ESG repositioning continues

The energy sector is a capital-intensive business, and the sector is a significant borrower of capital. Capital expenditure in the US energy sector is estimated at around US$500–600bn annually (according to McKinsey). The sector’s capital demand and consumption has remained high despite the volatility in commodity prices. For example, although commodity prices fell 59% between 2014 and 2015, the energy sector remained one of the biggest sectors in terms of capital expenditure in 2015 and 2016.

Energy lending requires sector expertise because lenders need to understand the various specifics of the industry including commodity risk and investment project lifecycles. The lending is asset-based as opposed to being based on short- and medium-term cash flows. In addition, there is a mid-market segment that has significant capital needs that are not being addressed by banks. In this respect, the new green energy loans are like conventional energy or infrastructure loans. The lending opportunity is heightened by secular trends towards non-fossil fuel in the United States, with wind and solar demonstrating particularly strong potential.

Traditionally, energy companies have had lower default rates with higher recovery values than the market in general. According to the Fitch US High Yield Default Index, the annual default rate of the energy sector averaged 2.6% between 2001 and 2017 compared to 4.9% in non-energy, despite commodity price volatility. At the same time, historical recovery rates in energy lending have been higher than average, according to Moody’s. Energy recovery rates benefit from lending being asset backed.

However, the mid-market energy companies have found their size hampers their access to credit markets. As credit markets have grown, they have been increasingly less interested in smaller and less liquid names. In addition to this, since the financial crisis in 2007–2008, banks have been cutting back their lending to several segments to de-risk their portfolios, including middle-market energy.

Non-bank direct lending is increasingly stepping in and filling the gaps left by banks and credit markets. However, non-direct lenders usually do not have the resources and experience to deal with the non-conforming characteristics of energy lending that require extremely technical credit analysis (due to the high cyclicality) and sector knowledge. As a result, the energy segment is extraordinarily underrepresented in direct non-bank lending. In 2018, while the energy sector represented 26% of bank lending for mid-market US companies, it did not account for even 1% of the non-bank market according to Refinitiv Loan Connector.

The mid-market energy companies nevertheless have significant capital needs. This has created a business opportunity for non-bank lenders such as RCOI with access to specialist teams and the deep sector knowledge to take advantage of the favourable credit supply and demand dynamics.

This specialist lending does provide premium returns. RCOI’s usual all-in (including fees) yields at entry point in investments are in the range of 11–13.5%. In some deals, there is further upside through equity or share warrants while sustainability linked loans have step-up interest rate clauses. Loans are usually first lien and loan to value are moderate (43% at the end of FY21). The loans typically have maturity dates of three to five years but an expected duration of one to two years. Borrowers are usually expected to replace this financing with more lower cost funding as they grow.

Because it invests in the energy sector, the topic of ESG is particularly relevant for Riverstone. Management has been committed to have a valid ESG policy, not just paying lip service to the issues.

Since 2021 this has resulted in RCOI repositioning its portfolio to entities predominantly engaged in building infrastructure and providing infrastructure services to generate, transport, store and distribute both renewable and conventional sources of energy, as well as those companies focused on the pathway to transforming the global energy sector from fossil-based to zero carbon. RCOI has no investments in the exploration and production (E&P) sector having exited four of these investments with strong returns.

This portfolio shift also fits RCOI’s strategy of limiting exposure to oil and commodity prices. At the same time, RCOI maintains its position that will continue to look at E&P lending opportunities, but the clear emphasis is on green and sustainability-linked loans.

RCOI’s loans to energy transition segment have included a company building and managing solar panels (Aspen Power Partners), a water infrastructure company (Blackbuck Resources), a lithium-ion battery producer (Imperium3 NY), a recycler of low-density polyethylene (Circulus Holding), a leader in environmentally advanced treatment solutions and equipment for hydrogen sulphide (Streamline Innovations) and most recently a company building off-shore wind turbine jackets (Harland & Wolff) with plans to make further energy transition investments.

RCOI’s approach to ESG includes structuring the investments to be certified green whenever possible. Circulus Holding (August 2021) was RCOI’s first fully green certified and followed the Loan Syndications and Trading Association’s (LSTA) principles. This included the LSTA principle that there should be financial penalties for borrower non-compliance with the green requirements. RCOI’s most recent loan (Harland and Wolff) was also certified green, following the joint principles of the LSTA, Loan Market Association and Asia Pacific Loan Market Association.

The Harland and Wolff investment also contains sustainability-linked clauses focused on social responsibility – in this case relating to apprenticeship programme aimed at the local communities where it operates. RCOI’s first sustainability-linked loan was Blackbuck in July 2021. All of RCOI’s loans over the last 12 months have either been green certified and/or have had sustainability-linked clauses.

Oil and gas prices have increased significantly since 2020 during the first wave of the COVID-19 crisis with the war In Ukraine further fuelling the rise. The number of distressed oil and gas loans has fallen significantly. The percentage of oil and gas borrowers at distressed levels was a little over 3% of S&P Global’s leveraged loan index at the end of January 2022 – this was 82% at the peak in the first half of 2020. In its report in February 2022 S&P Global said it expected the S&P/LSTA Leveraged Loan Index default rate to reach 1.5% in December 2022 (0.4% in January 2022), which is still below the index long-term average of 2.5%.

The key issue now for US credit markets is the rising likelihood of recession as inflation has been significantly outpacing wage growth and squeezing consumers. There is a significant element to this inflation from supply chain bottlenecks resulting from COVID-19 lockdowns, consumers spending money saved during lockdown and the war in Ukraine. The most recent lockdown in China also has not helped the near-term inflation outlook. At the same time, some of the inflation will likely stick for an extended period, although there is much uncertainty over the degree. Elevated inflation also raises interest rate expectations and higher financing costs can be an issue for some of the more highly geared borrowers.

The trend towards non-fossil energy looks to be a secular due to efforts to bring energy-related carbon dioxide emissions to net zero in the US and globally. In the US, wind and solar have the potential to become a significant source of energy and could meet up to 90–100% according to study published in Energy and Environmental Science journal in 2018.

Non-hydro renewable sources were only 11% (with solar and wind representing a third of this) of total energy in 2019 according to the US government’s Energy Information Administration (EIA). The EIA forecasts that this percentage will increase to 17% by 2023 and continue to grow.

The International Energy Agency in its report released in 2021, Net Zero by 2050, sees the amount of annual net zero emission investments more than doubling from about $2.3trn in recent years globally to $5trn by 2030.

26%

The manager’s Q121 portfolio update (April 2022) described conditions remaining favourable for the broader energy industry. They also believe their repositioning towards infrastructure and energy transition assets has helped to ‘further diversify the portfolio from macro volatility’.

The manager expects ‘RCOI will remain close to fully committed throughout 2022’ given the ‘current unfunded commitments, various expected upsizes of existing investments, and potential new investment opportunities’.

Exhibits 3 and 4 illustrate RCOI’s portfolio repositioning between FY21 and FY20. Infrastructure services and energy transition accounted for 58% (excluding cash) of committed capital in the portfolio in FY21 compared just 31% in FY20. Infrastructure has remained relatively constant while exploration and production has dropped from 28% at the end of FY20 to zero in FY21.

RCOI uses the term infrastructure to include both midstream as well as power generation. Examples of midstream would include pipelines, terminals and storage. Power generation examples are natural gas fired, solar, wind, hydro, geothermal and nuclear. Infrastructure loans can therefore also be green loans.

Infrastructure services are also asset-heavy, but are businesses that serve the infrastructure such as transportation, logistics, distribution, construction, maintenance, and equipment rental. Unlike infrastructure, Infrastructure services will often have assets that move. As with infrastructure, these assets can also contribute to the transition to net zero energy solutions.

RCOI classifies as energy transition businesses that aid the transition of a carbon-based energy world to one of net zero, but do not fit neatly as either infrastructure or infrastructure services. This includes businesses in areas such as conversion of existing infrastructure, electrification of transport, waste-to-value, agriculture and next-generation fuels.

The structure of the loans remains the same. They are US denominated to US companies, floating rate and have first lien on the operating company (the exception is Caliber Midstream, which is first lien on the holding company). Caliber Midstream is also the only loan so far that has resulted in a repayment problem.

At entry to investment, the average drawn coupon is 9.3% (9.7% a year ago) and average tenor is 2.7 years (3.2 years in FY20); the longest is four years. The spread on the undrawn portion is 4.4% at entry, compared to 4.0% a year ago. The loan to value is quite low at 43% (45%), which we would expect with asset-based finance.

Exhibit 5 shows some details of RCOI 11 loans (as of Q122) as well as the loan exits, all nine of them profitable. The average yield to maturity is 12.7%, assuming the loan are fully drawn and with upfront fees. Loans are typically structured to be more expensive over time to encourage borrowers to repay RCOI early. Loan interest rates usually step up 1–2% percentage points each year until maturity.

The loan book in Q122 had a gross unrealised value of ($79.3m) shown in Exhibit 5 and already paid out $32.0m (gross realised value). The total realised and unrealised value was $111.7m in Q122, 16% above the cumulative invested capital. Loans are usually valued on a discounted cash flow basis unless very recently invested in. At the end of FY21, RCOI disclosed that the weighted average discount rate was 11% for the infrastructure loans, 13% for infrastructure services and 23% for energy transition (it seems that Imperium3 New York investment raised this figure). In April 2022, Imperium refinanced itself and RCOI exited the investment with a 32.5% IRR and 25% gain on invested capital. RCOI retain equity warrants that could provide further upside.

Exhibit 7 gives brief descriptions of the various loans as of end of Q122 and we include Imperium, which was only sold in April. Most of these loans are co-invested with other Riverstone-managed or associated funds, which reflects the leverage of the Riverstone group’s expertise and support.

RCOI’s inception date was May 2019 and its trading history has been affected first by the COVID-19 pandemic crisis and now the war in Ukraine.

During the peak of the market turbulence in the first half of 2020, RCOI’s share price fell to almost 60% below issue price. RCOI’s NAV total return has remained resilient and in fact has outperformed since inception the S&P/LSTA US Leveraged Loan Index by 4.9%. The RCOI shares have recovered since their 2020 doldrums. However, they still have a wide discount to NAV at 16% and have underperformed the index by 7.8%

RCOI’s NAV total return has also outperformed S&P High Yield Energy Loan Index since inception (by 4.7%) while the shares have underperformed by 8%.

S&P Energy Bond Index has delivered slightly more (0.5%) than RCOI’s NAV total return but this index not as close to RCOI’s portfolio as the S&P High Yield Energy Loan Index since it tracks significantly larger companies.

Exhibit 11 shows a comparison of RCOI with a selected peer group of funds from the AIC Sector Specialist: Debt and AIC Sector Specialist: Financials sectors that have significant holdings in direct lending or similar investments. We note there is no pure energy direct lending peer; RCOI is fairly unique.

We compare peer performance over one year. We have also added longer time periods to give greater context to the short-term performance data.

Compared to its peers, RCOI’s NAV performance over the last 12 months ranks sixth out of eight and seventh out of eight since inception in May 2019. However, the performance has been adversely affected by the significant cash position, which it is steadily deploying.

RCOI is trading with an above-average discount to NAV (16% vs 10%) and a higher-than-average dividend yield (8.0% vs 6.2%). Its ongoing cost is close to average despite it being a smaller fund. Besides good cost control, it also reflects the lack of a base management fee and the benefit of being able to leverage the Riverstone group and its infrastructure.

RCOI pays dividends quarterly in April, July, October and January. It has an 8–10% target annualised yield based on its US$1.00 per share IPO price. It aims to pay 100% of its quarterly income (after payment of expenses) as dividends. However, it can retain up to 15% of its income if the board believes it is in the best long-term interests of the company.

RCOI paid a dividend of 7c in FY20 and FY22. Quarterly dividend payments in FY21 were evenly spread at 1.7–1.8c per quarter. The trailing annual dividend yield is 8.0%.

RCOI’s shares have been trading with a discount in their teens for about a year. This is despite the improving outlook of the oil and gas industry, the continued solid performance of the portfolio and good dividend stream. Although there has been a portfolio problem with one of their investments (Caliber Midstream, the only loan where the first lien was on the holding company and not on the operating entity), the overall performance has been good and we again stress the loans are all asset backed and with LTVs in the mid-40s; therefore they are likely to have good recovery values or to be successfully restructured with no investment losses to RCOI.

The company can buy up to 14.99% of its shares and did so in 2020 when the discount was even wider. The authorisation has to be renewed annually, usually at the AGM (the next AGM is on 18 May 2022).

RCOI launched in May 2019 and is an England-domiciled, London-listed, closed-end investment company with a focus on credit opportunities in small and mid-sized energy companies. It invests in companies at all stages of energy exploration, production and distribution. To diversify risk and provide synergies, the company aims to invest across different geographies (both in terms of production and end-markets) and in different commodities.

Investment maturities tend to be short to medium (the usual tenor is one to four years) and RCOI often welcomes early redemption as a sign that the borrowers are growing. Therefore, many if not most of the loans are expected to have full or partial realisations before maturity.

The portfolio so far consists of first-lien loans with floating rates and is expected to remain heavily skewed towards this type of lending. Typically, issuers will be domiciled in the United States (or with the majority of the operations in the United States), but the remit allows for lending to companies in other regions. The loans are also typically delayed draw term loans, with the borrowers paying some interest on the undrawn portion.

While most of RCOI’s investing will be direct lending, it will also look at capital relief and market-based opportunities. Capital relief transactions consist of RCOI buying non-conforming energy loans from banks that no longer can or wish to keep them on the balance sheet. Unlike direct lending, due diligence will typically be based on public information and RCOI is unlikely to be able to influence the underlying terms. These investments may also be part of a larger syndicate. Market-based investments will be conducted on the open market and can include bonds as well as syndicated loans. Both capital relief and market-based investments are expected to be secondary to direct lending and only carried out when the expected returns match or exceed the opportunities in direct lending.

AGM 2022 clarification

A resolution has been submitted for the annual AGM scheduled for 18 May 2022 to clarify RCOI’s definition of ‘borrower operating in energy sector’ in the company’s published investment policy to include:

RCOI is able to leverage the Riverstone Credit Platform and the wider Riverstone group (Riverstone Holdings), which is a key differentiating advantage. Riverstone was founded in 2000 and is a private investment firm focused on energy and power. It has raised US$43bn in more than 200 investments across its three platforms: Global Energy and Power, Renewable Energy and Riverstone Credit Platform.

Riverstone is the key source for RCOI’s origination and provides support for due diligence, risk underwriting capabilities and credit analyses. It offers access to market specialists and operational expertise, which helps manage risk and provides downside protection.

Christopher Abbate and Jamie Brodsky head Riverstone Credit Partners (RCP) and Riverstone Credit team that manages the platform funds, including RCOI. Both joined Riverstone in 2014 after a decade of leading energy leveraged finance at Citibank and Nomura, respectively. The Riverstone Credit team is made up of 10 people with industry knowledge, financial expertise (including origination, syndication and underwriting) and operating capabilities.

Since 2014, RCP has committed more than US$2.1bn in capital in RCP I and RCP II energy credit funds, both of them private (unlisted). As is the case with RCOI, these funds consist of floating rate, first-lien loans, secured and with similar average tenors and LTV ratios (in the mid-40s). The average loan yields to redemption have been around 13% and the cash yield of the funds has been 11–12%. These seem to be quite attractive returns. As a comparison, the S&P High Yield Energy Loan Index averaged just under 6% in the five years to the end of April 2022.

We describe the investment process in detail in our initiation note, Niche energy infrastructure lending, published on 11 March 2021.

RCOI had no borrowings as of the end of FY21. As set out in its memorandum of association, RCOI is permitted to borrow up to 30% of its gross assets, at the time of borrowing. This limit excludes non-recourse financing in any special investment vehicles such as the non-recourse loans in its two Delaware-based limited partnerships (Riverstone International Credit and Riverstone International Credit-Direct).

There is no base management fee paid by RCOI to the investment managers or to any Riverstone group entity. We believe this is an attraction that helps aligns the interests of shareholders with management. The remuneration for management will be solely through a profit share. RCOI does pay for reasonable reimbursable expenses as well as directors’ fees.

The incentive system is three tiered. It is paid quarterly but reconciled on an annual basis. There is no catch-up/adjustment on profit share beyond the fiscal year. Payment is 0% if the annual distributable income is less than 4%, 20% is paid out if the income is between 4% and 8%, and 30% if the distributable income is greater than 8%.

RCOI has a single share class, with 91.54m ordinary shares in issue. There are no rules restricting the directors’ ability to issue additional shares on a non-preemptive basis at any time. The directors may issue additional shares, pursuant to a placing programme or otherwise, if they determine this to be in the best interests of shareholders and Riverstone as a whole. No shares have been allotted since RCOI’s IPO in May 2019, when it raised c US$100m in proceeds through issuing 100m ordinary shares at US$1.00 per share, and all of its 100m ordinary shares were admitted to trading on the Specialist Fund Segment of the London Stock Exchange.

RCOI’s board is comprised of three non‐executive directors, all of them independent of the investment manager.

Reuben Jeffery, III, chairman has a broad range of financial services experience, particularly investment banking, and brings extensive insight into the US political and regulatory environment. He is vice chairman of Rockefeller Capital Management and served in the US government as undersecretary of state for economic, energy and agricultural affairs between 2007 and 2009. He also served as chairman of the Commodity Futures Trading Commission and as a special assistant to the president on the staff of the National Security Council. Before his government service, he spent 18 years at Goldman, Sachs & Co where he was managing partner of Goldman Sachs in Paris and led the firm’s European Financial Institutions Group in London. Before joining Goldman Sachs, he was a corporate attorney with Davis Polk & Wardwell.

Emma Davies is head of direct investments at Marylebone Partners, an independent wealth management firm. She was previously head of property and infrastructure at The Wellcome Trust, where she also helped to manage the public markets portfolio. She was formerly CIO of Big Society Capital and ran the European investments team for Perry Capital.

Edward Cumming-Bruce is the vice chairman of Gleacher Shacklock, which he joined in August 2003, before which he worked for 12 years at Dresdner Kleinwort Wasserstein, where he held a number of senior positions including co-head of global telecoms investment banking, co-head of UK investment banking and global head of equity capital markets. Mr Cumming-Bruce has extensive experience advising a range of major European companies on capital markets and restructuring transactions as well as mergers and acquisitions. Before Dresdner Kleinwort Wasserstein, he worked at Schroders.