Most renewable energy projects in the United States are financed with a “tax equity,” a form of equity that is a hybrid on the spectrum between debt and equity. The US government offers large tax incentives for using renewable energy to generate electricity. Most project developers cannot use the incentives directly, so they barter them for capital to build their projects. The tax equity market is in a weak state just like the debt market. Only a handful of institutions remain active investors.

The following is a transcript from a panel discussion in mid-December hosted by Infocast about the state of the market and whether new investors will emerge. The panelists included two arrangers who work on raising tax equity for projects: Phillip Mintun, managing director of Capstar Partners in New York, and Tim MacDonald, president of Meridian Clean Fuels in Boston. They also included four potential new investors: Michael Feldman, a managing director with Goldman Sachs, Joe Donahue, vice president for domestic tax planning at Marriott International, Inc., Darren Van’t Hof, a vice president with US Bancorp Community Development Corporation, and Stephen May, vice president for business development and asset acquisitions with PPL Development Company, an affiliate of PPL Corporation. The moderator is Keith Martin with Chadbourne in Washington.

MR. MARTIN: Phil Mintun, is it possible to get a commitment for tax equity today?

MR. MINTUN: The short answer is yes, but it is increasingly difficult because a number of the tax equity investors that have been in the market over the past two years have either exited or are currently on the sidelines. Some of this is due to consolidation in the financial institutions industry, and some of it is due to temporary issues.

MR. MARTIN: There appear to have been 18 large institutions that invested in the tax equity market in the last two years. How many do you think are still active?

MR. MINTUN: There are four still writing new commitments.

MR. MARTIN: If someone were to sign a term sheet today, when is the earliest he or she could hope to close the transaction?

MR. MINTUN: If no documents have been drafted and no due diligence has been done, then you are probably looking at something toward the end of the first quarter.

MR. MARTIN: Tim MacDonald, do you want to add anything to what Phil Mintun said?

MR. MacDONALD: Our view of the market is that it is very much in flux right now. For the most part, new commitments are difficult to get. I agree with what was just said.

MR. MARTIN: Phil Mintun, how long ahead are equity willing to lock in yields? If an equity quotes you a target yield today of 8.5%, how long will he hold that?

MR. MINTUN: We are seeing a lot of resistance against holding anything past the end of the first quarter.

MR. MARTIN: That’s three and a half months. What happens after the three and a half months?

MR. MINTUN: It depends. The yield might move after that until closing or funding based on an index like an appropriate swap rate.

MR. MARTIN: Where it is indexed to a swap rate, say a Bloomberg screen, would the yield generally move only up, not down? And would it move up a half point for every full percentage point increase?

MR. MINTUN: It really depends on the transaction and the sensitivity of the investor internal rate of return to some metrics. Typically what you see is a small band above and below the agreed IRR where a change in the underlying index would not lead to a change in the target yield. However, if the index moves beyond the band, then you would see an adjustment. Sometimes there is a half a basis point adjustment in IRR compared to a full basis point change in the underlying index. That is a fairly common approach.

In terms of up and down, the market has typically had both up and down movements, but with a floor on the downside. However, a downward adjustment in IRR is pretty tough to negotiate in today’s market.

MR. MARTIN: Tim MacDonald, if investors are unwilling to lock in yields more than one quarter at a time, what does a smaller developer do who needs an equity commitment at the start of construction to fund at the end and repay construction debt?

MR. MacDONALD: I’m not sure you couldn’t get someone to lock in at a price. I think our message is that we don’t know what that price is in today’s marketplace because the situation is fluid. However, in a normal market, there are investors who will agree that this is the price and they are in it for the duration of the commitment.

MR. MINTUN: In a well-functioning market, a benchmark index-type approach can work. One of the problems we have today is the general scarcity of capital means that potential investors are having to fight for capital internally within their organizations. There is no Bloomberg or Wall Street Journal-type index that one can look at to measure the internal fight for capital.

MR. MARTIN: Tim MacDonald, when do you see the tax equity market starting to improve? If we have only four investors today, when will it improve, and what will be the catalyst?

MR. MacDONALD: I think we will see new entrants in 2009. The big question is the general state of the economy. There are players today who have tax capacity and for whom yields are starting to look attractive, but if the economy continues to unravel, that changes.

A big part of what happens will turn on whether the credit markets unfreeze and banks resume lending. The hope is the credit markets will start to stabilize after the first of the year and, if that happens, then we would be pretty bullish that by the middle of 2009, the tax equity market will also have come back to life.

MR. MARTIN: Phil Mintun, any predictions on when in 2009 the market will start to turn around?

MR. MINTUN: No predictions, but I agree with Tim that it will take the fundamental return of some stability into the financial markets, and the re-entrance of existing investors or emergence of new investors will be key to bringing some stability back into our market.

Current Yields

MR. MARTIN: Where are yields today? Where would you say the bottom of the market is? I know the actual yield offered for any particular project turns on the market’s assessment of the riskiness of that project.

MR. MINTUN: The most common type of deal on the market at the moment is a portfolio of wind farms. There are still some deals that were committed earlier in 2008 that are working toward closing by the year end with yields in the mid- to high 7% range.

For new commitments today, people are looking at yields in the low 8s.

MR. MARTIN: Do the same yields hold for one-off projects? Are these figures just for wind? Would the same yields apply to solar PV? What about geothermal?

MR. MINTUN: I think for geothermal, depending on a number of factors, you are probably in the same ballpark. Maybe Darren Van’t Hof can address solar.

MR. MARTIN: Where would you put biomass?

MR. MINTUN: It has not been an active market recently, so I hesitate to answer.

MR. MARTIN: Tim MacDonald, any comments on yields?

MR. MacDONALD: I agree that the wind market appears to be trying to balance in the 8% range, but we see upward pressure on yields coming from the affordable housing market.

MR. MARTIN: Affordable housing is an alternative investment for many potential tax equity investors. Where are yields today in affordable housing?

MR. MacDONALD: They are in the 8% range and trending up.

MR. MARTIN: And the perception of the market is that there is less risk in an affordable housing investment than in a renewable energy project. Is that correct?

MR. MacDONALD: Yes. Generally, tax credits for affordable housing are more predictable because of the way the tax credit is structured. The affordable housing industry also has a very strong track record going back 15 to 20 years.

MR. MARTIN: Is the affordable housing market feeling the same strain as the renewable energy market in raising tax equity?

MR. MacDONALD: Yes, very much so. The housing market has been disrupted by the credit crunch.

MR. MARTIN: The yields you guys have been quoting have been driven largely by bank and insurance company investors. There is potentially a bifurcated market. You have a number of people sitting on the sidelines who probably would invest if the yields were much higher. You have the situation today where banks are offering the yields quoted, but they can’t fill out the syndicates, so developers cannot get full financing for projects at these yields. Is that a fair description of the current market?

MR. MINTUN: I think it is. There are less than a handful of people bidding currently on deals. The market has been dominated by financial institutions and, when you get outside of the world of financial institutions and talk to potential investors about joining syndicates, one of the things that you hear frequently is, you’re talking to us about an equity investment with a nominal after-tax return in the 7 or 8% range. That doesn’t sound like an equity return to us. The counter-argument is it is equity, but the partnership flip structure puts the tax equity investor in a preferred position where he gets his return before the sponsor. In some ways, what the investor has is an instrument with a stated return but a variable time frame.

MR. MARTIN: What is the difference in yields for leveraged versus unleveraged transactions and for PAYGO versus PAPS deals? For the audience’s benefit, PAPS means the investor pays the full purchase price to buy an interest in the project or projects at inception. PAYGO means the investor pays over time, usually partly as a percentage of the production tax credits on the electricity output. Leveraged means that there is debt at the level of the tax equity partnership or the project.

Phil Mintun, how do these things affect the yields?

MR. MINTUN: Historically, tax equity investors have not wanted to leverage deals because there is greater downside peril if the project isn’t performing. The nice thing about the unleveraged PAPS or partnership flip structure is that the structure allows the performance of the underlying project or portfolio to catch up, if you will, without the stress of a lender trying to foreclose or otherwise exercise remedies. Introducing a lender significantly increases the risk profile of the transaction for the tax equity investor.

Few leveraged deals have been done. Those that have been done have seen a premium on yield of somewhere in the range of 200 to 300 basis points.

With respect to pay-as-you-go structures, the IRS guidelines for partnership flip transactions limit the contingent payments to 25% of total consideration. When those deals were more common, you saw a premium on yield in the 75 basis point range. We have not seen much use of the PAYGO structure in the last year.

MR. MARTIN: Tim MacDonald, developers have a crossover point. As yields go up, at some point the money is just too expensive and the value they are getting for tax benefits is too little. The developers are better off keeping the tax subsidies, carrying them forward for up to 20 years, and using them when they can. Do you have any feel for where that crossover point is in terms of yield?

MR. MacDONALD: No, we haven’t really done that analysis, but keep in mind the following. Monetizing tax benefits is a nice way of raising money for developers who don’t have access to other sources of capital. There is a spectrum. For large, utility-owned sponsors who have access to a balance sheet and the capital markets, that analysis makes sense. I would suggest that smaller developers with fewer sources of capital on which to draw would still look at monetizing tax benefits beyond any crossover point at which a utility-backed sponsor might drop out.

MR. MARTIN: Escalating yields are another sign that the tax equity investors are paying less per dollar of tax benefit and a declining fraction of the project cost. What percentage of cost of a wind farm, for example, is covered by tax equity in the current market? What are the percentages for solar, geothermal, and biomass, if you know them?

MR. MINTUN: There is an interplay among a number of factors. One reason that tax equity is covering a declining share of project cost in the wind, geothermal and biomass markets that rely on production tax credits is construction costs have increased. The tax credits are tied to electricity output. The output doesn’t change. Therefore, the tax subsidy is smaller as a percentage of project cost.

That factor, combined with the higher yields on the tax equity, makes it very difficult to make these transactions as tax efficient as they could be. The tax equity investor runs out of capital before it can use all of the depreciation being thrown off by the project.

MR. MARTIN: So there are two problems in the current market. The investors are paying a declining percentage of tax subsidy value and then they are finding, because of the way partnership accounting works, they are not even able to absorb 99% of the tax benefits because they paid so little for them.

MR. MINTUN: That’s correct.

MR. MARTIN: So, in wind, there used to be a rule of thumb that tax equity would cover 65% of the capital cost. The percentage is probably closer to 50% today, perhaps even lower.

MR. MINTUN: That’s about right. It’s around 50%, and sometimes lower.

MR. MARTIN: What about geothermal?

MR. MINTUN: Geothermal projects by and large tend to have a little more room to play. You can still get up to in the 60s and even to the 65% level that you indicated.

MR. MARTIN: Why is that? Because there are additional tax benefits in the form of deductions for intangible drilling costs and depletion?

MR. MINTUN: It is due to a number of things, but the underlying project IRRs tend to be a little more robust.

Potential New Investors

MR. MARTIN: Let’s bring the other panelists into the discussion. Michael Feldman, you heard Phil Mintun describe these tax equity investments as approaching fixed-return investments with a variable time frame as a way of justifying what are essentially bank-driven yields. Does that ring true with you in terms of where yields ought to be on these types of instruments?

MR. FELDMAN: In general, I would say yes. They have many properties of fixed-income investments. In terms of risks, they also share a lot of characteristics of fixed-income, but we also have to be mindful of their operating risks, construction risks, things like wind risk and so forth.

MR. MARTIN: I believe Goldman Sachs had been an investor in these markets, but just not recently, and it is now interested in investing again. What sorts of projects interest you?

MR. FELDMAN: We have solar, wind, and geothermal tax equity positions in our portfolio and would very much like to be in more. We are interested in all of those spaces.

MR. MARTIN: What do you need to see to invest? What sort of yields? What else?

MR. FELDMAN: We are looking for high-quality transactions. We think about pricing within a context of other opportunities in which we can deploy our capital.

MR. MARTIN: What’s the comparison? I think you told me before the call you use a risk-adjusted return format. What does that mean?

MR. FELDMAN: We think about it in terms of risk-adjusted returns. Every project is a little different in terms of how risky it is based on its particular nuances, its offtaker, its level of other operating risks and so forth. In terms of what we compare it to, I would say it’s a basket of other fixed-income investments.

MR. MARTIN: Have you made any investments since the tax equity market started to struggle in mid-September?

MR. FELDMAN: Not yet, but we are looking at a number of opportunities, and we certainly hope to close some soon.

MR. MARTIN: Joe Donahue, has Marriott invested yet in renewable energy projects? If so, what kinds?

MR. DONAHUE: We were pretty big investors in the synfuel market. The tax credits on those investments expired in 2007. We are just beginning to look at new investments. We have done one solar transaction to date.

Getting back to the earlier question about whether partnership flip positions are debt-like or do they require higher returns, we approach these investments in part as a way to manage our effective tax rate. We don’t have a large portfolio of investments where we need to balance different risks and returns. I agree with Phil Mintun that the preferred position the investor has for his return justifies the lower level of return. The tax subsidies come effectively from the government, which is a pretty good credit risk.

We still have to report to our internal investment committee and we are competing with every other hotel or timeshare project that comes up. So we need to meet internal hurdle rates and investing standards. We have had some theoretical discussions about whether we should look at tax equity investments on a risk-adjusted basis, but we haven’t gotten a full buy-in yet. That is something that we continue to work on.

MR. MARTIN: Michael Feldman says Goldman Sachs compares these investments to a basket of other fixed-income investments, but you are comparing them to yields that can be earned on a hotel project. Where are those yields at the moment?

MR. DONAHUE: Different hotel projects have different yields. We have internal hurdle rates that we have at least to meet before we can present a project to our investment committee. And once you get in there, you are competing with other deals. A lot of what we have seen initially does not meet the hurdle rate. We continue to try to find transactions that will get us at least to that level.

MR. MARTIN: The one solar deal in which Marriott invested was a utility-scale photovoltaic project. Are there other renewable energy sectors — biomass, geothermal, wind, smaller-scale solar — where you feel you understand the business risks well enough to invest? Obviously you have stepped up to utility-scale photovoltaics.

MR. DONAHUE: We are in the process of learning about the different technologies and markets. As we did with synfuel, if we can get our arms around the operating risks, we can get comfortable with most of the different technologies.

MR. MARTIN: Steve May, there has been speculation about whether utilities can step into the breach and replace the banks and insurance companies that have withdrawn from the tax equity market. Utilities tend to have tax capacity. However, when you and I spoke on a prep call last week, it didn’t seem like PPL is ready to make the leap. Where is your company in terms of investing as a tax equity investor?

MR. MAY: We were starting to look at wind tax equity deals last summer and had done a fair amount of due diligence on one particular portfolio of wind projects. However, in September, we basically exited.

We had also looked at investing as true equity in wind farms and came close on a couple of transactions in the last couple years. However, what we were seeing in 2008 was that straight equity was being offered roughly the same yield we were being offered on wind tax equity deals. For that reason, we thought that the risk-return relation for wind tax equity at almost the same yields made sense for us, given that we can fully use the tax benefits. Unfortunately, once the financial credit crisis hit, we exited. We are out of the market for now.

MR. MARTIN: So what is keeping you out of the market is a desire to conserve cash?

MR. MAY: Capital is precious. It is very expensive to issue debt and equity. For those reasons, we are on hold for now.

MR. MARTIN: But otherwise, you have a tax capacity?

MR. MAY: Yes.

MR. MARTIN: This past summer, the IRS made it possible for utilities to own up to 99% of a project in partnership with a developer, buy all the output and take 99% of the tax benefits. A lot of people wondered whether this might open the door to more utility investment. But if your utility is typical of utilities generally, it sounds like that structure has no special appeal. Or maybe it does have appeal, but this is just a time when you need to conserve cash.

MR. MAY: We had been looking at owning part of a wind project and being 100% of the offtake. I’m on the unregulated side of the business versus the utility regulated side of the business. In some of the deals that we had looked at, we felt constrained not to take more than 50% of the tax subsidies because our affiliate was buying all the output. The fact that the IRS has now relaxed that limit is something that will be useful for us when we get back into the market. It provides flexibility.

MR. MARTIN: What is the credit rating for your holding company? Is it triple B? Single A?

MR. MAY: On the unregulated side of the business, our debt is rated BBB/Baa2, so mid-investment grade. The utility is rated A minus.

MR. MARTIN: The word on the street is that anybody below a single A is having a very difficult time raising capital. Even long-established and stodgy utilities and their regulated affiliates are having trouble. Is it your experience that the credit markets are not really open?

MR. MAY: It is pretty difficult to issue debt or equity today. I think it can be done, but it’s expensive. We would prefer not to do that.

MR. MARTIN: Darren Van’t Hof, I believe your message is that US Bancorp is open for business. In fact, you are eager to invest in solar projects, especially solar PV. Are you interested in solar PV across the board: residential, big-box stores, utility scale? Where do you draw the line?

MR. VAN’T HOF: It is all of those, and we have closed on sale-leasebacks. We have closed on partnership flips. We have done big-box retail. We have done residential. We’ve not done a utility scale; we are looking at a couple now.

I think unlike what was said earlier, we actually like a leveraged structure. We like to see debt in our transactions if it is structured so that there is a period of standstill to cover our recapture risk.

As far as the bank is concerned, we have a strong tax credit appetite. We have good cash and liquidity positions. We are open for business.

We are not actually doing any wind right now. We are not doing geothermal or biomass. We looked at wind a year ago and it wasn’t that appealing. We might look at it again.

MR. MARTIN: You just anticipated my next question. I know you personally work on solar, but you are saying there is no one else in the bank doing wind, geothermal, or biomass at this time?

MR. VAN’T HOF: We have an energy lending group in Denver and it is lending to wind farms. We are still evaluating whether we want to take tax equity positions in projects where the bank is also a lender.

MR. MARTIN: Do you have a preferred structure in the solar deals you work on? You said you do both sale-leasebacks and partnerships.

MR. VAN’T HOF: We defer to the customer. Whatever produces the most benefit for the project.

MR. MARTIN: You heard the discussion earlier about yields in the market and Phil Mintun deflected a question about where solar PV yields are compared to the benchmark rates he quoted for wind. What is your sense about where yields are in the PV market?

MR. VAN’T HOF: It is a risk-adjusted return. We don’t really use IRR as our metric for investment. We use a couple other things. Yields are going up.

MR. MARTIN: Michael Feldman, do you feel any constraints on your current ability to invest: a potential lack of tax capacity, a lack of cash or the need to conserve cash?

MR. FELDMAN: No. I would emphasize that we are open for business and are actively looking at transactions.

MR. MARTIN: Where would you put your time first on diligence to make sure it is worth investing more time in a possible deal? Let’s say somebody brings you a wind farm or a solar project. What do you look at first?

MR. FELDMAN: It is a series of different items, but the quality of the offtake agreement and its terms are very important, as are warranties and other aspects of operating risk.

MR. MARTIN: Joe Donahue, same question: where would you put your time first? You are in the tax department, so your focus tends to be on tax issues.

MR. DONAHUE: Right. We look first at the financial projections and make sure they meet our hurdle rates and make sense. We put them through our own internal modeling. Then it’s what is the technology? Who is the sponsor? We see what kind of expert studies have been done. Then we have a tax person look at the structure to make sure the allocations work. What are the risks? What level of probability are we going to get to on any tax opinion? Are we going to be able to book these benefits or not?

I don’t think you ever do one thing first. You just sort of jump in and start looking at a bunch of them. But I think the financial projections are the starting point. We may not get farther than that.

MR. MARTIN: The economic news is so unrelentingly grim these days, and we have read about a slowdown in business travel. I assume a hotel company would also feel some slowdown? Are there any concerns about tax capacity going forward?

MR. DONAHUE: We are a hotel management company, so we should have tax capacity going forward. Although I would encourage everybody to continue to travel and stay in hotels.

MR. MARTIN: Including Ritz-Carltons, which are managed by Marriott.

MR. DONAHUE: Yes, Ritz-Carltons are. We have capacity, although there is always uncertainty about the future. That may constrict cash and other competing investments could look better as the economy weakens and asset values weaken.

MR. MARTIN: Steve May, you come at this from the power company perspective. You are already in the power business. Where do you put your time first if somebody asks you to invest in a renewable energy project?

MR. MAY: We were looking at supplying wind tax equity earlier because we saw the returns in that market that were comparable, but with less risk, to a straight equity deal. Our main business is investing in different technologies as a straight equity investor, so if we had more capital, there are probably better opportunities for higher returns in those types of investments than there are in wind tax equity.

MR. MARTIN: Darren Van’t Hof, you are doing solar PV. If you could spend time on just one issue when a potential deal comes in the door to tell whether it is worth going farther, what is it?

MR. VAN’T HOF: The integrator and the sponsor are very important. So is the strength of the offtaker. It depends on how the transaction is structured. If we need a large amount of cash to reach our hurdle rate, clearly we will look a lot more closely at operating risks than if our return is made up largely of tax subsidies that are tied to the project cost.

Potential Legislative Changes

MR. MARTIN: Various ideas are being discussed within the Obama transition team and also on Capitol Hill to revive the tax equity market, and they include such things as making production tax credits and investment tax credits refundable or allowing tax benefits that cannot be used to be carried back for five years — possibly longer — and used to recover taxes that a company paid in the past. Whatever is done would only apply to projects placed in service during a one- or two-year window when the tax equity markets are expected to be struggling. Do you see refundability or extended carrybacks having an appreciable effect on the tax equity market? Will either of these ideas revive the market?

MR. DONAHUE: We have been a taxpayer and expect to be a taxpayer, so we think we can use the tax credits currently anyway. Neither idea would change anything for us.

MR. MARTIN: Would it make you more confident investing, because you don’t have to be as accurate about your ability to use the benefits?

MR. DONAHUE: Yes, I think so, although we don’t invest up to our full capacity.

MR. MARTIN: Tim MacDonald or Phil Mintun, you have been out in the market trying to raise tax equity. If you had either of these options in your arsenal, do you think it would help?

MR. MacDONALD: I’m not convinced it would make that big a difference. The bigger question is finding a hurdle rate that people like Joe Donahue at Marriott, which has tax capacity, feel provides them with an attractive enough return to invest.

MR. MINTUN: I agree with that. I think it may have some marginal benefit, but I think if people that are considering investing with tax equity in this marketplace have significant questions about their tax positions, they are more likely to exit outright than they are to rely on the ability to claim a refund either from the Treasury directly or by carrying back unused tax benefits. It may make a difference for one or two players. I’m not convinced it will have a huge impact at the margin.

MR. MARTIN: Maybe these answers should not be surprising. There were six ideas batted around by the industry with members of Congress to try to revive the market, and each one tended to focus on a different pool of potential new investors. Refundability looks to the government as the investor of last resort. It probably is of greater interest to developers; it doesn’t really expand the pool of private tax equity. It would give developers the ability to get a little cash for tax benefits that otherwise go to waste because they can’t use them and haven’t been able to do a deal yet.

If depreciation isn’t also refundable, but tax credits are, I suppose the developer might securitize the future refund stream. But he will only get a fraction of the tax subsidy he was hoping for otherwise. If the market recovers and somebody has chosen to get refunds of tax credits, but kept the depreciation, do you think it’s possible to do a deal around just the depreciation once the market recovers?

MR. DONAHUE: Most of our investors don’t value depreciation that highly. They really are driven by the tax credits.

MR. VAN’T HOF: I agree with Tim. Depreciation alone is not terribly attractive to us. Depreciation is discounted on our balance sheet.