2016 for the most part has been a difficult year for every sector in the shipping industry: weak rates for dry bulk, containerships, offshore and even tanker vessels exacerbated the financial distress for many owners and their lenders. Recently however the market has shown signs of hope, here and there, with freight rate and asset price improvements, but in general, the greatest hope of all has been that the worst days in shipping, likely, are behind us.
Great name for a bank by the water, but regrettably no shipping loans offered. Image credit: Karatzas Images
One driver in shipping that has not shown any signs of promise are shipping banks in terms of expanding their book in the industry. The market collapse since 2008 has been especially hard for the shipping banks which first saw their clients (shipowners) facing a weak freight market and rendering them unable to sustain the original ship mortgage payments, and then, a precipitous decline in the value of the assets (ships pledged as collateral for the ship mortgages) killed any motivation to keep making payment on underwater assets. Most shipping banks are in an expressed course of departing from shipping and actively have been selling their existing shipping loans for the last several years. The news of certain shipping banks turning their backs to the industry is challenging, but the more disheartening prospect has been that shipping banks still dedicated to shipping have not been able to adapt their models for the current market developments; probably because of the fact that they have to act within strict regulatory and auditing guidelines, shipping banks still active in shipping have been maintaining an almost religious focus on a handful of clients who seem to ‘check all the boxes’, while the vast majority of the market remains un-serviced.
As we had mentioned in the past, the funding gap left in the wake of shipping banks has provided opportunities for institutional investors to enter the ship lending market. Whether these funds are categorized as credit funds or lending funds or alternative capital funds or even disguised as leasing funds on occasion, effectively they are providing capital to the industry in the form of debt, as supposed to equity, and effectively in a sense are substituting for the role of a bank as a lender. On the surface of it, shipping is a capital intensive industry and someone, sooner or later, would had to step in to fill the gap left by the banks.
Credit funds, being institutional investors, have by default higher cost of capital than the funding cost of a bank (read customer deposits), and therefore one would expect that obtaining debt from a fund would have to be at a higher cost. And, indeed, debt financing from a fund typically starts in the low double-digits, all in, even for relatively conservative projects. In a sense, it’s unfortunate that credit funds cannot adjust downwards (below their threshold) the cost of debt of a project depending on risk, since their investors (LPs) have been assured of a certain minimum return, typically in the high single digits after expenses and fees. As expensive the cost of debt financing from credit funds as it may sound, one has to compare it not to what shipowners were accustomed to (and possibly spoiled by indulging shipping banks) a few years ago of a couple of hundred basis points (bps) above Libor (L), but to the real risk of the industry overall and the intricacies of the transaction in particular. If risk can accurately be described by variance and volatility, what risk a rational investor would assign to the dry bulk market when the BDI has varied between almost 13,000 and 300 points in a decade, or when the BDI has varied between 300 and 1,300 points in timeframe shorter of a calendar year?
In need of capital… ‘Ships in a Harbor’, ca 1873, Oil on canvas, Claude Monet; Denman Waldo Ross Collection (1906); Boston Museum of Fine Arts. Image credit: Karatzas Images
As expensive the cost of debt from a credit fund as it may sound, it’s still a relatively low return given that institutional investors typically aim at returns in excess of 20% by taking (mostly market) risk. In a sense, it begs the question why institutional investors would bother with debt investments in shipping. Probably, there are several answers to that: many private equity funds entered shipping aggressively in the last few years and their equity investments have shown a misunderstood industry and its risks; debt investments, on the other hand, either by the same institutional investors or funds who were browsing the industry, is a more measured undertaking of risk, in an industry notoriously volatile. Further, the state of the shipping industry has been so bad that shipowners these days casually consent to high debt financing given the alternative, or lack thereof. Thus, market conditions have pushed shipowners to modify their financing cost expectations and move from bank-related debt financing and closer to fund-related debt financing. And, last but not least, let’s not forget that we are living in an usually low interest rate environment where investors are starved for yield and returns from credit investments in shipping can be acceptable given the interest rate environment.
Depending on how one counts this, more than $5 billion have been committed to credit funds and platforms by institutional investors in the last three years. The mandate of some of these platforms includes investments in shipping loans in the secondary market (not just originations); and, discouragingly enough, some of these credit funds are not completely realistic in their expectations, so we hold doubts on whether their capital can be deployed (still, we cannot get over a really nice ad in the Financial Times a few years ago for a fund having just raised $1 billion to invest in distress, including shipping; they managed to deploy exactly zero dollars in the shipping industry so far, and their in-house shipping guru departed for balmier seas). And coincidentally, $5 billion is still a minuscule amount of money for the debt needs of the shipping industry given that the market of shipping loans stood at more than $700 billion at the top of the market a few years ago. Credit funds will not be able to fill the gap left behind by the banks, but again, that’s not their main mandate or concern.
Can credit funds be considered a strategic partner to the shipping industry? Probably a hard question to answer given that credit funds are still driven by institutional investors who are industry agnostic and tend to gravitate to industries / sectors / geographies in distress, and will not be able to accommodate shipping over the long term. But, for time being and for as long as credit funds are active in shipping, their relatively high cost of capital and their more conservative approach (than equity funds of recent or shipping banks of the last decade), one can be assured that shipping asset prices or newbuilding ordering will not get out of hand, as it has happened twice in the past decade. Credit funds may not be suitable for establishing ‘ceilings’ in the shipping industry but mostly to provide ‘floors’ and holding the market from dropping lower.
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