Despite Misgivings, Buyout Pros Still See Future In Ethanol

For a while, early buyout entrants to the corn-based ethanol market were sitting pretty.

The past few years have seen the highest ethanol production growth rates in 25 years, due largely to rising gas prices, the nation’s desire to become less dependent on foreign oil, and federal subsidies offered to handlers of the clean-burning renewable fuel.

But today, those same buyout firms are getting hammered. Gas prices have reversed course, while the price of corn, a key ingredient in ethanol, is on the rise. Meantime, ethanol producers must contend with high transportation costs and an increasingly competitive market. Among those that could be hurt if the downturn worsens: Ares Management LLC, Carlyle/Riverstone, Cascade Investment LLC and Thomas H. Lee Partners, all of which have made ethanol investments this year alone.

The problems are quickly multiplying for suppliers backed by these firms. Oil prices have dropped to about $61-per barrel—a price now accepted as moderate—and costs at gas pumps have followed suit, causing a shrinkage in demand for ethanol at a time when more and more production facilities are being constructed than ever before. As a result, the price for ethanol, which in June reached as high as $5.30 per gallon in some East Coast markets, is projected to fall to about $2.30 per gallon in December, according to

Making matters worse, the United States Department of Agriculture raised the estimated average farm price range for corn by 40 cents to $2.80 to $3.40 per bushel, partly due to the demand pressure set by new ethanol producers comming on line. Given that the price of corn accounts for about 70% percent of the per-gallon cost of creating ethanol, the pinch becomes apparent—especially in a market where producers are racing to establish themselves as the low-cost providers.

Corn-based ethanol is a clean-burning, renewable fuel that’s used in the U.S. as an additive to traditional gasoline. Most ethanol produced in the U.S. is used in a compound called E10, a mixture of 10% ethanol and 90% unleaded gasoline, that’s used at many gas stations across the country. A less common ethanol fuel compound, but one that producers hope will grow in popularity, is E85, a blend of 85% ethanol and 15% unleaded gasoline. E85 can only be used in vehicles built specifically to run on it. It’s no coincidence that the past three years, marked by growing conflicts in the Middle East, have been the ethanol market’s busiest ever. In 2003, U.S. ethanol capacity topped off at a record-breaking 2.8 billion gallons. This year that number is set to almost double, according to the Renewable Fuels Association.

But the market is by no means a mature one. The typical play for a buyout firm is to team up with experienced agricultural businesses and to provide project financing for the construction of new ethanol production facilities. To date, the public exchange has been the ethanol industry’s most liquid exit market given that the space is not yet efficient enough to attract a deep pool of secondary buyers.

“This is a very volatile industry where the inputs and the outputs have no correlation,” says Dorian Faust, a principal at Norwest Equity Partners, a Minneapolis-based buyout shop that invested $31 million alongside ethanol giant The Broin Companies to help fund the construction of ethanol plants Frontier Ethanol LLC and Horizon Ethanol LLC. “The price of oil has nothing to do with the price of corn. And now, with corn prices on the rise and as oil prices down, we expect to see a lot of [ethanol] plants losing money over the next few years.”

A number of production companies that IPO’d this year have taken a beating. Shares of Bluestem Capital-backed ethanol producer VeraSun Energy Corp.—whose share prices jumped 30% from $23 to $30 in its first day of trading this summer on the New York Stock Exchange—are now trading at $20.32 per share. VeraSun was the first ethanol producer to IPO in 2006. Similar is the story for the year’s second ethanol IPO. After debuting on the NYSE at $43 per share, the high end of its offering range, Aventine Renewable Energy Holdings Inc. is now trading down 45% at $22.90 per share. Aventine is a portfolio company of Metalmark Capital (f.k.a. Morgan Stanley Capital Partners), which acquired it for $75 million in May 2003. Meanwhile, Hawkeye Holdings, an ethanol producer backed by Boston-based Thomas H. Lee Partners, pulled its proposed $350 million IPO in September, citing adverse market conditions.

The Promise

The renewable energy market has traditionally been the stomping ground for venture capitalists investing in things like wind energy and hydrogen fuel cell projects. Meanwhile, their energy-investing brethren in the buyout world were content to keep busy with fossil fuel plays, buying out coal producers (think W.L. Ross & Co.) and oil and gas exploitation companies (The Carlyle Group and Riverstone Holdings). The dividing line was clear.

But no longer is that the case. Over the past few years U.S. buyout shops—energy-focused and generalists alike—have been dipping their toes into the alternative energy space, making piecemeal investments in areas like wind energy (Diamond Castle Holdings Inc.) and landfill natural gas (First Reserve Corp.). But, for the most part, the prevailing number of green-minded buyout firms chose to get their feet wet in the corn-based ethanol market.

Key ingredients that make the fuel ethanol market attractive for buyout shops include the safe abundance of corn in the U.S., its status as a proven technology (fuel ethanol has been being produced domestically for well over 25 years), and government subsidies.

Despite the signs of danger, U.S. buyout pros with an interest in the ethanol production market say they still see a lot of promise, as long as they can play the game right. Even a downturn has its advantages, says Norwest’s Faust, noting that, if the market were to turn south, Norwest is prepared to take advantage of its aftermath by acquiring, at a discount, some of the adversely-affected production plants.

And longer term, conditions do seem ripe for ethanol production to continue to rise. “There’s significant interest in ethanol production driven by energy security issues, an overall trend toward higher oil prices, and federal and state standards,” says Dan Reicher, President of New Energy Capital Corp., a Hanover, N.H.-based private equity firm focused on renewable energy investments.

The federal and state standards relate to the banning of the chemical MTBE, which is an additive known as an oxygenate. MTBE gets mixed with gasoline to reduce the output of harmful emissions. In some cases, MTBE has been linked with cancer and debates continue over whether or not to ban the substance and replace it with another oxygenate, like ethanol. At least 16 States have already passed legislation that would ban or restrict the use of MTBE in gasoline, according to the U.S. Energy Information Administration.

Another wind at ethanol’s back has been a federal subsidy called a “blender’s credit,” which provides the company that mixes the ethanol with gasoline and readies it for consumption with a 51-cent-per-gallon tax credit. “We don’t actually see the credit up at the [ethanol] production level, but the market anticipates it,” so it all comes out in the wash, new Energy Capital’s Reicher says.

Unfortunatley, the blender’s credit, which is slowly reduced year over year, is slated for termination on Dec. 31, 2007. “If that credit is not renewed beyond 2007, it will change the risk analysis and the economics of the whole market,” says Andrew Ritten, a partner at the Minneapolis law firm Faegre & Benson LLP.

Ethanol’s High Costs

Taking advantage of tax credits and other advantages, Ethanol producers have found themselves locked in a battle to become low-cost providers as the path to longevity. But ethanol production is not cheap.

It takes enormous amounts of corn to produce ethanol, and transporting vast tonnage of the commodity to a processing plant is very expensive, Ritten says. That’s why most ethanol plants are built adjacent to the corn fields and grain terminals that supply them. “The problem is that most of our corn comes from places like Iowa, when most the demand for the actual ethanol is in the major coastal cities thousands of miles away,” Ritten says.

Unlike crude oil, ethanol cannot be conveniently transported in a pipeline because it is soluble in water, which is used to clean out the pipelines. Therefore, moving the ethanol by rail has become the most popular, albeit expensive, option. “The challenge is picking [a] location with good transportation alternatives, such as spots close to water where you could use a barge to transport it,” Ritten says.

For example, Metalmark Capital-backed Aventine Renewable Energy plans to build an ethanol production facility in Mt. Vernon, Ind. There, on the lower Ohio River, workers will have access to roads, rail and dock infrastructure, including river access to the Mississippi, Cumberland, Tennessee and Tombigbee rivers, according to the company.

Challenges and competition aside, industry participants believe that the ethanol market will continue to see increased investment and construction, and recent deal flow confirms as much. Just earlier this month, the Carlyle/Riverstone partnership teamed up with Dominion Energy Services LLC to build up to 300 million gallons of new bio-refining capacity in Alberta, Canada., including a 100 million gallon-per-year ethanol facility. Construction is slated to being in Q1 2007, with Carlyle/Riverstone taking a controlling interest in the facility.

In fact, so much money continues to pour into ethanol production that some industry observers warn of over-capacity in the next five years. Production is already on par to surpass the 8-billion-gallon-per-year goal that the federal government has set for the industry by the year 2012. As of Oct. 30, 2006, U.S. fuel ethanol production had reached more than 5 billion gallons for the year, well up from the 3.9 billion gallons produced for all of 2005, according to the Renewable Fuels Association.

“As more companies currently under construction come on line, we’ll get some answers on what it takes to be the low-cost producer,” Ritten proposes. “Is it strictly all about location? Are there certain technologies that allow you to produce at lower price? Once those questions are answered, I think we’ll start to see some industry consolidation, at which point more private equity will enter the market.”

If they don’t get burned first.