Hedge funds sweeping through beleaguered ethanol industry for bargains

A mile down an unpaved road on the outskirts of Canton, Ill., population 14,500, stands a shuttered ethanol plant.

Corn farmers in the area chipped in $5,000 to $300,000 each — some even mortgaged their farms — to form the Central Illinois Energy Cooperative. They broke ground on the refinery in 2006, hoping that ethanol would bring higher prices for their corn and more jobs for Canton. The town had been in trouble since 1983, when International Harvester closed its plow factory there.

The ethanol plant was a poor replacement. Central Illinois Energy (CIE), the corporation that built the plant, went bankrupt in December 2007 without having produced a drop of fuel, hurt by construction delays and $40 million in cost overruns. The 260 farmers in the co-op lost every dime.

Some of them blame the flameout on Andy Redleaf, whose Minneapolis- based hedge fund firm, Whitebox Advisors controls the plant.

With $2.7 billion in assets, Whitebox is one of a small group of bottom-fishing hedge funds sifting through the wreckage of a highflying ethanol industry that started falling to earth on June 20, 2006.

That day, the price of ethanol peaked at $4.23 a gallon on the Chicago Board of Trade, buoyed by a strong economy and former President George W. Bush's pledge to replace 75 percent of the oil the U.S. imports from the Middle East with ethanol by 2025.

Distillers erected dozens of the plants across the Great Plains, backed by some very smart money. Microsoft co- founder Bill Gates invested $84 million in Pacific Ethanol, based in Sacramento, Calif. Hedge-fund managers David Einhorn and Daniel Loeb backed Denver-based BioFuel Energy Corp.

Then the financial crisis hit. Demand waned, and supply surged. BioFuel has made money in just two quarters since going public in June 2007. By December 2008, the price of ethanol had collapsed to $1.40 a gallon. Pacific Ethanol's plants went bankrupt.

"There was too much built too quickly, with too much leverage," says Neil Koehler, the company's chief executive.

Great Plains vulture

Whitebox's involvement in the Canton ethanol plant started when it bought a fraction of an $87.5 million syndicated loan that Credit Suisse Group arranged for the farmers' cooperative in April 2006.

It was part of a bigger ethanol play. Redleaf also bought $28.4 million of bonds issued by Pekin, Ill.-based Aventine Renewable Energy Holdings when it emerged from bankruptcy in March, a right he had as a holder of Aventine's original debt.

And he owned bonds issued by bankrupt Sioux Falls, S.D.-based VeraSun Energy Corp., which raised $420 million in a 2006 public offering and operated 16 ethanol plants in eight states before it went under.

Redleaf isn't normally an energy investor. The core of his hedging strategy is capital-structure arbitrage, in which he looks for bonds that pay fat interest rates, then hedges the risk of those bonds by making a separate wager that the issuing company's stock will fall, called a short sale.

If the bonds tumble, the stock probably will, too, and the arbitrageur makes enough money on the short sale to cover the bond loss — and still collects the interest.

Unlike Redleaf, the cooperative didn't have any shares to short. When the bonds crashed, Redleaf could have taken the loss and moved on. Instead, he took control of the plant in bankruptcy.

That's a source of bitterness in Canton. Before the co-op went bust, the farmers sought a new loan from Whitebox.

"Whitebox proposed a bridge loan, which was not workable because of onerous terms," says Jay Sutor, a farmer-investor.

The interest rate on the loan was about 20 percent, and Whitebox, already a small holder of the plant's equity, was to get 25 percent more as a fee, Sutor says. The farmers balked.

Whitebox also used its equity ownership to block the sale of the plant to other buyers, which could have salvaged some of the farmers' investment, says Dennis Streitmatter, an investor and co-op board member.

"It took a 100 percent vote to do anything," Streitmatter says. "And they always voted against it."

Whitebox Chief Operating Officer Jonathan Wood says he knows of no offers to buy the CIE before it went bankrupt.

Redleaf says Whitebox spent $30 million to finish the plant — much more than the farmers invested — and made a sincere effort to save it.

Going private

CIE was one of several private companies that Whitebox invested in over the past few years, a common occurrence among hedge funds in the boom years as they drifted away from publicly traded stocks and bonds in a search for higher returns.

Whitebox has sold several private-equity investments to return money to investors who redeemed their Whitebox stake after the 2008 crash. In April, the firm agreed to sell a dozen grain elevators to Toronto-based Ceres Global Ag for $74 million in cash and stock. Whitebox made money on the sale, Wood says.

Even so, Redleaf says he's done with running private companies.

"We prefer shuffling paper to making widgets," he says in his office overlooking Minneapolis's Lake Calhoun.

His desk is covered with newspapers, and atop the stack rests a magnifying glass that Redleaf, who suffers from macular degeneration — a disease that causes a progressive blurring of vision — uses to read.

That problem aside, Redleaf sometimes makes his short commute to work on a Segway scooter.

Redleaf says he has put the Canton plant up for sale and will avoid private-equity deals in the future.

Redleaf hasn't escaped Canton yet. The Illinois Environmental Protection Agency (EPA) in March asked the state attorney general to force CIE and a nearby grain-handling facility to clean up a discharge of black sludge that killed turtles in a nearby pond.

The closed plant contains 2.3 million gallons of toxic soup from the ethanol-making process, says Canton City Attorney Chrissie Peterson. The city has plugged a pipe leading from the plant to make sure none of the material makes its way into the town's water-treatment facility.

Wood says Whitebox is cooperating with the Illinois EPA.

"There were high hopes for the ethanol plant," Peterson says. "It has left a bitter taste."

Getting into ethanol

A Minneapolis native, Redleaf has been interested in the markets since he was a child. At 11, he started reading copies of Forbes and Value Line that his father, an options-trading doctor, brought home.

The ethanol cooperative Redleaf invested in was the dream of Mike Smith, an executive at MidAmerica National Bank in Canton. Smith convinced 260 farmers and about 100 other investors to pony up $4 million to form the co-op, according to farmers who invested. About 70 signed letters of credit for another $5 million.

Smith didn't return telephone calls.

The $4 million was barely enough for a down payment on the 37-million-gallon-per-year ethanol plant. The farmers went to Zurich-based Credit Suisse, which offered its $87.5 million syndicated loan.

Canton officials were eager to help, too. The town sold $26 million in bonds to upgrade its water system, partly to supply the 200 million gallons of water the plant would need each year.

Math is what attracted Redleaf to ethanol, he says. The price of corn determines much of its cost, while the price of gasoline, with which it is blended, helps determine the ethanol price.

"It's a series of complex options on inputs and outputs," Redleaf says.

The investment became more interesting in 2007, when ethanol prices plunged and the Canton plant suffered construction delays. The Credit Suisse debt dropped to just pennies on the dollar. Whitebox bought more.

The Whitebox portfolio manager handling the investment, Nick Swenson, had experience analyzing distressed assets at Varde Partners, another Minneapolis fund.

Swenson, who left Whitebox in February 2009 to found his own firm, declined to comment.

After the co-op had run through the cash provided by the Credit Suisse loan, Smith went to Whitebox looking for more money. Swenson assured co-op members that Whitebox would help, the farmers say.

"There were several times when they would offer to give us some money, and it wouldn't come through," says CIE board member and farmer Tim Wagenbach, who says he put up $63,000, including $48,000 via a letter of credit, and lost it all. "They wanted to own the company."

Redleaf says he never expected to own the plant.

In November 2007, with weeks to go before the plant had to make a payment to Credit Suisse, Swenson offered a $15 million bridge loan at 20 percent, the farmers say. They rejected the terms, and CIE declared bankruptcy in Illinois federal court on Dec. 13, 2007. Whitebox Chief Legal Officer Mark Strefling says he doesn't know the terms of any proposed bridge loan.

A group of creditors led by Whitebox won permission from the bankruptcy judge to take over the ethanol plant on April 24, 2008. The creditors held $80 million in CIE debt, 80 percent of it owned by Whitebox.

Whitebox renamed the facility Riverland BioFuels, finished construction and, in late 2008, fired it up. It halted production in March after a new slide in ethanol's price, to $1.53 a gallon on March 25 from $2.14 on Nov. 30, 2009. A Whitebox executive came to town and fired 31 of the 41 workers.

Stock rally

As of June 1, Aventine shares traded at $37.50 on the over-the-counter market. Houlihan Lokey, the Los Angeles-based investment bank that valued Aventine in bankruptcy, estimated that the new shares would be worth just $25.

The shares rose after Aventine reported to the bankruptcy court that its business had improved. The company had net income of $27 million in the second half of 2009, according to a regulatory filing.

"They've been making money like crazy," says Michael Welsh, who has been climbing around Aventine's Pekin plant for 16 years as a consulting engineer.

Whitebox COO Wood agrees Aventine is profitable. "It's a very good trade," he says.

The old shareholders, wiped out in the bankruptcy, are incensed. Welsh, who says he bought 430,000 Aventine shares before it went bankrupt, says the hedge funds forced the bankruptcy filing in order to take control.

Redleaf responds that his actions in Aventine were proper.

The still-unanswered question for Whitebox is whether the firm can make enough on its Aventine shares to cover potential losses on CIE.