Hunton & Williams Renewable Energy Quarterly, September 2009

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Renewable Energy Quarterly Green Investment Funds: Threshold Considerations and Challenges 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: Æ Æ 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. Æ Æ 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. Æ Æ 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. 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. 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 26 Renewable Energy Quarterly www.hunton.com
Renewable Energy Quarterly 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. Potential Investors 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, 27 Renewable Energy Quarterly www.hunton.com
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Hunton & Williams Renewable Energy Quarterly, September 2009

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