To carry out a sizeable securitization of distributed generation assets, an investment-grade credit rating is necessary. But structural challenges unique to the solar asset class make this difficult to achieve. These structural challenges were the focus of a panel discussion at this year’s Asset-Backed Securities (ABS) East conference in Miami on Sept. 20-23.
Securitization is the process of pooling debt and selling it to investors as bonds or securities.
Managing Tax Equity Complexity
Solar power is an asset that is incentivized through the tax code, including both the 30 percent investment tax credit (ITC) and the five-year modified accelerated depreciation schedule (MACRS), said Danny Abajian, senior director of finance at Sunrun.
The MACRS system allows taxpayers to make deductions from their taxes to compensate for the decrease in value of their property over time.
To monetize these tax subsidies and deliver benefits to customers, solar companies must partner with large financial institutions. This has led to the formation of complex partnerships with financial institutions where the tax equity investor usually gets a priority equity distribution of those cash flows.
This creates a challenge, according to the panelists, since paying lenders is typically considered lower-priority than paying tax equity investors. Because portions of the cash flows are monetized with the tax investors for the first five to seven years, the assets are left with insufficient debt in their capital structures. Solar companies must make up for these shortfalls with debt financing.
Deal structures like a partnership flip, which are used by many of the major players including Sunrun and Sunpower, can often be structurally back-leveraged so the lenders can expect to receive cash distributions after the tax equity investors are paid.
The panelists explained that tax investors are yield-based investors. In order for them to “flip down” the structure after year seven and start giving the equity sponsor 90 to 95 percent of cash flows, they must first hit their internal rate of return requirements.
For companies like Sunpower, it can be challenging to leverage partnership flip structures through the ABS market. According to Gerhard Hinse, senior manager of structured finance at Sunpower Corporation, some developers may choose to approach specialty lenders that are willing to accept the risks and complexity associated with tax equity in exchange for a risk premium.
The second challenge is the combined time and cost associated with setting up a bond or security issuance. But this is easier to handle than the structural challenges, the panelists said. Once the structural challenges are solved, the operational investments to set up the issuance will naturally follow.
A major concern expressed among the panelists is that it can be complicated to manage instances when changes are required to the capital structure and a new party is introduced to the partnership. Because the lender’s payout is dependent upon a sound capital structure, the lender may not agree or accept a new partner.
Handling the Risks of Investments
First-time issuers face challenges that result from risks perceived by rating agencies, such as operations and maintenance (O&M) and manager performance. These risk perceptions are held very strongly by rating agencies and the investment community because they can significantly affect system performance and subsequent cash flows. Therefore, they are very influential when calculating the investment rating.
According to Ron Borod, senior counsel at DLA Piper LLP, these risk perceptions are not always realistic and need to be dispelled.
Some solar developers, like SolarCity, have attempted to mitigate these risks.
Solar is unlike other assets, such as mortgage-backed securities, because this asset class requires the right O&M provider and a manager to perform as expected. Therefore, it is in the rating agency’s best interest to question the risks associated with the selected O&M service provider or system manager. If project developers can mitigate these risks, they are more likely to satisfy the rating agencies and execute an investment-grade issuance.
To do this, there must be a seamless and efficient response mechanism in place to manage any problems that may arise. Borod said the question is: “What is that mechanism – and is there enough talent out there [to manage it]?”
One mechanism included in all three SolarCity deals appears to involve the role of “transition manager.” This staffer helps institutions to mobilize and plan for transition if something goes wrong.
Communicating How Tax Equity Works
The panelists said tax equity is what has held issuers back from getting into the market; issuers need to put projects into a box that the market understands. According to Steve Viscovich, director at Credit Suisse, “Tax equity needs to be distilled into a simplistic transaction.”
The Solar Access to Public Capital working group, designed to facilitate capital market investment through securitization, is contributing to this effort. The working group recently completed a tandem tax equity solar securitization structure and is working with rating agencies to submit a solar securitization mock filing. The mock filing will gauge how rating agencies will assess solar asset class risks.
One viable solution is the inverted lease structure, in which the tax equity partner is one entity (the lessee) and the assets and manager of the assets are another (the lessor). SolarCity’s July 2014 securitization was built around the inverted lease structure. By separating tax equity from the lessor position (the issuer side), the issuer can mitigate many of the risks the rating agencies are most concerned about. Some of these risks involve pledged assets and control rights.
“Whenever you try to build something on top of existing tax equity, you’re at a negotiating disadvantage and trying to have them to pry their hands off of rights,” Borod said. “If we agree on structures set up from the onset to get tax equity and securitization lined up properly the day you start accumulating assets, you’ll solve the problem.”
Finding Alternative Financing
While these challenges still exist, alternative financing options are available to developers. Alternative investors, most notably traditional utility-scale project finance commercial bank lenders that are accustomed to banking large wind farms, are entering the distributed generation space. Sunrun has completed three back-levered transactions and has raised over $100 million.
Although these commercial lenders are new to consumer credit in this space, said Abajian, a few deals are complete. Understanding consumer credit is one of the biggest challenges commercial lenders face. Banks are used to working with an investment-grade utility offtaker paying for electricity at a wholesale price that is not expected to default. Now, they are dealing with 4000-5000 offtakers with the risk of default.
An offtaker is defined as a buyer who purchases the product that a project delivers. The offtaker makes an agreement with the project developer regarding the price and volume of the purchase. This provides the project developer with stable funds to repay debt, cover operating costs, and provide a return to the project sponsors.
A healthy appetite for new deals remains. “The entry of commercial banking into distributed generation a year ago has caused a massive spread compression in our asset class, to the tune of 400-500 basis points. That market is healthy and will satisfy industry’s need for some time, but as volume grows and we continue to see 50- to 100-percent growth rates and new customer originations, that market will not be as scalable.”
Spread compression occurs when the price of a bond goes up and therefore, the yield goes down.
Basis points are defined as 1/100 of a percent and are a unit used in the financial industry to describe the value of a yield, equity index, or interest rate.
“Ultimately, we all sit here and agree we need to get into capital markets, but today there are alternative forms that work better with tax equity,” Abajian said. “Other tax equity structures that accommodate investment-grade debt are the ones we’ll have to shift to over time to keep raising massive amounts of capital.”
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