Shipping, defined for the purposes of this article as a business that generates revenues from vessels that can propel themselves on water, is a capital-intensive industry, where depending on the type and size, a single income-producing asset (i.e. the ship) can cost tens of millions of dollars. Traditionally, many shipowners have financed the construction of new ships and the purchase of second-hand ships with bilateral loans provided by their relationship banks (many of them based in Europe). Because shipbuilding is a lucrative, labor-intensive industry supported by countries like China and South Korea, financing has also been made readily available by shipyards, often together with financing or credit support provided by their governments in an effort to boost job creation.
In the past decade or so, however, many banks that had been active in the shipping space have started to cut their exposure or outright exited from the sector. Regulatory pressures, precipitated by the global financial crisis, and a slowdown in overall world economic activity and trade (which has affected the shipping industry) have made it difficult for some of these banks to maintain profitable operations in the sector. Currently, there appears to be a gap in the supply of available capital to the shipping industry, which has created an opportunity for non-traditional capital sources, such as hedge funds, private equity and/or private credit funds.
We at Seward & Kissel have recently assisted a number of private funds both here in the United States and Europe on timely debt investments taking advantage of this market dislocation. This article is intended as a primer for ship finance and will examine (1) the typical ship finance loan structure and terms, (2) downside risks unique to ship finance loans and mitigants, (3) deal structuring considerations and (4) what private funds can offer to shipping companies in these types of investments.
Anatomy of Ship Finance Loan
Ship finance loans generally follow a similar structure. A ship finance loan at its core is an asset-based financing and has many of the same elements and techniques as project finance financing. Below is a summary description of a typical structure supporting the construction or purchase of a single ship.
- Borrower Structure
A shipowner sets up a bankruptcy-remote special purpose vehicle (“SPV”) to own a single ship — popular jurisdictions include the Marshall Islands and Liberia for ship registration and tax purposes. The SPV typically does not own any assets other than the ship, contract rights relating to the ship and bank accounts.
- Tenor and Amortization
A ship finance loan usually takes the form of a term loan and amortizes more like a term loan A than a term loan B – for example, amortization on a 10 to 12-year profile is not uncommon (as opposed to a typical 1% amortization in a term loan B). While deal-specific, the tenor can be longer than a typical 6 to 7-year maturity seen in term loan B products.
- Security
A ship finance loan takes a fairly straightforward collateral structure – that is, a mortgage over the ship, insurance policies covering the ship, earnings and ancillary contract rights relating to the ship and bank accounts. A lender typically lends only a percentage of the asset value (a loan-to-value or “LTV” ratio). 50-60% is not an uncommon LTV ratio for a typical ship finance loan. Often, credit support from the parent of the SPV in the form of a guarantee is also provided and boosts the creditworthiness of the borrower.
- Financial Covenant
As the only real value of the borrower is in the ship, a ship finance loan almost always has an LTV maintenance covenant, and a valuation of the ship needs to be procured on a periodic basis to test this covenant. A lender also often requires a debt service coverage ratio covenant to ensure that the cash flow generated by the ship is sufficient to cover debt service.
- Ship Covenant
Needlessly to say, a lender has an interest in making sure that the ship remains fit to serve its purpose and generate revenues. A lender typically requires extensive information with respect to the maintenance and management of the ship, ranging from the ship’s insurance cover, its seaworthiness, timely payment of crew members and suppliers and compliance with classification society and flag state requirements.
- Employment Requirement
As the borrower’s only source of cash flow is the rental income of the ship, the lender looks closely at the current and future employment prospects of the ship. Employment of a ship is typically documented via a “charter” or “charterparty” – the ship that has a long-term charter at a favorable rate is much more finance-able than those that do not. Depending on the deal, a ship finance loan agreement contains varying requirements for the employment of the ship, which could be an outright requirement for a long-term charter, or some other metrics to ensure that the loan can be serviced and repaid.
Default Scenarios and Mitigating Factors
What can go wrong in a typical ship finance loan? Below are some examples of default scenarios and some of the protections available to the lender.
- Loss of, or Major Damage to, the Ship
As a real operating asset, a ship could sink or suffer a major casualty that involves a significant cash outlay for repair. A lender would require insurance coverage that is in excess of the lender’s loan amount, and in the event of a “total loss”, would be entitled to the proceeds of the insurance policy as a loss payee.
- Insufficient Cash Flow
The ship, even if on a long-term employment contract, may not generate enough income to service the debt. This could happen, to name a few examples, when an existing charter is terminated or not renewed, the ship is unable to get a new charter in the spot market, the ship has unexpected repair needs or the ship is “off hire” because it is arrested, for instance, by a bunker supplier that is unpaid. Often, a ship finance loan requires a certain amount of cash reserves (for example, $500,000 per ship) to be maintained — while not a perfect fix to a significant long-term issue, the reserves can satisfy the debt service while working out a solution.
- Decrease in Collateral Value
A ship has a limited useful life (let’s say, 15-20 years depending on the size and type) and would, all things being equal, decrease in value, and this is one of the reasons why a lender would only lend a percentage of the value of the ship and require regular amortization over the life of the loan. In addition, depending on numerous factors, including the supply and demand in the charter market, a ship’s value can fluctuate. A lender would closely monitor the value of the ship by requiring appraisals on a periodic basis, and the LTV covenant would provide an early warning to the lender.
Other Considerations in Deal Structuring
Some of the other considerations in structuring a ship finance loan include the following:
- Technical Manager
The borrower may not have the technical expertise to operate the ship and could well outsource that function. It is important to ensure that the technical manager is reputable, as it is the technical manager that deals with the day to day maintenance and operation of the ship.
- Special Survey
A ship has to undergo periodic “special survey” inspections in order to maintain its classification status. This is a major endeavor and can cost hundreds of thousands of dollars or more. Assuming a 5-year cycle, a lender lending in the middle of, or near the end of, the period, should expect the anticipated amount of the special survey cost added in the borrower’s budget.
- “Secret” Maritime Liens
Maritime liens are secret liens that arise by operation of law. Maritime liens, which may arise, among other things, in connection with the provision of necessaries to a ship (crew wages, repairs, towage, maintenance, etc.), need not be recorded. Depending on the jurisdiction, such secret liens are often prioritized in the opposite manner of typical U.S. commercial liens — a “last in time, first in right” basis.
- Global Nature of Shipping Business
With operations worldwide, the borrower may be exposed to political risk, risk of piracy, corruption etc. Acts of piracy have historically affected ocean-going ships trading in regions of the world such as the South China Sea, the Indian Ocean, the Gulf of Guinea and in the Gulf of Aden off the coast of Somalia.
- Sanctions
In the similar vein, by nature of its business, a shipowner has a need to closely monitor the U.S. economic sanctions regime, which changes frequently, and a violation by the shipowner (whether intentional or inadvertent) can have consequences to its lenders. Careful examination of the borrower’s sanctions compliance program is warranted.
- Regulatory Concerns
Certain types of ships — for example, ships that carry goods between two points within the United States or those that engage in fisheries trade — are subject to extensive regulation, which often has implications for the lenders. There may be a citizenship requirement for the ownership of the ship, which raises a diligence issue (as the eligibility for a specific regulatory status affects the value of the ship) as well as an enforcement issue (in the event that a lender needs to become the owner of the ship).
What Distinguishes Private Funds from Traditional Banks
As mentioned, there is a noticeable gap in the availability of capital and the need for capital in shipping. However, not all ship finance opportunities are made for private funds for one reason or another. Traditionally, pricing on ship finance loans has been very favorable to shipowners. Given that a private fund likely needs to satisfy a threshold internal rate of return on its investments, there may be a sticker shock on the part of the shipowner seeking capital, which may require a justification for the higher pricing. Some of the areas where private funds can differentiate themselves from traditional banks are:
- Speed of Execution
Whereas a commercial bank may have internal constraints to move expeditiously on a deal, a private fund can be nimble and add significant value where there is a purchase contract already signed in place for a ship and the financing fell through for one reason or another.
- Fixed Rate Option
Ship finance loans are typically LIBOR-based. A private fund, without needing to price a loan with its cost of capital, can give the borrower certainty of debt service amount and save the borrower headaches when LIBOR is discontinued after 2021.
- Structuring Flexibility
A shipowner with a strong long-term charter will typically be able to get financing easily no matter what. It is those owners who do not check all the boxes that need creative solutions to their impending financing needs. A private fund can customize solutions much more easily than a traditional bank by offering a structure, amortization profile or collateral structure that may be different from a typical arrangement.
- Equity Exit Option
While a typical ship finance bank relies on the ship as collateral, it is reluctant to actually become the owner of the ship for a variety of different reasons. A private fund, depending on its strategy and internal fund document constraints, may well own the asset if it determines to be in its best interest. Such willingness to become the equity owner may be an advantage in approaching ship finance investment.
Summary
The ship finance industry is going through a transformation. Traditionally active players are exiting or pulling back from the market, and there have been new entrants that are not commercial banks that have plugged the gap to an extent. This trend may be continuing, and there could be attractive opportunities for a private fund interested in new investment options.
