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This is a guest article by Chris Lord of CapIron Inc. Chris also teaches our Solar Executive MBA. The next Solar Executive MBA session starts on September 15th. In the course, students will work a commercial solar project from start to finish with expert guidance from Chris along the way. The class is capped so to provide maximum student attention, but there are a limited number of discounted seats. You can get your $500 discounted seat here.
In the Solar Executive MBA, one of the most common topics students have questions about is about identifying, screening, and closing investors or buyers of their solar projects.
Most commonly, students focus exclusively on getting investors who pay the highest price per watt for their projects. In the article on the three keys to defining bankability, we discussed why this is not the best strategy. The investor actually wants the best returns on a project. The best returns means the project is economically strong and reliable.
From the developers’ perspective, there is risk in selecting the right investor. This article will address why it’s critical to address the competence of investors and how developers can screen investors to find the best ones.
Enter Chris Lord from CapIron, Inc
In today’s highly competitive solar PV market, project developers looking for an investor or purchaser for their projects tend to focus almost exclusively on finding those with the lowest project return requirement or willing to pay the highest price for a project.
But is this the best measure to use when locking in your solar project upside?
This article examines the importance of purchaser performance in selecting a project purchaser and outlines ways to collect data that will enable you to assess purchaser performance.
Here is an example of how a developer lost a lot of value in a very short time by ignoring the importance of performance or execution risk when selecting a purchaser for his solar PV projects.
The developer had a mid-sized distributed generation project for sale, largely shovel-ready. The developer asked outside consultants to conduct an auction process among a select group of purchasers. With the bids in, the results were arranged in a matrix to show dollar price against execution risk.
In the matrix, shown below, execution risk was estimated based on a variety of due diligence and market intelligence assessments. The highest execution risk was assigned a ten, and the lowest execution risk assigned a one.
One of the parties added late in the process by the developer offered the highest price at $3.18 a kW, almost $0.35 a kW higher than the average of the other six bidders, and $0.26 a kW higher than the next highest bidder. Based on market experience, the consultants interpreted that as a strong sign that rumors of financial distress at the high bidder were true. The prospective high bidder was desperately trying to bolster a weak pipeline in order to attract a badly-needed infusion of capital.
The consultants recommended a bidder offering a price of $2.85 a kW bolstered by the lowest likely execution risk. Focused solely on price, the developer ignored the recommendation and proceeded with the highest bidder.
After thirty days of intense negotiation on an LOI, and days before execution of the LOI, the purchaser’s parent filed for bankruptcy and the purchaser followed suit. Worse yet, when the developer turned back to the other bidders in an effort to salvage value, he found that they knew of his predicament and were inflexible on terms and soft on their original price bids. Ultimately, the developer settled for $2.82 a kW, but this did not account for the lost legal fees and time spent negotiating a deal that never closed.
1. Pricing vs. Performance
a. Why the focus on Pricing?
It is not surprising that project developers zero in on price when selecting a project purchaser. Particularly for small and mid-size developers, finding every possible dollar on the sale price is critical to covering the economic uncertainties inherent in a project’s development and construction phases and generating enough capital to fund continued growth.
The overriding problem facing developers is that there is a complete and natural disconnect between project costs (development and construction) on one side, and the valuation that an investor or purchaser might place on the project.
In the real world, purchasers look solely to the net cash and tax benefits that a project is expected to generate over the 15 to 25 years of its life. By discounting those net cash and tax benefits back to the present using their target return, a purchaser arrives at a price that he or she is willing to pay today for the project and related benefits.
For the capital costs of developing a project, the investor or purchaser is completely indifferent. If a developer spent more than the purchase price, then the developer will lose money. Any amount over the developer’s costs is how the developer generates a return on the development capital invested in the project. Either way, it has no impact on the value of a project to investors or purchasers.
This sounds simple enough but, given that most developers must find an investor or project purchaser before construction begins, and – worse yet – the actual costs of development and construction may not be known at this point, developers naturally steer to the highest price offered by a purchaser because there appears to be no downside. A higher price gives the sense of security – more margin to cover development and construction unknowns – and, should costs come in at or below projections, more profit to fund future growth.
b. What’s the downside?
By focusing solely or primarily on price, developers overlook other critical factors including investor or purchaser performance that can dramatically and sometimes adversely impact price. Sometimes this risk is characterized as “execution” risk. Whatever we call it, we are talking about the likelihood and cost of actually closing the specific, targeted transaction with a particular investor or purchaser on terms and conditions (including price) reasonably close to those the parties originally expected when they executed an LOI or otherwise first “shook hands” on the deal.
Performance is important because the ability of an investor or purchaser to follow through and close a transaction in a timely and cost-effective manner can have a bigger impact on a developer’s realized value than the promise of an incrementally higher purchase price from an investor or purchaser who fails to close.
In any financing, there is always a risk that a closing fails. There are at least three main classes of these types of risk: market risk, developer risk, and investor risk.
Market risk is the risk that arises from adverse changes in general market conditions. An example of a market failure, well known to most veterans of solar development, occurred in 2008 with Lehman’s collapse that fall and the onset of the Great Recession. Most project purchasers suddenly lost their tax appetite. Almost all major banks took economic hits to income that saddled them with substantial losses, wiping out the very profits that they were counting on to create their tax appetite. As a consequence, there was very little tax appetite among investors nationwide for the balance of 2008 and much of the first half of 2009. Even when investors did return to the market, tax-drive transaction volume in 2008 was substantially below pre-Lehman projections. In fact, Congress created the Treasury’s Cash Grant program in lieu of the ITC precisely to address that issue.
Other times the risk of a failed closing arises from unexpected and adverse changes in the economics of the project or the financial condition of the developer or offtaker. These kinds of risk fall in the category of development risk. Such risks may be a developer’s nightmare, but no developer can blame an investor or purchaser for failing to close a transaction when the deal no longer resembles the one that the parties originally agreed to do.
There are also investor and purchaser related risks of failure, and these are the kinds of risk that a developer must carefully consider when selecting investors or purchasers for a project. Among these investor or purchaser risks are the risk that an investor or purchaser experiences an adverse change in its own economic condition (independent of general market conditions), materially changes the terms and conditions of the deal, shows up at the closing empty handed, or simply, through inexperience or hard-nosed bargaining, unexpectedly runs up the legal and other closing costs. Sometimes these investor or purchaser problems are obvious, and sometimes they are subtler and have to be inferred from the investor’s or purchaser’s actions (remember the old maxim that “actions speak louder than words”). But in all cases, they have a common cause: the investor’s or purchaser’s inability to execute in a timely and cost-effective way.
Regardless of how investor or purchaser issues arise, the impact can be substantial to a developer counting on a smooth closing to produce a specific dollar payout at a specific point in time. In fact, the developer’s downside may be the need to write off the costs of the failed closing, and re-start fresh the due diligence, documentation, and closing process with an entirely new investor or purchaser.
2. How to Measure Performance
Given the importance of investor or purchaser performance, how is that risk measured? The answer, of course, varies from case to case, but there are some general rules to follow.
a. Gathering Investor Performance Data
As a first step, when you are considering a purchaser, begin with the purchaser’s transaction experience, and pay particular attention to execution risk. For an investor or purchaser with whom you have closed before, this is an easy process. Check with your counsel or others in your office to get a retroactive perspective on how smoothly the closing process went, including the actual vs. expected timetable, and how closely the final terms matched the initial terms. Often the developer working with a financial player is expected to pick up the closing costs of the investor or purchaser. In this case, you want to know whether actual closing costs were close relative to the budgeted costs.
Of course, you must also pay close attention to your own performance. Was the variance attributable primarily to activities for which you had primary control or responsibility? Or, were the challenges arising from the purchaser’s approach to the transaction and changes or unexpected issues raised by the purchaser? You have to be honest here to get the value of your analysis.
For purchasers with whom you have not closed, you might begin by asking for information about their transaction history generally and about renewable energy transactions specifically. Not surprisingly, most investors or purchasers looking to lock down a deal will approach your question in “sales mode.” So, you must listen closely and parse through the specifics. You might also ask these investors or purchasers for references, but again, remember that they are going to offer counterparties with positive experiences. Here, you can learn far more by going to the market and asking counsel, service providers (such as appraisers or accountants), competitors, and other industry players for their take. In this case, you must distinguish between fact and conjecture, rumor and reality. For problems, try to get a feel for whether the developer’s inexperience created more of the problems than anything the investor or purchaser did. Industry trade conferences can be an excellent venue for ferreting out information about prospective investors or purchasers quickly and efficiently.
When you’re screening potential investors, you’re looking to gather data on how on the following items:
- How much experience with solar a particular investor or purchaser has. You’d prefer to work with investors who are extremely experienced in solar. This increases the likelihood that they know exactly what they’re doing and that the project will close as expected.
- How the transaction process flowed. You want to understand how it was to work with the investors during the closing of the project. Again, easier is better.
- The efficiency with which the transaction moved from preliminary negotiations through to close. You should evaluate investors based on efficiency of time in length, time in the amount of time invested and the amount of cash that was needed in negotiation, closing costs, etc. In all of these cases, lower numbers are better.
- How flexible the investor or purchaser (and its counsel) were. A large amount of transaction costs to close a solar deal can come from negotiation. Investors that are easier to deal with have a lower transaction costs.
- Most importantly whether there were any or many adverse changes to the specifics of the deal.
b. Assessing Performance Data
Once you have gathered this data, you must weigh it and make a subjective judgment. Unfortunately, there is no magic, quantitative formula that yields a clean, bright-line conclusion, and so your ultimate answer is simply going to be your intuitive feel for the best path forward. But when you make your judgment, be careful not to overweight the incremental price offered by the highest bidder. The lure of a few extra dollars can be very tempting, but you are weighing the incremental upside against the full risk of execution.
Take execution risk seriously when selecting an investor or purchaser for your project by balancing economics (the quantitative) carefully against the qualitative likelihood that those economics are real.
Christopher Lord is a Managing Director at CapIron, LLC (www.CapIronInc.com), a strategic development and financing firm focused on renewable energy. He is also a co-instructor of HeatSpring’s popular Solar Executive MBA course offered online at: https://www.heatspring.com/courses/solar-executive-mba-training