BioCycle November 2009, Vol. 50, No. 11, p. 16
Investment banking professionals dissect recent transactions in the organics recycling sector. Their findings will guide other companies in this industry.
Andrew C. Kessler and Jason A. Seltzer

DESPITE the extraordinary economic challenges the U.S. and global economies have experienced, the organics recycling industry remains an active and attractive sector, weathering the economic storm comparatively well. Indeed, if you were at last month’s BioCycle conference, it was hard to miss the optimism and excitement.
To be sure, our industry faces significant challenges, including regulation, permitting, technology, competition and legislation. However, heading the list in this volatile economic climate may be access to capital. The best business plans and the most capable teams can do little without the capital to turn ideas into realities. And not just any form of capital, but capital at acceptable terms and structured in the appropriate way to achieve long-term economic viability. There are many examples of good businesses that fail because of bad capital structures.
So how does one go about determining what kind of capital is right for a particular set of circumstances, and what terms and conditions should be deemed “acceptable”? One way to address this question is to look at what others have accomplished. For example, what deals have been done in our industry over the last couple of years? How were they structured and why? What factors were unique both in terms of the participants as well as the general economy? What lessons can be learned? How might these apply to your particular situation? This article provides some basic tools to help answer those questions, including examples of recent transactions in the organics recycling industry.

CHOOSING THE RIGHT TOOL
Some key factors involved in making financing and capital structure decisions include whether to raise debt or equity, or some hybrid, and which types of investors to target (and how to access them). Understanding when and how to use certain tools or financial products can materially impact the quality of the end product (i.e., the capital structure and resulting financial obligations). Knowing how to proceed involves consideration of the following:

Strategic rationale. What is the end game? Decisions you make regarding your capital structure can often constrain your strategic alternatives.

Use of proceeds. All investors want to know how their capital will be deployed. Raising capital that is paid out to shareholders rather than used to build the business may be problematic to some capital providers.

Collateral. Investors will always run a “worst case” scenario. What if things go badly, very badly? Are there assets that an investor could rely upon to cover some of the investment risk? How does pledging or encumbering those assets impact your business going forward?

Cash flow. How much cash flow does the company generate? Is there consistency in the historical cash flows? Is there enough cash flow to meet anticipated debt service and payment over time of the principal? What kinds of risks are imbedded in the cash flow stream (e.g., seasonality, customer, product or market concentration, technology, etc.)? The profile of the cash flow must match the profile of the debt service and amortization schedule.

Maturity. Unlike equity capital, debt eventually has to be repaid. If you do not anticipate having sufficient cash to repay a loan, you are introducing “refinancing risk” into your business model. To compensate for perceived refinancing risk, lenders will seek higher interest rates and contractually limit things you can and cannot do within documents known as credit agreements (in the case of a bank loan) or indentures (in the case of a bond financing).

Market conditions. The presumption of rational behavior underlies most economic theories. But people make decisions about economic activities and people are, at best, only occasionally rational. Financial products undergo periods of fads, trends, bubbles and crashes. It is within these periods when, quite often, the market no longer rationally prices risk. During bull markets, risk is often priced too cheaply – the cost of capital is irrationally low and capital is available to unreasonably risky projects. During bear markets, the converse is true. Market conditions must always be taken into account and your financial tool chest will expand or contract accordingly.

ACCESS TO CAPITAL
Depending on a particular company’s situation, financial profile and stage of growth, there are a number of different ways to access capital. These include: Incurring debt by borrowing from banks, institutional lenders or other financial sources; Issuing new equity to private equity partners; Issuing new equity via the public capital markets (e.g., initial public or follow on offerings); and Selling the company itself to a third party.
Private equity firms, commonly referred to as financial sponsors, play various roles as sources of capital and acquirers of companies. Private equity sponsorship may be a compelling way to finance a company, particularly for early stage ventures when raising debt capital is not viable due to insufficient cash flow and operating history. In addition to equity capital, financial sponsors can provide many important capabilities, which can be particularly valuable to early stage companies. These include strategic advice; access to other sources of capital; network of relationships; financial analysis and modeling; corporate planning and structuring; and administrative and legal support.
But equity financing can be quite dilutive to existing equity holders. Issuing equity is granting another party the right to participate in the upside (or downside) of your company. A variety of private equity strategies cater to different deal sizes and stages of company maturity. Some financial sponsors require control as a condition of making their investment. Others do not, but even those that do not will want some degree of influence in the form of Board representation.
Some common categories of financial sponsors include: Angel investors – including professional investors as well as friends and family – are often the first source of third party equity; Venture capital investors invest in early stage companies; Growth capital investors fund more mature companies seeking expansion capital; and Leveraged buyout investors acquire control of companies and use debt financing from the target company to partially fund the acquisition price.
All of the financing and monetization options just described have been pursued by various companies within our industry. Within the set of transactions highlighted in this article, there are examples of: Borrowing to finance a large-scale facility (Peninsula Compost Company, LLC); Selling to a corporate acquirer (Garick Corporation); and Partnering or selling to a private equity firm (Harvest, Inc., Living Earth Technology Company and StormFisher Biogas).

SALE TO CORPORATE BUYER
In October 1980, Gary Trinetti and Patrick Mahoney founded Garick Corporation. Over the years, Garick has become a leading manufacturer and distributor of natural resource products servicing the landscape, recreation, lawn, garden and construction industries. In January 2007, Trinetti and Mahoney sold Garick to Hendricks Holding Company, Inc.
Although any financing that may have been used has not been disclosed publicly, Hendricks Holdings appears to have had the wherewithal and access to credit to make the purchase from existing cash flow and/or lines of credit. Hendricks Holdings is one of the largest private companies in the U.S., with a diverse portfolio of operating companies. ABC Supply (one of the principal assets in the portfolio) is currently ranked the 155th largest private company in the U.S. by Forbes, achieving sales of $2.9 billion with 5,005 employees. According to Forbes, Ken Hendricks himself had a net worth of more than $2.6 billion in 2007 and was ranked 91st in its list of 400 richest Americans.
Like most private transactions, this was a “friendly” deal. Trinetti met Hendricks 23 years ago at a conference in Houston. Over the years, the relationship grew. Discussions between the companies started informally as early as 2002 when Hendricks became increasingly intrigued with monetizing what others considered “waste” into valuable and marketable new products. By 2006, a common vision formed that led Garick’s controlling shareholders to sell the company to Hendricks Holdings and agree to stay on and carry out this common vision, a testament to the close relationship forged between the parties over many years.
Although Trinetti and Mahoney stayed on to manage the company, strictly speaking the transaction represents a clear example of a successful financial exit within the organics recycling sector. These are very important data points for investors, particularly financial investors who want to fully understand what exit strategies are viable before making investments in a given industry. In addition to the sale of a company, other exit strategies include taking a company public (commonly referred to as an Initial Public Offering or IPO) as well as “cashing out” over time through the receipt of dividends.

VENTURE CAPITAL SPONSORSHIP/INCUBATION
The story of Harvest, Inc. is less about a transaction than it is about the birth of a platform, i.e., the creation of a new company (versus an early stage company shopping itself to investors). Conceived on a white board in the Menlo Park, California offices of Kleiner Perkins Caufield & Byers, Harvest is an example of a company incubated by an entrepreneurial firm to take advantage of compelling opportunities they see in the organics recycling and biogas sectors.
Kleiner Perkins specializes in investing in emerging industries. Although it is more typical for a venture capital firm to invest in an existing early stage company, in the case of Harvest, Kleiner Perkins formed a view of the emerging biomass sector and assembled a team to execute its business plan. That team is led by Paul Sellew, who has been in the organics industry for more than 25 years. Harvest is an organics management company that integrates composting and energy production.
In the September 2009 issue of BioCycle, Amol Deshpande, a partner at Kleiner Perkins, wrote an article titled “Investing In The Biomass Industry.” Elements discussed in the article, which are relevant to this article, include: Monetize biomass on the basis of highest and best use; Distributed models that fit into existing organic feedstock supply chains will lead to more value than megascale centralized approaches which require creating enormous supplies of feedstock; Leveraging existing supplies of organic feedstock as opposed to growing organics to use as biomass feedstock; and Business model must be viable without the need for government subsidies.

MIDDLE MARKET LEVERAGED BUYOUT
Living Earth Technology Company is the largest recycler of organic material and commercial manufacturer of mulch, compost and soils in Texas, diverting and processing over 600,000 tons of material annually. Recognizing an opportunity to acquire an attractive platform in the organics recycling sector, the principals of Terra Verde Partners LLC acquired Living Earth from Republic Services, Inc. in November 2007. At that time, the principals of Terra Verde were part of the private equity division of Hunt Consolidated, Inc., a diversified holding company directed by Ray L. Hunt. Although Hunt’s principals have been active in the organics recycling industry for some time, Terra Verde was formed to focus exclusively on the environmental sector. One of its primary investment initiatives is to more aggressively pursue new investments in the North American organics recycling sector.
Living Earth was acquired for approximately $37 million in a classic middle market leveraged buyout by a financial sponsor. Republic had determined that Living Earth was a noncore asset (often referred to as a “corporate orphan”) and chose to divest the asset. Such transactions are commonly referred to as “carve outs”. According to Republic’s press release announcing the transaction, Living Earth had average annual revenue of approximately $50 million and generated low double-digit operating income margins. The investment appears successful. According to Terra Verde, within approximately one year following the transaction, revenue and operating cash flow grew by 7 percent and 35 percent, respectively, and the number of facilities increased from 13 to 16.
Consistent with traditional leveraged buyouts, the transaction was financed with equity from the financial sponsor as well as bank debt and mezzanine capital. Traditional bank lenders will typically only lend up to a certain amount; however, some investors will agree to lend more to a company in exchange for higher yield. In this case, Living Earth was able to access incremental debt from the mezzanine market. Mezzanine capital refers to deeply subordinated debt that often represents the most junior position within the capital structure aside from common equity.
Although mezzanine capital can be significantly more expensive than traditional bank debt, raising incremental debt enables the acquirer to reduce the amount of equity needed to fully fund the acquisition price. Generally, the less equity needed to acquire an asset, the higher the potential equity returns on that investment are likely to be. Of course, with the potential for higher return comes higher risk as one is now operating a company with more debt (commonly referred to as “leverage”) in the capital structure.

FINANCING A LARGE-SCALE FACILITY
Next month, Peninsula Compost Company, LLC will complete construction of its inaugural commercial composting facility in Wilmington, Delaware. The $20 million, 28-acre facility will be capable of processing 160,000 tons/year of organics and will be the largest food waste and yard trimmings composting facility on the East Coast. Peninsula has partnered with the W. L. Gore & Associates Company for use of Gore’s in-vessel composting system that will be used at the Wilmington facility.
The Delaware facility was financed with a combination of equity from the senior management team and local equity partners as well as bank debt. The bank deal was led by WSFS Financial Corporation. Peninsula was able to secure funding even as some of the most well known commercial and investment banks were undergoing unprecedented trauma. It found a local lender who understood the local market sufficiently to commit capital to this project.
Peninsula’s experience is a lesson in persistence and flexibility. During the spring and summer of 2008, Peninsula was pursuing a debt private placement and had been making good progress. When the capital markets began to severely deteriorate, commitments they thought they had were no longer reliable. By September 2008, they effectively had to start from scratch, but by May 2009, they had secured committed capital from the local lender and broke ground that month. Construction is expected to be completed ahead of schedule.
During times of economic uncertainly, the price of risk can rise dramatically. It is likely that Peninsula’s cost of capital and the amount of equity required in the deal was significantly higher than what they would have been had the deal been structured the prior year. Nevertheless, Peninsula was able to secure the necessary funding.

FINANCIAL SPONSORSHIP OF EARLY STAGE COMPANY
StormFisher Biogas is developing biogas facilities across North America utilizing anaerobic digestion technology. In February 2008, StormFisher announced that it had formed a strategic partnership with Denham Capital Management, a global energy focused private equity firm based in Boston, Massachusetts, to develop a $350 million (Cdn) portfolio of biogas projects.
According to StormFisher, Denham recognized that StormFisher had many characteristics that fit well with Denham’s investment criteria, including: High upfront investment needs followed by annuity cash flow; Replicable model; Low technology risk given well established anaerobic digestion markets in Europe/Asia.
We spoke to StormFisher about their recent experience in accessing debt to complement the equity investment commitment from Denham. The significant disruptions to the capital markets over the past year have had a negative impact on the project finance market. There is a greater appetite for larger ($100 million plus) deals with lower return profiles than smaller ($10 to $30 million) projects with higher return profiles. However, opportunities for debt financing from equipment finance groups, agricultural banks (“AG Banks”) and government sponsored funding for renewable energy projects remain viable sources of capital.
However, given the more capital constrained environment, lenders are even more focused on risk mitigation through contractual arrangements, including: Feedstock contracts to provide both volume and price certainty; Purchase power agreements; Engineer Procurement Contract remedies associated with biogas yield guarantees; and End product sales contracts for the compost, bedding, etc.

TAKEAWAY LESSONS
The emerging organics recycling and biogas sectors seem to have elements that appeal to different categories of equity investors, blurring the lines between angel, venture capital and later stage investors. We know examples of development stage companies within our sector that have attracted angel investors. Kleiner Perkins is an example of interest from the venture capital community. Terra Verde represents interest from middle market, leveraged buyout investors. And StormFisher’s experience demonstrates interest from large/global energy focused financial sponsors. This expanse of interest provides operators and entrepreneurs with a wide set of equity investor alternatives. It should be noted, however, that each approach can lead to very distinct outcomes for existing investors. As previously mentioned, some categories of financial sponsors typically require control as a condition of making their investment; others do not.
It is clear that the due diligence bar for accessing capital is higher than ever, which underscores the need for operators and entrepreneurs to do the work necessary to mitigate the risk profile of their business and justify all key assumptions that materially impact their financial projections. Ask yourself the hard questions and have answers to them before meeting with investors. There is not a “one size fits all” solution. Identifying and assessing some of the factors we discussed will help you hone in on what form of financing and structure is most appropriate for a given situation.

KEEPING THE PHOENIX FLYING
Although the prevailing economic environment can widen or narrow your financial tool chest, good projects with good management teams can be financed even in the worst of economic times. There are lots of examples of successful companies that launched during extraordinarily difficult economic environments, including: Procter & Gamble, The Panic of 1837; IBM and General Electric, The Long Depression, 1873-1896; General Motors, The Panic of 1907; United Technologies Corp., The Great Depression; and FedEx, The Oil Crisis of 1973.
We chose these examples out of dozens of brand name success stories to make another point. While good deals can get financed even in the worst markets, success over the long term and under changing competitive and economic conditions is much more difficult. The above list proves that “out of the ashes can arise a phoenix;” the real trick is keeping the phoenix flying over the long run.

Andrew C. Kessler (andrew.kessler@turningearthllc.com) is a Managing Director and Founding Member of Turning Earth, LLC, an organics recycling company focused on producing biogas, compost and sustainable agriculture. Prior to launching Turning Earth, he spent 15 years as an investment banker. Jason A. Seltzer, CFA (jason.seltzer@lovellpartnersllc.com), is a Partner with Lovell Partners LLC, which provides financial advisory, capital raising and general consultancy services for selected domestic and international clients. He has a particular focus on alternative energy. The authors thank the individuals at the companies profiled, including Phil Arra, Terra Verde Partners LLC; Amol Deshpande, Kleiner Perkins Caufield & Byers; Ryan Little, StormFisher Biogas; Gary Trinetti, Garick Corporation; and Scott Woods, Peninsula Compost Company, LLC. They also thank Deven Bhatt for his contributions to this article.