance sector in this century, we’d put the failure of bankers and commercial-scale investors to get behind the advanced bioeconomy in a more timely fashion. “It seems as if we’re paying for the sins of others,” sighed CEO Martin Sabarsky.

One CEO observed to us not long ago:

“It used to be that you’d go through gut-wrenching due diligence for project finance. Now, you go through it when you’re raising a Series A round. Who are your customers, what have you done to lock down feedstocks, what guarantees are there that the technology won’t fail? There’s always going to be the tough discussion about valuation, but now the talk even at the earliest stages is about project failure. That’s a sign of the times.”

But from the Digest’s point of view, we certainly see the problem for bankers of taking on excessive project risks.

These are guys that raise money at 1-3 percent and lend it at 6-8 percent. Even a project failure rate of 5 percent is catastrophic to the business model. And let’s put that in context, 4 percent of US home mortgages go bad — and that’s as stable a technology and business model as you’ll find.

Bankers are risk-adverse, we all know it, and there are perfectly reasonable reasons for it.

Yet, in the mortgage market, there’s the risk that the house burns down, or is carried away by earthquake or flood. Just as projects can be swept away by metaphysical equivalents.

That’s the role of insurance. You’ll never get a mortgage without fire and flood insurance — and sometimes you even need mortgage payment insurance. Yet, biobased projects are expected to finance without adequate insurance vehicles to spread the risk.

So, let’s look at that.

Let’s start down the road with a standard offtake-financing model. You sell some product to a customer, and you get money up-front, which is used to finance construction.

Builders use it all the time to reduce the financing charges for construction projects, and the buyer gets a reduced price in return for placing a construction deposit. Most home handyman projects are also done on the 50% upfront basis. And magazine subscriptions are sold that way — pay now, get 12 issues over the course of the year — and the money is used to create the product.

It’s been tried with the biobased economy.

“We’ve approached several customers with that model,” one CEO told The Digest. “We offered to sell two tons of product for future delivery at market price, for every ton purchased on an-up-front payment basis.”

Once again, failure risk bedevils the contract. The customer can’t afford the risk, even though in the example given above, there’s a 50% risk premium in the deal. Or rather, the customer rightly would fear for their job if the project failed, and that overwhelms any temptation contained in the discount.

Offsetting the offtake

But let’s go a step farther, because we have uncovered something valuable. The project can afford to offer some exotic risk premiums for a short while, because the project will generate profits for 20-30 years after the short-term “offtake special” expires. Like a drop of red ink in the ocean, it’s easily absorbed into the overall financial structure of the project.

It’s the old loss-leader. Why is that so problematic for the bioeconomy, when it’s used successfully in established industry?

The problem here is not the risk premium itself; it is the nature of the customer for it. The customer of the physical inventory — like the project finance banker — has to insulated from the risk. These guys provide offtake, and capital, they do not provide risk absorption.

No one is going to buy a car, even for 50% off, if there’s a meaningful risk that the car will never be made.

A new Risk Partner player

So, let’s separate the physical product cost from the risk premium.

So, look at it this way. Let’s say we gave the end-use customer a 20% financing discount for money upfront for the construction and initial production period — and the 100% risk guarantee on the back end from the risk partner. So, they get $1.20 in product for $1.00 in payment now.

And for a project costing $6 in capex per gallon in capacity, selling $3 fuels at a 33% gross margin, we’d owe the customer $12.00 in product (per gallon of capacity at the plant), and it would take us 2.22 years to produce the fuels, and we’d need $4 in working capital for production of the fuel.

But we also have $2 in profit to direct our risk partner, as profit for guaranteeing our risk.

Looking at a portfolio of risk

Let’s look at a 10-project portfolio of $150M projects.  At an (elevated) 10% project failure rate (the DOE’s average has been less than 5% on a dollar basis for the Loan Guarantee program), the risk investor would guarantee $12, lose $1.20 on the failures, and earn $18 on the successful projects.

But there’s a trick here. The capital from the risk partner is not tied up for 30 months. We didn’t need $1.5 billion from the risk partner to build the projects. We got that from the physical customer.

We only need the capital from the risk partner at settlement date. So we hold the capital in escrow for something like a week. The rate of return could be fantastic. It’s $16.80 earned over five years (per gallon of capacity), for tying up $6 (the project failure) for 2.2 years (the time until money is recouped on the successes)

What’s the rate of return? Get your helmet on. For the risk partner, its 59.68% per year. Those are higher than venture returns.

Who guarantees the guarantor?

So, the investor is going to accept some risk in return for the opportunity to realize those kid of returns. No one needs a 100% guarantee to justify a 600% p.a. percent rate of return to any group of investors I have met.

Let’s say the government guarantees 60% of the project investment — that’s what they do today through the USDA loan guarantee program.

With loan guarantees applied, the rate of return reaches 142.18%.

The public option

Finding it hard to raise capital from a single player, for a derivative-play in renewables such as the scenario above?

Why not roll up the risk into a RiskCo, and float it as a public entity? The company earns returns as a consequence of assuming risk. It’s not entirely different from an insurance company, and plenty of those are publicly-traded, and happily so.

Here’s how that might work. Buy the risk from 10 projects, raising private capital pledges to provide the necessary reserve fund. Float the portfolio as a public “renewables insurance” entity. If the projects are reasonably picked, the returns are exotic enough that the entity has real appetite for risk, and real capital-rising ability with investors seeking elevated returns.

Of which there are a few.

Which in turn pushes capital into risk-balancing, which in turn activates capital from offtakers, and into the hands of project builders. Who naturally receive nothing from individual project failure — so they are still properly incentivized to succeed.

No companies like that right now?

OK, so the public flotation route seems overly complex to you? Well, there’s another route. Simply bundle up the risk, and trade it as a default swap. The Big Short might give you some ideas about how to create a tradable security where one did not exist before, to generate exotic returns by untrapping a major opportunity.

The point is, give the customer what he wants. Sell risk to adventurers. Sell product to customers.

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