For renewable energy projects in which investors’ interests vary, the equity method of accounting under hypothetical liquidation at book value (HLBV) is often used to determine the investee share of earnings and losses for the period by allocating the project’s net assets.
An investor in these projects will typically report its investment included in its financial statements under the equity method of accounting. However, questions arise as to how to determine its share of earnings and losses each period when its interests in the project and its attributes are dynamic over the project’s lifetime. This is when HLBV may be the preferable method to apply.
Renewable energy projects are often structured as partnerships. This means a project’s operating agreement:
- Governs the allocation of income, loss, credits, and cash distributions
- Attempts to allocate these items to investors in an efficient manner
To achieve this, an operating agreement may require the partners share income, loss, and cash distributions at variable ratios over the life of the project. The outcome of a liquidation in a hypothetical situation may differ from that of an actual liquidation. The following sections will explore potential judgment issues, policy matters, and varying results that may affect elections that investors will want to consider.
HLBV Method Overview
The HLBV concept comes from guidance proposed by the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants (AICPA) in Statement of Position (SOP) Accounting for Investors’ Interests in Unconsolidated Real Estate Investments, released November 21, 2000. Although the guidance was never finalized, the HLBV approach is widely accepted and used in the renewable energy industry to allocate results to investors.
Paragraph 19 of the proposed SOP provides the following explanation of the HLBV approach:
Under HLBV, an investor determines its share of the investee’s earnings or losses for a period by, essentially, answering the question: How much better or worse off is the investor at the end of the period than it was at the beginning, taking into consideration only those transactions and other events that are recognized under generally accepted accounting principles (GAAP) by the investee?
To answer that question, the investor calculates, at each balance sheet date, the amount that it would receive or be obligated to pay if the investee were to liquidate all of its assets at recorded amounts determined in accordance with GAAP and distribute the resulting cash to investors and creditors in accordance with their respective priorities.
Renewable energy projects can produce cash and tax benefits to investors through:
- Operating cash flows
- Accelerated depreciation
- Investment tax credits
- Production tax credits
- Other incentives, such as property tax rebates and abatements or sales tax exemptions
Taxpayers encounter substantial statutory hurdles when trying to claim these incentives, which can often result in the benefits being underused or un-monetized. A renewable energy project’s value to an investor increases when an investor can use attributes as efficiently as possible.
Most tax incentives are applied to reduce a taxpayer’s tax liability. As such, the tax incentives can only be utilized by a taxpayer that has enough taxable income to absorb credits and other tax attributes.
Some investors may only want cash-on-cash returns, for example, while other investors that have large tax liabilities may seek accelerated depreciation and tax credits. An ideal scenario is to structure a project so that the attributes—cash or tax—can be allocated to the investor that can use them most efficiently.
In a typical HLBV model, the net assets of a project entity are allocated to the investors based on their respective capital balances as determined under the liquidation provisions of the operating agreement.
Following HLBV accounting:
- Project assets are deemed sold at their book-carrying values under a hypothetical sale scenario.
- Liabilities are settled.
- Remaining cash is distributed to the partners in liquidation of their interest.
The so-called liquidation waterfall, or how the liquidating cash would be distributed, is determined based on the provisions in the operating agreement.
The proposed SOP isn’t detailed in many aspects of how to apply the provisions in a hypothetical situation. For example, renewable project-centric ideas are not addressed, such as how to treat investment tax credit recapture in a premature liquidation scenario that’s only hypothetical.
In some cases, the operating agreement may also contain indemnification provisions or other consequences that could be triggered in the case of an event that causes a premature sale of assets.
If you work through a hypothetical liquidation in restricted periods in which there could be implications of a sale, you may need to consider all the potentially measurable provisions contemplated by the operating agreement.
For example, sometimes, the operating agreement won’t allow a flip in the allocation of attributes during the restricted period. This could be at odds with the operating agreement’s general liquidation provisions, which may allow a flip to occur in the event of a liquidation at book value when a tax equity investor meets its IRR.
The proposed SOP does state that the HLBV method doesn’t take into account any costs that would be incurred if such actions were actually taken. For example, a debt prepayment penalty wouldn’t be included when applying. This provision seemingly provides a general view that investors don’t need to consider all measurable consequences that might otherwise result in an actual liquidation event.
Accounting Policy Elections
Interpretations used in developing the estimate should be considered accounting policy elections. This is true even though it isn’t clear how much an investor can analogize the prepayment penalty example included in the proposed SOP to other potentially measureable consequences of a liquidation scenario under the operating agreement.
Where there’s room for judgment and accounting policy elections, investors should agree on how specific items will be treated under the operating agreement in a hypothetical liquidation as opposed to an actual liquidation.
Other potential issues relate to how benefits are deemed monetized by the investors under the operating agreement. If an investor can monetize attributes as a result of partner-level transactions occurring outside of the partnership, those attributes may need to be considered when determining the investor’s IRR. In yield-based flips, the impact of benefits on an investor’s return can have major effects on the investors’ equity if it’s using the HLBV method.
Potential Conflict Areas
Although operating agreements try to be specific about how benefits may be used, ambiguity or contradictions may manifest when such provisions are applied in a hypothetical liquidation scenario. Some examples follow.
Some operating agreements provide a predefined fixed tax assumption that all attributes allocated by the partnership to a partner will be monetized by the partner and factored into determining the partners’ IRR. However, that same operating agreement may have a provision that generally deems that in transactions that occur outside of the partnership, such as Section 743(b) transactions, the resulting benefits aren’t included in the computation of the investors’ IRR.
If not clear in the operating agreement, partners will then likely want to know if such a Section 743(b) provision extends to the partner-level suspended losses under Section 704(d) and whether this provision overrides the fixed tax assumption. The less ambiguous the language when such provisions are negotiated between the sponsor and the tax equity, the less likely disagreements will arise when determining the investors’ equity under the HLBV.
If losses allocated to a partner are suspended under Section 704(d) and shouldn’t be included as a monetized benefit in determining the partner’s return for purposes of the flip calculation, the operating agreement should clearly state that these losses won’t be considered along with the other provisions that exclude the Section 743-related benefits in a hypothetical liquidation scenario.
Hypothetical Liquidation as a Discrete Event
It’s also important to consider how a hypothetical liquidation will be treated during a particular reporting year. The liquidation could be considered a discrete event separate from the allocations that already would occur prior to the liquidation in an otherwise normal allocation year. The other option is to consider liquidation provisions alongside the otherwise normal allocation year items.
The liquidation provisions in a typical renewable energy project’s flip operating agreement would treat an actual liquidation as part of the operations for a year, but this could lead to some potentially disparate results if applied similarly in a hypothetical liquidation context. For example, under tax principles, a taxpayer wouldn’t claim depreciation on an asset that’s disposed in the same year. In some liquidation provisions, the class A or B investor is required to meet certain allocations of income or loss percentages for the year.
In both scenarios, the allocations and HLBV results will be affected by combining the liquidation impacts with other allocation year items or by treating the liquidation impacts discretely.
In the context of a hypothetical liquidation, disagreements also arise between investors during the allocation of reported capital when determining the allocation of income or distributable proceeds under the operating agreement’s provisions.
In most liquidation sections of an operating agreement, after a liquidation gain is determined, the waterfall provides a step-by-step approach to how income should be allocated to each of the partners when developing to-be-liquidated capital accounts. For example, most yield-based flip agreements provide that upon a liquidation event, all assets and liabilities will be deemed sold or settled and converted into a cash balance that’s distributed to the partners in liquidation of the partners’ respective capital accounts.
Renewable energy projects Operating agreements generally provide safe-harbor principles under Section 704(b), stating a partner must distribute liquidation proceeds based on the partners’ respective positive capital accounts. This contrasts with the target allocation or distribution based agreements that liquidate according to defined provisions that generally don’t follow capital account balances. This means the liquidation provisions generally provide a defined mechanism for specifically allocating income, gain loss and deduction using 704(b) asset values to a partner’s capital account with liquidating distribution proceeds made to the partners in accordance with the partners’ positive capital accounts. This approach allows the partners to achieve, at least to the greatest extent possible, the investors’ required returns.
A typical operating agreement will start with the net gain from liquidation and allocate it to build up the partners’ capital accounts. Generally, the gain is first allocated to the partners to restore deficit capital accounts and to satisfy minimum gain chargebacks.
Remaining gain is then allocated to the partners to achieve the targeted IRR as provided in the operating agreement. Once income has been allocated to allow an investor to achieve its targeted IRR, a flip is typically triggered in distribution percentages, with the remaining gain allocated to the partners based on post-flip percentages.
In most cases, these gains will determine the partners’ final capital account, and the net proceeds will then be distributed according to their respective balance in their capital accounts. However, in some operating agreements, the use of gain from liquidation or liquidation proceeds is used ambiguously. Disputes could occur if, for example, allocating liquidation proceeds favors a return to a tax equity investor and allocating liquidation gain favors a sponsor investor.
An income-based approach presupposes a return of the investor’s existing tax capital account balances before the allocation of proceeds under the waterfall that’s not inherent in the liquidation proceeds-based approach.
Fortunately, in many tax equity deals, the base case models contain an HLBV schedule that may clarify some of the contended issues. It can be beneficial to have a provision in the operating agreement that states the partners should default to the base case model when questions arise around mechanics or application of the law.
We’re Here to Help
Navigating the HLBV method can be difficult, especially if there are intricacies within your project’s operating agreements and varying interest among partners. To learn more about the method or how you can best allocate your assets, contact your Moss Adams professional.