Obtaining funding for AD plants Business model and documentation issues

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1 Obtaining funding for AD plants Business model and documentation issues 09/12/2009 This briefing note aims to summarize the requirements of capital providers considering investment in an AD project. Hopefully, this will enable smaller operators to organise projects from an early stage in a form that will be acceptable to external providers of debt or equity, thus avoiding wasted time and effort on both sides. This briefing note has been produced by Glendale Power for the UK Biogas Group of the Renewable Energy Association. The views expressed are those of Glendale Power and not necessarily of the REA. Equity funding is readily available for good management teams with quality projects. Bank debt is available where the developer has other assets against which to secure it. Project finance is in very limited supply due to the early stage of development of the industry. Most of the cost of finance is attributable to the funder s costs and perception of risk, rather than underlying interest rates. Thorough documentation and preparation before approaching potential funders can be expected to reduce the cost of finance. Where available, project finance will cost in the region of 9% pa and will require the project to offer a 17% IRR in order to generate sufficient cover for debt repayments. Projects will need to offer at least an 18% IRR to attract institutional equity funding. Venture capital funds will generally be looking to invest in a chain of plants and will want to see a clearly defined exit route. Glendale Power Ltd Roziers, Wissington Uplands, Nayland, Colchester CO6 4JQ tel: JE@GlendalePower.co.uk Director - Jeremy Elden Registered in England and Wales under number VAT registration number Glendale Power is a registered trademark of Glendale Power Ltd

2 Introduction Capital harder to secure and more exensive Documentation is key Capital, especially debt, is harder to come by in the current financial climate than prior to When a loan is still available it will be on different terms to previously. The key change being that risk has been radically repriced upwards and so spreads versus the risk free cost of capital have increased. In the present environment, for projects needing long term finance, the Base Rate is largely irrelevant as a guide to cost. This arises as long term risk free rates are well above base rate and most of what the customer pays will be the charge to cover costs and risk. A consequence of the current pricing environment is that a key focus from an early stage of a project should be to reduce risk by firmly securing those items which, if left open, give rise to risk. Examples include land title, waste supply contract, grid connection. Simultaneously, the developer needs to assemble the documents that prove what has been done. This is best done as the project progresses, rather than under time pressure during the due diligence phase of a funding offer. Different providers will have different documentation requirements, but the key principle is the need for a third party to confirm the agreement e.g. Land Registry for the land, network operator for the grid connection, feedstock supplier for waste or energy crops. For the feedstock supply, where there will usually be a long term contract involved, the project is only a good as the creditworthiness of the supplier. For example, a waste contract to supply 20kt pa of food waste with a gate fee of 50/t over a 10 year period, would have a total value of 10m. For such a contract to be bankable, the supplier would need to be considered a good credit for that amount of money. 2

3 The AD Business Model We see AD plants as a chain, all the links of which need to work in order to give a good outcome. Hence all the links, plus the overarching issues of regulation and operating ability will need to be demonstrated to potential third party funders. Figure 1: The AD plant business model Regulation Operations Feedstock source AD plant Product sales/ disposal The key elements which we expect will need to be demonstrated are set out in the schedule below: Feedstock source Contract Duration: commensurate with the financing sought. Typically years. Certainty: no get out clause for supplier. Plant economics still robust at minimum contracted supply volume. Creditworthy counterparty e.g. council, project developer growing energy crops on own land. Flexibility consistent with plant ability Plant Technology Needs to be proven. We have found no appetite for taking technical risk, as the upside in a single plant is not sufficient to justify this. Needs to be proven for the feedstocks to be processed. Land Secure tenure needs to be proven. 3

4 Access rights Room for expansion Contractor Experience Known to the funder? Balance sheet big enough to provide a meaningful warranty. Most technology providers would fail this test and so would need to partner with a major contractor. This will require a good relationship between technology provider and lead contractor, such that the lead contractor is willing to shoulder the risk. Grid connection Firm offer needed Services Physical outlets for waste water etc. Product sales or disposal Electricity Power purchase agreement (PPA) in place or use the feed in tariff (FIT). We expect that the FIT will give a lower income for most plants than a PPA plus Renewable Obligation Certificates (ROCs). The upside of the FIT is convenience plus certainty. This may allow a greater proportion of debt in the financing, or an overall reduction in risk if self financing by borrowing against another asset. Given the active market for power, the PPA need not be as long duration as the financing. The power market is generally in backwardation (further out prices are less than near term prices), hence one should expect a higher price through a series of short term contracts, rather than signing a long term fixed price deal. As with FITs, this represents a trade off between risk and revenue. Digestate Unlikely to get paid for it. Disposal could be an issue, hence need to demonstrate contracted outlets. Heat Need contracts as heat is not a fungible product. As with feedstock, the duration of contracts and the creditworthiness of the counterparties will be important. Regulation Planning Least certain and first permit to apply for. Hence most funders will require the developer to have obtained planning consent before they enter into a serious discussion. 4

5 Environmental and ABPR permits Require much more plant design and so are more expensive to secure. Equity funders will typically fund this stage of the work. Debt funders will not as, without the permits, there is no security for the loan. An exception might be on freehold land, where the land value could secure the first part of a loan. Operator Team Scale Conventionally, funders would look at the experience and track record of a proposed operator. This is tricky in AD, as most smaller developers have no record in the field. Hence the funder is backing the key individuals and it comes down to a personal judgement of their commitment and abilities. In addition, the funder will want to be confident that the management team has assembled the skills needed for the project. A further issue is that, for many VCs, a single AD plant is rather a small investment, with a high up front cost for them to learn about the industry. The return in the case of success, is also modest when compared to their high tech investments. Hence, some will only want to invest in a chain of sites so as to spread their learning cost over a more meaningful investment. They will be looking to back a management team with the skills to run such a chain. Types of Capital Only really two types of capital There are fundamentally only two types of capital that can be provided; equity, where part of the risk and upside lies with the capital provider, and debt, where both lie entirely with the developer. All of the variations on these two types, such as preference shares, project finance etc. can largely be described as a mixture of debt and equity. How much of each type of capital is sought will depend on the respective appetite for risk of the developer and funder. The payment to the capital provider needs to cover three elements: Use of money: This is just the risk free rate, currently around 3.5% for 10 year money. Risk premium: This can vary from 0.5% for the UK government borrowing through several percent for a sound private company to 10%+ for equity. Costs: The bank or VC needs to cover its costs of raising funds, assessing and monitoring investments. These may be bundled into the interest charge or billed separately. Expect to pay a few percent as an initial charge and perhaps 1% pa thereafter. Figure 2 shows the change in cost of financing, or required return to investor, as risk is transferred from developer to investors. At one end of the spectrum, secured 5

6 long term debt might be expected to cost around 8%. At the other, a project would need to offer a return of around 18% or more to attract equity finance. Figure 2: Build up of financing costs 20% 18% 16% 14% 12% Risk premium Costs Risk free rate 10% 8% 6% 4% 2% 0% Debt Equity Debt vs equity is all about risk Where in the spectrum the developer seeks finance depends on their own appetite for risk. However, finance of all types remains difficult to obtain for small businesses operating in a new sector. Pure debt funding is only available if there is another asset, such as land or an existing trading business, to secure it against. The AD plant itself can only act as security to the extent of its scrap value, or the value of removable equipment such as the CHP unit. This reflects the risk that the plant might not work as expected. Project finance, secured against the future cash flows of a project, is starting to become available for AD plants. However, fees will be high, as banks need to become comfortable with the technology and the supply contracts and other risks. Equity finance, largely from VCs is perhaps the most readily available form, with a large number of fund managers having raised funds to invest in the cleantech or renewable energy sectors. With many projects having been delayed, these funds are hungry for good quality investment opportunities. Target ratios Funders will all look at the financial strength of a project with slightly different ratios and tests, each funder believing that their own in house measures are the most relevant. Developers will therefore need to be able to present their business models in different ways to suit different audiences. For secured debt, loan to value and the ratio of debt to total business cash flow will be most relevant. For project loans, when available, banks will look at the ratio of free cash flow to total loan service cost over the loan period. A cover ratio of x will typically be needed, considering only contracted volumes. As a guide to project economics, 6

7 with an interest rate of 9% and a 35% equity component, a project would need to generate an IRR of 17% pretax in order to give a 2x cover on a 10 year loan. This is consistent with the level of return sought by equity providers. Venture capital funds will typically look for a projected return, expressed as pretax IRR, of 18% or more. They will also want to see a high multiple (at least 2 times) of money back vs money invested. This latter hurdle guards against the risk of investing in a very short term project with a high IRR, but little value created as the money is repaid too quickly. This scenario is unattractive, as risk tends to be concentrated in the early years of a project s life. The targeted return may seem unfairly high to the developer struggling to raise funds for a project. In our opinion, it is no more than reasonable, bearing in mind the following factors: Costs of investigating a technology that is still new to the UK Risk Asymmetry of risk; most of the surprises that occur after financial close will be negative delays, technical difficulties etc. Illiquidity Low upside; a successful high tech investment will deliver a return of many times the initial investment, a successful AD pant may give a 3x return. In the case of success, some of the profit will go to the developer, who will normally have share of the equity in the project, that is greater than their share of the investment. A crucial point for venture funds is that they will need to see a convincing exit route, that they can realise their investment after 5 7 years. This may not be easy for a privately owned farm based business to offer, unless the business could hope to buy out the outside investor. 7