"First of Kind" – the Financing of Advanced Bio-Refineries, Part I

Today, we inaugurate a three-part, in-depth series – “First of Kind” – the Financing of Advanced Bio-Refineries, from our trusty correspondent Tim Sklar, whose last series on torrefaction was so well received. In Part I, today, we look at “Identifying Risks”.

By Tim Sklar

Background

The February 7th issue of Biofuels Digest (BD) provided a feature article titled “Biofuels roars back”. This article suggests that the rebirth in interest in increasing biofuels capacity is being driven by EPA’s announcement that it will “enforce the 800 million gallon volume RFS2 requirement ”. In this same article, BD provided as Excel spreadsheet download, “a free bio-fuels venture valuation tool”, in the hope that that this tool would prove useful to bio-fuels project developers.

It appears that much of this mandated capacity is already  “in-the-pipeline”. According to recent industry surveys it has been reported that there are 46 renewable fuels plants are either being planned, in pilot stage of development or under construction as commercial scale facilities. As is always the case with surveys of announced projects, many of these plants may not ultimately be built as financing these projects remains as a problem.

The Digest has since reported that current pressures for deficit reduction may cut EPA’s RFS2 enforcement budget, force a shutdown of USDA and USDOE loan guarantees for renewable fuels projects,  and do away with Federal Excise tax blenders credits for ethanol and bio-diesel. The Digest has also reported on difficulties that bio-fuels project developers are having in obtaining private sector financing and the high rejection rate such developers are experiencing when applying for Federal loan guarantees. As a consequence, there are big questions that remain unanswered. How much of the 800 mgpy RFS2 “mandated” renewable fuels capacity will ultimately get built? Which bio-fuels projects will best be able to obtain financing, and why?

Identifying Risk, Quantifying Risk, Dealing with Deal Breakers

The purpose of this three-part article is to provide project sponsors and developers of advanced bio-refinery projects with information and guidance in order to improve their prospects for obtaining project financing. It is believed that project developers’ have a better chance of winning financial support for their projects: if they anticipate concerns that potential financial backers may have; if they fully disclose the risks that are inherent in undertaking the project; and if they provide potential financial backers with answers and possible solutions for mitigating  these risks.

Part I is titled “On Identifying Risks”. It includes discussions that focus upon the high risk nature of bio-fuels projects and more specifically on advanced bio-refinery  projects. Part 1 also presents reasons why financing is hard to obtain while offering suggestions as to what can be done to improve the odds.

Part 2 is titled “On Quantifying Risks”. It contains a summary of the type of due diligence inquiries that sophisticated  financial backers conduct and the kind of information they need to see,  before committing to major bio-fuels projects. Also included in Part 2 is a list of typical concerns potential financial backers have with respect to perceived risks associated with bio-refinery projects.

Another sub-section of Part 2 lists bio-refinery specific  “what if” questions that will in all likelihood be asked. It is hoped that Part 2 will prove to be a useful guide to project sponsors and developers in preparing for due diligence inquiries, in assembling information and in conducting analyses that will be needed when preparing loan requests, applications for loan guarantees, investment memoranda and prospectuses.

Part 3 is titled “Quantifying Risk Using Robust Financial Models”. It presents insights as to the how financial modeling can be used in quantifying risk and identifying “Deal Breakers”. Part 3 also includes a sub-section titled “The Anatomy of a Model”. This sub-section  provides a detailed description of the computational framework used in the financial model. It also describes how to use this model. And it presents in mathematical formula form, measures of financial viability. Also included is a case study for  typical but hypothetical bio-refinery project.

The data used is in tabular form, showing input assumptions used for optimistic, most likely and pessimistic scenarios. Also presented in tabular form is a set of key measures of financial viability that were actually calculated by the model for each of the three scenarios. Major findings are then presented and the “known-unknowns” that could become “Deal Breakers” are identified.  The Deal Breakers that are highlighted are  those that will require specific risk mitigation efforts. Part 3 does not include a sub-section on how this can be done, as it is varies from project to project and is beyond the scope of this article.

Hopefully, the ideas and information provided in this three part article will lead to more of these types of projects being successfully financed.

Part I- On Identifying Risks

This Part includes discussions that focus upon the high risk nature of bio-fuels projects and more specifically on advanced bio-refinery  projects. It also presents reasons why financing is hard to obtain while offering suggestions as to what can be done to improve the odds.

Why Advanced Bio-refinery Projects Are Hard to Finance

Project Complexity
Typically, an advanced bio-refinery project is a complex undertaking. Most are start-up ventures in which the teams of people involved in the project are new to each other and to the fuels industry and/or the biomaterials supply chain they are depending upon. In addition, the conversion of biomass requires pre-treatment measures that are often not initially anticipated, requiring remediation after operations are underway. The process technology that is often used is also complex, requiring  competent EPC contractors with personnel that are experienced, and on-site when problems occur. Ramping up advanced bio-refineries requires plant personnel with  operating expertise on a 24/7 basis as shakedowns of the process when ramped up to commercial scale may involve unanticipated problems.

Technology Still Evolving
Advanced bio-refineries are costly to build and operate and delays in their construction and commissioning and ramp-up could impair project liquidity and force closure. Further, the yield of biofuels from feedstock could vary based on the quality and mix of bio-mass being run and process changes may be needed to control by-product and process wastes. In addition, competing advanced bio-refinery designs may make the installed technology less economic, precipitating a shorter useful life.

Uncertainty in Bio-Fuels Demand and Prices
Fuels markets served are subject to events in world markets and prices received for bio-fuels could be subject to calamitous declines.

Uncertainty in Bio-Feedstock Availability, Cost and Yields
Bio-feedstock prices are subject to unrelated supply-demand forces, causing instability in supply continuity and cost. Further, new types of bio-materials may become available, requiring changes in the materials handling and pre-treatment infrastructure. And recalibration of the bio-refinery may be required to obtain adequate bio-fuels yields.

Erratic Government Support
If the realization of adequate gross margins depend on a bio-refiner receiving subsidies through blenders credits or through a favorable market for RINs, then the project may not remain financially viable and it could be considered below investment grade.

If adequate net cash flows are dependent on special tax breaks which could be suddenly curtailed or phased out, investors may not be willing to support the project, if their return on equity could become inadequate.

Likewise, if the project’s access to credit depends on permanent debt backed by Government guarantees, and if such guarantees could be discontinued when debt is rolled over, then replacement financing may prove unaffordable and/or liquidity could be impaired.

Valley of Death Challenges

Project Sponsor’s Capabilities Uncertain
There are some bio-fuels projects that are being sponsored by joint-ventures that have partners , companies who are already engaged in fuels related businesses, such as petroleum refining, petroleum products marketing and distribution and 1st generation bio-refining. These JV’s often have the know how to start, operate bio-refineries and produce and market bio-fuels. But more often than not, the organizations that are involved as sponsors of biofuels projects are “Affinity Investor” groups, such as farm cooperatives and timberland harvesters and perhaps, the provider of the bio-fuels technologies that the project sponsors  expects to use. This type of JV often lacks the skill set to develop and run a bio-refinery as a successful business and those asked to provide additional financing recognize the added risk associated with having a less qualified group at the helm.

Project Sponsor’s Financial Strength in Doubt
If the project sponsor is a small company or group of small companies, they often can come up with the funding needed to acquire their founders stock, but even if they each agree to back-stop the bio-refinery project JV with added funding during start-up and through ramp-up, they often do not individually or collectively have the additional collateral to obtain off-balance sheet financing that would be needed to cover cash shortfalls that often occur during the critical start-up period.

Project Sponsor Not Making an Adequate Case
It is possible for project sponsors with limited capabilities and financial strength to attract added investment and bridge loans during the start-up and ramp-up. But to have a chance, a case must be made showing why cash shortfalls can be avoided and how contingency plans will work to mitigate the known risks. For instance, project sponsors may be able to get interest only financing, deferred lease payments tied to commencement of operations, take or pay agreements and soft loans from contract buyers, inventory consignments from materials suppliers, and R&D grants from governmental agencies.

If the Bio-refinery project’s prospects for being able to cross the “Valley of Death” are dubious, venture capital firms, institutional investors, private investors and commercial banks that could provide bridge loans will not commit to support such projects. And who can blame them.

What Can Be Done to Improve The Odds

Anticipate Questions Being Asked by Investors and Lenders

Most investors and lenders will want to be given hard documentation as proof that the Project Sponsor has meaningful market commitments for products being produced, a secure ongoing supply of bio-materials, a technology that will perform as expected, and people engaged  full time in project development and operations  that have the necessary experience and a good track record.

Investors will want to be offered a compelling deal in which they can recover their initial investment quickly and participate in higher than average returns over a relatively short period of time. They will also want to be offered an opportunity to cash-out after that period, and receive a value in termination that reflects some of the expected future earnings potential beyond the termination date. In order to be convinced, they will want to see business plans, related financial projections and back up documentation of assumptions used.

Lenders will want to be assured that they will be paid back in full, even if expected project returns are not fully realized. They will want to see financial projections using sets of pessimistic assumptions and test the adequacy of the debt coverage under such circumstances.

Addressing a Project’s Known-Known’s, and Known-Unknowns

Former Secretary of Defense, Donald Rumsfeld recently published his memoir titled “Known and Unknown” which addresses among other things, his decision making in Iraq. Rumsfeld divides knowledge into four states, the “known-knowns”, the “know-unknowns”, the “unknown-knowns”, and the “unknown-unknowns”. It is a useful construct when trying to assess risk in developing projects.

For instance, in putting together financial projections for bio-refinery projects, project developers’ work with “known-knowns” in developing their most likely case. In other words, they use their best estimates of the start-up and ramp-up timetable, they use published prices, capital costs based on engineering estimates and contract quotes, operating costs based on metrics published from similar bio-refinery operations, cost of financing based on prevailing published rates and terms, etc.

Trying to quantify a project’s  “Unknown-Knowns” or “Unknown-Unknowns” and trying to use them in projections is not possible by definition, as one does not know what one should know or can’t possibly know.

But it is most important in this context to identify a project’s “known-unknowns”, as these variables exist, but are not quantifiable with certainty. We must treat them as sets of probable values that could occur and use sensitivity tests to see how outcomes are impacted. This is addressed in subsequent discussions about the modeling approach being recommended.

Focus on known-unknowns that could be Deal Breakers

The most obvious list Deal Breakers that are among a bio-refinery project’s “known unknowns” would include: a significant drop in price, a significant cost over-run in construction of the bio-refinery, a significant delay in start-up, a significant increase in direct cost per gallon over that which was expected, a significant loss of financing at a critical time, a significant problem in attaining expected yields (i.e., gallons of fuel produced from a ton of biomaterial) and an unexpected curtailment of government incentives or subsidies.

Prepare Demonstrations To Help in Risk Mitigation

After the Deal Breakers have been identified the steps needed to quantify their impact and find remedies to lessen their impact the following steps are offered:

•    Develop What-if Questions

A set of what-if questions is included in a subsequent section. Titled ” The what if questions that can be answered”.

•    Quantifying risks using financial modeling

Model input is modified to reflect possible values associated with each known-unknown that could be a “Deal Breaker” and the Model is rerun.

•    Obtain Better Information and Documentation

For those suspected deal breakers that have too  adverse an impact to ignore, try to find information and documentation that will support strategies as to how reduce the probability of project failure, by developing contingency plans.

•    Obtain Additional Backing and Assurances

If a Deal Breaker can be mitigated through more specific contractual terms, seek clarification, and MOUs from those who can share the risk or offer better terms to deal with contingencies. For instance, if feedstock costs are at risk of spiking, MOUs could be obtained from potential  buyers as their willingness to agree to  price escalation provisions tied to a bio-refiner’s pass through of increased cost.

•    Revise Strategies and Business Plans

Once refined estimates for the known-unknows are obtained, the bio-refiner may want to reflect on changes in strategy that could improve financial viability. For example, if it is suspected that producing and selling a by-product will always be uneconomic, the bio-refiner should consider feedstock and process changes that could absorb the by-product as a fuel or as a syngas to be used internally.

•    Provide Answers When Preparing Applications for Financial Support

Rather than not mention known-unknowns that are problematical, the project sponsor should discuss them openly with the potential investors and lenders, and let them decide on the risk they are willing to assume. Often business plans contain a SWOT analysis section where a project’s “Strengths, Weaknesses, Opportunities and Threats” are presented. The discussions on known-unknowns and the risks they pose as Deal Breakers should be included under the section titled “Weaknesses”.

More about Sklar & Associates, Biofuels Project Developers, here.