19 October 2011
At the height of the global financial crisis in the fourth quarter of 2008, shipping markets in all sectors experienced a dramatic free fall. For example, between June 2008 and December 2008 capesize day rates dropped from over US$230,000 to US$2,316, an all time low, representing a 99% loss of value in just six months. This marked the bursting of a bubble which had been growing for about seven years during which time many traditional ship owners were able to amass large cash reserves and reduce leverage.
When the crash came at the end of 2008, many players in the shipping industry anticipated a growth in mortgage enforcement and distressed sale activity.
While private equity houses and hedge funds required returns of at least 25-30% to make deals interesting, banks and investors were not prepared to take the haircut necessary to provide these returns. As the entire market had fallen, the attitude of many banks was that a new investor would not enhance returns from the operation of the ship beyond the performance of the existing customer. Accordingly, it was better to stay with the devil they knew than one they did not.
Furthermore, many owners had a cash reserve and were able to provide additional security and, in some cases, funded themselves (so the bank did not have to go to the interbank market) for part of the loans. As a result, there were far fewer work-outs and enforcements than anticipated.
The current situation
The ensuing three years have not seen significant improvements in charter rates. In particular, the charter rates for container ships, tankers and capesize bulk carriers remain challenged. While some newbuilding orders were cancelled after 2008, more were postponed or converted to different types of ship (e.g., bulkers to tankers). As a result, a huge number of new ships are being delivered into a depressed market. This has compounded the problem.
While a number of owners enjoy long term charters at hire rates which are now above market, most of these charterparties are coming to the end of their terms. This will free up more tonnage which will come into the market at the depressed rates of today.
All of these market conditions bring a number of problems:
- charterers who are now paying above market rates under old charterparties are looking for reasons to exit them (for example, inability of vessels to trade to Iran or other places or with cargoes sanctioned by the US, EU or UN);
- vessels which were ordered three years ago at high purchase prices are now being delivered at a time when charter rates are low and insufficient to meet operating expenses and debt service obligations; as new vessel values are also lower, owners have to fund, from their own internal, or other, sources, more of the purchase price payable to shipyards (as banks lend on the basis of the current valuations), which is causing some owners to sell existing vessels into an already depressed market to raise those funds;
- the decline in vessel values means that many owners are now in breach of asset cover covenants in their loan agreements and are required to provide additional security or partially prepay their loans; and
- long term charters, which give banks comfort regarding security of revenues, are becoming harder to fix and, when arranged, are bearing charter rates at historically low levels.
Furthermore, there are trends in the banking industry which make the financing or refinancing of ships more challenging. Most ships are financed for 7 to 12 years, but have a life of at least 25 years. Accordingly, there is usually a balloon payment at the end of the loan period. For older loans where this balloon is now due to be refinanced, the problems are (i) the value of the vessel will now be less than was anticipated when the balloon amount was determined and so the owner will not be able to raise so much debt to refinance the balloon and will have to contribute more equity; and (ii) the pricing of the loan is likely to be significantly higher. Also, for many banks, there is a flight to quality, and they will not finance vessels owned by companies which are not "blue chip" (whether listed or family) or which own predominately older vessels or only a small number of vessels.
In summary, the current situation is that owners have ships the value of which has diminished substantially, and they are required either to provide additional security or partially prepay their existing loans. Charter rates are depressed, often to a level which barely meets operating expenses with little left over for debt service obligations. Very few banks are active in new lending at the moment and those which are will generally be very selective in the deals they will finance and the customers they will lend to. For the banks that are still lending, the level of financing, pricing and security will reflect an inevitably conservative attitude to shipping risk at the present time.
Clearly, the shipping industry is facing a significant financing shortfall which will create opportunities for alternative sources of financing, such as private equity, but also challenges that will lead to a restructuring of certain businesses.
The next phase of opportunities
A number of owners are already experiencing severe financial difficulties, with ships which were acquired at high prices and are now operating in markets at low charter rates. Many of them have used up or committed their financial reserves, and have no more security that they can now give to the banks. For these owners, the current situation is unsustainable and two outcomes are likely: (i) a number of these owners will work with their banks for an orderly restructuring and disposal of part or all of their fleet, resulting in these vessels being sold to stronger competitors in the same market segment at prices which reflect current values and with new financing based on the current market conditions; (ii) other distressed owners (particularly those who have not issued guarantees) may simply hand the ships over to their banks and walk away from the problem.
While the traditional ship owning companies (often family businesses) will most likely fall into the first category, a number of recently listed companies and newer entrants to the industry are expected to fall into the second category. These owners have little or no ability to draw additional equity from their investors who have no emotional attachment to the industry and would rather cut their losses and move on to their next investment.
On the other hand, a number of investors see these depressed markets as temporary and unsustainable. They therefore perceive that there are opportunities to acquire assets at depressed prices with the prospect of enhanced returns over the next three to five years. While they may have difficulty raising traditional bank debt, shipbuilding nations (China, Korea and Japan in particular) are likely to support Export Credit Agency financing for their newbuildings, and vendor credits and other financial instruments will be available and will enhance their returns on investment.
A number of investment funds we are working with at the moment are looking to acquire shipping assets. A number of banks and ship yards have also expressed an intention to monetize shipyard receivables (i.e., instalments payable by buyers to shipyards during the construction phase of new ships) and at the same time banks and investment houses have expressed interest to acquire shipping loans and charterhire receivables. All of these are alternative investment opportunities which will continue to emerge in the next 18 months of the cycle.
Raising finance from the capital markets in the form of public and private offerings of equity and debt securities (including IPOs or secondary or follow-on offerings by owners whose shares are already listed on a stock exchange) represent other possible sources of financing. Hybrid securities such as convertible bonds and subordinated perpetual capital basket D securities are also being considered. Basket D securities are treated by rating agencies as 75% equity and 25% debt. In order to qualify, the security must give the issuer the right (or even the obligation) to roll-over payment obligations when they cannot be met to reflect the equity treatment allowed by the rating agencies.
Given the breadth of our service capabilities and the depth of our global shipping industry experience in our various offices in the Americas, Europe and Asia, our Firm is extremely well placed to advise on the legal issues arising from the opportunities and challenges in this sector.
By way of a recent example, earlier this month, Diamond S Shipping (a shipping business backed by private equity financing) announced the completion of the acquisition of 30 medium-range product tankers from Cido Shipping. We represented Cido in this transaction.
Mayer Brown has full service, global capabilities in finance, M&A, private equity, capital markets, restructuring and insolvency, regulatory and litigation supporting our international shipping practice.
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