Transaction advisor fees: Is the success fee model working for our industry?
This article is sponsored by 3Degrees.
Your company has taken the bold move to set renewable energy and carbon emissions goals. You have done the work to get the key stakeholders to consider a virtual power purchase agreement (VPPA). Now you’re wondering if you need an adviser to help you navigate the procurement process. Experienced advisers can help you avoid many pitfalls inherent in participating in the wholesale energy market. But how much do they — and should they — charge for the value they offer clients?
A trusted adviser can add significant value, helping with everything from building stakeholder support, navigating derivative accounting concerns, to running financial analyses and leading contract negotiations. The market for advisers offering their services has grown along with the appetite by corporate buyers for VPPAs. But clients’ understanding of advisory services costs under the widely accepted success fee model remains murky. Peeling back the layers of this business model can add greater clarity and transparency to the market.
The success fee model is the most common pricing model offered by renewable energy advisers. This model is akin to commodity brokerage services: Advisory services are provided to the buyer for "free" because the seller "covers" the cost.
In the case of a VPPA, the adviser provides support throughout the term of the engagement at no cost to the client and then receives payment at contract signing (or other key milestones) from the project developer. This fee can take the form of a payment based on project size (dollars per MW), an ongoing royalty (percentage of the long-term revenue from the project) or a combination of the two. In this scenario, a client avoids paying consulting fees in favor of ongoing payments levied on top of the VPPA price, paid over the life of the offtake agreement.
The success fee model has emerged as a favored pricing structure for good reason. Many VPPA initiatives are led by budget-constrained departments that have climate change or renewable energy goals, while the ongoing VPPA costs will be paid out of larger facilities, operations or treasury budget. In addition, even if a client fully intends to execute a deal, it can walk away with no money out-of-pocket if it decides not to execute a contract or if it is unable to find a project that meets its requirements. The success fee approach also helps ensure that the adviser works diligently to overcome any obstacles to bring the client an acceptable project and contract — or else it won’t get paid.
Unfortunately, this model also can create a misalignment of incentives. The adviser gets paid more for a longer term, larger sized or higher priced deal. Even though the advisory services required (such as stakeholder engagement, solicitation and contract analyses and negotiation) are the same whether the VPPA is for 10 MW or 200 MW, the adviser’s fees can increase materially for the latter. Additionally, because the adviser only gets paid if a contract is executed, this model can cause the adviser to focus more on getting a contract signed than on the nuances of the client’s best interests. This is a natural, human response to the incentives in place. Whether these potential conflicts are perceived or real does not diminish their impact on the client and points to the importance of trust and transparency in this relationship.
The chart below shows the fees which result from representative success fee engagements. As highlighted in the chart, seemingly modest differences in a VPPA can have a dramatic impact on the fees paid to the advisor. The chart assumes a simple combination success fee: $10,000 per MW paid upon contract execution and a 1 percent annual royalty from the developer’s VPPA revenue.
As these examples show, a simple change in technology from solar to wind, with a higher capacity factor, significantly can increase the payment to the adviser. VPPA advisory services can be highly lucrative, hence the reason why several advisers have been acquired by large energy companies.
It’s important to evaluate these fees in the context of cost and risk to the advisor. Typical time and materials VPPA advisory services that include stakeholder engagement, solicitation, analyses, negotiation, approval and execution of a VPPA may cost a buyer about $250,000 to $400,000. Even taking time-value of money into account, success fees come at a premium. Whether the premium is excessive in light of the "at risk" nature of the services can be determined only by the client.
In addition to the potential misalignment that this fee structure creates, some other aspects of advisory offerings deserve greater transparency. The royalty component of the success fee model is often marketed by the adviser as sharing project risk with the client because royalties are to be paid out over time by the developer.
In reality, some advisers are paid in a single, upfront lump sum payment by the developer (based on expected project revenue) or by syndicating those royalty streams — thus, the adviser can buy its way out of project risk. Also, agreements between advisers and developers may include non-circumvent clauses which prevent the developer from working directly with that client or prevent the client from engaging in a subsequent VPPA, without paying the adviser — regardless whether support for that transaction is provided.
Finally, some advisers exclusively source projects from their proprietary project database. The databases are often "pay-to-play," resulting in some developers reducing the number of projects they make available via the database, thus limiting the client’s true access to the marketplace.
While there is no doubt that advisers are an important part of the corporate renewable energy ecosystem, corporate buyers should understand the true cost of these services under a variety of scenarios and weigh their corresponding value.
So are success fees a bad idea? Not necessarily.
If you have full insight on the range of potential fees and believe you are receiving equivalent value, then a success fee can serve you well. However, it is important that you have a clear-eyed view of the adviser’s incentive structure.
You can push for full transparency by asking the following questions during the hiring process (or even asking your current adviser):
- What are your total potential fees (not just percentage of VPPA price or $/MWh) for a specific sized VPPA and what assumptions make up those fees?
- Will you show me the VPPA financial results both with and without the adviser’s fee embedded in the price?
- When will you be paid by the developer and will you tell me if these milestone payments change?
- Is there a cap on the total success fee amount? If not, why not?
- What contract terms do you require between you and the chosen developer and how could those terms affect me now and into the future?
- Will you provide advisory services on fixed-fee or time and materials basis and if so, what are the estimated costs for those services?
As an advisory firm that supports renewable energy procurement and offers a success fee model along with other payment structures to our clients, 3Degrees welcome these questions. We believe transparency creates a more efficient marketplace, enables educated buyers and improves decision making. Increased transparency naturally occurs in maturing markets, but further clarity is needed to ensure that cost equals value — with the value to be defined by you, the buyer. Advisers in the sustainability industry need to foster sustainable pricing models that serve the clients, fairly compensate the advisers and ultimately, promote more renewable energy being built to combat climate change.