Renewable energy finance is complicated — so is securitization. Fitting them together calls for some clever financial and legal engineering. This article is the first in a two-part series on the issue of commingling securitization debt and tax equity in the same project or portfolio capital structure. This first article will assess the challenge; the second installment will look at two proposed solutions.
Background
Generally speaking, the problem with securitization capital in the current solar finance environment is that some features of the legal structure required to execute securitization transactions may trigger recapture. That is, the act of securitizing the cash flows from a solar project or portfolio of projects could jeopardize the tax equity partner’s receipt of the tax benefits, thus depleting the value of its investment. Before drilling down into this, however, it is instructive to first go through some renewable energy finance 101.
Three financial structures form the basis of renewable energy project finance: the partnership flip, the sale-leaseback, and the inverted lease (sometimes called a lease pass-through). These structures have been developed and perfected over the last five years to monetize the federal tax incentives for which many renewable energy technologies are eligible: i.e., the production tax credit (PTC), the investment tax credit (ITC), and to a lesser extent, the accelerated depreciation benefits. Developers typically do not have the tax liability to use these credits for themselves, so they bring in tax equity investors to capitalize their projects in return for use of the credits.
The tax attributes of these financial structures are highly sensitive to structural changes, such as modifications to the leverage ratios, reallocation of the economic risks, or anything that may interrupt the investors’ legal ownership of the assets generating the tax benefits. Any of these changes could trigger a recapture of all unvested tax credits if they occur before the 6th year of project operation for ITC-eligible technologies and before the 10th year for those that are PTC-eligible. Accordingly, developers and their tax equity partners typically exercise a great amount of diligence in creating a financial structure to mitigate this risk.
The Problem
As mentioned, the process of securitization — that is, the legal structuring required to create a liquid asset from an illiquid one — includes a number of features that would directly affect some of the sensitivities in the financial structure. These features include:
- The requirement of bankruptcy “true sales” of the securitized assets to the special purpose vehicle . In this process, cash flows are transferred from the originator (the developer or third-party finance provider in the case of solar assets) to the special purpose vehicle that will eventually issue the securities.
- Pledges of first lien security interests in the solar assets and cash flows to the indenture trustee. If the trustee has first lien security interests, then it may look to the IRS as if the tax equity partner is not the true owner for tax reasons.
- Waterfall provisions that apply an order of priority to project or portfolio cash flows. These may place the payment of interest at or near the top, after trustee expenses.
- Possible replacement of the sponsor-developer as servicer by a “back-up servicer” in the event certain standards of performance are not met.
These features could shift the benefits and burdens of ownership to the bondholders and may be treated as a sale for tax purposes resulting in recapture and loss of future tax benefits. Additionally, in partnership flip structures, these features could force changes in the developers’ ownership of partnership or limited liability corporation (LLC) interests in the project entity. If these changes surpass a certain threshold, they may also be treated as an asset sale and thus trigger recapture. For this reason, tax equity investors will usually require limitations on such transfers, and these could effectively block the sponsor/developer from executing a securitization transaction.
Aside from protecting their tax benefits, tax equity investors also want to know (and trust) the party managing their investment entities. For this reason, they may also place limits on a developer’s ability to secure a loan against its partnership interest, as such a loan could result in foreclosure or the bank’s exercise of step-in rights.
Additionally, even after the tax equity investor has received the full value of the tax credits and depreciation benefits (i.e., post-recapture), it will continue to own certain residual rights if the sponsor/developer does not exercise its right to buy back the assets at fair market value. These residual rights may also obstruct a securitization transaction. In partnership flip structures, the interest of the tax equity investor does deflate (but not disappear) after the flip point; in sale-leaseback and inverted lease structures, the tax equity continues to hold tax ownership of the assets even after the recapture period.
Solutions
The decidedly easiest way to remove these post-recapture impediments is to buy out the tax equity, pursuant to the rights to do so that are normally present in all three tax structures. Securitization can be optimally executed at the point of exercise of this buy-out option, and the proceeds can be used in part to fund the buyout transaction. If, on the other hand, a solar developer wishes to seek capital market financing before year six of the project, it may have recourse to a pre-buyout structure.
A group of tax and finance attorneys in the NREL Solar Access to Public Capital (SAPC) working group (disclosure: the coauthor of this article is one of them) have been working to devise two legal structures that would allow for securitization to be executed at both the post- and pre-buyout stages of the project or portfolio. Part II of this series will look at both of these proposed structures and how each could circumvent the complicated tax issues arising from incorporating securitization debt into a tax equity capital structure.
This article was originally published on NREL Renewable Energy Finance and was reublished with permission.
Lead image: Solar panels via Shutterstock
