December 8, 2016
SOLAR TAX EQUITY UPDATE
Solar passed wind as the largest share of the US tax equity market in 2015, but appears, based on preliminary numbers, to have slipped behind wind in 2016. The year ahead could be challenging. Congress will spend a good part of the year rewriting the US tax code. A panel talked at the Solar Energy Industries Association annual tax and finance seminar in Washington in December about the potential effects of tax reform and other new developments on the market and what to expect in 2017.
The panelists are Mit Buchanan, managing director of J.P. Morgan, consistently one of the largest tax equity investors, Julian Torres, a director at RBC Capital Markets, a Canadian bank affiliate that is active in the US tax equity market, Martin Pasqualini, managing director of the CCA Group, a prominent tax equity advisory shop, and Jonathan Plowe, managing director of Tax Equity Advisors, which acts as both an advisor and a principal in investing. The moderator is Keith Martin with Chadbourne in Washington.
MR. MARTIN: Mit Buchanan, what effect do you expect Donald Trump to have on the tax equity market?
MS. BUCHANAN: I see two effects. One is an increase in interest rates. We watch the LIBOR swaps rate. It was 50 basis points lower on election day than it is today. The second effect will be a lower corporate tax rate. The market is keenly interested in what the new rate will be, when it will take effect, and what are the implications.
MR. MARTIN: We will come back to the tax rate change. What difference does it make whether interest rates go up? Tax equity yields do not seem to move up or down with interest rates.
MS. BUCHANAN: The tax equity yield can be affected by interest rates. A tax equity investor making a forward commitment may want to adjust the yield by the time he or she invests for changes in interest rates against an index. The parties usually agree to a dead band in which no adjustment is made. The index rate would have to change by more than the dead band to adjust.
MR. PLOWE: The interest rate also affects how sponsors think about their overall capital structures. There is only so much cash generated from the underlying customer contracts to support the cash component on the tax equity return as well as debt service on the back-leveraged debt. If interest rates increase, then that will increase the required debt service on the back-leveraged debt and will mean either less back-leveraged debt or less tax equity, or less of both, can be supported by the project.
The reaction so far to the Trump election is a little like the five stages of grief. It is initially stunned silence followed by a brief period of panic, and then graduating to a bit more comfort that the world is not coming to an end — until yesterday’s tax reform panel, when I think we may have tipped back to fear again.
Tax reform is the big question mark. We need to see what will come and when it will be effective. People have started to take a much closer look at how tax law change risk is being allocated and the protections for the tax equity investor.
MR. TORRES: I think you skipped over the anger stage that follows grief. We have seen an exponential growth in confusion and noise. The Trump election has caused some investors to pause. Some deals may be restructured or repriced that were not fully committed before election day. Trump’s win has given us a chance to consider tweaks to structures.
MR. MARTIN: How do you tweak the structure?
MR. TORRES: There is a list of fixed tax assumptions in partnership flip transactions that are risks that the tax equity investor takes. In most deals today, the tax rate used to track the investor’s actual rate in effect at any given time. However, there are still a few deals where the tax rate is locked in and is a fixed tax assumption. Trump’s win is causing people to adopt a floating tax rate and to think about whether it is even appropriate to size the tax equity investment still on the basis of a 35% tax rate.
MR. PASQUALINI: For deals with construction debt that have a tax equity takeout of $100, you plug in a 15% tax rate and the tax equity amount falls to $80 ignoring a host of other issues that present themselves due to the rate change.
Lenders want a floor on how much the tax equity amount can be adjusted for tax rate change, and they want more substantial shortfall guarantees, shortfall LCs. They also need to have essentially an alternate structure ready, locked and loaded, and pre-agreed, if the tax rate changes. Over the last week, we have seen lenders asking to address not only rate change but also draconian slowdowns in depreciation rates. It will be up to the sponsor ultimately to plug any gap in funding.
MR. MARTIN: A newspaper reporter told me yesterday that he understands J.P. Morgan is out of the tax equity market. True or false?
MS. BUCHANAN: False. There will be a collaborative effort with our clients to address tax change risk. We have signed equity capital contribution agreements. We have new deals. There is uncertainty. We do not know how things will shake out, but we are still in the market.
MR. MARTIN: Various reporters have been asking in the last week whether the tax equity market has shut down. Marty Pasqualini, you are shaking your head no.
MR. PASQUALINI: Next week, we will close our sixth new commitment since the election.
Tax Change Risk
MR. MARTIN: Since the election, it seems like there have been three areas of tension in deals. One is corporate rate change, which Julian Torres and Marty Pasqualini mentioned. The second is the possibility depreciation might change, but whether for the better or for the worse is a little hard to tell. Republicans want to accelerate depreciation. The third tension is in deals with multiple fundings. There is a debate about how far along in the legislative process a proposed adverse tax law change must have moved before the tax equity investor can stop funding.
Do any of you have other items to add to the list?
MR. PASQUALINI: A number of potential tax law changes are in play that affect the economics in tax equity deals. There are different levers you can pull to influence the internal rate of return to the tax equity investor and that will affect the amount of tax equity that can be raised. The levers include the percentage of project cash flows that go to the tax equity investor, how you allocate the tax items, and the size of the deficit restoration obligation. The levers will have to be adjusted to optimize the structure for sponsors and tax equity investors once it becomes clearer what tax law changes Congress is likely to enact.
MR. MARTIN: Your point is the basic economics may change due to changes in depreciation and the corporate tax rate. Let’s focus on the corporate tax rate. Does a drop in the corporate tax rate necessarily mean less tax equity can be raised? In a partnership flip transaction, maybe you have four years of losses and six years of income.
MR. PASQUALINI: It depends on the particular transaction. The negative effect of a tax rate change that hits in the first three years of a wind deal far outweighs the benefit of a reduced tax rate in the out years when the project is tax positive. In a solar deal, if the tax rate change does not take effect until after the first year, generally you are good.
We have run countless sensitivities to show the effects of rate changes on the internal rate of return, net present value and duration risk for the tax equity investor.
MS. BUCHANAN: That is why I call it a collaborative effort. We will all be doing those types of sensitivities. There is a great deal of uncertainty now, but hopefully the tax law changes will become clearer in the next few months. When we fund into a deal, we will either have to do so on the basis of the tax rate in effect at the time or the expected tax rate. For now, we are running sensitivities.
MR. PLOWE: We had a period of time between the election and year end when deals had to close. If we lived in an alternate universe where the US elections happen in January, we would have had a much more pronounced pause that could have been detrimental.
MR. MARTIN: Julian Torres made the point that sponsors are taking the risk of tax rate change, and I think that has been true for at least the last two or three years. Lately, tax equity investors have also been making sponsors take the risk that the depreciation calculations will change. The House Republicans are talking about accelerating depreciation. In view of this, are tax equity investors better off locking in the current depreciation that they used for purposes of pricing? The actual depreciation might provide an upside.
MR. TORRES: Maybe. Our sensitivity analyses suggest that the detriment from the tax rate reduction will far outweigh the benefit from faster depreciation.
Tax equity investors build a portfolio that seasons over time. We are seeing that our more seasoned investments will actually benefit from the reduction in the tax rate. The newer projects take a hit. A yield-based partnership flip is highly protective to the overall return.
MR. PLOWE: When you look at a partnership flip structure with a variable tax rate in the fixed tax assumptions, a sponsor with back-leveraged lenders that need to be comfortable still has a lot of flexibility with the flip date because most of the debt structures today are relatively short term. The focus of the back-leveraged lenders is less on the long-term value of project cash flows than on the first several years.
I think the impact might be more pronounced on equity values of solar sponsor entities over the longer haul. The partnership flip structure mitigates some of the impact of changes in tax rate and depreciation.
MR. MARTIN: Do you agree or disagree with the following? The tax equity market will remain open for business. This is what the tax equity shops do for a living. They will find a way to continue doing it. However, tax equity will make up a smaller percentage of the capital stack after the corporate rate reduction. Sponsors will have to fill in the gap with more debt or equity.
MR. PLOWE: I agree, but I also think that there are a few headwinds on the use of tax equity for sponsors, including an increasing percentage of direct sales of solar rooftop systems as rooftop solar companies, especially the publicly-traded ones, try to develop a better GAAP and cash profile for their businesses.
However, if the industry continues to grow rapidly, you should still see an increasing need for tax equity even as the percentage of third-party-owned systems as a percentage of total installations declines.
MR. MARTIN: Do you agree that tax equity will be a smaller percentage of the capital stack?
MR. PLOWE: I am not so sure. Tax equity investors need to invest a certain amount to make a transaction efficient. If there is a drop in the corporate tax rate, you end up asking tax equity investors who are loathe really to rely on the project’s credit to take more cash to reach their returns.
Most established investors want to make this look like a tax product and to the greatest degree possible mitigate their exposure to project cash flow. If we have a sea change in the makeup of the return, you may see a displacement of the traditional financial investors.
On the other hand, you can argue that the traditional investors will still find a need for shelter. If their effective tax rate ends up at 20%, they will still look for ways to reduce it to 15% because that is what they are supposed to do for their shareholders.
Or we could see more of what we saw a lot of last year in the utility-scale solar space, which is the strategic investors who were tax efficient provided the tax efficiency to the deal because they want to be long-term owners and understand the cash flows. That is the business they are in.
MR. MARTIN: Mit Buchanan, preliminary estimates are that the solar tax equity market was just under a $5 billion market in 2016, according to your colleague, John Eber. There have been suggestions that 2017 may be slower. What do you think?
MS. BUCHANAN: There is a huge amount of business teed up to be done over the next two years. The wild card is the uncertainty about the US tax code. It could affect what is ultimately brought to market. There are a lot of moving parts. Sizable deals are expected. It is just that everyone is reassessing the economics.
MR. PLOWE: Anecdotal evidence suggests that the market will continue to grow. We committed $300 million of capital just a few weeks ago with about a 12-month deployment time frame on it. That will already be about half spent as of the beginning of January. The pace of deployment in the distributed generation space remains pretty impressive.
MR. MARTIN: I stopped counting the number of tax equity investors at 35 in the summer 2015. It seemed like there was a new one every three to four weeks in 2016. Do you expect this pattern to continue into 2017?
MS. BUCHANAN: We saw new entrants during 2016, but the market dynamics have changed since the November election. It is too early to say what to expect during 2017.
MR. TORRES: There are 70+ institutional and corporate investors in the affordable housing market and some have started to shift their attention to renewable energy. We see at least three to five investors coming over from that side who are completely new to renewable energy.
MR. MARTIN: I know in the past, new investors were reluctant to dive in because they thought the tax credits were temporary. Why waste time learning about something that will disappear? Do you think the prospect of corporate tax change will cause people to say this is not worth the effort?
MR. TORRES: The long-term extension of the tax credits in late 2015 got a lot of investors to think about dedicating the resources necessary to understand a new asset class. However, it is two steps forward and then one step back with tax reform. Now is the time to educate new investors about how structures work, and in particular how the yield-based partnership flips work, since the investors are assured eventually of reaching their returns, assuming the project continues operating. That should give them comfort to proceed cautiously.
Other New Developments
MR. MARTIN: What other new developments have there been in the market? We talked about Trump. He is the biggest new development. What is next?
MR. PLOWE: Some of the biggest tax equity investors that deploy billions of dollars in the market may be starting to test limits that have nothing to do with tax capacity. Even if corporate tax rates are lower, there is plenty of tax capacity in that group of investors, but there is a sector exposure issue for some large tax equity investors, which is yet another reason why we need to continue to see more new entrants come into the market as we have over the last couple years.
MS. BUCHANAN: Are you saying that there are some sizeable investors who have reached their limits on exposure to certain sponsors?
MR. PLOWE: Not necessarily reached the limit, but the solar sector has grown very rapidly and some big investors have increased their exposure to that sector through both debt and tax equity in the last couple years. We are more likely to see senior management and risk managers say, “Let’s pause a little and think about the size of our exposure and see how we can prioritize our client-facing businesses around some limits.”
MR. PASQUALINI: There is an inconsistency in how some larger investors think. They tend to prefer established relationships. Some of these transactions are large. The aggregate exposures are large. Many of the larger investors had significant exposures to SunEdison. There is probably a bit more attention being paid by the folks who write the biggest tickets to their exposure levels to individual sponsors.
MR. TORRES: We see two camps of tax equity investors in the partnership flip market. One camp is focused on keeping as short a tenor as the tax rules allow for the targeted flip date, and the other camp is pushing out the target flip date and monetizing more cash. There are good reasons for either approach. They can co-exist.
MR. MARTIN: Why would a sponsor want to monetize cash at a higher tax equity yield than it could through back-levered debt?
MR. TORRES: If you think about the cash-on-cash return as a normal investor would, and not as we think about it for satisfying IRS regulations, it is a negative return. The amount of cash that we investors take against the upfront cash investment is a negative IRR. So I think that it is cheaper to monetize cash in the tax equity market than through back leverage.
MS. BUCHANAN: Another development this year was there was more aggressive structuring in terms of doing longer flip terms for several high-quality utility-scale solar projects that came to market. Rather than someone pricing to flip in six to seven years, they might price to flip in nine years or more.
MR. MARTIN: I assume the sponsor is pushing for a longer flip date. Why would the sponsor want to keep expensive tax equity in place for a longer period?
MS. BUCHANAN: It turns on the facts and circumstances of each project. Some of the larger balance sheet sponsors do not use back leverage and want more tax efficiency. The longer term allows them to drive up the amount of tax equity investment and reduces the need for the investor to agree to a deficit restoration obligation to absorb the depreciation.
Close to $3 billion of the $6.8 billion in solar tax equity investments in 2015 came from strategic investors — the Dominions and Southerns of the world — who were providing the tax efficiency through a partnership agreement with their partners, but they are real partners. They take 49% to 51% of the cash forever. In some of the deals we did, that strategic investor provided as much as 80% of the capital from inception.
MR. MARTIN: That is interesting. Most utilities appear to lack a current tax base because of the depreciation bonus.
It seems like there has been a shift to partnership flips and away from inverted leases and sale-leasebacks in solar. Do you agree?
MR. TORRES: That has been the general trend.
MR. MARTIN: What is driving it?
MR. TORRES: Banks, who are the largest number of tax equity investors, want to have shorter tenor investments. The sale-leaseback requires valuing the residual and fighting over what it is. It also is a credit structure, whereas the partnership flip is an equity structure. So you manage the risk differently in the two structures. Also, the accounting treatment for sale-leasebacks is not as good.
MR. MARTIN: And may be changing for the worse.
MR. TORRES: Correct.
MR. MARTIN: What percentage of the capital cost of a typical residential solar, C&I solar or utility-scale solar deal is raised through tax equity?
MR. TORRES: I see between 35% and 50% generally in the ITC world. On the residential side, depending on how many prepaid contracts you have, you may be solidly in the 40% range. In the C&I world, you are at the lower end. The perception in the market is they are riskier and, therefore, require a higher yield. The higher the yield, the less tax equity that is raised.
On the utility-scale side, you see much higher advance rates. People feel more comfortable with the projected cash flows with a A-rated utility as the electricity offtaker. You have high-grade builders under EPC contracts and experienced O&M contractors, so the cash-flow stability is accretive to the advance rate.
MS. BUCHANAN: I agree with that, but I see the range may be 35% to 45% in terms of the amount that we advance, and a lot of times you want to minimize the tax equity in those deals because it is more expensive than debt.
MR. MARTIN: Does percentage of capital raised in the tax equity market vary by solar subsector –- residential, C&I, utility-scale –- or is it 35% to 45% across all three subsectors?
MS. BUCHANAN: It varies. I do not have my cheat sheet in front of me, but certainly with utility-scale projects, the percentage is around 40%.
MR. MARTIN: The biggest tax risk in the solar market is the tax basis used to calculate the tax benefits. How common is it today for a tax equity investor to put a cap on how large a markup it is willing to see above the actual cost to construct?
MS. BUCHANAN: It is common. You work carefully with your management and your appraiser and tax counsel in terms of what the appropriate range might be.
MR. MARTIN: Does anyone think the market is coalescing around a general rule of thumb and, if so, what is it?
MR. TORRES: We do not have a set rule of thumb. It is a case-by-case analysis.
MR. PASQUALINI: I think that 10% is a general guideline, but some investors are willing to go as high as 20%. There are circumstances where the investors will go higher if you can clearly support the higher value. Investors invariably get a basis indemnity from the sponsor.
MR. MARTIN: Sponsors for the most part are trying to keep a larger share of cash and monetize it through back-levered debt. This creates tension between the tax equity investor and back-levered lender. They are like two farmers relying on the same river to irrigate their crops. The back-levered lender is downstream and wants to make sure all the water is not taken out before it reaches him.
How accommodating are you tax equity investors — Julian Torres and Mit Buchanan — to the needs of the back-levered lender? Will you set aside a certain amount of cash to pay principal and interest on the debt?
MR. TORRES: I view myself as accommodating, which is to say back leverage is back leverage for a reason. There is a risk premium built into the pricing for that type of debt. We try to structure deals, when the sponsor and project are strong enough, to subordinate any indemnity claims to payment of principal and interest on the back-levered debt.
MS. BUCHANAN: We have been accommodating in both wind and solar projects. You negotiate over how much cash can be swept to cover obligations to the tax equity investor.
MR. MARTIN: Are you seeing tax loss insurance and, if so, covering what risks?
MR. TORRES: I have only seen it in support of securitizations to protect against sponsor failure to make good on indemnifications for basis risk. The policies are specifically geared toward that single risk.
MS. BUCHANAN: I have seen what I call ITC insurance, which is you have a basis rep from a sponsor and you are looking for a portion of that to be covered by the insurance policy. The amount that is covered is subject to negotiation.
I have also seen insurance for certain panel matters where you are not concerned about a serial defect, but some other type of claim and you want an additional policy to cover you for that during the warranty period.
Potential New Areas
MR. MARTIN: Community solar is starting to get traction. What special issues does it raise?
MS. BUCHANAN: We are starting to look at it now. We are interested in it. Rather than have a single offtaker, you have a pool. There is due diligence associated with that. These are smaller projects. We have gotten comfortable with C&I deals. There are also potential securities law issues. The customer subscription agreements may be securities under federal or state law. Those are the three subjects on which we are focused.
MR. MARTIN: Julian Torres, you just closed a community solar deal. What special issues did it raise for you?
MR. TORRES: The special issues were about how subscribers are managed. What kinds of contracts and what terms are offered? Is there standardization across contracts? We just closed a community solar transaction after looking at a lot of other portfolios. The one we closed was the most homogenous one we could find. It was geared toward municipal offtakers and subscribers and partners that have strong balance sheets.
MR. MARTIN: Two more questions from me, and then let me ask the audience if it has any questions. There has been talk about combining PACE financing with tax equity. Have you seen any such deals?
MS. BUCHANAN: I have not.
MR. PLOWE: We see a lot of prepaid power contracts in the residential solar space. One must assume a portion of those may be financed with PACE loans, but we have no visibility into that. That is all handled outside of our purview.
MR. MARTIN: Is it attractive to tax equity investors if you can somehow use the property tax enforcement mechanism to ensure that customers pay on time? Will that result in a lower tax equity yield?
MR. PLOWE: Even if it is attractive, I doubt it will result in a lower yield. One thing about PACE is that so far the scale is not large. Some of those laws have been around for a while. We have seen a couple securitizations of PACE paper, but it will take time before PACE becomes a big component of the tax equity market.
MR. MARTIN: Storage facilities are starting to be added to renewable energy projects. Do they raise any special issues in your mind?
MS. BUCHANAN: We have to get comfortable that the equipment will work and that the warranties for workmanship and performance will last through the recapture period for the ITC and that the storage facility has been designed to qualify for an ITC. In some markets, it is a necessity to combine solar with storage. For residential solar in Hawaii, if you don’t have a battery . . . .
MR. MARTIN: So get used to it.
MS. BUCHANAN: Exactly.
MR. MARTIN: Please stand up and say your name and affiliation.
MS. CRAFT: Lauren Craft with SunEdison. C&I is an especially tricky sector. Are you seeing any efficiency gains recently with the deals that have been coming across your desks?
MS. BUCHANAN: The challenge is to get to a volume that justifies a tax equity investor putting the resources into it. Figuring out a way to make things more standardized can be a challenge. It is a challenge to determine whether the pipeline is truly real. You want to get $75 to $100 million out the door. C&I projects always take longer because of the fluidity of the development process. But having said that, there are investors in the space that consistently cover that market and have covered it very well. There are tax equity investors who are doing a fair amount of C&I. The key to bringing in more investors is to have standardized contracts and to minimize the number of power contracts so that so you can get to a $75 million investment with four or five contracts rather than 15 contracts.
MR. TORRES: The portfolios tend to have an extremely wide range of credit quality. You can have AA-rated municipalities and unrated offtakers in the same portfolio. It is difficult for sponsors to reach needed volumes. There is a temptation among tax equity investors to cherry pick credits and leave portfolios with an unfinanceable layer.
MR. MARTIN: Please say your name and affiliation.
MR. FRAGA: Chris Fraga with Alternative Energy Development Group. Can you comment further about the tax equity’s view of prepaid power contracts?
MR. PLOWE: When I was speaking about prepaid PPAs, I was speaking specifically about residential solar prepaid PPAs. Generally, we view them as a form of leverage. They are not a source of any ongoing cash flow. This affects the sensitivity of how the deal performs under different scenarios and how tax reform and all the other things about which we have been talking about affect the transaction. For example, if depreciation is worth less because the corporate tax rate is reduced, prepaid PPAs mean there is no additional cash to shift in the out years to the tax equity investor to make up the loss. Tax reform may prove the biggest headwind for prepaid deals.