President Trump addresses a joint session of Congress on Tuesday night and is expected to present further details on his infrastructure plan.
During the previous month, we have spoken to senior Republican and Democratic staffers on the House and Senate committees with jurisdiction over infrastructure and most indicated that the Administration, rather than Congressional leadership, will take the lead in advancing an infrastructure investment package.
As a reminder, the preliminary version of the Trump Infrastructure Plan proposed an 82% tax credit on the equity investment in an infrastructure project. The plan assumed a 5:1 ratio of debt to equity, which implies an overall 14% tax credit on the project’s cost. We summarized the plan and its prospects in Congress a few weeks ago.
If implemented as written, the Trump Plan would upend the landscape of infrastructure investing. In this post, we discuss several of the more nuanced implications of the plan for infrastructure investors. In summary:
- The Trump Plan would make equity cheaper than debt and theoretically incentivize all-equity financing.
- It is likely any implementation of the plan will limit the basis for the credit to prevent the possibility of all-equity financing as well as to prevent a massive hit to the federal budget.
- For investors without enough taxable income to use the credit, tax equity partners will be required. However, as written the plan may require tax equity to provide more than 81% of equity, something few tax equity investors are likely to be willing to do.
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Tax credit makes equity cheaper than debt; theoretically incentivizes all-equity financing
An infrastructure tax credit like the one proposed in the Trump Plan would make equity financing significantly cheaper than debt financing. Without some other constraint or incentive, project investors would have every incentive to use all-equity financing.
Assume every $1.00 of equity is eligible for an $0.82 tax credit. For equity to achieve a 10% return, it would only require an additional $0.28 ($1.10 = $0.82 + $0.28) in present value terms. Debt, on the other hand, while seeking somewhat lower returns than equity, would not benefit from the federal tax credit. Project cash flows would have to cover the entirety of debt’s return (perhaps 4%, so $1.04 in present value terms), not just $0.28 of it. With equity significantly cheaper than debt, project sponsors will use as much equity as possible.
We think it is likely that whenever the plan is codified, it will include some incentives or limits to prevent this. First, all-equity financing directly contradicts the 5:1 debt-to-equity capital structure suggested by the Trump Plan. Second, all-equity financing would have an extremely high cost to the federal government. If the Trump Plan results in $1 trillion of new infrastructure investment, as it aims to, all-equity financing would generate $820 billion in federal tax credits. Surely this is not the intent of the Trump Plan, nor would Republican (or Democratic) leadership on Capitol Hill likely agree to it. For the sake of comparison, the federal government’s annual defense budget is about $600 billion.
Basis for tax credit likely to be limited in legislation
To avoid an $820 billion reduction in federal tax revenue from the proposed infrastructure tax credit, Congress has several options. First, it could cap equity as a share of project capital for those projects benefitting from the tax credit. However, this could make financing projects with risky cash flows more difficult or impossible. For such projects, debt might require an equity cushion in excess of what the cap would allow.
Second, Congress could cap the amount of equity eligible for the credit. Equity would always contribute at least as much as the cap and possibly more, although any equity beyond the cap would be unsubsidized. Whether and how much more equity would depend on the riskiness of the project’s cash flows; the riskier the cash flows, the bigger the equity cushion.
Third, Congress could base the credit on the project’s total cost rather than the equity investment (as is the case with the Investment Tax Credit and the Low Income Housing Tax Credit). A 14% credit on a project’s cost would be equivalent to the Trump Plan’s assumptions of an 82% credit on equity and a 5:1 debt-to-equity ratio. Relative to a credit on equity, a credit on cost would not incentivize the investment of equity beyond a nominal amount; thus, the debt-to-equity ratio of a project would depend on the particular attributes of that project and the preferences of debt and equity.
Tax equity may need to contribute more than 81% of equity
The type (equity-based vs. cost-based) and size of the credit also have implications for the balance between sponsor equity and tax equity.
Assume a traditional project equity sponsor does not have enough tax liability to use the proposed infrastructure tax credit itself. This sponsor and a tax equity investor discuss using a partnership flip and allocating 99% of the tax credit to the tax equity investor. Under the Trump Plan, if the total equity investment in a project is $100, tax equity would in theory be eligible for an $81 tax credit (99% * $82).
However, if history and current regulations are any guide, the IRS is unlikely to allow an investor to reduce its taxes by more than the amount it has invested in a project. Historically, the government has required tax equity to be a true equity investor; it must have real exposure to downside risk. We expect that any legislation, in keeping with precedent, will provide for limitations preventing tax equity from receiving a tax credit larger than the amount it had just invested.
Moreover, we cannot imagine a situation in which sponsor equity would accept normal, risky returns while tax equity claims abnormal, risk-free returns. All of this suggests that tax equity, under the current Trump Plan, would have to invest at least 81% of project equity, a much higher share than we see in most other tax credit investments.
However, were the Trump Plan to be designed as a credit on project cost rather than on equity, tax equity might not need to contribute such a high share of overall equity. Consider a tax credit on total project cost of 14%; in this case, a $100 project would generate a $14 credit. If the debt-to-equity ratio is held at 5:1, equity would contribute $17 and tax equity would need to contribute $14 of that in order to not receive a tax credit larger than its investment (this is still the same result as an equity-based credit). But if the debt-to-equity ratio were relaxed, sponsor equity could contribute additional equity to the project without increasing the size of the tax credit. Thus, the combination of a cost-based credit and a flexible debt-to-equity ratio would allow tax equity to contribute less than 81% of overall equity.
That said, the Trump Plan proposes a credit on equity, not project cost, and this brings us to our next point—that tax equity’s atypically high share of overall equity would expose it to project underperformance.
Trump Infrastructure Plan exposes tax equity to project underperformance
Because tax equity, in all likelihood, would not be eligible to receive a tax credit larger than its investment, cash and (tax-shielding) project losses would be the only two remaining potential sources of return. However, project losses are likely to be either insignificant or nonexistent; infrastructure assets are generally not eligible for very accelerated depreciation. Tax equity would then have to receive significant amounts of cash to earn its target return, but this exposes tax equity to project underperformance.
Exposure to project underperformance, however, is an uncomfortable position for tax equity. While tax credits and project losses from depreciation are highly predictable, cash flows are less so. In fact, governments usually seek private equity investors precisely because of the inherent riskiness in certain infrastructure-related cash flows. In terms of risk profile, tax equity can be thought of as equity with debt-like characteristics; it might find this enhanced exposure to risk to be undesirable in and of itself or it might want to be compensated for it.
Threat of tax credit recapture due to foreclosure by debt might dissuade tax equity investors
Another reason tax equity might be uncomfortable investing under the Trump Plan is due to the presence of significant project-level debt. Tax equity investors tend to be wary of project-level debt because project underperformance could lead to debt foreclosing on equity, which would trigger a recapture of the tax credit (at least under current rules). This would be catastrophic for tax equity’s returns.
In our experience, with respect to project debt, tax equity investors either (1) refuse to allow it in the first place, (2) demand an additional risk premium, or (3) require debt to agree not to foreclose during the recapture period. In the case of the Trump Plan, the amount of debt at the project level is so significant that we see the threat of foreclosure/recapture as the single biggest impediment to securing tax equity investment.
One potential solution is back-levered debt. Sponsor equity or even the public partner could issue debt themselves or through another entity senior to the project company, which would then make an equity investment in the project’s SPV. This would eliminate foreclosure/recapture risk; however, it’s unclear whether debt would agree to this or whether the potential risk premium charged by debt would be agreeable to equity.
A modified Trump Infrastructure Plan
While the Trump Plan does provide a robust incentive for private investment in P3s, we’ve identified a number of challenges it would face. These include, but are not limited to, low tax appetite among infrastructure investors, constrained availability of tax equity, incentivizing of all-equity financing, and the allocation of increased performance risk to tax equity.
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