Drawdown will be a boost for investors in PV-manufacturer Suntech, which itself has an 86% stake in GSF and is listed on the New York Stock Exchange, because Suntech will be paid for some of the 40MW of solar modules it shipped to GSF’s investee/project companies in March 2009.

However, the deal is challenging. In addition to delays caused by the Italian Constitutional Court declaring Puglia’s permitting regime illegitimate, the ownership and control structure behind the project – which keeps GSF off of Suntech’s balance sheet despite Suntech’s 86% stake in GSF – appears overly complicated and inconsistent in its application.

To ensure that GSF avoids classification as a variable interest entity (VIE) under FASB accounting standards, and therefore consolidation onto Suntech’s balance sheet, Suntech has declared to the Securities and Exchange Commission (SEC) that GSF is independently managed, and that the debt raised for the GSF project will be entered into by the individual GSF investee companies, not GSF itself, nor will GSF be providing guarantees.

Yet GSF is providing some guarantees – there are legal risk and connection risk guarantees – for the project companies in its upcoming project financing for a 27.5MW PV plant in Puglia. And Suntech has stated in its official 20-F filings that sales of solar modules to GSF investee companies were done on an arms length basis that considered the availability of credit support from the parent GSF. In short, the investee companies are unlikely to have passed Suntech’s due diligence process without support from GSF.

Preventing a circular flow of capital and third-party control of GSF are critical to Suntech’s ability to book sales to GSF as revenue. Sales to GSF investee/project companies are arms-length and can be treated as revenue by Suntech because those investee companies are the borrowers under the GSF project financing – there is no recourse under the project financing to GSF and therefore there is no circular revenue recognition of Suntech’s own money – in effect, Suntech is not selling to itself.

However, the manager of GSF can sanction a capital call, of up to Eu258 million, from Suntech at any time with the consent of the general manager of the fund and the casting vote of either the CEO or CTO of Suntech. And the GSF manager can divert capital to GSF project companies as he sees fit: In June 2008, the company committed to acquire 86% share capital of Global Solar Fund as a limited partner for a total cash consideration of Eu258 million ($364.6 million). This consideration was not paid upfront, but rather through a series of capital calls – Eu125.3 million so far, leaving Eu132.7 million left to call.

A matter of control

Suntech’s principal argument for non-consolidation of GSF is third-party control. Suntech contends that GSF is controlled by an independent manager in a private equity arrangement with a general partner and limited partners. If, under US Generally Accepted Accounting Principles (GAAP), GSF were deemed to be controlled by Suntech, GSF’s accounts would be consolidated on Suntech’s balance sheet and Suntech could not count sales to the 86%-owned entity as revenue.

In response to the assertion that to all intents and purposes Suntech controls GSF, Rory Macpherson, investor relations director at Suntech, emailed the following reply: “GSF is not controlled by Suntech. The management company (General Partner) of Global Solar Fund (private equity fund composed of limited partners) controls the decisions and operations. Neither Suntech nor any related parties of Suntech have a shareholding of the management company. That is why GSF is an independent entity. This has been reviewed by Suntech’s auditors Deloitte [Touche, Shanghai].”

The general partner of GSF is Global Solar Fund Partners which is responsible for the management of GSF. The composition of the board of managers of the general partner is as follows: the category A manager is Javier Romero and category B managers are Suntech’s chairman, CEO and founder, Zhengrong Shi, and Stuart Wenham, Suntech’s chief technology officer. The category A manager is entrusted with the day-to-day management of GSF and any investment/ divestment decision shall always include the favourable votes of the category A manager and at least one category B (Suntech) manager of the general partner.

When Suntech reported $100.5 million sales to GSF in Q1 2009, Suntech CEO Zhengrong Shi was asked by an analyst, at the 21 May earnings call, who holds the residual 14% stake in GSF? Shi replied: “We are not in a position to comment on other investors.”

Who owns what

It later transpired during a 2009 filing and in the 2009 end of year report that Shi has a 10.67% equity interest through a British Virgin Island incorporated company, Best (Regent) Asia Group Ltd. So 96.67% of the share capital of GSF is held by Suntech and related parties.

The residual 3.3% is held “by an investment company that is controlled by the general partner of Global Solar Fund,” according to Macpherson. The category A manager and general partner, Javier Romero, says he is the residual 3.3% limited partner investor in GSF and contributed Eu10 million of his own money.

In response to an October 2009 letter from the SEC which asked for further analysis about how GSF could be considered off-balance sheet given Suntech’s voting rights, Suntech’s CFO Amy Yi Zhang reiterated Macpherson’s response that the day-to-day decisions reside with Javier Romero, the general partner and founder of the fund who is an unrelated party.

However on 31 March 2009 in Barcelona, Javier Romero spoke as the ‘President of Suntech Spain’ at a Business in Clean Energy conference. Some 13 months prior to this in February 2008 Romero formed the Global Solar Fund as an investment company in Luxembourg.

Javier Romero, the founder and 100% owner of the management company GSF Capital, says: “I’ve never been on the payroll of Suntech. For a while I had a non-executive role in Spain introducing Suntech to major Spanish clients such as Iberdrola, Gamesa and Endesa.”

He adds: “You ask me if I made a mistake appearing at the conference, of course I can say that now, given the noise around the issue, but I do not regret building relationships for Suntech. I am acting solely in the interest of maximising returns for the fund because it is in my interest as a) a limited partner investor in the fund and b) because my management fee is based on the private equity 2 and 20 model, so my personal return is aligned with the fund’s.” Romero has a total of three funds under management. Besides GSF, he manages a fund focused on the Asian wind and biomass sector and the other is focused on Chinese renewable manufacturers.

In a response to the SEC, and in support of accounting for GSF off-balance sheet, Suntech’s CFO, Yi Zhang, wrote that, among other things, Suntech as a limited partner cannot remove Romero without his consent; the business model of the fund is ‘entirely different’ from Suntech’s; the fund is anticipating additional investors; the fund is not obliged to purchase modules from Suntech and the fund does not depend on Suntech when making investment decisions.

The last two points appear contentious, given that all investment decisions must be cleared by either the CEO or CTO of Suntech. However, Romero points out that under the Articles of Association of GSF Capital, as general partner he can retire the Suntech category B managers. Furthermore, GSF will be using another module supplier: Because Suntech’s order book is full, the category B managers have sanctioned the use of another supplier for an 85MW PV project in Italy which has a central authorisation (AU) permit and is well advanced. The plants are spread over the regions of Puglia, Lazio, Sicily and Calabria. European banks are close to being mandated and financial close is scheduled for July.

Ironically, the argument for independent GSF management may be of concern to Suntech investors. Because the articles of association of the GSF management company allow Romero to eject the Suntech members and reinstate his own category B managers, capital calls could be made on Suntech without consent from a member of Suntech’s board. Also, Suntech cannot redeem its shares or liquidate GSF without Romero’s (the general partner’s) approval.

Beneficial timing

The sale of PV cells in the first quarter of 2009 to GSF was a timely boost for Suntech. Suntech duly posted net revenue sales of $100.5 million to the investee companies of GSF. These sales represented almost a third of Suntech’s $315.7 million 2009 Q1 earnings. These earning figures slightly missed analysts’ consensus forecasts but would have fallen well short without the GSF sales. In the second quarter the earnings proved crucial to the successful $277 million equity raising that was used to help strengthen Suntech’s liquidity position by repaying convertible bonds and providing working capital.

In its 2009 end of year filing, Suntech shipped 40MW to GSF investee companies with a total value of Eu91 million (equivalent $115.8 million), of which Eu14.2 million ($20 million) was paid by the GSF investee companies with the remaining Eu76.8 million booked as accounts receivable. In the 2009 first quarter earnings Suntech’s Yi Zhang said that “completion of the project will be before or between October to November” 2009 and that the accounts receivable would be fully paid by the end of 2009 at the latest.

However, the project financing was delayed: In April 2009, GSF approached project banks for the financing of the plants after discussions broke down about an outline structure that involved a Chinese bank providing a large leasing facility, with Italy-based banks asked to structure corporate debt around it. This floundered over difficulties in providing lender security.

Suntech has a 90 days-or-less customer credit policy, yet GSF’s payments for the modules will have been outstanding for more than a year. “When we purchased the modules from Suntech in March,” says Romero. “They took four weeks to be shipped to Italy, go through customs and go through classification and we were confident that we would close in April – I have bank emails to prove it.”

Project financing

Giving up on one large project financing, the PV plants were split into two and facility agreements were signed on 15 March for a capacity of 27.5MW. The project financing comprises Eu140.8 million of debt and Eu32.2 million of equity. The debt is split between a Eu128 million 18-year term loan and a Eu12.8 million 5-year VAT facility. The financing is being arranged by CDP, Unicredit, Intesa, Santander, and MPS. There were eight SPVs created for this portfolio, each a borrower for this transaction.

The project was delayed, split and delayed further principally because all of the projects received permits under Puglia’s fast track DIA regime (dichiarazione di inizio attivita). Under the Puglia DIA, projects under 1MW go through no formal permitting procedure, but rather must file a start of works declaration with the local municipality and then progress on a ‘silence means consent’ basis, whereby if 120 days pass after notice is given to third parties a permit is effectively granted. Legal opinion is divided as to whether third parties receive notice when construction begins or when it finishes. Case law would appear to favour the more conservative option that deems third parties to be given notice at completion.

Puglia restated its DIA law with some amendments to prevent the same developer splitting a PV plant into several 1MW units on the same site to avoid the central authorisation procedure (autorizzazione unica- AU) which involves an independent environmental assessment.

Puglia permits

On 26 March, Italy’s Constitutional Court declared that Puglia’s restated DIA law was illegitimate, as it was incompatible with the federal AU law that allows only a streamlined permitting process for PV plants upto 20kw.

However, the Italian government is set to enact a central authorising law later in 2010 allowing developers to receive fast track approval for plant under 1MW. It is still unclear whether projects under Puglia’s DIA scheme that have yet to be constructed will be grandfathered into the federal scheme.

In total, GSF’s 27.5MW deal covers 39 separate plants, each with separate DIA authorisations. Only three of the plants had permits granted under Puglia’s second DIA law – Regional Law 31/2008. Thirty-six of GSF’s permits were issued under Puglia’s first DIA law: Article 27 of Regional Law 1/2008.

The Constitutional Court is due to rule on Puglia’s first DIA law by the end of the year and although the Constitutional Court is certain to rule the same way, a first hearing has yet to be made by the court and a ruling is not expected until October at the earliest. The EPC contractor, Dalkia, is contracted to have all the PV plants installed and connected by September, thereby partially nullifying the Court’s ruling. Beyond the 120 day window, only the public authority can challenge the DIA and in that instance the authority would have to pay damages to the developer.

The delay is a bind for Suntech because the bulk of the 40MW sale to GSF remains as an accounts receivable entry on its books. As of 31 March 2010 the Eu76.8 million outstanding shows up as a $104 million receivable. The project financing will be a leveraging event for GSF that should allow for payment to Suntech for the 27.5MW of modules: On a consolidated basis Suntech has a current net cash outflow to GSF of Eu110.8 million (an equity investment of Eu125.3 million minus Eu14.2 million upfront payment for modules by GSF investees). At the end of 2009 Suntech had invested Eu74.6 million ($90.4 million) in GSF and the carry value in Suntech’s asset column was $86.5 million.

Bank comfort

Given the potential legal risk of the appeals against the DIA permits for GSF’s 27.5MW plants in Puglia, the lenders – CDP, Unicredit, Intesa, Santander, and MPS – are asking for some comfort. That comfort is coming mostly in the form of cash collateral, legal opinion, drawdown near construction completion and crucially, GSF guarantees. The legal risk of a DIA challenge is partially mitigated by an escrow account with cash of Eu9 million.

GSF or its investee companies have around Eu120 million of capital, but banks are believed to have an informal arrangement with GSF that it will make a capital call with Suntech if an unlikely widespread challenge occurs. According to one of the bank syndicate: “Change in law risk is not taken by the banks.” As is typical with most project financings the sponsor, GSF is taking 100% of the change in law risk. And as in AES Solar’s recent deals, the deal includes a sponsor undertaking to inject more equity if the plants are not connected to the grid by 2010, to preserve debt service ratios under a lower feed-in tariff.

The project banks are working on the assumption that not all of the 39 separate DIAs will be challenged – around five at most. The primary defence to a legal challenge following the Constitutional Court’s hearing is that the developer relied on the regional law to his detriment – the greater amount of construction, the stronger the defence. Orrick is advising GSF and Allen & Overy is advising the lenders.

Conditions precedent have been met, with just hedging and intercreditor documentation to be finished. The security package is expected to be signed 22 June and first drawdown on 31 July when the second payment to Dalkia is due. Drawdown is unlikely to be the leveraging event that both GSF and Suntech would have wished for because the project financing does not cover all of the 40MW of modules sold. The financing will, however, be seen as a positive by some investors as its shows that Suntech is serious about turning its long term receivables into cash.

Current market benchmarks for Italian solar projects are around a debt-to-equity split of 85/15 and GSF’s Eu173 million deal is roughly on an 82/18 split, but this falls if the Eu9 million escrow is taken into account. All being well with the financing, the cash collateral and contingent guarantee is expected to fall away once a clear legal opinion has been given that the projects will face no challenges. The ‘all clear’ is expected by the end of 2010.

The revenue posted for 40MW of cells was Eu91 million, working on that basis for 27.5MW, the cost of the cells is Eu62.56 million. GSF investee companies have already paid Eu14.2 million, leaving Eu48.36 million outstanding.

Impact of project financing

In a follow up to its October 2009 enquiry, the SEC sent a letter to Suntech on 4 January 2010 with some follow up questions that included the impact of the project financing on Suntech’s off-balance sheet treatment of GSF.

The SEC wanted clarification as to whether GSF has a sufficient amount of ‘equity at risk’ not to be deemed a variable interest entity (VIE). If GSF relies on the continued support of Suntech – that is, does not have enough of its own equity at risk – it is classed as a VIE and should be consolidated.

Although the ability to raise more equity through a capital call (up to Eu258 million) looks like equity support, Suntech says that the investment plan at each capital call was sufficient for its plans at that time.

The SEC also specifically wanted an explanation about GSF’s project financing plans and its impact on Suntech’s VIE analysis.

In response, Yi Zhang, who prior to joining Suntech was director and the chief financial officer of Deloitte Consulting China, wrote: “The facility agreement will be entered into by the individual investee companies of GSF, and not GSF itself. GSF has no obligation to fund or guarantee the repayment of the facilities. This facility does not represent an obligation of GSF and therefore does not impact the VIE analysis.”

Both aspects of Suntech’s VIE analysis appear at odds with GSF taking 100% of the change in law risk on the project financing and its undertaking to inject more equity if the plants are not connected to the grid by 2010. While there is no suggestion that this is either improper or illegal, it does highlight the weakness of US Financial Accounting Standards Board’s FIN 46R (which dictates VIE reporting), which is an interpretation rather than an accounting standard, and was ushered in as a response to the Enron fraud in 2001.

Why bother?

Given the effort required to maintain an off-balance sheet vehicle and the suspicion that has aroused in some analysts, why does Suntech go to so much trouble? Romero says that the limited partner fund model allows investment activity without the strictures and constraints of continual disclosure that consolidation within a listed company would bring.

However, Suntech’s off balance treatment of GSF exposes the deal structure to criticism from a number of contradictory angles – Suntech has too much control of GSF because one of its board has to clear investment decisions; Suntech has too little control because capital calls can be authorised at anytime because Suntech managers can be ejected; GSF is receiving preferential credit terms from Suntech (beyond Suntech’s 90-day payment limit) and yet GSF can use other module suppliers.

Furthermore, the underlying question born of this story is whether current regulation is inadequate – for example how to detect whether a third-party is truly independent and where the onus of proof should be – and whether the accountancy rules need tightening still further to protect investors and creditors. Is it right, for example, that whatever the construct a company can book sales to entities in which it or related parties have a 96.67% interest? Only the regulatory bodies can decide.

In the latter part of 2010, Suntech may have to revisit investors again to relieve short-term liquidity pressure. As of 31 March 2010, cash and cash equivalents decreased to $677.2 million, from $833.2 million at the end of 2009, while take-or-pay supplier obligations during 2010 stood at $1.368 billion at the end of 2009. This apparent liquidity threat may be explained away by Chinese cultural differences since Suntech’s suppliers are Chinese companies, and Suntech can draw on short term facilities from Chinese banks. Suntech seems able to renegotiate terms with its suppliers and lenders on a rolling basis.

Suntech will hope that more cash revenue rather than receivables starts to flow from its GSF relationship. Including the 27.5MW project, GSF has around 240MW of permitted projects in the pipeline that would require a capital cost of around Eu1.4 billion, and equate to module purchases of around Eu500 million. GSF has signed a facility agreement, 2 April, with the China Development Bank for a Eu530 million debt financing backing a 123MW project with plants across Puglia, Lazio and Sicily, and is expected to finance an 85MW project from European banks in July.