Negotiating to increase equity returns for your project

We’ve all been there before.  Our model is nearly done and we’re feeling pretty proud of ourselves.  The depreciation schedules were a pain, but we tied them together nicely.  The balance sheet needed some additional thought to get it to balance, but all appears stable and good, for now.  The debt amortizes within our tenor and DSCR constraints.  And our scenario tab is fully linked up with sensitivities that the investment committee will want to see.

But there’s only one problem: the returns are too paltry to get the deal done.  If we accept the project’s return profile as it stands, we risk not doing the deal and leaving cash on the table. So, assuming you haven’t done these yet, what are the metaphorical low-hanging fruit, what are the few items that deliver the most value?

Before we get started, it’s important to note what we can’t change.  We can’t change the fundamental laws of nature.  There’s obviously integrity to uphold. In the classes that I teach, I often joke about “classic returns boosting tricks” that I’ve seen in models. For example, I’ve seen analysts link open by the wrong sign, thereby acting as a revenue-generating item. Another 3% IRR, well done (sarcasm). I’ve seen escalation not being decompounded, which results in an artificially higher index over 30 years of revenue generation. I’ve seen gas generation turbines that are assumed to operate at maximum capacity and efficiency 24/7. So that’s definitely not what we’re talking about here.

We can’t change the yield on a power asset or the throughput on an infrastructure project.  Panels, inverters, and turbines all have a stated capacity. We have a technical envelope we need to operate within and reproduce faithfully in the model.

We also can’t change contractually agreed to items, like EPC or O&M or debt costs.  If you’ve finished negotiating any of these key contracts, best to concentrate your work elsewhere.  That doesn’t leave very much room, now does it?

Let’s get down to brass tacks, what are the things which shift an equity IRR calculation.

Going through these in order and using them as a framework for flushing out the key items. The size of the outlay is most affected by the gearing ratio. Have you optimised debt?

Let’s assume that you’ve “optimised debt”; you’re either at your gearing limit (e.g. 75%), or you’re at your DSCR target limit. If not, that’s another 10-200 bps for free. In the case that your gearing limit governs your debt size; you might pick up another 20-30bp from reprofiling debt.

Let’s assume you’ve run a process and you’re comfortable you’ve got the best deal on the price that you can – whether it’s a PPA, a toll arrangement, or an availability-based payment. And you’ve minimised costs as much as possible. What financial structuring can you do to increase your returns? A Shareholder Loan or Subordinated Debt structure can help to optimise the tax shield of the project – i.e. subject to thin capitalisation/base erosion & profit shifting regulations, increasing the interest expense in order to reduce taxable income and reduce cash tax paid.

Timing, in addition to the order, or cashflows is often a key lever that is overlooked. If we’ve done our modeling properly, I’ll bet we can play with those assumptions pretty seamlessly.  Which cash flows should we focus our efforts on?  Simple: the large ones that come earliest in the stream of net cash flows.

Focus on the biggest cash outlay – EPC costs. They also happen to come earliest in the stream of net cash flows, providing our first negative outflow.  “But you just said we can’t change contracts!” Yes, I did.  And certainly, if you’ve got a fully negotiated document, meaning all sides have taken pains to make sacrifices and put their best numbers in a contract, certainly proceed with caution.  However, if we’re still in the early phases of developing a project, what if we amended only the timing of cash payments to our EPC contractor, not their size?

What I mean by this is, what might the impact to the project’s IRR be if we moved a sizeable payment to your contractor back by a month or two? Likely, your EPC schedule contains more than a few payments spread out over several months.  Some payments may be for specific items like panels; some may cover more generalized services.  Can you be strategic in targeting these? So, some payments might represent cash items your contractor has gone out of pocket for, and hence might strenuously object to providing your credit for.  Some payments represent margin to your contractor and he might be willing to push those back slightly to accommodate your IRR requirements.

Gaining all 200 basis points of return by moving around a bunch of EPC payments will likely. get you substantial pushback from your contractor.  However, gaining 25 – 50 basis points by moving a few payments might be seen as a cost of doing business, if presented as such.

Bottom line: be sensitive to what you think the contractor will accept and don’t be greedy.  But do see if there is a way you both can be made better off by shifting the payment schedule in your favor.

Another way to pick up some yield comes from shifting the timing of equity deployment.  Likely you’ve agreed with your bank to allow equity first cash disbursal.  This means that equity gets spent first, then debt, during the construction period. Banks generally require this as a security measure; the idea being that they shouldn’t need to deploy capital into a project before you do.  Or, said differently, you have to convince the banks you are committed to the project as it is by putting your money on the table before they put their money in.

Generally, this isn’t a large source of concern.  Most equity players see it as a matter of dogma; get a loan, go first.  But should they?

Take a look at the tax equity market in the US, where the largest equity players in the game may indeed sometimes still deploy capital into solar or wind projects before anyone else.  However, in most cases, they’ve taken great pains to ensure their interests are protected.  First, most tax equity providers only inject a small amount of equity up front, reserving the majority of their investment until commercial operations have been achieved.  They also make sure to halt the debt provider’s ability to foreclose on the project during construction (or here called back leverage).  So, in this case, they’ve extracted quite a few concessions for the benefit of “going first.”  Might you do the same?

As soon as equity has been spent on a project, the IRR clock starts ticking.  Getting debt to step in first forestalls the start of the clock, which can be very valuable when your discount rate is high.  The downside of allowing debt to deploy first is a much higher interest during construction.  This will be offset slightly with lower commitment fees.  If your project isn’t large and risky enough, getting debt to go first may actually cost you money. Furthermore, lenders may be loathed to commit to this, unless the sponsor is extremely credit-worthy.  So why recommend it?

Because by being aware of these trade-offs, we can negotiate more nimbly with our debt provider.  Is their DSCR requirement too high?  Is debt sizing too small?  Is tenor too short?  Is the interest rate too high?  Debt service reserve requirement too steep?  Perhaps gently remind them that they get to piggyback off your firm’s commitment to the project and see if you might extract some concessions on any of these points.

A Debt Service Reserve Account (DSRA) may not necessarily be a mandatory feature in your project. However, the probability of default (Pd) will skyrocket without one. And hence the margin offered to you by the debt provider. Does it really make sense to tie up 2 quarters worth of debt service on the project balance sheet? Can your project achieve the same margin instead be a DSRF or L/C? You might negotiate terms on a DSRF, and model both options to see which one is cheaper.

There are a few other levers that one can pull, and naturally, these depend on the deal itself. For example, can you squeeze debt margins lower a few years into operations by refinancing?

Can you de-risk the project as much as possible by negotiating a performance earn-out in the Sale & Purchase Agreement? These are all things a savvy advisor or project financier will look at.

Moving the returns on a project model is fairly straightforward: always look at large cash flows that come earliest in the project’s life.  Timing of EPC payments and the order of equity and debt deployment into the project are two subtle ways to nudge the project’s economics in the right direction.  Manipulating both requires a firm sense of what’s possible and what’s ridiculous, as your counterparties might be upset if you propose to go too low.  Using a flexible and transparent model can help all parties rest assured they’re doing the deal that needs to get done.