Transforming Financial Reform

Bond financing is here—and all signs point to a perfect match
| May 20, 2011

On Good Friday more than a year ago, a team of renewable energy investors, lobbyists and lawyers met with 20-plus high-ranking members of USDA for several hours to discuss changes to the USDA’s 9003 Loan Guarantee program that offers up to $250 million of guaranteed debt to project developers. The results of those talks, along with more than 4,000 hours of unbilled time, have transformed the overall biorefining outlook from one of “could be someday” to one of “will be soon.” By incorporating the changes to the loan guarantee program first offered by the renewable energy all-star team that met with the likes of USDA Under Secretary Dallas Tonsanger and USDA Secretary Tom Vilsack, the USDA has already been able to supplant companies like Ineos Bio, Coskata and Enerkem as biorefinery developers that have already, or will in the next year, break ground and begin construction on their way to advanced biofuels and biobased chemical production.

For John May, managing director for Stern Brothers, the brainchild of the revamped loan guarantee program came down to a simple, yet incredibly complex idea: match the reality of the financial markets with a loan program whose entire goal is to provide imperfect applicants with the necessary funding to unleash an unproven technology into a world where off-take agreements, which might mitigate the risk of such commercially unproven technology, are more of a myth than reality.

With the help of Mark Reidy, partner for Mintz Levin, Cindy Thyfault, founder and CEO of Westar Trade Resources and John Kirkwood, partner for Krieg Devault, May and his team have singlehandedly shifted the hope for aspiring biorefining project developers away from the cash-strapped, heavily regulated banking atmosphere that had previously hindered the effect of loan guarantee programs like 9003, to what is today a trillion dollar market atmosphere where market players aren’t afraid to take on risk and they aren’t afraid to pay a lot for it: the bond markets. Now, with the continuation of funding to the 9003 program, future biorefining projects have in place a system that will create an unlimited—think in terms of trillions—source of debt financing that can provide the needed capital for projects like Coskata or Enerkem to go commercial, all while feeding the appetite of institutional investors looking to expand their portfolios through the bond market. If you are in the biorefining industry and you aren’t familiar with the bond markets and what they could mean to the growth of the industry, then now is the time to learn.

Why Bonds?
If a person were to sum-up the global economic climate over the past three years, there might be words like “bleak,” “tight” or “downright impossible” to describe the time period. Translate those sentiments into an impact statement on the biorefining industry that is still moving towards commercialization, and the result is an industry strapped by banks not willing or unable to lend the type of money, to the type of unproven clients, that is needed to make a bioprocess worthwhile.

“The problem with the 9003 program was that it wasn’t being used,” May says. “The reason for no use was that the program was designed to use commercial banks as the so-called lender of record, and the commercial banks did not have the liquidity or the risk appetite to be involved in transactions of renewable energy that presented technology risk and off-take risk.” In the wake of the subprime crisis and the credit crunch May says of the banks, “they couldn’t take the risk.”

But, the near-term economic climate isn’t the only factor to blame for the 9003 program’s lack of effectiveness. “A lot of the problems with the 9003 program were not something that was intentionally created by the USDA as a roadblock,” May says. “It was simply a holdover of an earlier era when small farm loans and agribusiness loans were made on very simple projects,” and most importantly, he adds, “I don’t think that when those regulations were put together that anyone thought the same sorts of regulations would be used by large biofuels projects with extremely complex technology and equipment.” This technology and equipment also comes with a steep cost per project, May adds.

With the help of other industry experts, May set out to change the landscape for the loan guarantee program. “I was trying to bring the 9003 program up to date and make it consistent with reality of not only the renewable energy market, but also the financial market,” he says. The team’s answer was the bond market. Why?

A bond is another form of borrowing. The money, instead of coming from the bank, comes from investors like mutual funds, life insurance companies or pension funds looking to invest. The market has been around for roughly 150 years according to May, and in the market “there are many, many investors.” Those investors are looking for several things, many of which coincidentally are provided by a USDA 9003 Loan Guarantee’s successful applicant.

For one, a bond investor typically has the financial ability to invest large chunks of money into a particular investment because of the size of the investor’s institution. This means that investors can invest in several areas and take on more risk if so desired. Second, unlike a bank-based lender, a bond-holder wants a long-term, 15-plus year lifespan for the senior debt (loan) in the hopes of earning more interest over time.

Time will tell if the new set-up is perfect for the biorefining industry, but so far, it seems that way. Typical project developers are seeking high amounts of cash to start a project, upwards of $100 million, amounts that the bond market can easily provide. Those project developers, however, can’t justify taking out a five- to seven-year loan with unfixed interest rates equaling double digits.

“It’s not like the old days when you had a grain plant with a crush margin of $2.50 to $3 because of the disparity of the price of grain that was so low and the price of fuel which was so high,” Mark Reidy says, “where the guys would take that and pay off their plants within two years or sooner.” He adds, “You aren’t going to see that anymore, so guys will want to amortize them as long as they can.”

As May says, somebody has to own these projects, “but they aren’t going to do it if they can’t make any money.” A more realistic, or at least better, situation allows those developers to spread out the debt over time, to know beforehand what the interest rate on that debt will be, and, to pass off some of the risk of investing in a unproven technology with no contracted end-user, refiner or oil company to start with. Because the bond markets can offer a fixed interest rate on more than three-fourths of the loan, and the USDA can guarantee that more than three-fourths of the loan will be covered by the U.S. government in the event that a project goes belly-up, the bond financing mechanism in the new 9003 program looks, if nothing else, pretty good.

Essentially, the bond market offers an alternative for financing. And if one looks at the numbers, considering how willing the banks have been, it is a welcomed alternative.

Bond Numbers
The most important number to remember about the 9003 program is really more about the ranking of the rating that the bonds created by the project developer will equal. Reidy says the bonds guaranteed by the USDA will be Triple AAA rated, or in bond rating terms, the best. The bonds earn that rating directly from the presence of the loan guarantee, which in effect acts as a major credit enhancer, and qualifies the bonds as investment grade.

The current system can be seen in this example. Consider an advanced biorefinery developer is awarded a $100 million loan guarantee from the USDA under the 9003 program. Through the system, 80 percent (or $80 million in this case) of the loan request will be guaranteed. The other 20 percent (or $20 million) will not be guaranteed. Because the USDA is guaranteeing 80 percent of the $100 million, bond holders will be willing to accept a lower coupon rate (interest rate) on the $80 million, somewhere around 5 percent. But, as Reidy explains, do to the reality that the bonds are financing an unproven technology (this is where the reality of the applicants come into play), the bond holders will be seeking a much higher coupon rate for the 20 percent of the loan that is not guaranteed, a rate that could be anywhere from 10 to 15 percent.

But, because the interest rates are blended together, the project developer will ultimately end up with the money needed to construct a facility at an interest rate between 8 and 10 percent spread out over a 20-year period.

Thyfault explains that the bond financing system inherently brings three major positives to the lender and two major benefits to the borrower. For the lender, she says, they can make more loans. Under the bond approach she also says a lender only has to carry 5 percent of the unguaranteed portion, the rest the lender can sell on the bond market, which allows the lender to expand a portfolio and take on less risk. Second, the lender, unlike a bank, does not have to go through syndication (or work with more banks) because the bond holders are the syndicates. And third, in the past when the unguaranteed portion of the loan was difficult for a bank to participate in, “the unguaranteed portion of the loan is readily accepted by the bond market.”

For the borrower, the advantages are related first to the length of the term of the issued bonds. And second, the borrower can typically see an interest rate for a bond that can be less than a bank loan, the result, she points out, “is a long-term, low-cost interest rate for the borrower.”

All four of the applicants that received USDA loans in 2010 used the bond financing approach, May says, and in doing so they helped prove May’s idea to revolutionize the way projects financed with a loan guarantee can work. The situation used to be one where, as May says, an applicant’s credit was good enough and the bank would do the deal, or the credit was not up to par and the deal was dead, but now has changed to a situation under the bond financing approach where “we can find a way to get the deal done,” a deal, he says, that is just a matter of how high the interest rate will be on the unguaranteed portion of the loan.

And even with four deals already done for biorefining developers earning loan guarantees, the most significant part of the new bond financing approach may be more linked to what hasn’t happened yet. “We filed four applications last year and receive four loan guarantee awards,” he says, “and we have half a dozen that we intend to file for in 2011.” And that, he says, is just his all-star team.

Reidy, who says nothing like this has ever truly been done before, is also excited about the potential for this type of renewable energy financing for foreign investors and other countries that his group has already spoken to, including China, India and several countries from Europe. “As long as we have a loan guarantee or something as good to credit enhance the bonds, because you have to credit enhance them to make them palatable for the institutional investors to buy them,” he says, “we can do these projects of any type offshore.”

From Reidy’s perspective, he could be putting together these types of deals for the rest of his career, and from May’s, the process has been rewarding to see an idea turn into reality—a reality it seems that will affect anyone who consumes energy in a sustainable way.

Author: Luke Geiver
Associate Editor, Biorefining Magazine
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