Giving Diligence its Due, Part II

The basic functions involved in a renewables project from initial development through final completion were explored in part I of this feature, published in the July/August issue. The process of evaluating these fundamentals is explored in this article.
 
To understand the typical due diligence workflow, few processes are better to study than the purchase of an operating asset because… 
  1. With the advent of the renewable energy yieldco and the increasing volume of mature ITC projects sailing past their recapture period, operating projects have become a hot commodity; and
  2. Diligence on operating projects is all encompassing, covering project execution from development through operational history.
Today’s renewable project developers and sellers don’t face the same restrictive marketplace of their forbearers. The new reality is, “Build it and they will come," and even weak projects find buyers with high levels of risk tolerance.
 
To be fair, this is not about sub-prime mortgage-backed securities; renewable energy has proven itself to be a reliable investment. But, just as with the mortgage-backed securities, the creep of high-risk projects into the industry has the potential to bring trouble. 
 
The Due Diligence Basics
Every buyer of completed renewable assets has a due diligence process. The exact process may be unique to them but they all follow a basic outline that has proven itself over time.
 
 
 
 
 
 
 
 
 
 
 
 
  1. Initial project screening – Ensure the project is “real” before spending valuable resources on it. This means using internal resources to vet the information provided by the seller. Sometimes a quick review of the project model is all it takes to find a fatal flaw. Some organizations have a dedicated team with a generic if/then logic workflow to perform this initial review. Others outsource the task and receive a project rating in return (usually for DG solar projects). Most use their experienced internal resources in a loosely structured effort to compile an evaluation. If the project is found to have merit it usually goes before the decision maker(s) for approval to proceed.
  2. Bid or offer creation – If the initial screening results in a green light then additional resources—typically Engineering, Legal, Finance, and Asset Management (Figure 1)—are brought to bear and apply greater scrutiny to the project. Again, some organizations have a dedicated diligence team that encompass all of these areas. Others outsource some or all of this work. The seller commonly provides access to the project documentation, and from this information the project is examined. With a sense of how well the project was put together and its economic underpinnings, the buyer places a bid or offer (usually not binding at this stage), which satisfies its required level of return under its threshold of risk acceptance.
  3. 2nd Round – There may be a second round of bidding where buyers who made the cut from the first round must now submit a second bid. This again is usually treated as a blind auction but can evolve into an open auction with counter-offers. Regardless of the seller’s processes, the buyer re-sharpens their pencil and fine-tunes the offer.
  4. Binding Commitment – If the buyer is fortunate enough to reach this point alone with a legitimate bid, then the money spent earlier has not gone to waste. Now the purchase/sale agreement negotiations begin; sourcing of capital to fund the purchase, finalizing of a finance structure, and further diligence is performed to meet the requirements of the financiers and investors. A closing target is established, Legal becomes heavily involved, and Asset Management is spun up for a handoff.
  5. Closing – At this point, the buyer and seller have an executed purchase/sale agreement and money will change hands. Long term financing is not necessary yet, but many buyers prefer to have the sale closing coincide with the closing of financing to avoid a large outlay of capital. There’s an official closing date, but in reality the closing can take several weeks or months because the transfer of ownership rights, assignments and obligations, and the changing of addresses, accounts, and contacts is rarely a simple event. (Figure 2)
This is a basic framework with lots of missing detail. Aside from large commercial off-takers with numerous cookie-cutter facilities, no two projects are exactly alike, so flexibility and agility are key to a successful completion in a fluid environment. Attempting to define a diligence process to cover all projects coming down the pike will result in ignoring an unwieldy process altogether.
 
Decision gates are typically located throughout the diligence process. Management, or an investment committee, either approve the use of additional resources or decide to abandon further investment at each gate. They make these decisions using information substantiated by those who lead the diligence effort, and by weighing the risks against the goals of the company. It’s never driven entirely by analytics; human intuition, or a feel for veracity, plays a part in the decision making.
 
One last note on due diligence basics: Thoroughness is important throughout. Anything missed or ignored has the potential to “move the needle” negatively. It may not be evident at first but it will become glaringly obvious down the road.
 
Fatal Flaws
A fatal flaw is a problem found in a project that brings it to an end. They are most common early in a project’s development cycle when studies are being performed and contracts negotiated, but they can appear right up to closing and beyond. They tend to concentrate around rules and regulations early on, then evolve into contractual obligations and modeling assumptions in later stages. Those early rules and regulations problems result from insufficient knowledge (hence the need for a diligent developer). The latter issues tend to arise from softer sources like erroneous information, misconceptions, and differing points of view.
 
One man’s fatal flaw can be another’s acceptable risk, especially when it comes to buyers of completed assets. At the highest level, it’s about the rate of return a project provides, and how that compares to the buyer’s requirements and those of their competitors. Does the competitor have access to cheaper capital, assume leaner operating cost assumptions, or—and this is the hardest to compete against—is their need for growth greater than their need for cash flow?
 
Other areas where potential fatal flaws are subject to interpretation are forecast generation and performance guarantees, environmental issues, tax and regulatory uncertainty, and curtailment. Underneath it all is an appetite for risk. More stomach for risk results in finding fewer fatal flaws during diligence.
 
Future Risk
Having touched on explaining project risk and broadened the definition of due diligence, it’s now necessary to look at scenarios for long-term future risk. Put forth a problem and a question. For example, new energy storage technologies become cost effective. Now ask: what are the hypothetical risks and opportunities (even the ridiculous) to a particular utility-connected asset?
 
Risks
  • Possible regulatory changes require retroactive installation of storage;
  • Behind the meter storage inefficiencies result in a reduction in energy delivery and revenue;
  • Storage results in an explosion of micro-grids reducing our utility off-taker’s appetite for further projects or extension of current PPA agreements;
  • Storage results in a mass exodus from the centralized generation model placing the off-taker at financial risk.
Opportunities
  • New markets are created and open to new renewable generation projects;
  • Storage becomes a viable service to sell in conjunction with our renewable generation;
  • Storage allows load shifting to take advantage of TOU rates on our applicable projects.
After each bullet point think about the likelihood of, and the risk associated with that idea: 
From the example above, a concern may arise around the health of the off-taker because their customer base is quite static, or on the positive side, storage would actually help the project by shifting generation into a higher TOU category. This is a great way to step out of the diligence grind and see the overall project. Issues may be identified which would otherwise be missed.
 
Looking Ahead
To many, standardization is the holy grail of project diligence. The argument says that by standardizing contracts, financing, and operations, both cost and risk can be greatly reduced. There has been a degree of standardization in the industry, but, outside of residential or large commercial account partners, it is still rare to find two identical projects. The key elements within the core documents are quite common across one-off projects; it’s the details that cause the inefficiencies. 
 
For example, nearly all utilities, and a growing number of commercial PPAs, have some form of guarantee, but the details are rarely cloned from one project to the next. It’s possible to speculate as to why this should be—a need to improve upon prior efforts, a migration of standards from more traditional businesses, messages in a lawyer’s dream—yet even having an answer would not solve the problem.
 
Years ago, inverter manufacturers and monitoring providers operated in a world of proprietary communications protocols. Then a group of industry leaders got together and created the SunSpec Alliance to agree on standards in commercial solar interoperability, resulting in a lesser degree of frustration from installers and operators.
Using that same model, NREL put together a group of industry insiders (including the SunSpec Alliance) to hammer out template contracts for residential and commercial PPAs. This is a great step in removing uncertainty for all parties involved, especially the host customer. Nevertheless, these PPA/Lease templates are still subject to all sorts of negotiated points that create unique detail and subsequent diligence inefficiencies.
 
It would do the industry well to expand the list of universally recognized templates into EPC contracts, land lease agreements, interconnection agreements, O&M, and MSA agreements. Accentuate them with industry-accepted language and detail on key segments, like the aforementioned performance guarantees, which would begin to streamline the due diligence process. In the end, there is no elimination of due diligence. The best we can do is to give diligence its proper due.
 
Bryan Banke is the managing director for asset management at Renewable Energy Trust Capital, Inc. 
 
Renewable Energy Trust Capital, Inc. | www.renewabletrust.com

Volume: September/October 2015