Lending to Troubled Ethanol Plants
By: TODD A. TAYLOR & RYAN T. MURPHY
March 2008
It’s no secret: High corn and energy prices coupled with low ethanol prices are squeezing ethanol plants’ margins and making it harder to service debt, purchase inputs such as corn and chemicals, and pay wages. The new Energy bill signed December 19, 2007 by President Bush increases the requirements for ethanol use, but the ethanol industry still faces challenges. This article provides a roadmap to meet the challenges associated with lending to ethanol plants in the current market.
Early detection of financial problems substantially increases a lender’s ability to protect its interests and an ethanol plant’s likelihood for continued success. When a plant is highly leveraged, as many of the newer plants are, this becomes even more important. In some cases, early detection may allow a lender to exit the relationship, limit further borrowings, or improve its position in the face of additional risks. It will ensure that a plant’s resources are not wasted in attempts to obtain short-term concessions from creditors. Such concessions may provide a plant immediate financial relief; however, particularly in the current economic climate, it will typically fail to address the fundamental issues driving the dwindling revenues. Temporary concessions may even exacerbate the financial problems by causing a plant to incur additional obligations such as interest and attorneys’ fees.
To notice the early warning signs, a lender must know what the economic challenges are and where to look for them. The new Energy bill increased the requirements for use of ethanol; however, economists project that the industry will add production capacity faster than the bill mandates use, leading to potential oversupplies. Current oversupply, driven by regional and logistics issues, has also driven down the price. As production continues to outpace demand and logistics hamper more efficient blending, ethanol prices are not projected to recover in the near term. Corn prices are also a major factor in ethanol plant economics. The price of corn as an input is roughly 80% of the production cost of ethanol. As corn prices rise, the cost to produce ethanol also goes up, and coupled with reduced or stagnant ethanol prices, this has hurt the operating margins of ethanol plants.
The problems of an ethanol plant that cannot meet these challenges will appear first in its financial statements. Due to oversupply, the accounts receivable will dwindle as inventory rises. In addition, the ratio of accounts payable to accounts receivable will decouple as the plant’s revenues fail to keep pace with the price of inputs such as corn. Loan documents typically provide for regular financial reporting, which should expose these problems. Lenders must diligently review these reports for the particular financial difficulties plants may be experiencing. Phone calls and visits to the plant’s facilities offer other means by which to monitor the credit relationship. The aim of these contacts is to determine if there are any changes in production, inventory, or payments to creditors. Such changes are harbingers of growing financial distress.
When a lender becomes aware of a plant’s financial problems, the lender must develop a strategy to deal with them. This strategy should not only be as beneficial as possible to its own interests, but also realistic. The process of developing a plan also benefits the plant by providing additional guidance from an independent perspective and reassuring the suspicious borrower that the lender is not out to cut its losses and run, an approach that rarely makes good business sense.
To develop a workable plan, a lender must analyze the loan file and its collateral position. The credit file must be closely reviewed, focusing on the description of the grant of a security interest, perfection of that interest, any third party obligors such as guarantors, and requisite demands that must be given to the plant and any other obligors. This review may change the desired course of the workout plan. Deficiencies such as in the perfection of a security interest may lead a lender to waive certain defaults or advance additional funds for a limited period of time. The timely recognition of these deficiencies allows a lender time to remedy them and improve its position.
A lender must also conduct a collateral audit. This analysis confirms the existence of the collateral and its value. Audits often require obtaining or updating appraisals, particularly of real estate or equipment securing the indebtedness. While rarely mathematically precise, the collateral audit gives a lender the first snapshot of what the likely outcomes may be. It also is the starting point for determining the best manner to police collateral through reporting and other requirements. Finally, the collateral analysis also allows a lender to prepare contingency plans to realize payment of its obligations from the sale of the collateral.
With a clear picture of the loan file and collateral in hand, a lender can then establish and implement the plan to ensure payment of the loan. Such plans are often limited only by the ingenuity of those devising them. However, they generally take three basic forms: standby, exit transaction, and liquidation. One alternative may be sufficient, but a workout plan often takes multiple forms.
The standby is the simplest of all the approaches. It is usually evidenced by a forbearance agreement with the plant and founded on a plan to renew operations. In exchange for a lender’s agreement not to exercise its rights, the plant is given additional time to implement an operational turnaround. This grant must be conditioned on a minimum level of performance and incorporate events of default designed to allow the lender to closely monitor the operations and, if there is a perceived risk, to act quickly to enforce its rights.
A forbearance period is often the first step to reaching an exit transaction such as a sale or refinancing. Both enable the plant to leverage current and projected cash flow to provide for the payment of the lender’s claim, unsecured claims, and hopefully a return to equity. Unfortunately, the current economic conditions have led to a buyer’s market in the ethanol industry and tightening of credit available to an ethanol plant. Due to the stresses placed on the ethanol industry, few parties are interested in entering the industry. Large industry players are always looking to consolidate, but at depressed prices in times of financial distress. Nevertheless, in spite of the short-term economic conditions, economics projections show consistent long-term growth. This counsels the parties to explore an exit transaction, which even if not successful, can provide critical information concerning the value of the collateral and reset the expectations of the parties, including the equity owners.
The final backstop is a liquidation of the secured assets. Throughout the workout process, a lender must remain keenly aware of the outcome. Thus, it is critical that the lender continue to update its collateral value analysis. If the best efforts of the plant fail to return its operations to profitability and a transaction does not materialize, the lender must be prepared to make tough decisions as the value of its collateral approaches the amount of indebtedness.
Takeaway
While the long term outlook for the ethanol industry remains positive, near term challenges require lenders to monitor their interests diligently. Such diligence will allow a lender to move quickly and decisively to protect its interest and allow the plant to return to financial stability. In the event an operational turnaround is unsuccessful, the groundwork will have been laid to explore and implement viable alternatives to ensure payment of the indebtedness.