Infrastructure debt: Shaping up and shipping out

The search for yield in this low-interest rate environment is pushing many investors to increasingly target niche asset classes. Among them is shipping, which is asset-based and wallowing in distress.

The decline of Hanjin illustrates the state many in the industry find themselves in. Among the largest shipping companies in the world, the South Korean firm entered into bankruptcy proceedings this year with the result that ports, fearful that it would not come good on paying fees, refused to accept its vessels. An estimated $14.5 billion worth of goods aboard 66 ships was stranded at sea as a result.

It is a peculiar situation, but an example of the kind of scenarios creditors could be facing if they choose to invest in the shipping industry. There is turmoil across the sector, although the degree of stress varies across the dry bulk, container and tanker markets. A slowdown in the Chinese economy has plunged the container and dry bulk industries into deep distress as companies deal with a supply and demand imbalance resulting from a glut of ships. In these difficult situations, finding the returns some debt fund managers are looking for may be trickier than first thought.

‘NOT HOMOGENOUS’

Tony Foster, chief executive of Marine Capital, says that shipping loans are different from corporate loans. “Shipping loans are not homogenous: the borrowers are largely unrated and rating agencies only look at the borrower, not the underlying asset or the charter covenant,” he says, adding that lending to the sector requires deep understanding of an industry that criss-crosses international jurisdictions and is highly cyclical.

As a result of the problems facing the industry, a number of banks, predominantly German, have begun reducing their exposure. In June, it was reported that Germany’s largest lender, Deutsche Bank, was shedding a portfolio of shipping loans valued at $1 billion – a sizeable chunk of its overall exposure to the sector, which is understood to be around $5 billion-$6 billion. Other German banks, including HSH Nordbank and Commerzbank, as well the UK’s Royal Bank of Scotland, are also understood to be looking to shift a number of their shipping loans.

Bank retrenchment opens up opportunities for debt funds to find a discount on the loans. US-based investment firm KKR snapped up a portfolio of loans valued at $1.5 billion from Norddeutsche Landesbank. The agreement, which is expected to be completed in the fourth quarter, is part of the German bank’s overall plan to reduce its exposure from €18 billion to between €12 billion and €14 billion. Gunter Dunkel, chief executive of Nord/LB, said it was a “milestone” for the bank.

KKR said the portfolio of loans obtained from the bank will form the “seed mandate” for a vehicle specifically targeting shipping assets and jointly managed with an unnamed sovereign wealth fund. Johannes Huth, head of KKR EMEA, said at the time of the announcement that the transaction was “in line with investing and managing banks’ non-core and under-performing assets”.

Representatives from KKR declined to discuss the details of the deal for this feature.
Clemens Hillmer, a banking & finance partner at law firm Watson Farley & Williams who specialises in loan portfolio transactions and is representing KKR in the transaction with Nord/LB, declined to elaborate on the details, but did say that generally the shipping market offers a number of opportunities to private debt funds. Buying loan portfolios from banks is an option as they will not continue to “kick the can down the road” forever.

SLOW MOVERS

“Debt funds could be more flexible and the problem with the banks is that they move slower and are more regulated by comparison. When you are looking to restructure a loan then the debt fund can arguably move quicker,” he says.

“But it is important that you have expertise in the industry and are aware that shipping is unique in that not many other commercial assets in the world burn more money than a vessel lying idle.”

In 2014, investment firm Hayfin Capital Management established a partnership with Breakwater Capital, a specialist lender to the shipping industry. Andrew McCullagh, managing director at Hayfin, says with increasing numbers of firms entering the private debt market, “the success of alternative lenders is predicated more than ever on originating investment opportunities from as broad a pool as possible”.

He explains that the partnership with Breakwater was necessary in getting the “understanding and relationships to access a sector in which demand for capital was strong but other, more generalist, alternative lenders lacked the technical expertise to invest”.

Additionally, banks are facing increasing scrutiny from the European Central Bank. The ECB was reported this year to be preparing a potential review of bank lending to the shipping industry, raising the prospect of further restrictions on how much capital is required to be on the bank’s books before lending money.

Further restrictions may spook the banks into action to offload these assets in the near-term, which may lead to debt funds seizing on the opportunity to enter the market. McCullagh says: “Banks’ attitude to the shipping industry is consistent with their overall lending strategy – the new regulatory regime is forcing a more disciplined approach. This, combined with legacy portfolio issues, has created opportunities for alternative providers who are set up in the right way.”

SHIPPING LANES

Speed and flexibility are the advantages of debt funds and the appetite for exposure to the industry is present among institutional investors, Johnny Adji, senior investment director at Cambridge Associates, says. “Shipping is relatively safe, as a physical asset. Technological improvements in GPS means you know exactly where your ships are at all times. The market for second-hand ships is quite liquid and transparent and the market is not as opaque as you think.

“Shipping debt fund products are getting interest from clients, particularly pension funds, because the current global environment is so starved for yield.”

But this is not without its challenges. Prising loans out of German banks on distressed terms is a difficult task. A note to investors from Marine Capital says that an industry joke tells of the streets of Hamburg being lined with the skeletons of hedge fund managers who died trying to acquire loans from German banks on such favourable terms.

And once you make progress, Foster says it’s important to be sceptical. “Banks are not daft; they are experts within this industry and the overall shipping industry is not dead. The industry is not lacking in liquidity and the underlying asset should be saleable in the market. If the bank could sell the asset in the marketplace, it would.”

Unlike real estate, asset valuations in the shipping industry are fairly transparent, but the varying levels of security means assessing covenant strengths could result in a lengthy due diligence process. For distressed debt investors looking for a quick in and out, this may be the source of many headaches, and that is before they have to undertake an exhausting enforcement process in the case of defaults.

“Some debt funds have invested in the industry successfully,” says Adji. “One of the critical factors to be successful in distressed debt investments is that you really need to know what you’re buying and the underlying value of the ships. For example, if you were buying debt secured by Panamax container ships, you would be in a difficult situation today because the recent expansion of the Panama Canal makes these ships obsolete.

“Some of the more successful distressed debt investments that we’re seeing are buying distressed ships from a court auction. They own this debt and convert it into equity ownership and sell it immediately.”

Simply put, owning, managing and maintaining a ship requires specialist knowledge. This and the enormous expense of an idle ship are something for distressed debt managers to consider if they are looking at loan-to-own opportunities.

While conservative LTVs on offer in the market and the retreat of German banks may on the surface present opportunities, there is no shortage of Chinese leasing firms or banks ready to step in.

Asset-based lending may be growing in popularity for many debt funds searching for new strategies, but it is only those with the patience for the long haul that will find success. As Andreas Povlsen, founder of Breakwater, says: “This has traditionally been a relationship business: ship owners are very focused on working with lenders who understand their market and have long-term aspirations in the space.”