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From Debt Equity to Tax Equity: How To Entice New U.S. Solar Investors

At this year's PV America conference, Jennifer Runyon spoke with Conor McKenna from Reznick Capital Market Securities, Tim Short, Capital Dynamics and Laura Jones of Hunton and Williams. They discussed the complexities of solar project finance and how to attract new entrants into the space.

Jennifer Runyon: You have each emphasised the importance of having a "well-backed" sponsor or developer in order to get a project financed. Why is that important?

Conor McKenna: At least from our perspective when we are trying to find other pieces of the capital stack for a deal, it is very important to get a debt provider and a tax-equity provider comfortable with the company that is going to be building and supporting this project over the long term. Without that strength of balance sheet, without that experience and comfort level, it is very difficult for a team that is working on a deal to get it through their own investment committee to be able to invest with you on that project. They are looking for long-term partners and the people that you want to invest with are going to be very strong and they in turn want you to be very strong.

Tim Short: I think it's also about knowing that the project is going to get done. We are often that partner to developers and that's because we can bring a balance sheet to a deal in order to meet a lot of the obligations that a project needs in order to start operating and producing solar energy. So one of the examples is that we need to post a lot of security for the ability to sell power under long-term agreements. That costs money. We need to be able to continue to fund the engineering of the project when the tax equity has already come in or online. That costs money. To be able to see that the project will get done for our tax-equity investor in particular and other providers like debt investors is very important.

Laura Jones: I would agree with my other panellists here. One of the key first things that a [tax equity investor] looks at is that sponsor equity or "skin in the game."

Jennifer Runyon: Laura, please explain the "dance" that you refer to that takes place between the tax attorneys and the developers or bankers?

Laura Jones: So, the title of the panel is "enticing new investors" and some of the challenges that we run into in bringing in new investors is that these are not simple deals and that tax rules are not simple. One of the key pieces with bringing in new tax-equity investors is understanding the tax rules and then allocating the tax risk associated with the transaction. Obviously the investor would love it if we could just say, "Ok, there's no tax risk associated with this deal." We do the best we can to cover all those risks and mitigate those risks but the business guys sometimes have a different idea. Obviously they want to get rid of every risk possible whether it's commercial, tax or otherwise but in the tax world to have a risk-free transaction is to have a bad tax fact. And so what we try and do is figure out the risks that stay with the tax-equity investor because those are important to the transaction being respected and then figure out what risks are appropriately kept with the developer.

In order to claim for the ITC [investment tax credit], it needs to be new property, it can't be used property. So that's something that you say, "Ok, developer, all your property needs to be new property, which is pretty simple," and now all that tax risk is allocated and properly allocated to the developer.

Tim Short: As a cash-equity investor and not a tax-equity investor, we try very hard to allocate away as many risks as possible. I agree entirely with Laura that when all the risks are going to all the counterparties from the perspective of the tax attorney, the deals not so attractive perhaps.

Jennifer Runyon: What about smaller sized projects, say in the 1-2 MW size. We have heard from smaller developers that there isn't any project financing available for them. Is that the case?

Tim Short: The message is [for developers with smaller projects] that it's getting better. That the threshold of project size that makes sense on its own without fancy, expensive transaction-cost-based solutions like tax equity is improving. And that's driven by declining costs, the increasing comfort that capital has with solar. So that's a positive. But at the same time, right now, we have a whole lot of transaction costs and investors and we have to say well, there's a threshold at which it [smaller project sizes] doesn't make sense.

Conor McKenna: I think there are actual players out there that are interested in those 1-2 MW systems as standalones. When I say [you need] a good PPA, and I just want to be a little more clear here, that means a good price with a good credit. If you have that, there are players on the regional level that have interest. It may not be the larger funds but there are players. We have seen them. We look to try and source projects that are in the 1-2 MW range with regional players that have appetite in that given sector. Regional utilities have interest: they are willing to go through the work there, as long as you play by their rules, they'll do that [project] with you. There are financial players on a regional level that will work on [projects like] this. They have mandates.

Tim Short: I think the other issue here is that a project with good enough returns will get done. But, if you're going to have a small project that's going to attract transaction costs, you need to be putting a project together that is economically more attractive in order to bring people into that threshold. And that's going to continue to be the case as costs decline, power prices rise but there is still going to be a threshold.

Jennifer Runyon: How long until we see more standardisation in projects in this 1 to 2 MW range?

Laura Jones: Hopefully before 2016! It's hard to say how long. It has definitely improved over the past seven years from when the ITC went from 10 percent to 30 percent. At that point, we got a lot of calls and there was a lot of interest in solar because there was enough juice in the deal in terms of tax preferences to actually get people excited. We saw a lot of interesting PPAs, we saw a lot of interesting transaction documents, project documents, and the like. I do think it is getting better but I still think we have a decent way to go. The developers that I've seen that have been very successful have a standard PPA that they try their darndest to use over and over and over again. It doesn't always work out that way, but it really helps when they go to their tax-equity provider.

Paul Detering from Tioga [has a] pre-reviewed PPA that when the tax-equity investor gets it, [they] run a black line verses that standard PPA and if all that's changed is the customer name and the address of the system, and the price of the system and the size of the system: we're done.

Tim Short: I agree with Laura. It is a matter of how quickly developers are able to bring that level of standardisation to the market. Now, residential works because it's standardized. In our space, we see a whole lot of different 1 MW projects with a whole lot of different contracts. And that has due diligence cost and the best developers that we work with and the ones that we do work with on 1-2 MW projects in portfolios are the ones that, like Laura said, did their darndest to force an absolutely standard contract when it comes to the PPAs, the leases, the structure of the deal, everything so at the end of the day we can be quick and efficient and keep those transaction costs down so we can do those projects that are at the smaller end of the scale.

Jennifer Runyon: Turning to Solar Real Estate Investment Trusts (REITs) and Master Limited Partnerships (MLPs), which would allow the general public to invest in solar projects, how would those impact the solar investment market if they were available?

Laura Jones: I have no doubt that if the solar REIT and MLP legislation gets passed – and not only the MLP legislation because there needs to be changes to the at-risk rules and the passive activity loss rules – and this is all (unfortunately) at the hands of Congress – but if that does pass, I have no doubt that it will increase capital. To what amount, I don't know. I get calls all the time from folks who say "I've got a couple wealthy individuals that are willing to invest in my project" and my first question to them is, "Have you heard about the passive activity loss rules?" If the answer is yes, we continue talking. If the answer is no, it's a fairly short conversation.

People are definitely interested in doing this and I know of larger institutions that would also be excited about this – banks that have access to or have a large stable of clients that are high-net-worth individuals, I think it could really open things up, it's just, you know, we've got the beginning point of changing the tax code, which is always an interesting undertaking.

Jennifer Runyon: Because these are good investments, right? The returns are attractive.

Laura Jones: if there was a change, I'd invest. I would love to invest in solar projects.

Conor McKenna: I think that also, too, the logical progression here will be towards things like REITs. I think REITs make a lot of sense if the rules change. These are very stable cash flows, you're not dealing with tenants that may be coming or going at any given time, you have a long-term contract, usually with one tenant, which either has good private credit or has a good credit rating. This would be an ideal investment for a REIT that doesn't have huge hurdle rates for their return.

Tim Short: I think anything that mobilises more private capital into the space and drives down the cost of capital for underwriting solar projects is fantastic. But it's difficult to bank on that when it requires an act of congress. So it's a 'wait and see.'

Jennifer Runyon: Finally, why aren't there more large institutional investors in the market right now? Google has already jumped in, who do you think will be next?

Laura Jones: We are seeing new entrants, they are there, but I think part of the reason why we aren't seeing tons of new investors is it takes time and education and a lot of hand-holding to get them comfortable with investing in a new type of asset class that may be different or foreign to them. There are tax rules that are complicated; there is just a lot of groundwork that needs to be done before cheques will be written. My bet is that folks who are end-users of solar, who have a tax appetite, you know the fortune 500 and the like, that have gotten comfortable with the technology – they've seen what it does – they may have capital that they are willing to deploy, they may have a green mindset, I think some of the pieces, parts are already in place there for them to take the plunge and actually be an investor, maybe even owning the project themselves. Isn't that the Holy Grail? You just install the project yourself, you don't have to involve tax equity and all these other players in one transaction. They build, own, and hire an O&M provider.

Conor McKenna: The reason why it's harder for certain types of investors to get in is because of the intricacies of the tax benefits involved in these projects. While it's a great benefit to solar, it also is – in certain ways – a significant hurdle to overcome. So as you need to get not only tax equity comfortable with coming into the space, you also need to get the investor comfortable with a tax-equity partner. A traditional infrastructure player is used to saying, "Ok, we are the equity, someone else is the debt, let's just get this built." But now you have a third piece of the pie that these traditional power infrastructure players are having to get used to. Once they get there, I think that's going to be a huge piece. You'll see more infrastructure players hopefully in the near future.

Tim Short: I think capital markets, public markets have a greater role to play but that involves all the benefits of solar being able to flow through to the investor and so this comes back to what Laura and Conor were talking about and that is a change in the rules. There are examples out there where public markets can come into the space, but it will require a change in the rules.

Lead image courtesy First Solar

To watch the video of the full panel discussion, click here: 


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