The Current: Financial Modeling and the Renewable Energy Investment

Published by Forrest D. Milder on Sunday, November 1, 2015
Journal thumb November 2015

Of particular importance to the monetization of renewable energy tax credits are projections, sometimes referred to as investment assumptions, the model or the spreadsheet. This set of numbers present the anticipated cash flows and tax consequences associated with the investment. Starting with the projections, parties negotiate the size and timing of the capital contributions and other important features of the transaction. In addition, counsel will often provide a tax opinion that may end with a statement similar to “the investor should get the bulk of the benefits indicated in the projections.”

So what should an investor and its counsel look for when reviewing the projections?

Overview of the Model

Many sets of projections start with a diagram of boxes, triangles and other shapes connected by lines and arrows. This provides a visual illustration of the flow of funds, who controls who and how the tax benefits are shared–including changes if there are flips or there will be additional partners or members admitted to the transaction. Obviously, it is important to make sure that the parties and their relationships have been properly identified. Of equal importance is assuring that the deal structure is properly displayed–the diagram should properly illustrate the basic flip, master lease pass-through (i.e., “inverted lease”) or some variation being used in the particular transaction. This is the time and place to assure that everyone agrees about whom the parties are and what the basic transaction looks like.

Silly Mistakes

A variety of easily corrected defects sometimes creep into an early model–references to historic tax credits in a renewable energy model, columns identifying features not in the current transaction, place holders for grants, state credits, tax-exempt bonds, and other attributes that are not quite relevant, or sometimes completely irrelevant. It can be important to get these basics correct. In the Historic Boardwalk Hall case, the Internal Revenue Service (IRS) and the appeals court paid close attention to the ever-changing projections and statements made in the marketing documents that were inconsistent with the tax treatment that the parties were after. Accordingly, it’s a good idea to avoid giving the IRS ammunition to challenge how the parties plan to treat the investment by providing erroneous labels and features in the model. There’s simply no reason to give the IRS or a court the opportunity to suggest that the parties weren’t serious about the transaction as evidenced by sloppy references and editing.

Verify the Assumptions

An initial model may be prepared early in the life of a renewable energy project, even before the parties have struck a deal. Subsequent negotiations and changes in the facts may not always make it into subsequent versions. So, it’s important to check many of the basics on an ongoing basis: the date that the facilities are placed in service, the timing and amounts to be invested, the pre- and post-flip percentage ownership of the parties and so on. Remember that even as things settle, deals evolve: fees vary, the names and roles of the parties change, and additional sources of funding may appear (sales of state credits or renewable energy certificates (RECs), for example), and it is important that the model keep pace with the transaction. Finally, remember to scrutinize “soft costs” and intangibles–it’s crucial to conclude that development fees are reasonable, that costs are properly allocated among different assets that have different depreciable lives and that headings like “other” and “miscellaneous” represent real costs that are properly reflected in the model.

Checking the Math

This is not easy to do, and many of us prefer to read the benefits as a set of printed pages representing a single snapshot of the transaction, instead of a “live” computer spreadsheet where a change to one cell ripples through the model in real time. Nonetheless, it is important to review the model for numbers that seem off when compared to the source material from which they were generated. For example, are REC sales properly included in revenue? Do capital accounts and basis adjustments appear to match the losses and cash distributions allocated to the parties? More important, have computations made on one page been properly transferred to another page where they are then applied? For example, have the principal and interest payments on the debt page been properly transposed to the tax and cash flow compilations that appear elsewhere in the model? Finally, keep an eye out for cells with error messages. These don’t merely suggest sloppiness–error messages may indicate that the model actually “doesn’t work” and needs to be fixed before tending to mere typographical errors. This is also the time to check for proper depreciation methods and techniques. For example, in recent years, some models have taken to including 50 percent bonus depreciation even before Congress (in its usual last-minute flurry of extenders) has approved the technique for the current tax year. You’re free to make whatever assumptions you like about changes in law, but you act at some peril if you assume that Congress will adopt something this year just because it did so last year.

Importance of Capital Accounts and Borrowing

In general, losses can only be taken against an investor’s capital contributions and share of the entity’s borrowings. As a tax matter, nonrecourse borrowing (where no partner or member is liable for repayment of the loan) is most often allocated to the investors in accordance with their interest in the entity’s profits. However, in the real world, nonrecourse borrowing may be harder to come by—lenders to the owners of many renewables projects seek guarantees from the sponsors of the project, meaning that the borrowing is allocated for tax purposes to the sponsor. As a result, the investor’s share of losses may be limited to the actual amount invested. If you see the investor’s capital account slip below zero in the model, make sure that this is consistent with the project’s debt financing. If the project’s debts are recourse to the general partner/managing member, there might be an error in the model.

Profit Motive

A particular function of the financial model is to show that the investor can demonstrate that it has a profit motive. Stated simply, does the investor anticipate that that the cash and tax credits that it will receive from the investment will exceed the cash that it is investing? The amount of cash invested and anticipated credits are easy enough to compute, but the cash distributions are a bit harder to ascertain.

First, there’s the annual cash distributions. Typically, this is a distribution equal to some percentage of the investor’s capital contribution for the first five years. Often, there’s also an anticipated variable return based on hypothetical amounts of electricity generated and assumptions about the price paid for electricity, and perhaps RECs. The investor’s share of these amounts may vary, both on account of the guesswork associated with these assumptions, and because of a flip in the investor’s interest after the five-year recapture period has ended. Second, there’s a possible liquidating distribution or purchase of the investor’s interest at the end of the investment.

Different tax advisors set different requirements for these cash flows; some like to see the investor receive a compounded percentage return that exceeds some number, while others seek a fixed premium, which might be as low as $1 over the investment. Many like to see variation in the annual cash returns to the investor, and not just a fixed percentage of the original (or outstanding) investment. Regardless, it is important for the projections to meet the tax adviser’s requirements, whatever they are. Sometimes, this means that the investor needs to have a higher post-flip percentage than 5 percent of its original share. In other words, while 5 percent of the ultimate proceeds from sale of the facility may not be sufficient to show a profit, 20 percent (or some other share) may provide enough of a boost to the amount potentially distributable to the investor to pass the tax adviser’s requirements. Of course, the project sponsors will likely want the investor’s post-flip share to be as small as possible. This explains why both parties want projections that enable them to set an appropriate post-flip percentage for the investor’s interest.

State Credits

While the project may well need local tax subsidies to pay all its costs, it’s not uncommon for this section of an early model to be blank or entirely hypothetical while a state credit investor is being found and deal terms are being settled. Make sure that the final model is consistent with the handling of the state credits and that it clearly shows which partners/members are being allocated gain or income related to the monetization of the state credits, if applicable. State credits are often sold at the landlord level in lease-pass through transaction and the investor, by way of the master-tenant, has a 10 percent or larger share of the resulting tax liability. The model illustrates the potential tax liability from this allocation, where applicable.

Variable Payments from the Off-taker or Master Tenant

Many transactions have an upfront energy or lease prepayment. The tax consequences of these transactions varies, but a large initial lease payment or irregular lease payments often require a schedule prepared in accordance with Internal Revenue Code (IRC) Section 467. These computations are complex, and require a sophisticated model to assure that the tax consequences are properly handled.

Term of the Projections

Between the profit-motive analysis, assuring that maintenance and replacement costs have been included in the anticipated cash flows and demonstrating that the project’s debts can be paid in accordance with their terms, the model must run for enough years. It is usually insufficient for the model to stop at six years (or some other really short number) on the theory that the investor will be leaving at that point and doesn’t care. In fact, there has to be a proper demonstration that the numbers are realistic and often this envisions at least the possibility that the investor will stay in the deal and that certain debts will come due or parts of the project will have to be refurbished or replaced. This can mean that the term of the projections will run into double digits, if not to the end of the projected useful life of the facility.

Conclusion

As you can see, the projections can present a minefield of potential tax and business issues. Accordingly, it’s important to not only undertake the close scrutiny described here, but that the person setting up and running versions of the model be particularly sophisticated. It’s one area where no one wants to find out a year after closing that the transaction was not properly modeled or that the numbers developed in one schedule were incorrectly computed or never made it to another schedule where they were crucial to investment decisions.