Tax Equity Bottleneck

Small to mid-size C&I projects have always struggled to obtain financing from tax equity.  Utility-scale projects have historically utilized the partnership flip structure, and in recent years have started to explore inverted lease structures more. Residential rooftop portfolios have almost exclusively used partnership flips and inverted lease as the preferred form of structure to raise tax equity. On a stand-alone basis, however, small to mid-size C&I projects cannot support the transaction costs that these more complicated structures carry.  This often results in developers aggregating projects into a portfolio and selling them into a single tax equity partnership or utilizing a sale leaseback structure for individual projects. In this post we outline the pros and cons of the prevailing tax equity structures and the emergence of transferability in an attempt to surface the reasons for a perceived bottleneck in tax advantaged capital in C&I projects. 

When comparing the three structures, each has its advantages and disadvantages: 

	Partnership Flip (“P-Flip”)	Sale Leaseback	Inverted Lease
Pros	Provides 30% to 60% of FMV as low cost capital to the project  Established, insurable structure	Maximizes tax equity proceeds Single provider of permanent financing and tax monetization Lowest transaction costs	Decouples ITCs from the ownership of the project(s)  Allows ITCs to be calculated on FMV  without a sale of project
Cons	Requires sale of project to achieve a “step-up” to FMV  Gain on sale is a taxable event	Sponsor must repurchase at FMV to realize residual revenues	Contractually complex  Provides comparatively least amount of capital

All three cases present unique challenges for C&I developers, but at the root are two main issues: size and standards. 

There is not enough juice in the squeeze. Smaller projects cannot sustain the costs of setting up and administering complex tax equity structures like P-Flips or inverted leases. Sale lease backs present an interesting opportunity, but most of the banks with tax capacity and the capability to underwrite project finance have minimum size and sponsor standards that preclude many C&I developers.   

Underwriting standards are high. The stakeholders making tax investments are generally risk averse. The majority of tax equity transactions are underpinned by investment grade rated offtakers. In some ways this is a product of complexity; having a credit counterparty that is perceived as a strong credit “simplifies” an otherwise complex process. However, most C&I offtakers do not meet this credit standard.  

The complexities of various tax equity structures have led many developers to sell tax credits generated by the project. Contractually this is a simple approach, but it does not allow for a fair market value step-up nor does it confer any depreciation benefits on the purchaser. Some projects are pursuing hybrid structures (known as “T-flips”), but the real issue is a supply-demand mismatch: there are more projects than tax advantaged capital can support. This causes a flight to simplicity and perceived quality... in other words: size and standards!