By Maria Mikolajczyk and Alexander Jörgens
Let’s rehash some key points: as discussed in Part I, the ship financing landscape has undergone drastic changes and has seen the exit of many traditional ship financing banks as well as the emergence of alternative capital providers. The existing financing gap can be reasonably expected to widen further due to shipowners’ higher capital requirements in order to comply with the IMO 2020 regulations and the expected choke on bank financing through the Poseidon Principles.
- IMO 2020: An international regulation aimed at reducing carbon emissions in shipping. Recall that operators are reduced to essentially three ways to comply with the sulfur level constraint: (i) installing exhaust systems, called ‘scrubbers’ in the vessels, (ii) buying more expensive clean marine fuel (iii) switching to LNG based propulsion. All alternatives will come at significant additional costs, either upfront or of an ongoing nature.
- Poseidon Principles: Launched by a dozen banks in June 2019, an initiative that aims to incentivize shipowners to comply with IMO2020. The principles are a framework for assessing and disclosing the climate alignment of ship finance portfolios. In a nutshell, the signatories banks (i.e. the participating banks) commit themselves to the following main principles: assessment, accountability, enforcement and transparency.
- The signatory banks will annually assess climate alignment in line with the technical guidance of the Poseidon Principles which includes strict carbon emissions requirements for the borrowers, among other financing covenants
- The signatory banks will require that ongoing compliance with the Poseidon Principles is made contractual in their new business activities using standardized covenant clauses
- The signatory banks will publish the results of the portfolio climate alignment score of their ship finance portfolio
These proposals are essentially tightening the (green) noose around shipping companies. Capital will not be limited for blue chip companies like Maersk, MSC or Frontline but is rather expected to become scarce for small to medium sized owners with older tonnage. Within the current low-interest rate environment, high yield debt investment opportunities are as rare as industries with an undersupply of capital, and hence the maritime space seems to be destined for an increase in high yield private debt activity by private equity firms. We anticipate several “sweet-spots” that could encounter a higher proportion of sponsor financing in future:
Opportunities for alternative capital providers
- Scrubber financings as an additional layer of debt subordinated to first-lien bank financing
Installing exhaust gas systems, so called scrubbers, deem an alternative to buying low-sulfur bunker. However, installation is comparably capex-intense with costs ranging to up 20m USD depending on the size and specs of the vessel (as a rough rule of thumb one could estimate that the costs of installing scrubbers equal 10% to 20% of the asset value). Traditional banks are expected to refrain from providing financing for scrubbers as the technology is still at an early stage. Consequently, banks will not assume the asset value of the vessel to increase proportionally, which would leave the financier with a substantial increase in the debt risk profile.
Furthermore, whenever the vessel is subject to a mortgage or a bareboat charter (similar to a finance lease), it is already difficult to obtain consent for traditional mortgage financing as it usually requires the authorization of the existing lender. Considering the fact that many loans are syndicated, it would be additionally cumbersome to include the financing of scrubbers in existing loan agreements. On this account the industry experts do not expect that banks will finance a significant proportion of scrubber investments, resulting again in a shortage of capital for shipowners. On the flip side, the shortage of capital represents an attractive entry point for private equity and credit funds. Structural subordination to first-lien lenders is nothing banks are keen to pursue given the risk profile and high equity adequacy requirements, which sets the playground for private equity. The urgent need for capital might direct shipowners towards private equity and increase the willingness to pay higher interests in turn. If owners and credit funds agree on the long-term benefits of scrubbers, a suitable financing that is subordinated to the first-lien mortgage loan can be easily structured. From an owner-perspective it also provides the advantage of a more flexible loan agreement in terms of lower annual repayments and payment in kind interests in order to sustain further downturns of shipping markets.
- Scrap value financing of older tonnage of owners that are not compliant with sustainability standards
Another opportunity that arises for alternative capital providers is the financing of aged second hand tonnage that either does not comply with the high standards of the Poseidon Principles or of which the owner is not a target client for traditional financiers. The trend towards green financing will further accelerate the squeeze in liquidity for these borrowers, which then ultimately might engage with alternative capital providers, e.g. niche-lending banks asking for high interest rates or credit funds. Interestingly, the characteristics of senior loans secured with matured second hand vessels provide an appealing risk-rewards profile for credits funds. Even though single loan amounts tend to be at the lower end, most of such loan is typically secured by the scrap value of the vessel. Scrap values are usually highly correlated with steel prices and were historically floored at 260 USD per ton (of the respective vessel), providing a floor in downside to the financiers. However, as these assets are somehow unappealing to finance and banks prefer to finance counterparties with larger fleets with better cross-sell potential, margins can go up to 5% and higher. Adding current USD swap rate levels for a 5 years horizon, fixed yields equivalently exceed 7% which is already an acceptable ballpark region for private equity backed credit funds.
- Non-amortizing, pay-as-you working capital/mezzanine financings to increase flexibility in switch to low-sulfur fuels
Lastly, many shipowners will not install scrubbers and will transition instead to more expensive low-sulfur marine fuel which will lead to a significant increase in operating costs. Considering that shipowners are not likely to push these costs through the freight or charter rates to clients, the mark-up in OPEX is borne by the shipowner. For many shipping segments, operating profit margins are comparably tight and hence an increase of operating costs will eat up profits, potentially also leading to breaches on liquidity covenants. Such a situation would also present an opportunity for credit funds through the offering of mezzanine or working capital financings that ease the liquidity shortage of the shipowners. Risk is obviously higher as leverage increases and security is second lien hence, credits funds will ask for some instruments for upside sharing.
In light of the backdrop of traditional bank finance in the maritime industry (which is also due to higher capital requirements in the context of Basel III and IV) alternative capital providers have a variety of entry points into the industry. The financing gap is expected to widen further, and hence attractive yield premia can be achieved. The liquidity squeeze will continue and so will the emergence of alternative financiers. In the era of new backers stepping in, many new funds are being set to target shipping companies. Pillarstone (a company managing non-core/ underperforming assets) recently launched a debt fund, which is targeting 1 billion USD in distressed shipping assets. Finav, is the biggest distressed- asset shipping fund in Italy and has acquired shipping assets from Intesa Sanpaolo and Unicredit at significant discounts. The fund comprises of debt which banks classify as unlikely to be repaid without fronting new money.
Other established credit providers pursue a more committed and strategic approach to target the maritime industry. Oak Hill Advisors, a US-based alternative investment firm, has recently restated its core focus on the maritime industries. The strategic shipping initiative focusses on both distressed and performing assets which can be primary or secondary nature. The fund can also opportunistically invest into equity structures. The approach is similar to that of other capital providers that have been around for the last years and which strategically committed themselves to the shipping space.
In addition to the ‘traditional’ sponsor financiers, digitalization and crowdfunding also led to new finance initiatives in the maritime industry. A noteworthy recently raised fund is YieldStreet, launched in 2015 with 700 million USD in assets under management. The company constitutes a new way of acquiring capital by combining technology, alternative finance and wealth management. The main idea is to reach a greater audience of investors via an online platform, which democratizes wealth creation and allows access not only to institutional investors. YieldStreet Marine Finance, launched in 2018, provided 140 million USD in loans in a year’s time. The platform offers special agreements to meet the borrower’s specific needs. For instance, for VLCC financing, the vessel is sold at an agreed-upon price that is in excess of the loan. YieldStreet offers a bridge loan to make the transaction possible and which is backed by the real asset. The loan is amortized over time with the cash flows from the vessel operator and the loan principal is measured as a percentage of the vessel’s scrap value. Such offerings are highly demanded on the market with the a target yield of 10.25%.
Editor: Eric Peghini
Authors: Alexander Jörgens, Maria Mikolajczyk