The shape of shipping

When private debt specialists are looking for a new niche to fill, the shipping industry has often stood out in recent years due to its combination of hard security, a return to growth in shipping activity after a long recession and a major retrenchment among the banks that have traditionally served the sector.

At the same time, the growth in private debt funds, particularly among the more traditional mid-market sponsored deal space, has driven some adventurous investors to seek out opportunities in more specialised offerings, with shipping, aviation and healthcare being among the niche areas that some limited partners are now investing in.

Since peaking in 2008, the shipping business has suffered more often than it usually does with declining economic growth in the developed world that has not been offset by relatively strong growth in Asia. Research by the IMF found that the average rate of growth per annum was 2.9 percent between 2008 and 2015, just half the rate seen between 2001 and 2008.

While it has seen a recent uptick as the euro zone has managed to drag itself out of its long depression, there is no guarantee that conditions will remain strong in this volatile market. With US President Donald Trump engaging in the early stages of a trade dispute with China, the industry could again find itself mired in recession.

Despite the difficult economic circumstances of the shipping business, there are reasons for investors to get excited about ships.

Firstly, a theme that most private debt managers will be familiar with is the decline of the banking sector since the financial crisis of 2008. In shipping as elsewhere, banks are becoming more cautious and have large amounts of bad shipping debt on their books, some of which is now being sold off. According to Citigroup, European banks alone are saddled with around $150 billion of distressed shipping debts, mostly in Germany.

This vast quantity of non-performing debt may signal a wealth of opportunities for private debt investors, but Tony Foster, CEO of specialist marine investor Marine Capital, said this debt is very risky for uninformed investors.

“German banks have huge swathes of non-performing loan debt on their books, but it is completely non-performing,” he says.

OVERHANG

Foster notes that the overhang of shipping debt has already been picked apart, with German banks having sold the ships they have been able to get hold of, and cautions that the remainder is very challenging to deal with.

“When we look at these debt portfolios, we increasingly see hedge funds outbidding us and buying up the debt. They seem to be overpaying for it and will find it very challenging to make money,” he explains.

Aside from the difficulties in turning non-performing shipping debt into performing debt, the opportunity in shipping due to the departure of the banks may not be as significant as it initially seems.

Liana Miliotis, a senior associate and shipping finance specialist at Norton Rose Fulbright, says: “While a number of banks have exited the shipping market, there are many banks continuing to lend selectively to ship owners. These loans will typically be to strong existing customers as well as to large shipping conglomerates.”

Traditional banks are likely to continue to try to keep the best customers and opportunities for themselves, while downsizing the rest of their portfolios. This means that alternative finance providers operating in the space will need to be able to act and make a return in the more difficult areas the banks have left behind.

However, Miliotis notes that even among banks still firmly committed to shipping, there is a degree of portfolio reduction taking place, and this could leave room for alternative finance.

Data and research firm IHS Markit agrees, and in a recent note said that pre-crisis ship owner capital structures would typically be 80-90 percent bank debt, paying rates of just 2-3 percent, with the remainder in equity. IHS Markit said the proportion of bank debt used today has dropped to 40-50 percent, with other high-cost financing filling the gap. On the surface, at least, this would appear to offer a good opportunity for debt funds.

FLAWS

But Foster believes there are flaws in this interpretation of the market and is doubtful high-cost leverage can be sustained.

“Ships have very visible cashflows so it’s not difficult for a lender to know what is happening and what the company will earn, so where cashflows are good and consistent, cheaper debt is easy to access,” he explains.

Of course, lending to slightly riskier borrowers is hardly new ground for private debt funds and the premiums charged should to some extend mitigate the risk. But in a volatile sector, being able to understand the factors affecting borrowers in the future are important not only for setting the right price but also in having terms and security in place that offer suitable protection when things don’t go to plan.

Securing the debt against the physical ship assets is one attractive feature of shipping debt that offers additional security that, for some lenders, may be sufficient to take on riskier clients. But having a good knowledge of ships as assets would be required in order to appropriately value the security. Even with this kind of security available, Foster believes the key problem facing debt funds is that there simply may not be many borrowers for which the private debt model is affordable.

He says: “Ship owners with good cashflows are not going to go after this relatively expensive debt, and the rest face such volatility in cashflows, are they going to want to pay 8 percent or more for an additional slice of debt? Anyone who does may already be broke.”

It is not enough simply to be able to take on the risk; alternative lenders also need to have clients who are willing and able to take on debt far higher than the sub-300 basis points debt currently available from banks to high-quality borrowers.

However, Miliotis says there is likely to be some appetite for alternative lenders, particularly if banks remain restricted.

“Alternative finance tends to come with a higher price tag, so it is often not as attractive to ship owners as traditional bank debt. However, alternative capital providers may be long-term players within the shipping industry particularly if traditional commercial lenders are not able to re-enter the industry in the medium term due to the increasingly stringent regulatory environment.”

Shipping is likely to remain a niche area with relatively few private debt players taking part. The complexity and volatility of the global shipping market and potential difficulties dealing in the kind of hard asset security used in the shipping business means only a select few specialists are likely to be able to get into the market over the long-term.

Buying up bad bank debt is also likely to be best done by experienced specialists who know how to value these difficult portfolios. However, with banks unlikely to be able to re-involve themselves with more complex finance cases, there may still be room for a select few funds to survive and thrive in shipping.