Tax equity primer for back-levered lenders
Back-levered loans remain a core financing tool in the US renewable energy market. Because such loans are behind tax equity in the capital stack for a typical project, it is critical for back-leverage lenders to understand key concepts in the tax equity arrangements because the tax equity has first claim on the cash flow needed to repay both types of financing. Many of these issues affect the lenders directly. Others are important pieces of the overall financial model for the project that should be understood.
There are several important concepts.
A partnership flip is the most common form of tax equity financing. About 80% of tax equity deals in the solar market and 100% in the wind market take this form.
The concept is simple. The US government offers two tax incentives for renewable energy projects: accelerated depreciation and tax credits. In most cases, the tax benefits can be claimed only by the owner of a project. By becoming a partner in a partnership that owns the project, a tax equity investor can be allocated a disproportionate share of the tax benefits on a project.
In a typical partnership flip, the tax equity investor is allocated 99% of income, loss and tax credits until it reaches a target yield. After the tax equity investor hits its target return, the partnership “flips,” meaning that the tax equity investor’s share of income, loss and tax credits drops to 5%. Cash is distributed in a different ratio. The cash sharing ratio varies from one deal to the next. However, the project developer typically takes a majority of cash both before and after the flip. The tax equity investor’s share of cash usually drops to 5% after the flip, although in some deals, it is as low as 2.5%.
The term “allocations” refers to how the income, loss and tax credits are shared by the partners. The word “distributions” refers to how cash is shared by the partners.
Lenders will be most concerned with cash distributions to the developer partner since back-levered debt is a loan to the developer partner against the future share of cash that partner expects to be distributed by the partnership. However, it is important for lenders to understand the allocations as well.
In some deals, the income, loss and tax credit allocations and cash distributions flip on different dates. However, in other deals, they flip on the same date (for example, the date that the tax equity investor hits its target yield). It is important for a lender to understand what triggers a flip in the cash sharing ratio and what might cause the flip date to vary from expectation.
There are different varieties of partnership flips, but most work as described.
The rest of this article assumes the tax equity partnership is a holding company that owns a special-purpose project company that owns a solar or wind project and the share of the tax equity investor in the project flips down once the investor reaches a target yield rather than on a fixed date.
Transfer of control
The primary collateral backing the back-levered loan is a pledge of the partnership interest held by the developer partner and the cash distributions to that partner. If the loan is not repaid, the lenders can foreclose on these interests and step into the shoes of the developer partner (or assume ownership of the developer partner). The developer partner is almost always the managing member of the partnership and is responsible for day-to-day operation of the business.
However, there are usually significant restrictions on transferring the developer partner’s interest with which a foreclosing lender must comply. These restrictions also often apply to indirect transfers (the transfer of the developer partner entity or even higher up the corporate structure). A “disposition” that is subject to change-of-control restrictions in the tax equity papers includes the transfer upon foreclosure (or in lieu of foreclosure) and any subsequent transfer of the developer partner interest or the developer partner entity.
A common restriction in existing tax equity deals is that the disposition cannot cause the tax equity partnership to terminate for tax purposes (often called a “technical termination”). A technical termination used to occur if there was a sale or exchange of 50% or more of the total interests in partnership capital and profits within a 12-month period. However, it no longer does. The new tax-cut bill that President Trump signed in late December 2017 eliminated the concept of technical terminations.
Other tax restrictions on the ability of a back-levered lender to foreclose include that the disposition cannot cause the partnership to turn into a corporation for tax purposes and cannot cause recapture of any tax credits claimed by the tax equity investor. It would be very unusual for these problems to arise. Some partnership agreements will permit a transfer that violates one or more of the transfer restrictions if the partner whose interest is transferred indemnifies the other partners for any harm.
If the lender forecloses, it may not be able to resell the interest to anyone buying electricity from the project. First, production tax credits, which are claimed on the electricity output from wind farms, can only be claimed on electricity sold to an unrelated person. A person, like a utility, that buys electricity and resells it immediately to its ratepayers is okay; the Internal Revenue Service ignores the intermediate sale. Second, the partnership will not be able to claim tax losses if it sells electricity to a partner or an affiliate of the partner.
More to the point, since the tax equity investor provided financing based on its belief that the developer was well placed to manage the wind farm, the investor will not be happy with a lender stepping into the role, and it may impose a time limit on how long the lender can hold the interest before transferring it to someone else, and it will require any subsequent transferee to meet net worth and experience tests. It will also want an experienced project operator in place in the interim while the lender is looking for someone to buy the developer’s interest.
If the tax equity deal is being negotiated at the same time as the back-levered loan, then the lender may be able to negotiate an advance waiver of some of the standard transfer restrictions in the tax equity documents that limit the ability of the developer partner to transfer its interest (whether in or out of foreclosure). It is time consuming and costly to negotiate consents after a deal is signed, if the tax equity investor is even willing to make any changes to the transfer restrictions.
In a tax equity transaction, the developer makes a series of representations and agrees to various covenants and must indemnify the tax equity investor if the developer breaches any of these undertakings.
Common tax representations that can trigger an indemnity if incorrect may include that the partnership is using the right tax basis to calculate tax benefits and when the project was first put in service. Tax credits might also be lost if the project was not under construction by a deadline that has already passed. The developer may be asked to represent that it was under construction in time.
In the case where tax credits are disallowed or recaptured, there is likely to be a very large indemnity payment owed to the tax equity investor, and the developer may have to add a “tax gross up” by dividing the underlying loss by one minus the corporate income tax rate. There also could be substantial interest owed to the IRS.
The developer will have provided a guaranty to the tax equity investor to guarantee payment of indemnities.
If the developer and guarantor fail to pay the indemnity promptly, then the tax equity investor is allowed to sweep cash that would otherwise have been distributed to the developer partner to pay the indemnity. Since this is source of payment of debt service on the back-levered loan, it is a problem for the back-levered lender.
Some transactions limit the percentage of cash that can be swept: for example, to 75% or 50%. Some allow cash to be swept only above the cash needed to pay scheduled principal and interest on the back-levered debt. Others allow a full sweep of all cash available for distribution to the partners.
In some deals, tax insurance may be purchased to pay the indemnity and avoid a cash sweep.
In a growing number of deals, the tax equity papers set a target flip date and if the flip has not occurred by that date, the tax equity investor is allowed to sweep cash to get to the flip yield as quickly as possible.
A lender needs to build mechanisms into the credit agreement to protect it in situations where sponsor cash is being swept to the tax equity investor. A common protection measure is a cash diversion indemnity or guaranty in which the parent of the developer partner agrees to contribute to the developer partner, for the benefit of the lender, cash to cover any cash diversions, which include, among other things, cash swept to the tax equity investor. Other protections that a lender might request include a cash reserve or other credit facility that can be accessed to make the lender whole.
Partnership flip deals almost always have “absorption” issues. Each partner has a capital account, which is a metric for tracking what the partner put into the partnership and is allowed to take out.
Since the tax equity investor will not have paid the full cost of the project for a fractional interest in the partnership, its capital account will not be large enough to absorb the full depreciation on the project. The only way it can be allocated 99% of the depreciation is by agreeing to make an additional investment, when the partnership liquidates, if the investor still has a negative capital account at that time. This is called a deficit restoration obligation or DRO. Tax equity partnerships do not liquidate in the ordinary course.
DROs have hit as high as 70% of the original investment in some deals recently.
The only way a tax equity investor will agree to such a high DRO is if the partnership continues to allocate the investor 99% of income from electricity sales after it reaches the flip yield. The additional income allocations increase its capital account. However, the investor will also want tax distributions to cover the taxes it will have to pay on this income. This will divert cash that would otherwise have gone to the developer partner who is the borrower on the back-levered loan.
The back-levered lender should examine the model to see when and to what extent the investor’s capital account will go negative and when the deficit is expected to be eliminated. The lender should require such tax distributions to be covered by a cash diversion guaranty,
Tax change risk
Tax equity deals negotiated during 2017 were being done at a time when no one could be sure what the US tax code would say. Congress spent most of the year talking about a massive tax bill. The bill was ultimately enacted at year end.
Fortunately, it did not change the amounts or already existing phase-out schedules for the investment tax credit or production tax credit for renewable energy projects.
However, the bill affected existing projects because it lowered the corporate tax rate.
The lower corporate tax rate has two main effects. First, a lower corporate tax rate makes depreciation less valuable. Each dollar of depreciation is now worth 21¢ per dollar of capital cost rather than 35¢ to a tax equity investor. A lender should look at the fixed tax assumptions — which is a list of tax risks that were borne by the tax equity investor — and at the instructions on computing the investor’s yield. The documents will say in one of these two places whether a fixed tax rate — for example, 35% — or the rate in effect at the time is to be used for tracking yield. Many older partnerships fixed the tax rate at 35%. More recent partnerships assume the “highest marginal rate” at any given time. The choice of tax rate could affect how quickly the investor will be considered to have reached the flip yield.
Many deals that were signed in 2017 require a one-time resizing of the tax equity investor’s investment in 2018 based on where the tax changes settled. In some deals, the investor is allowed to sweep cash to resize the investment if the investor invested too much based on the final corporate tax rate.
One thing developers will be interested in learning as 2018 unfolds is how tax-change risk will be handled in deals now that corporate tax reform is out of the way. Before 2017, with the exception of the corporate tax rate and sometimes how depreciation is calculated, the investor took tax-change risk about the deal structure, but otherwise tracked its yield based on actual tax results. It is too early to say whether the market will revert to past practice. ¥