The US wind finance market became a refuge for leasing professionals as their market collapsed. For some of them it was a comfortable exile. The production tax credit (PTC) was – until February 2009 – the main means by which the US encouraged the installation of wind generating capacity. The $0.021 per kWh subsidy was available only to the producer, could not be transferred, and was only of use to corporations that were not subject to the alternative minimum tax.

The financial sector added flexibility to the PTC via the partnership flip structure, an adaptation of an old template – once used to reward unconventional gas (shale, synthetic and biogas) producers – to the demands of the wind industry. Wind project companies became partnerships with two types of equity – class A developer equity and class B tax equity. The class B equity, typically underwritten by a financial services company, would gain access to the majority of the project’s tax benefits for the first ten years of the project’s life, the period during which the PTC was available, with the developer getting the majority of the project’s cashflows. At the end of the period the class B investor would receive a residual portion of the project’s cashflows, typically something like 5%.

The partnership flip provided an outlet for some of the leasing professionals’ skills, not least an in-depth knowledge of the tax code, psychology of the Internal Revenue Service, and access to a base of investors with tax capacity. Some sponsors liked the arrangement, because it typically flattered their returns on investment, at least for the first ten years. Babcock & Brown, which pioneered the application of the partnership flip to US wind, was particularly fond of this benefit, especially when it was able to spin off producing assets to satellite funds or third parties. Both tax equity and backlevered debt, which was secured against the class B tax equity units and used to boost its return, became scarce from October 2008 on.

Enter the ITC

The 2009 American Recovery and Reinvestment Act allowed wind projects to join their brethren in the solar market and receive an investment tax credit (ITC). It then allowed them to claim, subject to them meeting fixed dates either for the start or the end of construction, a cash grant in place of the ITC. The depreciation losses can be set against taxable income under the modified accelerated cost recovery system, whose abbreviation, MACRS (pronounced “makers”), is the name by which the benefits are known.

Unlike the PTC, transfering ownership of an asset will not prevent the new owner claiming the benefits of the ITC, providing the new owner applies for the grant, or the old owner claims it before the sale-leaseback takes place. Sponsors have until three months after a project enters service to close a sale-leaseback and monetise these benefits, after which the tax basis for the depreciation becomes lower, making the benefits less attractive. After receiving the grant, 85% of the project’s costs are still eligible for the accelerated depreciation treatment.

The lease, leveraged or otherwise, requires greater discipline on the part of developers than a partnership flip. Tax equity investors are looking for a total after-tax return on investment, and are accepting of the volatility in cashflows that wind’s intermittent nature causes. Lease equity investors expect to receive their rent on time and in full, or they will call an event of default. According to Lance Markowitz, senior vice-president and manager of Union Bank’s leasing and asset finance unit, “probably the biggest challenge is properly structuring for the variability of wind. It certainly creates a greater challenge than on flip deals.”So, while a tax equity investor might be persuaded to finance a wind project’s P50 production, or the production that can be predicted with 50% certainty, a lease investor is looking to finance at most P90 production. It is also likely to demand a hefty suite of reserve accounts, much as a bond investor would.

Hunting for lease equity

Partnership flips and leases have their partisans, and in a market where any tax-focused investors are hard to come by, the debate has a more-than-academic quality. As Dan Morash, a managing director at Marathon Capital, with a brief to develop sources of lease equity, notes, “sources for all types of risk capital for renewables projects are hard to come by, and in this kind of environment, proven structures have considerable advantages.” Morash thinks that leveraged lease equity will be attractive to several institutions that have been unable or unwilling to participate in the tax equity market.

But partnership flip deals have an educated, if occasionally unreliable, investor base, and the template has been adapted to the presence of the ITC and cash grant with minimal disruption. “There is roughly 15,000MW of wind capacity that has used a tax equity-based structure,” says John Eber, a managing director at JP Morgan Capital, and a leasing veteran who turned to tax equity structures for wind early in the last decade. “If you’re talking about what structure can most effectively attract capital, I think the partnership flip will account for the majority of wind financings.”

JP Morgan Capital has made $2.7 billion in wind farm tax equity commitments, according to its most recent corporate and social responsibility report. Moreover, as Eber notes, the leveraged leasing market for non-recourse deals was never large. Most aircraft, railcar, and even a majority of power deals, were based on corporate credits, for better or worse.

There are some remaining pockets of expertise. GE Capital was once one of the biggest players in the project leasing market, but gradually reduced its presence in leasing after judging it an uneconomical use of its capital, accortding to sources familiar with the market. GE Capital, rebranded in the sector as GE Energy Financial Services (GE EFS), re-emerged in the middle of the last decade as a dominant player in the tax equity market, helped by lenders’ and developers’ fondness for its SLE 1.5MW turbines.

But GE’s losses on its consumer and real estate finance portfolio have dramatically reduced its tax appetite, and forced a reduction in staffing levels at GE EFS. Its presence in the tax equity market has shrunk dramtaically, and it has now focused its attention on providing common equity and debt products in support of turbine sales. It is one of the agents on the roughly $400 million in debt for Exergy’s Idaho Wind Partners, in which it also has an equity stake.

In response to Project Finance’s questions about its interest in leasing, a spokesperson for GE EFS responded that it had never done a lease deal. GE was once one of the loudest proponents of an extension to the production tax credit, but now lobbies hardest for an extension to the cash grant, which requires much less tax capacity. GE is not alone. CIT, the other big player in project lease equity, suffered well-publicised liquidity issues, and exited the market. The travails of the leasing industry owe something to its taste in clients. “I sometimes think of leveraged leasing as having a 20-year period of decline. Outside of rail there has been almost nothing for the last four years,” says one structured equity arranger.

Some providers are more comfortable with both structures. Union Bank closed the first lease for a wind farm, a $51 million construction to single-investor lease financing for Project Resources Corporation’s Ridgewind facility. Union Bank’s Markowitz says it is open to both types of deals, with single-investor leases possible for smaller deals like Ridgewind. Single investor leases have been common in the solar industry, and present fewer structuring challenges than leveraged deals, but tend to make the most sense for transactions under $150 million in size.

Alta wind the first test

Lease equity appetite is still untested. Beyond Union Bank’s Ridgewind deal, there has been only one other leasing deal, though it has attracted considerable market attention. Terra-Gen closed, with the Alta Wind bond transaction, both the first greenfield wind 144A issue, and the first leveraged lease for wind assets. It chose to do it in part based on its experience with similar structures on its Coso geothermal assets, which it acquired when it bought Caithness Energy’s renewables portfolio.

It priced the $580.2 million 25-year bond issue for Alta in July, for a coupon of 7%, on the back of strong investor demand, bringing in a fifth phase at Alta. Citi, which led the bonds together with Barclays Capital and Credit Suisse, is underwriting the lease equity for the portfolio. The issuer of the bonds is Alta Wind 2010 Pass-Through Trust, which repays the debt through the debt component of rent payments from lessor special purpose vehicles for each phase. Each lessor would sell to, and lease back from, the issuer/lessee the projects at completion.

The financing for Alta, say bankers that worked on the deal, involved many of the same arguments that surround leasing generally, with one adding: “A lawyer working on the deal told me flatly that it couldn’t be done. I explained that wind isn’t the only industry that has to cope with cashflow volatility.” But the market is untested, and its ability to sell down its roughly $300 million lease equity position in Alta’s phases II to V as they near completion will be closely followed.

Citi has been an active player in the tax equity market, despite its struggles at the corporate level during the crunch, and may be in a position to lock in a respectable premium if it can syndicate down this lease equity. Whether it can use the Alta tax benefits, should it need to digest them itself, is another question. Citi, as highlighted in a recent dispute between banking analysts, is currently sitting on $50 billion in deferred tax assets, which account for roughly one third of its tangible equity. These assets would include the difference between the accelerated depreciation that Citi might claim on a wind farm it buys and leases and the slower book depreciation it records for accounting purposes though such renewables-related assets account for a fraction of this total. Citi made $60 billion in pre-tax losses over the 2008-9 period, and will need to make healthy profits in the coming years to claim back all of its losses. It has said however, that  “Citi is very comfortable with the recording of our deferred tax assets”, an indication that it thinks it has the capacity to absorb wind equity commitments.

The 576MW Alta deal was large enough to justify a bond financing, and the bond financing in turn required a conservative approach to establishing reserves and stressing production forecasts that mirrors lease investors’ concerns. The bonds gained the requisite BBB- ratings from Fitch and S&P, itself a considerable feat, because ratings agencies have never before given investment grade public ratings to a US greenfield project bond. Crucially, the project benefits from a 20-year power purchase agreement with Southern California Edison, a longer tenor than many PPAs in the wind market.

What’s to love for sponsors

Sponsor preference will have something to do with the financing route. Ridgewind’s Project Resources is a community wind developer, and sells down equity to local investors. Explaining to these investors that they receive a share of what ever cash is left after the lease rent is paid is easier than walking them through the ins and outs of a partnership flip structure. But other sponsors are wary of locking themselves into a long-term structure with a very rigid and expensive buyback option, which must be determined by reference to the asset’s future fair market value and stipulated loss value. At the end of the term of the lease, a project will need to have both a residual value of 20% of its value at the start of the lease, and 20% of its useful life remaining.

The two leases to date also illustrate different approaches to incorporating the cash grant, because on Ridgewind the lessor claimed the cash grant and passed on the benefit to the lessee through lower lease payments, while on Alta, the proceeds of the grant are used to repay $496 million bank debt led by Calyon. Structurally, the simplest option is to let the lessor apply for and absorb the grant, though claiming it before closing a sale – easeback does not reduce the depriable basis.

The next challenge for wind lease arrangers will be to combine lease equity with bank, rather than bond, debt. Bond financing, with a long-dated maturity but higher reserve requirements, fits the lease. Bank requirements, by being less onerous and having maturities at closer to 15 years than 25 years, combine to make leasing less attractive. Nevertheless, Union Bank, together with Dexia, is thought to be arranging a bank finance leveraged lease for an enXco-sponsored wind project.

The partisans of leasing hope that all deals that opt for a ITC instead of an PTC will eventually gravitate towards the leasing market. Broadly speaking, the better wind resources are more suited to using the PTC, though sponsor preference still plays a part in this choice, particularly how it would account for its income from wind assets. The cash grant has skewed sponsor preference towards the ITC, but will only be an option for projects that start construction by the end of 2010, or are in operation by the end of 2012.

The future of the leasing market is likely, then, to depend on if, and how, the US Congress extends the current suite of incentives for wind projects. The PTC, a production-based incentive, was introduced for wind in part as a reaction to the failure of a 1990s-vintage investment tax credit to encourage the installation of economically viable wind capacity. There is still a tendency in Congress that believes that wind has reached maturity, and should be able to live without subsidies, and this may find common cause with vocal fiscal conservatives.

One developer with a track record of financing PTC-eligible wind projects hopes for a strong start to the leasing market, if only so that it broadens the base of tax-driven investors in renewables. “Throughout the growth of the tax equity market, we heard from arrangers that they were working to broaden the tax equity market to less conventional investors, those doing affordable housing and the like. And it became fairly apparent after 2008 that the market was still dependent on a handful of financial institutions. I’m hoping that this time when the leasing guys say they can cultivate an investor base they do that.”

But in a neat twist, the arrival of the ITC may have brought about the long-predicted widening in the tax equity investor base. The allocation of MACRS to tax equity investors requires them to have a much smaller tax bill per kW than the receipt of production tax credits, and they are typically used over a period of 4-7 years rather than the PTC’s 10 years. Investors are also less exposed to production risk, though performance risk is still an issue. According to JP Morgan’s Eber “If we have to do 6-7,000MW in capacity per year we will need to expand the investor base, and activity is picking up. We have about seven deals in the works, of which five are ITC and two are PTC.”

Finally, there is the spectre of changes in accounting rules that might pressure the appeal of the leasing market, and with it the broader application of wind leasing. The Financial Accounting Standards board has proposed changes to the way that lesses account for their obligations, and these may push them onto lessee balance sheets. Both leveraged and single-investor leases would be affected, and while the draft standards have yet to be finalised, some market participants say that the impact, particularly on long-term sale-leaseback transactions, would be severe. But, as one equity arranger notes, “Flip deals are already usually consolidated”.