Investment Strategies

Calmer Waters Ahead For Investment In Shipping - Mercer

Ryan Bisch Mercer Manager researcher 31 August 2010

Calmer Waters Ahead For Investment In Shipping - Mercer

Editor's note: occasionally, this publication looks at specific businesses from a broad investment point of view. Mercer, the US-based financial services, advisory and consultancy giant, lays out what it sees are some of the benefits - and risks - of the market for shipping.

(To view an associated report on the subject, click here.)

The shipping industry is notoriously cyclical and the recent global financial crisis saw a contraction in the industry led by a significant and sudden reduction in global trade. There is no doubt the shipping industry in general has demonstrated considerable historical volatility, subject to the boom and bust nature of maritime freight rates, which are inherently linked to global trade. However, there are signals that the shipping industry is at the bottom of the current cycle, and things may be looking up.

Introduction

Ships are the largest transporter of merchandise and commodities including crude oil and iron ore, transporting almost 90 per cent of global trade to produce total global revenue in excess of $600 billion annually.

To cater for various cargoes and routes, the shipping industry is divided into three main vessel subsectors: cargo/dry bulk (which transports, for example, iron ore), tankers/wet bulk (eg crude oil) and container ships (eg manufactured goods). Each vessel sector has its own characteristics, including return drivers and supply/demand dynamics.

The shipping cycle in motion

Upwards

For a five-year period, beginning in 2003, the shipping industry experienced significant charter rate increases and strong vessel value appreciation, driven by strong economic growth, increased demand for shipping capacity and availability of debt that allowed expansion in the industry.

Downwards

Then came the global financial crisis, and a drop in trade demand. Initially, the greatest impact was felt in the container ship sector. Subsequently, the impact extended to the dry bulk sectors, as demand for raw materials from China began to slow. Spot market charter rates for some bulk carriers declined significantly, with rates falling by 99 per cent. By May 2009 rates for crude, product and chemical tankers had also fallen sharply, down by 95 percent.

The aggressive credit expansion supported by vessel value growth from 2003 to 2008 meant that many ship owners faced covenant breaches and a period of re-financing risk as loans matured and banks put pressure on borrowers. This added further downward pressure to asset valuations.

The benefits of timing

The value of a ship is calculated using the expected future cash flows it can generate over its useful life. Fluctuations in charter rates (future income), are therefore reflected in ship valuations. 

So, a ship’s purchase price is directly linked to the charter rate environment at the time of acquisition and is one of the key considerations for determining the capital structure for a newly purchased ship.

Rapidly rising charter rates during 2003 to 2008 increased the expectation of future cash flows, driving up vessel prices. However, in the wake of the financial crisis, vessels purchased at those higher prices are now finding it increasingly difficult to generate positive returns.

Nonetheless, vessels purchased at today’s asset prices and chartered at current charter rates can be profitable and therefore appropriately matched and able to generate operating profit. 

Investors with “fresh capital” should be able to acquire attractively priced assets that, while earning charter income at current levels, are able to generate acceptable profit margins.

The opportunity for investors

Investment managers believe that net internal rates of returns of 18-25+ per cent are achievable in the current environment. However, the investment thesis is opportunistic and high returns are dependent on a partial recovery in underlying vessel asset prices.

This opportunity is an extension of the current capital scarcity theme. Historically, the shipping industry has been dependent on capital sourced from a limited number of "shipping focused" commercial banks (eg HSH Norbank, RBS and Lloyds TSB) or directly via ship-owner equity. Overall capital from traditional sources is expected to be restricted over the medium term as, in some cases, traditional lenders are re-focusing on domestic lending activities or have been forced to exit the shipping industry.

Shipping investment strategies typically target a mixture of income and capital appreciation. Income is generated via charter income; historically, unlevered net income yields have been in the 10 to 15 per cent range. However, opportunities sourced in the current environment may offer 14 to 17 per cent unlevered net income yields. Capital appreciation is expected to occur as demand increases and asset prices pick up, as the industry cycle begins its uphill climb once more.

Risks

Demand is one of the most significant risks in a shipping investment strategy. A prolonged economic downturn, a severe slowdown in emerging market economic growth or decreasing levels of global crude oil consumption or consumer demand would have significant negative implications.

With the majority of shipping banks largely withdrawn from current ship lending as they tackle their own balance sheets, lack of debt capital has seen the valuation of second-hand vessels falling to very low historical levels.

Practical issues

Mercer has identified a limited number of investment managers currently raising distressed shipping funds. We believe they will meet internal rate of return (IRR) targets in the high teens to mid-twenties.

The primary focus has been on dedicated shipping funds where the typical structure of the investment provides liquidity via cash distributions (which will range from 30 to 50 per cent of the total return). Most funds are structured with two to three-year investment periods and four to seven-year fund terms. Management fees of approximately one 1 per cent to 2 per cent per annum, and performance based fees of 10 per cent to 20 per cent (above a hurdle rate) are the norm.

Shipping as part of the investment mix

Potential investors should carefully evaluate the risks of shipping investment, together with the specific strategy and fund manager quality. Shipping is an illiquid investment, expected to have a private equity-like return profile, albeit with a significant yield component.

This is classified as an alternative investment, focusing on return enhancement rather than exposure to an alternative risk premia.  However, shipping can be an attractive opportunistic investment option for investors with a risk appetite and ability to invest in private assets.

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