While a number of leading corporations are participating in the $20 billion annual tax equity market, tax equity remains an under-utilized tool for companies seeking to deploy thoughtful and strategic tax strategies. An analysis of public companies in the Russell 3000 Index found that approximately 61 percent were qualified tax payers that could have benefited from utilizing a credit strategy, yet less than 50 public companies disclosed taking advantage of credit programs in meaningful volumes. This lack of participation resulted in over $400 billion of underutilized or inefficient tax liability that could have supported programs for affordable housing, historic preservation, or renewable energy projects and brought billions of dollars back to the companies and their shareholders.
A study by Foss & Co. found that the Low-Income Housing Tax Credit (LIHTC) and renewable credit programs (the Production Tax Credit (PTC) and the Investment Tax Credit (ITC)) remain robust and vibrant markets and can serve as viable outlets for corporations seeking to strategically manage their effective tax rate and create shareholder value.
THE BASICS: WHAT IS TAX EQUITY?
A tax credit is a type of tax incentive that can reduce a company’s tax liability dollar-for-dollar. The U.S. government uses tax credits to incentivize certain types of projects that produce social, economic, or environmental benefits. Common tax credit projects include affordable housing, rehabilitation of historic properties, low-income census tract economic development, wind energy, and solar energy. For these projects, the tax credit is an important source of capital, yet many developers do not have enough taxable income to take advantage of the tax credits themselves. In such cases, the developer may monetize the tax credit by attracting a “tax equity” investor.
Tax equity is a term that is used to describe a passive ownership interest in a qualified project, where the investor receives a return based not only on cash flow from the project, but also on tax benefits. In such a transaction, a partnership is often formed among the parties to facilitate injection of investment capital and the allocation of tax credits. The specifics of each partnership vary by project, tax credit type, and transaction structure.
In practice, a tax equity investment utilizes the same dollars that are earmarked to satisfy a company’s tax liability. Those funds are repurposed and then invested into qualified projects that generate tax credits, such as a solar farm or affordable housing project. The tax benefits generated from the project flow back to the investor, eliminating a corresponding amount of tax liability. The investor typically additionally receives cash returns from the project for participating.
Returns on tax credit investment can vary widely depending on the program, the counterparties, and all standard risk factors associated with real estate or energy project underwriting. Generally speaking, after-tax returns to investors usually fall between 5 percent and 12 percent depending on the quality of credit and other project risk characteristics. LIHTC tends to fall on the lower end of the yield scale for reasons that will be discussed in the following section, while utility scale renewable energy projects fall in the middle, and mid- to small-scale renewable energy projects drive the top of the yield scale.
The tax equity market in 2017 was approximately $20 billion, divided up amongst five primary categories: Low-Income Housing Tax Credit (real estate), Historic Rehabilitation Tax Credit (real estate), New Markets Tax Credit (real estate), Production Tax Credit (wind), and Investment Tax Credit (solar). Each type of credit has a different set of parameters including the expiration of the credit, and the timing of when the credit can be applied.
Summary of Tax Credit Investment
The Low-Income Housing Tax Credit (LIHTC) was the largest single component of the market, at approximately $9 billion or 45 percent of the market share, followed by the Production Tax Credit (PTC) for wind at $6 billion or 30 percent, and the Investment Tax Credit (ITC) for solar at $4.25 billion or 21 percent. The Historic Rehabilitation Tax Credit and New Markets Tax Credit are both very small comparatively, at less than $1 billion total.
Perhaps unsurprisingly given their familiarity with the housing market as a product of their respective mortgage businesses, the largest participants in the LIHTC market are the big banks and financial institutions, such as Bank of America, Wells Fargo, Citigroup, and JP Morgan. These institutions contributed a combined 35 percent or more of the total LIHTC market in 2017. Regional banks with large mortgage divisions (Key Corp, PNC, etc.), independent financial firms (Capital One), and large insurance companies also were investors. It is also worth noting that bank investors in LIHTC and NMTC projects typically qualify for Community Reinvestment Act (CRA) Community Development credit. Banks are compelled to make a certain amount of CRA qualified investments every year, and as a result, need to invest in these types of projects and often compete heavily for them.
Clearly, strong ties to the mortgage and finance market are a commonality amongst the larger LIHTC investors. However, we would suggest that this is likely due to familiarity with the players and programs, rather than a strict need to be directly involved in the mortgage market. The LIHTC is a permanent tax credit, not subject to expiration as renewable credits are, which is advantageous for long-term tax planning. Likewise, the large size of the market and underlying need for low income housing development means that there should continue to be access to a sizeable supply of LIHTC tax equity.
Not without its share of consternation and worry due to tax reform, the renewables tax equity market (PTC + ITC) came through the year virtually untouched. The renewables tax equity market was approximately $10.25 billion in 2017, down from $11 billion in 2016. A notable shift from solar tax equity to wind tax equity beginning in 2016 remained in effect in 2017, with wind comprising about 59 percent of the market (up from 45 percent of the market in 2015, and 49 percent in 2016).
The five largest renewable energy project developer of tax credit projects in 2017 were fairly representative of the overall complexion of the developers as a group, including an independent utility (NextEra) and two European utilities (Enel Green Power and EDP Renewables). Out of about 40 notable public project developers of tax credit projects, the top five largest comprised about 33 percent of the renewable energy tax equity market. About 50 percent of the total project development market generating tax credits is created by several hundred smaller private renewable energy development companies.
The top five largest investors in renewable energy tax equity in 2017 (JPMorgan, Bank of America/Merrill Lynch, GE Financial Services, US Bank, Citigroup) were very similar to 2016. Similar to the top five investors list, the top five developers of tax credit projects represented the majority of deal value, at approximately 68 percent of the market.
Noteworthy Trends in Renewable Energy Tax Equity
A look at the composition of the renewable tax equity market in 2017 clearly distills some trends that made industry headlines last year; notably, the availability and desirability of tax equity for U.S. Wind, in particular, by European independent utilities (E.On, EdP, Enel, EDF).
While North American-based utilities made up about 19 percent of the market, European utility tax equity deal volume in the U.S. has stepped up markedly, to comprise about 13 percent of the market in 2017 with a dollar value about three times higher than their 2016 level. This speaks to several factors, including the relative saturation of onshore wind and recent continued lack of large-scale solar projects in European markets. Likewise, while offshore wind is still an active market in Europe, long development and permitting time-frames led to a lumpiness in capital deployment that U.S. onshore wind, with an abundance of cheap real estate, easier permitting, and still-available PTC credits, helps to smooth out. This trend of European independent utilities coming west is likely to continue, as European mandates for renewable investment don’t necessarily cease because home markets are saturated.
Private equity-linked and other private/non-disclosed financings continue to play a large part in the market, at roughly 39 percent of deal volume in 2017. Private-equity linked companies backed by mega-firms such as Brookfield, Riverstone, Centaurus, Blackstone, Starwood Private Equity, and new arrival Capital Dynamics continue to make good use of the tax equity market, leveraging their relationships and large financial/legal staffs to navigate through the sometimes complex financing arrangements that other publicly-traded corporates may find less appealing due to higher deal-related general and administrative expense (G&A) or other shareholder concerns. Boutique investment firms like Foss & Co. also syndicate transactions on behalf of investors and manage tax equity fund vehicles for corporate investors that seek the benefits of tax credits, but don’t want to develop in-house capabilities to transact directly in the space.
Although there are only a handful of remaining residential solar developers, their appetite for, and ability to monetize tax equity, doesn’t appear to be on the wane, comprising approximately 13 percent of the deal volume in 2017. Specific transactions are more difficult to see since Tesla’s acquisition of SolarCity (Tesla does not press release each tax equity deal the way SolarCity used to, nor does it detail them in SEC filings). SolarCity’s soft retrenchment, with its pivot towards solar tiles, reduction of sales force, and elimination of traditional door-to-door sales in favor of co-selling with Tesla vehicles, could cause a reduction in need for tax equity finance from SCTY/Tesla, although it may be too soon to call. Yet in the wider U.S. residential market, growth in geographies outside of the traditional California stronghold, especially from SunRun, signals that demand for tax equity financing in residential should continue, with average per household ticket sizes set to grow as solar+batteries are gaining traction in a handful of markets.
Industrial companies and operators of smaller renewable projects make up a relatively small segment of the tax equity market, at about 7 percent in 2017. Public filings show that many of the industrial companies that generate renewable credits as part of their operations plan to use them to offset current tax bills, while small renewable project operators may have a harder time using tax credits to build new projects because the typical tax equity buyer finds the deals to be too small. Leading tax equity buyer and market expert JP Morgan Chase was recently quoted at an industry event as pegging the average bite size of the larger tax equity buyers at around $150 million per deal, many orders of magnitude larger than an average corporate tax payer might be able to deploy in a given project.
North American Utilities Diverge in Use of Tax Equity
A deeper dive into the findings shows that while North American multi-regional independent utilities have a strong need for tax equity investors, U.S. regional utilities are only a small part of the tax credit market. notable independents, such as renewable market leader NextEra and peers such as Sempra and Southern Co, continue to generate and sell tax credits and make up about 78 percent of the 2017 tax equity market for North American utilities. In stark contrast regional utilities, small and large, make up only 22 percent of the 2017 totals for the subset, despite the fact that they still play a major role in supplying the North American power market. This is partially a result of the regional pace of renewables buildout—off to a slower start in the Upper Midwest and South—as well as a corporate preference by some utilities to have the customer pay via rate-basing the buildout of new renewables, rather than the corporation via debt, equity and tax equity financing.
Corporate Buyers of Tax Equity Were Less Visible in 2017
The anticipated increased participation from corporates like Amazon and Google seems to have hit some headwinds in 2017, falling off the pace of 2015 and 2016’s splashy announcements. In 2016, Google announced a group of deals that brought it close to the top ten investors in renewable tax equity. Other notable corporates more active in 2015 and 2016 included Amazon, Patagonia, and Toyota. Together, the group invested in about $700 million of renewable energy tax equity in 2016. Yet it’s been mostly quiet in 2017 and 2018 on the corporate front. This doesn’t mean that there haven’t been transactions. However, to the extent that there have been, they’ve not been widely publicized nor reported in SEC filings, perhaps because they’ve been smaller dollar amount investments, below a hurdle rate that would subject them to material disclosure.
This less-than-frequent participation reinforces the viewpoint of the tax equity investor market that there are 15 to 20 frequent sizeable investors—mostly banks and insurance companies—and then 25 to 35 less consistent or opportunistic corporate investors that participate directly, through syndications, or through tax equity investment fund vehicles.
To expand the total tax equity market beyond its current 30 to 50 usual corporate investors would require the remaining 1,800 tax paying organizations within the Russel 3000 to better understand value proposition and to integrate tax equity investments into their tax planning strategies. Some of the smaller or less frequent investors likely need to be converted to “regular investors.” While individual corporate motivations vary, simplifying the tax equity investment process and reducing associated deal-related G&A for publicly traded corporates could help. Additionally, with the preferred deal size for large active investors being $150 million, a steadier flow of large projects is likely necessary to provide a more consistent flow of larger tax equity investments. Here, more participation in tax equity by Regional Utilities, previously mentioned as under-participating, could help augment the flow of sizeable deals. Alternatively, project developers could do a better job of unifying project attributes to assemble large portfolios consisting of smaller projects, and insurance companies could step in to aggregate and normalize disparate off taker risk. Multi-investor tax equity fund vehicles can also expand the broader tax equity market by educating potential corporate investors, aggregating deal flow, and managing transactions so investors can make singular large commitments to tax equity.
INFORMATION AVAILABILITY AND TRANSPARENCY
Even for a professional financial researcher, finding accurate and complete data on tax equity is an arduous task. Buried in 10-K footnotes, inconsistently memorialized in press releases, and gleaned here and there from industry newsletters, the tax equity “market” is an opaque one, unless you happen to be a client of one of the law or accounting firms or top banks actively engaged in the market. The lack of consistent reporting of tax equity financing is one of the barriers to growing the market and making its use more widespread. While it shouldn’t necessarily be required SEC reporting for public companies due to the additional cost associated with filing, public companies could include it in annual CSR reporting to shareholders, piggybacking on the trend of reporting corporate involvement in sustainable practices. This is an audience already interested in a company’s activities in sustainable financial practices like renewable tax equity, and the document has a much lower legal reporting threshold and attendant fees. One way of encouraging companies to elevate Tax Equity finance in CSR reporting would be to lobby the Sustainable Accounting Standards Board (SASB) to focus on this category.
WHY TAX EQUITY IS UNDER-UTILIZED: AWARENESS, ORGANIZATIONAL IMPEDANCE, AND DEAL SIZE
We’ve found that there are three primary reasons that companies don’t take advantage of tax equity, including a lack of basic awareness and education on the opportunity, organizational inertia, and a misguided preference to only invest in mega-deals.
Put simply, most of the public companies that aren’t making tax equity investments don’t participate because senior corporate tax and financial decision-makers don’t know the credit programs exist, don’t understand the basic mechanics, or haven’t taken the time to learn and understand the concept. If these executives don’t happen to socialize with tax and finance leadership at one of the 30 to 50 companies that are active in the tax equity market, or their tax advisory partners don’t advise active investors, there is a low chance that the executive will figure out the opportunity in their spare time or through self-directed learning. Deploying new business or tax management strategies requires attention, time, and diligence, which can be difficult for many executives to spare relative to what they perceive as their primary responsibilities.
Organizational inertia and improperly aligned incentive structures can also play a role. Many tax directors don’t have a clear mandate to bring new ideas to the table or to make the company money. This is often reflected in their compensation plans and departmental KPI that is typically designed to minimize or offset the corporation’s tax burden. It’s a rare case where we find tax professionals that are encouraged to seek yield investments—this is more often a task for the CFO’s office. Simply staying the course and paying the company’s estimated federal tax liability seems straightforward and risk free, especially to professionals that may have more to lose than gain by exploring new strategies. Corporate tax professionals may also be reticent to participate in tax equity investments because the risk/reward seems too good to be true or feels like a loophole. Also, with limited department headcounts in most corporate tax groups, it can be challenging to add the headcount required to pursue something new or unproven. Hiring a dedicated resource to originate, underwrite, invest, and asset manage each deal is perceived as a risk in itself, even if it could add millions of dollars to the company bottom line.
Lastly, for large public companies, the preferred tax equity deal size is around $150 million. Yet opportunities to deploy capital in that size are on the decline as mega onshore wind projects reach a saturation point in geographies best suited to wind, and solar projects tend to be relatively smaller. This leaves a crowded market for very large deals, and yields have compressed as a result, meaning that some of the tax equity appetite of large public companies has gone unfulfilled or the value proposition has diluted. Investors could pursue smaller targets, but this likely requires more corporate resources in understanding of variation between underlying asset classes and increased headcount, looping back to the education and organizational challenges listed above.
Tax equity investments remain an underutilized tool for tax liability reduction and financial gain to the business. In particular, the ITC for solar is currently an attractive option for tax equity investors, especially those with shorter tax planning horizons. For instance, a company can take all of the credits that it derives from a solar project in the tax year the credits are generated, making tax equity a viable strategy for non-recurring tax liabilities such as one-time M&A events.
The opportunity for new participants in the tax equity market appears to lie with the myriad smaller developers that are still very active in sizeable, but not mega-projects. In fact, recalling that 68 percent of the $10.25 billion of tax equity invested in the ITC/PTC in 2017 was done in big tranches by big players, we should point out that the other 32 percent of the renewable tax equity market where some of the smaller private deals were done was also very active and earns a significant yield premium.
While that might sound obvious, recall that only 30 to 50 companies or 2 to 3 percent of the qualified tax paying companies in the Russell 3000 Index are actively participating in a $20 billion annual tax credit market. Companies that haven’t explored the concept, underwritten the asset class, aligned their tax and finance departments, and intentionally adopted a strategy around the practice missed out on billions of dollars of return due to inefficient capital allocation and tax planning.
The asymmetries we’ve found in the market present an opportunity for both large and smaller companies alike. While the supply of mega-projects and thus $150+ million deal sizes are on the wane, there is a huge opaque market of development projects getting done every day in the U.S., with billions of dollars of tax equity capacity available to investors. In our view, all public companies that are U.S. federal tax payers should consider investing in portfolios of smaller deals to more reliably satisfy their tax equity appetite. If the average deal size seems prohibitive, the companies can outsource the process through a managed fund structure where they commit capital in more significant tranches and leave the rest of the process to the fund management team.
To take advantage of the program, a company should be a widely-held C corporation, a federal tax payer with a tax liability sufficient to use the tax credits, and should be estimating at least $5 million for year of investment. Consistent tax liabilities are preferred, but are not required. While the research in this article showed that banks and insurance companies are some of the heavier users of tax equity, we argue that there is no particular reason other types of corporations should not be involved. Manufacturers, high tech, service providers, large retail, and industrials would serve to benefit from adopting a tax credit investment strategy.
Alex Tiller is Managing Director at Foss & Co., a 35-year-old investment firm that specializes in making tax advantaged investments on behalf of its institutional clients. Tiller spent the last decade of his career leading several solar companies that financed, developed, constructed, and asset managed renewable energy projects in the U.S.
Foss & Co. provides public companies the ability to make tax equity investments through its managed tax credit investor fund structure.