State of the tax equity market
Many renewable energy developers are having a hard time raising tax equity this year. A number of mainstream investors are no longer writing term sheets. Even investors who are still doing deals are turning down new business.
Four mainstream tax equity investors talked on a widely-heard conference call in late May about the state of the market. They are Peter Cross, a managing director with Credit Suisse Securities, Jorge Iragorri, head of the alternative financing group at Morgan Stanley, George Revock, head of alternative energy and project finance for Capital One, and Darren Van't Hof, managing director of environmental and community capital at US Bank. The following is an edited transcript. The moderator is Keith Martin with Norton Rose Fulbright in Washington.
Tax equity supply
MR. MARTIN: Darren Van't Hof, more developers than usual appear to be having trouble this year finding tax equity. Is that because there are more deals in the market or because there are fewer tax equity investors?
MR. VAN'T HOF: Developers are more anxious about getting commitments. The number of tax equity players has probably remained the same. There are roughly 12 to 15 traditional tax equity providers. Of those that we have been in contact with, they are fully intending to close on their commitments. Some are writing new term sheets at varying degrees of pace.
Separately, we have just over 20 investors that we bring into our transactions as co-investors. We have added a couple this spring that we had on hold. We have not had any investor say it is out of the market. There is some delay in getting commitments, but by and large, we think that commitments can still be had. Lastly to your point, there are more deals in the market. There has been an acceleration of activity, as was to be expected because of the four-year window to complete projects and the step down in tax credit amounts.
MR. MARTIN: Let me ask the same question of the others, starting with Peter Cross: are more developers than usual seeking tax equity or are there fewer tax equity investors?
MR. CROSS: Both. We have heard of a couple of investors tapping the brakes slightly, but I think concern about liquidity in the tax equity market has driven sponsors to line up, particularly in light of grandfathering issues, so there has been a little bit of a run on tax equity desks.
MR. MARTIN: Do you expect to do less, more or the same volume as last year?
MR. CROSS: About the same. Our business is really all solar, primarily in the commercial and industrial and residential sectors.
MR. MARTIN: Darren Van't Hof, do you expect to do less, the same, or more volume this year than last year?
MR. VAN'T HOF: Our current forecast is to do the same, but our hope is that we will be able, in the second half of the year, to increase our commitments over the plan. We have a few things to sort out before we can get there.
MR. MARTIN: Like what?
MR. VAN'T HOF: First and foremost, whether the additional opportunities fit within our risk framework. Second, the additional opportunities require more work. In a normal year, we are stretched from a human-resource capacity and this would simply exacerbate that.
MR. MARTIN: I think you are doing more syndication rather than direct investment this year. Is that correct?
MR. VAN'T HOF: We do about 50-50, so we hold about half of what we originate. We do full-on commitments to our developer partners, so when they get a US Bank commitment, it is from us. It is not contingent on being able to syndicate part of the investment. Between when we give the commitment and when the project is placed in service, we either sell down the entire position or a portion of it, with the assumption that if we are unable sell down, we will close the deal and hold the investment.
MR. MARTIN: Jorge Iragorri, what volume do you expect this year compared to last?
MR. IRAGORRI: Around the same. Given the uncertainty around COVID-19, we are still re-running numbers, but as of this moment, around the same.
MR. MARTIN: Is it your sense that there are fewer tax equity investors this year overall? Are there more deals pressing for attention? Peter Cross said that there seemed to have been a rush by sponsors to get in line so as not to be caught flat-footed later in the year.
MR. IRAGORRI: There was some slowness in March and April, for obvious reasons, but not due to lack of appetite. One thing that is different this year is deal quality. There are probably more deals generally, but there has been some deterioration in quality. The deals of poorer quality are still sputtering, and I think that may account for some of the indigestion that you hear about.
MR. MARTIN: When you say deals are of poorer quality, what do you mean?
MR. IRAGORRI: Some it is too much geographic concentration. Some markets are being massively overbuilt. Some of it is more offtake risk. Some of the offtakes, as everyone knows, have more embedded risks that we did not have to deal with in the past. Underwriting those risks is more challenging, particularly at a time when investors are being careful where they deploy capital.
MR. VAN'T HOF: A lack of quality deals does not necessarily translate to a lack of tax equity.
MR. MARTIN: George Revock, will Capital One do less, the same or more volume this year than last?
MR. REVOCK: There is plenty of deal flow to be had. However, we do not expect to have much tax capacity in 2020. That is primarily because we are already flush with tax credits from existing investments in low-income housing, new markets and renewable energy projects. We are bumping up against the 75% cap on how much tax liability can be reduced by claiming tax credits.
MR. MARTIN: Has your tax capacity been affected by coronavirus and the economic slowdown?
MR. REVOCK: Yes. We expect to remain profitable in 2020, but tax capacity for the year will be down. The question to which we still do not have an answer is how much 2020 pre-tax income will be generated and what does it translate into in terms of tax capacity.
MR. MARTIN: Do you expect to do any deals at all this year?
MR. REVOCK: We are expecting to do deals that commit this year and fund in 2021, unless there are changes in the tax code.
MR. MARTIN: Renewable energy tax equity was a $12 to $13 billion market last year. It had been expected to hit $15 billion this year. Given where things stand, does anybody have a sense where the figure will land ultimately? [Pause, no response.]
I take that as a no. It is a very concentrated market. Last year, two tax equity investors, JPMorgan and Bank of America, together accounted for about 50% of the market. Each did $3 billion. We have heard from one of them that it expects to do about $4.5 billion this year, and the other is also saying it is business as usual. That, plus the fact that three of the four tax equity investors on this call are still in the market doing a normal volume, suggest that we should do at least the same volume as last year and maybe a little higher.
MR. VAN'T HOF: The one thing to mention is that deals will slip. I think that the volume is there, but some of it might translate into 2021 volume.
MR. MARTIN: Good point. My numbers are commitments made during the year even though the funding may not be the same year. If someone comes in now with a new deal that he or she wants to close this year, what would be a realistic closing date?
MR. CROSS: The answer depends in part on whether it is a new client. If it is a repeat client and we have documents we can pull off the shelf, the deal will move faster.
We are getting to the stage where we are at risk of bumping up against the year-end deadline, and we are starting to look ahead to 2021. I think we could still get off a deal this year, particularly for an existing sponsor, but it is tough. We are getting kind of close to the end of the 2020 season.
MR. MARTIN: Jorge Iragorri, does it feel like we are at the end of what can be done in 2020?
MR. IRAGORRI: Yes, it does feel that way. We are closing on a variety of deals that we originated either last year or the beginning of this year. Any new mandates at this point are really for funding in 2021.
MR. MARTIN: Darren Van't Hof, same answer?
MR. VAN'T HOF: I would say we are getting pretty close, like Peter said. If it is an existing customer, we can move a little faster, but new customers will take longer.
MR. MARTIN: How have the tax equity terms have been affected by coronavirus, if at all?
MR. VAN'T HOF: Tax equity yields have gone up a bit. The sponsors are having to pay a bit of a premium in exchange for certainty and an ability to execute.
MR. MARTIN: Can you give us a sense how much yields have gone up?
MR. VAN'T HOF: People look at yields differently. Some people focus on the net present value and others look at internal rates of return. It may be a function of what metric you use, but let's say maybe 50 basis points.
MR. MARTIN: We heard last week on a lender call that debt spreads had widened by 50 basis points, but that many borrowers are waiting for the market to normalize before pulling the trigger on new borrowing. Jorge Iragorri, has there been any other change in tax equity terms as a consequence of economic conditions?
MR. IRAGORRI: Not many. Credit spreads to tax equity have a significantly delayed effect. We heard on one of these calls a couple months ago about yields widening in the bank term loan B and project bond markets. That generally does not translate immediately to the tax equity market. We have just been in a period where the spread had narrowed significantly. Net net, I am seeing roughly similar terms, probably slightly higher yields in exchange for execution certainty, but not a lot of changes elsewhere.
MR. MARTIN: Peter Cross, same answer?
MR. CROSS: Same answer. Maybe 25 to 50 basis points higher.
MR. MARTIN: Has any of you run into any force majeure or supply chain issues in deals on which you are working?
MR. REVOCK: We have a couple deals where suppliers have had issues that will push them into 2021. We have also had contractors warn that they may have to invoke force majeure, but none has done so yet.
MR. MARTIN: How has the pace of deals been affected by having to work from home?
MR. REVOCK: Aside from missing out on a three-hour round trip to commute to New York City, we have not missed a beat. The bank's management did a nice job preparing our systems for something like this. Obviously we miss the camaraderie of seeing our teams and our clients and other industry professionals, and my family is sick of seeing me every day, but it could be worse.
MR. MARTIN: Has anyone else on the call seen the pace of deals affected by having to work from home?
MR. VAN'T HOF: No effect. To echo George, I think our institution did an exceptional job of preparing folks to work from home.
MR. CROSS: We are firing on all cylinders.
We also canvassed all of our existing sponsors to assess their preparedness. This was in the early days when we were concerned about their ability to continue operating and maintaining projects for existing funds and deployment for funds that are currently in tranching mode. We have been impressed with the level of preparedness that all of our sponsors have. They were all working remotely. In many instances, they still had boots on the roofs.
It is not surprising that the big financial institutions have this in hand, but so do the sponsors.
MR. MARTIN: Do any of you have concerns about offtaker liquidity?
MR. IRAGORRI: We are re-evaluating every offtaker in a COVID world. We are looking at every offtaker, credit quality, liquidity, etc. So far, the offtakers that are in our pipeline all remain strong.
MR. MARTIN: The CARES Act authorized companies to carry back losses up to five years and get back taxes paid in the past. Will this make tax equity investors more interested in claiming a 100% depreciation bonus?
MR. REVOCK: The five-year carryback is helpful, but it really does not help us because tax credits cannot be carried back. If a company remains even slightly profitable in 2020, the carryback does not help at all. The tax credits we earn this year could be carried forward and might actually reduce our tax capacity in future years.
What would really help would be to allow a five-year tax credit carryback as opposed to a five-year carryback just for net operating losses. That would help us make full use of all the tax credits from our existing investments and also open up capacity to fund transactions this year and increase our tax capacity in future years.
MR. VAN'T HOF: We look at this quite a bit on the syndication side. If there were to be another round of stimulus bills, something that would be extremely beneficial not just to this industry, but also to other capital-intensive industries would be to allow tax credits to be carried back in time.
The ability to carry back net operating losses is marginally beneficial because they can be carried back to a period with higher tax rates. But the ability to carry back tax credits and allowing them to offset more than 75% of tax liability would have a much greater impact. These are ways Congress could support the market without having to initiate a big new program.
MR. MARTIN: There has been some discussion on Capitol Hill about these suggestions, but it is hard in the current climate to know what might ultimately be in the next bill.
Let's switch topics. President Trump issued an executive order on May 1 that immediately bans purchases, use or transfers of as-yet-unidentified equipment supplied by foreign adversary companies that could harm the US power grid. Darren Van't Hof, how are you dealing with that order?
MR. VAN'T HOF: We are looking at it closely. There has been a ton of discussion about which equipment, which countries and what parts of the grid are affected. The Solar Energy Industries Association and the American Council on Renewable Energy have been on top of this. We are just riding their coattails. There are no clear answers yet.
MR. MARTIN: Has anyone on the call formed a view about how to deal with the executive order? The Department of Energy is assuring the industry that the order will not prove disruptive.
MR. CROSS: The guidance we have gotten is that it does not apply to distributed generation, so we are of the view and hope that it does not affect our business.
MR. MARTIN: The order itself says that it does not apply to distributed generation. You are in an unusual position because of your focus on distributed generation. Jorge Iragorri, how has Morgan Stanley reacted to the order?
MR. IRAGORRI: Wait and see. We are waiting for other organizations to sort things out.
MR. MARTIN: George Revock, wind projects that were under construction for tax purposes in 2016 must be completed by the end of this year to qualify for tax credits.
The developer can buy more time by proving that continuous efforts have been made to advance the project since construction started, and an IRS notice is expected to allow five years instead of four to finish.
What happens when a project takes longer than the allowed time? Suppose a developer is prepared to offer proof of continuous efforts. Is he out of luck or will you finance projects that take longer than the four- or five-year period to construct?
MR. REVOCK: That's a tough question. We have been talking to some clients who are looking to go that route potentially. Unless the developer can get a private letter ruling from the IRS confirming the project still qualifies, it will end up being a supply-and-demand issue. We will focus first on projects that do not have this complication. We would probably look to avoid the scenario if we could.
MR. MARTIN: The IRS is not issuing private letter rulings on construction-start issues. There are developers who have kept very good logs showing what was done from one week or month to the next and who have tables showing significant costs being incurred steadily over time. Jorge Iragorri, how does Morgan Stanley look at this?
MR. IRAGORRI: We are more focused on solar than wind, so this has not really been an issue for us.
MR. MARTIN: Tax equity deals done between 2008 and 2015 are reaching flip points when sponsors can buy out the tax equity investors. Discount rates in the M&A market have gone up reflecting a perception of greater risk. One would think this should reduce sponsor call option prices. George Revock, has it?
MR. REVOCK: We are a relatively new player that started in 2014, so we have not really had any buy-out discussions yet. We expect to have the first couple ones within the next 12 months. Usually, our sponsor call options are priced at the greater of two or three amounts. Fair market value is just one of the amounts.
The higher discount rate would certainly reduce the fair market value, but the other prongs are an amount that protects our full-term yield and an amount that is at least the GAAP book balance.
MR. MARTIN: Darren Van't Hof, have you seen any change in sponsor call option prices?
MR. VAN'T HOF: A bit, but we are also seeing ones that are indexed to fair market value in our residential portfolio where candidly the prices are coming in higher than we projected. We have a sizeable portfolio of residential solar that tends to offset transactions on the C&I side or the utility side where discount rates have gone up.
MR. MARTIN: Has coronavirus affected the type of deals that you are prepared to do? For example, has it affected your interest in doing projects with corporate PPAs, hedged projects, rooftop solar, projects with community choice aggregators in California or community solar? Peter Cross, you are focused on C&I solar. You are dealing with a lot of corporate credits. Has coronavirus changed anything?
MR. CROSS: As Jorge Iragorri said, we are looking closely at all of our existing investments. We have a big residential solar exposure as well. I think there is clearly going to be hardship in that market.
We have always taken the view that we should be in a relatively good position since the alternative to paying the solar bill is to pay the local retail price for electricity, and it is higher. Logically you would think that the solar bill would be the last thing people will stop paying.
We have not seen, either on the corporate side or the residential side, a dramatic impact at all. It is still early days. We all need to keep watching. We are aware that some sponsors have implemented deferral plans in one-off situations where people are in economic distress. Any effect will be felt after a time lag.
MR. MARTIN: When you say there will be hardship in the residential market, are you referring just to these deferral plans where some homeowners may be out of work and do not have the cash to make payments in the short term?
MR. CROSS: Exactly.
MR. MARTIN: Jorge Iragorri, has there been any change in the types of deals you are prepared to do as a consequence of coronavirus?
MR. IRAGORRI: No. Our pipeline remains C&I, mostly focused on high-quality offtakes, and utility-scale again with high-quality offtakes. We have done some deals with CCAs as offtakers. We are not doing residential rooftop deals. Everywhere else we continue to do business as usual on a credit-by-credit basis.
MR. MARTIN: Has there been any change in appetite for merchant solar projects in ERCOT?
MR. IRAGORRI: No change. We would need an offtake.
MR. MARTIN: Does that mean you would not do them because there is no offtake contract? In the past, Morgan Stanley has been the tax equity investor and also provided a hedge.
MR. IRAGORRI: There has to be a hedge or a PPA.
MR. MARTIN: Darren Van't Hof, has there been any change in types of deals you are prepared to do as a result of coronavirus?
MR. VAN'T HOF: No, not wholesale. We are just like other institutions. We are doing a much deeper dive than maybe we would have done two years ago when we might have relied on a credit rating for the offtaker. The mix of project types is the same as in prior years.
MR. MARTIN: Electricity prices are falling. This leaves less cash flow and reduces the amount of tax equity raised, making it harder to absorb all of the depreciation on a project. Investors sometimes deal with this problem by agreeing to a deficit restoration obligation or DRO. How high are you seeing these go?
MR. VAN'T HOF: We have seen on the top end as high as 50%, but that is the extreme. Retail electricity prices have not been falling. On the utility-scale side, there are pockets of falling prices, but that has not been a driver for whether we need to accept a DRO.
MR. MARTIN: So falling electricity prices do not affect whether you need to post a DRO. Has anyone seen DROs go above 50%? I know we saw a term sheet yesterday at 70%.
MR. REVOCK: We have gone north of 50%, but in deals where we are taking a 100% depreciation bonus rather than five-year MACRS depreciation. At the end of five or six years, you are still in the same place, but your initial DRO might be very high because of expensing.
MR. MARTIN: Has there been any change in the percentage of the capital stack that is tax equity in the typical solar or wind deal, and what is the percentage?
MR. CROSS: Our product is different than the common tax equity structure. We are more of a hybrid of debt, cash equity and tax equity in that we will advance against as much as 99% of contracted cash flow. As a result, our flips are much farther out than the typical six- or seven-year structure. We could be advancing 80% of the capital stack.
MR. MARTIN: I think you are doing leveraged inverted leases where you are both the tax equity investor and lender. Is that correct?
MR. CROSS: We have moved to partnership flips of late.
MR. MARTIN: Jorge Iragorri, has there been any change in the percentage of the capital stack that is tax equity?
MR. IRAGORRI: No. We are doing solar partnership flip deals with a flip in seven or so years. The tax equity is between 30% and 40% of the capital stack. We are flexible on cash flow allocations, but we prefer more cash than normal.
MR. MARTIN: George Revock, where do you think tax equity is as a percentage of capital in wind deals?
MR. REVOCK: It has come down a little as pay-go structures become more common. We usually see it at 50% to 60% of the capital stack.
All of these percentages will drop as the tax credits start to step down. You might see the amount of cash that we get start to increase as we move more toward a lending type-proposition where the tax credits plus the depreciation become less of the tax equity return. Maybe at that point we start taking more cash, not only with the help of a DRO, but also to get to a more efficient structure.
MR. MARTIN: Why is the market moving to more pay-go structures? How does taking more cash get you to a more efficient structure?
MR. REVOCK: There are a couple of primary reasons for pay-go. For tax equity, it is a risk mitigant in downside wind scenarios. For the sponsors, there is less tax equity on day one, and this could create a more efficient structure. Pay-go is also expected to increase future cash distributions to the sponsor. If a structure is constrained by a DRO, one solution is to increase the tax equity investment, which may require additional cash to hit the flip. That said, such an approach could require a trade-off between an increase in the tax equity pre-tax cash return with a corresponding reduction to after-tax return to create a more efficient structure.
MR. MARTIN: Let's move to audience questions. Several questions come down to the same thing: how small a deal will you look at? One person framed it this way: would you invest in a series of $10 million deals from the same developer that add up to $100 million over time? Peter Cross, I assume that works if you set up a master financing facility for a series of C&I projects, correct?
MR. CROSS: Yes, if we put them into a single partnership. Our bite size is probably $100 million total.
MR. MARTIN: Darren Van't Hof, US Bank has traditionally looked at smaller projects. Where are you drawing the line at this point on how much tax equity is required for a deal to be of interest?
MR. VAN'T HOF: We are probably at $30 to $40 million on the small end. We see a lot of portfolios that have anywhere from five to 15 different projects. If they are all under one master PPA with one offtaker but happen to be at different sites, that is a lot different than if there are 10 sites and 10 different offtakers. The latter is inefficient to do from a legal and due diligence standpoint.
MR. MARTIN: We have a ton of audience questions and only about six minutes remaining. I will ask a question, and mention a name. Give me short answer that so we can fit in as many as possible.
Jorge Iragorri, are you putting out more or fewer term sheets now than you did pre-COVID-19?
MR. IRAGORRI: About the same. We slowed down a bit in March and April as we were trying to navigate the situation, but that did not stop us from putting out term sheets.
MR. MARTIN: George Revock, how strong is the appetite in the tax equity market for more deals in west Texas?
MR. REVOCK: I am probably the wrong guy to choose on that one. We have a lot of west Texas exposure in our portfolio. We are looking outside ERCOT because more than 50% of our portfolio is in Texas currently.
MR. MARTIN: Darren Van't Hof, are you seeing renewed interest in inverted leases since they do not make capital accounts go negative?
MR. VAN'T HOF: We still do a fair number of them. They are helpful particularly if you have a sponsor that can absorb some of the depreciation. On the syndication side, we have some investors that much prefer them. We are probably split 50-50 currently between inverted leases and partnership flips.
MR. MARTIN: Is the 50-50 split between inverted leases and partnership flips a consequence of the times or were you headed there anyway?
MR. VAN'T HOF: We were probably headed there anyway. We have not seen coronavirus or the economic shutdowns affecting choice of deal structure, at least not yet.
MR. MARTIN: What percentage of projects are taking bonus depreciation today? Is it more or less than in the past?
MR. VAN'T HOF: About the same. Bonus depreciation really is not that exciting for investors. If we need to take it for the benefit of a sponsor, we will, but the ability to absorb it is a challenge, and whether we will do it is a decision we make on a deal-by-deal basis.
MR. MARTIN: Has the inclusion of energy storage in more plain-vanilla solar and wind deals created any obvious hurdles or underwriting issues?
MR. VAN'T HOF: We are seeing a lot of storage. From an underwriting perspective, it comes down to an independent engineer review and technology review and the strength of the warranty. If the manufacturer does not have strong financials or the warranty falls short of what we need, there are insurance products around that. We are looking at a raft of ways to mitigate storage as it is still evolving as a technology.
MR. MARTIN: Peter Cross, there has been a lot of talk about C&I solar on this call. Are there any particular metrics that you are watching to determine whether there may be short-term problems?
MR. CROSS: We are always watching our accounts receivable, time outstanding, first customer payment dates and the like. They are nothing new or different, but we are keeping a sharp eye on them.
MR. MARTIN: Are any of you interested investing in carbon capture projects with section 45Q tax credits?
MR. VAN'T HOF: Not at this time.
MR. MARTIN: George Revock, once you have tax capacity, will they be of interest?
MR. REVOCK: We have looked at them. We will probably look at them a little more deeply in association with enhanced oil recovery, but it may turn out to be a tough market for us to wrap our hands around.