Since the financial crisis, the expansion of European private debt has been driven by both sides of the supply-demand equation. On the demand side, new regulations required banks to curtail their leveraged lending, thereby creating a funding gap for mid-sized corporate borrowers; on the supply side, institutional investors’ appetite to allocate capital to private debt products steadily increased.
The emergence of the European direct lending market, where funds provide an ever-greater proportion of senior-secured loans to mid-market companies, exemplifies unfulfilled borrower demand attracting a growing supply of institutional capital.
Similar demand exists from ship owners: globally, there is an estimated financing requirement of $100 billion annually. Moreover, it is going unmet by traditional credit. The European banks historically most active in maritime finance have not only been subject to more stringent rationing of capital, but also suffered distress in their shipping loan books and faced political pressure to refocus on domestic lending. Consequently, as the fleet has increased by more than 80 percent, they have slashed their exposure, resulting in strong demand for, but constrained supply of, bank financing.
However, the capital supply-side dynamics are somewhat different. Despite the opportunity created by banks’ withdrawal, institutional capital has not been readily forthcoming. This is partly because shipping is seen as a problematic space, but also because many European funds lack the scale and expertise to operate the dedicated team required for this specialised market. Institutional investors may therefore rarely encounter this form of speciality lending product.
For investors seeking exposure to variants of private credit that offer attractive risk-adjusted returns, that should be grounds for frustration. Strong borrower demand, a shortage of capital and high barriers to entry are conditions characteristic of a lender-friendly market. Shipping loans are not coming under the same pressure as European direct lending, where fierce competition between funds over a finite pool of loans to mid-market companies is weakening investor protections. Accordingly, transactions offer strong risk-adjusted returns and sound structures.
There are a couple of routes through which institutional capital can access this opportunity. One is via distressed debt and hedge funds that acquire portfolios of non-performing loans originally extended to ship owners by banks. This allows the funds to quickly and opportunistically build up a large position, typically at a discount, as banks actively seek to reduce their exposure.
However, this provides little scope to scrutinise or amend the loan documentation or properly underwrite the underlying assets against which each loan is secured – namely, the ships. Historically low asset valuations mean that the implied loan to value ratio of any loan is conservative. However, break-even levels and potential high capex remain critical considerations.
But even though these trades are becoming fewer, non-specialist funds without industry relationships have typically preferred this route for deploying capital into shipping – despite the challenges posed by potentially weak collateral packages or sub-standard vessels.
Alternatively, investors can commit capital bilaterally. Here, the fund builds the kind of relationship with each borrower that only the largest, most creditworthy ship owners get from banks, whether for refinancings, acquisitions or in selectively acquiring discounted secondary loans. This is our preferred approach. We see multiple reasons why acting as a long-term finance partner to ship owners enhances returns.
By focusing predominantly on primary loans, rather than stepping into existing documentation, managers can structure and price loans more efficiently. If you have the opportunity (and the expertise) to underwrite the underlying ships in the due diligence process, you can tailor the loan according to the state of the asset.
It is essential to understand the precise condition, history, specification and provenance of the vessels that back each loan. Unlike other specialty finance – such as aviation debt, where there are only two major producers – there are a number of different shipyards, designs and technical specifications to assess that will impact future value. Fund manager oversight and expertise are needed to avoid lending against the wrong assets.
Lenders known for long-term partnerships will find it easier to originate deals with the most desirable borrowers. Owners with confidence in their borrowing arrangements are more likely to fund their ships with additional equity capital, de-risking the loan. It is also easier to actively manage a loan within your portfolio and work with a borrower on an operational level, when you have that sound structure and strong bilateral relationship.
But even when these two different approaches to investing in shipping are available to institutions, the cyclicality and volatility associated with the industry can be a deterrent. There are two characteristics an investor can prioritise in a manager to insulate themselves from this risk.
First, a primary focus on bilateral off-market credit opportunities, rather than owning highly levered ships, provides greater downside protection, particularly with historically low asset values reducing the implied leverage of an investment. That said, a flexible mandate that allows a manager to pivot across the capital structure to capitalise on the well-understood volatility remains important.
Second, the range of sub-sectors that comprise shipping, such as dry bulk, containers, tankers and offshore support, tend not to progress through the cycle at a uniform pace. Accordingly, a manager can make a virtue of the market’s inherent cyclicality, by adopting a countercyclical investment approach and deploying capital within the trough of each sub-sector’s respective cycle.
When an asset’s cashflows are constrained, as happened to dry bulk in 2016 or tankers in 2018, it is possible to achieve strong asset coverage. By structuring the transaction to provide a sustainable capital solution that combines a balance of upfront fees, running cash margin and back-ended fees, call protection or upside sharing, managers can drive strong risk-adjusted returns.
Sustainability and trade tensions
One further increasingly important consideration may deter allocations: sustainability. Yet, having been a laggard a decade ago, shipping is more progressive in this respect than many people appreciate.
Sea transport is a cleaner form of cargo transport than trucking or flying. Furthermore, the maritime industry is one of the most heavily regulated in the world, with the International Maritime Organisation 2020 regulations on low sulphur fuels the latest example. Strict enforcement and public documentation of these regulations has engendered a standardised diligence protocol and high levels of transparency.
More still needs to be done, and this will pose difficult questions of charterers, owners and investors. Ships are long-life assets, so technological and regulatory change raises the spectre of obsolescence and necessitates retrofits. However, ambiguity around the implementation of green technologies should benefit lenders in the long term. Uncertainty has contributed to historically low orders of new ships in all sub-sectors, leading to potential constrained vessel supply in the future that should boost valuations and rebalance cashflows.
If the environmental drivers for investing in shipping are positive, the macroeconomic backdrop is more ambiguous. Global trade tensions look set to continue affecting the industry – albeit not necessarily negatively. Tariffs and sanctions could extend trade routes, as more efficient supply chains become politically unpalatable, thereby increasing the total ton-mileage transported by ships.
The geopolitical environment therefore remains a ‘known unknown’ of which investors in shipping must be mindful. But it is the market’s other key dynamics – banks’ withdrawal, a capital shortage, institutional investors’ growing interest in its lender-friendly environment – that make it an exciting frontier within European private debt.