Securitizations and tax equity
Solar securitizations may see a hiatus for part of 2016. Seven deals have been completed outside the PACE market, with the cost of debt increasing in Q1 2016 deals to 5.81% and 6.25% with 74% or 75% advance rates compared to debt rates in the 4% to 5% range earlier. The higher rates reflect general market conditions. ABS spreads reached a 3-year high in January.
Four of the seven deals to date were securitizations of revenue passing through tax equity structures before it gets to bondholders. Tax benefits on solar projects are worth 56 cents per dollar of capital cost of the equipment. Few developers can use them. The core financing tool in the solar market is tax equity transactions that barter the tax benefits for capital to build projects.
Wind and solar tax equity was a $13 billion market last year. This contrasts to $234.5 million raised in solar securitizations last year and $242.5 million in two deals done so far in 2016. SCTY, the largest issuer to date, plans to raise $1.8 to $2 billion in tax equity this year.
More than 900 people attended the annual solar finance and investment summit in San Diego this year, up from 500+ people the year before, and the solar sessions at the annual ABS convention in Las Vegas were standing room only. Congress extended the key tax benefit for solar -- a 30% investment tax credit -- on December 18 and, in so doing, gave the solar industry a five- to seven-year additional runway for projects. Securitization transaction documents include detailed representations about eligibility for the tax benefits.
Securitizations are all about the revenue stream: where is it coming from and how certain is it? In many deals, it passes first through a tax equity structure.
There are three forms of tax equity structures with two important variations: partnership flips, inverted leases and sale-leasebacks. The securitizations to date have been confined to the rooftop sector. Most deals in that sector today are partnership flips with some inverted leases. Sale-leasebacks have fallen out of favor.
In a partnership flip, the solar company brings in a tax equity investor to own an interest in a large portfolio of solar rooftop installations that are used to supply electricity to homeowners and businesses. The customer agreements tend to run 20 years. The customers either lease the equipment for monthly rents or buy the electricity for an agreed price per kWh.
The tax benefits are allocated 99% to the tax equity partner. Cash is shared in a different ratio, with the solar company keeping 40% to 60%, sometimes more. It is the solar company's share of cash flow that is securitized. Between five and nine years out, the tax equity investor's interest in cash flips down to 5%, and the solar company has an option to buy out the investor.
In an inverted lease, the solar company leases the solar equipment to the tax equity investor and assigns it the customer agreements, putting the investor on the front line with the customers. It collects the revenue and pays most of it to the solar company as rent. The tax benefits are split.
What can reduce or block the cash flow for the solar company? The principal risks in the rooftop market are customer vacancy risk, policy changes around net metering and tax basis risk. Four states have revisited their net metering rules so far this year. It is possible another eight will do so.
Tax basis risk is the risk that the IRS will say the tax benefits were overstated. The tax equity market puts that risk on the solar company. Most projects are financed in a way that allows the tax benefits to be calculated on the fair market of a rooftop installations rather than their cost. This leaves room for argument.
The industry is watching several key cases that are moving through the US Federal Court of Claims involving the basis issues in wind and solar projects. They could go to trial later this year.
A significant issue in tax equity deals is whether cash otherwise payable to the solar company can be diverted to the tax equity investor to compensate the tax equity investor if, for example, the IRS reduces the tax credit. This can be done through cash sweeps or extending target IRRs and makes the sponsor share of cash flow less certain. Larger sponsors argue the tax equity investor should be satisfied with a parent guarantee of the indemnity payments.
The potentially moving flip date until the investor reaches its target yield is also a major source of uncertainty in tax equity deals that will be combined with sponsor-level debt. Basis risk feeds into this in cases where an indemnity will not be paid. Tax insurance has also been used to protect the securitized debt against this risk.
The collapse in the SunEdison share price last July 22 and the fall in share prices across yield cos and rooftop solar companies led analysts to question how they had been valuing solar rooftop companies. SCTY and RUN are rumored to be considering selling portfolios in order to establish a market valuation. Discount rates are expected to range from 7% to 9%, but the companies would like to prove 6%.
Tax equity raises about 40% of the fair market value of rooftop solar or $1.75 a watt. The companies are raising roughly another 80 cents a watt in back-levered debt at the sponsor level. Such debt is being used in tax equity structures at LIBOR + 250 to 350 bps to bridge to securitizations. ABS deals are easier once the tax equity has been taken out.
The market is interested in the use of PACE bonds in combination with tax equity to make the customer revenue stream more certain. The structures work, but the arrangers say they need residential customers to be able to deduct their payments over time to the solar company as property taxes or, alternatively, deduct them in part as rent on a home equity loan.