Can private equity save the distressed shipping market?
August 2013 | PROFESSIONAL INSIGHT | INVESTMENT FUNDS
Financier Worldwide Magazine
Private equity (PE) is an asset class consisting of equity investment in companies that are not publicly traded on a stock exchange. With the decline in world industrial and consumer demand following the worldwide economic pullback beginning in 2008, the shipping industry, still working through oversupply five years later, is an obvious target. This article explores some of the risks of an investment in shipping.
For shipowners, PE is hailed as the panacea for saving an otherwise distressed market that has suffered from a lack of bank finance – more fallout from the credit crunch. With the shipping indexes (most notably, the Baltic Dry Index, or BDI) testing record lows, US bankruptcy filings by international shipping companies have proliferated. Meanwhile, the still large newbuilding order book, which includes orders for ‘eco’ ships for the future, remains largely unfinanced. Against this gloomy backdrop, PE investors are brightening up the landscape. Increasingly, investors and shipowners are strategically aligning their respective interests and forming shipping private equity ventures (SPEVs).
The shipping industry needs alternative financing sources to fill the vacuum as the banks have pulled back. The current state of the shipping markets is attractive to PE investors, where investment in distressed industries is among the most common investment strategies. Most analysts view the major shipping sectors as being at, or just past, their bottoms; the odds now favour a move up.
The potential for consolidation is another big attraction for the PE sector. The majority of ships are owned by privately controlled companies – often run by “swashbuckling, larger-than-life characters”, to quote the legendary investor Wilbur Ross, speaking in June 2013 at the Marine Money conference in New York. This structure makes shipping a good fit for PE.
According toMarine Money, the PE investment in shipping jumped 13-fold to $3.3bn in 2012. Nevertheless, most industry experts would argue that the majority of firms considering shipping private investments have looked, smelled, poked and prodded – but have not committed. As familiarity grows, however, more are wading into shipping’s waters. Whether PE will fill the industry’s big finance void is not known yet.
Investing successes attract more money. ‘Home runs’ (borrowing a term from sports parlance), vastly exceeding the generally hoped-for 20 percent IRR, over a three to five year horizon, actually do happen in the maritime world. Three decades after the fact, tales circulate about Majestic Shipping – the Loews/Tisch mid-1980s tanker investment timed at the exact bottom of the last major tanker downturn. With calculated advice from shipping and energy experts, Loews bought six ULCCs (ultra large crude carriers) for roughly $30m in total. While considerable expense went into maintaining each asset’s value, in roughly five years, a half interest in the six ships was sold for $150m.
Recent PE investors have included Mr Ross’s W.L.Ross & Co. ($900m investment in Diamond S Shipping, 30 tankers hauling refined oil products – a sector benefiting from changing patterns of energy trade, and a consolidation play in Navigator Holdings Ltd., a transporter of gas cargoes); Blackstone Group LP (nine refined-product tankers from a German operator, and control of US ‘Jones Act’ tanker operator, American Petroleum Tankers); Apollo Global Management LLC (Principal Maritime Management LLC, formed in 2010, operating a fleet of 11 Suezmax oil tankers); Greenbriar Equity Group LLC (160M IPO of Ardmore Shipholding Ltd.); and the Ontario Municipal Employees Retirement Fund (investment in V.Ships, Monaco-based ship management company).
Clearly, PE investments require careful analysis and market understanding. While the economic terms of a transaction can be negotiated (capital contributions, length of investment period, termination procedures, etc.), PE firms have quickly recognised that the shipping markets clearly have their own nuances and issues. These include the following:
Terminology. This arcane and sometimes antiquated terminology is but one of the factors that have frightened away PE interests. Consider, for example, bareboat charters, demurrage, general average, bunkers, and libel (not the kind you are thinking).
Inherent risks. Shipping has its own risks, including dangerous cargoes, civil and criminal oil pollution liability (all ships can spill fuel oil) and the public’s perception of corporate irresponsibility. Furthermore, there are inconsistencies among local, national and international regulatory regimes. In addition, while gross negligence and wilful misconduct can lead to criminal liability, there is also statutory liability for oil pollution.
Jurisdictional concerns. Shipping is an international business with movable assets. “A shipping venture may touch a number of countries and involve the laws of a number of jurisdictions. For example, a vessel may be owned by Greek principals through a single purpose Liberian owning company, flying the Panamanian flag, chartered to Danish charterers, mortgaged to a U.S. bank, be entered with a London protection and indemnity (P&I) club, and have hull insurance placed through the German insurance market … In short, the obligations and legal arrangements of a vessel and her owners may be affected by the laws of a number of nations” (Lennard K. Rambusch and Jovi Tenev, ‘International Maritime Workouts’, Business Workouts Manual (2d ed) (Thompson Reuters/West: Boston, 2008)).
Oversight of management. PE oversight can be difficult, even if formal agreements are in place. Commonly, the technical operation and commercial management of the new entity’s assets are controlled by the minority partner: the shipowner. In addition, it is common for the SPEV to indemnify the ship owner for any actions taken on its behalf without liability other than losses resulting from the manager’s gross negligence, wilful misconduct or fraud.
Also, potential conflicts of interest may arise between the shipowner’s existing operations and the SPEV’s business. The SPEV’s corporate documents should outline each investor’s ability to manage and control the investment as reflected in the structure of the governing body (including numbers of representatives, and their powers and classification for voting and operating purposes). However, agreements will need provisions regarding conflicts due to potential vessel acquisitions or chartering opportunities between the SPEV, the shipowner and their clients, counterparties and staff.
Tax issues. The SPEV, the shipowner and the PE interests each will have different investors and hence different tax concerns. For investors located in the US, additional tax considerations need evaluation.
These include: (i) current taxation of earnings (whether or not distributed) if the SPEV’s US ownership causes the SPEV to be a ‘controlled foreign corporation’; (ii) current taxation of earnings (whether or not distributed) or a punitive interest charge on disposition of shares if the SPEV is treated as a ‘passive foreign investment company’; (iii) tax information reporting obligations; and (iv) qualification for exemption from US federal income tax on US source shipping income and gain from sale of ships under Internal Revenue Code Section 883. Of particular note is that in order to qualify for the benefits of Section 883, a foreign corporation must generally obtain statements signed under penalties of perjury establishing its ultimate ownership. Private equity funds may have difficulty obtaining such statements from their investors. It should also be considered whether the amount of US source shipping income earned by the venture will be material as such income is generated only when a vessel calls at a US port. In addition, if the SPEV is determined to be an investment entity that is treated as a ‘foreign financial institution’ under the Foreign Account Tax Compliance Act (FATCA), the SPEV will have registration, investor status verification, reporting and withholding obligations under FATCA to avoid FATCA withholding.
Repayment. Key to any PE investment is the means of repayment. In a shipping venture, repayment will primarily consist of income from charter hire, and hopefully, asset appreciation in connection with future asset sales. A bareboat charter is the best means of establishing a payment stream to repay the private equity investor. In the case of time and voyage charters, the SPEV’s net income can be dramatically affected by maintenance/repair responsibilities and operational costs.
The exit strategy. The control and planning of an exit strategy can be difficult in a fragmented market largely controlled by entrepreneurs. Restrictions on transferability of assets, including rights of first refusal, as well as voting restrictions need to be agreed at the creation of the SPEV. However, the failure to plan against transfers to unwanted third parties (such as competing shipping owners or other private equity investors) can have dire consequences.
A sale of assets or equity in the company, merger or an initial public offering, all of which can be effective exit strategies, also require advance planning. However, in the case of the IPO concerns related to the SEC registration of advisers to private equity funds, or requirements to disclose preferential terms or arrangements offered to select investors (in the interest of transparency and protecting rights of co-investors) can have unwanted ramifications.
The sometimes competing interests of the PE investor and shipowner partners, and shipping’s complex jurisdictional and tax issues, all necessitate careful planning. It has taken careful study for PE to address concerns regarding criminal liability for oil pollution, international US Foreign Assets Control trade sanctions, and even piracy. Nevertheless, the movement of PE investors into the maritime sector is a significant development in maritime finance.
Brad L. Berman is a partner at Holland & Knight, LLP. He can be contacted on +1 (212) 513 3371 or by email: email@example.com.
© Financier Worldwide
Brad L. Berman
Holland & Knight, LLP