By Ed Zaelke

The US government pays at least 56% of the capital cost of a typical wind farm in the United States in the form of tax subsidies. Few US developers can use the subsidies. Many barter them to banks, insurance companies and investment banks that can use them in “tax equity transactions” in exchange for capital to build their projects.

Such transactions can take three forms, but the most common is a partnership flip where the wind developer finds a tax equity investor to own the project with him as a partner. The partnership allocates as much as 99% of the economic benefits from the project, except possibly cash, to the tax equity investor until the investor reaches a target return, after which the interest of the investor in the project drops to 5%. The developer has an option to repurchase the remaining 5% interest of the investor after the flip. Cash might be distributed 100% to the developer until the developer gets back its equity investment in the project, after which cash follows other partnership items.

The following is an edited transcript of a mock negotiation between two tax equity investors and two wind developers that took place at a wind finance forum sponsored by the American Wind Energy Association in New York in April.

The tax equity investors are Martin Torres, vice president of Morgan Stanley, and Jerry Smith, managing director of Credit Suisse Securities. The developers are Raimund Grube, president and chief operating officer of Element Power, and Ciaran O’Brien, chief financial officer of Wind Capital Group. The moderator is Ed Zaelke with Chadbourne in Los Angeles.

MR. ZAELKE: Let’s start with the first issue in tax equity. How will you size the commitment? Let’s start with Martin Torres.

MR. TORRES: We will run a downside scenario and look at the P75 and P99 output projections to make sure that, even in the most stressed scenarios, we still expect to hit our target yield. We ideally will size in a production tax credit-driven deal to a 10-year flip based on the P50 output numbers, but depending on where the P99 flip would occur, we may reduce the amount we will commit to fund.

Forward Commitment

MR. ZAELKE: Raimund Grube, is your ability to get a commitment from the tax equity investor at the start of construction to fund at the end of construction purely a matter of numbers or are other factors at work?

MR. GRUBE: The quality of the developer and its ability to get the project into construction and built is important.

MR. ZAELKE: The initial sizing becomes the basis for paying off your construction debt and setting up the whole project. Ciaran O’Brien, it is now eight months after the initial commitment and your project is nearly complete. Do you expect a resizing of the tax equity commitment? If so, what does your lender think about that?

MR. O’BRIEN: There should be no resizing, because you are looking for a firm commitment from your tax equity investor to be there upon commercial operation. The work to size the tax equity is done. The only thing that might be changed would be a small tweak in capital cost and maybe the wind numbers. I don’t know how many deals have done it, but I have never resized a tax equity commitment more than a couple million dollars. It is tweaking rather than resizing. You might have added more turbines to the project.

MR. ZAELKE: Martin Torres, what does Morgan Stanley think about that? Let’s say you have made a commitment to fund $50 million for which you need to write a check eight months later. Things are different. What is fair game?

MR. TORRES: We have to look at what factors might change during construction. We don’t typically reopen the size of the commitment for changes in the wind study. We do our work up front and agree on what the wind is supposed to be. I agree with Ciaran. I don’t think that we have had a substantial resizing in any transaction from commitment to funding that we have closed. One area that was always a concern, until the stimulus bill passed and extended the deadline to place projects in service to qualify for tax credits, is whether the project would make it in service in time to qualify for tax credits.

MR. ZAELKE: Does the deal get resized after a change in law? Let’s say a domestic content requirement is imposed on the cash grant. Would that be a typical kind of “out”?

MR. TORRES: There is a small list of factors that, if changed, would lead to a resizing. Legislation in Washington may or may not be one of them. There are solutions to a number of these problems. For examples, changes in the Treasury cash grant program might be addressed by moving to production tax credits or investment tax credits.

MR. ZAELKE: Jerry Smith, what about a material adverse change in the developer or the developer’s parent or the project? The construction lenders will oppose anything that might let you out of your commitment to fund.

MR. SMITH: I think what you’re highlighting is really who is taking construction risk. The commercial operation date is generally the time when the money comes in from our perspective. The lenders take the risk that the plant never makes it into commercial operation. It is perfectly fair for that type of “out” to exist in a “firm” commitment.

MR. O’BRIEN: It is not that big of a deal because the construction window on these projects is very short and they are not that complicated to build. What tends to happen is that if the tax equity investor does its diligence and the project looks wobbly to start, it won’t proceed. In these times, you are not doing anything that is wobbly to start, so the likelihood of material adverse changes occurring has gotten very, very slim.

MR. ZAELKE: Suppose you have your construction lender on one side and the tax equity investor on the other side and neither of them wants to take this construction risk. Who do you get to take it? Is it the old money? The construction lender eats it because its money is already on the table.

MR. O’BRIEN: When these deals get going and $200 million is being spent, you will be amazed how much incentive everyone has to settle these issues. People work it out. However, in the end, the lenders and the tax equity look to make sure the sponsor has the financial means to be able to resolve issues that arise during construction.

MR. ZAELKE: Martin Torres, let’s stay with what Ciaran was saying. We expect to start construction this year and complete in February 2011. February comes along and, just before commercial operation, some rare, endangered chipmunk appears on the scene and construction stops for a while. How long do you hold the agreed internal rate of return for the deal? Do you renegotiate if the target completion date is missed?

MR. TORRES: I think it goes back to what the expectations were at the time of commitment. If we are providing a forward commitment, then we have not typically thought about the specific contingencies that might arise, but have considered categories of issues that might come up to prevent us from reaching completion as expected. We usually write an outside date into the document after which our commitment ends. We will have already agreed that the yield is good for three to six months, depending on how far forward we have provided that commitment.

Start of Construction

MR. ZAELKE: Let’s switch to some other deal terms. Ciaran O’Brien, Jerry and Martin want a representation from you that you commenced construction before December 31, 2010 in order to qualify for a Treasury cash grant. Can you give that representation?

MR. O’BRIEN: I think this becomes a non-issue this year. There has been a lot of talk as to what starting construction means, how the 5% test works and how you deal with frame contracts for turbines. My sense of it is that if you have a good site, you start your civil work. You are more likely to be considered to have started construction with people employed on the site digging dirt.

MR. ZAELKE: Raimund Grube, are you willing to give a representation that construction has commenced? As a developer, do you have to do that in today’s market?

MR. GRUBE: I think I would be counseled strongly not to make such a representation by whoever was representing me in the negotiation, but I share the view that Ciaran expressed. I think meeting the standards that you have to meet to qualify by the end of the year is probably something you could do. It’s probably not that significant a risk to give the representation.

MR. ZAELKE: Jerry Smith, from the tax equity perspective, you will be asked to write a $50 million check at the end of construction and you find out 60 days later when it comes time for the Treasury to pay a cash grant whether or not construction did in fact commence before December 31, 2010. Are you going to make that commitment to Ciaran or Raimund without their 100% ironclad representation that they in fact commenced construction?

MR. SMITH: I think it’s a multi-tier answer. I would not put all that much reliance in a guarantee from the sponsor on that particular point. We would put our heads together and collectively determine what we think the rule is or is likely to be. The way I would address it is to have certain factual conditions precedent to closing that we collectively agree occur. This puts us in a pretty good place and then I would look for a top-up representation that says that if, for some reason those conditions precedent prove false and we don’t qualify, there is an obligation on the developer.

MR. ZAELKE: Martin, will you be equally reasonable at Morgan Stanley?

MR. TORRES: Sure. These issues can be dealt with contractually in advance. I’m not sure how many developers and how many tax equity investors will be in this situation. We will see what happens at the end of the year.

Sponsor Guarantees

MR. ZAELKE: How about other remedies? What happens if you get this representation and it proves false? Do you look at a parent guarantee as support. Is it even reasonable in today’s market to ask for such a guarantee?

MR. SMITH: Yes. We usually want a parent guarantee to support risks that the developer has agreed to take. I come back to a point made earlier that if it is possible for no grant to be paid, the smartest approach is to work out in advance what will happen in such a situation.

MR. O’BRIEN: I would be reluctant to give a parent guarantee for something that the tax equity investor should be able to confirm by diligence.

MR. ZAELKE: Raimund Grube, how would Element handle this?

MR. GRUBE: We would be careful to try to meet the start-of construction threshold by a wide margin. We would not want to provide a parent guarantee. As Ciaran said, it is something that the tax equity investor should be able to confirm on its own as a condition to closing. It is black and white in our opinion, and we would invest to make it a black-and-white determination.

MR. ZAELKE: Jerry Smith, as Martin suggested, do we need a fallback to production tax credits should you advance funds and the cash grant not come through, especially if the construction debt is not going to be guaranteed by the parent? Is that something you will be able to take to your credit committee?

MR. SMITH: Your assumption is that we have not demanded a parent guarantee. I think the loss of cash grant on grounds that construction failed to start on time is a relatively low-risk problem. The developer has more insight than we do into the facts and whether it met the test to be considered to have started construction in 2010. It is not much to ask it to have its parent company stand behind its representation to us that construction started on time. That said, as an investor, I do not rely entirely on representations. We do diligence. We also try to build fallback plans into the documents to address contingencies.

Intercreditor Issues

MR. ZAELKE: Let’s change topics: leverage. Ciaran O’Brien, how involved is the tax equity investor in your decisions about your debt documents?

MR. O’BRIEN: I would try to limit the number of people involved in the sausage making as much as possible. We usually negotiate the debt in the first instance and the tax equity later. If you get everybody involved at the same time, it can be difficult and the entire financing will take longer to conclude. Some of the deals that we have done were nearly scuttled because they became such complicated ordeals between the tax equity investor and the lender.

MR. ZAELKE: Let’s move to other issues with the cash grant. What if the project is transferred during the first five years — for example, the lenders foreclose during that period on the project. Is the cash grant recaptured?

MR. SMITH: Recapture only occurs if the project is transferred to a disqualified investor. The bank is not a disqualified investor. But there is a larger issue. Any lender at the project level would have to agree to forebear from foreclosing on the project for a period of time to allow the tax equity investor to reach its target yield. The lender could foreclose in the meantime on the sponsor interest and, in that manner, take over day-to-day control of the project.

MR. ZAELKE: Martin Torres, what happens if the project runs into operating difficulties — say the wind doesn’t blow or a turbine breaks and, as a consequence, the project defaults on the debt? Can you sit down with the lender when the deal is first being negotiated and say, should this happen, we want you to give us X period of time to work out these sorts of issues before foreclosing on the project?

MR. TORRES: Yes, you can certainly have that conversation. The reality of the situation is the parties will confer at the time and try to work something out. There will be a requirement in the documents for the lender to give the tax equity investor notice and an opportunity to cure before declaring the project in default and moving to foreclose. Whether the period from notice to exercise of remedies is three months, six months or 12 months, that’s negotiable.

MR. SMITH: Another point to keep in mind is that everything doesn’t usually fail in one go at a wind farm. The project consists of multiple turbines. Each operates separately. Okay, so it may taken a bit longer than expected to work out operating kinks, blades have fallen off, blades have cracked, the gear boxes have problems, but all of these things get repaired gradually without total failure at the site.