Published by North American Windpower on January 6, 2016
Written by Nick Knapp, Managing Director, CohnReznick Cap Markets, and John Richardson, Associate, CohnReznick Cap Markets
Editor’s note: This is the second in a two-part series. In Part I, the authors addressed the peak of a seller’s market for the cash portion of tax equity membership interest in operating renewable energy assets. Part II will address the motivations for selling, with a focus on the structuring and return profile of a sale.
There have been two sales processes launched for the equity interest in cash sweeping tax equity interests for wind portfolios since our first article. There are at least two additional wind portfolios that will likely hit the market in the first quarter of this year. This new trade is now front and center in the wind mergers and acquisitions market, and investor appetite is strong. New sellers are launching in parallel, and as a result, a broad buyer universe is evolving for this strong cash yield play.
Motivating the sale
Why are financial institutions selling their cash equity positions? There are two primary motivations here: regulatory and economic.
Regulatory: Without diving into banking regulations, the traditional tax equity banks are approved to participate in partnership flips because equity ownership has debt-like characteristics. The partnership flip offers a coupon rate with the stated target yield and an implicit maturity with the target flip date. When a project underperforms, the implicit maturity is pushed out and, in many cases, is no longer achievable. This changes the nature of the investment to perform more “equity-like” in the eyes of regulators.
Economic: From an economic standpoint, the investment profile is changing from primarily yielding tax benefits to delivering a cash return. These investments were approved by investment committees based on a defined pre-flip holding period, in most cases being nine to 10 years. Once this holding period becomes uncertain, there is increased risk that adds pressure to prove liquidity and the ability to exit within the original investment timeframe. The investments were also originated to serve as a means to offset a corporate tax liability. Once the economics shift from tax benefits to cash benefits over a long horizon, it moves away from the focus of the tax investment group within the financial institution.
How are these investments structured?
Some of these investments are sales of 100% of the tax equity interest (Class A). However, the majority are structured using an upper-tier partnership to allow remaining tax benefits to be retained by the seller without losing value for buyers that may not be tax efficient. The seller contributes or sells its interest into a newly created partnership with the buyer. The investor then buys into this partnership and initially receives 95% of the cash distributions along with 1% of tax allocations. These allocations are an effort to stay well within the Internal Revenue Service’s Revenue Procedure 2007-65, which governs wind partnership flip transaction structures.
The upper-tier partnership flip date is set to align with the expiration of production tax credits (PTCs) for the portfolio. When the flip occurs, the new tax allocations become 95% and the cash distributions may remain at 95%. As with the traditional partnership flip structures, there is also a call option at this point for the new buyer to purchase the 5% residual interest at fair market value. As we are still under Revenue Procedure 2007-65, a positive pre-tax internal rate of return is required.
As such, there may be a requirement to lower the post-flip cash distributions from the 95% down as far as 80%. If the PTC period has already expired, there would be no need for an upper-tier partnership and the buyer could simply purchase 100% of the Class A interest.
In addition to understanding the underlying asset performance, there are a number of structuring and deal complexities that must be addressed for a successful sales process:
– Structuring as a straight sale vs. creating an upper-tier partnership to divide cash and tax benefits and maximize transaction economics;
– Determining how to contribute or sell ownership interest to an upper-tier partnership;
– Navigating transfer consents and right of first offer provisions in underlying assets (sponsors and other Class A investors);
– Assessing the GAAP gain or loss prior to launching the sale process;
– Collaborating with an independent engineer to determine that any reasons for underperformance have been substantially resolved. Capacity factors are not the economic driver for this analysis, rather a focus on congestion, mechanical issues and operations and maintenance;
– Ensuring that all historical operating numbers and resulting cash and tax allocations to members are current in the valuation model with the monthly operating reports and annual tax returns being used as the source documents; and
– Working through sensitivities to ensure the flip protection holds in downside cases (i.e., the investor obtains the target yield and achieves a flip within the asset’s useful life).
Economic profile for the new buyer
The new buyer is getting a cashflow available for distribution (CFAD) resulting in a range of annual yield between 10% to 15% over the first five to 10 years and an unlevered after tax internal rate of return of 8% to 10% over the investment period. The break-even typically ranges between five and seven years. As these returns are sweeping 95% to 100% of unlevered project cashflows until the target yield is achieved, many of the traditional wind back leverage participants are beginning to consider this debt product as well.
It is evident that the buyer profile has changed from purely financial institutions to also include infrastructure funds and institutional investors that are targeting stable CFAD yields. Additionally, a segment of funds has emerged with a strategy that is focused on acquiring a controlling position of the underlying assets, improving operational performance and optimizing project returns. The first step to accomplish this strategy is acquiring the cash sweeping Class A interest.
In the past, the major hurdle for these buyers has been issues with returns including “merchant risk” – uncontracted power sales subject to prevailing power market rates. Investor sophistication around uncontracted renewable energy assets has increased considerably, especially among institutional investors.
Smart investors are achieving their risk-return objectives in today’s market. They are doing so by combining their educated views on the power markets, historical asset performance and, most important, the flip/yield protection offered by these partnership structures.