Choosing A Development Capital Path

Renewable project development is a cash intensive endeavor. Usually too much so for an individual to bear the costs, yet not enough to garner the attention of traditional investors – a “no-man’s-land” of capital requirements. Most of this cash is needed before project value and timelines are clear. A developer needs to show value and mitigate risks to attract capital, but needs capital to create value and mitigate risk – the first of many chicken-egg problems to come. Amidst a pandemic injecting uncertainty and obliterating liquidity, the age-old conundrum is on steroids. So….what to do?

Each developers’ personal and/or corporate financial situation is different, so the question comes to the fore at different points for different teams, but at some point nearly every smaller developer comes to this fork in the road. In our experience, there are essentially four different routes to take:

1.   Self - finance (or friends and family)

2.   Raise capital at corporate level

3.   Sell to a large developer/IPP/fund (a “big fish” buyer)

4.   Raise project-level development capital from a third-party

This piece will primarily focus on the relative benefits and costs of options 3 and 4, but before diving into that, lets briefly consider the first two.

Option 1 – Self-Financing

Self-financing is attractive for two obvious reasons: i) no ownership dilution or interest costs, and ii) complete, unfettered control. If a developer has the means (cash), the conviction, and the risk tolerance to self-fund the next step in development…then they probably should. Project/portfolio value can step up quickly in the early stages, so carrying opportunities through the next marginal step can bear significant fruit. That said, incremental value rarely increases in a linear fashion (see figure 1 below) and a negative finding in diligence can take an asset with immense theoretical value to zero overnight. Accordingly, “betting the farm” on something with a binary outcome is probably unwise, and renewable project development is a cash-intensive game, making this option a rare luxury.

Figure 1: Illustrative Step-function of Project Value

Binary risk of this nature is best absorbed into a larger portfolio of assets, where the law of averages offers protection. Developers seldom enjoy such circumstances, so must confront a brutally difficult choice between i) control and upside vs. ii) healthy personal/family asset allocation. When the latter wins out, one must look elsewhere. 

Figure 2: Pros and Cons of Self-financing

Option 2 – Corporate “ABS” Loan

Corporate financing is a great option for those who can access it -- emerging or established developers with significantly advanced development portfolios or operating assets. These loans tend to price lower than project-specific development capital as corporate lenders use cross-collateralization and protective borrowing ratios to reduce their risk exposure. And, once the capital is available, developers don’t lose incremental control over the projects in question simply by choosing to use some of their corporate financing proceeds to support them. 

For these (and other) reasons, asset-backed corporate-level loans have served as a critical driver of the renewable energy industry’s growth in recent years. A few savvy lenders have provided much-needed solutions - and done very well for themselves in the process – by lending against a pipeline of development assets and then selling down to larger, lower-yield lenders as the pipeline matures. These corporate facilities understandably come with an all-assets pledge, controls at the corporate level, and are not unlimited… so they don’t suit everyone. 

Developers who choose to take on such a facility must guard against the “growth treadmill” trap that corporate facilities tend to induce. The interest accumulates quickly, and the developer only creates equity value if they generate all-in returns (including SG&A!) greater than the corporate interest rate. When the universe of projects with such returns thins out – and it does - the natural reaction is to seek more volume. But more volume leads to lousier execution (lower margins) and more SGA. For some, this chain of events results in a company “chasing their tail”, focusing on little more than staying out of default. This is avoidable with a combination of i) appropriately conservative asset value assumptions, and ii) prudent, conservative sizing of debt. Alas, conservatism and prudence are not the first two words that come to mind when one considers developers, so the growth treadmill is common.

If the situation is right, option 2 is often the best option, but not every developer has the ability to raise platform financing, or the discipline to use it wisely.

Figure 3: Pros and Cons of Corporate ABS Loan

So, the classic situation: you, the developer, stare at a project (or portfolio) that appears promising and potentially valuable, but need resources to continue to push it towards the finish line. You have exhausted access to any more personal cash and the corporate coffers are low/empty: options 1 and 2 are off the table. You must now turn your attention to options 3 (selling out early to a bigger fish) and 4 (3rd party development capital). 

Before jumping in, I must acknowledge some bias. My current firm makes project-level investments in development-stage projects with the sole objective of generating a good risk-adjusted return while helping a trusted partner turn a concept into an operational power plant. Therefore, we fit squarely into the 4th group.  Furthermore, in past lives I was part of large vertically integrated developers where I lead/approved dozens of transactions in the option 3 category. So I've seen those movies; in fact, I directed a bunch of them, and in doing so came to see more clearly the limits and embedded inefficiencies of the "sell-out early" option. With that bias out in the open, a closer look at these options:

Option 3 – Early Sale to a “Big Fish”

You, the smaller developer, were probably early to the market or sub-region, but you know you’re no longer the only game in town. A couple “big fish” in the same pond are expressing interest in “partnering” or buying the project outright as a means to bolster their existing development efforts or gain a foothold in the new, exciting market. This seems compelling. And why wouldn’t it? There are some alluring numbers being tossed around, you’re flattered that this brand-name firm is knocking on your door, and it sure would be nice to go to battle with someone who has some weight (and cash) to throw around.  

The most common transaction structure for such a deal is a sale with deferred milestone payments (sometimes through a separate services contract like a DSA). Usually some upfront payment – reimbursement of costs incurred to date is a common yardstick – is paid through the membership interest purchase agreement (MIPA) in return for transferring 100%(!) of the project company. The developer’s profit potential lies in payments to come at later development milestones.  Call it a "joint development agreement" if that helps you sleep at night, but that's rarely what it really is. This is where things can get dicey.

Figure 4: Pros and Cons of a Sale to a “Big Fish”

Common payment/success milestones include i) execution of a revenue-contract, ii) execution of an interconnection agreement, and iii) NTP. The concept is logical, of course, as value is passed through to developer/seller as it is created. But here’s how problems can arise:

i)          The developer does not control achievement of milestones. For example, no non-owner contractor would ever be granted authority to actually enter into a PPA. Putting an executable PPA on the table? Sure. But who signs it? (hint: the project company owner). Or what about NTP? Remember, a project being ready to go under construction is NOT a project under construction. NTP is something that is actively issued, the issuance of NTP is controlled by the party to the EPC agreement…which is the project company….which is controlled by buyer.  

ii)         The buyer does not always have the same goals as the developer. Large developers and IPPs are usually in multiple markets, and vertically integrated to boot. A wide swath of business units compete for a finite pool of attention and cash. Market shocks impacting any of these other endeavors could impact the buyer’s ability or willingness to provide ample support to a given project. Furthermore, within the sub-market in question, a large developer probably has a fleet of potential projects. They often need to triage and prioritize the most promising ones, which may or may not include the developer/seller’s project(s). Even worse, the developer/seller’s project(s) might even serve to cannibalize other projects in the buyer’s portfolio, putting it on the chopping block. While “catch and kill” acquisitions are very rare in our experience, circumstances could arise that cause developer/seller’s project to be cancelled because doing so is what’s best for the buyer’s portfolio at-large. And frankly, buyers should not be faulted for that perfectly rational choice. It’s simply a misalignment of interests which could result in developer/seller receiving no further compensation for a project which, in isolation, has value. In such circumstances, developers/sellers usually have an opportunity to buy a project back, but in a game where time-is-money and value monetization windows open and shut abruptly, this rarely offers much consolation.

iii)        Buyer profit and seller payments are in a zero-sum-game. The headline numbers in these transactions can be intoxicating. Developers, naturally, assume the best fathomable outcome when assessing their economic prospects in the transaction. Sometimes they simply under-appreciate how much of their headline MIPA price is deferred and contingent. But there’s a more subtle source of potential downside which is wildly underappreciated – cramdowns.

Let’s talk about that last one a bit more. Remember how the buyer truly holds the keys to various milestones being achieved? Well, what happens if the “big fish” buyer reaches, say, a PPA or NTP milestone and doesn’t particularly like the economics they see after considering the costs they face in the form of deferred developer/seller payments? I expect this phone call will sound familiar to some: 

“Hey _____, we know you’re excited to have this project hit NTP, and we would be too, but for the fact the project is kind of under water for us right now. It doesn’t really make sense for us to move forward and issue NTP. We would, it’s just the economics don’t pencil for us with your deferred MIPA payments in there. Now…if you were to agree to get paid X% of what’s in the contract instead of what we initially agreed to, then we would issue NTP and pay you that amount.”   

Sometimes a “big fish” buyer might play that hand simply because they have the cards and the willingness to take a Machiavellian approach. In my experience, those cases are outliers. More commonly that message is delivered truthfully from a rational actor who is not behaving especially greedy [author raises hand]. You can’t force someone to build a project on which they stand to lose money. The point is, the “purchase price” is theoretical in practice. A smart developer/seller thinks about it as their ceiling, not their expected proceeds. From the buyer’s standpoint, it’s almost like an option they purchase at the MIPA closing payment – if everything goes swimmingly, sure…pay the developer the full MIPA purchase price. If not, pay what you can afford to pay, and the developer will have to choose between receiving that, or getting nothing. If you’re picturing Mr. Burns or a conniving man in a top hat twirling his moustache, that’s not quite right. It isn’t that sinister, or even intentional. The negotiations probably started with a more realistic purchase price – one less susceptible to forthcoming cramdowns. But developers adore their “children” (projects) and believe they are exceptionally special (valuable). A “big fish” buyer is bullish on the asset, but maybe not quite to the same degree. The competitive pressures of the M&A market serve to reinforce the developer’s conviction (and vice versa). At some point, sensing the only alternative is to lose the deal, buyer gives in to a different approach: “fine, well if this plays out as you swear it will, I’ll pay you that big number”…and then thoroughly protect themselves against shortfalls and failures in the transaction documents. 

Why is this so commonplace when two ethical, professional, and well-intentioned parties transact? The buyer is a developer too! Both participants generally share the same enthusiasm for the potential of the asset and want to “lean-in”, believing the project can get over the remaining hurdles on time and under budget.

Herein lies the problem: things almost never go as planned with renewable project development, especially if the plan was optimistic from the outset. If there are more granular conditions precedent for deferred payment milestones, odds are a couple of them won’t be satisfied as they lie. Maybe a non-critical lease amendment doesn’t show, or a property tax abatement gets rejected in the city council meeting. These probably aren’t binary issues for the project owner, but the documents say they are binary issues for the developer/seller getting paid. It’s not horseshoes or hand-grenades, even if a developer feels like it ought to be. Not every “big fish” buyer will take advantage of that situation, but some will, and in many cases the project economics have considerably worsened, giving them ample justification to walk away from the project or change the terms. After all, they have the contractual right to do so and you didn’t deliver the goods. Welcome to Cramdown City, population…well, actually I’ve lost track.

Option 4 – 3rd Party Development Capital

Anecdotal market chatter and brochure-level mandate descriptions would understandably cause most developers to believe the capital markets are bursting at the seams with true development capital. Walk out your front door with site control plus a queue position and a 10% “development loan” will fall in your lap.  This ludicrous notion is a child of the capital overhang that persists in the operational/infrastructure part of the capital market. As that supply/demand (MW/money) imbalance has steadily grown over the last decade, first long-term owners sought competitive differentiation by purchasing projects at NTP. Then, as the rest of the market followed suit, many of the same players began transacting in the very late development stages.  Those players – still struggling to get the dealflow they promised their investors and stakeholders – make some bold claims about providing “development capital”. And many of them do!... which is a wonderful market evolution. 

But experienced developers know that not all “development capital” is the same. Posting a refundable interconnection deposit 10 weeks before construction start is not the same as providing cash for an interconnection application and feasibility study 30 months before construction start, with no offtake contract in hand. Both are needed, but the later remains substantially harder to come by. Most investors who seek long term power plant ownership will steer clear of riskier development investment - those are two very different investment types that probably shouldn't be comingled in the same strategy. In the end, their closing conditions look an awful lot like NTP; so, while the capital is very welcome in the market, its applications can be limited.

But a few other groups in the market do invest across the development spectrum, and there are some compelling reasons to consider this financing option. 

Figure 5: Pros and Cons of 3rd Party Development Capital

Third party investments take a variety of forms, including debt, preferred equity, common equity, combinations thereof, and everything between. In the earlier stages, equity investments are more likely given the return potential needed to justify the risks taken. In a sense, third party investment firm taking similar risks play the same role venture capital funds take in, say, the tech industry. Many/most of the investments contain binary risks and, therefore, could fail fabulously, which means there needs to be a realistic chance for an exceptional return. These returns are usually measured by their multiple-on-invested-capital instead of IRR. This might explain why a true development investor will struggle to answer the question “what’s your cost of capital?” If you’re looking for a simple answer (“it’s 9%!”), you’ve come to the wrong place and/or are improperly assessing the risk profile of your assets. Though it may be harder to unpack, any “big fish” buyer of the same project is expecting a similarly strong return multiple on their investment. They’re no dummies. They may not articulate the calculus in the same way and/or obfuscate their true return, but sophisticated shops know development risks and costs well enough to know that those risks and costs aren’t justified for a modest, single-digit IRR. 

As one member of the Option 4 pool of investors, I can speak to some of the tenets which guide investment selection, structuring, and underwriting:

-      Economic alignment between the developer and the investor

-      Decisions should be made by the most informed/knowledgeable people on that topic

-      Transparency in both directions

-      Everything is for sale, but nothing must sell

-      Make decisions based upon the long-term partnership not near-term profits

Lining up everyone behind the simple goal of maximizing the risk-adjusted return for all parties results in the most value creation. In my experience, this means retaining flexibility on when to exit a project/portfolio. The market is so inefficient and quirky, it’s near impossible to predict when a fantastic offer will show up. Most third-party development investors appreciate that reality and try to take advantage of it by eschewing any rigid notion of how/when/why they sell-out. A “big fish” buyer isn’t usually going to play it that way. They have a business model…they have different SGA-heavy verticals which exist to add value, and doggone it those groups are going to add their value! This rigidity can be costly to a developer who has hitched their wagon to a buyer early on. Similarly, Option 2 (asset-backed corporate facilities) are limited by loan term which can have the effect of forcing a developer to sell assets at sub-optimal moments in the development cycle. 

At the same time, our goal is to avoid ever needing to sell. The renewable energy market is chock full of lopsided transactions where a seller/borrower has run out of options or time, and the buyer/lender knows it. Illiquidity and insufficient project financing expertise are the most common cause of the lopsidedness. We strive to always have at least two pathways forward and to avoid the value erosion found in being a leverage-less term-taker. That optionality generally derives from ensuring the assets are underwritten correctly on the front-end, and the partnership has maintained enough liquidity to maximize value creation at any point. 

A third-party development investor is usually only going to invest in a group they believe in and trust, because they aren’t equipped to take the reins. This differs from some “big fish” buyers who presume superiority and grab control themselves. This is, of course, their prerogative, but often results in value destruction because the people best positioned to make a smart decision are no longer making the decisions.  We try to avoid this, limiting our heavy-handedness to areas of expertise and being a good steward of our investors’ capital. This approach gives developers a chance to have more control over their own destiny while having access to OPM (Other People’s Money) and an aligned party providing guidance, expertise, and relationships.

Figure 6: Summary & Comparison of Options 1-4

Learning from the Past

With third-party development capital being an attractive option for many projects and developers, it can be frustrating when this option is unavailable due to the lack of capital providers offering the product. Furthermore, the dearth of options has been clear for a few years now, so why hasn’t the market grown? 

Well, the market is growing, but it takes time, data, and scale – all things which renewable energy is accumulating nicely. It might be helpful to consider some other more mature market sectors which once struggled to attract capital for early stage efforts.  To ponder a few:

Oil & Gas – There was a time when upstream “wildcatting” was self-funded and mostly accessible to well-off individuals and families. It was deemed highly speculative (and was), unscientific (right again), because the probability and costs of finding oil were not well understood. As time passed, our understanding of oil basins improved, more data accumulated, and third-party investors emerged. First it was banks making high interest loans, and then a whole industry around E&P funds evolved. Today hundreds of those, plus an entire private equity sector, give wildcatters a bevy of options.

Tech – Ambitious new hardware/software ideas once faced the same conundrum that renewable projects face today. Either take uncomfortably large risks with your own (or your friend’s/family’s money) or join a company like AT&T and hope Bell Labs makes your dream a reality. The investments were seen as scary science projects. No one knew if there was a market for this stuff, and what it would pay if it existed. But then Fairchild proved that semiconductors was real business. Its diaspora went on to found the first venture capital funds (Kleiner Perkins, Sequoia), those funds understood how to “diversify out” risk, invested in a company called Apple which had an IPO in 1980….and today we see ~30,000 early stage venture investments a year[1]. Now when a technology developer thinks they are on to something, they don’t call up GE and see if they’ll acquire an idea, they seek 3rd-party development (venture) capital on Sand Hill Road to help turn the idea into something which is worth more. Things can change quickly when a model is proven.

Pharmaceuticals – For many decades there was no realistic pathway to develop a drug outside of a major pharma company. If you had a compound, you patented it and then sold it for pennies to big pharma. There weren’t many “funds” seeking to create a “biotech” startup. But in the early 2000’s big pharma companies started isolating their drug acquisition efforts into corporate venture units, and the broader capital market realized this portfolio approach would probably work within an unaffiliated fund structure. Access to FDA data improved around the same time, and standalone biotech funds started popping all over the place. In 2002 only 42% of drugs originated outside a big company[2]. According to Pfizer and J&J annual reports from last year, that number is now is now ~85%. Many of these drugs still end up being commercialized by big firms – just like many renewable projects initially supported by third-party capital are eventually sold to a more appropriate long-term owner – but in both cases substantially more value is created and realized before that sale occurs. 

Real Estate – Perhaps the most obvious sector to compare. The pervasiveness and relative simplicity of real estate meant that bank loans have been available for ages. Though a local game until the 1980s, finding third-party capital for real estate development has been comparatively easy in modern times. But one particular evolution comes to mind in the context of renewable energy – the REIT Act of 1960. This Act lead to the creation of large, liquid public vehicles with a low cost of capital. The market responded by upping supply – more projects under development to chase that sweet, sweet public money. Sound familiar? Ah yes, yield-cos. Now, although the yield-co boom has subsided, it served to pull in myriad sources of yield-hungry, long-time-horizon, deep-pocketed power plant owners. Just as the emergence of REITs lead to a massive influx of real estate private equity funds – who now felt pretty good about their exit/monetization options – so too will the renewables market enjoy a growing pool of firms who are emboldened by their own exit/monetization prospects. 

Based on these, and other, paradigms, I believe the renewable energy market is going to continue to drift in the direction of the third-party development capital model. But sometimes change comes so slow it’s barely perceptible. Other times it’s non-linear. For example: in the 2000’s there was actually decent liquidity for development efforts in the form of investments from venture capital firms. 

Figure 7: Venture Capital Investments in Renewable Energy (Source: Bloomberg New Energy Finance)

Not all the capital in figure 7 went to development efforts, of course. From 2006 to 2009, on average of ~25% of the dollars (and, coincidentally, transactions) went to companies materially engaged in project management[3]. From 2010-2013, however, the investments abruptly shifted to financing companies (e.g. Solar Mosaic, RETC), CPV (e.g. Brightsource), Software (e.g. PowerScout, Mercatus, Aurora), or BOS widgets (e.g. TIGO, Qbotix, Allion)[4]. But in the late 2000’s there was some serious cash sent to project developers, and moreover it came in the form of equity investments without many strings attached.  Eventually, VC’s figured out that infrastructure (power plant) development i) wasn’t really about technology at all, ii) was actually kind of boring and unlikely to “hockey stick”, iii) was very cash intensive, and iv) a long-time-horizon game. The spigot went dry. 

But this was bound to happen and did not have a grave effect on development capital liquidity once the financial crisis passed. The void was mostly filled by a very robust M&A market. Pipelines within Recurrent (twice), REC, SunEdison, Canadian Solar, FRV, Main Street Power, Axio, Heliosage, Nextlight, and countless more received liquidity injections via acquisition. This phenomenon didn’t eliminate the need for some earlier capital, but it certainly decreased the amount required to get to an exit, making self-funding far more realistic, especially at a time when rapidly declining cost curves supported robust project margins which could, in turn, support pipeline assets. 

And then “yieldco’s” had their moment. Terraform started the trend, and many followed (or attempted to). The yieldco’s would not directly invest in development stage assets, of course, but their presence deeply impacted the capital markets further upstream. One of the primary examples of this is the emergence of corporate/ABS debt options. Sensing very healthy downstream markets for operating power plants, private lenders with the ability to underwrite development collateral brought the “Option 2” product described above to market.  

Stepping back, it’s almost as if the “baton” was handed from VC’s to the M&A market to the corporate/ABS market. 

Figure 8: Illustrative Development Capital Liquidity Sources Over Time

Figure 8 is obviously a non-scientific oversimplification of things. For one it ignores government funding like DOE loan guarantees, grants given as part of “SunShot”, and dozens of other federal and state R&D grants. Three themes are hard to dispute, however:

1.   Generally, the main avenue for financing evolved from VC, to M&A/consolidation, to corporate/ABS facilities

2.   Cost of capital decreased in each of those phase changes

3.   Increasing diversity of capital sources over time

Each of those themes are directionally consistent with experiences and observations from other capital-intensive markets.

The Future of Development Financing

The renewable energy industry will continue its maturation and evolution, and development financing will be a big part of that. I expect that journey will look fairly similar to those taken in pharmaceuticals, O&G, tech, and real estate, with a general shift toward third party investment firms – both debt and equity – capitalizing development efforts at both the project and corporate levels, and a gradual decline in earlier stage M&A activity.  

Figure 10: Projecting Development Capital Sources Into the Future 

Should this come to pass, it will probably serve to make the market more efficient and scalable. Project M&A – including earlier stage acquisitions - will always be an important part of the renewable energy ecosystem, but a more robust universe of alternatives would serve the market well by providing options to developers and, in many cases, lower cost of capital.

Conclusion

There is no right way to do this. Even option 3 – which I have been critical of in this article for the sake of argument – is often a prudent path to take. Plenty of smaller developers have achieved wonderful results by partnering/selling to a large developer or IPP relatively early in the development cycle. Many of these buyers act with integrity and help their sub-developers achieve their goals. In our experience, there’s a very wide range of outcomes down this path and developers tend to assume they’re assured of the best of those outcomes. The developer community should take a more critical and balanced look at these arrangements and seek an option in category 4 to consider as an alternative. I believe the availability of such options will improve steadily. In the long term the capital markets for renewable energy development are going to continue to evolve like many sectors have before it - in the direction of more 3rd-party investment with a reduction in the reliance on the early sale.

[1] TechCrunch “The Q4/EOY 2019 Global VC Report”

[2] EvaluatePharma database

[3] Source: Pitchbook, New Energy Finance, NREL “A Historical Analysis of Investment in Solar Energy Technologies (2000-2007)” published December 2008

[4] Source: Pitchbook