Cleantech Finance Insider

Foundations of Energy Project Finance pt. 1

Anyone who writes a blog has to make some assumptions about their audience. I assume that readers are interested in the cleantech/renewable energy/sustainability arena in general. I also assume that there is a specific interest in the inner workings of the money raising process needed to get new firms financed and projects built.

I encounter some confusion about what types of entities put up money for energy projects. Often people think that all risk capital is venture capital. That is not really true. There are funds of monies that are under the large umbrella of "Private Equity" that do not take on technology risk (like VCs do) but will assume project completion risk (among others) that are associated with building energy producing facilities. They can be wind farms, ethanol plants, anaerobic digesters or even merchant transmission lines.

What these investors are looking for are entrepreneurs, sometimes referred to as developers, who can put together all of he necessary pieces to create an energy (and more importantly) profit producing project.

So what do these Private Equity project finance funds look for when they are evaluating an opportunity? There really aren't many hard and fast rules on this but the more of these the developer has lined up, the better his project looks:

A business plan that describes the opportunity, the need and the prospective financial performance

Control of the land for the project by ownership, right of way or most likely, option

All necessary permits

Knowldege and cost control of the inputs (feedstock, fuel, process chemicals)

A well-established, proven energy conversion technology

Credit-worthy, long term buyer for the output

Established, deep-pocketed EPC contractor

Experienced project operator and maintenance contractor

It's as simple as that! While I can hear my readers groan over the above list let me remind you all that few projects have all of these lined up when first approaching capital sources. They constitute what I have referred to in an earlier post, "the ten pound butterfly." It is something everyone would LIKE to see but no one really expects to. Nonetheless, over the course of putting together the project and lining up the money to build it, developers will have to address all of these issues.

In my next post, I'll drill down on each of the items in the punch list. In the meanwhile, I invite the readers to post comments on any additional factors that they think may have been overlooked or that don't belong.

Lessons From Biofuels

The corn ethanol industry doesn't need another voice to deride it's performance and unexpected consequences of late. In today's blog, I'd like to consider the lessons that we can all learn from it and some related renewable energy industries.

Much of the corn ethanol business proposition could be summed up by these facts:

1. Farmers know how to grow corn.
2. Lots of people know how to ferment and distill corn to make ethanol.
3. Ethanol can be blended into gasoline.
4. The Federal Government will pay people to make such ethanol.
5. The cost of gasoline is high and looks to be headed higher.
6. A big chunk of the cost to make ethanol is in the corn itself.
7. The cost to grow corn is well understood and more stable than the cost of gasoline.

In looking back, everyone was right except for #7. The cost of corn has risen faster than the cost of gasoline. As a result there are a lot of ethanol plants that facing hard times.

I could write the same list of "facts" for biodiesel, substituting soy or canola for corn. While it doesn't get the same degree of negative press, there are many well-intentioned biodiesel plant owners who are faced with buying palm oil from Southeast Asia that has a lot of environmentally negative baggage with it.

Growing palm for the oil is amongst the most productive source of agricultural oils on a land use basis. It also grows best in areas that have extensive biodiversity. The end result often being that the biodiesel plant owners are faced with the prospects of choosing between closing their plant or supporting the bulldozing of tropical rain forests to get cheaper feedstock.

Where with this surge in demand show up next? I'm already hearing about rapid changes in the cost of woody biomass - sawdust, waste wood, etc. It is clear to me that this is a trend. In fact, while NDA's prevent me from saying what the "waste" feedstock is, I'm seeing or hearing simultaneous proposals to convert the same nusiance feedstock in the same geographic region, a feedstock that people now pay to have hauled away. The end products are energy and more valuable recovered co-products.

If your project economics are predicated on getting paid to take the raw materials you use, suddenly having the shoe on the other foot is going to be a huge setback. While everyone strives to have some kind of protected intellectual property, there often isn't much technical advantage to the individual patents and knowhow around mass and energy conversion.

What then is a developer to do? How do you carve out a business that is sustainable?

The best (and most difficult) way is to enter into long term contracts for your feedstock and your off-take (products, co-products, etc.) that covers the length of any loan against the project. Then at least, you can weather periods of low profit or no profit without the fear of foreclosure.

The problem is that long term forward contracts (as their called in the commodity business) are hard to come by. Even in the commodity exchanges, the most mature forward markets in existence, contract terms are usually measured in months not years.

One competitive advantage that impacts most of these opportunities however, is shipping cost. Smaller plants that are using locally available feedstocks to produce locally consumed energy or other products will have a natural advantage. The trick will be in finding the right balance between economies of production scale versus the cost of input and output transportation.

Does this then limit the developers' prospects for building a big business? Not necessarily. As McDonalds has proven so well, you can build a very big business with repeatable, profitable, smaller businesses. If the economic model for local waste to energy works in one community, it often can work in others. Developers who demonstrate their ability to create those smaller, profitable businesses will find many organizations who are interested in helping to bankroll the next 5 or 10 of them.

The long term advantage will belong to the first movers. The bold, smart developers will get their chance at financial success based on their savvy and execution in the roll out of these smaller plants. As it should be.

Borrowing Money for Your Project

I realize that I've been tardy in posting new thoughts this last week but things have been heating up in all aspects of my business. Let me ease back into regular communications by making a short entry today that refers to a lengthy but very valuable article by another.

Stefan Schmitz of the UK law firm Squire, Sanders & Dempsey has written a fine article for the Renewable Energy World website dealing with the issues of debt and lending analyses for wind power. Here link

While the article only discusses wind power, I would hasten to add that the methodology is common across all forms of project debt financing. The main factor to remember that the "debt service ratio" discussed is arrived at by both technical analyses and qualitative experience. The more familiar a lender is with your project and technology the more they may feel free to lend.

Finally, while we are all reading about the big institutions who are taking a bath (and another bath, and another) in the debt markets from the subprime lending fiasco, there is still A LOT of money out there looking for good cleantech projects to fund. Carpe deum.

Don't Make Me Beg

I was talking with one of the founders of a very large renewable energy private equity fund the other day. The conversation turned to a favorite topic of mine, entrepreneurial success factors (see some of my earliest posts). I asked him what the biggest reason was that project developers with good ideas get turned away by his firm. He immediately said that it was because they won't or haven't fully committed their ideas to paper in a business plan.

That was very surprising to me. Not because I always see good business plans associated with the opportunities that I consider but because I felt that I MUST be unlucky in finding so many entrepreneurs with writers' cramp.

I (and every other financial professional) know that business plans are out of date as soon as the laser printer spits them out. We also realize that you can't know everything that will happen in year 2 at the beginning of year 0.

What we don't know is how do you think. How deeply and comprehensively have you considered the problems before you? No one needs a business plan if everything goes well. The problem is that inevitably, everything doesn't goes well.

We know that entrepreneurs are busy. So are we. To begin with, we shouldn't have to pepper you with every question we can imagine about the business just to get a basic understanding. It is up to us to figure out if you are the kind of person who is really committed to his idea or just committed to raising some money. Are the day-to-day activities of the founder and his team dedicated to today's tactical sales opportunity or are they trying to realize the bigger, longer term value of the firm? The plan, by identifying that vision of value can give a great leg up on that answer and be a valuable tool for management priorities as well.

Most people think of risk capital investors as looking for "home run" investments that generate huge returns. It is true that we all do that. What is just as important is that we are also looking for deals and the entrepreneurs behind them that will find a way to salvage something of the opportunity even after the original plan has been dashed by circumstances beyond their control.

The investment decision-making process includes not only understanding the proposed business but understanding what is known and unknown about that opportunity. The internet bubble days of raising millions based on something drawn on a paper napkin are long gone. These days, and for quite some time to come, the absence of a basic business plan is itself an item of implicit investment risk.

Everyone can appreciate a persuasive business pitch. If you really want to get the pros reaching for their checkbooks, put it in writing!

Courageous Thinkers

If you have glanced over that the "I'm Reading" list on this blog you will have seen the topic for today's entry: Break Through - From the Death of Environmentalism to the Politics of Possibility.

The co-authors, Nordhaus and Shellenberger are excellent writers with impeccable credentials in the envoronmental community. They have shown themselves willing to question many if not most of the current approaches to managing climate change.

For me, they put their fingers on problems that I never understood and they expose flaws in my own reasoning that I didn't want to admit. In short, these guys will make you think.

"Environmentalism offered something profoundly important to America and the world. It inspired an appreciation for, and an awe of the beauty and majesty of, the nonhuman world. If focused our attention on future generations and our responsibility toward them. and it called upon people to take valiant risks, from saving rain forests and whales to inventing wondrous new technologies that will help us overcome the ecological crises we face.

But environmentalism has also saddled us with the albatross we call the politics of limits, which seeks to constrain human ambition, aspiration and power rather than unleash and direct them. In focusing attention so exclusively on the nonhuman worlds that have been lost rather than also on the astonishing human world that has been created, environmentalists have felt more resentment than gratitude for the efforts of those who came before us. And the "rational" environmentalist focus on just fixing what's wrong with the present narrows our vision at a time when we desperately need to expand it."

I was particularly taken by the arguments made about the ineffectiveness of "buying up" the Brazilian rain forest to protect it. In places like the rain forest or for much of the rest of Brazil, there is a serious poverty problem. The people aren't cutting down trees to have a better view. They are cutting down trees to float them to a market that will pay them and allow them to feed their families. The fact that some North American ecological foundation has come in and bought "their land" isn't going to make the economic incentive go away. In fact, it makes those charged with preventing such poaching all the less likely to put in much of a police effort. If a tree falls in the rain forest but there is no environmentalist to hear it, does it still make a sound?

The authors' premise is that until there are better economic opportunities for rain forest workers than poaching trees and clear land, they will continue to poach trees and clear land. The Brazilian economy has shown potential but is currently burdened with over $500 billion in sovereign debt, much of which was run up by a military dictator in the 1960s. They propose that the only way to fix the ecological problems in the Amazon is to fix the economy of Brazil and that won't happen without canceling all or most of this dictatorship debt.

But those are freely traded securities in the public markets. How would you do that?

I don't know and as a finance-type the whole idea steps on my toes, but I have to say that I see their point.

As I said, these guys will make you think. Happy reading.

Who is Bankable?

Much of the time, the cleantech entrepreneurs that I work with are new to the space. That’s not too surprising given the relative newness and growth of the sector. Many are even new to the energy arena altogether. It is only fair to wonder how investors look at these entrepreneurs and what makes some more immediately “bankable” than others.

I’ve blogged before on my keys to success but I’d like to drill down today on what specifically makes the fundraising process easier for some entrepreneurs than others.

At the top of the list of qualities is having made money for investors in other endeavors. There is nothing sexier to venture capital or project finance equity investors than making money. That’s what makes people like my fellow Northwest Energy Angel, Martin Tobias link, look like Heidi Klum link to risk capital investors. Martin grew the Internet media company Loudeye and took it public in 1999. It made a ton of money for his early investors. When he later joined Imperium Renewables, a start up producer of biodiesel, it soon had over $200 million in growth capital available to it.

OK so we can’t all be Internet millionaires. What else do investors like to see? If you can’t show that you’ve made big returns, at least show that you’ve been a responsible steward of other people’s money. P&L responsibility is best but having managed big project budgets well is a fine feather in the cap.

The last quality of bankability that I'd like to mention today is demonstrated ability to create influence that extends well beyond ones actual control. As a manager of a start up company, every other company will be bigger than yours. No one really needs you or your product for their success but your company will need the cooperation and business of others. Have you faired well when your responsibility was high yet your authority was low? You could be bankable!

Time and Money

One of the more subtle ways that an entrepreneur’s optimism can get the better of him is in underestimating the timing of the fundraising process. It takes time to fund even the best deals.

While I am also an angel investor in energy technology companies, my “day job” is in raising funds for cleantech projects. Often these deals make use of provisions in state and/or federal tax code to improve the return to the investors. They are likely to use a “flip structure” to maximize the benefits to the parties involved. The linked article describes how the flip structure deal can work. link The net effect is that it allows investors who value tax credits to take the lion’s share of the tax credits while allowing the developer to take most of his cut of the pie as cash with an ownership interest “flip” in the out years.

The developer in such a deal is a bit like a juggler, keeping many plates spinning atop so many slender sticks in the air. Find the resource. Strike a deal for access to the land. Get someone lined up to operate and maintain the project. Pick the best technology. Get a delivery schedule. Identify a constructor. Find a way to market for your power and often then and only then, look for a suitable investor.

As you would expect, the more complete your preparations are, the easier it will be to get favorable terms from an investor. Where the optimism may trip up the developer is in the sense that when they finally have all of the pieces of the puzzle together, surely the investment community will quickly appreciate the opportunity that has been created. Finding the right investor and getting through the decision-making process takes time.

There is added difficulty when there are other time constraints that might impinge on the investor and therefore weigh on his decisions. Can you get it all built and operational by the (current) production tax credit deadline of 12/31/08? How long can you keep your place in line for production equipment? Is the option on the land due to expire?

It bodes ill for the project when I have to tell a prospective investor that there is a investment decision deadline after which the project could die, even a deadline many weeks away. No one likes to be rushed into a decision to commit capital be it to buy a car or a windfarm.

Even the best of projects take time to be evaluated, modeled by the in-house Excel gurus and brought before the investment committee for a favorable decision. It is never too early to get on the radar screens of prospective investors. If you or your financial advisors are not talking to prospective investors at least 6 months in advance of needing a commitment, you are falling behind.

Meeting of the Minds

The process of financing the ideas of entrepreneurs is simultaneously an art and a science. The approaches of the parties involved are so disparate that sometimes it’s hard to believe that they ever get a deal done. But they do.

Entrepreneurs by their very nature must be optimistic about their specific ideas. Investors, be they venture capitalist or private equity (project) investors are optimistic about their industries yet initially cautious, if not skeptical about the specific opportunity that they are being pitched on. They have, as the saying goes, “deep pockets, but short arms.”

For the investors, the evaluation process often happens in three stages.

Stage 1: Could this really be as good as the entrepreneur says?
Stage 2: What could go wrong to keep him from achieving those goals?
Stage 3: What’s it really worth to me?

Most entrepreneurs are good at presenting to the Stage 1 questions. They draw their energy from the prospects of realizing their vision for something great and out of the ordinary.

Some however, have trouble handling the second stage. It may seem that the questions suddenly went from appreciating the upside to dwelling on the negative and taking a generally pessimistic outlook on things.

What happened? Did the entrepreneur “blow it?” Generally no. In fact, as long as prospective investors are asking questions, the process is still underway. If the pitch has been well received and the opportunity for a noteworthy upside established, then the next big questions are around avoiding outcomes that derail that vision.

It is not necessary to know and control every aspect of the business, but investors will insist that entrepreneurs know and share what is known and what can be controlled as well as explain what is still to be understood and resolved. The more one can eliminate risk the easier it will be to raise funds.

Once it has been established in the minds of the investors that there is, in deed, an attractive opportunity whose risks are known, then we move to value. Stage 3 is the creation of the term sheet laying out the offer of investment subject to verification of assertions by the entrepreneurs, among other things.

Term sheet valuations will reflect the investor’s view (realistic, they’d say) of the opportunity in light of the remaining risks. It will also be chock-a-block with protections for the investors should things not go so well.

Once the entrepreneur has that term sheet and the advice of his legal counsel, the decision to proceed with funding is his. His job of convincing investors is done (at least for now).

All that remains is to deliver on his promises!

State of the Industry

Today's Wall Street Journal included an 18 page special section on "ECOnomics, creating environmental capital." I found it to be an excellent series of stories and interviews that capture the flavor of the financial community's interest in cleantech.

Perhaps most telling was the interview with Jeffrey Immelt of GE. He was asked why he has led GE into the "Ecomagination" era and emphasizing cleantech opportunities. "Was it PR? Was it personal conviction? Was it opportunism?"

His answer? "I work for investors. I don't believe in hobbies."

That was a more direct answer than I would have expected but I'm sure it was the truth. Entrepreneurs who are looking for financing will soon discover that there are very few people who will accept a lower rate of return to make targeted investments in environmentally sustainable businesses. There are considerably more people who will invest in opportunities that offer a better return, regardless of the ecological impact of the business.

The groundswell in venture and project finance for cleantech endeavors is not because of a wave of social guilt from the institutions making fund investments. In fact, as a fiduciary, pension funds, university endowments and the like are FORBIDDEN by law from making investments based on anything except risk-adjusted return on investment. Institutional investments in cleantech are up because of the widely held belief that this field offers some of the best moneymaking opportunities available today.

When meeting with your prospective investors, don't get confused on why they are there. Investors like to feel good about the businesses they help start. They HAVE to feel good about the returns that can be expected.

The Pitch

Yesterday I was with a local group of angel investors who hear seed investment opportunities in the clean energy space. I think that the biggest idea had the worst pitch.

In the venture investing arena, we hear tons of ideas, not many of them can meet the criteria necessary to get an investment, perhaps only a few percent. With in boxes always full of new business plans to review, there is always a temptation to look for the reason to decide to move on.

The entrepreneur was a young African-American man who carried himself with confidence and presented himself in a way that revealed his considerable intelligence.

He opened his pitch with "XYZ company is a minority/woman-owned business. I am personally committed to sustainable, green ....." I found myself struggling to stay open minded. Why did he open with the ethnic/gender background of his ownership and personal philosophy? If we (a mostly white group of angels) were to invest, we'd likely have to structure some kind of clever financial instruments to let him keep that designation and by the very nature of the setting only clean energy opportunities were to be heard. Even after refocusing, I found myself looking for and dwelling on the the "flaws" as I saw them in the presentation. It was 90% into the presentation before he got into the more compelling parts of the story.

After the presentation was concluded, we conferred privately about the opportunity. Most of us were put off by the presentation. One prominent angel, himself a successful, serial entrepreneur, told us that he had invited the presenter. He said that while the entrepreneur is admittedly unseasoned, he felt that there was a real idea worth investigating at least and proceeded to give us the "why should you care" pitch that we didn't hear in the formal presentation.

Entrepreneurs need to structure their presentation to tell their story while piquing the curiosity of the listeners. After learning more of the backstory, I think that I know how that same opening line might have been followed in a way that would have had us all leaning forward in our chairs.

"XYZ company is a minority/woman-owned business. Our target customers are Fortune 500 members who are regularly fined for missing regulatory mandated MBE/WBE purchasing quotas. The US addressable market for our product is measured in the billions of dollars annually."

Now, I still might have been incredulous, but I would not have had any trouble listening as carefully as possible through the entirety of the presentation.

The old saying "you only get one chance to make a good first impression" is never more true than in the entrepreneur's pitch to a VC.