Ethanol: private equity's next big thing or just a pipe dream?

For all of us who have taken at least one finance class beyond the core, we have learned about the business characteristics that make good leveraged buyout candidates: 1) leading position in a established market; 2) stable and predictable cash flows to pay down debt; 3) strong management team; and 4) limited capital expenditure requirements, to name a few. However, one of the latest trends in private equity is investing in ethanol manufacturing companies, a sector outside the realm of traditional private equity and curiously lacking a few of these essential characteristics. According to New Energy Finance information service, private equity investment in biofuels (not just ethanol) topped $1 billion in 2005, up from negligible amounts just two years ago.

Traditionally, ethanol investing was relegated to the domain of venture capitalists, beginning at the turn of the century as the technology became commercialized. The risk associated with investing in these types of emerging market sectors is in alignment with the venture capitalists' ("VC's") risk tolerance - VC's focus on emerging technologies and a significant number of portfolio companies are expected to fail or generate minimal returns as result. However, such failure rates are not consistent with the expectations and needs of private equity ("PE") firms. A complete loss of an investment would likely materially diminish an entire buyout fund's return. The question is: why are private equity firms interested in the additional risk associated with ethanol investments and not sticking with traditional buyout sectors?

There are many possible answers to these questions. For one, there is no technology risk associated with ethanol production; it is only reliant on manufacturing. Second, and more importantly, the Energy Act of 2005 stimulated demand for the fuel by requiring refiners to ramp up ethanol use from 2.5 billion gallons last year to 7.5 billion gallons by 2012. In addition, a 51-cent tax credit is paid to blenders of the fuel for every pure gallon blended with gasoline and a 54-cent tariff exists on imported ethanol to keep cheaper foreign producers out of the market. Furthermore, MBTE (the traditional fuel additive for oxygenating gasoline that makes gasoline burn cleaner), did not receive liability protection in the 2005 energy bill from groundwater contamination lawsuits. As a result, ethanol has become a popular gasoline additive given its limited environmental liability.

Combined, these characteristics lead to the potential for high returns for PE groups that can gain an equity stake in an ethanol production facility. According to Forbes magazine, "ethanol is paying off handsomely, especially for those who got in early: Last year, the return on investment in the fuel surpassed 50%." For example, Thomas H. Lee Partners acquired ethanol company Hawkeye Holdings Inc. from fellow buyout firm J.H. Whitney & Co. last month, and within a few weeks, set plans to take Hawkeye public. Additionally, middle market investment bankers with Comerica and National City Equity Partners recently noted that over a dozen active ethanol deals were currently being pursued by PE firms.

While some of the most well-known firms in the buyout business are investing in ethanol, the economic and environmental incentives listed above may not be the only drivers of the recent explosion of activity. Some of the recent investments may be correlated to the amount of capital chasing deals within the overall buyout asset class. In 2005, a record $173.5 billion was raised by PE firms, compared with an average of $32.7 billion raised in each of the years from 2001 - 2004. As of November 2006, an estimated $215.7 billion in uninvested capital is available for new deals. With this amount of deployable capital and increased competition, purchase price multiples are increasing as the PE firms bid up the price for deals. This in turn reduces the IRR of the deal. However, PE firms must still generate strong returns (in the range of 20-25% IRR) for its investors. Therefore, many firms must now seek untraditional industry sectors for deals that can produce above average returns.

How successful will ethanol investments be for PE groups in the long term?

Regardless of the current level of interest among buyout groups, the answer is unclear. Ethanol investments put investors at the mercy of not one but two commodity cycles: agriculture and oil. In addition, as with any highly regulated industry, the government could change the regulatory and incentive structures, which would shrink the demand for ethanol. Also, ethanol cannot be transported in pipelines, because it picks up impurities, and therefore must be moved by truck or rail which is costly and logistically cumbersome.

Despite these risks, there are 107 ethanol production facilities in operation in the United States, totaling to 5.12 billion gallons of capacity that could potentially use private equity dollars to capitalize on current market opportunities. Fifty additional facilities are under construction, which represent an additional 3.84 billion gallons of capacity.

At the end of the day, the verdict will remain undecided for some time, as many of these deals are still unrealized. We will just have to stay tuned.