IMIF BUFFET LUNCHEON
Date: Thursday 12th December 2013
Venue: The Baltic Exchange, 38 St Mary Axe, London. EC3
Host: Jeremy Penn, Chief Executive, the Baltic Exchange.
Speaker: Simon Lew, Partner, Norton Rose Fulbright LLP
Subject: “Alternative sources of debt finance for shipping”
Report by James Brewer
Use of secured shipping bonds could develop significantly now that many of the traditional shipping banks have turned their backs on funding the industry. It was a possible way forward, taking a lead from the aircraft finance markets where secured bonds are regularly used to finance new aircraft.
This was one of the main points made by Mr Lew, who said that for the past two years in particular, he had been analysing strategies that might fill the gap left by the withdrawal of the banks from the ship financing market. In his presentation, Mr Lew focused mainly on the debt capital markets, and he suggested that the finance market was beginning to develop again, thanks to new trends.
The three principal sources of capital for the industry since 2009 had been: bank loans; equity in the form of initial public offerings and private equity transactions; and bonds.
Entering the caveat that the data he was quoting were taken from announced deals (some transactions, particularly those involving private equity, are not publicised and some others are restructurings of existing financings and therefore do not involve new money) he said that in 2007 the total of new capital for the shipping and offshore industries in commercial bank loans, equity and bonds was close to $170bn, a figure which fell to around $115bn in 2012. The total might have been better in 2013 than in 2012, but the point was that there was quite a significant gap in capital that had been going into the industry, and pretty well all that gap was accounted for by a reduction in commercial bank lending. In 2007, approximately 75% of the capital going into the industry was in the form of bank debt. In 2008, around 90% was in bank debt. In 2012, only about 45% of the capital took the form of bank debt, and for the first time, bond finance was pretty well at the same level as bank debt.
Mr Lew felt that 2013 would show a different picture. “There has been a recovery of sorts in the total of bank debt going into the market, but this is only for the most robust sectors such as offshore and liquefied natural gas. For the majority of shipowners and sub-sectors it is still a very big struggle to find anyone to lend. This year there has been a notable increase in equity, private placements and IPOs.”
Why did the banks retreat? They were continuing to shrink their balance sheets in order to be compliant ahead of the implementation of new, more stringent capital adequacy rules under Basel III. As a consequence, there has been increased competition within banks for the use of limited capital: specialised lending (including asset finance) is capital intensive in regulatory terms. In addition, many of the traditional European shipping banks are perceived as being over-exposed to Eurozone sovereign debt and so face continuing US dollar funding issues. Finally, bank credit committees are increasingly taking a more negative view of a highly cyclical industry.
What are the alternative sources of finance? Mr Lew defined them for the purposes of his presentation as “anybody other than the traditional shipping banks!”
There is an increasing interest from private equity providers, and there is a growing shipping IPO market, particularly in the US, he said.
There are “new” banks coming into the industry, including the Chinese banks (although they remain largely domestic lenders). Some of the US banks and Japanese banks that were more active a decade or so ago are beginning to show renewed interest in the industry, but this is still a drop in the ocean compared with other sources.
Export credit agencies have been providing much needed capital to the industry in this interim period.
Financial leasing is growing. In particular, the Chinese financial leasing companies are acquiring large fleets very quickly. The received wisdom is that they support only their domestic market, but that is changing, with reports that deals of the type include finance leases for five post-panamax ships with options for a further seven, and for an order involving three 18,000 teu containerships, all for European operators.
We are starting to see the emergence of a cross-border Chinese leasing market. “These are big players, they have a lot of money, and they grow extremely quickly.”
“KG-style” leasing products are being marketed to retail buyers. Mr Lew expected this phenomenon to go on growing.
Then there are bond investors: pension funds, insurance companies, private equity and other investment funds, corporates, high net worth individuals and banks. Bond issuance has soared since 2009.
From approximately $5.8bn in 2008 (5% of industry funding), bond issuance rose to more than $42bn in 2012, around 45% of industry funding.
People say that “bond financing is more expensive,” and there was some truth in that for specialised sectors, said Mr Lew as he outlined the pros and cons. A number of bond deals were pulled in 2013 in favour of commercial lending because the latter worked out more cheaply.
Bond financing had a great deal of flexibility, but for a first time issuer it takes longer to put a bond in the market, and it costs more. That said, follow-on offerings will be a lot cheaper and a lot quicker.
Mr Lew said that the Norwegian market is very much an international investor market that is comfortable with the offshore industry; the reason for its popularity is that it is very quick and very cheap and “documentation-lite.” It might take four to six weeks for a new issuance, less for a follow-up. The US market has a deeper investor base, but there is a lot more ‘disclosure’ required under US rules and it takes longer and is more expensive. Both the Norwegian and US bond markets have been active in the last couple of years. Other markets included Germany and Asia. Mr Lew cited a Rickmers deal in Germany, as well as bonds placed in the US for issuers including Navios.
By definition, all of those bonds are going to be high-yield, he said.
Mr Lew then described a product known as the offshore project bond which has been used extensively to finance drillships, rigs and FPSOs for oil and gas producers like Petrobras (which has used this product to finance more than $4bn of offshore assets since 2010). It has also been used in 2013 to finance LNG ships.
Turning to the question of secured shipping bonds, Mr Lew said that they had a similar security and covenant package to a bank loan. The structure was based on a combination of the corporate debt rating of the shipping company, and security over the asset, with debt service payments sourced from the charter hire payable under a bareboat charter of the ship. The main drawback compared with a bank financing is that the bond investors do not like to take pre-delivery (construction) risk and they will expect to be paid a make-whole premium on any early redemption of the bond.
Credit enhancement for the bond is provided by ownership of the assets in bankruptcy-remote special purpose vehicles, and sectioning the debt in tranches (the lower the advance level, the higher the rating). In addition, a liquidity facility is provided to ensure that debt service on the highest rated bonds continues following a default when the asset is being repossessed and re-marketed.
The idea is to make sure the Class A noteholder (the holder of the most senior tranche of bonds) will always get paid. The structure has been used widely in the aviation sector, allowing the Class A note to be rated at a level two to four notches above the corporate senior debt rating of the operator. The liquidity facility provider has to be rated at the same level as the rating of the Class A notes.
Mr Lew said that such a format could enable a sub-investment grade shipowner to raise finance at investment grade pricing, but he cautioned that this type of financing structure depends a great deal on legal analysis of repossession risks: how long would it take to arrest or recover possession of the ship in a default scenario; how long would it take to sell or re-charter the ship? The answers to these questions impact on the length of liquidity facility required and this in turn affects the cost of the deal.
Finally, Mr Lew spoke of the development of export credit agency-wrapped shipping bonds. A guarantee provided by an export credit agency should allow the bond to be rated at the same level as the sovereign debt rating of the country of the export credit agency. Precedents for ECA-wrapped bonds have been set in the aviation sector by US Exim, UK Export Finance and Coface. The question was: “Can you do this for shipping?” A key legal issue was: will the guarantee constitute an irrevocable and unconditional obligation of repayment on the bond?
Possible participants in such transactions in the shipping industry could be Export-Import Bank of Korea (Kexim), Export-Import Bank of China, China Export Credit Insurance Corporation (Sinosur), Japan Bank for International Cooperation, Nippon Export and Investment Insurance, SACE (Italy), Euler Hermes (Germany), KUKE (Poland), and Atradius (Netherlands).
One transaction of this nature has been completed: a $300m Kexim financing of 18 ships for Scorpio Tankers in October 2013 which included a $125m guaranteed bond tranche. “Because the Koreans have done it, I am convinced that others will be forced to follow,” said the speaker.
Our chairman Jim Davis remarked: “When I first started in shipping, we used to pay cash for our ships,” quickly adding: “I thought that would draw a laugh here.”
Mr Davis said that when it came to people considering newbuilding orders, “how much notice is taken about the employment of the ship? And how much interest do these clever financial people take in that, in respect of the transaction? I fear, not enough. I just hope that shipowners, as borrowers, have learnt their lessons from the past, and say I am not going to take this money unless I can really take employment – and that goes for both sides of the deal.”
Although Mr Lew had suggested that ship finance might be “rather a dry subject,” Mr Davis observed that it was clear his presentation had drawn considerable interest as seen in the pertinent questions from those present. He thanked Mr Lew warmly, and expressed the appreciation of those present of the welcome and hospitality extended by Mr Penn.