With the Obama administration’s focus on renewable energy and the implementation of the American Recovery and Reinvestment Act of 2009 (“ARRA”), we are seeing increasing investment interest in the renewable energy sector. Existing private investment funds with a generalist mandate are increasingly looking to deploy capital in the renewable energy industry. In addition, investment bankers and energy industry experts are increasingly looking to raise private investment funds devoted to renewable energy investing. Whether raising a new fund, or investing from an existing fund, there are some basic, threshold considerations and challenges the investment team should take into account. Those considerations and challenges are introduced below. This article is not intended to deter investors from this class of investment, but merely to inform on the threshold issues investors should consider and plan around before diving in.
When talking about renewable energy investment funds, we tend to think of funds in several discrete categories, based on the way the fund needs to be, or is typically, structured in relation to its investment thesis, including:
- Clean Tech Funds. Clean Tech Funds seek investments in “green” or other energy-related technologies. These funds tend to follow a structure and investment program similar to traditional, technology-focused, venture capital funds.
- Energy Services Funds. Energy Services Funds make investments in operating businesses that derive revenue from the energy industry — development firms, engineering firms, manufacturers and similar businesses. These funds typically employ a traditional, generalist private equity or buyout fund model.
- Project Funds. Project Funds seek investments in renewable energy projects and installations. These funds can focus on the early, development stage of the project or a later, mature stage of projects that generate cash flow. The projects typically sought include wind, solar, geothermal, biomass and other renewable resources, and, as a result, may be eligible for federal tax credits, accelerated depreciation, newly implemented federal grants and other federal and state incentives. Traditionally, these funds were often structured like tax credit funds and catered to tax-driven investors. Today, the structure and role of these funds is in flux in light of the implementation of ARRA and investment trends. These funds often involve more complicated, tax-driven structures and terms, and confront legal and tax issues not typically confronted by other types of funds. This article focuses mainly on these types of funds.
- Impending Regulatory Reform Existing fund managers, and especially those considering launching a new fund, should be aware of the pending regulatory reform that is likely to increase regulation and compliance burdens of private equity fund managers. While none of the reforms are final, many who follow these matters expect that some form of the current proposals discussed below will likely become reality.
The single biggest pending change is the requirement for almost all fund managers to register as investment advisers. A number of proposals have circulated in the past year that would require managers of private investment funds to register as investment advisers under the Investment Advisers Act of 1940 (the “Advisers Act”). The most recent proposal, the “Private Fund Investment Advisers Registration Act of 2009,” proposed by the Obama administration on July 10, 2009, would eliminate the private adviser exemption found in Section 203(b)(3) of the Advisers Act (also known as the “15 client” exemption). Many investment advisers to private funds rely on the private adviser exemption as well as the client counting rules found in Rule 203(b)(3)-1 to avoid registration under the Advisers Act. The elimination of the private adviser exemption would require all investment advisers with $30 million or more in assets under management to register with the SEC. Although general partners and managers to private funds are already subject to the antifraud rules of the Advisers Act, if they are required to register as investment advisers, they will become subject to all provisions of the Advisers Act, including its rules relating to client asset custody, recordkeeping, advisory contracts, limitations on performance fees, ethics and personal trading policies, investment and financial reporting, and advertising.
In addition to the regulation of fund managers under the Advisers Act, another recent proposal would subject private investment funds to additional regulation as “investment companies” under the Investment Company Act of 1940 (the “Investment Company Act”). Also under this proposal, “large investment companies” (those with assets under management of $50 million or more) would be required to register with the SEC under the Investment Company Act and comply with other disclosure, reporting and examination requirements.
Another proposal, the “Corporate and Financial Institution Compensation Fairness Act of 2009” (H.R. 3269), which was passed by the House of Representatives on July 31, 2009, includes a requirement that the SEC and other federal regulators adopt rules requiring investment advisers and other covered financial institutions with assets of at least $1 billion to disclose incentive-based compensation arrangements and prohibiting certain incentive-based payment arrangements. As of this writing, there is little information regarding the disclosure rules and types of incentive-based compensation practices that would be prohibited by investment advisers, such as fund sponsors. The Senate has not approved comparable legislation and the prospects for the bill being enacted into law are uncertain as of this writing.
In addition, the SEC has proposed for comment rules placing restrictions on political contributions and the use of placement agents in connection with soliciting investments from governmental plans. These restrictions may make it harder for first-time fundraisers, but would only impact marketing to public pensions. For the reasons discussed below, these public pensions may be less likely candidates for investment in Project Funds.
Changing Tax Rates
Once again, Congress is attempting to increase taxes on the lucrative incentive compensation that private equity fund managers receive from the funds they manage. Currently, the character of income received from a partnership such as a private equity fund is determined at the partnership level, so that partners report ordinary income, capital gain and/or qualified dividend income depending on the character of the income received by the partnership. Thus, if the partnership recognizes long-term capital gains and qualified dividends, the individual partners would be subject to tax on that income at capital gains rates. Recently, the U.S. Treasury Department (“Treasury”) proposed to tax income and gain from a partnership profits interest received in exchange for services (known as “carried interest”) as ordinary income regardless of the character at the partnership level, unless the income or gain was attributable to the partner’s “invested capital.” The income from a carried interest would also be subject to self-employment taxes. The carried interest proposal would apply to all partnerships and would be effective for taxable years beginning after December 31, 2010. In addition, the proposal would eliminate the current 33 percent and 35 percent tax brackets and would add tax rate brackets of 36 percent and 39.6 percent for individuals with income over $250,000 (or $200,000 for single taxpayers). The proposal would increase the tax rate on capital gains and dividends to 20 percent for individuals with income over $250,000 (or $200,000 for single taxpayers), effective for taxable years beginning after December 31, 2010. Due to the number of recent proposals to modify the tax treatment of carried interest and the lack of any apparent significant political opposition to such a proposal, it seems likely that some form of the current proposals to tax carried interest at ordinary income rates will be approved in the near future.
Sponsors considering investment of existing funds in renewable energy projects, and those raising new Project Funds, should focus on whether their current or anticipated investor base can benefit from relevant government programs, the incentives from which often make the difference between viable and nonviable projects. Project Funds and renewable project investments were traditionally sought mostly by tax equity investors. The Project Fund could allocate the federal tax credits and accelerated depreciation to the taxable investors seeking an after-tax return. However, in mid to late 2008, the traditional tax equity investors found themselves without a tax reduction appetite and equity investment in these projects stalled. The Obama administration and Congress offered some help in the form of the ARRA. The ARRA permits taxpayers to claim cash grants in lieu of production or investment tax credits for certain types of renewable energy facilities, such as wind, closed-loop biomass, open-loop biomass, geothermal, solar, landfill gas, waste-to-energy, hydropower or marine/hydrokinetic facilities, placed in service in certain specified time periods. The cash grant program seems to have become an attractive alternative to the federal tax benefits. In addition, there is no limit on the amount of grants available through the grant program, making it an attractive alternative for funds that have not yet developed or placed facilities in service but plan to place such facilities in service within the relevant time periods.
Notwithstanding this broadening of benefits for renewable project investing, a major source of capital for private equity funds — tax-exempt investors, such as governmental plans, private pension plans, endowments, foundations and the like — are largely unable to participate. Although the grant program essentially converts tax credits to cash, many of the investor eligibility and fund structuring concerns for a tax credit fund will still apply. In particular, the Treasury guidance for the grant program provides that each direct and indirect investor in a partnership (such as a private investment fund) must be eligible to receive grant payments in order for the partnership to be eligible to receive grant payments. Many types of tax-exempt investors are not eligible to receive grant payments. Although the Treasury guidance further provides that the Treasury guidance expressly permits a partnership to establish a “blocker” or taxable C corporation through which these ineligible investors may invest, the tax impact associated with a blocker often decreases after-tax returns below a viable threshold.
In addition, high-net-worth individuals also generally cannot participate in these federal renewable energy investment benefits. Noncorporate investors (and certain closely held, personal service and S corporations) are subject to the limitations on using losses and credits from passive business activities to offset certain types of income such as interest, dividends and capital gains from portfolio investments. There are also certain limitations on the amounts of partnership items that can be deducted by noncorporate taxpayers and closely held corporations. A private equity fund’s income or losses generally will be treated as passive activity income or losses. However, passive activity losses from renewable energy investments can be used to offset passive income from other sources, such as rental income, so high-net-worth individuals who have substantial qualifying passive income may still find such a fund attractive. Accordingly, individuals and closely held corporations or other entities subject to the passive activity rules should reasonably expect to have sufficient unsheltered passive income from other sources to use the tax losses and credits anticipated from an investment in the fund. Losses and credits that are currently disallowed under the passive limitations are suspended and may be carried forward to subsequent taxable years. If an investor subject to the passive activity rules does not have sufficient unsheltered passive income from other sources, the full extent of the tax benefit of the investment will not be realized by the investor. As a result, such investors may find such a fund to be a less attractive investment.
Offshore investors are also a source of significant capital for traditional private equity funds, but may not be good candidates for a Project Fund. As discussed above, the tax credits, grants and related incentives often make viable a project that might not otherwise be viable. If the offshore investor is not a U.S. taxpayer, these benefits will not enhance its return. Moreover, a foreign person or entity may be eligible for a grant payment only if at least 50 percent of the income of the person or entity is subject to U.S. income tax, so the participation of ineligible offshore investors may disqualify the fund from participation in the grant program.
Each Treasury grant will vest ratably over a five-year period (similar to an investment tax credit) and must be repaid to the Treasury if certain events occur. These recapture events include: (1) the sale of any interest in the property, the owner or the partnership that is a direct or indirect owner to a disqualified person; (2) the property ceasing to qualify as specified energy property; and (3) other specified events applicable to particular types of renewable energy. A property may be sold to an entity other than a disqualified person without triggering recapture, so long as the property continues to be specified energy property, and the purchaser of the property agrees to be jointly liable for any recapture. Private investment fund sponsors should consider addressing potential recapture issues in fund partnership agreement provisions prohibiting transfers and assignments of fund interests to disqualified persons, investment guidelines prohibiting dispositions of projects to disqualified persons, distribution clawbacks requiring partners to return distributions associated with the recaptured amounts, and provisions establishing specific reserves.
Because of these difficulties in providing maximum benefits (and therefore returns) to some of the traditional sources of private equity capital — tax exempts, high-net-worth individuals and offshore investors — sponsors of a new Project Fund should carefully consider its target investor base before launching the fund. Before embarking on a renewable energy project investment or strategy, an existing fund should consider its investors and any provisions in its partnership agreement or other fund documents that allow it to consummate investments while excluding certain investors.
The Treasury began accepting applications for the grant program on July 31, 2009, and awarded approximately $500 million of grants in the first round of awards in early September 2009. For property placed in service in 2009 or 2010, an application cannot be submitted for a project until after the project is placed in service, and must be submitted before October 1, 2011. For projects that are under construction in 2009 or 2010, but not placed in service until after 2010, applications must be submitted after construction has begun, and before October 1, 2011. As a result of these timing issues, fund managers may have a limited window in which to deploy capital under these beneficial programs, so will need a plan to raise and invest this capital on a diligent basis.
Existing and new private investment fund sponsors confront several threshold considerations in determining whether renewable energy investing is right for them. Fund managers generally are likely to come under increasing regulation and scrutiny, and it is likely that taxes on traditional forms of private equity compensation will increase. Federal and state governments have traditionally provided incentives to investors in renewable energy projects, and those incentives have recently been expanded. However, fund sponsors should consider whether these benefits can be adequately transferred to their anticipated investor base, as several traditional sources of private equity capital may have problems realizing these benefits or require special structuring in order to do so. There are strategies to deal with many of these issues, but they should all be confronted early in the planning process so all parties have realistic and achievable expectations.