Key Inter-creditor Concepts in Renewable Energy Transactions
(By David Markey and Jeff Atkin from Foley & Lardner LLP)
The capital used to construct, operate and maintain renewable energy projects in the United States is by now fairly well established. Of course, there are variations depending on the deal, but typically three sources of capital are used as needed:
1) construction and term debt;
2) tax equity; and
3) sponsor or developer equity.
The second concept (tax equity) makes the financing of renewable energy projects in the US somewhat different from those in other countries. Its need stems from renewable energy projects such as wind and solar projects being incentivized in the United States by federal tax credits, rather than certain other methods such as feed in tariffs or subsidies.
Unfortunately, often renewable energy developers do not have the appropriate taxable gains to be able to use the tax credit. Instead, they will seek a party that does. These are typically large financial institutions, insurance companies or large corporates with appropriate tax appetite. These “Tax Equity Investors” provide cash, in the form of equity, to the project. In return they are allocated the vast majority of the tax credits that they can then monetize within their organization.
For a developer in the US, this creates the additional task of finding a tax equity investor as well as sources of debt and pure developer/sponsor equity.
The construction and term debt component is fairly simple from a structuring perspective for anyone familiar with off-balance-sheet financing. It can be provided by bank lenders, financial institutions through private placements or other markets. For the purposes of this article we will refer to the entities providing this debt as “Lenders”.
On a typical deal where there is a tax equity commitment, Lenders will size their construction debt so that part of it will convert into a term loan when the project is built, whereupon the developer will start repaying principal on the loan from the revenues of the project.
However, they will also often size based on a tax equity commitment from the tax equity investor. That component of the construction debt will be repaid when the tax equity investor invests its capital. This occurs on or around when the project is switched on, but, due to various tax rules and regulations needs to be carefully monitored for timing.
At the time of the bridge component being taken out by the tax equity investor, the Lenders will also release their asset level security, leaving them with upstream equity security but excluding equity interests and rights of the tax equity investor.
For structuring purposes the sponsor or developer equity piece Sponsor or cash equity is generally simple. The developer either provides this themselves or receives an investment upstream from the project finance structure. As a result, it does not typically play a major role in interparty relationships. This article concentrates on the relationship between the Lenders and the tax equity investors.
Why the need for interparty arrangements between Lenders and Tax Equity?
The simple answer is that at least two large financial institutions are investing capital in a project at the same time and have competing interests. This is particularly prevalent in solar projects.
On the one hand, Lenders are providing a construction loan, using off-balance-sheet financing and taking a security interest on the assets of the project as it is built, including all of the equipment, the permits and the contracts (including the revenue contract or PPA).
On the other hand, to receive the Investment Tax Credit used in all solar projects, in all but one tax equity structure, the tax equity investor must “own” the project by the time it is “placed in service” (a term developed under the tax code but essentially is a time on or around when the system is switched on and connected to the grid). To satisfy this test, it is generally accepted that the tax equity investor should have at least 20% of its total investment invested prior to the placed in service date.
Therein lies the interparty conundrum. Lenders have asset level security on the project, but tax equity have invested a significant amount of capital in the project that is at risk of being wiped out if the Lenders foreclose as tax equity is structurally subordinate to the Lenders.
At the same time, Lenders often sized their construction debt to include a bridge loan component to a partial take out by the tax equity investor.
Each party is therefore incentivized to enter into an interparty agreement that allows them to preserve their investment. Although the market has evolved and precedent has emerged, the negotiation of interparty arrangements can be some of the most difficult and time-consuming of a renewable energy project financing.
What do Lenders want?
As outlined above, Lenders have often sized their loan to include a bridge component bridging to the partial takeout of their construction loan by tax equity. The remainder of the construction loan will convert to a term loan and the developer will repay it over a period of time.
- To ensure that takeout by tax equity, Lenders may ask for a pledge of the contribution agreement under which the tax equity investor committed (subject to satisfaction of a number of conditions precedent) to fund their tax equity investment along with various step in rights to cure any issues and make sure those conditions precedent to tax equity funding are satisfied. This protects the Lenders from tax equity walking away from the deal and gives them at least an opportunity to be repaid the bridge component of their loan.
- However, being a financial institution, the Lenders may not be in a position to do this, so they may ask for the opportunity to step in, foreclose on their lower tier security and transfer the project interest to someone else.
- Of course, the tax equity investor does not want this transferee to be somebody with no experience or credit, so they will ask for this transferee to be a “Qualified Transferee”. This will typically be a party that satisfies a predetermined credit and experience test (i.e. investment grade and/or net worth test, together with experience of having owned or managed solar projects of a minimum amount of megawatts and for minimum amount of time).
- The Lenders will also often ask for additional time to cure problems under the project documents to satisfy the tax equity conditions precedent given that they will be stepping into a situation that was not of their creation.
- Often Lenders will also request a replacement agreement concept, so that if the project company is caught up in bankruptcy and the Tax Equity commitment document is rejected in bankruptcy for some reason, the tax equity investor will agree to enter into a replacement commitment document, again so that the lenders have the ability to step in, satisfy the conditions precedent to the tax equity funding and ultimately be repaid the bridge portion of their construction loan.
- Under the tax equity documents the tax equity investor may have to remove the developer as manager of the project “for cause”. Lenders may also be interested in having input as to who the replacement is.
- In portfolio deals (i.e. deals where a portfolio of solar projects is being funded), a further complication arises. Often tax equity may not want to continue to throw good money after bad by funding projects if there is a default under the loan documents. However, Lenders will argue that tax equity should fund “good” projects if all of the conditions precedent to the funding of those projects are met. Naturally, the “bad” projects will be unlikely to be funded because they will not meet the conditions precedent to funding under the tax equity documents.
- Finally, tax equity documents often contain cash sweeps should there be a breach by the sponsor/developer under those documents. Lenders will often argue that despite the cash sweep from the developer/sponsor to the tax equity investor that the waterfall should include a special provision to allow principal and interest under the debt documents to be paid before the cash sweep comes into effect.
What does tax equity want?
In a typical solar project, tax equity will have put at least 20% of its capital at risk prior to the project being placed in service (generally around mechanical completion of a project). However, because the Lenders still have lower tier security, tax equity is structurally subordinate to Lenders and without interparty provisions, would bear the risk of their investment being wiped out were Lenders to foreclose on the projects.
In typical transactions, tax equity can be protected in a couple of different ways. The way in which they are protected may depend upon they are analysis of the tax rules and what their 20% investment being “at risk” actually means. Different investors have different interpretations of this.
- Tax equity will often take the view that it will only allow Lenders to have step in rights to foreclose on their asset level security, provided that the Lenders refund the 20% investment. This leaves tax equity with little risk because they know that if there is an issue, the Lenders will simply refund their 20% in consideration for being able to foreclose on the project (the developer will remain on the hook for any deficiency). Some tax equity investors will settle for the return of a portion of their initial investment but look to other methods with the sponsor of being made whole. Others will look for interest on their invested capital, but normally the developer will be responsible for that portion.
- Tax equity may also argue for forbearance or step in rights. This allows them to step in and cure any defaults under the loan documents, prior to the lenders for foreclosing.
- Tax equity will want to restrict the potential transferees to whom Lenders can transfer their interest. They do not want to be in a partnership with an inexperienced or on creditworthy partner. This is not only true during an interim period or the Lender still has its asset level security, but throughout the term of the loan. Therefore, as mentioned above, they will argue that any transferee of the Lenders has sufficient creditworthiness and experience in renewable energy development.
- More importantly, tax equity will want to ensure that the Lenders can never foreclose and sell to anybody who will jeopardize the tax credits and cause a potential recapture of the tax credits by the IRS. As a result, there will be strict measures about to whom the sponsor (and the lenders if they foreclose) may transfer their interest. This would include at the very least a prohibition on anybody who is a disqualified person within the meaning of the ITC regulations and anyone who would jeopardize the continued operation of the project.
While many Lenders and tax equity have come to agreement on these deals and what goes into the interparty arrangements, allowing them to regurgitate precedent, every deal brings its own challenges and Lenders and tax equity investors should go into interparty discussions with a clear picture of what they need and how to protect their interests. Despite clear precedent on some deals, the interparty arrangements still often take up a large portion of the time and cost of complex renewable energy deals. Where a party ends up, will very much depend on the experience of its advisors and its comfort with all of the counterparties in the deal.