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Sai S. Devabhaktuni, Gregory Kennedy
In spite of the current woes in the shipping industry, including a significant erosion of value and a glut of new vessels, we see the potential for a brighter future on the distant horizon – especially as the order book of new vessels begins to shrink and emerging market growth provides a much-needed driver of demand.
As a result, select opportunities to buy the debt of operators or to buy portfolios of vessels at prices below their intrinsic value are now available to informed investors – and could offer attractive long-term returns. Capitalizing on this anticipated rebound, however, requires patience, dedicated long-term capital and a strong understanding of industry fundamentals and maritime restructuring dynamics. These waters demand careful navigation.
A brief history of the voyage to today’s marketThe global shipping industry is in the midst of its worst cycle since the 1980s. A recent Bloomberg article highlighted that “the combined market value of the world’s 80 biggest publicly traded shipping companies plunged by $101.7 billion in the four years to March 23, 2012.” What caused so much value destruction? The combination of an excess supply of new vessels that were financed at the peak of the market and a global recession from which there has been an uneven recovery has led to persistently low charter rates and plummeting ship values. In its wake is nearly $500 billion of debt, the overwhelming majority of which is held by European banks.
Over 90% of world trade activity depends on the shipping industry’s global fleet of 58,000 ships, according to Clarksons and J.P. Morgan. The fleet includes tankers, dry bulk ships, container ships, chemical tankers, liquefied natural gas (LNG) tankers and other cargo ships across what is a highly fragmented industry. As the global economy expanded and international trade increased after the end of the Cold War, world seaborne trade increased by nearly 50% from 1990 to 2000, from about four billion tonnes to six billion tonnes annually, which helped the shipping industry recover from the vessel oversupply it faced in the 1980s (see Figure 1).
The global shipping industry has long cycles and was historically driven by demand and GDP growth in developed economies. But by 2003, demand from emerging economies like China began accelerating, which pushed global seaborne trade to over eight billion tonnes by 2008. China’s demand for coal and iron increased nearly 20% per year from 2004 to 2011, and the country is now a net importer rather than exporter of coal. This insatiable emerging market demand, combined with increased prosperity due in part to the credit bubble in developed markets, led to a vessel shortage, driving shipping rates to new highs (see Figure 2).
The shipping industry responded to these historically high shipping rates by ordering what turned out to be an excessive number of vessels. From 2003 to 2008, over $800 billion of new ships were ordered, with half of the orders placed in 2007–2008, when vessel prices were at their peak, according to Clarksons. During these boom years, bank lending was widely available for new ships, as banks offered financing of up to 80% loan-to-value (LTV) for new vessels (versus 50% to 60% today), leaving little margin for error in vessel values. Most of those vessels were scheduled for delivery in the years immediately following the financial crisis of 2008–2009, compounding the oversupply issue.
Rough seas follow the expansion As a result of the order book overhang resulting from overly optimistic expectations of demand (i.e., volume) growth, shipping rates have faced persistent headwinds from net new vessel deliveries at about twice the rate of shipping demand growth during the recovery of the past few years (see Figure 3). With the exception of the under-fleeted LNG tanker market, all three major shipping categories (bulkers, tankers, containers) have been suffering from a supply glut. This, combined with higher fuel costs, has led many shipping companies into financial distress.
Because of new vessel deliveries over the past three to four years, the global fleet is fairly young, which means there are not as many older ships available that would typically make economic sense to scrap. And while delivery slippage of the order book and cancellations help to slow the supply of new vessels entering the market, there is an incentive for shipyards to maintain their order backlog. Shipyards have historically tried to maintain “full employment,” which is an elegant form of state capitalism, and this has led to lower new ship prices as shipyards compete for a diminishing number of new orders. As vessel values have continued to fall (see Figure 4), banks that finance the industry are increasingly faced not only with distressed borrowers, but also decreasing value for the collateral that secures their loans.
Banks work with companies to keep them afloatShipping bank debt is typically very illiquid, as it is not widely syndicated and is usually tightly held by the issuing banks. These banks have traditionally dictated the financing options of the industry. When the shipping industry faced oversupply in the 1980s, banks foreclosed on vessels of overleveraged operators. But this often left their loans impaired as they sold ships into a depressed secondary market.
More recently, banks have taken an approach to help shipping companies weather the storm by providing covenant and debt amortization relief. This can make the motives of banks similar to that of equity holders in that they are incentivized to preserve the optionality that rates and asset values will turn around. This potentially avoids banks having to foreclose on ships or restructure their loans into equity, thus avoiding crystalizing losses. The extent to which banks will work with operators is not only driven by each unique situation, but also by how well capitalized the bank is, how committed they are to lending to the industry going forward, and how well they underwrote their current loan book. Each bank faces unique challenges and opportunities based on those and other factors.
Despite the shipping industry’s high fragmentation, it is financed by a relatively small number of banks. According to Petrofin Research, there is about $500 billion in shipping debt. Of this:
Although banks have worked with ship owners through this down cycle, they have also pulled back from financing the industry, with the top 10 banks reducing their shipping loan book by over $50 billion since 2008, according to Marine Money. Petrofin estimates a funding requirement of over $100 billion over the next three years for the industry, as Clarksons estimates the current order book stands at about $300 billion. Investors have lined up to take advantage of the opportunity this gap presents. But with several mechanisms at their disposal to prevent them from taking losses on shipping loans, most banks have been reluctant to sell them on a large scale at distressed prices. This dynamic has led to a wide “bid-ask” between banks that are interested in reducing their shipping loan exposure and private capital that is interested in buying it from them.
While the “bid” that new investors are willing to pay is unlikely to go up without improved fundamentals, the “ask” at which banks are willing to sell could come down as time goes by. Among the catalysts that could lead banks to more aggressively sell their shipping loan exposure are tighter capital rules under Basel III and other regulatory rules for capital adequacy. As banks have to increasingly comply with these rules, holding onto shipping loans becomes more expensive, which could lead them to sell more of their distressed loan exposure.
In the meantime, it is important for investors to note that because traditional shipping bank groups may not have the same motives as distressed investors in a restructuring, banks could drag along the group into solutions that protect their book value and ship lending franchises. As a result, investors need to understand which rights they can enforce when purchasing shipping bank debt, as they may not be able to effect their intended strategy.
Navigating the treacherous waters of shipping restructuringsThe combination of maritime law, complex international corporate structures and the capital-intensive nature of the shipping industry can create very challenging restructuring scenarios. Unplanned bankruptcies can be expensive and complex, as maritime law requires that vendors and other creditors be paid or they can physically arrest the asset (i.e., ship). As a result, shipping companies in bankruptcy must ensure that creditors are kept current to avoid business disruptions. When combined with likely negative unlevered cash flow heading into bankruptcy, bankrupt shipping companies often need significant post-petition financing to fund their operations. This debtor-in-possession financing (DIP) primes the existing “pre-petition” bank debt, forcing banks to either lend companies more money or face subjecting their loans to subordination by a new lender in bankruptcy.
Another restructuring consideration is the jurisdiction in which it occurs. Depending on where a shipping company files for bankruptcy, investors could face very different restructuring regimes (including but not limited to U.S., English, Dutch, Greek, Marshall Island and Liberian law). Some shipping companies with virtually no ties to the United States have recently filed for Chapter 11 protection in the U.S. in order to prevent lenders from foreclosing on their ships and liquidating their assets (for example, Marco Polo and Omega Navigation). There may be few insolvency regimes that allow a shipping company to reorganize its vessels and its operations throughout the world. For example, Dutch law only protects assets in the Netherlands; Greek insolvency law, Marshall Island and Liberian law do not allow reorganization as a practical matter. In some European jurisdictions, significant value can be distributed to junior creditors, equity holders, and employees, diluting the value that banks can recover. As U.S. bankruptcy law is considered “pro-organization” when compared with other European jurisdictions, it is likely that other shipping operators will follow suit. Understanding the jurisdiction in which a particular shipping company would restructure is critical to anticipating potential investment outcomes.
Opportunities for patient capitalIn addition to competitive challenges, shipping companies face risks such as shifts in the supply/demand of the underlying transported goods, developments and changes in seaborne and other transportation patterns, geopolitical volatility, labor inflation, management of the increase in fuel costs, natural disasters, terrorism and international hostility, acts of piracy, increasing insurance premiums and compliance with international environmental and safety standards as well as regulatory developments.
However, given the current low point in the cycle, downside risks are likely minimized in the shipping industry for new lenders and investors. Vessel values are depressed by rates that are sometimes below owners’ operating costs and by an oversupplied market that suppresses secondary market values. While the order book is not as daunting as it was three years ago, there is more capacity to be delivered and the convergence of supply and demand is still out of view.
Capitalizing on these multi-year opportunities requires global resources and a patient and informed approach to each unique situation. At PIMCO, we seek to understand the interconnectedness within and among numerous industry verticals to assess the best opportunities within a particular value chain. We believe a patient and protective approach, with an adequate margin of safety, is warranted when investing in the transportation sector in general and in the shipping vertical in particular.
Biographies Mr. Devabhaktuni is an executive vice president in the Newport Beach office and head of corporate distressed portfolio management. Prior to joining PIMCO in 2012, he was founder and managing principal of Monocle Group LLC, an investment firm focused on opportunities in stressed and distressed securities, post-reorganization securities and special situation equities. Previously he was one of three managing principals for 12 years with MHR Fund Management LLC, a New York-based private equity firm specializing in the distressed securities market. Earlier in his career he was an analyst with Highbridge Capital Management LLC and Nomura Securities. He has 19 years of investment experience and holds an undergraduate degree in economics from The Wharton School of the University of Pennsylvania.
Mr. Kennedy is a vice president and distressed credit analyst in the Newport Beach office. Prior to joining PIMCO in 2010, he was a principal at Redrock Capital Management. Previously, Mr. Kennedy was an associate in the investment banking division of Goldman Sachs and a senior consultant with Deloitte Consulting. He has eight years of investment experience and holds an MBA from the University of Chicago Booth School of Business and an undergraduate degree from the University of Florida.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2014, PIMCO.
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