Update: Tax Equity Market
Most renewable energy projects in the United States have been financed in the past largely with tax equity. The US government pays as much as 65% of the capital cost of such projects through tax incentives. Few developers can use the incentives directly, so they barter them in tax equity transactions to raise capital for their projects.
The tax equity market largely collapsed after Lehman went bankrupt in September 2008. Congress reacted by directing the US Treasury in an economic stimulus bill in February 2009 to pay owners of new renewable projects completed in 2009 or 2010, or that start construction in 2009 or 2010, 30% of the project cost in cash in place of part of the tax incentives. The tax equity market started to revive after the Treasury issued rules implementing the 30% cash grant program in July 2009. There were at least 15 active tax equity investors by April 2010, down somewhat from the number before the market collapsed.
The following is an edited transcript of a discussion among six of the largest tax equity investors about the state of the market at an Infocast wind finance summit in late February in San Diego. The panelists are John Eber, managing director of energy investments for JPMorgan Capital Corporation, Jeetu Balchandani, director of private securities, structured leasing and tax investments at MetLife, Jack Cargas, managing director of energy and power finance at Bank of America, Lance Markowitz, senior vice president of the equipment leasing division at Union Bank of California, Marshal Salant, a managing director at Citigroup, and Jerry Smith, a managing director at Credit Suisse. The moderator is Keith Martin with Chadbourne.
MR. MARTIN: What do you see in the year ahead for the tax equity market?
MR. MARKOWITZ: It will be a much stronger year than 2009. We should see a large number of deals. There will be more variety in deal structures. There are more tax equity investors in the market.
MR. BALCHANDANI: The pipeline of deals expected to come to market this year suggests a demand for tax equity that will far outstrip the supply. Anyone looking for tax equity in 2010 should keep in mind there will be limited capacity. Start talking to potential tax equity investors as early in the year as possible.
MR. SALANT: I agree with the point that was just made. Demand for tax equity could easily reach $10 billion a year in 2010 and 2011. If JPMorgan takes $1 billion, we take $1 billion and each other person at this table takes $750 million, you are still $5 billion short, and it is not a simple matter for any of us to close on that volume of transactions this year. The days of casual dating are over in tax equity investing. Tax base is a precious commodity. Investors will want to preserve it for use with their most important relationship clients.
MR. EBER: More deals were done last year in the tax equity market than I think most people realize. We counted 19 wind tax equity deals that reached funding last year for total tax equity of $1.8 billion. That is about half of the tax equity invested in wind in 2008, but it is still a lot more than most people expected given how weak the economy was in 2009.
The most interesting thing about 2009 — and it will continue into 2010 — is that wind developers have options. The US Treasury is paying the cash value of the tax credits on wind farms. Wind companies no longer need to use tax equity, and a lot of companies did not last year. There was a lot of debt raised. Over $5 billion in debt went into wind farms in 2009, more than double the amount of debt the year before.
I agree that tax equity remains scarce. We will see the gap between demand for and supply of tax equity filled with debt.
MR. MARTIN: You said 19 deals last year. How many involved cash grants? How many were legacy deals where tax equity investors committed in 2008 but did not fund until 2009?
MR. EBER: Eight of the 19, or about half, were carryover, almost $1 billion of the $1.8 billion. The majority of the legacy deals — maybe five or six — were deals in which the tax equity investor is claiming production tax credits. We counted seven transactions last year involving Treasury cash grants. Going forward, most deals will involve cash grants.
Mr. MARTIN: Jeetu Balchandani, how many deals will MetLife do in 2010?
MR. BALCHANDANI: Somewhere between eight and 10. In terms of total dollars out the door, somewhere around $500 million in tax equity.
MR. MARTIN: Jack Cargas, is there a way to measure the number of deals that Bank of America will do this year?
MR. CARGAS: There is a way to measure, but I’m not sure I am going to say exactly what that measure is. [Laughter.] We have hundreds of millions of dollars to deploy this year. We will do more than a few transactions, but fewer than too many. [Laughter.]
MR. MARTIN: Lance Markowitz, what about Union Bank?
MR. MARKOWITZ: We will be disappointed if we do fewer than seven or eight transactions this year. Like everyone else, we are constrained not only by a limited tax capacity, but also by internal resources — people.
MR. MARTIN: Jerry Smith, what is the number for Credit Suisse?
MR. SMITH: No exact number. We are looking for the right opportunities. We do not have a cap on how many deals we can do, but there is a natural cap based on internal resources and the quality of transactions that are presented.
MR. MARTIN: I am getting a sense that developers can wait. They do not have to call you next week. There is enough tax capacity in the market that they can wait until March, for example. [Laughter.]
MR. SMITH: Next week would be good though. [Laughter.] We have a hole to fill in the middle of the year.
MR. MARTIN: John Eber, are there parts of the country or types of wind deals that you just will not do? For example, is Texas off limits?
MR. EBER: We have a pretty diversified portfolio. We have done 58 wind deals in 16 states, so we are not worried about geography. However, we are looking for deals with the right characteristics. We are looking for projects with power purchase agreements. We want reliable transmission. There are some parts of the country and specific areas within certain states where there are transmission constraints and projects are at risk of being curtailed.
MR. MARTIN: Will you do offshore wind?
MR. EBER: No one has brought me a deal, so I have not had to answer that question yet.
MR. MARTIN: Marshal Salant, what is the answer from Citigroup to the same questions I just put to John Eber?
MR. SALANT: No one has shown us an offshore wind project yet that was far enough advanced to be able to analyze fully. Geography is not a constraint at this point. Generally, we want projects with PPAs, but we will do projects with hedges where we are providing the hedge or we are comfortable with how the hedge is structured with another hedge counterparty. We are not doing merchant projects. With all the deals to choose from right now, it is hard to convince people it is worth taking the risk.
MR. MARTIN: Is there anyone on the panel who will do merchant projects or who thinks he will be doing such projects by the end of the year? [Silence.]
MR. MARTIN: I suspect if I were to ask this panel to look at the list of top wind companies, all of you would want to do tax equity deals with the top ten companies and none below that. Is there a way to describe where you draw the line on developers who are too small, too inexperienced, or who have too small a pipeline of potential transactions?
MR. EBER: We have done deals with small developers. When we started in 2003, most developers were small. Many of them were privately owned. To us, it is more a question of the developer having not only the requisite skills to develop and operate, but also having some real capital to put into the project alongside our capital. We want the developer to have significant capital at risk. That’s more important than sheer size.
MR. CARGAS: I agree with what John just said. There are several small developers whom we are actively considering because the project metrics look good, the return looks good, and they have significant capital at risk, which makes us more confident they will be as interested as we are in seeing the project succeed. I don’t think it is accurate to say we are all focused on just the top 10.
MR. MARTIN: Jerry Smith, are yields headed up or down in the tax equity market?
JERRY SMITH: Up.
MR. MARTIN: Before we set a pattern that developers won’t like, does anyone think that they are headed down? [Laughter.] [Silence.] Does anyone think they will stay where they are currently for a good part of the year?
MR. EBER: I think they will remain stable. The returns we have been getting for the last six to eight months have not varied that much. I don’t see that changing in the near term.
MR. MARTIN: John Eber, at the REFF conference in San Francisco last fall, I said tax equity yields were in the 8% to 9% range for the least risky assets — for example, wind farms with proven turbines in places other than Texas. You said yields were at the bottom end of that range. Does that remain true?
MR. EBER: Not much has changed since then.
MR. MARTIN: Those are after-tax yields in unleveraged transactions. Does anyone on the panel disagree with what John just said. [Silence.] At an Infocast conference in late January in New Orleans, Ted Brandt from Marathon Capital argued that tax equity is less expensive in lease structures than partnership flips. He suggested yields in leases could be in the 7% to 8% range. Does anyone want to agree or disagree with Ted?
MR. SMITH: I disagree with him. I see no reason why a tax equity investor would take a lower yield in a lease than he would in a flip partnership.
MR. EBER: The only leasing we have seen getting done currently is in the solar space. It is single investor and the returns we have seen are pretty consistent with the partnership flip returns in the wind space.
MR. MARTIN: Lance Markowitz, what drives the tax equity yields? How closely correlated are they to interest rates, for example?
MR. MARKOWITZ: There is some correlation to interest rates, but tax equity yields are driven more directly by supply and demand. As we were discussing earlier, many traditional tax equity investors did not have much tax appetite last year. That made for a smaller supply of tax equity in relation to demand and drove up yields.
MR. MARTIN: Do the rest of you see it the same way, or is there a stronger correlation with interest rates? Debt competes with tax equity as an alternative way of financing projects.
MR. CARGAS: Interest rates play a role, but it is a loose correlation. The biggest driver for us is how we value our tax balance sheet and how we want to price it. Competing demands on our money from other market segments also has an effect on how much we will want for use of our capital for a wind deal. For example, we have done some pretty significant single-investor leasing of solar projects. We, as well as others on this panel, are involved in the low-income housing tax credit market. That’s another place to put capital and yields in that market have been significantly higher on a risk-adjusted basis lately than in wind.
MR. SALANT: I agree there is an indirect correlation to interest rates if for no other reason than banks have a cost of funds for the capital they invest. I see four variables, one being what it costs banks or others to fund their own balance sheets. Another is hurdle rates within different firms. The spread between cost of funds and hurdle rates is wider now than before because we just went through a credit meltdown and people are more risk averse than they were before. Then there is tax capacity. The last factor is yields on competing uses of funds, like other forms of renewable energy and low-income housing.
MR. MARTIN: Let me test what John Eber said about yields remaining steady. I heard no disagreement from any of you about that, but I also heard that you are expecting to be overwhelmed this year by demand for tax equity. I also heard that the cost of funds will be a factor, and I have been reading in the paper about Greece, and possibly Spain and Portugal, having economic trouble, with the result that credit default rates are going up. Is there a disconnect? Can yields remain steady if you have such pressure on the demand side and the cost of funds?
MR. EBER: The reason I say that yields will remain steady is that, for years in this business, we were really fortunate that people had to use tax equity and, as I mentioned before, today, most companies don’t appear to have to use tax equity. It is a nice option. It gets more value for tax subsidies than the subsidies are worth if the developer retains them and carries them forward. However, there is a cap on how high tax equity yields can go above which developers will just borrow money, forgo immediate use of the tax subsidies and use them later in the life cycle of the wind project.
MR. MARTIN: That is how tax equity yields are tied to interest rates.
MR. EBER: Yes. There is an equilibrium imposed by the competition with debt financing, and that is a new phenomenon. The fact that the developer can trade the tax credits on his project for a cash grant from the US Treasury changed the dynamics of the tax equity market.
MR. MARTIN: Let me throw this question out like a jump ball. What percentage of wind deals in the tax equity market this year will involve production tax credits versus Treasury cash grants?
MR. EBER: Ten or 15%.
MR. MARTIN: That’s small. Anybody disagree?
MR. SALANT: All the deals we are looking at now involve cash grants. If you are talking about future deals, maybe one out of 10 will involve production tax credits.
MR. MARTIN: Jeetu Balchandani, how much of a premium does a tax equity investor charge for use of his money if there is leverage at the project level in a partnership flip transaction?
MR. BALCHANDANI: We think current yields in leveraged flip deals are between 13% and 15%.
MR. MARTIN: Whoa. If you are at 8% or 9% without leverage, that is a huge premium.
MR. BALCHANDANI: Yes.
MR. MARTIN: Does anyone have a different view of the premium?
MR. SALANT: Leveraged yields have bounced all over the place. Most of the deals that Citi is looking at today are leveraged transactions; some even include DOE guarantees on top of the debt. The spreads are definitely wide. We have not seen any leveraged yields get anywhere close to 10%. I would say 12% is a good number. I would not expect to have to go to 13% to 15%, but it depends on the deal.
MR. MARTIN: John Eber, you and I have been on a lot of panel discussions together. In the past, people have always said the yield premium for project-level debt was 250 to 300 basis points. How does that square with what you just heard?
MR. EBER: They were talking about the yield premium on the old production tax credit flip deals that were leveraged and, on those deals, the average life of a tax equity investment was much longer, so you could get a couple hundred more basis points and be adequately compensated on a risk-reward basis. If you look at the deals with the Treasury cash grant, the tax equity gets paid back incredibly fast, so this high return you just heard about is a little deceptive because the tax equity investor is earning it over a very short period of time. His book earnings and the nature of the investment are significantly different than in the old PTC deals; therefore, the yields that investors have been looking for in cash grant transactions will look different.
MR. MARTIN: Isn’t there something inconsistent with saying the investor needs a much higher yield than before if there is leverage, but he is getting paid back more quickly so that he is not exposed to the debt for as long a period of time as before?
MR. EBER: There is a faster payback, but leverage creates long-term issues. The investor’s yield tends to go backwards as the debt is being repaid because cash goes to repay debt, but the investor still has to report the electricity revenue as taxable income. It could take you 15 or 16 years before you finally get out of that position.
Cash Grant Issues
MR. MARTIN: Has any of you run into issues with the Treasury cash grants or is the program just working fine?
MR. CARGAS: We have run into a few issues where payment of grants was delayed while the developer responded to questions from the Treasury. We have been hearing in the solar residential sector that there may be a cap on how large a grant the Treasury is willing to pay per watt of installed capacity.
MR. EBER: We have done wind deals with Treasury cash grants. Everything has gone smoothly. The grants were paid quickly. We have been pleasantly surprised at how well the program has worked.
MR. SALANT: We were also pleasantly surprised on the AES deal that we did. The Treasury delivered the money right away. Everything went incredibly smoothly.
MR. MARTIN: If there are no other issues with the current program, has any of you had time to look at the bill that was introduced in the House last week to extend the cash grant program, but make the grants look more like tax refunds. If so, do you have a view whether that works?
MR. EBER: Economically, it seems to be the same as what we have currently with the grant. My sense is it was just a way to move the whole program more under the IRS and get it out from under DOE and NREL, but it looks to me like a nice substitute. The real beauty of it is you are talking about a two-year extension of a cash-type program. The industry would prefer to extend the existing grant for two another years without any changes, but that doesn’t seem to be on the table at the moment, so it looks good to me to get two more years of a similar kind of program.
MR. CARGAS: My reaction is why not leave well enough alone? Congress seems to going out of its way to emphasize that the refundable tax credit would work just like the existing cash grant. Well, in order to do that, one must codify a lot of law. Why not simply change a date and extend the existing program?
MR. MARTIN: There is a feeling in the House that if the date were merely changed, then the spending committees would have to get involved. It would require a new appropriation. The mood has turned dark in Washington on additional spending. The public is concerned about large budget deficits. The House tax committee wants to find a way to extend the program without having to get a new appropriation.
MR. SMITH: The biggest issue I see is there has been a trend to bridge the cash grant either with debt or tax equity. It is easy to get a tax equity investor to bridge the grant when it is a 60-day exposure. Changing to a tax refund program elongates the exposure. There is more uncertainty about when the refund will be paid.
MR. SALANT: It really is a shame. This is a classic story of Washington politics. We are taking a program that everyone believes works well and making it so much more complicated because we are trying to avoid having to pass it through multiple committees in Congress.
MR. EBER: There is also some irony because the industry asked last year for a refundable tax credit. Everyone likes the cash grant program that Congress gave us instead. Now the House is proposing to go back to what we originally requested. It puts the industry in an awkward position to turn it down and ask for something else when that something else is not even on the table.
MR. MARTIN: Let me take a flash poll of the audience. How many people are concerned that the federal budget deficit it too high? [Laughter and show of hands.] How many of you think the government ought to cut spending as the principal way to address this problem? [More laughter and show of hands.] How many think the government should increase taxes? [Few hands.] How many think the government, despite cutting spending to address the deficits, should spend more on extending cash grants for wind? [Many voices and laughter.]
That’s the political problem, and that’s why the House tax committee is trying to find a way to turn the cash grants into a tax program that does not — at least on its face — require more spending.
What happens next year if Congress does not extend the cash grant program and you are faced with a few projects that are grandfathered for cash grants and a host of other projects that qualify only for production tax credits? Do you have such a strong preference for cash grants that it will be hard for developers to do PTC deals in 2011?
MR. EBER: We will do either. We are doing PTC deals today and we will remain happy to do them, but I think the industry will be in tough shape if Congress fails to extend the program because there is still not enough tax capacity to handle all the tax credits that would hit the market.
MR. CARGAS: We have a fairly strong preference for unleveraged cash grant partnership flip deals. We will look at all structures, but that is our preference this year and it will probably continue into next year.
MR. BALCHANDANI: We also have a preference for cash grant deals. Even if the cash grant program were to lapse and we could use tax credits, the accounting treatment for investment credits is better than for production tax credits and neither is as favorable as the treatment in a cash grant deal.
MR. SALANT: I think all of us probably have the same view. Certainly at Citi, we would say whatever Congress dishes out, we will figure out how to deal with it. We will make it work. It is the developers who would get hurt, because the cash grants give them the option of skipping tax equity and financing with debt.
MR. MARTIN: Jeetu Balchandani, a reporter for Power Finance & Risk asked yesterday about the accounting treatment for cash grant deals. Is it worse when you move to a cash grant than it was for PTCs, she asked, and is that making it harder for developers to raise tax equity? You suggested no. In fact, the accounting treatment is better with cash grants. Why?
MR. BALCHANDANI: We account for PTC deals on a pre-tax book basis. There are negative earnings. When we look at grant transactions, we use grant accounting and that allows positive pre-tax book income.
MR. MARTIN: Let’s move to a lightning round of questions. I am looking for quick answers. Feel free to add to what someone else has said.
Most wind developers are claiming either Treasury cash grants or production tax credits on their projects, but they have the option to claim a 30% investment tax credit and that option will remain available through 2012 during a period when it may no longer be possible to claim Treasury cash grants on some projects. Jerry Smith, does the partnership flip structure work as well for projects on which investment credits are claimed as it does for projects claiming production tax credits or Treasury cash grants?
MR. SMITH: Yes, I think it does.
MR. MARTIN: Is it helpful or unhelpful that a developer plans to make a depreciation bonus part of the tax structure?
MR. EBER: It is helpful. The bonus is an additional benefit.
MR. BALCHANDANI: It is not a plus for everyone. I think the answer depends on your tax capacity. Adding a bonus makes the claim on tax capacity lumpy at the outset. It helps the developer to say the depreciation on a project is more rapid, but the additional time value may go unused by the investor.
MR. MARTIN: It might knock an investor out of the market earlier in the year, and the investor would rather spread his capacity over more deals?
MR. BALCHANDANI: I think that’s right.
MR. MARTIN: What share of the capital cost of a project can a wind developer raise in a partnership flip structure? Is it 20%, 50%, less, more?
MR. EBER: As much as 65% to 70%.
MR. MARTIN: How common is it for a developer to be able to raise 65% to 70%?
MR. EBER: It is not uncommon. It is a function of how much cash the project generates and the amount of the Treasury cash grant. The grant is 30% of the project cost. The tax equity will fund it but get the money back when the grant is paid. His remaining contribution may be as much as 40%. In a project with production tax credits, the number will be a little less. Then the developer turns around and arranges back leverage to raise the remaining capital.
MR. MARTIN: Jerry Smith, you did some partnership flip transactions last year on projects with Treasury cash grants. What share of project cost was the developer able to raise in tax equity?
MR. SMITH: It was around 20%. It depends on whether the tax equity investor bridges the grant or whether there is a lender at the project level who bridges the grant. If the tax equity bridges, you are looking at a total tax equity investment of something like 47% of the project cost.
MR. MARTIN: Lance Markowitz, what was your experience last year?
MR. MARKOWITZ: The developer raises about a third of the project cost if you exclude the Treasury cash grant.
MR. MARTIN: So the developer raises about 63% of the project cost if the tax equity bridges the cash grant. Does anyone else on the panel want to offer a different figure?
MR. EBER: You have to be careful with these numbers, Keith. In a grant world, you can structure the transaction so that the flip is expected to occur anywhere from year seven through 10. The more distant the flip, the more tax equity the developer will be able to raise. Another factor is whether there will be debt at the project level. What you heard from Jerry Smith may be for a leveraged deal where there is debt being used in place of tax equity.
MR. MARTIN: How do the two factors — leverage and when the flip is expected to occur — affect how much tax equity can be raised?
MR. EBER: Debt at the project level reduces the amount of tax equity that can be raised. The tax equity investor will want a higher yield to compensate for the risk that it will be squeezed out after a debt default before it reaches its target yield. There will also be less cash for the tax equity investor because cash will go first to pay debt service. A cash-poor benefits stream to the tax equity investor discounted back at a higher target yield means a lower number.
The length of time before the flip is expected to occur cuts in the other direction. The longer that period, the more the tax equity investor will invest because he will get a larger share of his return in cash.
MR. SALANT: On a leveraged deal, if you add up the various tiers of the capital structure, you have a Treasury cash grant, project-level debt and tax equity, but there is still an amount that the sponsor has to contribute in pure equity. In the leveraged deals that we see, the sponsor equity would be as low as 15%, but 20% is more common. There have been some deals as high as 30% and perhaps one or two as low as 10%.
MR. MARTIN: We did a deal with you where the sponsor equity was 13%. I was going to get there. What percentage of the capital structure should be developer expect to have to put in as sponsor equity?
MR. EBER: Somewhere around 15% to 20% by the time you get down to it. The sponsor may be able to raise its equity by borrowing back-levered debt at the sponsor level.
MR. MARTIN: Will you do a partnership flip deal with project-level debt?
MR. CARGAS: We will look at it, but we have a strong preference for unleveraged cash grant partnerships.
MR. BALCHANDANI: Yes, we will. Most of the transactions at which we are looking at currently are leveraged partnership flips.
MR. MARKOWITZ: Yes.
MR. SMITH: Same.
MR. EBER: Yes.
MR. SALANT: We actually prefer leverage, so we are at the other end of the spectrum from most tax equity investors.
MR. MARTIN: Why do you prefer leverage? Citibank provides the debt?
MR. SALANT: Maybe. More often the lender is another bank. We are seeing two problems currently. One is the developers are looking to minimize what they actually have to put in as equity. The other issue is the emergence of super large deals that we did not see in the past. We have been looking at three deals that are in the one and a half to two billion dollar range. There is not enough tax equity to do a two billion dollar deal with just sponsor equity and tax equity. The only way deals that size work is with leverage.
DOE Loan Guarantees
MR. MARTIN: Will you do a partnership flip deal with leverage if the lender is the Federal Financing Bank or a private lender backed by a DOE loan guarantee?
MR. MARKOWITZ: It is less attractive.
MR. MARTIN: Why?
MR. MARKOWITZ: We do not see a lot of deals closing to begin with and adding the Department of Energy to the mix creates additional friction. The concept of having to negotiate with the US government if the deal runs into difficulty and goes into workout mode is a little daunting.
MR. MARTIN: I think you mentioned to me at one point, Lance, that your phones have been ringing off the hook with people seeking tax equity. Is the issue why spend your scarce time on a deal that may be harder to close?
MR. MARKOWITZ: That’s the other point. If you are restrained from a resource standpoint, and one deal has a clear path to closing and the other one does not, which one will you take, other things being equal?
MR. MARTIN: Has anyone had to deal yet with DOE on working out the tax equity-versus-debt issues?
MR. SALANT: Yes. I guess we are gluttons for punishment because we have two live ones. One has a section 1703 loan guarantee, so the lender is the Federal Financing Bank. Lance is right. I would be lying if I said it was easy, but we are working through everything, and the DOE team in Washington seems to want to do the right thing. The other transaction is expected to involve a section 1705 loan guarantee through the FIPP program. It is a very large deal and we are spending hundreds, if not thousands, of hours working through 120-page term sheets. Keith, you are aware of the transaction. The documentation may ultimately be a thousand pages. It is not fun, but we are working through it and, hopefully, the next time around it will be quite this difficult.
MR. MARTIN: Does a partnership flip deal work if the construction lender bridges the cash grant so that the cash grant goes to pay down debt and all the tax equity investor is left with is depreciation?
MR. SMITH: Yes, it does. We just closed a deal where that was the case.
MR. MARTIN: You receive the same cash? It just comes later in time? The Treasury cash grant paid down the debt so that the debt does not require as much cash to pay debt service over time?
MR. SMITH: Absolutely right. I should say one thing. Although most of the market prices things on an after-tax basis, we think of the world as a pre-tax world. We tell developers your debt costs this much, and the tax equity is providing a mezzanine level of capital. You should think about how expensive it is, but not really worry about what we get from it. Whether our tax capacity is there to provide a benefit or not, it costs X. Returning to your original question of whether it works if someone else gets the cash grant, it does. The benefit we see is not so much the timing benefit of the depreciation but the permanent tax basis step up.
MR. MARTIN: Permanent tax basis step up? Explain that.
MR. SMITH: Most people think of the grant as causing a basis step down. In other words, for accounting purposes, the project company gets the cash grant in and that reduces the carrying value of the company’s assets for book purposes by the amount of the grant. However