The Current: What is ‘Back Leverage’ and What Do I Need to Know About it?

Published by Forrest D. Milder on Tuesday, May 9, 2017

There was a time when most renewable energy tax credit (RETC) projects were financed with a combination of project-level debt and equity. If an LLC owned the project, typically the managing member (MM) provided the “sweat” and a small amount of cash. The investor member (IM) provided cash proportional to the tax credits it was being allocated and a lender provided the balance, sometimes on a nonrecourse basis and sometimes with the benefit of a guarantee by the MM or an affiliate. The lender took a lien on the facility, leading to some concern for the investor that following a loan default during the five-year recapture period, the lender might foreclose on the facility and thereby cause tax credit recapture. 

The possibility of foreclosure led to the rise of “nondisturbance agreements” and “super nondisturbance agreements” or “SNDAs” intended to limit, as much as possible, the possibility of the lender actually transferring the project during the five-year recapture period.

While there continue to be many RETC transactions financed at the project level, there has also been a great increase in the use of “back leverage” or “mezzanine financing,” that is, a loan made to the MM, which it, in turn, uses the proceeds to fund its capital contribution. With this structure, in the traditional flip-model, there is no longer a risk of foreclosure and transfer of the project because the lender’s loan isn’t even made to the project company and there is no lien given on the project. With a lease pass-through (or inverted lease) transaction, the sponsor of the project might own the project (depending on how the tax-equity investor’s capital is put into the transaction) and it might provide a lien to the lender. In that case, the regulations provide that a transfer of the ownership of the project will not affect the tenant’s claim to the credits, so long as the new owner is not exempt from taxation (e.g., a university, a government entity, a retirement fund). 

Consider the implications of using back leverage:

1. Accuracy of the Financial Projections and Review of MM’s Potential Obligations. If the MM does the borrowing, then the lender is going to want confidence that there will be cash available to the MM to repay its loan. Similarly, the MM will want to know that distributions to the MM will be large enough to repay the MM’s debt. Finally, the IM will want assurance that MM distributions will not be so large as to prevent the LLC from distributing appropriate cash to the IM, which may consist of both the preferred and variable distributions associated with ordinary operations, as well as cash, if needed, to maintain the IM’s return in the event of a breach of representations or covenants by the MM. Obviously, we’re going to need two things here: First, projections that properly accommodate the demands of all three parties–the IM for its return; the lender, to repay its loan; and the MM, to leave enough money or value to justify its putting the transaction together. Second, a comfort level that the likelihood of the IM wanting to “trap” the cash on account of breaches is small enough to satisfy the lender. Plainly, this is a negotiation, with each of the parties getting comfortable that its concerns are being addressed. The IM and the lender may reduce their investment depending on how comfortable they become.

2. Control of the Venture. Even if back leverage protects the project from being foreclosed upon by the lender, this still leaves the MM pledging its interest in the LLC as security for its borrowing. Accordingly, the parties must negotiate what will happen if the MM’s interest, which otherwise controls the venture, is lost to the lender following a default. Regardless of whether a single-tier flip structure or a two-tier inverted lease structure is used, the IM will want to be sure that the lender can’t transfer the MM interest to an inappropriate person (e.g., a transfer of the MM’s interest to a tax-exempt entity could cause a recapture of some of the credits or extended depreciation) or force a sale of the facility (or termination of the lease, if applicable) before the end of the recapture period.

3. Allocations of Losses. When there was project-level debt, there was the potential for the IM to use this debt to generate minimum gain (if the debt is not guaranteed or provided by the MM or an affiliate), thereby enabling the IM to be allocated losses even after its capital account has been reduced to zero. You will remember that minimum gain is the income that would be recognized if the property was foreclosed upon, because the property is considered sold for amount of the debt, even if a smaller amount is actually received. 

The same is not true when the MM borrows the funds at the mezzanine level, so that MM and IM simply have capital accounts and there is no entity-level debt. In this case, losses must generally be allocated in accordance with these capital accounts, meaning that significant losses will be allocated to the MM. 

4. Deficit Restoration Obligation. It is not always necessary that the losses be allocated this way. If the IM is willing to take on a deficit restoration obligation (DRO), then it can be allocated losses in respect of its obligation to contribute capital when the venture liquidates in the amount necessary to offset these losses. Even then, these allocations are not of any current value. Since the IM’s capital account has been exhausted and there is no debt to increase its basis in its interest, the losses will be suspended and only usable at some future date when the IM’s basis in its interest has been increased to an amount sufficient to use the losses.

The obvious possibility is that the IM will satisfy its obligation under the DRO and then get to use the losses. This hardly seems a good trade for losses, since the DRO represents an actual cash obligation, while the losses are only worth 35 cents (or less, depending on tax reform). 

But that is not the only way to satisfy the DRO. Income allocated to the IM when the venture generates revenue after depreciation has ended can also bring the IM’s capital account back to zero, thereby reducing the DRO to zero. The suspended losses could then be used to avoid tax liability on this allocated income. With no debt on the facility, it seems unlikely (barring a catastrophe, which might give the IM a claim against the MM anyway) that the venture would otherwise be liquidated before the IM has seen the DRO eliminated by these allocations of income. Even if the IM sells its interest, it would be expected to recognize income when the buyer assumes its deficit restoration obligation, and again use the suspended losses to shield it from the associated tax liability.

5. Respecting the Transaction. Still, if the allocation of losses in a back-levered transaction does not generate something of value to the IM, then why bother? Many tax advisors think that there should be a share of losses allocated to the IM, consistent with its share of credits. There is not universal agreement, especially as to how many months or years these allocations should be paired. Some would allocate losses to the IM for at least the five-year recapture period, while others would allocate losses only through the month or the year that the facilities are placed in service. In either case, the intention is to make it clear that the IM is not “purchasing” only the tax credits. 

Of course, there are contrary arguments–indeed, the Treasury regulations contain an illustration of tax credits being allocated in accordance with partners’ interests while the losses are “reallocated” to the partner who still has a positive capital account. And the lease pass-through (or inverted lease) structure, found in the Internal Revenue Code and regulations, is plainly a method for allocating only tax credits to the investor in a RETC transaction, while the sponsor/landlord keeps the depreciation. 

In any case, as discussed above, when a DRO is used to back up the allocation of 99 percent of the losses to the IM for some period of time, it is not anticipated that the IM will have to actually lay out cash to satisfy the obligation. Instead, it is anticipated that the IM will have income and suspended losses to offset the risk of the DRO in almost all situations.

The bottom line is that back leverage can be used to eliminate one problem associated with debt finance (i.e., trying to negotiate an acceptable SNDA) while generating a different set of problems (in particular, assuring that there will be sufficient cash available to the MM to pay off its mezzanine-level debt obligation). The MM and IM can control some of these issues in the LLC’s agreement, recognizing that the back-leverage lender will have to be satisfied with its rights to cash or there won’t be a loan anyway. 

Forrest David Milder is a partner with Nixon Peabody LLP. He has more than 30 years’ experience in tax-advantaged investments including the tax credits that apply to affordable housing, energy, new markets and historic rehabilitation, as well as the tax treatment of partnerships and LLCs, tax-exempt organizations, and structured financial products. He can be reached at (617) 345-1055 or [email protected]