In this article, we will review the renewable energy funding in the US.
Most of the renewable project developers in the United States are inefficient taxpayers, and to monetize the tax benefits generated by the wind and solar projects, tax equity structures emerged since 2005 utilizing the special allocation of tax benefits allowed by the IRS.
Tax equity is essentially a structure where two parties form a partnership, and one party assigns all of the tax benefits of the partnership to the other party, in exchange for the equity investments in the project.
The party, which assigns the tax benefits to the other, is a developer and a general partner in the partnership.
The party, which receives the tax benefits, is the efficient taxpayer and is a limited partner.
One example where allocation is not static is to distribute the tax benefits to the limited partner until a limited partner reaches its hurdle rate (its target IRR). Once the hurdle rate is reached, we can change the tax benefit allocation rules. This is referred to as yield based flip when we flip the allocation based on the required yield achieved by the limited partner.
So, flip refers to the date when tax equity reaches its target yield and when the allocation of tax and cash items change.
Tax equity investors are large financial companies that have predictable tax liabilities such as Citigroup, J.P. Morgan, and Bank of America. So, these are sophisticated investors with large resources to devote to the tax equity transaction analysis and structuring.
Remember that the tax equity investor is not interested in the renewable project itself, he invests only to take advantage of the tax benefits that the project generates.
We will now review the tax equity structure with a special allocation of the tax and cash items.
We’ve got the two members now, member A is the sponsor and Member B is the tax equity investor. They will form the LLC and invest in the LLC and then they will be given their interest in the LLC in line with their investment.
LLC will develop the renewable project and generate the cash flow, and, in this case, a loss. And then we will allocate disproportionately 5 percent of the tax items and distribute 95 percent of the cash flow to the sponsor.
And we will allocate to the tax equity the opposite of what we have given to the sponsor.
We can expand on the tax equity structure by including debt financing in our diagram.
We again start with the LLC, which develops the renewable project.
The tax equity partner invests equity in the project and receives the tax benefits from the LLC.
Then we’ve got the sponsor who, typically, invests in the LLC through the holding company.
Next, the LLC can raise non-recourse debt and this would be a project-level debt. However, you usually do not see project level debts in tax equity structures because tax equity wants to avoid having debt in the partnership.
First, lenders are typically senior to any partner in the company they lend to, so they have the first claim to the project’s cash flows, and this is not suitable for tax equity who usually wants to minimize any risk of him achieving his target return.
Second, If for some reason lenders foreclose the asset, this would be a change of ownership and subject to Investment Tax Credit recapture by the IRS for solar projects. In other words, the tax equity investor would have to give back some of the ITC to the tax authority, if the change of ownership happens within 5 years, which would reduce the tax equity returns significantly.
For allowing the debt at the project level, tax equity investors require around 10 to 12 percent IRR compared to 6 to 8 percent IRR without the debt at the project level.
So, what we usually see is that the debt is raised at the holding company owned by the sponsor, and this is called a back leverage debt or back levered loan.
The back-levered lenders take the sponsor’s equity interest in the holding company as a security for the back-levered loan.
So, the cash distribution from the LLC goes to the holding company first, which uses that cash to pay the principal and interest of the back leverage loan.
And then, the remaining cash flow is distributed to the sponsor.
So, this is a typical back leverage structure in the tax equity transaction.
Having reviewed the tax equity flip structure, we can now review the objectives of the parties in the tax equity transactions.
First, the sponsor tries to maximize the tax equity and debt financing without scarifying cash flow. The sponsor is not interested in the tax benefits because he cannot use those tax benefits efficiently.
Then, the sponsor wants to achieve an IRR of at least 6 percent, and the range is really between 6 to 10 percent in the United States.
Next, the sponsor wants to purchase the tax equity’s interest in the post-flip period on favorable terms.
Finally, the sponsor wants to manage the renewable project as efficiently as possible to maximize the cash flows.
On the other hand, tax equity has a different set of objectives.
First of all, tax equity wants to take the maximum tax credits from the project. He wants to maximize his tax efficiency, and as we shall see later on in the course, the tax equity may not be able to use all of the losses allocated to him immediately and he has to carry them forward and generally, tax equity wants to avoid this and be as efficient as possible.
Tax equity wants to make sure he achieves his target yield by the target date. And tax equity wants to minimize the downside risk.
So, how much each of the parties contributes in financing to the project?
Typically, 30 to 70 percent of project funding comes from the tax equity investor, 15 to 40 percent of project funding comes from the back leverage lenders, and, the remaining funding comes from the project sponsor.
In this article, we learnt about the debt service reserve account in project finance transactions. To learn about financial modelling for project finance please enroll in our courses.
Learn more about tax equity structures by watching this short video