What is the PAYGO debt trap? Here are the main takeaways:
- Off-grid solar PAYGO companies use debt to fund their growth strategy with their asset portfolios as collateral
- The industry needs KPI standards and monitoring tools to properly analyze portfolio performance
- Without those monitoring tools equity providers can be caught off guard as debt providers are first in line when cash needs to be distributed
The off-grid solar industry has experienced significant growth over the years: approximately $1.5 billion have been invested since 2012. For good reasons, many companies entered the market using pay-as-you-go (PAYGO) models. Some were successful and were able to capitalize on the opportunity of this untapped market while others were less successful and struggled to meet their own, arguably unrealistic, expectations.
There are a lot of articles telling success stories. What has been written on the failures has tended to focus on issues related to uncontrolled growth (quantity versus quality of sales), disproportionate overheads, or wrong choice of business model such as selling systems under energy service contracts rather than lease-to-buy. Much less attention has been paid on what we believe is one of the most important contributing factors of all – company debt and its relation to cash flow management.
Asset leasing VS PAYGO
The cash flows of a PAYGO off-grid solar company are in many ways similar to any other capital-intensive leasing company. That is to say, upfront investments in inventory, CAPEX and/or costs of sales are required to originate a long-term cash generating contract. The free cash flows from an asset that should become available to the capital providers are determined by payments received minus the handling and administrative costs to collect those payments. These costs should include amongst others: transaction costs like mobile money, call centers, maintenance teams, admin and management. In turn, these free cash flows should be capable of hitting multiple milestones throughout the contract lifetime (landed costs covered; costs of sales covered; repayment of capital providers; resulting in actually making an overall profit).
If the last milestone is reached, a company could opt for paying out dividends or to use the profits for expansion.
A leasing company with a double-digit growth strategy does not have time to wait so long and would therefore seek to “fast track” this process. Typically, these solutions involve attracting new equity, opting for a loan facility with the asset and/or contract as security, or selling the asset-contract combination.
The loan facility or sale of the asset is only possible if both parties understand the risks associated with the assumed free cash flows of the asset/contract and if both parties agree on how risks are divided between the two of them. To optimize transaction costs, both parties typically agree on a portfolio of assets rather than one asset. If the company opts for a loan, the challenge is to align the risk distribution and cash flows generated into an actual cash flow distribution to the capital providers. This cash flow prioritization mechanism is the cash flow waterfall, where senior lenders are paid first, junior lenders second, and shareholders last.
… but different
PAYGO companies usually differ from other leasing companies on flexibility in key components of the leasing agreement.
|Asset Leasing Companies||PAYGO Companies|
|Fixed periodical payments||Flexible payments in both time & amounts|
|Fixed contract lifetime or tenor||Automatically prolonged contracts|
|Contract termination penalties||No termination penalties|
|Recourse on borrower||Non-recourse on borrower|
Disregarding these differences, the expected cash flow management outlined above and its relation to taking on loans based on the cash flows generated by a portfolio of assets is essentially still applicable. However, the practice that can often be found in today’s PAYGO market is often quite different with respect to the following three key points:
- PAYGO companies are not looked at from a return on asset point of view; instead, companies are valued based on an existing client portfolio.
- There is no standard way of assessing a PAYGO company’s ability to take on debt from the banking side (i.e., through a combination of assessing the asset portfolio’s ability to generate future cash flows in combination with the existing client portfolio).
- Cash waterfalls determining a hierarchy of payments, described in the beginning of this article and more common in project finance, are not implemented properly.
Respectively, these issues can lead to 1) an inadequate focus on asset performance and asset redeployment management, 2) over indebtedness in relation to the future cash flows which can be generated by the asset portfolio, and/or 3) a misalignment of asset-generated cash flows and repayment obligations (especially under today’s common lending practice of long grace periods and large bullet repayments). Taken together, PAYGO companies are, possibly unknowingly, not building up sufficient equity cushion to absorb any type of external shock. This applies for business in general and especially so for businesses operating in emerging markets.
With the above in mind, PAYGO companies would try to cover future debt service with the cash flows generated from portfolio growth and expansion. Over time, a debt-laden house of cards is built leaving the equity investors, potentially caught off guard, with a poor or no return on equity.
If the PAYGO sector wants to grow to a +10x size in the next 5 years, there is a need for larger and institutionalized equity investment. This will only come once institutional investors feel that a large part of the sector has a proper grip on their portfolios and operations. This underlines the need for a transparent, standardized and disciplined system for PAYGO companies to keep track of their cash flow cycles stemming from their asset portfolio and the implementation of cash waterfalls to provide lenders with the transparency needed to tailor financial products to the characteristics of the PAYGO business.
Other than transparency and additional capital flowing into sector, this standardized system will have other positive effects. For example, it will allow multiple companies to start pooling their assets on an aggregate level. Second, an increased visibility on portfolio risk should allow for overall better financing terms. Both of these will push down the cost of capital leading to more stable companies and improved affordability for the end user as well as the start of a more virtuous circle for the sector as a whole as it continues to mature.
REM Capital is a financial advisory boutique which focuses on, among others, international project and corporate finance advisory in the global renewables, waste, water and infrastructure sector. REM Capital is part of the SDAX listed Hypoport group which has a background in fintech. By uniquely combining international financial advice with IT-based solutions, REM Capital with Hypoport can offer innovative and creative financing solutions tailored to the needs of your business or project.