Boats of the Highly Levered Seas

There used to be a time when the financing options for a shipowner where simple: seed capital was levered with a ship mortgage from a bank, and the loan was paid off based on an agreed-upon principal repayment profile from the operating profit. The terms of the shipping loans from banks were very similar and often the only differentiating factors for shipping loans were a few quantitative factors, principal among them the so-called spread, the difference over Libor for the cost of the debt.

Obviously, for any rational borrower, the lender with the lowest cost (interest rate) would get the business. When all things were equal, it was easy to note the sole differentiating factor, and push for the lowest number. Borrowers (shipowners) did not really have to create an “indifference curve”, their optimal set of choices. The leverage was in the 60-70% of FMV, the terms and covenants comparable, and thus the choices were limited. The “product” was one-dimensional and business was earned on the lowest spread.

Now that we live in times where by necessity there have been more types of capital than seed capital and traditional debt, such as alternative capital, mezz, senior and junior debt, etc, there is a greater opportunity to see the choices of preference for the shipowners.

There are funds that provide senior lending at only 500 basis points (5%) over Libor, but they do so at rather conservative terms, such as by lending in the 50-60% range of the FMV in today’s depressed asset pricing market environment. We would think that such financing is both cost competitive (in absolute terms) and also acts as prudent financial gearing for an owner to maximize returns and stay flexible when market conditions turn bad.

On the other hand, there are funds that provide close to 80% leverage, or even more, but at much higher cost, typically in the 8-12% range plus expectations of profit sharing, etc. The financial gearing is almost as sizeable as in the go-go days of the stratospheric market of a decade ago, but such levels of financial gearing add a lot to the costs of running profitably a vessel, and also multiplies the risk that when markets turn bad, the whole financial structure will not stand for more after the first few waves of the crisis reach the beach.

The options outlined above are as distinct as they can get, and although there are a few shades of gray between these two opposites, borrowers (shipowners) seem to gravitate to either of these polar opposites in terms of debt financing. And, watching shipowners make choices in the present market offers some insights on he direction of the market, the utility curves of the shipowners, their willingness to pay at various ranges of the curve, their risk appetite or risk aversion, and the inflection points thereof.

Even after the debacle of the last decade and the massive decade and rather fair prospects looking forward for shipping, there is a clear trend whereby shipowners prefer the high leverage, high cost (and high risk) option set over the low leverage, low cost (and low risk) alternative. There are many more shipowners who would rather borrow 80% of the value of a ship at 8% (spread) interest than shipowners who would borrow 55% at 5% (spread) interest. Credit funds and lenders in the former category are much more active than lenders in the latter camp.

Stephen, the Roaring Lion. Image credit: Karatzas Images

Apparently, shipowners (borrowers) seem to think that this is a time for “risk on” investments and thus higher financial gearing (at higher cost) makes sense. Asset prices, in the dry bulk market especially, are up by 30-50% on average in the last eighteen months, and thus, allegedly a high stakes strategy has paid off. Improving world economies and trade, and a historically low newbuilding orderbook add more fuel to the argument. But, playing the proverbial devil’s advocate, adjusted for risk, is a 50% asset appreciation investment justified on an 8% cost of debt?

In general, over the last decade, cost of capital (mostly debt) is going up in shipping. Interest rates have gone up, especially when they are expressed in terms of spreads. And, leverage overall has come down in shipping in the last decade. Likely, when shipowners (borrowers) are slowly adjusting their financing cost expectations, they seem to focus more on (and prefer) higher gearing at the trade of cost. In a theoretical binary choice of “give me more leverage or give me lower cost”, they are for the former, hands down. It may be that it takes a lot of time for habits to die?

High leverage at high cost has its risk, as mentioned. Already there are several transactions in the market where borrowers have already run into trouble and they desperately look to refinance high-priced transactions based on this structure. There are ships that have been arrested or are very close to arrest, ships financed with high leverage at high cost. And this is at a time when 2017 and 2018 freight rates are dreamboats of the 2015 and 2016 monster freight markets. Thus, in a relatively decent freight market, these high leverage preferences do not seem to always work out very well. We are afraid that after the debacle of private equity investments in 2011/2014 going sour in a major way and resulting in massive write-downs, the industry is setting itself up for another round of misguided investments powered by institutional money.

Shipping is a unique industry with its high volatility and risk at an operational level as this can be counted by the spot freight market (in the last eighteen months, BDI has been up by a factor of 5 but down 40% in the last month or so). Financial gearing over operational gearing can easily get out of hand.

But again, how fortunes have been made… or…

Stitt, the Quiescent Lion. Image credit: Karatzas Images

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