The Fed has been increasing interest rates to combat inflation since Q1 2022, including four hikes this year. The most recent one was in July, so why is the industry all of sudden buzzing with concern about hurdle rates rising and project buyers having to renegotiate deals?

In the past month, the Conductor Solar team has heard that “project hurdle rates are going up” at least a dozen times, which is more than we heard that phrase in all the prior months of 2023 combined. Projects and portfolios are coming back to the market more often than usual, and developers aren’t seeing the value that they once thought was possible. This sudden change is frustrating and it doesn’t make sense on its surface when you compare it to the consistent Fed rate hikes over the prior 18 months.

*Source: https://www.forbes.com/advisor/investing/fed-funds-rate-history/*

The question we get asked most often is: if the fed funds rate has only risen 0.50% since May, why are project returns getting hammered? The easiest way to answer this is by looking at the 10-year treasuries rate, a better benchmark for solar project return targets.

Why is the 10-year Treasuries Rate a good benchmark?
Solar projects have a long life, typically 20-35 years. Most revenue contracts are in the 15-25 year range. Projects are typically financed with some mix of sponsor equity, project debt, and tax equity. For simplicity, let’s assume the following mix of those three sources:

As you can see above, approximately half of a typical solar project is financed by debt. Debt is sized based on the contracted revenues of the project and the weighted average timing for those cash flows tends to be around the 10 year mark, which is what makes the 10 year treasuries a good comparison for project debt pricing.

How does this impact the project’s hurdle rate?
When we talk about a project’s “hurdle rate,” we generally mean the unlevered IRR. This is the return metric that doesn’t care about how an investor finances the project and is what Conductor Solar uses to estimate its autopricing. This is the true north for a project’s valuation, and is a simplified way to view the world that works the majority of the time. However, since investors really do care about their equity returns, it makes sense to dig a level deeper here. We’ll highlight how the market forces are impacting each of the key parts of a solar project’s capital stack.

Project Debt: This is what’s impacting rates the most. As you can see in the 10-year Treasuries chart above, that pricing has increased 1.40% in the past few months. While other factors are at play, it’s safe to assume that the cost of debt for solar projects also has increased by 1.40% in the same period.
Tax Equity: For purposes of this article, we’re going to keep things simple and assume that tax equity is unchanged. There is reason to expect some tightening here too, at least in the short term, and we’ve seen some evidence to this effect. But the tax equity market is very dynamic right now in the context of these macro trends and the recent introduction of tax credit transfers.
Equity: This is the riskiest part of a solar investment, as it is repaid last after debt and tax equity. Investors in solar project equity often compare its returns with other general asset classes. As it becomes easier to invest in things like 10-year treasuries to earn a decent return, it means that the equity for solar projects needs to provide slightly higher returns to continue attracting investment. While this lags a bit behind the 10-year treasuries rate, the general impacts from rate hikes over the past 18 months are starting to show through here, too.

The Bottom Line
The impacts of all of these changes are that the unlevered IRRs for solar projects are increasing by ~1.00% in order to continue attracting project buyers. That can have a pretty dramatic impact on a project’s value, upwards of a 7-10% reduction on the total project value. If you’re a developer who waited until the project was fully derisked, you might find that your project isn’t commanding anywhere near the value that you thought it would.

Guidance for Developers

If you run into trouble with a project, use the Conductor Marketplace and find new offers
If you’ve signed an LOI but have not yet contracted, confirm your investor’s pricing
Have patience with investors, who are doing the best that they can while the cost of their money is constantly changing

Guidance for Investors

Keep every commitment that you can, to maintain credibility
Communicate early and often if something in a deal needs to change; and be transparent demonstrating why - so it’s clear to your developer that this isn’t just a grab for more value
Expect that developers will seek alternatives, and keep their loyalty by continuing to be a great partner in every way possible

Conductor’s Take

An inherent asymmetry is present once exclusivity is granted; developers rely on their investors to be credible, trustworthy, and to follow through on their offer
Investors get a bad reputation if they exploit this asymmetry with great offers during bidding that get rolled back during diligence. Bait and switch.
That’s not what’s happening here, for the most part. But it probably feels the same to many developers.
Conductor screens investors and works with high integrity shops who price competitively and follow through with solid execution. This is very hard to screen up front, which is why we leverage our insight into their behavior through dozens of deals with different parties. And this is very valuable for our developers, especially when they’re looking for a new investor partner.

Macro Update on Project Hurdle Rates

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