Memorandum by H K Leggate (FUS 12)
THE FUTURE OF THE UK SHIPPING INDUSTRY
FINANCING ISSUES IN THE UK SHIPPING INDUSTRY
There are two elements to the financing problem
facing the UK Shipping Industry into the 21st century. The capital
intensity of the industry combined with an ageing fleet means
that financing requirements are high. Access to capital is however
limited due to the risk status of the sector.
According to recent research, the industry's
finance requirements over the next five years could exceed $150
billion, with newbuilding finance of $125 billion, and second
hand finance of $33 billion.
Of this the UK requirement is expected to be $2.22 billion.
This increased demand is combined with a fall
in the number of banks providing shipping finance. The Asian crisis
combined with poor market conditions particularly in container
and dry bulk shipping meant that in the latter half of 1997 and
1998, various banks disposed of their shipping portfolios. This
included some very well established banks such as Hambros, Long
Term Credit Bank of Japan Banque Paribas' Geneva Shipping Unit
all withdrawing their shipping facilities. Other commercial banks
were also forced to make sizeable loss provisions in response
to poor performance in the sector.
The reticence of the remaining shipping bank
sector to support the industry has lead to a tightening of credit
facilities, particularly for the smaller companies, which are
now turning to the capital markets to obtain the necessary finance
for investment. The use of such markets is not in itself a problem.
However, the investor perception of the shipping industry is such
that they demand particularly high levels of return which can
exacerbate cash flow problems and even lead to default.
This memorandum examines the financing requirements
for the UK industry over the next five years and analyses the
options that are currently available to the shipping companies
in terms of debt and equity. Finally there are recommendations
to alleviate the particular problems faced by such a cyclical
industry, namely, government backed loans, and an extension of
the Enterprise Investment Scheme to encourage equity funding.
The shipping industry is very capital intensive.
Furthermore, the age of many vessels in the UK and indeed the
world fleet suggest that investment in newbuilding is fast becoming
a necessity. Table 1 shows the average age of the fleet for the
various sectors of the industry in terms of number, gross tonnage
and dead weight tonnage. These statistics reveal an average age
of 19.8 years for the total trading fleet, and 22.3 for the total
non trading fleet, with all sectors around this high average.
The demand for capital is therefore increasing.
|Average age of the UK fleet 31 December 1997 (100 GT and above)
|Total dry bulk||15.4||13.8
|Total other dry cargo||19.3
|Total trading fleet||19.8
|Total non trading fleet||22.3
|Source: Lloyd's Maritime Information Services/Chamber of Shipping.
Recently produced estimates of these financing requirements
for the world fleet, based on age and future predictions for the
industry are shown in table 2.
For newbuild the financing is based on 80 per cent of the total
purchase price, and for second-hand vessels 60 per cent in line
with the industry averages.
|Financing requirements 1998-2002 (World Fleet)
|Newbuild (Finance @ 80 per cent $ million)
|Second hand (Finance @ 60 per cent $ million)
|1 Based on proportion of UK fleet to world fleet in terms of DWT.
Source: Drewry Shipping Consultants.
The table shows that for the UK, approximately $2,222 million
will be needed for vessels, $1,759 million for newbuilding and
$463 million for second hand ships. Given these high financing
requirements, and the nature of the industry, financing investment
in vessels poses a particular problem for the industry. It should
also be noted that this analysis focuses entirely on financing
for ships. Companies in the industry also need to finance working
capital and for the restructuring of existing capital. The following
sections examines the options currently available and their relative
suitability for the industry.
The investor's opinion of the industry is typified by the
credit rating agencies Standard and Poors and Moodys.
Both see the industry as high risk because of its economic
sensitivity, capital intensity and competitive structure. All
these factors lead to volatility of freight rates and company
Ratings are based on the following information:
five years of audited financial statements;
interim financial statements for the last financial
detailed narrative descriptions of operations;
detailed investigation of the company by a team
Companies with larger fleets tend to achieve a higher rating
than those with smaller fleets. Associations with other companies,
a highly rated parent company, or a highly rated charterer also
affect the decision.
Recent ratings of shipping companies in the light of bond
issues have shown them to be below the investment grade, and thus
carry a relatively high risk of default. A "B" rating
represents a 25 pre cent risk and "BB" a 15 per cent
risk. Such ratings suggest that inability to meet payments or
coupon and/or principal is inevitable for some companies over
the period of the bond issue. Investors therefore require high
rates of return to compensate them for the high risk.
As far as equity is concerned, again the perception is of
high risk, with volatility in the freight markets leading to volatility
of the share prices. Furthermore, small company shares suffer
from low liquidity. Placements are often achieved in times when
the market improves, but these windows of opportunity close very
quickly. Some companies are however, considering initial public
offerings (IPO) on NASDAQ, the over the counter equity market
in the US.
The debt versus equity debate is one which features largely
in any discussion of corporate finance. Equity is the risk bearing
capital of a business, due to the uncertainty of return from dividends
and capital gain. Debt on the other hand cost the company less
because it is perceived to be less risky since coupon payment
are fixed, and there is a guaranteed maturity value. Debt becomes
even cheaper due to the tax deductibility of interest payments.
The level of debt finance or gearing of a company increases
the risk to the equity shareholders, since for a highly geared
company, high levels of interest must be paid before any dividend
may be declared. Shipping companies tend to have high levels of
gearing, which in turn makes equity investment less attractive.
Also, for high levels of debt, more debt finance may be difficult
to obtain because of the risk of default.
The following brief analysis considers the characteristics
of equity and two main types of debt, bank loans and bond issues,
and their suitability for the industry.
The main advantage of equity is that it is a permanent source
of capital. However, the costs of a share issue are relatively
high (7 per cent of funds), and there is an expectation of a high
return for risk. Dividends are also paid out of after tax earnings.
Debt finance is non permanent. The capital ultimately has
to be repaid. With a typical bank loan, interest and capital are
paid throughout the period of the loan. Interest payments are
however tax deductible. The interest on bank loans tends to be
lower than the coupon on bonds, and banks tend to be more sympathetic
towards companies experiencing difficulties. As already stated
bank credit has been recently squeezed making it more difficult
for smaller companies to obtain loans.
Bonds can have a cash flow advantage over bank loans in that
there is no amortisation of principal. The issue costs are also
much lower than those of shares (3 per cent of funds). However,
experience of companies who have followed this route are that
the coupon payments are high compared to other companies with
similar ratings. Cash flow may not be able to withstand the high
interests payments. Furthermore, bond holders have a low tolerance
in terms of default. Most would sell defaulted bonds which could
ultimately lead to winding up of the business. A few well publicised
defaults could make future bond issues almost impossible for the
The shipping industry is unique in that it must suffer violent
market swings which have a dramatic impact on cash flows of the
business. The special problems faced by these companies are clearly
not understood by the existing markets for capital, making financing
increasingly difficult. At the same time the demands for finance
for the industry are increasing.
Possible solutions could be provided by:
Government guarantees for loans, particularly
for the smaller companies experiencing difficulties in obtaining
An extension of the Enterprise Investment Scheme
which offers relief to qualifying individuals (investors) providing
equity to qualifying companies for qualifying business activities.
This currently is available to unquote companies, up to a maximum
of £5 million for certain ship chartering and operating activities.
Clearly this maximum is insufficient in the light of the requirements
outlined above. Some consideration should therefore be given to
expanding the limits and indeed making it available to certain
smaller quoted companies.
H K Leggate
London School of Foreign Trade
Centre for International Transport Management
London Guildhall University
13 December 1998
Ship Finance: Choices, Competition and Risk/Reward Equations'
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