Acquiring a Development Stage Asset in the USA
Hi all, looking for some guidance on what I think might be a super simple question.
I am looking at the acquisition of a renewables development stage asset. We will be putting forward our own capital structure on the asset and will be looking at the combination of the three to fund the asset: back-levered debt, tax equity, and our own sponsor equity
Our own equity would be used to pay the development (acquisition) fee and some portion of the capex. The project can qualify for 50% ITC (vs. the base 30% ITC) that you typically see, which means that we can get a larger tax equity investment than normal
Two question that I am looking for guidance:
- Project Finance (not tax equity) lenders tell us that our maximum gearing on the asset can be 90%. Does gearing take into account “tax equity (TE) investment” ? My understanding is that TE investment counts as preferred equity and is not included in the gearing definition. Can someone here pls confirm
- More importantly, my fund wants to target a 20% IRR on the development stage asset. And the way my capex and capital structure is unless I assume that we pay zero development fee (i.e. acquisition fee) and reduce our equity to 4 to 5% of the total capex, only then we can get a 20% levered IRR return. With a third-party’s tax equity investment included in the definition of equity, total equity would be ~70% of the capex.
I am not sure, but I don’t think any back-levered debt lender would be OK with us putting only 3-4% of sponsor equity into the asset. Which begs the question in my head whether a 20% return is even financially possible. I feel like this might be a dumb question and so am curious what some more experienced infra/renewables guy here think about this
Based on the most helpful WSO content, here are the insights regarding your questions:
Gearing and Tax Equity Investment:
Achieving a 20% IRR with Low Sponsor Equity:
In summary, while it is theoretically possible to achieve a 20% IRR with a low percentage of sponsor equity, it is often not practical due to lender requirements and the overall capital structure. It might be necessary to reassess the capital structure or adjust the IRR expectations to align with market realities.
Sources: Renewable Energy PE Overview, Renewable Energy PE Overview, Specialty Lending (GS/TPG) - Any insights?, Rough mental return calculations?, Real Estate Private Equity Technical Qs
Development assets do not transact at 20% IRRs in the US, they transact at like 12%-15% depending on the stage of the project. So no, 20% is not going to happen.
Thanks for responding
20% was just as an example. I could have said 15%. The question is what model assumption (s) could I realistically flex to achieve the desired IRR?
Got it, I thought the 20% was the more important part because you started that bullet with "More importantly" and asked if a 20% return is even financially possible.
The answer is that you can't flex much other than recontracting rate at the end of the contract. Tax equity is what it is, maybe you'll find someone offering slightly better terms, same with debt, but these structures are pretty copy/paste in most circumstances.
Thank you. Makes total sense.
So basically your returns are capped here.
Can I also please ask that when lenders say max gearing is 90%, does that include tax equity investment under "debt".
Correct, lenders are not going to let you get away with putting in 5% of the project capital. Even 10% is surprisingly low, I'd expect to have to put in more like 20% although my assumption there might be slightly outdated.
Agreed, I typically see something like 20-25% sponsor equity with the rest divided between tax equity and back-leverage debt.
Thanks, appreciate your response. I was talking about the capital structure at COD. Below are the rough splits of my capital structure at both start of Construction and at Operations. As you see, my equity is 20% during construction, but at COD, my equity goes down due to surplus tax equity related funding coming in (I was assuming that I can only draw up to 90% of my TE investment in the form of a tax equity bridge loan at start of construction). Based on your response, my simple question is if I am smoking crack by running my base case assuming this capital structure?
Start of Construction Phase
Construction Debt - 35%
Tax Equity Bridge Loan - 45%
Equity - 20%
Start of Operations
Back Leverage Debt - 35%
Tax Equity Investment - 60%
Equity - 5%
BUMP
What’s the FMV Step-up you’re assuming on the deal?
15%
The lowest I have seen is 10% equity so I really doubt you can flex down your equity to 4-5% to get your desired IRR. And do not underestimate COD financing…seen plenty of times where we have had to keep in the equity from construction or even put more in. Shit happens all the time in this business.
is it because of construction going over budget (and over time) and / or some issue with the grid or offtaker?
Usually construction, legal issues, etc.
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