Recovery Zone Facility Bond and New Market Tax Credit Financing: Financial Theory Collides with Market Reality
By Chris Elrod, Principal
Energy Asset Advisors, LLC
June 23, 2010
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Sorting through the multitude of financing options available for developers of renewable power projects, Recovery Zone Facility Bonds (“RZFBs”) and New Market Tax Credits (“NMTCs”) rank high on the list. Both programs, born out of recovery and stimulus acts of the past decade, have attracted much fanfare and attention but have not been as widely used, or even recognized as available, for renewable power project financings as hoped. RZFBs date back to the ARRA of 2009, and are most akin to manufacturing facility bonds – i.e. their intent and purpose is to stimulate growth in the manufacturing and industrial projects while providing investors with tax-free interest (via a quasi-municipal bond structure). NMTCs were initially allocated to investment funds for the purpose of revitalizing and renewing urban distressed and disadvantaged areas by leveraging tax credit investors’ funds in qualified investments to businesses or projects within those areas. These NMTC loans to qualified businesses are typically structured more favorably than commercial loans (lower DSCRs, lower interest rates and less strict covenant requirements).
However, while both types of government-sponsored financial products have their economic merits, there are inherent difficulties in their respective market implementation. The future for the RZFB program is uncertain as states are required to use their allocations by year-end with no apparent view as to whether or not the program will be extended. NMTCs, although not facing a similar expiration deadline, continue to succumb to a bogged-down investor community with limited experience to date in renewable power financing.
A Comparative Financial Analysis of RZFBs and NMTCs
We have conducted a comparative analysis between the traditional forms of project financing and the benefits of using the RZFB and/or NMTC programs. The current capital market environment makes the use of RZFB and NMTC programs highly economic. The following table summarizes the return outcomes of a $26.5M investment with EBITDA/Gross Revenue margins held constant at 72% and 20-yr straight-line depreciation assumed for 100% of the book value of the assets:
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The pre-tax IRRs for both the RZFB and NMTC (Cases 3 & 4, respectively) have a comparable economic profile. The RZFBs are assumed to fully amortize over 10 years while the NMTC loan is interest-only and has a bullet maturity due at the end of the 7th year (typical for the majority of NMTC deals). While a company might benefit from the interest-only payment structure of the NMTC, the refinancing risk of the bullet is an important investment consideration. The additional NMTC example (Case 5) shows an additive return based on a given Sponsor’s investment into the NMTC loan. In this case, the Sponsor would not only benefit from the 39% tax credit on the investment, but it will also take advantage of earning interest – almost like a preferred return – on its investment that is incremental to the profits it earns as a common shareholder.
This example is more clearly illustrated in the following diagram:
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Since the NMTC Investor is, in effect, the Project Sponsor, it benefits from the incremental interest and NMTCs generated from the investment and loan to the Project. Furthermore, the NMTC loan can be leveraged (i.e. Step 1a) by including a debt portion that allows the NMTC Investor to claim additional tax credits in contrast to if the NMTC Investor simply made an all equity loan to the Project. For example, an NMTC Investor could deploy $10M into a vehicle on an unlevered basis and receive $3.9M in tax credits from the transaction; however, if the NMTC Investor chose to lever the Investment Fund to include an additional $10M of capital, the NMTC Investor could then claim tax credits on $20M of basis (or $7.8M in value). Thus, the combination of the equity investment and leveraged loan through the Investment Fund Conduit to the Project can generate substantially greater returns for the investor than traditional, unlevered government-sponsored financial products, particularly when taking into consideration the after-tax comparison of the products.
Implementation Shortcomings
The RZFB program expires at the end of 2010, and what’s more troubling is that the adoption of this financial product has been all but a rapid embrace by the capital markets (actually, what’s more troubling is the lack of visibility of lenders, making an already obscure program even harder to actually access). In fact, because most states still have substantial remaining bond allocations in the program, the last six months of 2010 are likely to be characterized by a frenzy of activity in all quarters to get the dollars out the door.
NMTCs have experienced a different roadblock when faced with financing renewable power deals. Although NMTC allocations still remain for the coming years as the appropriations from Congress have yet to be fully utilized under the current program, the efficacy and deployment of these funds has been problematic with respect to renewable power investments because (i) traditional allocatees (or “CDEs”) have not focused on investing in renewable power projects and thus have a learning curve to overcome and (ii) in many instances there is a ceiling on how much NMTC capital can be deployed in a given transaction (problematic for expensive renewable power deals) as CDEs are typically not allocated substantial enough amounts of credits from the Treasury Department for these deals.
Thus, to the extent RZFB and/or NMTC funding may be available for a given project, it makes sense to weigh the quantitative / qualitative benefits and risks of the two products. And, as the RZFB program’s future is unclear, it may make more sense to focus on NMTC financing opportunities particularly if a project is small enough in size to merit such a transaction (typically a maximum of $10-20M of available commitment per CDE). Perhaps the best use of either of these types of products is simply to add them into the mix of traditional financing options for a given project in order to drive yield and create value for shareholders, as well as the communities in which these businesses operate.
Whichever program you ultimately pursue, make sure you (or your advisor) have done so with eyes open to the risks (funding availability, duration of program, administrative hurdles, etc.) & rewards (returns, T&C’s, etc.) of each.
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