What do we mean when we call something "development capital"? — by Leslie Hodge
“What is the difference between a candy apple and a truck?” my toddler recently asked me. As I searched for an answer, my mind turned to development capital. It’s difficult to differentiate between various types of development capital. The market is opaque, characterized by a lack of standard terms and conditions. Capital providers offer a diverse array of products. Often, these products are sold using just headline economic terms (i.e., interest rate of X, cost of capital of Y, expected IRR of Z). But because of a lack of transparency into the terms and conditions of this money, it’s almost impossible for developers to do a candy apple to candy apple comparison.
Well-capitalized developers have the resources to manage an organized, competitive process to vet capital providers. Such processes generally result in splashy headlines about Developer X having received a corporate debt facility (or “revolver”) from Investor Y. Similarly, developers needing to satisfy later-stage needs, like security deposits, in the months leading up to notice to proceed will benefit from competitive pressures, resulting in something resembling “market” terms and structures.
But for more diverse development capital needs how do you compare offers if you do not have the time and resources to run a dozen live negotiations? Fortunately, despite a marketplace that is continuously evolving, patterns emerge. Below are some trends that we at Segue are seeing in the market, interpreted through the lens of our experiences as former developers, project buyers, and mercenary lawyers.
Generally, development capital falls into four categories:
- Corporate-level Development Capital
- Project-level “Partnership” with a Larger Developer or IPP
- Project-level Development Capital
Big Idea: The market is teeming with various flavors of development capital, each with a particular risk profile and cost. Comparisons must consider more than just numbers, namely a deeper understanding of how the risk is distributed, shifted, and shared, along with the particular terms and conditions being offered by the capital provider. Below is a detailed description of the four development capital options.
Option 1: Bootstraps
Developers who can self-finance enjoy complete control over their projects and do not need to worry about dilution of equity in their business. If you are still reading this post, you likely do not need a primer on the virtues and costs of bootstrapping. So, let’s move on.
Option 2: Corporate-level Development Capital
The market for corporate-level debt/investment/acquisition is frothier than a pumpkin-spiced latte. Transactions make headlines and rumored valuations fire through the collective synapses of our industry at a dizzying speed. Slowing down for a bit, let’s consider some important trends:
Opportunity and Autonomy: In general, corporate-level capital tends to price lower than project-level capital (such as Options 3 and 4 below), because the capital provider can cross-collateralize across the entire pipeline to reduce its risk exposure. Additionally, the developer often maintains a certain level of autonomy to decide where and when to spend the development dollars. These two features (lower cost and greater autonomy) make this type of capital attractive. Nevertheless, the next three features of this investment require closer analysis.
If the corporate-level capital is equity… This type of capital is not available to all developers (see 2.4 below). With equity investments, the developer’s ownership interest in her own company is diluted. The new equity investors will have certain expectations with respect to approvals for project budgets, when to deploy capital, and when to abandon projects. Equity investors may also want control over whether to enter new markets or pursue new strategies. This can be particularly challenging for a development team that identifies opportunity but is prohibited from pursuing that opportunity. Finally, as with any equity investment, if the investor is the majority owner, close attention should be paid to potential transfers or sales by the majority investor. Developers are advised to know what tag-along and drag-along rights come with the offer, and on what time-horizon their would-be investor is hoping to “exit”.
If the corporate-level capital is debt… This type of capital is rarer in the market with a few savvy providers offering a specialized product. Asset-backed (i.e., backed by the pipeline) “borrowing ratio” products are the most common. This is typically a senior secured facility that requires all assets pledges and various forms of collateral, up to and including personal guarantees by individual developers and, if applicable, their spouses. Additionally, developers should expect controls at the corporate level (including limitations on spending). Given that the debt provider’s pitch likely includes promises of “flexibility” and “autonomy,” developers should ask for a full understanding of what these controls are early in negotiations. Finally, developers should guard against the “growth treadmill” here – a common phenomenon where interest accumulates quickly and the universe of projects thins out (as it naturally would through the development cycle). This pressures the developer to seek volume for volume’s sake. Hiring ramps to meet the need for volume, quality suffers, execution suffers, and soon the bills for all that overhead and interest come due.
Not Everyone Is Invited: Most corporate-level capital providers have threshold criteria in order to transact: (a) a pipeline of a certain size, (b) a pipeline of a certain maturity, and/or (c) an experienced management team. Thus, new developers or developers with an earlier stage pipeline may find that corporate-level capital is out of reach. Where offers are made to such developers, they may face low valuations and/or be expected to give up large amounts of equity.
Option 3: Project-level “Partnership” with a Larger Developer or IPP
Pursuit of pipeline is the name of the game for large developers and IPPs these days. For years, they have been on an acquisition spree for NTP-ready assets and now they are looking to “partner” with developers on early-stage assets. Partnership may be attractive, if it offers the ability to team with a name-brand company and a written commitment to fund the project.
The written commitment of this “partnership” could be (a) a development services agreement, (b) a purchase agreement, (c) an operating agreement for a joint-venture, or (d) any combination of the above. Regardless of the title of the legal paperwork, certain features tend to characterize each of these arrangements:
- Control Over Development: Typically, larger developers and IPPs (we’ll call them LD/IPPs) control when and how milestones are achieved. Development is less science than art, and the middling stages of development (between site control and NTP) are the messiest. What if you and the LD/IPP disagree on whether a milestone has been achieved, or whether to continue to spend on the project, or whether to abandon the project entirely? Generally, the LD/IPP expects to call the shots here.
- No Requirement to Develop to COD: Most arrangements do not obligate the LD/IPP to continue to develop to COD. In fact, it is not uncommon for a developer to find that she has agreed to a partnership that allows the LD/IPP to abandon development, without any right to take the project back. This allows the LD/IPP to hold the project hostage if there are any disagreements during development. Some LD/IPPs offer “buyback” options if the LD/IPP has truly decided to abandon the project, but often these “buyback” options require the developer to refund all sums paid, plus any third-party costs incurred by the LD/IPP, plus interest. If this price-tag is out of reach, the developer is unable to recover any value from the project.
- Different Priorities and Goals: At the outset, the developer and the LD/IPP share the same goal – optimize the project to achieve maximum returns. Along the way, however, goals may diverge. For instance, if the project size decreases, such decrease may have a greater impact on one party’s economics than the other. Additionally, LD/IPPs have competing considerations, including gigawatts of other projects, shareholder/investor value, and other corporate goals. Finally, trouble can arise if your project is one of many in an investment committee process that is pre-occupied with other newer, bigger, or shinier projects.
- Cram Downs: Even if the arrangement provides the illusion of certainty with respect to a final purchase price for the project, make no mistake: You still wear the development risk and may take on a disproportionate share (or all) of the downside. The LD/IPPs will expect to insulate themselves from any diminished project value. In certain cases, a price adjustment or fee adjustment may be fair and reasonable. A classic example would be interconnection costs exceeding an assumed amount. However, expect adjusters for anything and everything (lost acreage under site control, a higher PILOT rate, a change in PPA rate, a change in PPA terms and conditions, etc.). The penalty to you may be outsized with respect to the diminished value to the LD/IPP. Most importantly, after all the adjusters, the purchase price may end up significantly lower than it would have been were the project to have come to the market in its final form. The LD/IPP pockets this value.
Option 4: Project-level Development Capital
This fourth option can take a variety of forms, including debt, preferred equity, common equity, and combinations thereof. Project-level capital for early-stage development (where attrition risks remain very real) is still rare in the market, as investments which carry a significant risk of some/all loss of capital are “out of bounds” for most capital providers in the renewable space. Further, many investors who do have the requisite risk tolerance do not have the expertise to underwrite the assets. Therefore, a smaller pool of capital exists here.
- No Dilution of Equity; No Pledging of Pipeline: Project-level development capital enables the developer to retain equity in and control of its development business. There is no requirement to securitize or encumber the other assets in the developer’s pipeline. And the developer is free to continue to explore and venture into new markets.
- Shared Control: Most project-level development capital providers will expect a certain amount of control over development. There is a spectrum here, with some providers requiring operational control and other providers allowing the developer to control development within the confines of a mutually approved budget. In most cases, however, it is safe to assume that you will avoid some of the pitfalls in Option 3 because the provider is not a developer first-and-foremost.
- Cost of Capital: It would be a mistake to expect economic terms in line with Option 2 (Corporate-level Development Capital) and Option 3 (Project-level “Partnership” with a LD/IPP). The risk is inherently different. In Option 2, the risk is cross-collateralized and may include enterprise value as consideration. In Option 3, the risk is disproportionately worn by the developer and the nominal “purchase price” is really just a theoretical best-case scenario. It is only in Option 4 that risk is concentrated on a single asset (or a small group of assets) and genuinely shared between the developer and the capital provider. Because of this risk profile, the capital provider will expect returns more common in the venture space (and less common in the infrastructure and private equity spaces). Returns most likely will be based on a multiple-on-invested-capital (a “MOIC”), instead of an IRR. You might consider asking yourself if the anecdotal interest rates or “costs of capital” numbers you’ve heard in the market really apply to the circumstances (project maturity and desired retention of control) you face.
- Patience is Key: These types of arrangements work best where the capital provider can be patient. Patience allows the developer and capital provider to monetize the project when the project’s value and remaining risks are most favorable. Compare this to Option 3, where the project value for the purposes of determining the developer’s share is at a low point. In Option 4, the capital provider may have return expectations measured as a MOIC, but the developer’s returns are likely to increase because their realized (not nominal) value will increase by more than the incremental cost of capital provider’s MOIC.
For this style of investment to be successful for all parties, the capital provider and the developer should be aligned and ready to navigate the twists and turns of development together.
At Segue, we are in the business of providing project-level development capital and adhere to the following principles in order to achieve the best outcomes:
- Alignment of incentives between the developer and the investor
- Hands-off approach, unless we can truly be helpful
- Value flexibility and optionality
- Fundamentally, valuable projects tend to “find a way” – be patient and creative if you have one
- Make decisions based upon the long-term partnership not near-term profits
Most simply, we believe that aligning both parties toward the goal of maximizing risk-adjusted returns results in the best value for both the developer and the capital provider.
We hope this post will help you decide between the candy apples and trucks out there.