What HTC Developers Need to Know About Evaluating and Negotiating Term Sheets
So you plan on rehabilitating a historic building and have begun the process of exploring the opportunity of monetizing the historic tax credits (HTCs) the rehabilitation can generate by obtaining equity from a HTC investor as part of the development project’s overall sources of capital.
Generally, the first step in the process of raising equity is to obtain HTC equity term sheets from prospective HTC investors that will contribute equity for the right to be allocated the HTCs. The term sheet’s primary function is to establish the general legal and business structure that the HTC investor and the developer will use as the framework for the drafting of the operating agreement for the tax credit partnership. The term sheet will identify key economic terms of the proposed arrangement, such as price per dollar of HTCs, equity pay-in schedule, sharing of project cash flow and HTC investor buy-out price. In addition, the term sheet will address nonfinancial matters such as the proposed legal structure of the arrangement, HTC investor and developer rights and obligations, guarantees and lender forbearance requirements.
What process will the developer generally go through to obtain, negotiate and finalize a term sheet from an HTC investor?
Term Sheet Basics
First, let us discuss obtaining the term sheet from potential investors. Because many investors will require certain financial information to evaluate the investment opportunity, they request a tax credit accountant to prepare a preliminary financial model (financial forecast). This is where tax credit accountants begin our involvement the process. We obtain from the developer information related to the project’s sources and uses of funds and operating income and expense assumptions, from which we will develop the anticipated financial transaction structure, HTC calculations, cash flow and taxable income/(loss) schedules. Once prepared, the financial forecast will be submitted to prospective investors with the intent of receiving term sheets.
Once multiple term sheets are received, our role continues to the next step of monetizing the HTCs by comparing the economic and noneconomic terms of each proposal and providing a financial evaluation of the key economic terms for the developer to use to determine which investor they will chose to begin the negotiating process. Often, the developers will focus solely on the price per HTC the investor is proposing to determine their total equity contribution. This fixation on the “pricing” factor and strictly relying on one economic provision in determining which investor to choose can result in the wrong net financial benefit that the HTC will generate for a developer for their project.
When doing a financial comparison, all key financial terms should be evaluated, starting with total anticipated equity and then adjusting for costs associated with the tax credit equity. These offsets to the gross equity proposed include preferred returns, residual cash-flow-sharing requirements, investor put price (amount to be paid by the developer to the investor at the end of the HTC compliance period to acquire their interest), asset management fees paid to the investor, certain third-party transaction costs such as legal and accounting, and any incremental increase in borrowing costs because of timing of HTC equity pay-in schedule and required reserves. Each term sheet will contain these factors (and possibly others). The above analysis would be prepared for each term sheet, with the conclusion being the net benefit that would be derived from the HTCs generated by the project and transferred to the investor (gross equity less offsets discussed herein). The net benefit is the more meaningful comparison of the various investor proposals as compared to strictly comparing based on HTC pricing.
As noted above, a term sheet will contain other key requirements that also need to be evaluated. Some of these requirements are as follows: transaction structure (single tier vs lease-pass through structure), forbearance or subordination and non-disturbance agreements that lenders must agree to mitigate potential HTC recapture when a loan goes into default, guarantees, liquidity requirements of guarantors and investor rights. There are challenges with comparing each of these investor requirements, but they are important for the developer to understand the impact of them before choosing an investor. Your tax credit accountant and legal counsel will play a significant role in assisting the developer in understanding all these provisions and how to compare among term sheets.
Negotiating the Term Sheet
Now that the developer has been provided information to assist with the decision and the key financial terms have been evaluated, the developer will select an investor to begin the next process of getting to an executed term sheet. Therefore, once the investor is chosen, the next step is negotiating the term sheet. This is a collaborative process among the developer, its counsel, the tax credit accountant, the HTC investor and their counsel. The goal is to clarify, document and agree to all business and legal provisions of the planned partnership between the developer and the tax credit investor that will allow for a smooth transition to drafting of the operating agreement and eventual agreement to that document. Again, the goal is for the parties to agree on the key terms and get to a financial closing with the tax credit investor such that the planned equity contributions become actual capital available to help finance the project’s development costs.
To conclude, the above is the general process that a developer should understand should they be looking to monetize HTCs that would be generated from the rehabilitation of a historic building. The process begins with engaging your tax credit accountant to prepare a financial forecast that will be the framework that investors will use to create their respective term sheets. Once obtained, a financial analysis should be done to compare all key economic provisions, such that the overall net benefit that is calculated is a key tool for the developer to use while they choose a HTC investor, though keeping in mind that not all the provisions will be financial and but will still need to be evaluated. Then, once that is completed and the developer makes that decision which investor to move forward with, the process of completing the term sheet such that both parties are in agreement to all of its provisions can begin, which will allow the parties to get closer to achieving a financial close.
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