New Financing Strategies
A wave of new strategies has started to appear in the US to drive down the cost of capital. Developers are turning to publicly-traded "yield cos," synthetic MLPs, self-help MLPs, REITs, foreign asset income trusts and securitizations as new financing tools or exit strategies to raise capital around operating projects. How easy are they to use? How much do they reduce capital costs? A panel discussed these and other questions at the 24th annual Chadbourne global energy and finance conference in June.
The panelists are Lyndon Rive, CEO of SolarCity, Bob Hemphill, CEO of Silver Ridge Power (formerly known as AES Solar), Jeff Eckel, CEO of Hannon Armstrong Sustainable Infrastructure, Ed Fenster co-CEO of Sunrun, and Carl Weatherley-White, CFO of K Road Power. The moderator is Keith Martin with Chadbourne in Washington.
MR. MARTIN: Carl Weatherley-White, there has been a lot of talk about yield cos. What is a yield co?
MR. WEATHERLEY-WHITE: There has been a lot of fresh thinking about this in the renewable energy industry, although it is not a fresh concept. Yield cos have been around for many years in energy, real estate and other industries. A yield co is a publicly-traded company that is formed to own operating assets that produce cash flow. The cash is distributed to investors as dividends.
MR. MARTIN: Many people think the best use of a yield co is to take operating assets that have been de-risked to produce a predictable cash flow stream and use it to raise capital at a low yield from retail investors. K Road does not have operating assets. Why does it make sense for you to be thinking about using a yield co?
MR. WEATHERLEY-WHITE: For a company like K Road that has developing assets, a yield co is a possible future way of financing our assets. Investors are willing to pay more for assets that have a proven history than for those that are merely under development. Separating the more volatile activities of development and construction from the more stable and less volatile cash flows of operating assets is a good choice. NRG recently filed an initial public offering for a portfolio of contracted assets in the hope of attracting capital at lower cost.
MR. MARTIN: So you would put operating assets in the publicly traded vehicle and put the development pipeline in a separate entity. The publicly-traded vehicle would have an option to buy the development assets once they have reached construction?
MR. WEATHERLEY-WHITE: That is correct. There is a long history of a similar arrangement in master limit partnership deals for midstream and other energy-related assets where you have the operating assets held in the public company and development assets held in a parent or an affiliate with varied arrangements for eventually transferring the development assets into the public vehicle.
MR. MARTIN: Yield vehicles were hammered in the last week on rumors that the Federal Reserve Board will back away from its continuing monetary stimulus called quantitative easing. Yield investors looking for an intermediate yield vehicle that pays something a little above what a bond pays are finding that bond rates are rising enough that interest has dampened in yield vehicles, according to market watchers. How has this affected your move to a yield co, if at all?
MR. WEATHERLEY-WHITE: We looked at the correlation of how yield co, master limited partnership and real estate investment trust units perform against underlying interest rates. You can look at 10-year Treasury notes or BBB bonds as benchmarks. There are some indexes that track those different sectors. As one might expect, yields increase slightly as Treasury rates increase. There is a correlation, but it is not a one-for-one effect.
MR. MARTIN: Bob Hemphill, you attempted to do on the Canadian exchange exactly what Carl Weatherley-White described, putting your operating assets in a publicly-traded vehicle and the development assets in a separate vehicle. You had to pull back the offering. Why?
MR. HEMPHILL: We pulled for the same reason everybody pulls back an offering: we didn't get the kind of price and volume response that we had anticipated. That was disappointing.
MR. MARTIN: Why did you choose Canada rather than the US to do this?
MR. HEMPHILL: We were told that the Canadian market appreciated yield and energy projects, and there was plenty of money. The process was allegedly smoother, quicker and cheaper. It took us a year and $10 million, so I am not entirely convinced. [Laughter.]
MR. MARTIN: What is the fall back plan? Are you going to try it again after waiting a while?
MR. HEMPHILL: Take a vacation? [Laughter.] We are still going through the stages of grieving; we have not gotten to the stage yet of coming up with a new plan.
MR. MARTIN: First Wind put its operating projects in New England into a holding company and sold a 49% interest to Emera, a Canadian utility holding company. The development projects are in a separate entity. The company was able to raise capital at a pretty good rate. Why not do that rather than one of these publicly-traded vehicles?
MR. HEMPHILL: We have a solid business with 50 power plants operating and another big plant that is about 33% complete in California, and we have real revenue. We generate $50 to $75 million a year. It is a nice solid business, and we do not have to do anything tomorrow. On the other hand, we have investors who would like to see some return on their money, and we have an obligation to get them that return, so we are reexamining everything at the moment and, hopefully, we will come up with a better choice than going back to Canada.
MR. MARTIN: Christopher Hunt, you own Pattern Energy, a wind company. I have read in the trade press that you are planning to take it public in Canada. Why?
MR. HUNT: I cannot comment on whether we are doing that, but Pattern is different from Silver Ridge Power in the sense that it has a sizable business in Canada.
MR. MARTIN: Jeff Eckel, two data processing companies, Iron Mountain and Equinix, announced in the last week that rulings they were expecting from the Internal Revenue Service to convert into REITs are being delayed while the IRS forms an internal working group on REITs. [Ed. See related In Other News item on page __.] You have a ruling. You converted into a REIT. Have you heard anything about what the IRS might be doing?
MR. ECKEL: We have not.
MR. MARTIN: The Equinix ruling was that an operating company that owns data storage centers can sell the data centers to a REIT to raise capital and then lease them back. Your ruling addressed a different issue. Can you say anything about your ruling? It was a private ruling that has not been made public yet by the IRS.
MR. ECKEL: I am not sure why our ruling is not out yet. We received it last fall. We have converted our company into a real estate investment trust. A REIT must own mainly real property or loans secured by mortgages over real property. The assets that Hannon Armstrong owns are building components. They are real property, affixed to buildings, or there is a mortgage over such assets. We asked for confirmation that our assets are eligible assets for a REIT. It was not a contentious issue. Lighting, heating and cooling components are within the bounds of what has traditionally been considered good REIT assets.
MR. MARTIN: Before you converted into a REIT, did you consider other publicly-traded vehicles like a Canadian publicly-traded company, US yield co, synthetic MLP or Canadian income trust and, if so, why did you choose a REIT?
MR. ECKEL: We have REITable assets, so that is a good place to start, but then we did look at a private REIT as opposed to a publicly-traded one, MLP's and an initial public offering as a regular corporation. Our desire was to get permanent capital after 32 years of operating. The question was which form. A REIT is friendlier to investors than an MLP. Investors get simple 1099 forms at year end with the amount of their dividends. They do not have to fuss with complicated K-1 forms reporting cash distributions, allocations of various kinds of income, capital accounts, outside bases and the like.
Our business fits very well into the REIT investor universe and has appeal to both classic green investors and specialty finance investors. This is also why we put "sustainable infrastructure" in our name. Sustainability is a defining issue for a new generation of investors, and it is also very important to us.
MR. MARTIN: How has converting to a REIT affected your cost of capital?
MR. ECKEL: Now that we have capital, it is actually worth the time required to figure out what it costs. [Laughter.] The REIT has given us another financing tool on top of our existing securitization and syndication broker dealer capabilities. It allows us to do a lot more than we could before. The three things together are a very powerful model for us. We are finding good deal flow and good things in which to invest.
MR. MARTIN: There are two types of REITs. There are equity REITs where the REIT owns the assets and then leases them to an operating company, and there are mortgage REITs where the REIT makes loans and takes back a mortgage over real property. In either case, at least 75% of what the REIT holds must be real property or mortgages over real property. You are largely a mortgage REIT. You are prepared to lend to renewable energy developers. Is there enough real property in a wind, solar or geothermal project to make a REIT potentially a significant source of debt for such a project?
MR. ECKEL: We think so. We are starting out with $1.6 billion in existing assets. That is not an enormous amount of money, but it is certainly enough to get some developers interested. We also have the ability have up to 25% assets that are not real property through a taxable REIT subsidiary.
The 25% is calculated on a net basis rather than a gross basis, so when you subtract the leverage, we really have the ability to combine real property with other assets that are not real property on a one-to-one basis.
MR. MARTIN: What interest rate could a developer of large solar projects like Bob Hemphill expect to have to pay on a loan from the REIT?
MR. ECKEL: We could compete with the banks and term loan B market on these large utility-scale projects, but that market segment does not look terribly attractive at the moment.
MR. MARTIN: What is your hurdle rate?
MR. ECKEL: The renewable industry is hoping these vehicles will get them to a lower cost of capital. Our investors are really not that interested in giving capital away to support the renewable energy business. There is a middle ground between our cheaper capital and what are able to offer.
MR. MARTIN: Lyndon Rive, SolarCity went public in December. It was a highly anticipated and watched public offering, and was very successful. Stock values have quadrupled. What lessons did you take away from that experience?
MR. RIVE: When we went public, the climate for renewable energy was not good. The financial markets were rough. Unfortunately, it felt that we were lumped into the category of a generic manufacturing company during a period when the manufacturing industry was taking a significant beating.
We tried to explain that we were a different business model. It felt like we were swimming against a strong current and it was more than just an investment decision for potential institutional investors; it was a situation where if they made the investment and it went negative, they would be fired.
Some investors understood the business model, but they had a hard time assigning a value. It is really complicated from looking solely at our current profit and loss statement to recognize the value. Revenue is expected under customer agreements with 20-year terms, but there are only a few years of operating history. Even where people recognized the value, there was skepticism. It was difficult to punch through. We had to take a significant haircut on valuation in the actual offering.
Then the market started to grasp the business. It began to see the long-term contracted cash flows and to appreciate that we are not a solar manufacturing business but a true energy company.
MR. MARTIN: The tax equity market is getting more and more comfortable with rooftop solar installations as an asset class. Is it helping you to raise tax equity now that potential tax equity investors see how the broader investment community has valued your company?
MR. RIVE: Absolutely. That combined with the aging of the assets creates very good asset quality. As the assets get older, you see more and more data associated with them. You see the default and recovery rates, and you compare them against the mortgage industry.
Our customers have three options: pay us, pay the utility more or don't have electricity. Given those three options, we are the winner. This is proving to be a very good asset class. The coverages are very conservative and, from an investor perspective, there is a favorable yield-to-risk ratio.
MR. MARTIN: How has your weighted average cost of capital been affected by going public?
MR. RIVE: The key things on which we are focused currently are monetizing cash flows and reducing the cost of debt. The first step has been to roll over short-term debt. We refinanced some of our assets at around 3 1/2%. That's short term for about two years. We are now in the process of going through the rating agencies with the aim of replacing short-term debt with longer-term borrowing. If that goes well, then there will be many different avenues we could take hopefully to get to something like a 6% weighted average cost of capital.
MR. MARTIN: Ed Fenster, is one of your goals to go public?
MR. FENSTER: We really have two businesses. We have an operating business with existing assets, and we have a development business. The costs of capital for the two are maybe 20 basis points different. The rate of return that corporate-level investors expect from us is very different than the rate of return that people are expecting investing directly in our projects. We need orders of magnitude more project capital than operating capital, and so we spend all of our time and attention in minimizing the cost of our subsidiary level of capital and maximizing the extent of that capital.
Because of this, we have not been as focused on taking the holding company public. We are still growing really rapidly. We will address it at an appropriate time.
MR. MARTIN: Both you and Lyndon Rive have voracious appetites for capital. You are deploying rooftop solar systems at blinding speed. You have raised dozen tax equity funds, and Lyndon Rive has raised at least two dozen, if not more. Are you finding tax equity harder to raise or are there more tax equity investors today? What tax equity yields are you being offered?
MR. FENSTER: There are two forces -- supply and demand. Our supply of projects is growing at a very fast rate. Also, the supply of tax equity is growing, so our perception of the tax equity market is colored by the ever increasing amount of projects that we are trying to finance. We have seen the cost of capital for tax equity come down a little, but the rates appear fairly stable. Supply appears to be keeping up with demand.
MR. MARTIN: What does tax equity cost currently?
MR. FENSTER: It depends on how you structure the deal. I think the tax equity investor's internal rate of return is a terrible metric. We don’t think in terms of tax equity IRR.
MR. RIVE: It is definitely a wide range. We have seen from 6 1/2% to 12%. The 12% is coming down quickly.
MR. MARTIN: What is your preferred structure?
MR. FENSTER: We prefer partnership flips or inverted leases.
MR. MARTIN: Bob Hemphill, you and I were at a White House meeting about a year ago and you mentioned on the way out that you were finding it hard to find tax equity for large utility-scale solar projects. Is that still the case?
MR. HEMPHILL: Yes, but I have a grand total of one data point. If you need to find a lot of money, it does not matter what type of money it is or who it is from. Finding a lot of money is hard. If you are going to finance 200 megawatts at a time, you are going to spend a lot of time trying to find a large amount of money.
MR. MARTIN: Jeff Eckel, you raised tax equity for a geothermal project but it was unusual because you had a Treasury cash grant. The tax equity transaction was a way to monetize the depreciation. Many people wondered if it was possible to do such deals. You proved that it is. The money was expensive, but it was worthwhile. Why?
MR. ECKEL: The depreciation was of no use to the project or to its owners, so any amount raised for it was found money. It was a model transaction. We have a great partner in Chevron and that business.
MR. MARTIN: Lyndon Rive, your general counsel, Seth Weissman, has been at the center of a National Renewable Energy Laboratory effort to create a market for securitizations where solar rooftop companies could package together customer revenue streams from residential solar installations and borrow against them in the public markets. That effort is about to move into a mock transaction. By the fall, the rating agencies should be able to rate the mock deal. Suppose securitizations open up as an avenue for raising capital. Will you do them in place of tax equity? Do you think it's possible to marry securitized debt with tax equity?
MR. RIVE: We will need to find a way to combine the two. Traditionally, the industry is focused on project-based financing, and we are trying to move it toward cash flow financing. In the residential space, you have fairly high cash flow. Currently, you pay your tax equity investors and then you can allocate the rest of your cash flows to a holding company.
A lot of the tax equity funds are not that big, and there are multiple funds, so marrying debt at the fund level with every single fund is very, very difficult to scale. So what you want to do is have all the cash flow up to one entity and then potentially take that to a different financing source.
MR. MARTIN: Ed Fenster, do you see securitization as something of interest to you before 2016 when the investment credit drops to 10%?
MR. FENSTER: Probably not. We spent a lot of time considering two different capital structures last year, one of which was securitization. We got initial ratings feedback from Standard & Poor's and came very close to closing a big warehouse facility. Ultimately, we found the weighted average cost of capital on a pre-tax basis to be higher in that approach.
The reason is we can be confident about 75% to 80% of the net present value of the cash flows. Therefore, you should be able to get a low cost of capital on that percentage. If you have a tax equity deal, you layer that most predictable cash together with tax equity, and the combination looks really attractive. Then there is the question of what to do with the remaining 25%. There are no current distributions; it is mainly a residual interest. Even if you have current distributions to support a borrowing and put them in a holding company and get a BBB rating, you end up with a higher pre-tax cost of capital on it and on the overall capital stack.
In the alternative, if you were to marry tax equity with a yield co-type structure, although you will end up paying more to the yield co investors than you would in the securitization market, the weighted average pre-tax cost of capital is lower. We anticipate doing that. Lyndon may be doing a securitization. I imagine it could be a boon to his common stock value just to announce it and have it be a standard that the industry has overcome.
Right now, securitization makes sense if your holding company's cost of capital is below 12% on an equity basis and if you are taxable. If a big utility gets into the market, maybe it will start thinking about securitization or about recapitalizing old tax equity deals. When you consider the transaction costs of dealing with the rating agencies, going through a public securities offering and negotiating intercreditor agreements, I do not expect it to be a winning capitalization structure for a long time.
MR. MARTIN: Lyndon Rive, do you see a role for securitization beyond the use as a form of back leverage that you described?
MR. RIVE: Regardless of where the capital comes from, the more sources, the better. When you look at MLPs, REITs and the other structures, this is all positive movement toward financing and bringing additional capital. It is nice to have the choice. Greater supply brings down cost. We can decide later how to use it.
MR. WEATHERLEY-WHITE: I will use one of my favorite terms that I learned a few years ago from Goldman Sachs -- yield equalization. This is what happens when you get lots of different types of capital chasing a single asset. You get the capital more cheaply.
FAITs and MLPs
MR. MARTIN: Bob Hemphill, did you look at a foreign asset income trust as an alternative to listing on the Toronto Exchange?
MR. HEMPHILL: Yes. Both have real benefits in Canada, but significant disadvantages for investors in other countries. We decided that it was not appropriate.
MR. MARTIN: Jeff Eckel, there is an effort in Congress to allow renewable energy companies to restructure themselves as master limited partnerships. These are partnerships whose units trade on a stock exchange. If MLPs opened up, would you convert to an MLP from a REIT?
MR. ECKEL: No. I think we are in exactly the right spot. The MLP market is an interesting one, and I certainly hope Congress allows their use for renewable energy. There are questions whether traditional investors in MLPs will be interested in renewables. The structure has been used mainly for oil and gas.
MR. FENSTER: It saddens me that the renewable energy industry has put so much effort into MLPs. It requires a big act by Congress, but it does not add much value. I wish the focus were on solar. Being able to structure an MLP would be advantageous if you could relax the passive activity loss rules and eliminate investment credit recapture on changing ownership. Then you could create a publicly-tradable tax equity structure that would radically increase the size of that market.
Our perception is that as awesome as that would be, that is a very unlikely outcome. Look at the after-tax benefit that you could achieve even just as a regular C corporation, never mind the REIT. If you have 15 years of significant depreciation, distributions to your investors will be treated as returns of capital. The tax deferral that you can get in a C corporation looks a lot like the tax advantages in an MLP and a REIT. It is an enormous amount of brain damage for not much improvement. As an industry, we only have so many opportunities to ask Congress for something. It feels to me like that was a bad choice.
I think the most significant single thing that Congress could do to lower the cost of capital for solar would be a refundable tax credit. That is the constraining point in the marketplace.
MR. WEATHERLEY-WHITE: I agree with Ed Fenster on that. There may be a marginal benefit to eliminating double taxation of earnings, but it is not nearly as helpful as finding ways to benefit fully from the existing tax subsidies.
MR. HEMPHILL: If someone gave me one for free, I would take it. The chance of Congress doing anything that basically counts as a tax expenditure is about as likely as the Easter Bunny and the Tooth Fairy getting together.
MR. RIVE: I am optimistic. It is a big lift, but if we can get the two things that Ed mentioned, the recapture and the passive activity loss rule changes, it would really open up the market. Without those changes, it is not much of a benefit.