Building a Better Backstop — New Energy Risk
By Matt Lucas, PhD; Managing Director, Business Development
At New Energy Risk (NER), we cheered the recent announcement that clean energy leader and icon Jigar Shah would be leading the DOE’s Loan Programs Office (LPO). We share his goal of seeing the office streamlined to maximize its effectiveness. We have interacted with both DOE and USDA loan guarantee programs for multiple years and have first-hand experience: One of my colleagues led his former company’s successful LPO application process.
Given the need to deploy hundreds of billions of dollars to meet climate mitigation goals, create post-pandemic jobs, and commercialize frontier technologies, there’s room for all sources of capital. We hope this post will inform project sponsors and highlight factors to consider when evaluating their project financing options.
Coverage Triggers: Key Differences Between Government and Private Solutions
It is important to understand how government loan guarantees and private-sector solutions work in a downside scenario. Although similar in intent-both solutions protect project lenders-the mechanism of coverage is different, which has significant impacts on project owners, equity investors, workers, and other stakeholders.
For government loan guarantees, the project is expected to exhaust all its contingencies, maintenance reserve, and debt service reserve in the event of revenue shortfalls. If the project is unable to meet its debt service obligations after these measures, then the project would be in Default (with a big ‘D’) of the loan. To recover its investment, the lender is required to foreclose on the project and liquidate the assets. The bank is then audited by the government and only then does the government pay the bank for the portion of the debt it was unable to recover. Project owners and equity are on the outside looking in, with their investment completely wiped out.
The impacts of this are severe: The sponsor and all equity has been zeroed out, the project has been shuttered and liquidated, and the technology has suffered a very public failure that will be adverse to any future financings. The government might have succeeded in making the bank whole (notwithstanding the challenging liquidation and audit processes), but every other stakeholder has been thrown to the wolves, the technology will not be commercialized, and the carbon mitigation and jobs co-benefits go unrealized.
NER has a better solution that ultimately protects the lender while also benefitting other project stakeholders. We also help protect capital at risk, including but not limited to senior debt. While there are efficiencies in time and cost ahead of financial closing (see considerations below), the key difference is that our solutions are designed to avoid a lender default, preserve the project, and secure a cure. Unlike the government loan guarantees, which provide after-default support to the bank, we step in earlier to support the project and avoid a default in the first place. While the insurance might directly benefit a lender, this design also benefits subordinate and equity investors who would otherwise be washed out and workers who would lose their jobs, and gives the technology a chance to be improved and repaired. NER could be compared to a standby lender, providing necessary liquidity to project sponsors to service debt while enacting cures or fixes to restore project health.
11 Considerations for Project Sponsors When Comparing Backstops
Total Cost of Debt
The cost of debt is more than the cost of capital: Government capital is probably the cheapest option on the market, but this is often balanced by other advantages of private debt. As Jigar noted on a trade group call, “[LPO] is a commercial bank so we price where the banks should price. We are not subsidizing capital.” Jigar provided a median estimate for an all-in cost of debt from LPO of 5.5–6.0%, based on a fixed cost of capital from Treasury around 2.0%.Bank or bond borrowing, when coupled with insurance solutions such as NER’s, can provide comparable pricing. As of this writing, 10-year Treasury (1.66%) and BBB spread (1.15%) leave a private cost of capital (2.81%), near the LPO’s cost from Treasury. With 300+ bp of spread for the lender and insurance, it is possible to provide private-sector senior debt on similar terms. Our clients Fulcrum BioEnergy closed on over $100M in financing on 20-year notes in 2017 at 6.25% and Brightmark (formerly RES Polyflow) closed on 20-year paper at 7% in 2019.
Time to Close
There is always a rush to get projects financed. A bank loan can close in three months. A bond offering might take four to five months. NER can close in as little as three months.The government works on a different timescale. Jigar acknowledged that timelines for LPO can be long and he’s working to streamline that. Historically, projects have had to march through a multi-stage process that routinely drags on for a year or more. Anecdotally, one of our clients just took 4.5 months to receive back their initial review.
In his recent podcast, Jigar said that typical underwriting and closing fees (outside the risk premium) are $2M. These fees must be borne by a project even if a closing is never achieved and are accrued prior to receiving a term sheet. For this reason, LPO is most appropriate for larger loans. Anecdotally, one of our clients incurred more than twice this cost just to reach a term sheet (not yet closed).By contrast, NER’s fees for underwriting and closing are more than an order-of-magnitude lower. While LPO can defer and even waive fees, the process is uncertain, while we require no similar efforts.Another distinction is when third-party reports are due, such as market reports and the independent engineering report (and must be paid for by the sponsor). LPO requires these documents prior to offering a priced term sheet. By contrast, a private lender would only require the reports as a condition for financial close. By delaying these transaction costs for the sponsor, private lenders align costs with certainty of reaching financial closing.
Certainty of Closing
Sponsors seek to de-risk their projects and increase certainty. NER has a decade-long track record of delivering The Power of Certainty™ to our customers. 100% of our engaged clients have received priced term sheets and 100% of accepted term sheets have resulted in approved policies.The government has additional requirements that increase execution risk. These include a “policy factors” review by Office of Management and Budget, minimum credit ratings for key counterparties, required credit rating opinion on the project, and in some cases a National Environmental Policy Act (NEPA) review, which can take up to 24 months.
International Expansion and Capital Limitations
Government loan guarantees only support projects in the US and have limits on how many projects of a certain type they will support. Since it takes five to eight years of robust operations to achieve bankability without a government or private backstop, LPO’s limitations can impact domestic growth after project one or international growth. NER can support your entire portfolio, both domestically and abroad. Having a single partner with a single diligence for your entire portfolio smooths execution.
Covenants and Other Restrictions
Loan agreements include standard covenants that ensure good project governance, but additional covenants can be constraining to sponsors in a detrimental way. LPO covenants include dividend restrictions, made-in-America requirements, and qualifications on equity sponsorship. These are not typical of private lending and are not required by NER.
Flexible Capital Structures
NER supports a variety of capital structures including senior debt, mezzanine and sub-debt, tax equity, preferred equity, and combinations of the above. Government loan guarantees are limited to senior debt. We can support other capital tranches, in conjunction with government guarantees, if it makes sense to do so.
A Partner, Not a Bank
NER aims to be your partner in executing your project. In the last few months, we’ve leaned in to connect our clients with EPCs, lenders, equity investors, bankers, and LCA consultants. LPO, as a governmental agency, is restricted in its ability to make connections to key counterparties due to confidentiality concerns and the need for the government to remain neutral.
Project-Level Workout Vs. Bank-Level Guarantee
A government loan guarantee is designed to pay the lender in the event of a loss but does not help avoid the project default in the first place. In contrast, NER seeks to avoid a lender default from occurring by stepping in sooner and achieving an early workout at the project level. This approach is advantageous for the project, benefitting subordinate investors and workers, and allowing the project to return to operational and financial health.
Amount of Debt Capital Required
If a project requires more than $1B of debt capital, then working with a government program is the right choice. However, most first- or first-few-of-a-kind projects require vastly less debt, making a government program less attractive. In any case, larger projects are often best structured as multiple phases/tranches to segment risk, which also allows for private backstops.
LPO works with public dollars and helps projects ensure commercial risks are minimized, while often being overly conservative and going beyond levels that the private market would bear. Previously, LPO urged fixed priced offtakes, which are not available for some projects. Jigar shared that LPO will now consider indexed offtakes with Renewable Fuel Standard (RFS) and Low-Carbon Fuel Standard (LCFS) credits for bioeconomy projects, which is promising. NER will work with projects that have commercial risks acceptable in the private markets. We routinely support projects without fixed priced offtakes. In the bioeconomy, offtakes rarely match the debt terms and are typically indexed rather than fixed price, and can be heavily dependent on RFS or LCFS revenues. In some circumstances we can also hedge these credit prices.
Thinking about how to fund your project? New Energy Risk is often the first partner aligned to help with the financing of a project, so we serve as a sounding board and advisor to sponsors as they consider their multiple capitalization pathways. We look forward to partnering with you to help your project achieve funding.
Originally published at https://newenergyrisk.com on May 18, 2021.