For many years international banks were the main source of ship finance, loans being made to single purpose companies, secured on the vessel and supported by a personal or parent company guarantee. As investments became necessarily larger, the result of the demand for increasingly sophisticated vessels, equity and bond markets took an interest, where the associated capital raising costs can only be justified with larger sums.
Then came the events of 2008 with economic uncertainty, declining oil prices and collapsing freight rates. With new players entering without the same emotional ties, such as hedge funds, along with new financing methods, the market was transformed once again.
In this article we look at vessel financing pre and post 2008 together with some of the latest trends likely to impact the market.
High freight rates in 2007 had contributed to record new build contracting that year. At that stage the total world order book stood at 460m dwt, over 45% of the world fleet at the time. Newbuild prices continued to increase across the various ship segments. China’s economic growth at the time lead to a surge in demand for dry bulk vessels, with more than 55% of all new vessels ordered in 2007 being such carriers.
Second hand prices were also following the same trend, surging over 212% compared to November 2002.
When the markets crashed in 2008 the consequences were loans from banks along with syndicated loans drying up, any loans that were made available were for shorter periods with aggressive repayment schedules with the imposition of lower gearing levels. Stricter covenants became the norm, for example encompassing market disruption, residual value guarantees and loan to value clauses.
Events after 2008 have seen both a geographical shift as well as one to new sources and preferred products.
The German KG financing model
When looking at events pre-2008 one cannot fail to mention one of the most notable developments in the ship financing market that had taken place: the introduction of the German KG model. Really taking off from around 2003/4, it lead to Germany at one stage being one of the largest ship owning nations in the world. This rapid growth came about through a combination of tonnage tax, limited partnerships (Kommanditgesellschaften, “KG”) and a demand from investors looking for high returns with little or no risk.
German tonnage tax – a flat rate method to calculate a deemed taxable profit based on the capacity and operating days of an individual vessel – was intended to sustain and secure jobs in the maritime sector. Still available, it allows owners of vessels to elect to be taxed on this almost fixed, possibly more predictable basis rather than on the normal variable profit before tax. Once made though, the decision is irrevocable.
At its peak, according to the German law firm Kravets, around 440,000 investors had bought shares in single ship KGs, giving them partial ownership of a vessel, with limited liability, and the ability to share in profits generated which bore a fixed, low-rate of tax.
When freight rates were high the model worked well: high profits meant lower than what would have been the usual tax was then payable, and at the same time, because of that, higher vessel values were maintained. With a collapse in chartering rates, sometimes with vessels not even covering their costs, the model was quickly undermined – the KG sector collapsed.
Prior to its collapse, a whole industry had sprung up around the KGs, with promoters being paid a profit up front when monies were raised, which could sometimes, with a mix between mortgage and equity funding, amount to an unsustainable 120% of the vessel’s value. Compounding the problems caused by taking money out early, was the fact that some of the mortgages were in foreign currencies, thereby introducing a currency risk compounding the risk arising from earnings volatility. From German one-ship KG’s accounting for around 26% of tonnage on order in 2007, that number fell to around 2%, at the same time as hundreds of one ship KGs becoming insolvent.
Post 2008: Geographical Trends
Since the financial crisis in 2008 there has been a shift away from money being available in Europe. Whilst European banks had always lead the financing of the shipping sector, since 2008 there have been a number of factors that have contributed to a reduction in their influence.
Increased scrutiny of shipping loan books from the European Central Bank (ECB), in its supervisory role of Eurozone banks, resulted in a change in strategy by the European banks. Stricter risk management policies, regulation and supervision lead to a divestment of their shipping portfolios.
The collapse in the German KG funds meant German banks focussed more on clients they perceived to be less risky, as well as lending to domestic owners in preference to those based outside of the country. Germany’s HSH Nordbank for example, in 2008 had a shipping portfolio worth US$58bn, by 2013 this had been cut by 40%.
The other significant geographical influence has been the gradual elimination of shipbuilding in Europe, tending to leave only specialist yards such as those in Norway. With fewer shipyards the local financing of new build vessels dropped.
The decrease in European bank funding has been taken up by banks in the Far East, increasing by around 140% over the period 2010 to 2018, most significantly by the Chinese. The European share of the global ship finance market dropped from 83% to 58.7%, with the Far Eastern share accounting for 34.8%, in 2018.
Chinese growth was assisted by support for shipping and shipbuilding from Beijing. After 2008 the negative impact on the sector was significant with an increasing number of cancellations, resulting in Chinese shipbuilding coming close to collapse. Financing from Chinese Banks increased, with support from the Government, the objective being to minimise the number of cancellations at the same time boosting the order books for local shipyards.
Post 2008: Changing solutions
With the reduction in traditional bank lending post 2008, there has been a shift towards alternatives, especially driven by demand from smaller owners who found that banks, having to accommodate stricter regulatory requirements with tighter risk management, were now more focussed on larger borrowers.
These changes came at a time of low freight and charter rates, which meant that owners and charterers were looking for ways to reduce costs. They did this by not only, for example, improving the energy efficiency of existing vessels, but also by investing in larger and more energy efficient newbuilds.
In addition to traditional mortgage-based lending, finance sources now include:
- Bond markets – corporate/convertible bonds
- Mezzanine finance – used as top ups
- Equity markets – IPOs and follow on equity issues
- Private equity – which is becoming more important for medium term investments
- Leasing – including both capital and operating leases
- Export Credit Agencies (ECAs) – government support given to aid clients of local shipyards
Export Credit Agencies have played an increasingly significant role in recent years, the largest being the Export Import Bank of China (CEXIM), controlled by the Chinese Government. From 2013, with the Belt and Road initiative, Chinese banks and leasing companies have become even more active.
Aiding the growth, since 2005, the laws governing leasing companies in China have been amended several times to make it easier for them to conduct their business internationally. Since then, the barriers to setting up a financial leasing company have been lowered; the business scope has been widened by, for example, cancelling some foreign exchange restrictions; and, importantly, allowing Chinese leasing companies to establish both onshore and offshore subsidiaries that specialise in shipping.
Chinese leasing companies are now in a position to provide finance for vessels built in foreign yards. The result has been their significant expansion into the international arena. Before the crisis Chinese shipping lending was focussed on the home market, supporting Chinese shipyards and Chinese shipping companies. Now EximBank and China Development Bank are in first and second place, with Bank of China fourth, in the rankings of global shipping portfolios, dominating the top 40 banks that still operate in the sector.
With regard to other sources, the last successful shipping IPO was for Gener8 Maritime in June 2016, subsequently merged with Belgium’s Euronav in June 2018. At the same time, the Monaco-based Goodbulk owner and operator postponed its proposed IPO, due to “adverse market conditions”. Prior to that Navios Maritime Containers shelved its plans for an IPO.
IPOs generally in 2019 have continued to be abandoned, possibly a reflection of the global economy, not helped by uncertainty surrounding so-called “technology” companies (WeWork being the most notable, but probably more accurately described as a real estate company) and the continuing unrest in Hong Kong with its effect on deals in Asia. The exception of course is the unique Saudi Aramco IPO, although its size was reduced to reflect some lack of interest. Whilst still early days, its value has initially soared post float.
With less shipowners looking to Wall Street for capital, and with increasing caution from the banks, private equity, leasing and export finance look to be the alternative sources of funds needed to fill the gaps. The high returns sought by private equity funds may however limit their contribution to making up the shortfall.
A number of events and ongoing trends around the world have impacted the shipping sector this past year, and with it the availability of finance.
The ongoing US-China trade war has had a significant influence on global shipping, not least by causing increasing levels of uncertainty. Chinese imports and exports have suffered as a result of US tariffs. In an announcement in the last few days Trump claimed an “amazing deal” had been reached between the two countries, with the reaction from Beijing more muted. With a lack of detail, there are fears the deal will fail to resolve key underlying conflicts, with some experts predicting the truce will not last and even that the trade war may never be settled. Economic growth in China was only 6% in the third quarter of 2019, the lowest it has been for 27 years. Whilst this is still within government targets, it does still represent a significant slowdown. One of the measures introduced to tackle this has been to allow increased access to credit with a view to improving local business and investment.
Uncertainty is widespread, with Brexit being a major, drawn-out strain, especially for Europe over the last three years. In or out, extended deadlines, and deal or no deal, the uncertainty has made life very difficult, if not impossible, for any organisations needing to make medium to long-term investment decisions. With the December General Election over, and the Conservative Party gaining the majority needed to push the EU exit through at the end of January 2020, there is now slightly less uncertainty. However the terms of any deal still need to be agreed along with a transitionary period, and so unfortunately the Brexit contribution to uncertainty is not over, not just yet anyway.
The IMF World Economic Outlook in October 2019 was not encouraging for investment, observing that “the outlook remains precarious”: weak global economic activity, especially in manufacturing, with rising trade and geopolitical tensions leading to reductions in business confidence, investment decisions and global trade. With interest rates remaining at very low levels, the monetary tools that were once available to Central Banks to counter such downturns are also now severely restricted.
Hardly a day goes by without mention in the media of climate change, with its serious threats to health and livelihoods. Notable high profile current events include flooding around the world and the record temperatures and such disasterous consequences experienced in Australia. Extinction Rebellion climate change activists, Greta Thunberg Time Magazine’s 2019 Person of the Year, and others are successfully raising their profile around the world, drawing attention to the irreversible consequences that will follow if counter measures are not adopted in the near future. This year’s UN climate conference, COP25, has just concluded in Madrid, the aim of which was to finalise the rulebook of the Paris Agreement. Consensus was not reached in a number of areas, many matters being delayed until 2020, with the UN General Secretary expressing disappointment about a missed opportunity. Regardless of the differences seen between the developing and developed world, climate change will undoubtedly have a major influence on shipping in the future.
Although it has taken a number of years to implement, IMO 2020 with its low sulphur fuel requirements has been influencing investment decisions in the maritime sector for some time now. It too has also brought with it uncertainty: over fuel prices and availability; the acceptance or not of different scrubber technology in various ports around the world; and the impact all of this will have on future freight rates.
The so-called Basel Standards are the post-2008 minimum requirements that apply to all internationally active banks, the response of the Basel Committee on Banking Supervision, the aim of which being to address the shortcomings of pre-crisis lending. They are designed to provide a regulatory foundation for a stronger banking system. These standards relating to the capital requirements of banks impact on, for example, attitudes to credit risk and operational risk, which in turn affect decisions by banks on whether or not to lend, who they lend to and on what terms.
Higher capital ratio criteria and other central bank regulatory requirements, including those defined by the EU, have resulted in a restriction of funds being available to the shipping sector, especially from Western banks. This situation has been aggravated by a desire by those same banks to reduce their existing exposure to shipping, the result of high volatility and disappointing earnings. More recently, banks have increasingly favoured the earning of fees rather than interest, lending only against low risk assets, and from services, in other words, a move to quality as against quantity.
Contrary to this, compared to banks, Far Eastern leasing companies are relatively unregulated. Although they are still attentive to quality, the emphasis is more on “commodity” financing, where higher volumes and standard terms are typical.
Bank lending now appears to favour only the most creditworthy customers, and those with long standing relationships. Whilst cash flows and security have, and always will figure in lending decisions, the perceived quality of a client has come to the fore. This means banks are taking a closer look at strategy, management experience, track record and the financial stability of a potential borrower, including ownership, support and access to other capital.
In its latest annual survey, Petrofin has observed that the top 40 banks’ lending stood at US$300.7bn at the end of 2018 (having been reduced by US$44.3bn over the previous 12 months), the lowest level since it started monitoring the global portfolio in 2008. France and Greece have however seen a gradual increase in lending.
As mentioned above, IMO 2020 relating to low-sulphur fuel, along with other initiatives such as those relating to ballast water management and the Hong Kong Convention on the Recycling of Ships are evidence of a movement and awareness that is here to stay and is growing. Climate change is considered by some banks as a challenge to the financial system. The Poseidon Principles, developed by a number of the largest banks in shipping finance (representing a loan portfolio of around US$100bn, or about 20% of the total) in conjunction with some of the largest ship owning companies, are designed to ensure climate considerations are taken into account when making lending decisions, the aim being to promote the decarbonisation of shipping.
Efforts have been made to persuade Asian banks and governments to join the initiative and, although initial responses have been promising, it still remains to be seen whether they will sign up to the framework.
Not only is climate change influencing bank finance, but also the same principles are affecting the investment decisions of asset funds – both where to invest new money as well as whether or not to stay with those companies deemed to be “less green”. The effects of climate change are now much more visible to consumers, and over time this will increasingly affect supply chains, and in turn both methods of shipping and the places of manufacture of those goods demanded by increasingly aware and sensitive customers.
With vessel prices rising, partly the result of regulatory demands such as for environmental reasons, shipowners have been increasingly looking to leasing as a means to free up capital whilst still being able to operate and trade as owners. Chinese financing, especially for Chinese built vessels, has become increasingly important in this regard. With traditional mortgage based lending not available to many shipowners, particularly the smaller to medium sized owners, leasing continues to grow in popularity. Not only this, but Chinese financing for locally built vessels has also been given an additional boost from the support felt necessary by Beijing following the slowing down of the country’s economy.
China’s role in global shipping has in recent years been most visible through its influence as a major importer and exporter of dry bulk commodities. Not only does China manufacture 90% of the world’s containers, the throughput of cargo and containers has been the largest in the world for a number of years.
One of the most publicised initiatives has been the development of the new “Belt and Road”, launched in 2013, a 21st century version of the original “silk road”.
Over the last few years there has been major funding of infrastructure from Asia through to Europe. The maritime “silk road” has seen significant investment throughout, notably with the acquisition of a majority share in the Greek port of Piraeus. The largest port in the Mediterranean and the third largest in Europe, China first took an interest at the beginning of the Greek Debt Crisis, by leasing two terminals for 30 years.
There is however growing public sentiment against the Belt and Road Initiative (BRI), with India being the first to argue that the BRI was a debt trap for smaller countries, the aim they said being to further China’s geopolitical interests. Most Western powers now support this view. The US Secretary of State recently described the BRI as “predatory economic activity”.
The BRI does however continue to impact global shipping. During a visit to Greece in November 2019, President Xi announced a US$660m investment to further develop Piraeus, the intention being to transform it into the biggest harbour in Europe and the most crucial transit hub for trade between Europe and Asia.
According to UNCTAD, the China merchant fleet increased from 183 mDWT to 206.3 mDWT, i.e. 13% from 2018 to 2019. At the same time its role in shipping finance has also continued to grow. The Chinese banks are increasingly more outward looking and improving and streamlining their loan structures. This has made them a favourite source of finance amongst the world’s leading shipping companies.
2020 and beyond
Climate change is one of the biggest challenges currently faced by mankind. With public awareness and concern continuing to grow, and with increasing pressure on countries around the world to reduce their emissions, it seems likely that tighter restrictions and regulations will continue to impact not only shipping but all business sectors over time. In May of this year, the IMO MEPC 74 session approved amendments to strengthen existing mandatory requirements for new ships to be more energy efficient; initiated the Fourth IMO GHG Study; adopted a resolution encouraging cooperation with ports to reduce emission from shipping; approved a procedure for the impact assessment of new measures proposed; agreed to establish a multi-donor trust fund for GHG; and agreed terms of reference for intersessional working groups in order to expedite the work. The International Chamber of Shipping – which represents 80% of the global shipping industry – is proposing a levy of US$2 per tonne of marine fuel purchased for consumption by shipping companies worldwide. The funds raised would be used to finance an International Maritime Research and Development Board (IMRB). The IMRB would be overseen by IMO Member States, its aim being to accelerate the development of commercially viable zero-carbon emission ships by the early 2030s, “to pave the way for de-carbonising shipping”. Clearly the maritime sector can expect its costs to rise over time as these various initiatives are implemented.
The introduction of new technology will impact not only the vessels themselves, and their costs, but also everything that surrounds them, from the creation or elimination of jobs, energy demand, business models and the ways in which value is created, through to the systems and processes that enable global trade to function. Smarter ships are initially likely to cost more, however to counterbalance the capital costs we can expect to see increases in efficiency and a lowering of relative operating costs, with financing models responding accordingly. Although vessels themselves will always be needed to transport goods between ports, their role in the value chain and possibly their ownership structures will change. As data becomes increasingly available, supply chains will develop in response, with all parties up and down those chains making best use of that data.
Unfortunately, uncertainty will not be going away. Brexit for example continues to impact decision making in the short to medium term as the consequences of the terms of the UK’s exit play out during the transitionary period. Similarly, uncertainty surrounding China’s relationship with the rest of the world continues. The tit for tat measures seen between the US and China have no sign of disappearing. Just recently, ahead of trade discussions between the two countries, Beijing has ordered all government offices to remove any foreign computer equipment and software within the next three years. Uncertainty about future volumes of trade serve to increase the risk associated with investment decisions.
Geopolitics also figure in those decisions – from the ever present tension in the Middle East, China’s claims and manoeuvring in the South China Sea, through to the US presidential elections coming in late 2020. Off to an immediate bad start, the Middle East has seen attacks and counter-attacks from the US and Iran, with an immediate impact as well as uncertainty for the future over the price and transporting of oil.
Such uncertainty not only makes long term decision making more difficult, it will no doubt have a direct impact on the financing of vessels. Along with an increased sensitivity to climate change, when making lending decisions banks will take into account the risks faced by ship owners. It seems likely they will increasingly favour the stronger, bigger candidates, with proven records to ride out the ups and downs that are likely to come over the next few years. And with China having accounted for much of the recent growth in ship financing, especially leasing, it remains to be seen how its relationship with the rest of the world will affect its willingness to continue replacing those traditional finance sources which are likely to carry on contracting over time.
A few words about CompassAir
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