Why (and How) the Solar Finance Market is Changing in This Crisis

The renewable energy asset class in the U.S., particularly solar
and wind projects, is something of a safe-harbor for investors
looking for non-correlated, stable, dollar-denominated long-term
cash flows. But the solar market, like every sector of our economy,
is changing amidthe COVID-19 pandemic.

It is tempting to collapse these changes into a simple takeaway,
“tax equity is fine†or “rates haven’t changed.” But the
$20+ billion financial market supporting the solar industry is
anything but simple, and COVID-19 will have different impacts on
different segments of the industry and different players within
those segments.

Here’s how we see COVID-19 impacting the different parts of the
capital stack.

COVID-19’s impact on institutional investors

The investment community generally works like a waterfall in
which institutional investors drive investment into companies,
assets, or funds, which in turn often invest themselves.

Institutional investors are generally defined as pension funds,
insurance companies, sovereign wealth funds, mutual funds,
commercial banks, and endowments investing on behalf of themselves
or their members. These investors rank investment opportunities
based on the underlying stability of returns, historic volatility,
counterparty risk, liquidity, and other factors. The different
asset classes are characterized along a spectrum, running from
“core” to “opportunistic.”

A core investment in solar energy might be a fund or portfolio
strategy focused on purchasing debt instruments on a 20-year
contracted asset with an investment grade IG counterparty. An
example is the $2 billion in green bonds that Bank of America
offered in 2019. An opportunistic investment might be a private
equity firm investing in a portfolio of development assets in PJM
expected to yield double digit returns.

Both types of investments are impacted by COVID-19, but not
equally.

During times of crisis, institutional investors narrow their
investment aperture and there is a reallocation of investment from
the higher risk/yield investments in opportunistic funds to lower
risk core funds. These investors immediately slow down the
origination and underwriting machine until they have a better
understanding of what is going on. In the last three months a good
number of opportunistic investments have become impaired amid the
downturn. They might also set cash aside to support the investment
or try to sell their interests if there is a liquid market.

Finally, the commercial paper market (debt backing corporations)
is over $1 trillion in value, and this market has a massive impact
on almost all institutional balance sheets because these investors
hold so much of these investments. In one example, while Disney+
may be doing well, Disney itself was recently downgraded due to
COVID-19’s impacts on its theme parks. Once a corporate credit
rating is downgraded, an institutional investor who owns commercial
paper must set aside additional capital to support the investment.
This reduces liquidity.

Institutions can also sell the security, but when multiple
corporates are downgraded, everyone begins to sell at the same
time, and pricing declines precipitously. This is one of the most
important credit markets for the economy, which is why the Federal
Reserve of New York recently launched the
Commercial Paper Funding Facility
to support this market.

This broad reallocation of risk and investment impacts the
entire solar industry, but especially impacts those funds that
support the more entrepreneurial efforts that have historically
helped expand the market.

Impact on sponsor and development funds in solar

Funds that are backed by institutional capital and are
structured to buy and hold assets long-term generally target more
conservative returns with long-term contracted cash flows. Assuming
these funds have committed capital, they will weather this storm.
Similar funds that have not been closed and committed may take
longer to close given restrictions on travel: try closing a $500
million fund over Zoom. But this asset class was compelling prior
to COVID-19, and it will continue to be in the future.

Investments in private equity funds that are seeking higher
returns in exchange for risk may struggle in the current
environment. Those funds that have committed capital will likely be
more cautious in deploying it, and riskier assets may receive less
attention. Those without committed capital are going to struggle to
raise it in this environment.

This risk-off cycle will hit investments in merchant assets,
development assets, aggregation facilities, non-investment grade
strategies, high yield portfolios, and developers seeking
development capital. These entrepreneurial efforts are critical and
sow the seeds for the industry’s future. Inevitably, these
constraints will favor companies with access to larger balance
sheets, and it will accelerate the developer consolidation
already underway
in the solar industry.  

COVID-19’s impact on tax equity and debt

Banks are the primary participants in both the tax equity and
debt markets for solar. Bank exposure to the recent economic
downturn has been driven primarily by loans, and in some cases,
loans made to extractive industries and to retailers who have been
hit hard by this crisis. The themes here are similar.

Debt

On the lending side, even as interest rates have fallen, the
spread (generally a premium over LIBOR) has increased from 1.25 to
1.75 or 2.00, and in some cases higher. The scale of the
opportunity and the commercial weight of the lender matter. Lending
fees have increased proportionately as well. Bank spreads and fees
increase to compensate them for lower all-in returns on capital
that results from lower interest rates. It will be interesting to
see how this market changes in the next few months as the country
attempts to return to normal.

Compounding this is an overarching concern around liquidity. As
concerns grow around the integrity of outstanding loans, banks
suffer the same capital constraints as institutional investors and
funds. Further, because this is an industry-wide issue, banks are
struggling to syndicate loans out to other bank partners. As larger
banks struggle to make money on syndicating loans, they must
underwrite the entire loan to a long-term hold, all driving up the
cost of capital.

Lending has always been a relationship business. It certainly is
now. In the current market environment, if a developer or
independent power producer doesn’t have scale or historic
relationships it can be challenging to secure loans. The stronger
the relationship and the larger the opportunity, the better the
terms.

Tax Equity

Tax equity provides anywhere from 30-40 percent of the capital
stack for solar. A functioning tax equity market is critical to a
healthy solar industry. 

From the outside, the solar tax equity market often looks
monolithic, with a half dozen primary participants. The reality is
that there are dozens of participants behind these entities
investing in funds or through syndication structures. Some of the
largest solar tax equity investors are syndicating 50 percent of
their volume. This has pros and cons for the industry.

A broader population of tax equity investors means that markets
are more resilient than most people assume. A good number of
investors are grocery chains and tech companies that are weathering
the crisis. Syndication also means that the solar industry is
incentivized to find new tax equity. That’s mission critical for
everyone.

The drawback is that syndicators don’t control or always know
the profitability or commitments of their clients. This is why many
of the large tax equity investors are honoring the term sheets in
front of them but are slowing down new origination. Many smaller
syndicators representing corporate customers are putting deals on
hold. And of course the banks themselves have their own challenges
right now and some of the largest banks have stepped out of the
market as their exposure to industries like natural gas hammers
their portfolios.

This is our single largest concern for the industry, which is
why we’re working closely with SEIA to explore whether there may be
tools at the federal level (like refundability of the Investment
Tax Credit) that can help address these issues.

The path forward

Anyone who has helped build a company in this industry knows the
relentless struggle. The most that we can do for one another is to
share our experience and perspective. Here are a few
suggestions.

First, if you’re a developer, avoid transitioning into owning
assets if you don’t already. This is not the time to be
initiating a new phase in your development business, and it may be
a good time to consider simplifying it.

Second, if you are going to work with banks to secure long-term
debt or construction debt for your projects, find a good partner
and invest in that partnership. Ask about their approach and ensure
you trust them. Same goes for tax equity. We’ve seen both sides,
having both deployed tax equity and worked with our partners to
secure it. Relationships matter.

Third, if you’re developing early-stage assets or
semi-merchant assets, ensure you’re focused on quality and tenor.
Also ensure you’re capitalized to carry your assets a bit further
into the development cycle than you may have planned. If you are
not, prune your portfolio.

Most importantly, stay sane and stay hungry. Solar remains the
future, and we’re building
that future together
.

***

Yuri Horwitz is CEO at Sol Systems, a national solar finance and
development company.

 

Source: FS – GreenTech Media
Why (and How) the Solar Finance Market is Changing in This
Crisis