Update: Tax Equity and Debt Markets
More than 400 people listened to a panel discussion called “Show Us the Money: Insights from Active Tax Equity Investors and Lenders” at the fall finance conference of the American Wind Energy Association in New York in mid-October. The following is an edited transcript. The panelists are John Anderson, head of the power and infrastructure group at John Hancock Financial Services, Yale Henderson, a managing director of JPMorgan Capital Corporation, Gisela Kroess, a director of project finance for UniCredit Bank in New York, Timothy Howell, head of the origination team at GE Energy Financial Services, Christopher Stolarski, a senior vice president at Mizuho Corporate Bank, and Lance Markowitz, senior vice president and head of the leasing group at Union Bank of California. The moderator is Keith Martin with Chadbourne in Washington.
MR. MARTIN: Gisela Kroess, can one borrow today from a bank to make installment payments on turbines?
MS. KROESS: Not in the classic sense. I think most lenders stopped making turbine loans about 15 to 18 months ago. The classic turbine loan was structured as a revolver. The bank had a security interest in the turbines it was financing, but did not always have a broader interest in the underlying projects. Banks are shying away from such loans in the current market because they worry turbine prices will continue to fall. We might be prepared to provide a bridge loan secured by all the project assets, but development work on the project would have to be far enough along to have minimal development risk.
MR. STOLARSKI: You can call it a pre-construction loan. Construction should be ready to go but for administrative approvals and things like that.
MR. MARTIN: Not much help for a developer who must put out a lot of capital well before he is ready to start construction. Someone told me before this panel that turbine vendors — and perhaps export credit agencies in countries where the turbines will be manufactured — are the only real remaining source of turbine financing.
MS. KROESS: You also have developers trying to raise equity to cover those expenses.
MR. MARTIN: Shifting gears, what share of the project cost can one expect to cover with construction debt?
MS. KROESS: If you include an equity bridge loan for the Treasury cash grant for which the project expects to qualify at the end of construction, a developer can borrow up to 80% of the project cost during construction. The math goes basically as follows: because of conservative debt sizing in the market, the project must have 1.0 times debt coverage using the one-year P99 output number. That translates to a maximum of 50% leverage. The equity bridge loan or the Treasury cash grant gives you an additional 30%.
MR. MARTIN: Chris Stolarski, do you agree?
MR. STOLARSKI: Yes. There may be a few cases where we are prepared to go above 80% for a well-known sponsor with a track record of building successful projects.
MR. MARTIN: Let’s stick with Gisela’s math and assume there are two tranches of debt. There is an equity bridge loan for 30% of the project cost that is repaid with the Treasury cash grant at the end of construction. There is a separate tranche for 50% of the project cost that rolls into term debt. Is there a lower interest on the equity bridge loan? Isn’t it a loan against a federal government credit?
MS. KROESS: You can make an argument for a lower interest rate or upfront fee. You might get a discount on the interest rate or upfront fee of up to 50%.
MR. MARKOWITZ: I would charge the same interest rate on both tranches. They are both construction loans. If the project does not get built, neither tranche is repaid. The lender is taking the same risk on both.
MS. KROESS: It depends on how comfortable you are with the construction risk and the likelihood that the project will be built. The construction risk on a typical wind farm is pretty manageable. It is usually a short construction period. If you have a sponsor with a proven track record of finishing projects on which he starts construction, then a case can be made for lower pricing on the equity bridge tranche because it is basically a loan against a federal government credit.
MR. MARTIN: What does a discount of up to 50% mean? If the interest rate on the tranche that converts into term debt is 7%, what is the rate on the equity bridge tranche?
MS. KROESS: If you have a 3% margin and upfront fee on the term loan tranche, meaning you are charging 3% more than your cost of money, the rate and upfront fee on the equity bridge tranche might be set as low as 2%.
MR. STOLARSKI: I agree with Lance Markowitz. We are inclined not to discount the equity bridge tranche because the risk is the same on both tranches. If the project is not completed, then neither tranche will be repaid.
MS. KROESS: You no longer have traditional construction loans in this market. In many wind projects, the construction debt used to be taken out with tax equity at completion. Nowadays, embedded in the construction loan is a commitment to convert to term debt if the tax equity fails to fund. That’s why a higher interest rate and upfront fee are justified on the portion of the construction debt that exceeds the amount of the future Treasury cash grant.
MR. MARKOWITZ: I still disagree. If the construction loan will convert at the end of construction into term debt, the project reaches completion and the lender converts the loan using its own money. The risk of that not happening is lower than being paid the amount of cash grant for which you calculated at the start of construction the project will qualify. I am not saying there is a high risk of the Treasury failing to pay the grant, but there is more risk than the loan will convert to term when the time comes.
MS. KROESS: I think if you are really comfortable with the guidance the Treasury issued about how the cash grant program works, and we are, and you see how quickly cash grants are being paid in fact, you can get very comfortable with that risk. The commitment to convert to term debt, especially if it involves a change in banks, is a higher risk.
MR. MARTIN: Many lenders speaking on panels at conferences this year have said that bank debt is pricing at 350 basis points above LIBOR and requires a 300-basis-point fee be paid up front. Term debt runs seven to 10 years. Loans are being made in a mini-perm structure. Do you think that is where the market is today? This is bank debt, not insurance company debt. I will come back to the insurance companies.
MR. STOLARSKI: I think that is out of date. There is more liquidity coming back into the market. We are seeing some downward pressure on rates. The tenors are pushing more toward 10 years than seven years. There has not been a big change; I don’t think you are going to see that as much as a gradual return of liquidity into the debt market. There are still a number of lenders who are sidelined or operating at limited capacity for the foreseeable future.
MR. MARTIN: Gisela Kroess, you said before the panel today that tenors are moving from seven to 10 years to eight to 12 years, but the rates have not changed.
MS. KROESS: Yes. We have seen the range of mini-perm tenors moving in the last couple of months to as long as 12 years, and just recently I heard about some banks being prepared to go back to fully amortizing term debt over as long as 15 years, but that will be the exception. There is clearly a momentum toward longer terms, although there will not be a return to the terms we saw in the past because banks, especially European banks, are now subject to Basel II, and they have either to reduce their risk assets or raise capital, and raising capital is pretty expensive. I do see gradually increasing liquidity in the bank market as a whole.
MR. MARTIN: How many banks are active in the wind market?
MS. KROESS: Sixteen to 20.
MR. MARTIN: The alternative to bank debt is insurance company debt and that tends to be much longer term. John Anderson, there are four or five insurance companies supplying debt, correct?
MR. ANDERSON: That’s probably right. The market is a bit untested. The private placement market was not competitive on price with the banks. There has not been much deal flow over the last year and a half. However, our private placement activity, which is more corporate-level debt than project debt, is now priced competitively again after the rally in the institutional bond market. I have talked to some colleagues in investment banks looking into private placements and I think they can get to $500 million in terms of dollars raised per project.
MR. MARTIN: You are offering 20-year, fixed-rate debt?
MR. ANDERSON: Yes.
MR. MARTIN: Bank loans are floating rate?
MR. STOLARSKI: I think we could swap to protect our ourselves against changes in rates.
MS. KROESS: There used to be some deals where the sponsor gets the best of both worlds by arranging a shorter-term bank tranche within a longer-term institutional tranche.
MR. MARTIN: Coming back to John Anderson, you offer 20-year debt. The banks are offering seven- or eight- to 10- or 12-year debt in mini-perm structures. Bank debt is pricing at something like 350 basis points above LIBOR with an upfront charge of 300 basis points, plus a swap charge. Where are you in terms of cost of money?
MR. ANDERSON: It is tricky to say where the institutional market is, because the prices change every week, but it is something like Treasuries plus 350 and 1% up front.
MR. MARTIN: Most banks are insisting that the entire syndicate be put together before any of them will fund, and no one bank is taking more than about a $50 million ticket. Is that still correct? Gisela Kroess, you are shaking your head.
MS. KROESS: I don’t think that remains correct. The market is not back to 100% funding by one institution, but we are seeing banks return to underwriting. We closed a deal a couple of months ago with another financial institution with both of us undertaking a 50% underwriting; two more banks came in later. We are now looking at a deal where we might be prepared to underwrite as much as 60% or 70% of the loan with another bank coming in for 30 to 40%. Hence, there is some form of underwriting in terms of 50 to 70% underwriting one commits at closing with another bank taking 30 to 50%. Following initial closing, you approach two to five other relationship banks later to round out the syndicate. It is easier to get to closing with just two banks than to have to negotiate with an entire syndicate.
MR. MARTIN: Let’s move to tax equity. Yale Henderson, do you get the sense that there is as much interest among developers in raising tax equity this year as in the past, given that the Treasury Department is offering to pay developers a large share of the tax subsidies in cash?
MR. HENDERSON: Developers are curious about what we are willing to do. I think what happened in the early part of the year with the grant option is developers focused on getting their construction financing in place with a term loan takeout so they knew that they had a fallback position where they could just stick with permanent debt. Now they are exploring tax equity alternatives that may make the deal more economic and avoid the need to use the term debt.
What we are seeing as the year draws to a close is a little bit of analysis paralysis. Everyone got comfortable in 2007 and 2008 with the tried and true partnership flip structure and production tax credits. Production tax credits made the decision how to finance easy, since the statute allowed only one financing structure. Now you have developers talking about sale-leasebacks, inverted leases and other structures. People are trying to figure out how real these other options are versus a partnership flip. They don’t want to make the wrong call early on.
MR. MARTIN: So developers are evaluating other structures. Tim Howell?
MR. HOWELL: The biggest challenge in the market this year has been the inability to finance projects without power purchase agreements. It is hard for developers to persuade utilities to sign power contracts on economic terms with gas prices falling. That said, we still see lots of developers who want to convert tax benefits on their projects into current cash. There is heavy demand for tax equity. We think there will be a lot of deals next year.
MR. MARTIN: Lance Markowitz, one US developer is in the market currently trying to raise tax equity for a wind farm using a sale-leaseback. Does a lease work for a wind farm?
MR. MARKOWITZ: The cash flow is much more unpredictable because wind is less predictable. Lessors like fixed rent payments; it is not clear that wind farms are suitable for leasing. There is more use of lease structures in the solar market.
MS. KROESS: The other issue with leasing is debt tenor. Leveraged leasing offers better accounting treatment. However, it is hard to do a lease without long-term debt that comes closer to matching the lease term than the mini-perm debt currently on offer in the market.
MR. HOWELL: You have so much more flexibility to deal with variable revenues in a partnership flip structure, and developers prefer the partnership flip because it lets them keep more of the residual value.
MR. MARTIN: So it costs more for the developer to get the asset back at the end of the lease term and, Gisela Kroess, your point is mini-perm debt at the lessor level creates complications if it requires a balloon payment before the tax equity investor reaches its target yield. There is big refinancing risk.
Yale Henderson, to come back to you, how many active tax equity investors are there currently in the market?
MR. HENDERSON: It varies day to day, but I would say three.
MR. MARTIN: Three? There are more than three of you on this panel. [Laughter]
MR. MARTIN: Tim Howell, any sense of how many tax equity investors are active?
MR. HOWELL: I would say five or fewer.
MR. MARTIN: Current tax equity yields in the wind market seem to be between 8% and 9%, perhaps at the lower end of that spectrum. Do you have a sense which direction yields are headed?
MR. HOWELL: It is a hard question to answer. There are deals in the market today that certainly fall in that range. There are others that are outside it.
MR. MARTIN: My count is that there have been five partnership flip deals done in the wind sector involving Treasury cash grants since July 9 when the Treasury explained how the cash grant program works. Does anyone have a different count? How many more transactions are expected to close this year?
MR. HENDERSON: Our radar shows three other active transactions that have a good shot at closing this year.
MR. MARTIN: So that would be eight in total for the year?
MR. HOWELL: We expect to close at least a couple more traditional tax equity transactions by year end.
MR. MARTIN: Those are wind?
MR. HOWELL: All wind. I count 10 possible deals this year.
MR. MARTIN: Compared to 2007 when there were something like 18. I haven’t seen a count for 2008.
MR. HENDERSON: We are talking about new commitments in 2009 on current deals. There were several legacy 2008 commitments that also closed in 2009.
MR. MARKOWITZ: We’ve closed five deals this year.
MR. MARTIN: Those were all wind?
MR. MARKOWITZ: Yes, but not cash grant deals.
MR. MARTIN: Were they legacy deals to which you committed before the market collapsed?
MR. MARKOWITZ: Four were legacy deals.
MR. MARTIN: So you have one new deal done since July 9?
MR. MARKOWITZ: No, I thought you said since January.
MR. MARTIN: I am not sure where that leaves us. It sounds like there were a number deals done early in the year, but most were legacy deals and none involved cash grants. Since July 9, there have been five cash grant deals with another five teed up possibly to close by year end. How long a commitment will a tax equity investor give at the start of construction to fund tax equity?
MR. HENDERSON: Historically, within a year. We are very comfortable currently with commitments to fund within six months. When we start going beyond that, the parameters around the commitment may not change.
MR. MARTIN: For example, the yield goes up the longer the commitment?
MR. HENDERSON: Yes. I think many developers would trade a lower yield subject to adjustment for a higher fixed yield committed for a longer period. They would rather not have the uncertainty.
MR. MARTIN: The Internal Revenue Service said last month that developers can have an option to buy the residual interest of the tax equity investor after the flip for a fixed price that is set at the start of the transaction. Do tax equity investors ask for a higher yield in exchange for giving the developer a fixed-price purchase option?
MR. HENDERSON: No. The existence of such an option will not affect the flip yield. I don’t see the IRS announcement having a big effect on what the market has been doing, particularly when you consider most deals being done in the market today have 20-year power purchase agreements. The investor’s residual value is fairly predictable.
MR. MARTIN: Tim Howell, is there an extra charge for giving a developer a fixed-price purchase option?
MR. HOWELL: I agree with Yale.
MR. MARTIN: So every developer should ask for such an option. There is no cost to the developer.
MR. HOWELL: You can, frankly, but the option price will have to based around a P50 case, so that the fixed price might end up higher than fair market value when you actually get to the flip.
MR. HENDERSON: The big value is in deals where the power purchase agreement is shorter than 20 years. If the PPA is only five or 10 years and the project is exposed to upward power prices and potential carbon and REC prices, that is where the discussion will get very interesting. The interesting question will be at what level to set the fixed price.
MR. HOWELL: I agree. The option appeals to developers who think there is a massive upside in these projects.
MR. MARTIN: There used to be a rule of thumb that tax equity raised through a partnership flip would cover 65% of the capital cost of a typical wind farm. That hasn’t been true for at least a year. The figure was more like 50% before the Treasury moved to cash grants. What percentage of the capital cost can be raised in a cash grant partnership flip today?
MR. HENDERSON: On an unlevered deal, it would come out somewhere between 55% and 70% of upfront costs. I am counting the grant as part of that funding, so we are getting 30% of the project cost back 60 days after we fund.
MR. MARTIN: So 25% to 40% tax equity on top of the cash grant?
MR. HENDERSON: Yes.
MR. MARTIN: Tim Howell, do those numbers sound correct?
MR. HOWELL: We offer a broader range of products, so we will fund anywhere from 50% to 90% of the project cost whether it is with or without project-level debt.
MR. MARKOWITZ: A lot does depends on the structure. The cash grant is 30% of the project cost. We generally see the tax equity funding an additional 20% to 25% of the project cost in unlevered deals. The amount of cash that the project is expected to throw off is the key variable.
MR. MARTIN: If there is project-level debt, what would the capital structure look like?
MR. MARKOWITZ: The tax equity provides another 15% or 20% of capital on top of the cash grant.
Combining Debt and Tax Equity
MR. MARTIN: Gisela Kroess, I think you said the typical wind farm will support term debt in the amount of roughly 50% of the project cost.
MS. KROESS: Yes, based on a one-year P99 projection and average capacity factor.
MR. MARTIN: What’s the required coverage ratio using P50 numbers?
MS. KROESS: The P50 coverage must be 1.4 to 1.45.
MR. MARTIN: Chris Stolarski, are you in the same place?
MR. STOLARSKI: Yes.
MR. MARTIN: So if you have 50% debt, what is the rest of the capital structure?
MR. HOWELL: My answer is the same with or without debt.
MR. HENDERSON: We’re not that active in looking at leveraged deals, but it is a very interesting structure from the investor standpoint, particularly this year when there is still a 50% depreciation bonus on projects. The investor probably will get close to all his money back in the first 60 days with the Treasury cash grant and the depreciation bonus.
MR. MARTIN: Does it make you nervous as a tax equity investor to get all of your money back so quickly?
MR. HENDERSON: I think we can get comfortable that we are the owner if we have an ongoing interest in the asset and the transaction has been structured to remain within the IRS guidelines for partnership flip transactions. The concern is a practical one. You have put a lot of work into a deal and have made only a short-term investment.
MR. MARTIN: You want your money to remain invested and earning a return for a long period of time. Lance Markowitz, Union Bank has been offering developers to put both tax equity and term debt at the same time into a project. What is the attraction to developers?
MR. MARKOWITZ: We sell the term loan to another lender. It is a way of underwriting the debt. Having only Union Bank at the table makes it easier to close the transaction.
MR. MARTIN: Have you had many takers for the product?
MR. MARKOWITZ: We did a couple deals, but we are not doing them today because the underwriting market is largely nonexistent.
MR. MARTIN: So it is hard to resell the debt paper. Yale Henderson, how much of a premium does the tax equity investor charge in the current market if there is debt at the project level?
MR. HENDERSON: A significant one. Grant deals with debt at the project level are pricing in the low- to mid-teens on tax equity yields. However, the internal rates of return quoted are misleading because the tax equity gets back a large share of its investment in the first 60 to 180 days.
MR. MARTIN: So the internal rate of return overstates the real burden to the developer?
MR. HENDERSON: Most of the yield is paid quickly through the Treasury cash grant and depreciation. If you focus solely on the ongoing cash flows, the tax equity is probably only getting a 2% or 3% return on a pre-tax cash basis, if not lower.
MR. MARTIN: What if someone has been out of the market this year? He was familiar with how partnership flips were done the last couple years. What, if anything, has changed about how partnership flip deals are done in a cash grant world?
MR. HENDERSON: I think the biggest change is you can do shorter tax equity deals. Partnership flip deals were structured before the cash grant so that the flip was projected to occur in year 10 under a P50 case. You wanted to wait to flip until all the production tax credits had run. They run for 10 years. Today, there is no such constraint. Deals may price to flip in year six or eight. It depends on how much of the future cash flow you want to sell to the tax equity investor. The biggest constraint is investors run out of capital account before they can absorb the full depreciation on the project.
MR. MARTIN: Tim Howell, one of the ways people have gotten around the problem that the investor has too little capital account to absorb the tax benefits is to have the investor agree to step up to a deficit restoration obligation, meaning the tax equity investor promises to put money back into the partnership if he has a deficit in his capital account when the partnership liquidates. Are tax equity investors still agreeing to deficit restoration obligations? There used to be a rule of thumb that an investor would agree to put back up to 20% to 22% percent of his investment. Is there a similar rule of thumb today?
MR. HOWELL: Yes, but it is hard to state a rule of thumb. Investors are more likely today when agreeing to a deficit makeup obligation to insist on protections, like special allocations of income to eliminate the deficit after the flip occurs with additional cash allocated to the investor to make him whole.
MR. MARTIN: Lance Markowitz, will you agree to a deficit makeup obligation?
MR. MARKOWITZ: Yes.
MR. MARTIN: Is there a limit on how high it can go or is it open ended?
MR. MARKOWITZ: There is a limit; we analyze what we are comfortable with based upon various scenarios. It usually ends up in the 20% range.
MR. HENDERSON: Capital account deficits are more tolerable in cash grant deals. In transactions with production tax credits, there is a risk not only that the investor will be unable to absorb all the depreciation, but also that production tax credits will shift to the developer, who cannot use them. There is no risk of the cash grant shifting to the developer after the investor runs out of capital account.
MR. MARTIN: There are a number of tax equity investors who invest and then want to sell down the paper they are holding. Some have to — Lehman is an example. These pieces of paper are like bonds. As yields go up from where they were when the tax equity deal closed, the value of the paper goes down. Is there much of a secondary market? How do sellers of tax equity paper purchased at low yields avoid taking a loss when they resell the paper in today’s market?
MR. MARKOWITZ: Who said they are avoiding losses?
MR. HENDERSON: Exactly. The only sellers in the current market are companies that are bankrupt and don’t have a choice. The way they see it, they can either take a loss now or take the same loss over time. They sell in order to raise cash to pay off creditors.
MR. MARTIN: Let’s talk briefly about prepaid service contracts. Three wind farms have now been financed with such contracts. The project sells its output under a long-term power contract to a utility. The utility prepays for a large share of the electricity to be delivered over time. Are you comfortable providing tax equity to such a project?
MR. HENDERSON: We are comfortable with the structure. The prepayment is economically equivalent to project-level debt.
MR. MARKOWITZ: There is nothing wrong with the structure, but there are more deals in the market than there is time to do all of them, so we are spending our time on other structures that work better for us.
Outlook for 2010
MR. MARTIN: Chris Stolarski, what do you expect from the debt market for the remainder of this year? What do you expect next year?
MR. STOLARSKI: We see continued improvement through the end of this year as far as liquidity is concerned, and further improvement next year. Do we return in 2010 to the same level of liquidity that there was 18 months or 24 months ago? I don’t think so, but the market could get to 70% to 75% of where it was.
MR. MARTIN: Increasing liquidity brings lower interest rates?
MR. STOLARSKI: Not significantly lower in the next year or so.
MR. MARTIN: So more people can borrow but they still pay the same rates?
MR. STOLARSKI: There is still a backlog of deals and lenders are picking and choosing among potential transactions. You might start to see some easing in borrowing costs once supply and demand come back into balance.
MS. KROESS: It is important to keep in mind that we are in a record low interest environment. The argument can be made that even though margins are high, real interest rates are lower than they were two years ago. There is pressure on upfront fees and margins; for the right sponsor, they may fall below 300 basis points. However, I don’t expect them to return to the 1% level any time soon.
MR. MARTIN: The 1% you are referring to is the upfront fee?
MS. KROESS: Yes, and the margin. There was construction debt on offer two or three years ago for margins as low as one and a quarter. I expect volume to be up substantially next year. We did a count of debt deals in the wind market in the last year and came up with 18 deals closed with about $3 billion in volume. This doesn’t take into account the institutional debt market. Institutional debt added at least another $1 billion.
MR. MARTIN: John Anderson, what do you see for the debt markets for the remainder of 2009 and in 2010?
MR. ANDERSON: We closed on a project financing this year, but hadn’t done one for 12 months before that. It is nice to see the institutional debt markets come back to life with competitive pricing. I see the market picking up momentum as we move into 2010.
MR. MARTIN: What is a good year for your shop? How many deals do you look to do in a typical year?
MR. ANDERSON: We invested $3 billion in 2008. It was a combination of corporate bonds, project finance and private equity. We have done $2 billion so far in 2009. If there is a lot of project financing, that’s great, but if not, we will invest the money in corporate bonds or private equity funds.
MR. MARTIN: Lance Markowitz, what do you see for the remainder of this year and in 2010 for the tax equity market?
MR. MARKOWITZ: This was a transition year. I think we will see more investors coming back into the market in 2010, and there will be a lot more deal flow. We will also see more varied transactions; not everything will be a partnership flip deal.
MR. MARTIN: Tim Howell?
MR. HOWELL: The bottleneck in 2009 was lack of debt and tax equity. It will shift in 2010 to more market-driven constraints like difficulty getting power purchase agreements. There is no strong need for additional generating capacity anywhere in the country, so what will drive growth? It will have to come from something like a national renewable energy standard. I agree with Lance Markowitz: the worst is over in terms of tax equity and debt liquidity. The market will not come roaring back, but it will make a gradual recovery.
MR. MARTIN: Yale Henderson, what do you see for the tax equity market for the rest of 2009 and then 2010?
MR. HENDERSON: We are closing deals and getting money out the door this year. I see some of the old players who were out of the market returning in 2010. We spent a lot of time in 2009 trying to find other investors to come into deals with us because we have a limit on exposure to a single project. We feel we are making progress with three to five potential investors and hope to see some of them get across the finish line with us by early in 2010.