Project Finance for Solar Projects
I. Introduction. The practice of solar project financing has emerged from several independent and overlapping strains of transactional practice, including traditional project finance secured lending, tax equity partnership and lease structures, development financing from early-stage investors, joint ventures, and the frequent acquiring and flipping of projects that goes on among a wide variety of solar industry participants. Though, at its core, solar project finance historically shares much with wind project finance as well as traditional energy finance, the unique issues associated with solar projects result in a highly specialized practice. For instance, the comparatively low technical risk of constructing and operating a properly sited solar facility, the reliance on large volumes of mass-produced component parts available in a global market, and the opportunities for developing distributed generation projects on residential rooftops and in community solar gardens set solar projects apart from other electricity-generating projects.
Developers, independent power producers, solar panel manufacturers, engineering, procurement, and construction (“EPC”) contractors, utility companies, financial investors and, more recently, commercial and industrial end-users all participate in the financing of solar projects in different manners and at different times. Though certain common structures dominate throughout the market, it is no exaggeration to say that no two deals are the same. It is also not uncommon for projects to change hands two or three times during development before the sponsor seeks full-scale financing for a project, or for the same project to seek financing on more than one occasion. All solar industry participants are well advised to remain on the lookout for issues that may impact a project’s ability to obtain financing, regardless of where in the pipeline or life cycle the project is.
Financing can be viewed as the epicenter of all aspects of project development. In order to survive the close scrutiny that lenders and investors require to approve a financing, all aspects of the project must be aligned, such that the end result will be, in all likelihood, a fully functioning, revenue-generating, and legally permitted project returning sufficient value to the investors. Accordingly, transacting on a solar project finance deal is not merely a negotiation of financial structuring but rather necessarily involves an analysis of real property rights, construction and development contracts, equipment warranties, power purchase and interconnection agreements, cash management, environmental permitting, energy regulatory matters, and, of course, tax analysis. This chapter begins with a brief discussion of the basic tenets of project finance; compares the alternative investment structures of debt financing, tax equity financing, and cash equity financing; and finally touches on the interplay between deal participants when those structures are used in combination.
II. Project Finance Basics.
A. Risk Shifting. The golden rule of project finance is one of risk mitigation: the deal structure must allocate risks that could affect the project’s cash flow or assets to a creditworthy party with the ability to mitigate that risk. Much of the tension in negotiating a solar project financing will derive from each participant’s efforts to shift various risks to others while retaining the particular benefits that the participant seeks from the transaction. The project sponsor seeks to shift technology risks to the equipment manufacturer and construction contractor while preserving for itself as much of the cash flow and appreciation in project value as possible. The lender will seek to shift risk to the project owner by taking paramount positions in the project revenues and assets, and to third parties such as the equipment manufacturer and construction contractor by getting the benefit of the warranties and contractual obligations of these participants, all to enhance the prospect of the loan being repaid on schedule. The tax equity investor will aim to push all project-specific risks on the sponsor through broad representations and warranties, backed up by parent guaranties and sweeps of distributable cash.
The risks at issue in a project financing can be classified in many ways, but broadly speaking the major categories of risk include the following: (a) construction risk – the likelihood that the project will reach commercial operation without running overbudget or behind schedule or encountering insurmountable construction issues; (b) technology risk – whether the technology incorporated into the project will perform as functioned and whether it has been tested and proven; (c) counterparty risk – will each project participant remain creditworthy, solvent, and capable of performing its particular contractual obligations when required of it, such as the EPC contractor’s capacity to pay its subcontractors, procure equipment when required, or make good on a warranty claim; (d) revenue risk – a specific type of counterparty risk focusing on the certainty of payments received under the power purchase agreement (“PPA”) from the offtaker or, in distributed generation or portfolio deals, the offtakers; (e) operational risk – can the project be operated to achieve the level of performance and power output that was forecast in the project’s engineering and design plans, and what other factors (such as weather) can degrade this performance; and (f) regulatory risk – the risk of governmental action interfering with the project, including denial of discretionary permitting approvals, changes in state programs authorizing a solar program, and changes in tax law applicable to the project.
Risk shifting may be accomplished by various legal undertakings: grants of liens on the project assets, revenues, and key project agreements; warranties and contractual requirements for the equipment and the work performed in making it operational; requirements for various types of insurance products to cover certain adverse events; and guaranties of each participant’s obligations from creditworthy entities. Project financing focuses on the negotiation and documentation of these risk-shifting devices and ordinarily results in documentation of substantial length and complexity.
B. SPVs, Portfolios, and Recourse. In most instances, all assets for a particular project are housed in a single special purpose vehicle (“SPV”) that is a separate legal entity from the ultimate upstream owner of the project. This means that legal title to any project real estate interests (whether outright ownership, leasehold interests, or otherwise) should be in the name of the SPV, and the SPV (and not any upstream entity) should execute all project contracts. The SPV is commonly referred to as the project company. Putting all assets into an SPV is a simple step but has significant implications for the ability to sell, buy, and finance a project. In a sale, purchasing the equity interests of the SPV is almost always simpler than assigning title to each asset individually. In a secured financing, a lender will want the SPV’s parent company to pledge the equity interests in the SPV as collateral, in addition to or in lieu of the pledge of project assets, to provide a simpler route to foreclosure in the case of a default. In a portfolio financing, multiple different projects can be financed together by transferring ownership of multiple project SPVs to the same holdco, and investors can view each SPV’s equity interests as a separate cash flow stream. If the portfolio financing involves a tax equity investment, the structure will often require that SPV ownership be transferred to the tax equity partnership just prior to a project being placed in service.
Portfolio financing in essence allows an investor to diversify its risk among multiple different projects through a single point of investment. In this scenario, the effect of one project’s default on another project becomes a prominent question. Where the effect of a financing agreement default by one SPV also creates a default for a second “sister” SPV, the projects are said to cross-default. If the default by a project is self-contained and does not permit the investor to take enhanced action against other projects in the portfolio, there is no cross-default.
In addition to facilitating transactional flexibility, the use of SPVs also permits another central distinction to be made in project financing, that of “recourse” versus “non-recourse.” If the financing provider has a claim against the balance sheet of the project sponsor/owner to support repayment of the debt, the debt is said to be “recourse” to the sponsor. However, when the financing provider has recourse not to the sponsor’s assets generally but only to the assets comprising the project in question, the debt is said to be “non-recourse” or “limited recourse.” (To be clear, the term is always meant as “recourse” or “non-recourse” as to the sponsor. Even “non-recourse” claims would still have recourse to the project and SPV.) The financing provider’s remedies in non-recourse financing are fundamentally limited to the value of the project itself, and, in a worst case scenario, the sponsor could have the full value of the project taken from it through foreclosure, sale of the project, diversion of the project cash flow stream, equity dilution, or other remedies. While project financing generally means non-recourse financing, many deals will include specifically negotiated sponsor guaranties, other parent credit support, or equity contribution obligations that blur the margins of the non-recourse structure.
C. Milestone Terminology. The risks placed upon, and the benefits available to, investors in solar project financings will vary depending upon the specific stage of a project’s development at the time of the financing. The exact timing of an investor’s funding often hinges on a project’s achievement of certain development milestones, with the financing documents incorporating concepts defined in other project contracts, the U.S. tax code and Treasury regulations, or other sources. It is thus useful to define a few key development-related concepts and acronyms before proceeding:
- “Notice to Proceed” or “NTP” refers to the formal directive given to the EPC contractor to commence full-scale construction and purchasing work. The issuance of NTP generally requires making a large mobilization payment to the EPC contractor and requires a large sum to be funded by a financing provider.
- “Mechanical Completion,” “Substantial Completion,” and “Final Completion” are terms frequently used to describe the key staged completion milestones under an EPC contract. Mechanical Completion generally means the facility is constructed and capable of being operated, subject to being physically interconnected into the grid and satisfaction of performance testing. Substantial Completion means the facility is fully built and performance tested, with only minor punch list items left to be completed. Final Completion signifies completion of the punch list and the end of the EPC scope. These three terms are not universal, and some EPC contracts use other nomenclature or have more milestones (but generally not fewer).
- “Commercial Operation Date” or “COD” is the term generally used in a project’s PPA to signify construction completion, facility operation, and interconnectedness into the grid. An offtaker’s obligation to purchase power under the PPA generally begins no later than COD.
- “Placed in Service” is the U.S. tax code concept defining when a project is placed in a condition or state of readiness and availability for a specifically designed function. The equity ownership as of (or within a certain time frame following) the Placed in Service date is a crucial concept for tax equity financing relying on the U.S. Investment Tax Credit (“ITC”), and thus the Placed in Service date is used as a guidepost for the timing of tax equity investments.
III. Debt Financing.
A. Overview. Though the prevalence of debt financing has perhaps been overshadowed in the solar industry by its cousin tax equity (more on that below), most solar projects are financed at some point in their life cycle with some manner of debt. Debt is, at its core, a contractual obligation by a borrower to repay a sum of borrowed money that will, in most instances, receive preference vis-à-vis the borrower’s other creditors. In comparing the spectrum of financing options, debt tends to be a “safer bet” than any sort of equity financing, representing the prospect of limited risk (payment priority and, often, assets pledged as collateral securing repayment) for limited rewards (an interest rate and possibly other lender fees, but no further upside).
For solar projects, it is useful to classify debt primarily in relation to the project’s life cycle. Roughly speaking, there are three categories of debt for solar projects, each discussed in more detail immediately below: (i) development-stage debt for the pre-construction period, (ii) construction debt to finance the period of active EPC work, and (iii) permanent debt for the post-construction period when a project is operational and development work is complete.
B. Development Loans. Development loans can involve a variety of structures to finance early-stage project development work, including upfront interconnection deposits, PPA deposits, solar resource studies, permitting, and site control costs. As the value of the project assets remains somewhat prospective at this early stage, development lenders may forgo a full collateral pledge of project assets, opting to rely solely on a pledge of project company membership interests, or may require security interests in deposits and material assets. There is no established market for a typical development-stage loan, and terms vary widely among what are fundamentally bespoke deals. Many entities act as development financiers in order to claim a seat at the project table, for instance, entities interested in buying or funding the project if early-stage development proceeds to full construction, contractors looking to secure the project’s EPC work, or module manufacturers looking to ensure their product is used in the project. Development loans can also be a bridge to future funding, providing a quick, relatively low-cost transaction with minimal documentation, a very short tenor, little borrower flexibility without lender consent, and a high interest rate, and often involving a promise to grant the lender a right of first refusal to the next round of larger financing.
Though we speak here of development loans as debt instruments, many early-stage investments involve collateral security and operational covenants securing a future payment (and are thus debt-like in their protections) without the payment obligation actually constituting indebtedness on the obligor’s balance sheet. One such variant appears commonly in early-stage membership interest purchase agreements (“MIPAs”), where project sellers may retain a lien on the equity interests or assets of a project sold to secure full repayment of the MIPA purchase price, which may provide for staggered payments to the seller upon NTP or other development milestones. Though the payment obligation secured (the purchase price) may not technically be indebtedness, the creation of the lien on the SPV equity interests or project assets makes this structure function similar to secured indebtedness.
C. Construction Loans. A project’s capital needs are highest during construction, when all equipment and component parts must be purchased and contractors and subcontractors are engaged in on-site physical work and must be paid on schedule. There are long-term implications of a construction process running overbudget or behind schedule. Payment streams must be managed, aligning invoices for required uses of cash with sources of cash from equity or debt funding or liquidated damages claims from tardy counterparties. As such, construction loans tend to be the most procedurally complex loan transactions, involving the most detailed covenants outlining what a project may or may not do and imposing the highest hurdles to accessing funds.
Tax equity investors will generally not take construction risk with their funds. Thus, the task of financing construction falls to lenders and sponsors together. In order to ensure proper alignment of sponsor’s incentives, and to avoid extending loans beyond the project’s expected collateral value, construction lenders will generally require a certain minimum sponsor equity contribution requirement as a condition to any construction loans being released, often expressed as a percentage of expected project costs. Further, construction debt commitments will be sized to avoid a project exceeding a certain debt-to-equity ratio. If construction costs exceed budgeted contingency amounts, projects will fall back on any cost overrun guaranties or available contractual liquidated damages, but ultimately if no other sources of cash are available, it will be up to the sponsor to provide financing or risk losing the project to the secured lender.
Hallmarks of construction loans include the following:
- Very tight and detailed covenants, restricting all project activities other than development in accordance with the permitted construction contracts, prohibiting amendments to project contracts or project design plans without lender consent, restricting transactions between the project company and its affiliates, and requiring detailed progress reporting to the lenders and an independent engineer.
- A construction cash flow waterfall governing all project cash, which requires all available cash flows to be applied to pay budgeted project costs and then, typically, required debt service, lender expenses, and any mandatory prepayments. Since solar projects generally generate no revenue from power sales during construction (other than perhaps following Mechanical Completion once COD has been achieved or payments for test power, if applicable), available cash flows generally include only construction loan proceeds, any equity contributions or proceeds from equity issuances, any liquidated damages payments from counterparties, and any insurance proceeds received. Construction debt documents typically restrict all cash distributions to equity holders.
- Construction loan collateral packages are generally straightforward: all project assets. This entails a pledge of equity interests in the applicable borrower-side entity or entities, as well as the project company granting a security interest in all its real property interests (whether a leasehold interest, fee ownership, or other access or easement rights), all project contracts (including construction and development contracts, PPA/offtake arrangements, and asset management and operation and maintenance contracts), all permits, and all cash.
In addition to taking assignments of the contracts from the project owner, the lender will also require that each counterparty to a material contract consent in writing to the assignment in a manner in which the counterparty acknowledges the lender’s rights, agrees to give the lender notice of any default by the project owner, and agrees to grant the lender certain cure rights. Consents may also include a so-called bankruptcy replacement clause whereby the counterparty agrees to enter into a replacement agreement with the lender in the event the project owner is the subject of a bankruptcy proceeding. Finally, when payments are or may be owing by the counterparty to the project owner under the contract (for example, the PPA), the consent also makes provisions for those payments to go directly into an account controlled by the lender.
To ensure the ability to benefit from a tax equity commitment, construction loan collateral packages may also include pledges of upstream equity interests or interests in the tax equity transaction documents containing the tax equity commitment.
- Staggered construction loan fundings. Rather than extend the full amount of the construction loan commitment up front, lenders generally disburse loans for budgeted project costs or amounts that are immediately applied to invoiced project costs then due. As standard contract payment terms require payment within 30 days of invoicing, projects typically borrow on construction loans once or twice a month during construction. Lenders typically also require lien waivers from contractors, subcontractors, and major equipment suppliers as a condition to each construction loan used to pay such counterparty.
- A breach or default under any tax equity document will typically prevent the borrower from accessing any further construction loans. As the tax equity investment often serves as a source of repayment for a portion of the construction debt, lenders are wary of any event that could jeopardize the tax equity investment.
For typical solar project finance deals involving debt and tax equity, the construction loan is sized to be repaid from some combination of the permanent term loan and the tax equity investment. Where a cash equity investor provides financing to repay a construction loan as well (or instead), this investment will also be taken into consideration to size the construction loan. Thus, construction loans may often be earmarked by tranches to refer to the expected source of repayment (for instance ITC bridge loans as the bridge to a tax equity commitment). These tranches may have different features, including different interest rates or disbursement requirements.
D. Permanent Loans. Following achievement of COD and completion of construction of a solar facility, a sponsor will typically trade its restrictive and expensive construction debt for permanent financing, allowing recoupment of invested capital. When a project incurs permanent debt financing, the result is a comparatively gentler set of loan terms than during construction. Though covenants, collateral security, and defaults remain tight to ensure that project ownership and operation protects the facility and maximizes the revenue stream, the lender takes a somewhat more passive role in supervising operations than construction.
To call debt “permanent” is of course somewhat of a misnomer, as even permanent debt comes due on a maturity date. But as the term is used somewhat synonymously with “long-term debt” and is a category of “permanent financing,” we use the term here. The permanence aspect of long-term project financing is that project revenues will cover debt service to significantly (or fully) pay down the loan before the maturity date, thus slotting permanent debt in the category of permanent financing solutions that operating companies typically rely on.
Permanent loans are generally single-draw term debt, with one funding on the date when the construction loan “term converts” or “terms out.” When coupled with tax equity or cash equity, the term conversion will occur simultaneously with investor funding, and the closings will be cross-conditioned.
- Cash Flow Waterfall and Distributions. A key aspect of permanent project debt is the cash flow waterfall, through which project revenues are used to pay project expenses and investor returns in a pre-determined priority. Many variations exist, but in general lenders permit cash flow to be applied as follows, on monthly or quarterly dates: first, to pay project operating expenses; second, to pay lender expenses not constituting debt service; third, to pay debt service (interest and scheduled principal payments); fourth, to fund any required cash reserves for the project, including reserves for debt service, maintenance expenses, and capital expenses; and fifth, to make distributions to the equity owners. To the extent the sponsor performs asset management or similar services through a contractual arrangement with the project, these costs will generally be paid at the priority first as operating expenses. Any other equity return comes solely from the last priority.
Permanent project loan agreements will also typically restrict distributions to only those time periods for which the project can demonstrate compliance with a specified financial covenant. Typically, the limiter is a Debt Service Coverage Ratio (“DSCR”) test, which requires that cash flow over a certain period (such as cash flow available for debt service for the trailing four quarters) exceeds required debt service during that period by a certain ratio, e.g., at least 1.25:1.00. If a distributions covenant is subject to a DSCR test and the project is not producing sufficient cash flow to clear the ratio at the time the waterfall is run, available cash will be trapped in the depositary accounts, and the borrower will not be able to distribute the cash to sponsors. If this occurs on a number of successive testing dates, the funds in the depositary accounts may be required to prepay the loan.
- Back Leverage Debt. We noted previously that tax equity investors do not like to take construction risk. This statement can be expanded to say, more broadly, that tax equity investors do not like to take sponsor risk. When placed in an upper tier of the capital structure above project-level secured debt financing, tax equity investors and sponsors share much of the same perspective as project sponsors on two key risks: (a) upon an event of default under the loan agreements, a secured lender could foreclose on the project assets or an equity pledge and sever the ownership chain between the upstairs owners and the project and (b) loan agreements impose distribution restrictions that can cut off cash flow streams. While tax equity investors can bear these risks during a brief overlap period in respect of construction loans (subject to extracting certain terms from lenders via interparty agreements, as more fully described below), tax equity often views these two risks as nonstarters in permanent loans. Equity foreclosure by lenders can lead to recapture of the ITC allocated to the investor, and a structural subordination of tax equity’s cash flow threatens the certainty of its preferred returns. Therefore, tax equity investors are often unwilling to sit behind secured debt in the capital structure.
In response to the unique challenges of matching the demands of secured permanent debt and tax equity investments, many renewable energy project finance deals use a back leverage debt structure. Back leverage simply moves the debt from the project level up to a holding company level, above the tax equity investor level, such that the sole collateral securing the debt is the sponsor-side equity interests and the associated cash held by the holding company borrower. As a result of the high quality of the solar asset and the relatively low operating risk, the value of the sponsor-side cash flow streams in an operational solar facility can be significant enough to fully secure permanent debt for the project, even without project-level collateral.
The back leverage structure also offers an enhanced opportunity for a lender to diversify its risk among multiple solar projects, capturing the cash flow streams at an upper-tier holding company that indirectly owns sponsor equity positions in a portfolio of projects. The back leverage portfolio structure necessarily pairs well with a portfolio tax equity structure, which in combination provides a valuable tool for large-scale financings. This financing structure has been used to great effect by independent power producers to facilitate growth, effectively reducing the cost of transacting on a single project through large portfolios.
IV. Tax Equity Financing. Tax equity financing is a structure of project finance unique to renewable energy project finance, owing its existence to the U.S. tax code, subject to the whim of federal politics and tax policy. As discussed more thoroughly in Chapter 8, the ITC permits an equity owner of a qualifying asset, including a solar power facility, to claim a tax credit equal to a percentage of the value of the asset’s eligible basis. An owner may also be able to claim accelerated or bonus depreciation with respect to the asset’s value. In combination, these benefits can offer a sizeable reduction to the federal tax liability of a solar project owner, allowing the owner to offset its taxable income from other unrelated sources but based on the value of the solar project.
Often solar project developers, sponsors, and owners do not themselves have taxable income sufficient enough to take advantage of the benefits from the ITC. Rather, a relatively small group of financial institutions and corporations with significant federal tax burdens have emerged to invest in projects as equity owners. The work of structuring transactions to permit these tax liability-laden investors to match up with qualifying solar projects and claim the benefit of the ITC is the central function and challenge of solar tax equity financing.
To achieve the goal of maximizing the ITC tax benefits, tax equity investors seek to accomplish several competing and sometimes conflicting goals. Federal tax law requires that investors put their dollars at risk in the project and share the benefits and burdens of ownership as an equity owner prior to the time the project is Placed in Service in order to claim the ITC. However, tax equity investors would prefer a position as purely financing providers, investing in the project only when offered a comparatively secure position resembling that of a lender. Tax equity investors are loath to take on risks alongside the sponsor, instead requiring certainty as to a project’s viability and construction completion before investing and demanding structural priority of repayment and other fallback protections uncharacteristic of normal equity positions. Tax equity investors initially leave management of the project squarely in the hands of the sponsor, policing the management through covenants and representations and warranties. On the spectrum of equity to debt, tax equity must sit squarely on the equity side of the line, but it wants to sit only barely over the line.
One key way in which tax equity structures achieve this balancing act is through sponsor guaranties. The tax equity investor looks first to the project itself and the cash flow stream coming from the project to provide the required economic return. But management of the project is left to the sponsor and, unable to rely on any collateral security position in any project assets, the tax equity investor is exposed to potential risks of the sponsor’s mismanagement of the project, such as breach of a project contract or other event leading to diminution in a project’s value. To counteract this risk, tax equity investors generally require that a creditworthy sponsor parent entity guarantee the sponsor-side project management obligations owed to the tax equity investors, protecting the tax equity investors from damages resulting from sponsor-side breach of covenant, misrepresentation, environmental liability, certain ITC recapture events, and, depending on the transaction, post-funding change in tax law.
Tax equity structures rely largely on the ability to bifurcate cash and tax benefits available from the project. In the partnership flip and inverted lease structures, the tax items of a partnership are allocated separately from the partner’s respective cash flows and management rights. In a sale-leaseback, the ITC is passed through to the tax equity investor, while the sponsor retains cash from the project less periodic rent payments.
A. Partnership Flip. In a partnership flip transaction, the tax equity investor will invest in a holding company, an entity taxed as a partnership and jointly owned with the sponsor, which holding company will own the project or multiple projects in the portfolio. The projects will either be contributed to the holding company by the sponsor or the holding company will purchase the projects from a sponsor affiliate for their fair market value at Mechanical Completion. The tax equity investor will be entitled to allocations of substantially all of the tax attributes, including the ITC, from the partnership, and specified cash distributions from the partnership until the “flip date,” when the investor achieves an agreed-upon after-tax return or a specified period of time has passed, depending on the requirements of the investor. Once the “flip date” occurs, the allocations of tax attributes and cash will change, and the sponsor will be entitled to the bulk of the remaining tax attributes and cash from the project thereafter. Also at the flip date, the sponsor will be entitled to exercise an option to purchase the tax equity investor’s interests in the partnership for fair market value. Certain tax equity investors may require a withdrawal option, allowing the investor to determine whether to exit the partnership if the purchase option is not exercised by the sponsor.
B. Sale Leaseback. In a sale-leaseback transaction, the sponsor sells the project to a tax equity investor, within 90 days following the Placed in Service date, for fair market value. The tax equity investor then leases the project back from the investor for prepaid rent and periodic rental payments, which rental payments may be subject to a sponsor-level payment guaranty. The investor will be entitled to 100 percent of the tax benefits from the project while the sponsor will retain the right to use and operate the project and receive the revenue from its operation for a period of years, subject to paying a fixed rent payment. On one or more occasions during the term of the facility lease, the sponsor will have an option to repurchase the project from the tax equity investor for the fair market value of the facility.
C. Other Leases. In a lease pass-through transaction, the project company is often structured as a partnership, owned 49 percent by a tenant entity and 51 percent by the sponsor. The tenant is owned 99 percent by the tax equity investor and 1 percent by the sponsor. The project company leases the project to the tenant prior to the date the project is Placed in Service. The project company then elects to have the ITC, based on the appraised fair market value of the project, passed through to the tenant. The tenant partnership is structured as a partnership flip, where tax allocations and cash distributions will “flip” after a fixed period of time.
V. Cash Equity Financing. The final element of solar project finance discussed here is cash equity financing. The cash equity position shares the sponsor position and serves as permanent financing that can be used as an alternative or in addition to back leverage debt. From the perspective of the tax equity investor and lenders, a cash equity investor appears the same as a sponsor, and the tax equity investor will generally require guaranties from both the sponsor and the cash equity investor. However, this position is generally held by a pure financial investor that either does not have the desire or the necessary means to manage the ongoing operation of the project. The sponsor with the management role will be responsible for indemnifying the cash equity investor if a breach by the manager results in losses to the tax equity investor that are subject to guaranty payments or a cash flow sweep. The cash equity investor may acquire all or substantially all of the sponsor interests in a project, while reserving the management role and a portion of the sponsor financial position for the original sponsor.
Cash equity deals are custom designed deals, specifically negotiated with the particular cash equity investor, and thus significant variation exists between transactions. However, since the relationship between an active sponsor manager and a passive financing investor in cash equity deals mirrors the similar relationship at the core of tax equity deals, cash equity investments often resemble tax equity transactions (minus the structured allocation of tax benefits). Cash equity fundings are often cross-conditioned on the tax equity investment, and cash equity investor consent rights may overlap with the rights held by tax equity investors.
VI. Interparty Issues.
A. Construction Period. Because in several tax equity structures the tax equity investor must be an owner of the project before it is Placed in Service, the tax equity investor must take limited construction risk and invest in the project several weeks prior to repayment of the construction loan. Generally the tax equity will invest between 5 percent and 20 percent of its expected total investment before the project is Placed in Service, with the balance funded once the project achieves COD. This creates tension between the tax equity investor, who wants to be assured its investment is adequately protected, and the construction lenders, who require unfettered (or substantially unfettered) access to their collateral prior to repayment of the construction loan. Tax equity investors and lenders have individual requirements to address this risk, but increasingly tax equity investors will permit the lenders to return the initial tax equity investment in a project prior to exercising remedies with respect to the project collateral. Certain tax equity investors will require this repayment option to be structured as an option to repurchase all of the tax equity investor’s interest at fair market value, rather than an “unwind” of the transaction, to minimize any tax structuring risk. Tax equity investors may also require a time period to cure any defaults of the project company under the construction loan documents to allow the transaction to proceed as intended.
B. Operational Period. Many tax equity investors will require that before any cash can be distributed to the sponsor, the tax equity investor should be fully compensated for any indemnity claim (or cash otherwise available to the sponsor should be escrowed until any disputed claims are resolved and then paid to the tax equity investor or distributed to the sponsor). If the maximum amount of this sweep is uncapped, this will impair the sponsor’s ability to raise back leverage debt. Sponsors should undertake to limit the cash sweeps to a 50 percent maximum to allow debt service to be available to the lenders. Also, similar to the construction period, the permanent lenders will require an unrestricted ability to foreclose on their collateral, which, during the operational period, is the sponsor’s interest in the tax equity partnership or partnerships. Again, the permanent lenders will require unfettered (or substantially unfettered) access to their collateral. Accordingly, the transfer provisions in the tax equity partnership agreement need to be negotiated to permit a lender foreclosure and transfer to a subsequent owner that meets certain criteria acceptable to the tax equity investor and lenders.