For the Shipping Industry, a Matter of Interest and Indebtedness

Ever since shipping banks (and banks in other industries) have been curtailing their lending to shipowners (and for other banks outside shipping to small and middle-market companies), there has been a big funding gap, a market need, that has to be filled for the economy to grow. Many credit funds or alternative capital funds have popped in shipping that lend money for those who look for financing to buy or refinance ships. On a broader scale, many brand-name private equity funds have been setting up credit funds in order to serve the market need of lack of debt financing in numerous industries; with more regulation for banks (among other things), un-regulated lenders step in to serve the market.

There are substantial differences in the way a bank evaluates a loan in shipping than a credit funds approaches the market; although effectively they both look to undertake credit risk (they both lend money), there are always more types of risk entangled around credit: asset risk, operational risk, counterparty risk, etc No doubt that credit funds, as non-regulated lenders typically, have much more flexibility of the structures and the terms of the loans they can underwrite. For starters, credit funds can also take a little or a lot of residual asset risk (balloon payments, etc), market risk (profit sharing, etc), asset risk (finance older vessels, etc), that is, they can think outside the “credit risk” box and provide commercially more flexible structures (of course, at a higher cost of capital.) Also, since credit funds are not regulated, when there is a default of a loan, there is no reporting to a regulatory body which would have consequences on ratios and strategy; a credit fund would have the precious luxury to convert late payments to equity or accept payment-in-kind (PIK) or impose a higher profit sharing scheme and eventually take over the asset, if things really go bad. To be sure, a default for a loan is a painful experience for all those involved, for the shipowner / borrower of course, and also for the financier / creditor, whether the creditor is a regulated bank or a credit fund as practically no-one wishes for such an outcome of default (unless the lender is really a niche vulture fund specializing on feeding on carcasses and liquidation, but honestly, this is the exception than the rule.)

The typical credit fund these days would charge approximately 8% interest for a first preferred ship mortgage; for some, this is expressed as annual interest in absolute terms, but for others, it’s the spread over Libor (L+800 bps), meaning that the borrower also undertakes interest rate risk (at a time when the Fed and other central banks shifting to a tightening mode.) The amount of leverage is dependable, but most likely it populates in the 60-70% range, inlying that still a respectable percentage of equity is required; of course, more equity means that the shipowner has to be selective with their projects and also that the credit risk for the creditor goes down as the percentage of equity goes up. Although some credit funds can accept a bullet payment of the principal (under certain circumstances), a certain level of amortization is required for most cases. And, there are the usual assignment of earnings, minimum value clause, minimum liquidity clause, negative covenant clauses, and also pledge of shares, undated signed director resignations, and, more frequently these days, demands for a personal or corporate guarantee. All in all, the loan terms these days seem to be the extreme opposite of the easy credit days of a decade ago of name lending and loans agreed on a handshake.

Although a few short years ago shipowners would never had conceded to a first preferred ship mortgage with an interest rate above 4-5% or other funky terms, these days there are few options, and thus the reason that 8% has become the prevailing cost of the debt for ship mortgages. Different types, different norms, as said before.

For a theoretical example of a five-year modern panamax bulker valued at $22 mil and 65% leverage and five year term, at 8% annual interest, the daily interest payment alone is appr. $3,000 per diem; presuming that there is a requirement for the principal to be amortized by 50% over the term of the facility, then another $4,000 pd had to be added to the financing payments. Based on a back-of-the-envelope assumption of $6,500 pd vessel daily operating expenses, the cash expenses for operating such a ship range from $9,500 – $13,500 pd; just as a reminder, only in the last eight months panamax freight rates sustainably moved above $10,000 pd, meaning that many borrowers, at best, they were breaking even in the last eighteen months. Of course, there is the hope for higher asset prices and higher freight rates, but, as they say, hope does not make for a good business plan. This model of 8% cost of debt financing would never work with modern, expensive ships (as the interest payment would become exorbitant in today’s freight market), while older tonnage (to the extent that a credit fund can be enticed enough to consider it) has more favorable economics.

There are a few corollaries to the prevailing market practices that need come elaboration:

  1. the cost of debt financing has moved to such high levels that it’s barely economically feasible to undertake new projects or buy ships for the smaller, independent shipowner
  2. borrowers undertake severe interest rate risk at a time when interest rates are moving higher (unlike a shipping bank with its interest rate swap desk that offered a full package, credit funds do not offer such service, and the borrower has to search a dis-incentivized market for this product for effectively project finance and small amounts)
  3. there is a lot of risk for both the borrower and the creditor under such scenario of high interest rates, and it will not take much for many of these financing projects to be underwater, so to speak
  4. as several more tight covenants have been added to these types of loans, in the event of defaults, it can be really ugly; if the overall market turns south (an unlikely scenario for now, but as we have learned, in shipping even unlikely scenarios are probable), there will be a massive cascading problem (credit funds will not be as cavalier as shipping banks with arresting ships, but then how they would be operating them or sell them in a declining market?)
  5. with so many credit funds having been set up for shipping, potentially there could be the possibility of them having to compete and lowering their standards in order to gain business; we are well aware of at least one credit fund that between April and October 2016 made a complete U-turn on their credit underwriting as they could not get one deal done.
  6. as cost of debt financing is too high, many financial sources keep looking entering the market which likely would undermine the credit fund market; we are working with a Chinese-originating fund providing first preferred ship mortgages at 5% interest for 50-60% leverage and very normalized covenants.
  7. disappointedly, for credit funds being private equity funds and well versed in structured finance, their proposed structures are extremely monolithic and inflexible, which will cost them a lot over the long term; being unregulated and flexible, only imagination could limit structures where they could make big returns if they were willing to be flexible and exchange some credit risk for some market risk and some asset risk and some residual risk and some counterparty risk and some… All credit funds have been pigeon-holed into credit, they compete heads-one with every other credit fund, and the only reason they do business now is that shipping is desperate for capital; this market could easily move away. But again, most of these credit funds have been run by former shipping bankers with some trying to exonerate themselves for the shipping bank mistakes of the last decade…

For now for sure, shipping debt is an interest-ing market to watch…

For some, a foggy market… One World Trade Center in Downtown Manhattan. Image credit: Karatzas Images

© 2013 – present Basil M Karatzas & Karatzas Marine Advisors & Co.  All Rights Reserved.

IMPORTANT DISCLAIMER:  Access to this blog signifies the reader’s irrevocable acceptance of this disclaimer. No part of this blog can be reproduced by any means and under any circumstances, whatsoever, in whole or in part, without proper attribution or the consent of the copyright and trademark holders of this website. Whilst every effort has been made to ensure that information here within has been received from sources believed to be reliable and such information is believed to be accurate at the time of publishing, no warranties or assurances whatsoever are made in reference to accuracy or completeness of said information, and no liability whatsoever will be accepted for taking or failing to take any action upon any information contained in any part of this website.  Thank you for the consideration.

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Sailing the Seas Depends on the Helmsman

Once upon a time, there was an independent shipowner with, let’s say, ten modern product tankers. Three of their tankers were mortgaged with a major European bank, a very well-known name and with proven past commitment to the shipping industry. And, the shipowner themselves, have been in the shipping business for more than a couple of decades and enjoying a solid reputation in the shipping community and with charterers. These, being legacy shipping loans, their terms were highly competitive in this market despite some success of the bank to tighten the loan terms since the market collapse a few years ago. Actually, the terms of these loans were exceptional, by today’s standards, as the spread was just 300 basis points. And, of course, the shipowner had watched these loans like the apple of their eye, and they were current with interest payments and principal repayments and the loans were comfortably meeting the loan-to-value (LTV) covenants.

Eighteen months ago, the shipowner got a note from their mortgage bank that since they (the bank) were exiting the shipping industry, the shipowner was given notice to make arrangements to pay back the loans (there was a small discount offered) or the bank would had to take matters in their own hands. Since these were performing loans, the mortgage bank could sell the loans at close to par, likely to a credit fund or an institutional investor, or possibly even to another bank if there were still banks out there buying shipping loans – not a likely cozy prospect under any circumstances.

It took a few months for the shipowner to recover from the first shock, having a brand-name bank giving them notice on performing loans. And, it only got worse from there. The shipowner’s shock got greater as soon as they started “shopping” the market for new financing: few shipping banks had interest in new clients or business or the capacity to finance a three-vessel package. While approaching institutional investors, the strategy was modified to squeeze the mortgage bank for a hefty discount of the loans, but with the institutional investors sharing (a great deal of) the economics of the transaction and not just to provide new loans. Almost a year passed since the mortgage bank had given notice and the shipowner could not find a new “deal” good enough. But again, having to replace shipping loans priced at L+300 bps in today’s market, one feels like they have been punched in the stomach.

And, while the shipowner was taking their sweet time to find the perfect financing they thought they deserved, the product tanker freight market started deteriorating: first freight rates dipped and then halved, and, as one would expect, secondary market product tanker sales started taking place at lower price levels. While the shipowner had a few million in cash in the bank, dry-dockings and other expenses started chipping away on the balances. And, the lower asset prices triggered LTV defaults now, giving much more leeway to the bank to sell the vessels themselves, and not just the loans – an even worse prospect for the shipowner.

And, lower freight rates and lower asset prices were making financing the original loans more difficult: cash flows now would only support lower financing, and institutional investors lost appetite since any discount now had less value in a weakening market.

All being told, the shipowner managed to finance just two of the vessels at today’s prevailing conditions (lower leverage, tighter covenants and cost in excess of L+600 bps.) And, the third vessel was let go and was sold (at a small loss) since no financing could be found within the parameters of a weak freight market and limited “sweat equity” from the shipowner.

This is a real story (unfortunately) and no names or other details can be divulged; but, such details do not matter really. If there are lessons to be learned is that first, in this market, shipping finance is the “determining factor” of the shipping industry, the independent shipowners. Shipping finance is the new battlefield where shipowners will be called to fight; if they cannot sort out their shipping finance game in the new market, they will be driven out of business – as simple as that. Second, in this difficult market, it’s not only “bad shipowners” who have problems; if your bank is not committed to shipping or you or they are having higher priorities unrelated to shipping, that’s the weakest link in the business, even if the loans are good and performing. Third, it pays to be pro-active in this market and tie loose ends as soon as possible; looking for the perfect financing at the expense of time, one can lose much more than a few hundred basis points – not arguing that two hundred basis points are not worth fighting for, but again, this is not a time when banks and lenders can bend much, if at all. And, lastly, independent shipowners had become a substantial part of the industry based on their shipping and operational expertise and efficiencies and not on their financial expertise (shipping banks were lending in the past liberally and just on the basics of how to extend credit); the present market is much more sophisticated than that and hiring competent shipping advisors may very well be warranted; trying to avoid paying an advisory fee can cost one whole ships.

“Sailing the Seas Depends on the Helmsman” was a revolutionary, patriotic song for Mao Zedong’s Red Guards in the 1960’s and 1970’s exemplifying the Chairman’s leadership skills, metaphorically speaking. For an independent shipowner these days, sailing the seas depends on the helmsman navigating the new reality of the shipping finance markets.

A long shadow over one of world’s most important shipping cluster. Image credit: Karatzas Images

© 2013 – present Basil M Karatzas & Karatzas Marine Advisors & Co.  All Rights Reserved.

IMPORTANT DISCLAIMER:  Access to this blog signifies the reader’s irrevocable acceptance of this disclaimer. No part of this blog can be reproduced by any means and under any circumstances, whatsoever, in whole or in part, without proper attribution or the consent of the copyright and trademark holders of this website. Whilst every effort has been made to ensure that information here within has been received from sources believed to be reliable and such information is believed to be accurate at the time of publishing, no warranties or assurances whatsoever are made in reference to accuracy or completeness of said information, and no liability whatsoever will be accepted for taking or failing to take any action upon any information contained in any part of this website.  Thank you for the consideration.

Shipping Finance Elements and Concepts

Following Presentations on Shipping Financing have been found on the internet. They are reproduced here as a matter of convenience for readers interested in the subject of how ships have been financed under different structures and different business models, at present and over time.

MV NEPTUNE THALASSA 13 BMK_5610 @There is debt (senior or first preferred ship mortgage, second lien, junior loans) and equity (owners’ equity or sweat equity, friends-and-family money) for the archetypal structure available to independent (individual) shipowner. Shipping banks over time had been the prime financiers of the shipping industry mostly in  the form of asset-backed financing (mortgage). There is leasing whether operating or financial leases, sale and leaseback, or uniquely structured Japanese Operating Leases (JOL), and financing earned via long-term charters (time charters and long-term bareboat demise charters). Independent shipowners have been dealing with shipping banks and often financed vessels via project finance, and when circumstances fertile, dealt with private equity as well. For owners who sought public equity and underwent an IPO process, the capital markets for equities and for bond (shipping bonds) have offered more alternatives. Shipping finance has been experiencing tectonic changes since 2008 and has moved from relatively self-explanatory terms of vessel valuations and Loan-to-Value (LTV) to terminology to accommodate Basel III with its Tier 1 Capital (CET1) to Risk-Weighted Assets (RAW) and the Capital Adequacy Ratio.

Copyright to the presentations and articles listed herebelow belongs to their perspective owners, and hereby duly acknowledged. Presentations have been found posted freely on the world wide web, and reproduced here as a matter of convenience.


Elements of Ship Finance
Zan Yang and Jian Chen
Department of management, Dalian Maritime University                                                  Last accessed on the internet on July 26, 2016.                              http://www.paper.edu.cn/scholar/downpaper/yangzan-2.html


Risk vs Return for Lenders and the Economics for Borrowers
by R. Philip Bailey, June 2015
Last accessed on the internet on July 26, 2016.

By Allan D. Reiss, Morgan Lewis & Bockius LLP, 2014

Last accessed on the internet on July 26, 2016.

Deloitte, 2011
Last accessed on the internet on July 26, 2016.

Irish Maritime Development Office, 2015
Last accessed on the internet on July 26, 2016.

Shipping Finance: A New Model for a New Market                                                  Citi, 2015                                                                                                                       Last accessed on the internet on July 26, 2016.                                    https://www.citibank.com/tts/trade_finance/financing/docs/citi_ss_v2.pdf


The Impact of the Basel III Capital Accord of Asset Finance
by Angelo L Rosa, 2012
Last accessed on the internet on July 26, 2016.

by Basil M Karatzas, 2010
Journal of Equipment Lease Finance
Last accessed on the internet on July 26, 2016.

Dissertation by Alex Orfanidis, 20014
Last accessed on the internet on July 26, 2016.

Ariff Kamarudin, 2012
Lehigh University
Last accessed on the internet on July 26, 2016.

© 2013 – present Basil M Karatzas & Karatzas Marine Advisors & Co.  All Rights Reserved.

IMPORTANT DISCLAIMER:  Access to this blog signifies the reader’s irrevocable acceptance of this disclaimer. No part of this blog can be reproduced by any means and under any circumstances, whatsoever, in whole or in part, without proper attribution or the consent of the copyright and trademark holders of this website. Whilst every effort has been made to ensure that information here within has been received from sources believed to be reliable and such information is believed to be accurate at the time of publishing, no warranties or assurances whatsoever are made in reference to accuracy or completeness of said information, and no liability whatsoever will be accepted for taking or failing to take any action upon any information contained in any part of this website.  Thank you for the consideration.

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