The financial picture for distributed solar projects is in the midst of a substantial evolution. Deals are getting more complex. Transactions have started to involve more players, new issues have arisen, and the total revenue available from a project has decreased due to falling power off-take prices. The following are three considerations you should take in order to adapt to these changes:
1. Fill out and optimize the capital stack.
When the solar industry started to take off, developers had a hard time raising capital to cover the cost of a project. At best, a developer could expect only to raise tax equity (investments in which the primary source of return was benefits). These transactions only covered 35% to 50% of the capital stack. The rest of the project cost was covered with the developer’s equity. There were no other partners, and there was no debt.
John Marciano III
Some developers make the mistake of assuming a simple structure copied from earlier transactions will work today. But, with margins coming down, it is ever-more important to take a more sophisticated approach. Most projects now have either project-level debt or back-leverage, at a minimum. Back-leverage is debt that is subordinate to the tax equity – the only security is the developer’s interest in the partnership with a tax equity investor.
Consider equity participants that can buy into a developer’s cashflow stream at a lower weighted average cost of capital. New entrants are coming to the market every day. Insurance companies are a popular source. Many have recognized the stable cashflow stream and diversification of distributed solar. Some banks and funds will offer a similar mezzanine debt product, which we call “back-back leverage,” as it sits behind other debt in the transaction.
Each rung of the capital stack needs to be set up such that you can extract the most value from it. Separate cashflows for each capital source as much as possible.
2. Don’t blindly cost cut.
Distributed projects are the hardest to finance. They have the diligence needs of a utility-scale project without the economies of scale. Many assume this means they should cut all costs at all costs. It does not. Sloppy project documents will sour the economics of an otherwise good project. Make sure you have a crisp site lease and off-take agreement. Try to follow the Department of Energy forms, at least as a base. We see many distributed deals in which the project documents need to be reworked (and recalcitrant off-takers); this often leads to an unfinanceable project.
Community solar in the right jurisdictions offers a good way to address this issue, as power prices are closer to retail rates for these projects.
3. Recognize political risk on the horizon.
It is important not to be blindsided by looming law changes. There is always some degree of betting the curve when pricing off-take. Typically, this means betting that costs will come down is not a sure thing. The price you bid for the power contract may be out of the money if development or operation costs end up higher than expected. Do not assume they cannot go up.
Several states and utility districts have advanced plans to make it more difficult to connect distributed projects to the grid. A deal can still be financeable in a jurisdiction where these initiatives are contemplated, but they have to be understood when you are negotiating the off-take arrangement.
The Trump election has brought the possibility of tax reform into the foreground. It is likely that the corporate tax rate will decrease. For solar, this means that depreciation could be worth less. Buyers and lenders have started to change the way they price transactions. Many will assume a 20% or 25% tax rate in the model.
John Marciano III heads the Washington, D.C., office of Akin Gump Strauss Hauer & Feld’s renewable energy practice. His colleague Ed Zaelke also contributed to this piece.
