Riverstone Credit Opportunities Income — Attractive returns with greater sustainability focus

RCOI has been repositioning its portfolio towards energy transition, infrastructure and infrastructure services, and placing less emphasis on the exploration and production (E&P) sector. Energy transition and infrastructure service investments accounted for around half of RCOI’s portfolio at end July 2021, while the infrastructure segment represented the other half. There were no outstanding E&P loans in the portfolio with all four investments in this segment exited with strong returns.

RCOI will continue to look at E&P lending opportunities, but there is clearly greater emphasis on the other segments including green and sustainability-linked loans. This shift also fits in with RCOI’s strategy of limiting exposure to oil and commodity prices.

RCOI made its first energy transition loan in December 2020 to Aspen Power Partners, a company building and managing community solar portfolios in the United States. It followed this with loans to Blackbuck Resources (a water infrastructure company) and Imperium3 NY (a lithium-ion battery manufacturer), both in July 2021. Blackbuck Resources was RCOI’s first sustainability-linked loan with interest rate step-ups if certain sustainability targets are not met.

The first fully certified green loan, following the Loan Syndications and Trading Association’s (LSTA) principles, was completed in August. The borrower (Project Sphere) is a recycler of low-density polyethylene (LDPE) for use in food-grade packaging, injection moulding applications, bags, films and other high-end products. A key point of the LSTA principles is that these loans will incur financial penalties for non-compliance with the green requirements.

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 similar to conventional energy or infrastructure loans. The lending opportunity is heightened by secular trends towards non-fossil fuel in the United States, with wind and sun demonstrating particularly strong potential.

The Riverstone group has an ESG policy on how it handles issues such as ‘natural resource management, health and safety, community and stakeholder impact, climate change, greenhouse gas emissions and governance, among many others’. Riverstone has established a formal ESG Committee, which oversees processes in accordance with policy. These processes include training, access to ESG resources, and identifying possible risks and mitigating damage before an investment is made. There is also active portfolio monitoring regarding ESG issues. Both the due diligence and investment committee assess ESG risks, while third-party experts are used for assistance as needed. Riverstone is a signee with the United Nations Principles for Responsible Investment (UNPRI), an international network of investors working to implement ESG driven principles into investments worldwide; its website is www.unpri.org.

In its Q221 commentary in July 2021, Riverstone Investment Group (RIG) noted that the portfolio ‘continued to show resilience’ against a backdrop of an ‘uptick in oil prices and strengthening in supply and demand’ in the period. RIG believes that the ‘focus on infrastructure, infrastructure services and energy transition investment opportunities will provide downside protection and allow the portfolio to continue to generate positive returns and income for shareholders’.

While RIG accepts that it is a volatile time for the sector, it believes that if it measures the risk correctly and prices it accordingly, there are still good opportunities to invest. RCOI is obtaining good prices in its investments and equity-like returns are being achieved with lending that is carried out only on a secure first-lien basis.

Exhibit 1 shows RCOI’s loan portfolio as of H121. This excludes the Project Sphere three-year loan completed in August 2021 (US$12.5m committed with an estimated yield to maturity (YTM) of 13.5%). All of the loans are US dollar denominated, to US companies and floating rate. They are all first lien on the operating company. The only exception is the loan to Caliber Midstream, which is first lien on the holding company.

At entry to investment, the average drawn coupon is 9.3% and average tenor is 3.0 years; the longest is four years. The spread on the undrawn portion is 4.4% at entry. All of these figures have been fairly constant since inception.

The infrastructure segment (typically this is transport, storage and wholesale marketing) accounts for 53% of committed loans, infrastructure services accounts for 33% and energy transition represents 13% of committed loans.

RCOI’s cash position was 25% of net asset value (NAV) ($23.9m) at the end of H121. However, we estimate that the cash position has fallen by US$6m to 19% of NAV during Q321, with the new Project Sphere loan of US$12.5m and the US Shipping loan exit of US$6.5m. Management expects the cash position to further decline by the end of the year.

Exhibits 3 and 4 show details of RCOI loans as well as loan exits, all of them profitable (the average margin over invested capital on sales is 14% for investments held for a year on average). The average YTM of the loan book at end H121 was 13.0%, assuming the loans are fully drawn and with upfront fees. Most loans are invested in the 11–13% range. Loans are typically structured to be more expensive over time to encourage borrowers to repay RCOI early. Loan interest rates usually step up 1–2pp each year until maturity.

The loans at the end of H121 had a total fair value (FV) of US$88.2m, which is similar to the gross realised and unrealised value shown in Exhibit 3. Loans are usually valued on a discounted cash flow basis unless very recently invested, as is the case with Blackbuck Resources, which was only completed in June 2021. The discount rate used ranges from 11% (midstream segment average) to as high as 25% in the case of Aspen Power Partners.

Exhibit 5 gives brief descriptions of the various loans. Most of these loans are co-invested with other RIG-managed or associated funds, which reflects the aforementioned leverage of the RIG’s expertise and support.

RCOI’s inception date of May 2019 is relatively recent. Its performance has been dominated by the COVID-19 pandemic crisis and its impact on the energy markets, particularly oil. During the peak of market turbulence, RCOI’s share price had fallen almost 60% below its issue price. The shares have rebounded but are still substantially below both the issue price and NAV.

RCOI’s NAV per share has outperformed the S&P/LSTA US Leveraged Loan Index (LLI) by 2.5% over the 12 months to end August 2021 and has been in line with the index since inception (Exhibit 6). RCOI’s NAV per share has also been in line with the S&P High Yield Energy Loan Index since inception, but underperformed by 6.3% over one year to August 2021.

Over the same periods, RCOI’s NAV has outperformed the S&P Energy Bond Index, which tracks bonds from larger energy companies, by 0.5% and 2.9% since inception and over one year, but this index is not as close to RCOI’s portfolio as the S&P High Yield Energy Loan Index.

Exhibit 9 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 that there is not a pure energy direct lending peer; RCOI is fairly unique.

We compare the performance over one year. We have also added longer time periods for the peers, 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 since inception in May 2019. However, performance has been adversely affected in this period by the significant cash position, which it is steadily deploying.

RCOI stands out by having the second largest discount to NAV and one of the highest dividend yields. It is also at the lower end of the scale when it comes to costs, despite being a small fund. Besides good cost control, it reflects the lack of a base management fee and the benefit of being able to leverage off 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. RCOI 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 2.57c in Q419, followed by 1.8c in the next two quarters, 1.4c in Q320 and 2c in Q420. The dividend paid with respect to 2020 was 7c per share. Dividend payments in 2021 were 1.7c and 1.8c in Q1 and Q2. The trailing annual dividend yield is 8.1%.

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 on the short to medium side (the usual tenor is one to four years) and RCOI often welcomes early redemption as a sign that the borrowers are growing in size. 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.

RCOI is able to leverage off the Riverstone Credit Platform and the wider Riverstone group (Riverstone Holdings) and this 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$41bn in more than 200 investments across its three platforms: Global Energy & Power, Renewable Energy and Riverstone Credit Platform.

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

Christopher Abbate and Jamie Brodsky head the RCP and the 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 loan to value (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 January 2021.

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 FY20. 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 RIG 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 currently has a single share class, with 91.54m ordinary shares in issue. There are no rules restricting the ability of the directors to issue additional shares on a non-pre-emptive 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 (SFS) of the London Stock Exchange.