US solar financing update
Activity in the US solar market has picked up considerably as developers race toward a deadline at the end of 2019 to start construction of remaining projects to qualify for a 30% investment tax credit on new solar projects. More projects are seeking financing than in 2018. The race is on to start construction of as many projects as possible. Senior executives of four solar companies talked at the annual Solar Energy Industries Association finance workshop in New York this spring about the state of the market. The following is an edited transcript.
The panelists are Samir Verstyn, chief investment officer and chief operations officer of Origis Energy, Rob Martorano, chief investment officer of Greenskies Renewable Energy, Sripradha Ilango, chief financial officer of Soltage, and Vincent Plaxico, managing director for project finance at Recurrent Energy. The moderator is Keith Martin with Norton Rose Fulbright in Washington.
MR. MARTIN: What new trends are you seeing in how solar projects are financed?
MR. VERSTYN: One trend is that some tax equity investors are also providing the back-levered debt. This creates efficiencies and reduces the transaction costs. Tax equity is also playing a different role in the capital stack.
MR. MARTIN: Have you seen many tax equity investors also offer debt or is it still just a small subset of tax equity investors?
MR. VERSTYN: It is a small subset. We know a couple that are doing it, but more are looking into it. There are complications under Reg. W. The complications affect how such deals are structured.
MR. MARTIN: What advantage is there to the sponsor of shopping for debt and tax equity in the same place?
MR. VERSTYN: You have one counterparty in essence, although they are different affiliates.
MR. MARTIN: But two sets of lawyers.
MR. VERSTYN: They may be more willing to try to accommodate each other. It is a smoother process. There may be efficiencies with the number of insurance and other consultants that have to be brought into the deal. The downside is that Reg. W limitations cause your equity ticket to go up on the sponsor side.
MR. MARTIN: You said tax equity is playing a different role in the capital stack. What did you mean by that?
MR. VERSTYN: It is not so much a different role, but the reduction in the corporate tax rate to 21% means that the tax losses are worth less so the amount of cash the tax equity needs to stay at the same level of investment has gone up. That affects how we look at tax equity. It is an expensive source of capital. We take this into account when we analyze our optimal overall capital stack.
MR. MARTIN: Rob Martorano, what new trends do you see?
MR. MARTORANO: We are seeing more use of sale-leasebacks in the commercial and industrial and distributed solar markets. The tax equity investor in a sale-leaseback provides the entire capital stack.
MR. MARTIN: Are the lessors mainly regional banks?
MR. MARTORANO: Yes.
MR. MARTIN: Have you seen any large banks in the sale-leaseback market?
MR. MARTORANO: Occasionally, but they still need large volumes which is not always as easy for a C&I solar company to provide.
MR. MARTIN: The large banks tend not to like sale-leasebacks because the financing term is too long. They prefer shorter-term financings. Sponsors have tended not to like sale-leasebacks because they suspect the banks are not paying anything for the residual asset value. It galls sponsors to have to buy back the asset at the end of the lease term. How do you get past this issue as a sponsor?
MR. MARTORANO: Some lessors offer fixed-price purchase options. We factor that into the cost of the financing. We may also push for a shorter-term lease.
MR. MARTIN: Are banks doing sale-leasebacks claiming a 100% depreciation bonus?
MR. MARTORANO: Yes. That makes for better financing terms. Sale-leasebacks also tend to have lower transaction costs.
MR. MARTIN: Shrips Ilango, what new trends are you seeing?
MS. ILANGO: Our challenge has been how to finance large portfolios of small assets that are geographically dispersed. Before, we had to go to three different lenders for three different geographies. As the market has matured and as the banks have looked for repeat business, they have been able to get comfortable with different risk profiles. Doing a series of financings with the same parties helps make the transactions efficient and quick.
MR. MARTIN: Vince Plaxico, new trends.
MR. PLAXICO: I have three. There has been a fusion of corporate and project finance, which can help developers with earlier-stage capital. I will be a little bit vague there.
MR. MARTIN: I was going to ask what does that mean?
MR. PLAXICO: We will get to it. [Laughter]
Next, banks are more willing to lend against the merchant tail, or the projected revenue after a power contract ends. Finally, the spread on debt for projects with community choice aggregators as offtakers, especially in California, continues to improve.
MR. MARTIN: So what does “blend of corporate and project finance” mean?
MR. PLAXICO: As developers, we need different sources of capital, whether it is letter-of-credit facilities or just debt that is more development-stage and not based on projected cash flows. We are starting to see banks take a view that traditional project lending at rock bottom rates may not be the best use of their capital, so they may want earn a higher rate by lending during the development stage. These are commercial banks. I am not talking about hedge funds.
MR. MARTIN: How early in the development stage?
MR. PLAXICO: It varies but some projects might only have site control and interconnection agreements. Others might have power contracts, but still have development milestones ahead.
MR. MARTIN: What is the pricing on such development loans?
MR. PLAXICO: It depends what type of collateral you give the banks.
MR. MARTIN: I can see where this is headed. [Laughter] Let’s go back to the full panel. In many conferences over the past few years, people have talked about a wall of money chasing projects. Do you feel like there is still a wall of money? Are people throwing money at you?
Wall of money
MS. ILANGO: As a qualified statement, nobody has ever given me money for free. [Laughter] That said, there is a lot of capital interested in this space. We have seen returns tighten across the capital stack, even maybe for tax equity. There is a lot of capital chasing a limited number of projects, but it doesn’t mean that deals are being done irrationally. Everyone has a return requirement that is based on his or her underwriting standards.
MR. PLAXICO: We sold about 700 megawatts of projects last year, and 60% of the projects we sold were to international investors. Interest from Asian and European investors remains high.
MR. MARTIN: Do you have a sense for what discount rates the winning bidders were using to price?
MR. PLAXICO: It depends on project characteristics. However, high-quality operating projects clear in the high 6% to 7% levered IRR range, assuming a 35- to 40-year useful life and taking the merchant curve from a third party without a major discount.
MR. VERSTYN: We also see a lot of European money coming in. We have an international business, so we see what is happening in countries like The Netherlands and Germany where levered yields on solar assets are around 4.5%, with the floodgates being potentially reopened by the European Central Bank. Falling interest rates in Europe bring more money to the US in search of higher returns.
MR. MARTIN: What return are developers getting on projects: single digits? If so, how do the private equity funds play in this sector?
MR. VERSTYN: Yes. It is single-digit leveraged returns.
MR. MARTIN: How do the hedge funds play in this sector? Maybe the answer is they don’t. They usually look for returns in the mid- to high teens.
MS. ILANGO: They don’t.
MR. PLAXICO: I agree.
MR. VERSTYN: It is not viable because you are bidding for PPAs in a very competitive market. If you start factoring in that cost of capital, you will not be able to win.
MR. MARTIN: Is there any part of your business for which there is a shortage of capital? Early-stage development? Late-stage development seems to be flush with money.
MR. MARTORANO: We are doing C&I and small ground-mounted distributed solar. There is no shortage of capital for any stage of our business. It is just a matter of the terms that come along with it.
New financial products
MR. MARTIN: What new financial products have investment bankers and others been pitching to you lately?
MR. MARTORANO: Mostly securitizations.
MR. MARTIN: So borrowing in the public debt market against customer revenue streams from C&I portfolios. It is a form of back-levered debt and probably a way to borrow at a lower rate than you can borrow from a bank. What rate are you seeing in that market?
MR. MARTORANO: We have not done it yet, but what has been talked about is in the 5% or sub-5% category.
MR. MARTIN: That doesn’t seem to be much better than what the banks are offering.
MR. MARTORANO: It’s really not, but the idea is to put the facility in place and save on future borrowings.
MS. ILANGO: There is also a benefit from aggregating portfolios. The effect is to start mimicking the rates on offer in the utility-scale solar market.
MR. MARTIN: So the next big thing for developers of smaller projects is aggregation to save on borrowing costs. Is there a next big thing for utility-scale solar that people are pitching?
MR. PLAXICO: We are getting pitched for sell-side M&A due to our business model. We are seeing inbound investor interest in projects that have exposure to PG&E. We are also being pitched on equipment loans to borrow and stockpile equipment that can be used as a basis for qualifying projects for the investment tax credit.
MR. MARTIN: Investors interested in projects with PG&E exposure are making a bet that the politicians will pull PG&E back from the brink?
MR. PLAXICO: They think there is an additional spread to be earned right now due to the uncertainty.
MR. MARTIN: Let’s talk more about equipment loans. Solar companies are pressing against a deadline of the end of this year to start construction to get a 30% investment tax credit. One way to start construction is to stockpile equipment. Few companies have the money to stockpile lots of equipment. What equipment loan terms are you seeing on offer from bankers?
MR. PLAXICO: We are seeing a lot of interest from banks. The pricing is around LIBOR plus 3% in cases where there is a reasonable loan to value.
MR. MARTIN: What do such lenders take as collateral: just the equipment?
MR. PLAXICO: They will get a little bit more than that.
MR. MARTIN: Has anyone else seen banks pitch for equipment supply loans?
MR. VERSTYN: Not necessarily banks, but what we have seen is private money willing to lend based not so much on the spread, but with the intention to get their hands on the projects because they have long-term ownership aspirations.
MR. MARTIN: No matter how you start construction, whether you do it by physical work or stockpiling equipment, there will be supply constraints. There was a story in Recharge this afternoon about how wind developers are already running into difficulty getting cranes to put up turbines in ERCOT that have to be up by the end of 2020. Are you already running into supply constraints in the solar market as you start thinking about how to start construction by the end of 2019?
MS. ILANGO: We saw the same thing a couple years ago in Massachusetts when the SREC II program came to an end. EPC prices went up significantly. Panel prices went up significantly. We fully expect something similar to happen, and it will be a balancing act among EPC price, panel price, the investment tax credit stepdown, getting a lower price on everything and getting a 26% rather than 30% tax credit by waiting to start construction next year.
MR. MARTIN: You are all developers. What is your current thinking about whether it is better to start construction with physical work or by stockpiling equipment?
MS. ILANGO: I think there is a warehouse in New Jersey where you can still find section 1603 panels. [Laughter]
MR. VERSTYN: The lowest-cost option from a capital perspective is to start construction by getting work started on transformers. You need a dedicated project in order to do so because your transformer is customized.
The other side is that incurring at least 5% of the project cost by taking delivery of solar panels or other equipment provides greater certainty that you will be able to raise tax equity. We see scarcity and prices creeping up as a result of that. There are no shortages at this point in time, but things could start to change in the next couple months.
MR. MARTIN: Rob Martorano, physical work or 5% test?
MR. MARTORANO: We’ll probably go with the 5% test. We probably have 100 to 150 projects at the end of the year that we will need to safe harbor. It is easier to rely on the 5% test.
MR. MARTIN: What equipment will you stockpile?
MR. MARTORANO: Panels.
MR. MARTIN: Are you worried about the efficiency of panels improving over time and making your stockpiled panels worth less?
MR. MARTORANO: Not overly concerned about that. It is a matter of price. If we can procure panels at the right price, then we eliminate a supply risk. We are already seeing shortages pop up in various sizes for projects that we plan this year.
MR. MARTIN: Vince Plaxico, what do you plan to do?
MR. PLAXICO: Some tax lawyers have said it will be easier for tax equity investors to get comfortable with the 5% test than physical work, so I think that is where we will end up. It might be modules, it might be other equipment.
MR. MARTIN: The solar panel tariff will drop to 20% next February and to 15% a year after that. I suppose you could hold equipment outside the country and bring it in later when the tariff has eased a bit.
Let’s switch gears and talk about electricity prices. They have been falling and so there is less cash in deals. How is that complicating financing?
Changing capital stacks
MR. VERSTYN: It depends on what part of the capital stack you are focused. There is less cash to borrow against, so the amount of back-levered debt that can be raised is decreasing. If the electricity price under the PPA increases over time, you have a snowball effect where the amount of cash available in the early years is not enough to service the debt. Turning to tax equity, the reduction in the corporate tax rate means that tax equity investors require more cash to make up for the loss in value of tax losses.
MR. MARTIN: So you must need more equity in the capital stack because you are not raising as much tax equity or debt. What is your typical capital stack? What percentage tax equity, debt and true equity?
MR. VERSTYN: It is 30% to 40% tax equity, 30% back-levered debt and 30% sponsor equity or maybe a little less on the sponsor side. In the good old days, it was definitely a lot less. Our investments are done on a full equity basis, so we only source the tax equity portion, and deployment of larger ticket sizes is beneficial to us, so it is not a real problem, but even in the levered deals, you still need a lot of sponsor equity.
MR. PLAXICO: I agree. We have also seen investors who plan to be the long-term owners purchase assets on an unlevered basis. They get rid of the back leverage. Along with less cash in deals, PPAs are getting shorter, so are these investors able to break even by the end of a 15-year PPA term? Maybe. Will they break even when PPA terms are 12 years? No, and at 10 years, definitely not. Going forward, investors will not get their money back though the contracted period, and a new trend will be how investors adapt to this new reality.
MR. MARTIN: Rob or Shrips what is your typical capital stack?
MS. ILANGO: For smaller assets, it is typically one-third a piece, give or take, on the tax and the cash equity side. One of the disturbing trends we are seeing is utility-scale assets bidding out PPAs in the low single digits. It used to be 3¢ PPAs were good, and then we heard about 2¢ PPAs. I am not sure whether these projects are getting financed.
Now we are seeing the same prices coming to the two- and three-megawatt segment. It is leading to a significant number of stranded assets that are difficult to finance.
MR. MARTIN: Rob Martorano, typical capital stack, one-third, one-third, one-third?
MR. MARTORANO: Yes. That’s pretty much what we are doing. We see those same projects. We are bidding into those with a reasonable bid, and the winners are bidding lower at rates where you know they will never be able to make the economics work.
MR. MARTIN: I imagine the weighted average cost of capital is going up in this market because there is more sponsor equity and less debt and tax equity. What do you think it is for utility-scale solar?
MR. PLAXICO: The cost of equity is the range of discount rates I quoted earlier. On the back-levered debt side, rates continue to be extremely low for quality projects: LIBOR plus 137.5 basis points or lower.
MR. VERSTYN: That’s about right. On the debt side, we see some compression still on the margins, which helps us out. The supply of tax equity remains good, and then some new players are coming into the market which also drives down the return expectations from tax equity, but not significantly. Tax equity remains the most expensive capital.
MR. MARTIN: That remains a source of frustration for sponsors and lenders who earn less than the tax equity investors and are behind them in the capital stack. Where are current tax equity yields? They seemed to be in the mid-6% range for a while for utility-scale solar.
MR. VERSTYN: We have seen some drift a little lower. Some are a little higher. We see concessions in other kinds of attributes within the tax equity deal that sweeten the pie for us. DRO levels are creeping up a bit, which is helpful. Flip tenors are going longer. The investors are competing with one another for deals and using various levers to do so.
MR. MARTIN: What is the weighted average cost of capital for C&I and community solar projects?
MR. MARTORANO: We are seeing somewhere in the 7% to 8% range, but on a levered basis. It is all really a matter of what the assumptions are going in. Everyone has a different return requirement. You hear that a project went off at a seven, but, when you back into what the numbers are, it may not actually be a seven. Everyone basically has his or her own assumptions. The numbers may be as low as 6% to 6.5% to 10% levered.
MS. ILANGO: Based on what Vince was talking about from an underwriting standpoint, a 35- to 40-year life with a third-party market-based merchant curve on the back end, you could safely add a couple hundred basis points to the utility-scale number, so 9% to 10%.
MR. MARTIN: Are any of you seeing front-levered debt —debt ahead of the tax equity —or is it all back-levered at this point?
MR. MARTORANO: We do both.
MS. ILANGO: We have seen both. Back-levered is our preferred choice just because it gives us a little more flexibility as we build out the portfolio and want to manage the sponsor side better.
MR. VERSTYN: On the utility-scale side, we see only back-levered debt. While there may be interest in front leverage, forbearance has been so difficult to work out that front leverage is really painstakingly costly and time consuming.
MR. MARTIN: Rob Martorano said that he is getting the benefit of the depreciation bonus by doing sale-leasebacks. Are any of the rest of you able to get tax equity to price in a depreciation bonus?
MR. PLAXICO: Not yet.
MS. ILANGO: No.
MR. VERSTYN: No.
MR. MARTIN: Say your name and affiliation, then your question.
MR. WALKER: Chris Walker with GRID Alternatives. You have been great witnesses under this cross examination. [Laughter] What opportunities do you see to be innovative in how these projects are financed?
MS. ILANGO: If I can take a contrarian view to that . . .
MR. MARTIN: There is none? [Laughter]
MS. ILANGO: Solar has succeeded in becoming extremely boring. If you look back 10 years ago, it was the cool place to be. There were SRECs. California was doing something funky. Now pretty much every state in the US has some program to incentivize solar, some kind of net metering (whether it is successful or not), some kind of a community solar program, and a lot of utility scale.
The real value-add is to take the risk away from the solar assets and not make them riskier. That is where solar has succeeded.
People who are trying to earn a better return do so by taking more risk, maybe in terms of doing more innovative community solar financings or adding storage to their assets, for example. But plain solar, in my view, should be plain vanilla and then you can start adding other factors to get better returns.
MR. PLAXICO: One innovative feature is we used an insurance policy yesterday as part of an M&A transaction.
MR. MARTIN: Was it reps-and-warranties insurance?
MR. PLAXICO: It was a first-of-a-kind policy.
MR. MARTIN: To cover what risk?
MR. PLAXICO: Let’s chat later. [Laughter]
In terms of mitigating risk and finding ways to be innovative, it is not just finding new sources of capital that are cheap. It is also finding ways to make your project more valuable (if you’re a seller like we are) for investors.
MR. MARTIN: There has been a frenzy among consultants about opportunity zones. Do you see any role for opportunity zones in your capital structure?
MR. VERSTYN: Not yet. It is another tool that we may be able to use by setting up an early fund ourselves and basically trying to invest. As we expand our footprint and look for new areas, we see that solar projects are often in lower-income areas. We have seen appreciation in value of property in areas that have been designated as opportunity zones.
MR. MARTIN: So the land is more valuable because of the designation.
MR. VERSTYN: Correct.
MS. ILANGO: There seem to be a lot of constraints around what qualifies as an opportunity zone project. I sat through an opportunity zone panel earlier and they were talking about a 90% qualified asset test, a 50% gross income test, a 5% cap on financial assets and other tests, and it just seems like a lot of constraints for a solar asset to hit. I will be curious to see how much opportunity there really is in the solar market for those kinds of funds to invest.
MR. MARTIN: So this is one area where finance is not boring. [Laughter]
MR. PLAXICO: I missed the panel earlier, but a pitch deck I was sent talked about a 13% to 14% return, and that is before the tax benefits that one would get for investing in the opportunity zone. These types of returns will be hard to achieve in utility-scale solar.
MR. MARTIN: Are any of you adding storage to your projects? If so, how is that complicating the financing, if at all?
MR. VERSTYN: Yes. I think 90% of our projects going forward will probably have a storage component unless it ends up complicating things. It depends on the use case.
MR. MARTIN: Give us a sense of the math. If you add storage, presumably you are increasing the cost-per-installed megawatt of the project, but you must be earning more revenue to offset that. How does the math work?
MR. VERSTYN: It depends on the time at which storage is going to be put in place. If you are talking about a 2023 versus a 2021 asset, the investment required for storage could be fundamentally different.
One of the things that the whole industry is examining is where solar panel prices were 10 years ago with the expectation that storage costs will follow a similar trajectory. The cost of deployments in 2022 or 2023 should be significantly lower than it is today.
MS. ILANGO: There is a lot of work to be done by the developers to pick the right technology, pick the right use case, and then convince the financing parties that this is financeable. We look at the SMART program in Massachusetts. The program makes the addition of storage more financeable from a revenue standpoint because you get a fixed fee for adding storage. The expectation is that the market will figure out how to earn other revenue. It is a little bit of risk sharing. The jury is still out, but it will be a good test case for the next year.
MR. MARTIN: But the math. I’m still hazy on the math.
MS. ILANGO: In the SMART program, you get another 3¢ to 7¢ per kilowatt hour for adding storage. Most developers are planning on adding lithium-ion batteries.
MR. PLAXICO: I second that. Lithium-ion from our perspective should not add any incremental technology risk. We are getting a capacity payment for the battery under existing PPAs for two 150-megawatt solar-plus-storage projects with two community choice aggregators in California.
MR. MARTIN: Last question. What solar-related fears keep you awake at night?
MR. VERSTYN: I don’t know if it is solar-related necessarily, but policy changes. Just look at the last two years for the kind of changes in tax law and tariffs that have affected our industry. The changes have been fundamental. The ongoing trade negotiations with China could have a huge impact.
MR. MARTIN: So you are worried about the policy getting worse.
MR. VERSTYN: Worse or better. It is the unpredictability of where policy will go.
MR. MARTORANO: I agree. It seems every year we adjust to one fundamental change and then another thing hits. It is trying to anticipate what that can be and then figuring out what it means for projects as you are lining them up, especially ones that take a while to develop.
MR. MARTIN: From where do you think change is mostly to come? The competition among different types of generators is playing out in many different places: for example, in the zero emissions credits that some states are offering to keep nuclear power plants operating, the Perry proposal to keep coal plants operating, the MOPR proceeding at the Federal Energy Regulatory Commission to address the prices at which renewable energy projects can bid into the PJM capacity market. The government had a finger on the scale until recently in favor of renewables. Are you worried it will shift to the other side of the scale?
MR. MARTORANO: Yes. I worry about what might happen over the next two years.
MS. ILANGO: Since we play in the distributed and community solar space, we rely a lot on state-level regulations, so the rate of change in which states implement programs to incentivize solar development is something that I think about a lot.
MR. MARTIN: Are things improving or getting worse?
MS. ILANGO: Getting better. We see a lot of activity even in the non-coastal states, which is long overdue.
MR. PLAXICO: I stay up late at night if a transaction has not yet closed. Major fluctuations in third-party reports and other market dynamics can significantly alter the value of