The Biofuels’ Debt Offensive: Protection of the many, by the many, means finance for the many

As any farmer will tell you, it makes no difference if you plant the finest seed in the world in perfect conditions, and fail to protect the crop.

Can changing the way we protect debtholders change lender and bondholder enthusiasm?

In Part I of our series, we looked at the slowdown in bioenergy financing, the Administration’s policies, and the gaps between what’s needed and what’s available. And the certainty that vision and technology means nothing without financing.

The reality of debt structures

“The biggest misunderstanding in the industry is that lenders will not lend unless perfect de-risking is achieved,” says John May, managing director at leading industry investment bank, Stern Brothers. Lenders (bond funds, not commercial banks) will lend non-recourse to below investment grade-rated bio projects where residual risks still exist and must be assumed by them.”

“The only approach to making debt financing available in bio,” May added, “particularly for first commercial scale, is to educate the lenders as to the nature and scope of the residual risks left in the deal.  This can be accomplished by using the latest financing structures to de-risk technology (insurance), feedstock (credit wraps,) and offtakes (several structures, but most importantly establishing that some merchant risk can be tolerated by the lender).”

“What these structures accomplish,” May said, “is that they enable the lenders to assess the residual risks and price them. This, in turn, allows them to arrive at a reasonable interest rate based upon the higher credit quality created.

More about de-risking

May explains: “The basic idea behind project finance (non recourse debt) is assigning project risks to the parties in the transaction who are most able to bear those risks financially. In biofuels and biochemicals, these risks are, in order of priority from the perception of the lenders:  technology, offtake and feedstock. (Complete mitigation of construction risk is presumed).

“The “problem with debt financing” in bio, is the inability of developers to fully de-risk these elements to the standard of the classic contracted cash flows project finance model. In our industry, it is simply not realistic to assume anything other than partial de-risking.”

So, the real problem is…

“When we first review most projects and project owners,” May noted, “they have neither fully defined nor taken steps to mitigate these basic project risks in a way that makes the financing marketable at a reasonable interest rate.”

The existing structures and the gaps

Where can risk minimization be most useful? In gaps such as:

1. The long out-years of a project, past the point where there are good offtake or input contracts available, but before the loan is paid back.

2. The gap between the extent of loan guarantee coverage and a loan amount.

3. The execution risk and the unknown-unknowns where first-of-kind projects fall short for unforeseeable reasons. Could be outright failure but, more insidiously, could be project delay or falling short of nameplate capacity.

Why project insurance is not an instant remedy

A number of industry voices call out for forms of project insurance. In essence, transferring the risks to an insuring party and away from the lender. Solves the lender’s problem, but who pays for the insurance? The project risk is the project risk.

Seeking an overall solution: Risk-pooling

Ultimately, the problem lies not in sector risk, but individual project risk. We know that project finance, as a whole, has a 6 percent failure rate worldwide, for all projects. But it really comes down to 100% failure for one project and its backers, and 0% failure for another project and its backers.

In times gone by, pioneer communities featured wood houses, extensive use of dry straw for roofing and bedding, and indoor fires for heating and cooking. The fire risk was tremendous — and ultimately led to the development of volunteer fire departments.

The theory of the volunteer fire department is simple. You join to save others, not only out of brotherly love but in hopes that should fire ever come to your home, others will be there to help. And because it boosts confidence.

Protection systems

Tell you one thing, lenders and bondholders respond to strength in all its forms.

Protection is valuable because it is transformative in its impact. But not all protection can be feasibly provided by a single individual at risk. Farmers form co-ops for mutual opportunities in advancement and protection, even though they remain independent businesses. It’s a powerful model.

So — think not only insurance, think self-insurance, and think in terms of pools.

In tomorrow’s Digest, in Part 3 of 3 we’ll look at The New Players.