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

© 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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Smart Investments in Shipping

At a recent shipping conference, we were asked to present on the topic of smart investments in shipping given the present phase of the business cycle. The shipping industry is ever changing and the so-called investment thesis for shipping investments can change structurally in much shorter periods than in other industries; what looked awfully appealing a year ago can be facing challenging winds now. The opposite can be just as true.

More than $30 billion have been invested in shipping by institutional investors in the last five years, not to mention the commitments by independent shipowners, charterers and cargo interests, shipbuilders – directly or indirectly. For the investors who had in mind a relatively timely and well projected exit strategy, a reality check of their investments in shipping at present rings rather disappointingly; for the investors who had in mind the long term, a marked-to-market analysis is of less importance, but still, unfavorable clouds have replaced, to a certain extent, the optimism of the tradewinds for a smooth sailing. Whatever the goal and the timeframe, shipping investments of the last five years have genuinely been a disappointment.

The Dry Baltic Index (BDI) has been flirting with thirty-year lows and shipping asset prices seem temptingly low, whether for dry bulk, containerships or even tankers (which have been trading much livelier than any other sector.) For certain asset classes such as panamax dry bulk vessels, ten-year old tonnage can be had as inexpensively as twice their scrap value. There is no doubt that asset prices are getting at ‘interesting’ levels. For those believing in the adage ‘buy low, sell high’ it seems that the present asset pricing environment is a no-brainer for outright purchases of ships.

Could ‘going long’ the market be the best way to invest now? Whether investing for ‘alpha’ or trading for ‘beta’ would seem equally obvious choices to ‘play’ the market, since asset prices are historically low.

But again, why one would like to invest in equity in shipping?

The world fleet in all asset classes is rather new, newer than five years of age in certain asset classes such as the capesize market. A great deal of vessels were ordered just prior to the crash of 2008, and many more were ordered ever since, with a massive newbuilding wave in 2012 and 2013. A relatively young world fleet cannot precipitate an accelerated level of demolitions, and likely the owners of young vessels, however un-economical, would hold onto them for as long as possible. It’s well known to traders than when there is plentiful of ‘inventory’, the probability in price spiking is rather weak.

Looking just beyond the existing fleet, the outstanding orderbook is not negligible either. Since not all asset classes ‘picked’ at the same time, there are waves of varying strength of newbuildings in different asset classes, but still the overall orderbook is a robust at 20% of the world fleet; some asset classes seem better balanced in this respect (containerships and tankers), but still, there are almost no mainstream markets where the outstanding orderbook is nor higher than 10% in terms of the existing fleet in the same asset class. Linking together a young world fleet and a meaningful existing (that cannot be cancelled) orderbook, one has to wonder that tonnage oversupply will always keep a lid on pricing, at least in the next year and possibly longer.

Maritime Heritage Trail_BMK_3585

Cayman’s rich maritime history can accommodate more than cruiseships! Image Credit: Karatzas Photographie Maritime

One may be tempted to say that in two years then, when more demolitions will have taken place and the presently outstanding orderbook will have been delivered, it’s a reasonable horizon to aim at for asset appreciation. And, in any event, vessels ordered today likely cannot be delivered before then, within two years, considering that it takes about nine months to physically build a vessel and the existing backlog of newbuildings. But again, shipbuilding capacity, especially for dry bulk vessels, seems to be un-limited; Chinese shipyards can keep building commoditized dry bulk vessels day-in, day-out, including Sundays and holidays. Yes, some shipbuilders seem too weak financially and can survive; on the other hands, it doesn’t take much to expand shipbuilding capacity for commoditized vessels. And even for bigger sized vessels, Chinese strategic interests like China Merchants (CMES) and with Vale, didn’t seem to be a problem for obtaining fairly prompt slots for VLCCs and possibly fifty more Valemax vessels.

Thus, the world fleet is relatively young, the outstanding orderbook is relatively strong and shipbuilding capacity is potentially there to accommodate a market expansion; all these three factors do not pertain well for the market, at least as equity investments are concerned.

But, if tonnage supply is to expand, is there sufficient finance available?

Cayman sunset_BMK_6156

A Sunset from the Caymans. Image Credit: Karatzas Photographie Maritime

Private equity funds and institutional investors are still there to consider equity investments in shipping, possibly for ‘doubling down’ on existing investments, or possibly to enter the market with a lower cost basis than their competition or even possibly to feed on the distressed opportunities presenting themselves form time to time. If newbuilding capes (of the eco-type) were a bargain at $58 mil, why newbuilding contracts for capes at $50 mil or even lower cannot offer a better opportunity, especially since additional fuel savings and other improvements can provide an incremental benefit (beyond the price) to the newly ordered tonnage? And newbuilding prices can stand to drop, as commodity pricing (read: iron ore) has been heading south and likely to remain weak; and, China (read: good news for Chinese shipyards) have already produced too much steel plate in the past, so much so that are getting close to formally be taken to World Trade Organization (WTO) by the US for ‘dumping’ steel plate in the international markets below their cost. Private equity funds and institutional investors do have the dry powder to invest, shipbuilders can afford to lower newbuilding prices; and, the low interest rate environment can have a magnifying impact on making many projects appealing when the discount rate for NPV calculations can be awfully attractive.

And, there is always the question on demand! China, the horse that many an industries and projects are trying to hitch their wagon at, has been at a decelerating growth curve; long forgone are the days of double digit growth; the growth rate of 7% achieved in the last year is expected to reach 5% within a couple of years, and some educated projections are looking for a growth rate meaningfully lower than that.

It seems then that investing in equity in shipping (going ‘long’ the market) is a tricky way to invest, given our litany of factors mentioned hereabove. We think that there are opportunities to invest in equity in shipping and still have a good chance to make money; however, any such play will require expert knowledge of the market, ability to act fast, to select high quality vessels and pay cash; such play would require strong chartering relations, operational expertise, and certainly strong conviction and some luck. In our opinion, such opportunities likely to be few and between.

Cayman Yacht Club Lighthouse BMK_5753

A Lighthouse for Guidance! Image Credit: Karatzas Photographie Maritime

However, the flip side of our argument, that a weak freight market is likely to persist, then investing in credit may be the optimal way to invest in shipping. For starters, most traditional shipping banks have left or are vacating the shipping industry, leaving behind them a huge gap to be filled. Additionally, the weak freight market generates an ever-increasing need for financing, as shipowners are running low on working capital, to operate vessels on a daily basis and also capital for mandatory capital expenses such as drydocking and special surveys. Such funding needs are never to be considered by traditional lenders, since they entail a balance sheet and the borrowers are typically are of lower credit standing. There are also the ‘legacy transactions’ where newbuilding orders were placed on speculation with no financing in place, as incredible as it seems now; for such projects, the option set for the shipowner is tight: either default on the newbuilding contracts and lose 10-30% of the down-payments on the original price or borrow (with the vessel as collateral) at hefty rates in order to get the vessels on the water and get to live another day, hopefully a day of strong freight rates to pay for the costly mortgage. In our business practice, we routinely see shipping projects in need of financing that can provide the vessel as collateral that can allow for 7% return with strong covenants and very favorable loan-to-value ratios; for projects with some ‘hair’, returns for credit investments can be double-digit and can also allow for convertible to equity or upside potential based on market performance.

The question to be asked is why credit investments in shipping wouldn’t be ‘smart investments’? Favorable terms and tough covenants that allow for high single-digit returns with the shipping asset as a collateral, minimal or little market risk, and with the option to convert for the riskier projects. Could ‘debt’ be the new ‘equity’ (or preferred equity) in a weak, risky, unpredictable shipping market environment?

An abbreviated version of our presentation from the conference can be found here.


© 2012-2015 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.