by Paul Hildebrand
So, let’s say you’ve got a few PV/BESS projects in the works, but they’re barely more than a lease option and an interconnection application at present; you’re still very much in the “first inning”. It’s an exciting time; your thesis just became genuine projects in your pipeline that you can tell people about! Bragawatts! It’s also an anxious time because, unless you have unusual personal wealth at your disposal, the clock is now ticking until the day that your new development shop runs out of money.
But, despite the fact these projects are only a few months (or even weeks) old, somehow you already have a handful of folks knocking at your door. They’ve heard about what you’re working on (or saw your interconnection applications in the queue). They like your development thesis and credentials and are interested in “helping fund the development of your project.” All of a sudden, you have a term sheet in your inbox promising you, let’s say, a $10 million “development fee” (note to self: do a post about how great it would be if we eradicated this term), plus immediate access to (seemingly) extremely cheap development capital to ensure that you have no obstacles in getting to that “NTP-ready” milestone.
The IPP’s Perspective
This is where we pause the scene and hop over to the desk of the entity who just sent you that term sheet, we’ll call them “IPP X”. Why did they give you such a “great” offer?
- IPP X needs to show growth to its investors. Last year’s annual report showed IPP X’s “early stage” pipeline grow from, say, 9,000 to 11,000 MW. They’re going to cancel 1,000 MW and “promote” another 3,000 MW to “late stage” this year, so that’s 4,000 MW of early-stage volume they need to originate this year to break even, plus more if they want to show growth. Meanwhile, IPP X’s top developer in ERCOT/PJM/CAISO/wherever just left and they are facing an extreme supply/demand mismatch when it comes to experienced developers who can originate and manage early-stage projects. IPP X is ravenous for bragawatts; you have bragawatts that they can acquire very cheaply, while waiting until later to decide if it’s worth sinking real capital into the opportunity.
- IPP X can gain control over your project very cheaply. The notion of getting a $10M dev fee in a few years is so compelling, and the projects are so new, you’re unlikely to push back and ask for a substantial portion of it upfront (which IPP X will probably not give you anyway). The same way that you were delighted when you acquired site control for a $4M parcel of land by paying the owner $10,000 at signing of the lease option? That was a steal, right?? That’s how IPP X feels now. They are gaining control over your project for fractions of a cent, with CP’s, milestones, and “outs” galore between now and the $10M coming due.
- IPP X can always pull the plug when the big checks come due. It is a dead certainty that IPP X will have “off-ramps” in the documents that allow them to bail on the project in the face of headwinds or steep capital needs, even if you believe the project still has a shot. It’s not unreasonable for IPP X to demand off-ramps; for example, if IPP X learns today that your whole site consists of a single, enormous wetland, then they should not be required to fund a $5M interconnection deposit tomorrow. But the legal docs will intentionally allow enough ambiguity for them to stop funding if and when they decide they’d rather deploy capital elsewhere. They might use terms like “capital call,” “line of credit”, or “revolver” to imply that the future project development capital is really at your beck-and-call when, in reality, what IPP X gets is the option to continue investing in the project. Keep in mind that IPP X is one of the largest firms in our industry, and you are, well…not. Your negotiating power against them will always be limited, your right to an amicable breakup is constrained, and are you seriously going to try to take a $10+ billion company to court? IPP X has asked themselves those questions; you should too.
- IPP X will never actually buy your project from you if it causes them to lose money. So, two years from now, on the cusp of NTP, you get a phone call: “Bad news, we’ve got the final model for our investment committee approval, and a few inputs have moved against the project such that we’re now below our minimum return. So as it stands, we have no choice but to terminate the project before we hit your payment milestone….that said, we really want to make the project work, and if you agree to reduce your $10M NTP dev fee to $3M, we should be able to get approval.” Regardless of what the legal documents say, “cram downs” like these happen all the time in our industry; IPP’s must act in their own self-interest, and will invariably stick their elbows all the way out when it comes time to split the pie and protect their returns. It’s a frustrating place to be as a developer; you have no control over the headwinds the project faces (whether tax equity, EPC, etc.) but bear all the cost (and timing) impacts of those headwinds. The size of the pie is fixed (project margin at NTP minus your profit equals IPP X profit). The incentives are perfectly at odds and, again, you are a one-person shop going up against one of the largest companies in our sector. It’s hard to win as the developer...conversely, from IPP X’s perspective, it’s hard to lose.
- IPP X can prevent you from shopping the project to their competitors. This is perhaps the most important point. IPP X needs bragawatts now, but they also need to be planting seeds for real, operating megawatts in their portfolio in 3-5 years (which is why bragawatts matter). From IPP X’s perspective, they can either (a) “box out” their competitors now by getting you to sign a compelling subdevelopment capital offer, or (b) wait until NTP, bid against all of their peers, and have a 10% chance at winning the right to overpay for the project. From your perspective, you want IPP X (and IPP’s, Y, Z, etc.) to be clamoring to overbid on your NTP-ready project; when you sell the project in the “first inning” with the back-weighted dev fee, this prohibits you from leveraging market competition to realize the project’s full market value.
All in all, it’s important to recognize that the term sheet is a pretty great deal for IPP X as well! They’re showing pipeline growth to their investors without spending (or committing) any significant hard capital; all of their commitments to the project are contingent and full of off-ramps; and when it comes time to actually pay you your “dev fee”, they will have a huge advantage in leverage as to the final purchase price paid, while “boxing out” their competitors and keeping you from running a competitive process to discover the true “market value” of your project. Even if you’re able to win a few key concessions from IPP X in negotiating the term sheet, the structure itself leaves IPP X with what looks like a no-lose transaction.
So, with this in mind, what do you do with that term sheet?
- Remember that you have options. My colleague Leslie Hodge’s blog on the "varietals of development capital” would be a good place to start (for clarity, the piece you are reading right now concerns “Option 3” in that piece)
- Ask yourself: how long of a runway do I actually have until my Plan A capital sources run thin? Can I take the project to the third inning on my own? The fifth inning? Consider how much your negotiating position will improve, and the number of suitors will increase, as the project matures and the market starts to open up
- If it is the right time to start figuring out the dev capital piece, go get a few more proposals / term sheets from others offering different capital structures, and find the right attorney to help you sift through them. Ask a good attorney how much the documents will lean on you trusting your counterparty to behave differently from what the documents allow; then ask yourself if you trust them. Is that a person you trust or the institution itself? And, finally, whose priorities will win out when millions of dollars are at stake – 1-2 people you have a relationship with, or the large fiduciary-duty-laden corporation who employs them?
- Keep your focus on the dev fee you will receive at closing, versus at some later milestone, and discount the back-weighted cash flows VERY heavily. Perhaps even take a zero off the end. Do not count your chickens before they hatch. A $10M MIPA with $100k paid upfront is only a sale in that you transfer ownership to someone else – in practice, it’s a $100k option that caps your upside.
Zooming out
Despite what you’ve just read, Segue does not believe that the tried-and-true “development partnership” structure is a bad choice for all developers. Building a development business from the ground up requires you to make some uncomfortable tradeoffs, and this may be the right structure for you despite the risks. But it’s important to enter this type of partnership with eyes wide open as to how these deals have tended to go in the past. Some work, more don’t.
The main reason that we launched our firm was to provide an alternative structure to the one described above; project-recourse development financing without an exclusivity requirement or a pre-negotiated purchase price. Simply put, we believe that independent developers should have options that allow them to stay independent while seeing their projects through to a shovel-ready milestone. If that sounds interesting, we’d love to hear from you.
