Uncharted waters | White & Case LLP International Law Firm, Global Law Practice

Uncharted waters

The absence of market equilibrium in the marine sector poses a threat to all stakeholders. Owners and operators have faced restructurings and some have failed. Various banks have exited the sector or reduced lending levels. How will the industry obtain the capital it needs given the challenges it faces?

The financial crisis of 2008 set in motion a series of events that converged to threaten all stakeholders in the marine sector. Global trade slowed as economies contracted and crises in the financial markets and banking sector saw banks retreat from prior lending practices. And yet the order books for fleet expansion remained at significant levels.

As new vessel deliveries continued, the supply-demand imbalance was exacerbated, earning capacity for fleets dwindled further, and it became increasingly difficult for many shipping companies to service debt and pay other operating costs. Economic growth failed to revive enough to restore financial health to many parts of the sector and, eventually, various operators were forced below the break-even point.

A wave of restructurings followed, some consensual and some resulting in formal insolvency proceedings. It is unlikely that the industry has seen the end of this downturn and its consequences.


Present challenges and outlook

The fundamental challenges facing the industry are relatively simple. There are still too many vessels for too little trade. The banking sector — the traditional source of finance for the marine industry — is not expected to be able to provide the full amount of capital needed to address anticipated capital expenditure and refinancing requirements in the coming years. By some estimates, more than US$215bn of debt capital is required by the maritime sector through the end of 2014.

On the revenue side, two industry benchmarks paint a sobering picture. The Baltic Dry Index has fallen from a high of 11,783 points on 20 May 2008 to a range of 700–2,000 points in 2013. Rates for capesizes — large-sized bulk carriers and tankers typically above 150,000 deadweight tonnage — are expected to average US$11,500 a day in 2013, according to the median of nine analyst estimates compiled by Bloomberg. This might be 40 percent more than 2012, but it is still well below the US$16,000 a day the largest ships need to turn a profit, according to estimates by Oslo-based investment bank Pareto Securities.

The picture is not all gloomy, however. For 2013, although the IMF predicts subdued growth of 3.1 percent in world trade, projections increase to 3.8 percent for 2014. Technological advances in the maritime sector offer potentially substantial cost savings as a result of fuel efficiencies for those able to finance a large modern fleet or the necessary retrofits to existing vessels. The opening of the Northern Sea Route similarly offers cost savings on the Europe to Asia routes. Strategic partnerships, such as the one between UASC and China Shipping Container Lines, as well as the alliance of Maersk, MSC and CMA CGM, are expected to produce operational efficiencies.

There are other bright spots. The transport of LPG (liquefied petroleum gas) and LNG (liquefied natural gas) is expected to grow. The market for offshore rigs and related assets remains strong. Product and crude tankers are seen as a relatively healthy part of the industry, with rates expected to rise. In 2013 and for the coming years, new deliveries of many vessel classes are expected to finally begin to slow down.

These developments are positive, but in the absence of a broad-based return to health for the global economy and corresponding increases in world trade, more is required.


Financial discipline

Banks, particularly in Europe, have significant exposures to the marine sector. Petrofin Research believes that European banks hold approximately 75 percent of an estimated US$450–500bn in global shipping loans. These banks have been hit particularly hard by the downturn.

Many industry insiders lament the way in which the marine sector has inflicted harm on itself. To these people, credit was extended too easily to finance new builds or roll over existing debt during the boom years. Similarly, unjustified optimism about the future health of the industry and/or an unwillingness to face the bleak realities of the downturn delayed the type of enforcement action on nonperforming loans or restructurings involving a deleveraging of the balance sheet that might have brought a much-needed sense of financial discipline to the sector.  What developed has been referred to as an "amend and extend" approach, one where creditors deferred repayments and restructured terms to avoid foreclosures without a timely write-off of a portion of the relevant loans or the taking of other action in collaboration with the relevant shipping company to address the underlying economic realities.

Undue criticism of these actions, many of which were taken in the chaotic aftermath of 2008 or at a time when a return to prosperity was the expectation of many analysts, seems harsh and unnecessary. More importantly, there are some clear lessons to be learned. On the creditor side, those lessons have begun to be heeded, encouraged by a variety of legal and regulatory developments, governmental pressure and investor demands to improve returns. Among other things:

• new bank credit lines appear to be based on healthier loan-to-value ratios, with some falling to the 60–70 percent range;

• a number of banks have made clear their intent to reduce new lending and/or to shrink, sell or wind down existing loan portfolios;

• faced with the challenges of a complex and wide-ranging restructuring of particular debtors, some banks have been prepared to accept equity positions in consideration of further credit extensions and/or modifications of existing payment terms and covenants; and

• a number of banks have begun using warehousing and other similar structures, thereby segregating nonperforming assets with a view to ultimately addressing their exposures, whether through portfolio dispositions, joint venture or other structured arrangements with alternate operators or otherwise.

The transaction concluded in April 2013 between HSH Nordbank and the Navios Group is illustrative of the actions that may need to be taken. By restructuring its existing exposure of approximately US$300m into senior and nonrecourse subordinated loans and partnering with an experienced operator, HSH was able to reduce its risk exposure and put in place an arrangement that will allow it to mitigate potential losses if the underlying assets ultimately begin to perform profitably again.

European banks have not signaled an en masse retreat from the marine industry. Some have openly committed to the sector for the long term, despite substantial exposures. Many of those are, however, focusing on a "flight to quality," whether in respect of underlying credits and/or those sectors deemed to be in relatively better health (such as offshore rigs and related assets or LPG and LNG carriers). Others are adjusting their strategy and adopting a broader-based focus on transportation assets in general.

The cleanup has begun in the banking sector. While the necessary corrective actions are far from over and there are likely to be further challenges arising from additional restructurings and/or failures of particular operators, this is an important step. That said, a funding gap has nonetheless opened up given the extent to which the banks have reduced their overall lending to the sector.


Funding the future

Where will the money come from if not from the banks? This is a question that applies to all financing challenges the industry faces and the answer is not going to be the same in all cases. Significant variations are expected depending on the credit quality of the underlying obligor, the relevant class of vessel or other marine asset, the particular financing need or opportunity being addressed and a variety of other factors.

European bond market

Some relief on the debt side has been found through the issuances of corporate bonds by European shipping companies. In June 2013, Hamburg-based Rickmers Holding raised €175m through an issue on the Frankfurt Stock Exchange's specialist SME board. In August 2013, Teekay LNG Partners sold NOK 900m of five-year senior secured bonds in the Norwegian market.

Some are skeptical about the significance of these transactions for the broader marine sector, citing among other factors limited availability to a relatively select group of high-quality issuers and the discrete size of the Frankfurt and Norwegian exchanges.  For the companies involved, however, a vital new source of capital has been accessed.

US capital markets

These offer an intriguing and potentially significant source of finance for the marine sector. Institutional investors in the United States, many of which have provided lending for other transportation sectors, have demonstrated a willingness to consider alternate asset classes as a way of addressing their own portfolio objectives.

The US private placement transaction closed this summer by Meridian Spirit ApS (Meridian) is illustrative. Meridian refinanced the debt associated with an LNG tanker by issuing US$195m of debt in a transaction rated Baa1 by Moody's. The security package included a traditional ship mortgage (and related assignments and pledges) as well as an assignment of a long-term charter to Total E&P Norge AS (TN). Particularly noteworthy is that the notes had a 17-year tenor, with a final maturity in August 2030, a few months before the scheduled expiration of the underlying charter with TN.

In its analysis of the transaction, Moody's noted among other things the importance of the credit quality of both TN and its parent, Total S.A. (rated Aa1 negative), and the importance of the LNG market to Total. Also relevant were what Moody’s considered to be the favorable terms of the underlying charter and the particularities of the LNG market and LNG transport sector, which were noted as being "less risky" than other oil and gas financings.

Whether the success of the Meridian transaction will be able to be replicated for other participants in the marine sector remains to be determined. That transaction had the benefit of one of the sector's bright spots from an asset class perspective (LNG tankers), combined with the likelihood of relatively stable long-term cash flows as a result of the charter arrangements.

Different and likely harder challenges will exist for the financing of other classes of marine assets in the US market, but those may be able to be addressed if, for example, investors are presented with financing structures used in other transport sectors.

The disclosure requirements that need to be addressed in this market may limit the universe of issuers prepared to consider this alternative. That notwithstanding, the fundamental forces affecting the industry make it likely that there will be increased activity for US investors and shipping companies alike, at least for so long as the US market offers issuers the potential for pricing advantages with tenors no longer (or rarely) available in the bank market (or elsewhere) and/or until investors have better or preferred means of satisfying portfolio diversification strategies.

Export credit agencies (ECAs) and other state support

ECAs and other instrumentalities of state-supported finance have a clear rationale to support the maritime sector where jobs and "the national interest" are in play. In Asia, this is particularly acute given the rivalries between the shipyards of Korea, Japan and China. An added element is also in play in the region in the case of LNG vessels and technology. The shift in Asian energy policy towards LNG effectively creates a double strategic benefit – supporting the economic health of the shipyards and securing transportation for the resource required to meet domestic energy demand.

The type of support provided by the Asian ECAs is evolving. The Korea Trade Insurance Corporation (K-Sure) and The Export-Import Bank of Korea (KEXIM) are reported to be planning additional products, including insurance and/or guarantees of bonds to be issued by purchasers of marine assets built in Korean shipyards. While other ECAs, notably in the United States and Europe, have issued similar products in support of aviation manufacturers, this will represent an innovative development for the marine industry. This will particularly be the case if such arrangements are provided in conjunction with direct loans by the ECAs, effectively enhancing the leverage provided by state support and bringing new investors into the marine space.

While offshore rigs and LNG vessels are likely to be the primary targets for these products, broader usage should not be ruled out, especially where the asset purchasers are deemed sufficiently strong from a credit perspective and/or the assets are scheduled for usage under favorable charter arrangements. The announcement by Scorpio Tankers Inc. on 28 August 2013 of a letter of intent from KEXIM for a loan facility of up to US$300m to finance various new builds upon delivery, subject to various conditions, indicates the importance of the role to be played by the ECAs.

State support can no doubt be helpful in isolation, but widespread intervention is suggestive of systemic ill health.

"The overall environment for commercial debt has cooled considerably. But the shortfall is partly being filled by enhanced capital allowances and export-import finance orders, and by government support for the shipbuilding industry," says Erik Nikolai Stavseth, an analyst at Arctic Securities.

"This represents a risk to recovery, as most segments need to have their access to additional capacity constrained."

Private equity and other funds

There has been much talk in shipping circles of an influx of private equity and hedge fund or similar capital, and a number of high-profile transactions have been completed.

Costamare formed a joint venture with York Capital Management for investing in box-ships. Delos Shipping and Tennenbaum Capital picked up majority control of German KG König & Cie. Other private equity sources have been active in a number of different segments of the maritime industry, including through investments in General Maritime and that company's successful prepackaged chapter 11 plan of reorganization. In addition, private equity has recently been active in the secondhand market and has provided funds to acquire a fleet of MR tankers from TORM A/S, as well as  pursuing strategic joint venture partnerships with both Ocean Bulk Maritime and Rickmers.

There is skepticism in various quarters about the role that this capital source will play in the marine sector, with previously anticipated investment levels having failed to materialize. Some believe that the industry does not fit the classic model for the relevant investors.

"Traditional private equity looks for an exit before it invests," says Paul Slater, chairman of First International. "Where is the return from shipping in three years, or five years?"

Such skepticism notwithstanding, the speculation surrounding this capital source has intensified in recent months, with some projections anticipating, finally, significant increases in investment. In August 2013, Kohlberg Kravis Roberts announced its entry into the marine space through a new finance company capitalized with US$580m of equity. Its focus will include the structuring, underwriting and distribution of secured debt financings in the marine sector.

Given the cyclical nature of the industry and the opportunities that exist in a down cycle, there are investors seeking discounted investments in the secondary debt market and/or in respect of low vessel valuations. This may increase if further restructurings are faced by the industry.

Others in this area are exploring the possibility of an operating lessor model not dissimilar to that used in the aviation sector.

The deployment of this new capital source will not be without significant challenges. New investors will have to conduct careful diligence and select partners with the necessary industry expertise to ensure an understanding of, among other things, regulatory compliance with sanctions-based regimes, potential trading and environmental risks and liabilities, contingent maritime liabilities, the interaction between trading routes, risks for maritime arrests from unsecured creditors and potential board and shareholder liabilities. The length of time for which capital is intended to be deployed will also be significant, and whether that is tied to potential exit opportunities through IPOs, secondary listings or otherwise will also have to be considered.


Uncharted waters

The world of maritime financing will likely look very different in the coming years when compared with the bank-driven finance market of 2008.

It remains to be seen whether ECA intervention will ultimately be viewed as having provided a necessary bridge between the old and new regimes or as having contributed to an extension of the sector's supply-demand imbalances. What seems evident, however, is that the sector's financing needs will not be able to be met solely by the ECAs.

Additional capital sources will be required, and whether these ultimately come from the issuance of bonds, capital markets offerings and/or private equity and hedge or other funds, or otherwise, it seems likely that these new sources of capital will bring changes with them. New capital providers can be expected to approach the industry with a different type of investing discipline, as well as using techniques and structures deployed with success in other industries. It is to be hoped that the combined effect of these changes will help the industry return to financial health.

Future growth in global trade will of course also be a significant determining factor in how and when the industry returns to health. And then there are the imponderables, such as the impact of recent discoveries of a variety of energy sources in the United States. As noted by Poten & Partners: "With crude oil production in the US rising to levels unseen in 22 years, the self-imposed restrictions on the export of crude oil is resulting in the refining of this product and an increase in product tanker movement from the Gulf Coast to the South American, Central American and West African zones. Although the US oil surge is having a positive effect on US product tanker movement, it is hurting the already weak European refining and product tanker markets, and could prove to have longer-term negative effects on European refiners if current conditions persist."

This development highlights both the uncertainties and the opportunities faced by the maritime sector and all of its stakeholders, including those considering entry for the first time.  Five years on from the crisis of 2008, the industry remains in uncharted waters.


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