How to plan ahead for back-leverage
By Sue Wang
Cash is king as developers race to start construction on US projects before wind and solar tax subsidies disappear. Back-levered debt is a reliable way of getting more cash into the hands of developers. Back-leverage rates are competitive, and some lenders are willing to give credit to merchant sales beyond the term of the initial power purchase agreement.
Back-levered debt sits upstream of both the project and any tax equity financing. There are three forms of tax equity financing. All wind projects and most solar projects are financed using a partnership-flip structure in which the developer and a tax equity investor own the project through a partnership.
The developer borrows against the monthly or quarterly cash distributions that the developer receives as its share of cash flow. The loan is secured by a pledge of the developer’s interest in the tax equity partnership.
Back-leverage financing is sometimes closed before or simultaneously with the tax equity financing, but it is also flexible enough to be added at a later date. Unlike tax equity, back-leverage financing can be added to projects that started commercial operation years ago. This flexibility is one of the most appealing aspects of back-leverage financing.
To leave the door open for a future back-leverage financing, it is important to make sure that a tax equity deal does not contain any elements that would offend a back-leverage lender. The two sets of investors should be able to co-exist peacefully.
There are two fundamental questions that back-leverage lenders need to answer when they diligence the tax equity deal.
First, what issues could potentially stop the expected share of cash flow from reaching the developer? Next, if a cash-flow problem were to arise and the back-leverage lenders decided to exercise their enforcement rights, would there be any significant barriers to foreclosing on the collateral?
Engaging with these two concerns thoughtfully is critical at the outset. Doing so will enable future back-leverage lenders to come into a deal without disturbing the existing tax equity agreement. Nobody wants to re-open the tax equity deal for amendments and inter-creditor agreements, so pre-bake your tax equity deal with the things every back-leverage lender will need. A little bit of advance planning goes a long way.
Cash Flow and Cash Sweeps
Most term sheets include a tidy chart indicating how cash flow is split between developers and tax equity investors, and in most cases developers assume that cash will follow the chart. However, lenders and tax equity investors are always considering the downside scenario.
Tax equity investors dislike risk, and tax equity vehicles often include cash sweeps of 50% to 100% to cover any indemnities owed to the tax equity investor and, in some cases, to help the tax equity investor reach its target yield once the expected date for doing so has passed.
A cash sweep means that some portion of the cash that otherwise would have been distributed to the developer will instead go to the tax equity investor.
To reduce the likelihood of a cash sweep, it is important to pay careful attention to the events that could trigger an indemnity obligation. Anything off-market would raise questions from back-leverage lenders. Some of the indemnification risk can be addressed by purchasing tax insurance when closing the tax equity financing. In addition to protecting the developer and tax equity investor, tax insurance coverage would also give comfort later to the back-leverage lenders that, if the tax character of the project is challenged, cash flow would only be temporarily diverted while the insurance claim is pending.
In cases where back-leverage and tax equity financing are being negotiated simultaneously, it is common for back-leverage lenders to ask that scheduled principal and interest payments of their loan be excluded from the cash sweep.
However, room can be reserved for back-leverage lenders even if there is limited visibility on a future back-leverage loan. As long as the maximum cash sweep is less than 100% of the developer’s distributions, there will be some cash flow for the back-leverage lenders to lend against. A 50% cash sweep usually leaves enough room for back-leverage loans, but the actual sizing depends on the cash outlook of the specific project. It is rare to see a project that is able to support back-leverage loans if the cash sweep is above 75% of developer cash flow, unless scheduled principal and interest is excluded from the cash sweep.
Back-levered debt is secured by a pledge of the developer’s interest in the tax equity partnership. This is called the class B pledge because most of the market has fallen into the practice of calling the tax equity investor the A partner and the developer the B partner. There is no significance to the order.
Without careful attention to drafting, restrictions in the tax partnership agreement can make it impossible to pledge the class B shares without consents and waivers. A specific carve-out is often required to allow the class B interest to be pledged as collateral to a lender. Without a specific carve-out, pledges of upstream interests may require consent from the tax equity investor, which can cause unnecessary costs and delay.
It is also critical that the partnership agreement allows enough room to maneuver for the lender to enforce the class B pledge. If the loan is in distress, the lender needs the ability to sell its collateral quickly, without getting consent of any kind from the tax equity investor. The sale could be an auction or a private sale, or the lender may foreclose and hold the interests itself for a time.
Many tax equity investors impose restrictions on changes of control because they want to make sure the developer stays with the project, but a carelessly drafted change-of-control provision can have an unintended consequence of closing the door on a future back-leverage financing.
When working out the details of a tax equity deal, an experienced negotiator should specify that the class B interest can be pledged in favor of a back-leverage lender, defined as a lender whose collateral package does not reach the project assets. Furthermore, foreclosure (and a transfer in lieu of foreclosure) by the lender should be specifically permitted without investor consent, as long as a specific list of conditions is met. A favorable set of papers would include a special exemption for the first entity to whom the lender transfers its interests.
In favorable conditions, the only restrictions upon a transfer by the lenders would be regulatory requirements and tax considerations. Any transfer that would cause the IRS to treat the company as a corporation, for example, would not be permitted. Likewise, any transfer that triggers recapture of tax credits claimed on the project is either flatly prohibited or can only done with an opinion from outside counsel that no recapture will occur or with an indemnity from the developer for the recapture liability.
Most lenders are not granted unfettered freedom to resell the class B interest to whomever they please. The developer, as the class B member of the tax equity partnership, has managerial responsibilities and indemnity obligations, and the tax equity investors need to be comfortable that any successor to the class B interests can perform both obligations. Tax equity investors do not want to find themselves in a partnership with a stranger.
One way to balance the competing priorities is to establish a set of objective criteria at the outset to define an acceptable transferee. Financially, the transferee is usually required to meet specific measures of financial strength and to deliver a parent guaranty to replace the parent guaranty of the outgoing class B member.
Operationally, the transferee must be capable to managing the project. Experienced negotiators will specify clear, objective criteria in advance so that potential transferees never need to be individually evaluated and approved. The criteria usually include a minimum quantity (in megawatts or in dollar value) of renewable power projects that the transferee has developed or operated, plus a minimum number of years of experience in the industry. Furthermore, the operational experience should always be able to be satisfied by entering into a professional service contract with an acceptable third-party manager.
Having clear, objective criteria in advance is the last piece of the puzzle that makes lenders feel comfortable that they will be able to foreclose on the class B interests without needing to go back to the tax equity investor for consent. The lender itself should not be required to satisfy these metrics to foreclose on the interest after a debt default.
A back-leverage lender will always diligence the tax equity documentation because the tax equity partnership sits between it and the cash flow. Tax equity investors do not generally object to having back-leverage lenders in the capital stack, but it is not their job to think about what such lenders will need.
It is the developer’s job to manage the capital stack, and it is the developer’s burden to ask for consents and amendments if the back-leverage lender is not satisfied with the existing agreement. This article has covered the key items that every back-leverage lender looks for, but there is one additional clause that smart developers always check: make sure the confidentiality provisions allow investors and potential investors to review the documents.