Alternative Funding Solutions for Dry Bulk
By Co-Founder & Chief Investment Officer, Soo Cheon Lee
Marine Money – August/September 2015
Given the current ill health of the dry bulk industry, it would be hard to criticize financiers if they decided to give it a wide berth. But, for those with an appetite for creative lending to distressed situations, alternative shipping finance is an exciting area for both growth and opportunity.
With the Baltic Dry Freight Index bumping along at all-time lows since earlier this year, it is clear the industry is in a particularly severe cyclical downturn. China’s well-documented growth slowdown only tells us half the story of weaker global trade. On the supply side, the industry is awash in dry bulk ships.
As shipping rates have collapsed, there is not a corner of the industry — from shipyards to operators and owners — that has escaped the pain. As the industry battles to put its fundamentals back on a surer footing, this has led not just to a number of bankruptcies, but has also resulted in the scrapping of ships, and the shrinking of order books and conversions from bulker to container or tankers.
An added challenge is dealing with an ongoing upheaval in shipping finance that has made funding more difficult, particularly at the distressed or riskier end of the spectrum. Initially, there was a retreat by major European lenders following the global financial crisis. Today, most banks — European or not — now typically only lend 50% to 60% of loan to value, down from a pre-crisis average of 80%-90%.
Now, many global banks are again coming under pressure to reassess their shipping exposure as the arrival of Basel III regulation effectively makes marine lending less profitable by requiring higher regulatory capital buffers.
Although in recent years private equity and large Asian banks have entered shipping lending, distressed situations are rarely their sweet spot. Private equity typically needs to find capital appreciation in its exit, which shipping and fund cycles often do not meet.
The result is that the funding required to allow industry players — from ship owners, operators to shipyards — to regroup and weather the current cycle can be difficult to find. This is where alternative shipping finance fills the gap.
In general, SC Lowy prefers to get involved where there is a liquidity issue at the heart of the business failure or problem.
This often involves providing loans for working capital or investment purposes. Typically, we will work with management to agree on a viable business turnaround plan, including capital restructuring.
Our underlying mode of operation is not based on seeking to speculate, but instead for a risk-adjusted return on investment. To achieve this, we look to get involved in lending situations where we have real insight and can add value to the process.
In addition to rigorous financial analysis, this usually comes from being able to make prudent judgment calls and pricing risk based on our longstanding expertise and relationships in the industry.
Closing transactions also requires the capacity to move quickly and the ability to achieve client trust to provide confidential and un-conflicted advice. Being able to bring co-investors into deals we lead also adds flexibility to scale-up when necessary.
One of the major areas of distress currently in dry bulk is loss-making lease arrangements where shipping companies’ long-term charter-in rates become uneconomic, when the spot rate moves below the charter rate.
The solution would be for the ship operator to buy out the contract to compensate ship owners via what is known as “damage claims.” However, when shipping firms are financially challenged, this is often not an option, risking a worst-case outcome of liquidation for the ship operator and right-off losses for the ship owner.
Bankruptcy is never in anyone’s interest. Vessel owners rarely want to resume operation of its assets and become ship operators, as that is not its core business; they do not want to be maintaining and operating ships, and neither do they have the necessary customer relationships.
In such a situation, the alternative finance solution is to seek monetisation of “damage claims” which is achieved by purchasing the claims at a discounted price to face value. A risk-adjusted price is calculated after carrying out diligence on the company and assessing the wider likelihood of recovery.
This transaction enables a liquidity infusion that can either be used for working capital, to buy new vessels, or to lease new vessels at current prices that are financially attractive.
A great illustration of how this type of financing can be successful is the case of Korea Line Shipping. Here, SC Lowy assisted with the turnaround of the company through an $85 million debtor-in-possession financing (a special form of financing provided for companies in financial distress, including those under Chapter 11 bankruptcy protection in the US). The financing helped the carrier continue its long-term contracts with Posco, Kepco and Kogas, and ultimately led to a successful merger & acquisition. Another example is where SC Lowy led a similar exercise with South Korean bulker operator STX Pan Ocean. In STX, through a court-assisted process, damage claims were converted into debt and immediately tradable equity, following which a successful M&A transaction ultimately paid out the debt portion in cash in a relatively short period of time.
Another area where alternative funding can help is when shipyards are involved in contracted new vessel builds, and purchasers walk away from their contractual obligations.
This can give rise to situations where a ship might be 70-80% complete but, until it is finished, it is effectively valued as scrap. There is an opportunity here to provide specialized bridge financing for completion. This is achieved via the lender — in this case, SC Lowy — taking security over the asset, plus some form of equity upside on the resale value of the vessel. Here due diligence would also include assessing the time-frame to complete the newbuilding, as well as projected market valuation of the vessel at such time. This type of financing can also be done working in partnership with the ship owner who may want to complete the build, yet may not have 100% funding available.
Another area for opportunistic financing is tanker conversion, which seeks to arbitrage the divergent fortunes between dry bulk and the more resilient tanker market. If ship owners need funding for conversion, we will look at this opportunity as well. This phenomenon is not completely new, but a reversal of the trend we saw 5-6 years ago when tankers were being converted to dry bulk.
Any risk assessment must also include calculating the time-frame of conversion before the asset is generating income again, as well as the complexity of the process. It is generally a larger undertaking to convert dry bulk, given that tankers have higher specifications, such as double holds. Then there is the question of whether the strength of the tanker market is going to last over the period during and after conversion. To manage risk, we will seek a guarantee from the shipyard on completion or, if appropriate, will add some specifications to the refit to enable the vessel to be chartered.
While this type of alternative financing is at the more complex end of the scale, there is robust demand given the amount of idle capacity in the current market.
Another opportunity to meet an unmet financing need is in the area of ship repair. This arises because there may be a timing gap of some years before insurers will pay out funds due to the number of parties or complexity involved in a claim. For instance, there can be multiple cargo owners — as well as vessel owners and operators — all engaged in the process. This could involve as many as 10-20 different parties.
Alternative financing can help by providing funds to bridge the timing gap between the claim filing and insurer payout. This allows vessel owners to obtain immediate working capital so that, while vessels are idle, they can undergo enhancement or repair. Here, risk assessment requires analyzing the vessels’ underlying customers and contracts. A notable example where SC Lowy entered this space was with MSC Flaminia, which suffered a fire in its cargo hold that left it heavily damaged. SC Lowy stepped in to provide financing prior to insurance claims being paid so that the owner could quickly return the vessel to its fleet. Not only was the MSC Flaminia repaired, after consultation with the different stakeholders involved, it was modernised and upgraded to an eco-friendly vessel.
Another important area where alternative financing can strengthen the shipping industry is by developing a robust secondary market for stressed/distressed debt. This can assist the shipping industry in two ways. Firstly, a secondary loan market helps release bank liquidity by allowing banks to sell their stressed/distressed loans, thereby freeing up capital for new lending opportunities in the shipping sector. Secondly, such loan purchases are typically part of a process where a loan repayment plan is worked out with the borrower’s management and shareholders to revive the company. Alternative financing investors are typically in a better position to achieve such positive outcomes due to their greater flexibility than bank workout teams.