Consider these facts:
- 90% of world trade is transported by sea,
- The world will ship by sea 2.5 times more iron ore per year in 2018 than in 1998,
- Transporting a pair of jeans from Asia to the US costs less than the taxi ride to go and buy them.
So, what would happen if the traditional investors in maritime financing downsized their commitment to funding the construction or secondary sale and purchase of the ships that the global economy relies on for international trade? It could be reality, if the current apathy towards the industry continues and alternatives are not sought. In this article we explore the possibilities, including the role alternative finance may play.
Unprecedented Forces of Change Are Afoot
We all acknowledge that the business cycle faces periods of growth, followed by adjustment phases correcting misallocations, usually caused by credit-fueled expansion. The 2002-08 maritime asset investment boom was no exception, but was also driven by China’s 2001 ascendancy to the WTO. The reality is that eight years on, we are still faced with a large dislocation between supply, demand and asset prices that are outside of traditional trend levels. In a broad sense this is actual (in dry bulk ships particularly), but in some other sub-sectors it is perceived (container feeder).
These perceived dislocations are building more immediate upside risk into the asset class, which is a positive that has been missed by many. In areas of actual overcapacity, with asset life averaging 20-25 years, the industry is fast approaching the halfway period of much of tonnage deployed around the time of the credit crisis. With ongoing low levels of profitability, there is a strong likelihood of accelerated scrapping of older or less well maintained vessels.
Adding to the pressures on financing for the maritime industry is the debate around the global trade fundamentals that drove much of demand, specifically whether the reliance on export-oriented strategies and the associated trade imbalances are correct. This is not helped by the collapse of asset inflation, the decline in debt-based consumer consumption, and new banking rules surrounding the financing of risk-weighted assets. This controversy will not be solved overnight. Therefore, no matter who the maritime tonnage owners are, they are going to have to change their approach towards finance in order to survive.
Chart 1: New Build Prices Index
Source: IPSA, Clarksons
Change, but with Wider Consequences
In 2014, Deutsche Bank estimated the value of the maritime tonnage responsible for cargo transportation to be US$820 billion. Traditionally, maritime assets have seen equity funding provided by high net worth individuals, family offices and privately held corporates who operate outside of the main institutional investment forums. This has been matched by a small number of banks who are comfortable with shipping providing junior and senior debt facilities. Of this last group, circa 80% of the senior funding was historically supplied by banks in Europe, some of which were severely hit by the credit crisis and have formally announced lower exposure going forward. Many of the capital providers to the industry have fewer financial resources at their disposal.
Heightening the pressure on maritime industry financing are Basel Banking Accords surrounding risk-weighted assets. Maritime asset funding is in one of the higher-cost categories. Some of largest traditional senior and junior debt providers are, as a result of these rules, forced to downsize their commitments. Moreover, Asian and Middle Eastern banks face the same rules, and also tend not to have the expertise and therefore the risk appetite to fill the gap. But even excluding these constrained balance sheets, it is estimated that the industry is still facing a US$100 billion shortfall in funding.
Yes, press headlines highlight oversupply and that’s fine when global economic growth is anemic; but what happens when it isn’t? After all, there is on average a two-and-a-half-year lead time for delivery of new ships, and supply dynamics are beginning to adjust back towards equilibrium. As referred to above, industry assets have a finite life.
With current low returns in certain sub-sectors and a broader perceived uncertainty, there is an increasing risk of under-investment in the sector in the next decade. A prolonged disruption to finance, be it origination or refinancing of the maritime sector, could create systemic risk and cost of capital implications for industries reliant on global trade.
When Passive Participation Moves Toward Active
Finance has been a key driver for the maritime industry for centuries, be it the building of vessels sent to explore new worlds and find trade opportunities, or risk mitigation through Lloyds of London, which was established in 1871.
Whilst historically finance has played a passive role, it has been an active tool in developing global trade. Despite the current macro debates, the themes of outsourcing, an emerging middle class and urbanization are driving more active participation for a number of reasons:
The equipment and its infrastructure are more capital intensive than two decades ago. Not only have ports needed to be constructed to handle oil and petrochemicals, iron ore, coal and containers, but the assets in their own right are now larger in size, as trade volumes have increased and lower unit costs are demanded by end customers. The sheer size and cost of these assets is requiring financiers to consider the amortization of investments over longer periods of time. In some cases, the traditional seven-year tenors are now as long as 12-17 years. Traditional commercial banks have struggled to accommodate these demands. Alternative finance can meet this demand, if matched to the right counterparty, but in these circumstances investment management needs to be more active and industry specialized.
Direct ownership through default: Traditional and alternative financial firms are becoming increasingly involved in the ownership and operation of intermodal assets. Initially, this arose from the evolution of international trade, but more recently it has been a result of the credit crisis and the untimely demise of some traditional owners who over-indulged in cheap credit.
With real-world assets, diversification is required: Aircraft leasing, water treatment plants, PPP/PPE assets, ports and airports in the late 1990s fell into the illiquid bucket of many pension, insurance, private equity and sovereign wealth funds, and therefore were considered non-mainstream. However, over the 2000’s, assets were acquired at multiples not to be imagined a decade earlier as funds looked for new asset classes. As a result, these assets were increasingly perceived as liquid and mainstream, a perception encouraged by the active involvement of a variety of financial firms and ratings agencies. International commercial vessel fleets have not yet shifted to this profile, mainly because they didn’t need funding prior to the credit crisis. However, due to the above-mentioned changes to the financing of these assets, maritime asset owners and operators are beginning to review the structuring of asset cash flows and residual values. This move, coupled with returns in other real world assets being bid away by the competition for a smaller number of deals, is beginning to build a more active and direct focus by traditional investors.
Maritime asset exposure offers portfolio diversification and lower volatility for multi-asset and alternative investment managers: This profile is starting to drive investment in commercial maritime assets, particularly those that offer steady income, as they provide institutional investors, such as pension and insurance firms, with a tool for asset-liability matching, portfolio diversification and competitive yield. Moreover, the asset class offers lower volatility over time to investors, if specialist management is deployed. Furthermore, it is in most cases compliant with the principles of Islamic financing.
Chart 2: Industry unlevered returns IRR% versus New Build Prices
Source: IPSA Capital, Clarksons.
The Average IRR is a weighted average of 3-, 5-, 7- and 10-year holding period return across the three key sub-sectors — Dry Bulk, Container, Tanker — weighted on fleet capacity measured in dead weight tonnes. Purchase price is the new build price. Exit price is taken as secondhand price corresponding to the holding period. Revenues are 12-month time charter rates. Operating expenses include dry docking expenses amortized over the appropriate period. S&P commission: 1% charged on purchase price and exit price, allowing for deal expenses. Charter commission: 2.5% of 12-month charter rates is deducted from cash flows. Past returns are not a predictor of the future. Furthermore, typically new build vessels can be delayed, meaning returns are estimates and allow for a framework for discussion. Rates are assumed at 12-month/1-year charter rates; in practice contracts can be for shorter or longer periods, which could smooth volatility and boost returns.
Chart 3: Portfolio diversification provision
Source: IPSA Capital, Clarksons, Reuters.
Average risk and return of various asset classes starting from 1990 until December 2015. Global Bond Index is comprised of JP Morgan GABI index from 1990-2013 and Barclays aggregate bond index for 2014 and 2015. Commodities Index is CRB index up to 2005 and Thomson Reuters Index to Dec.2015.
Risk management is no longer just through insurance, but via synthetic financial instruments and provision of regulatory capital as well: Shipping derivatives, while relatively young compared to mainstream assets, evolved out of the high volatility seen in the maritime markets and are designed to help manage risk.
This risk emanates from fluctuations in freight rates, bunker prices, vessel prices, scrap prices and the more traditional areas of interest rates and foreign exchange rates. Maritime principals cannot provide this liquidity or expertise.
Often, direct exposure by financial institutions is not preferred or needs to be investment grade. However, the benefits of industry financing can also be enjoyed through regulatory capital relief trades. This arises from the evolution of the Basel banking rules. It is widely expected that alternative investment managers, with expertise in the shipping arena, could shortly deploy equity relief capital to well-managed shipping banks. This has been recently seen in the SME funding, infrastructure and auto finance sectors to name a few. The benefit to the banks is a lower cost of equity and a multiplier effect on existing equity allocated to their shipping portfolios. The benefit for the investor is a return competitive to alternative sectors and assets and greater protection from any asset price pressure. This is similar to Collateralized Loan Obligation trades, but allows for the underlying bank to remain the front-facing name. Although the success of this trade is going to highlight the need for specialist investment managers should the loan fall into default. This way, investors have a manager with the knowledge of how to protect capital in a work-out scenario through their knowledge of the asset and network to redeploy it.
What Is Required to Achieve Best Practice?
Acceptance by the maritime trade that its relationship with the financial community is set to change will take time. Once seen as an industry that repelled mainstream institutional investors providing direct or alternative finance, it is likely that inclusion is to be driven by necessity. This, we believe, will take another three to five years. Meanwhile, challenges will need to be overcome, namely:
- Transparency: With the allure of high returns in 2002-07, uninitiated alternative asset investors made a headlong rush into maritime sub-sectors with low barriers to entry, particularly dry bulk. This saw the fleet more than double in tonnage terms. With charter rates now at or below breakeven, cost management and governance is ever increasingly being examined by the finance industry.
- Governance: From 2001 to 2008, the maritime industry benefited from the large sums of capital available. This came through a number of high-profile alternative debt and equity offerings, the avenues of which are likely to remain a component of the new investment landscape. Due to the mainstream profiles that this capital deployment has brought, there is now an increasing amount of pressure to deliver better governance.
- Acceptance by ratings agencies: Investors and industry participants are slowly demanding an improved hearing and profile by ratings agencies. However, this is likely to be difficult, not only because of ownership fragmentation in various subsectors, but also because the wave of cheap credit and asset inflation in the 2002-08 period and subsequent collapse has left the maritime industry struggling to deliver investment grade characteristics. If the ratings agencies are willing to adapt to accepting the industry’s importance to world trade and operators are able to provide stable cash flows via longer-term contracts and credit enhancement, then relative to other industries there is no reason parts of the industry cannot be investment grade.
Is the Current Approach Best Practice?
To date, regrettably for some limited partners, alternative investment has come from mainstream alternative investment houses, some of whom have limited industry knowledge or networks, and have in some cases ignored fees and costs or available strategic knowledge investments. This high-cost approach comes at the detriment to limited partners’ returns, which has therefore curtailed investor appetite for the asset class. Moreover, it has for now slowed maritime owners’ and operators’ acceptance of alternative funding.
The simple fact is that investors in this space are best served by using specialist real world asset managers in navigating the maritime industry to achieve optimal risk/reward parameters. The industry, while critical to global trade, remains small and is at its simplest based on relationships. Use of specialist managers who have these networks and relationships helps considerably to bridge the current gaps in knowledge and expectations that exist in both the finance and maritime industry.
One way or another we expect change to occur. The reality is demand for finance by operators is at a cyclical low. As such, we are yet to see the true demand for finance in the brave new world that is coming over the horizon. It is hard, though, to imagine that the cost of capital for operators and owners is set to be lower in the medium term than it is today. Therefore, the true rewards are going to be reaped by those prepared to act now to be positioned for the coming up-cycle and do so with specialist advice and industry partnerships.
David Lepper is Founding Partner and CIO of IPSA Capital, a global asset management and advisory group specializing in alternative assets and special situations. He is formerly Head of MENA Research for HSBC and Pan Regional Head of Asian Small-Mid Cap Research and Global Coordinator for Shipping Research for UBS.
 Deutsche Bank (DB) Arab Maritime Forum May 21, 2014
 Makan, Ajay, and Mark Odell. “Wave of Private Equity Money Flows into Shipping” — FT.com, October 27, 2013