^Four Factors of Production. Image Courtesy of Constantine Pankin at ShutterStock.com
The Importance of Finance in Shipping
In order to start the production of any kind of goods or services, you need four main essentials. Capital, land, labor, and enterprise. Economists refer to these as the four factors of production.
As an entrepreneur, you do possess an enterprising nature. But in order to acquire land and labor, you need capital. For most business ventures therefore capital is often the starting and the most vexatious point.
Now, shipping is amongst the most capital intensive of industries. LPG tankers cost hundreds of millions, warships even more. The U.S. Navy’s mammoth aircraft carrier USS Gerald Ford will cost over $13billion.
Unsurprisingly, capital repayments form the largest chunk of cash flow of shipping companies. Again, shipping companies do not normally comply with a shrewd banker’s criteria of predictable returns, defined ownership, transparent dealings, and codified financial framework.
Assets are mobile, revenues volatile, and return on investment (ROI) lower than the market average. Ship values can change by a staggering 60% over a few months. Shipowners can make or lose a fortune in a short duration. Banks can lose fortunes if they back the wrong client.
Despite all these deterrents, shipping is blessed with an oversupply of funds. This is a mixed blessing for although excessive investments make funds available for this capital hungry industry, they also intensify the boom and bust economic cycles of shipping.
Debt Finance i.e. loans from bank is the most widely used method for financing the purchase of ships. Equity Finance or the sale of stock / shares is also used and so is Lease Finance. Mezzanine Finance i.e. mixed debt and equity is rarely utilized in practice.
So what is it about ships that attracts many? What are the risks involved in shipping? And what are the different types of funding methods available to shipowners in view of these peculiar conditions?
Economic cycles of shipping present the greatest risk. Shipping derives its demand from the global economy. An infinite number of factors lend the global economy and, by extension, shipping a capricious character.
When the global economy is doing fine, people make money and spend it. This spending creates demand for goods and services. Ships transport over 90% of the globally traded merchandise. Global boom is thus beneficial for shipping.
Increased demand hikes the freight rates and ship prices making investors flood the shipping market. But none can predict the exact demand in the future. Inevitably, there is over ordering of ships and supply soon exceeds demand.
Overcapacity causes a fall in freight rates and ship prices. Shipowners look to sell or scrap their ships. Again, there is over scrapping that makes demand overtake supply. The cycle continues. Each cycle is unique making it tough to predict their durations and severity.
Risks involved in shipping include:
- Economic Risks: shipping is geared to the fickle global economy more than any other industry
- Market Risks: related to shipping cycles are particularly severe because these cycles balance demand and supply in uncertain conditions of the present and future
- Operational Risks: include the breakdown of ships and bad weather that affects voyage. Mid-sea breakdowns are particularly expensive and time consuming
In order to minimize risks, top financers and shipowners understand each other and the peculiar features of each cycle before moving ahead with their plans. Banks usually back companies who buy when ship prices bottom and sell when prices top.
Evolution of Shipping Financial Models
In early 20th century, major European governments started to offer easy credit to shipping as they discovered the link between shipbuilding on one hand and economy, defense, strategy, and employment generation on the other.
With an increase in the size and price of ships, individual owners gave way to joint stock companies. Before the 1950s, most shipowners did not borrow for purchasing and operating ships using their reserves instead. Although safe, this model did not expand shipping or attract investors.
Rapid rise in demand for ships due to massive expansion of raw material trade in the 1950s made cargo owners contract shipowners for large, specialized ships over the long term. Such a system was non-speculative because you could not use these ships for other purposes.
This was Charter Backed Finance. It lasted till the early 1970s when economies of scale (i.e. using larger ships to reduce transport costs) peaked and when bulk trade in iron ore and crude oil started to shrink. Inflation and breakdowns also proved disastrous for shipowners.
Then came the Asset Backed Finance wherein shipowners borrowed with the hull as collateral. This somewhat diluted the link between supply and demand. Under charter backed finance, owners borrowed only if there was a demand placed by the market.
With shipping thus opened for speculation, there followed excessive ordering of tankers that was further fueled by the Oil Shock of 1973. The same happened with other ships in the early 1980s. The bust that followed lasted deep into the 1980s.
Now that ships were available at throwaway prices, many speculative, non-shipping investors arrived on the scene to profit from the buy-low-sell-high model. This was the Asset Play Model of the late 1980s. Through all these tumultuous times, shipyards offered credit to large clients.
Shipping Finance: Avenues & Flow of Funds
Companies, investment managers, and private investors invest their funds in capital markets (long term debt), money market (under one year debt), private placement (directly to the borrower), and equity market (public stock exchanges).
Merchant or investment banks, mortgage banks, commercial banks, leasing companies, and finance houses then channel these investments to the shipping companies. These companies also use a part of their retained earnings for finance.
Those with funds can either lend their money as debt or equity. Debt is a loan with relatively low interest rates. The borrower has to pay back in fixed installments irrespective of whether he makes money.
Banks or other lenders do not get a share in the profits because they are not part owners. This is precisely why banks are so interested in your vessel’s value during slowdowns. They are not much concerned of how much you make during booms because their returns are fixed.
In equity finance, the borrower sells shares to investors who become part-owners of the ship and/or the shipping company. The borrower is not under the obligation to pay dividends immediately. This is very comforting during slowdowns when ships don’t make great returns.
Debt is somewhat inexpensive but you have to pay back or face foreclosure i.e. confiscation. Equity is expensive and complicated to obtain. Moreover, large shareholders are seasoned investors who may take control of the ship or, worse, the shipping company.
Debt: is the favored way of financing ships. It can be:
- Commercial Bank Loan: is the most common method of financing ships. Five important aspects of the loan arrangement are the:
- loan period (5 or 7 years etc.)
- bank fees
- interest rate
- collateral (security)
- security conditions
Borrowers usually create one shipping company per ship for obtaining the loan and provide the bank with the rights of first mortgage i.e. the bank gets priority rights over the vessel in case of default and does not have to share the vessel with other lenders
Banks normally lend 50-100% of the calculated value of the vessel. Large companies find it frustratingly slow to borrow against individual ships. They borrow as a company using their account statements as collateral
Large loans involve loan syndication i.e. borrowing from numerous banks. Under the asset sales system, banks may sell the shipping loan, partly or totally, to other banks
Bond Issue: by selling bonds in the capital markets. Is available for borrowers with good reputation, high credit rating, clear corporate structure, and persuasive strategy. Investment banks handle this lengthy, cumbersome process
- Shipyard Credit: shipyards offer credit for newbuilds because commercial banks usually do not. Banks will think of lending only if the shipping company has a long term contract with the cargo owner that specifies the returns over the long-term
Purchasing new ships is many times more expensive, and therefore more risky, than buying second hand ones. Plus, the borrower needs the funds quickly. Commercial banks do not normally lend large amounts quickly
- Private Placement Debt: borrower gets this loan directly from insurance companies, pension funds, and leasing companies. Such debt is expensive and available to creditworthy borrowers with a good sales story
Benefits include long repayment durations, fixed interest rates, and non-confiscation of the borrower’s personal assets in case of default
Equity Finance: pension funds and insurance companies are the most significant equity investors. Such finance can be:
- Owner Equity: the owner raises equity through his own savings, retained earnings from his other ships, or direct investment by family and friends
Public Offering: involves sale of stock / shares at stock exchanges such as New York, Singapore, Oslo, Stockholm, and Hong Kong. Liner companies are most suited for such fundraising
A complex process, public offering requires 10-15 weeks of work. Investment banks do this for you charging about 5% in fees. Using this method, you can raise capital at any time. You have to issue a large number of shares for this to work though
- Ship Fund: is a special investment vehicle that raises finance through private placement i.e. direct interaction between the borrower and a few wealthy investors
Normally, investors look to purchase ships at low price and sell high. The lack of clarity and the practice of treating ships as pure commodities limit its utility
- Limited Partnership: such as the Norwegian K/S Partnership that was popular in the 1980s. Returns were tax free if investor-partners reinvested the ROI within a specified duration
Lack of regulation and transparency caused it to fail in the early 1990s. But they did partly finance the shipping boom in the late 1980s
Lease: is similar to renting out properties or machines. The owner (lessor) allows the lessee to use the ship in return for a fee. The lessee returns the ship to the lessor at the end of the term. Leases can be Finance Lease or Operating Lease.
Most shipping leases are finance leases. These operate over the long term. The lessor is only the financer-owner. The lessee operates and maintains the ship. If the lessee cancels the lease, he has to compensate the lessor.
Governments encourage ship leasing via tax incentives for lessors. The lessee may benefit through lower rent. The main merit is the low-cost, long-term finance available for 15-25 years that most commercial banks will not provide.
On the downside, lease finance is available only for top shipping companies because lessors are wary to lease ships to unproven lessees. And, tax laws might change. All this necessitates complex paperwork.
Mezzanine Finance: is mixed debt-equity. You raise finance via debt with the possibility of converting it to equity for the lender at a later date. This is usually available through private placement. This is not widely used for financing ships.
Return on Investment (ROI) & Shipping’s Investment Paradox
Fickle demand, slow supply adjustment, and their dependence on umpteen factors make shipping a risky yet low return business. Return on Investment (ROI) for shipping is given by:
- 0 & 1: respectively stand for the start and end of the Investment Period
- R: Trading Cash Received during the Investment Period
- DP: Depreciation of the Ship / Fleet
- MV: Market Value of the Ship / Fleet
- R1 – DP1 is the Trading Profit / Loss i.e. the revenue earned by trading the ship on the time or spot market
- MV1 – MV0 is the Asset Play Profit i.e. the change in Market Value of the Ship / Fleet
A fresh fleet makes more trading profit because of low operating costs. High capital costs however reduce their ROI. Old fleets generate low trading profits but have less capital invested. The key is in finding the right mix of ships for the fleet.
This makes shipping a high-risk and yet low-return business where the ROI (about 10%) is lower than in most other sectors. But the assets (ships) are large and easily trade-able and entry-exit is simple.
Few can actually predict shipping cycles correctly. These few good men and women buy ships at low prices and sell them when during price peaks. It is this prospect of becoming billionaires that attracts investors despite the volatility and low ROI.
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