For many years now, tax equity partnership flip structures have been used primarily to finance investments in solar and wind projects and it is a common source of confusion for financial modellers working to prepare a dynamic and transparent representation of this event. Efficient monetization of tax credits remains the driving force behind these complicated structures for these industries. This sophisticated form of partnership balances both the short/medium term appetite of an investor who chooses to defray net income with solar and wind tax credits, and the long-term involvement of a sponsor relying on development fees and project cash flow to achieve their target returns.
Best practice financial modelling of partnership flip structure without VBA macros
This partnership structure entails a change, or “flip”, of cash flow and tax benefits allocation at a predetermined date or after the investor has achieved their target returns. Financial modeling the latter option can be challenging and the use of VBA macros is a common practice, with the unfortunate outcome that models get les dynamic and native functionality such as Data Tables become unavailable for the analysis. This financial modelling tutorial demonstrates a best practice method to model the tax equity “flip” without the use of macros to increase transparency and reduce complexity of the model.
The example below is an extract from Corality’s course Financial Modelling for Renewable Energy Projects.
What is a partnership flip structure?
As with other partnerships, this structure requires a minimum of two owners, usually an investor and a sponsor. While the sponsor returns are mainly driven by cash flow generated by the project, the tax investor is primarily motivated by the tax benefits.
Considerations for the Tax investor in relation to the flip structure
The tax investor, also called Limited Partner (LP), provides most of the capital to the project and receives most of the tax benefits along with a small amount of the project’s cash flow. The investor usually has a diversified portfolio with sufficient taxable income to utilize the tax benefits of the particular project from other investments. They would get allocated a high share of tax credits and income / losses, for instance 99% of the total, in the first few years. The LP realizes its return targets by using these benefits to offset taxes elsewhere in addition to collecting a small share of the project’s cash distributions.
The investor has a short / medium - term involvement in the project as they get most of the tax benefits and project cash flows allocated in the first years, before the flip occurs. They expect to meet their target returns at flip date and after that either exit the project or receive very limited upside from it.
How does the Sponsor / Developer see the flip structure
The sponsor, also referred to as General Partner (GP), is the entity sponsoring and developing the project. The sponsor has less capital to invest into the project and often has a limited appetite for tax benefits, which means they only get a small allocation of tax benefits, frequently only 1%, in the pre-flip period. The GP relies mostly on the project cash flows to reach their hurdle rate of returns during this period.
Confident in the ability of the project to generate long-term cash flow, the sponsor expects to receive a reduced share of cash flow in the early years and only achieve their target returns later during the post-flip period.
What is a ‘Flip event’ and how to represent this in a financial model?
Two distinct phases of Partnership Flip
The flip entails a change in the allocation of project cash flow, tax benefits, and income / losses. The idea behind this is that once the tax investor has reached his pre-determined return threshold, the sponsor will then need the reallocation of cash and tax benefits to help secure his return target.
In a standard tax equity partnership flip structure there are two main phases: the period before the flip has occurred and the period after the flip date. During the first phase, most of the tax benefits and cash distributions are allocated to the tax investor. This logic reverses after the flip when the allocations to the investor are reduced, in favour of the sponsor.
Note that it is common to have the first phase split into two sub-phases.
Events triggering the flip
The flip can be triggered by two main types of event:
- Target returns: flip occurs once the tax investor has achieved pre-determined target returns, such as after tax IRR. This usually occurs between 5 and 10 years.
- Pre-determined time: either a date or a number of years trigger the flip
Example of tax equity flip partnership
Financial modelling the partnership equity flip and returns
Our financial modelling example uses a simple partnership structure, with two different phases and a flip occurring once the investor target IRR is achieved. From that date onwards, the allocation of the cash distributions changes in favour of the sponsor.
Note: for demonstration purposes federal tax has been excluded from this tutorial and will not be included in the sponsor and investor returns calculations.
Finding the flip date in a financial model
The key to avoid circularity, and associated VBA macros, is to do things step by step in the right order:
- Step 1: Calculate the investor net cash flow (equity injections and distributions) using the pre-flip allocation only. This is a notional calculation used only to find the flip date.
- Step 2: Discount this net cash flow using the agreed target investor flip IRR
- Step 3: Calculate the cumulated discounted cash flow
- Step 4: The flip date corresponds to the payback period,e when the cumulated cash flow becomes positive
- Step 5: Calculate the flip date partial period percentage required to achieve an exact target return, by dividing the flip period discounted cash flow by the cumulated discounted cash flow
Returns calculation in a financial model
Once the flip date is known, returns for investor and sponsor can be calculated:
- Step 1: Creation of binary flags enable users to distinguish between the pre-flip and post-flip phases easily.
- Step 2: Calculate the net cash flow by creating two rows for distributions (one for each of the phases) and use the appropriate cash flow share for each of them. Note that distributions for the flip date period need to be adjusted using the flip date partial period % (see Step 5 above)
- Step 3: Calculate the IRR and/or Net Present value (NPV) of the cash flow
- Step 4: For the investor a check can be added to make sure its actual returns before flip are equal to its target returns
Corality’s new course Financial Modelling for Renewable Energy Projects is aimed at project developers, sponsors, financiers and investors looking to improve their skills set in financial modelling to ensure robust, efficient and transparent analysis.
Tax equity, partnership flips, pre-tax and after-tax IRR requirements, maintenance reserve accounts, sculpted amortization profiles – These concepts aren’t supposed to be straightforward. Through our course programs, we can bring clarity to these subjects and give you full confidence in your own analysis.