By Alexander Jörgens and Maria Mikolajczyk
Contrary to the mythic Greek portrayal, neither violent nor ill-tempered, the modern Poseidon will stand guard to keep maritime trade in a new sustainable order. As a consequence of new government regulations – IMO2020 – shipping will encounter a future of cleaner open waters. The chief objective of the change is to reduce sulfur emissions in order to establish a more sustainable shipping environment. The Poseidon Principles are new rules implemented on the financing of the shipping industry with respect to the IMO2020 reform. The question is how this directive will impact the industry and what are the broader implications? In Part I we outline the maritime shipping industry, its trends and the IMO2020 initiative.
- Maritime financing history
An armada of international trade, the maritime freighting industry was a booming sector experiencing one of its most prosperous periods before the crisis. Prior to 2008, the average cargo vessel’s value could jump to upwards of 600 percent over 5 years; this created a dramatic increase in demand for such vessels and logically amassed a significant number of investments in such assets. Entering the industry was most certainly fashionable, in fact, 90 percent of all trade measured by volume was and remains transported via ships. Companies were ordering new freighters, often turning to second-hand dealers to omit the long production time and exploit the momentum of the erupting industry. The sector continued to grow, deals were made and new ships were ordered until the crisis subsequently rocked the boat. Following 2008, supply significantly exceeded demand while freight rates soared which led to both financial distress and caused vessel values to plummet. As the industry couldn’t absorb the costs it was bearing it began to recede leaving all the financing players, namely banks, in great uncertainty about the future. The financial environment became very competitive as the only corporate strategy for agents was survival until the recovery. However, this was in line with the cyclicality of shipping, which is characterized by extensive periods of losses between booms.
Fleeing over the bulwarks, banks abruptly retreated from the industry, refusing to take on any new transactions. Shipping companies experienced a significant decrease in the number of conventional financial deals with traditional banks. Loan volume fell from 120 billion USD in 2007 to nearly 50 billion in 2016. Many European banks, which formerly dominated the market, announced their plans to exit. The race to dispose of shipping portfolios became a new trend. For instance, Deutsche Bank sold its non-performing loans (NPLs) worth 1 billon USD to a joint venture of two private equities, namely Varde and Oak Hill, in June last year. Commerzbank, which prior to the crisis financed some of the leading cargo fleets in Germany, withdrew from shipping in July this year selling the remainder of its loans to the US private equity firm Davidson Kempner. As the market shifted from good to bad news there was no deep pool of funding competition. Adding the slowdown of the Chinese economy, less cargo and shorter ton miles to the equation, earnings were almost non-existent, and fortunes were lost. Reduced bank capacity and investors withholding equity made room for alternative financing to step in.
- Maritime financing landscape
Which brings us to the present day. Three niche players grew into paramount importance: (i) lessors, (ii) institutional bond lenders and (iii) ’alternative’ financiers. The predominant source among alternative sources of financing is leasing, which comprises high leverage, competitive pricing and only few covenants, but in most cases a highly rated corporate guarantee. On the other hand, the transactions imply high cash breakeven rates on account of rich pricing and high leverage mitigated by reduced amortization. Moreover, the purchase options provide flexibility only when substantial amounts of capital for refinancing are needed. This leaves small and mid-size (SMEs) shipping companies somewhat behind. The leaders of the sector are Chinese leasing companies, which partially filled the financing gap contributing a combined new business volume of 12.9 billion USD in 2018.
Issuing private placement debt is a very selective process as it requires an investment credit rating. Only few can access the market directly with favor expressed mostly towards well-structured projects with long-term charters to strong counter-parties. Nevertheless, shipowners are becoming increasingly interested in considering structures such as high-yield bonds, convertible debt, operating leases, preferred equity structures and secured bond placement in the Norwegian debt capital markets.
The transactions with alternative financiers are usually asset-based transactions with high leverage and risk- adjusted returns. Deals are carefully structured to minimize lender’s risk. The size of this kind of capital provider is of lesser importance than their inclusivity; although small, they are becoming very effective and their role within the industry is expanding. Many private equity companies enter the industry in order to buy NPLs from banks at large discounts to experience immediate profits or make direct credit investments through newly founded debt funds. The reduced price paid by PE firms for shipping loan portfolios means the funds should be able to exit for a profit. The acquisition of NPL by PEs also provides opportunities to the ship owners that can enter into bilateral discussions with their new lender of record. Given that the loans were acquired at a discount to LtV, owners might be able to seek arbitrary refinancing schemes which can be used to repay their existing loan with the PE.
Through this, alternative sources of capital are becoming more prominent, but the industry is still lacking the pre-crisis levels of liquidity. The following chapter will introduce financing and liquidity constraints in the context of sustainability and evaluate their impact for alternative financiers.
- Sustainability becoming a factor
Nowadays, the topic of sustainability is disrupting the vast majority of industries and has become an even more socially relevant debate after the Fridays for Future movement and the reincarnation of green parties in the political landscape. In the context of global warming and sustainability, the shipping industry seemed to be a seldomly touched discussion point but the discourse has grown over the last year. The environmental impact of the shipping industry includes a variety of air and water pollutions including greenhouse gas emissions. According to researchers, ships are responsible for approximately 20 percent of some air pollutants and accounted for circa 2 to 3 percent of the global human-made carbon dioxide emissions in 2012. Due to the complexity of the international regulations, regulators and maritime organizations have been fairly reluctant to introduce stricter regulations. Yet pressure from the population, lobbyists and multinationals is accumulating and new policies are taking shape:
- IMO 2020: A new regulation, governing the use of marine fuel will become effective as of January 1st, 2020. The regulation that will be introduced and overseen by the International Maritime Organization (IMO), an agency of the United Nations, is widely regarded as the most disruptive legal framework that the industry has observed in the past decade. The new standard limits the emissions from marine fuels to 0.5 percent sulfur per content of fuel, in comparison to an estimated 3.5 percent allowance today. Even though the new regulations came as no surprise (the initiative was announced in the direct aftermath of the financial crisis), the majority of the ship owners currently do not comply with the future threshold levels.
Marine fuel consumption was equal to roughly 4 million barrels per day in 2017, comprising half of the global fuel oil demand. The shift in regulations will increase the volatility in the bunker market and require shipowners to pursue high capex investments in exhaust systems. Alternatively, the owners face higher operating costs caused by the required purchase of cleaner fuels with low sulfur levels in case they decide against an exhaust system. Equity research analysts quantify the impact to the industry in the ballpark of 30 to 50 billion USD. There are several ways how the ship owners could achieve the required level of sulfur emission: (i) installing exhaust systems, called ‘scrubbers’ in the vessels, (ii) buying more expensive clean marine fuel that reduces the sulfur emission or (iii) switching to LNG based propulsion.
All alternatives will come at significant additional costs, either upfront or they will be of running nature. As the maritime industry is, since the crisis, notoriously lacking access to capital, the most probable option for many shipowners will be to use cleaner fuel, which will be cheaper upfront but significantly more expensive in the long run. Analysts estimate that operators will be paying a premium of up to 200 USD per barrel of marine fuel. Even though the impact on operating expenses is significant, such costs would present only a minor part of the problem if they could be passed onto the customers via an increase in freight rates. Capital markets, however, deem this unrealistic given the supply and demand imbalances of the industry and the tendency to have new built ships ready for LNG conversions. Hence, much of the cost burden of cleaner fuel will need to be carried by the owners. Installing scrubbers is a capex-intense decision which is often seen as an excessively expensive alternative for shipowners of older tonnage. The costs for such exhaust gas systems start at approximately 2 million USD for smaller vessels and can increase to up to 15-20 million for ultra large carriers. The reduced access to capital makes it nearly impossible for smaller shipowners to cover such expenses. The situation is comparable in the case of LNG, such conversion is expensive even for LNG ready ships. Traditional financing banks often consider the capex attached to these investments as working capital investments arguing that nowadays the increase in value may not be proportional.
- Poseidon Principles (further detailed in Part II): In June 2019, a dozen banks launched the Poseidon Principles, an initiative that aims to incentivize shipowners to comply with lower carbon emissions. The principles are consistent with the policies and ambitions of the IMO 2020 regulations. The Poseidon Principles are led by Citi, Société Générale and DnB which together with the other participating banks represent 20 percent of the global ship financing market. The participating banks, so called signatories, are required to comply with Poseidon Principles in any new business that is originated in order to catalyze sustainability in the maritime industry. The overall cost of ship financing is consequently expected to increase as banks and other financial institutions will require sustainable ship operations; this makes access to liquidity more restricted for those that do not comply.
Altogether, a new set of regulations and governance structures will lead to a major shift towards sustainability in the shipping industry. The compliance with the IMO 2020 principles creates higher barriers for funding which will further squeeze liquidity. The Poseidon Principles will act as the IMO enforcer, further cumbering the access to bank financing, and it can be inferred that small to mid-size ship owners will experience a shortage of capital (and potentially be chased out of competition) in order to comply with the stricter environmental standards. In the light of the notorious capital shortage in maritime finance, there arises a question how the capital gap will be filled. The second part of this series will provide more color on opportunities for private equities in the current industry environment.
Editor: Eric Peghini
Authors: Maria Mikolajczyk, Alexander Jörgens