STOCKHOLMS UNIVERSITY SCHOOL OF BUSINESS AUTUMN TERM 1998 BACHELOR THESIS TUTOR: EMMANUEL PARASYRIS
SHIPPING FINANCE
A CASE STUDY ON THE METHODS FOR FINANCING A SHIP ACQUISITION
by
Jannis Valsamidis Christina Giannoulidou
Acknowledgements
We would like to take the opportunity here to thank all the people who have helped us to complete this thesis.
First of all, we would like to express our gratitude to those who devoted some of their valuable time to us for interviews and gave us valuable information and pricelees advice:
Chiliadakis Lefteris, Shipping Director – Midland Bank, Greece
Kokinis Christos, Vice President – ABN AMRO, Greece
Tsakkos A.- Tsakkos Shipping, Greece
Svante Hellberg, Cool Carriers, Stockholm
Michaela Dahlman – ATC Shipping, Stockholm
Hans Ost Hejberg – Financial officer, Ocean Bulk
Svejn Ung Debdahl – Financial Manager, Grindlays Bank, Piraeus
We would also like to thank our opponents Emma and Thomas and our tutor
Emmanuel Parasyris for all the support.
ABSTRACT
This dissertation presents a description and an analysis of the various financial methods that shipping companies can use to acquire a new ship.
Various financial methods have been analyzed from the traditional methods such as bank loans, private equity and shipyard finance up to modern financial instruments such as bonds, private placement and public offering.
All the above methods have been examined with help from bank executives, managers from shipping companies and various shipowners.
Finally, we present the advantages and disadvantages of every method giving the opportunity to the reader to understand where these methods can be applied in the shipping industry.
For the financial analysis we have used the Capital Asset Pricing Model (CAPM) presenting also the expectations that a potential investor might have from such an investment.
Key words like “modern corporate structure”, “competent management” and “well organized company” are a necessity for managerial success leading to profits.
Following the analysis, the conclusion found was that the majority of shipping companies will continue to use the traditional methods in order to finance addition of new ships to their fleet. That depends to a great extent on the nature of the private-owned companies who do not meet the financial requirements from the investor’s side. As to the new methods examined, junk bonds is the most attractive financial source among Greek shipping companies while public offerings will play a more important role in Scandinavia.
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CONTENT
ABSTRACT ...... 1
1.1 INTRODUCTION ...... 4
1.2 FORMULATION OF THE PROBLEM ...... 5
1.3 PURPOSE ...... 6
1.4 LIMITATIONS ...... 7
2. METHODOLOGICAL ISSUES ...... 9
2.1 SCIENTIFIC APPROACHES...... 9 2.2 QUANTITATIVE AND QUALITATIVE METHODS...... 10 2.3 TYPE OF ESSAY...... 11 2.4 STRUCTURE OF THE ESSAY...... 11 2.5 TREATMENT OF THE INFORMATION...... 12 2.5.1 SOURCES OF INFORMATION AND THEIR CRITIQUE...... 12 2.5.2 INTERVIEWS...... 13
3. DEFINITION OF A SHIPPING COMPANY ...... 15
3.1 THE DEMAND FUNCTION ...... 16 3.2 THE SUPPLY FUNCTION ...... 18 3.3 FLUCTUATIONS ON THE FREIGHT MARKET ...... 19
4. THE SHIPPING FINANCIAL METHODS ...... 21
4.1 THE TRADITIONAL WAY ...... 21 4.1.1 BANKS...... 21 4.1.2 PRIVATE EQUITY...... 24 4.1.3 SHIPYARDS...... 24 4.2 THE NEW ENVIRONMENT ...... 26 4.2.1 PRIVATE PLACEMENT...... 26 4.2.2 PUBLIC OFFERING...... 27 4.2.3 JUNK BONDS...... 29 4.2.4 LIMITED PARTNERSHIP...... 30
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5. ANALYSIS OF THE FINANCIAL METHODS ...... 32
5.1 OPERATIONAL VIEW ...... 33 5.2 HEDGING RISK ...... 33 5.3 FINANCIAL THEORY ...... 35 5.3.1 LIQUIDITY RATIO :...... 36 5.3.2 SOLVENCE RATIOS:...... 36 5.3.3 LEVERAGE...... 37 5.4 INVESTORS SIGHT ...... 39 5.4.1 OPERATIONAL VIEW...... 39 5.4.2 FINANCIAL RATIO DISCLOSURE...... 39 5.4.3 COMPETENT MANAGEMENT AND WELL CORPORATE STRUCTURED...... 40 5.4.4 RATIONALIZATION IN STRATEGY AND THINKING...... 40
6. CONCLUSIONS ...... 41
6.1 FINANCING METHODS ...... 41 6.2 FINAL EVALUATION ...... 44
7. CRITICAL EXAMINATION ...... 46
7.1 THE ESSAY’S VALIDITY ...... 46 7.2 THE ESSAY’S RELIABILITY ...... 47 7.3 SUGGESTION FOR RELATED STUDY AREAS ...... 47
APPENDIX 1 ...... 51
SHIPPING COMPANIES INTERVIEWS...... 51
APPENDIX 2 ...... 53
BANK INTERVIEWS...... 53
APPENDIX 3 ...... 54
ABBREVIATIONS...... 54
List of figures: 3.1 Demand for shipping services 17 3.2 Supply for shipping services 19
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1.1 INTRODUCTION
“ God must have been a shipowner. He placed the rawmaterials far from where they were needed and covered two thirds of the earth with water”. Earling Naess
The above sentence describes shipping quite well. The function of sea transport like that of any other form of transport is to move things from one destination to another.
Its success lies in finding people who have things to move and in its ability to move them safely and efficiently. Shipping by sea continues to provide the lowest unit transportation cost and as it is the principal form of transportation in international trade, it is by definition international in scope.
The hardware of seaborne trade is the ship. Naval architects design ships having in mind mostly what is technically possible, what cargoes are most likely to carry, environmental safety and finally what port they are most likely to trade.
But the construction of a new ship or perhaps the purchase of an older one from the second hand market, and shipping in general, is a major capital intensive business.
One of the major challenges today for shipping companies is to explore new sources of finance.
Past mistakes must be avoided. The ease with which finance was available in the past gave huge surpluses - especially in the tanker industry - something that can be
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avoided in our days.
Investors have realized that they have to put a lot more equity in new projects in order to satisfy today's technical and environmental standards.
That must be done at the same time that a great part of shipowning has suffered by great losses during earlier economic crises.
Therefore, the shipping industry has become a part of the international market with a great need for efficient financing in order to raise the funds to continue their competitive position in the transport area.
1.2 FORMULATION OF THE PROBLEM
The useful life of a vessel is estimated between 15- 20 years depending on vessel's type. I t has been estimated that by the year 1999, 62% of the tanker fleet and 40% of the bulk fleet will be over 15 years of age.1
That means that shipping industry has to be prepared for new newbuildings in order to cover the deficit of tonnage.
Prices today, both in newbuildings and in the second hand market has risen significantly in conjunction with freight rates that have been stable since 1995.
The result is that shipping companies does not have the possibility to finance their projects by own capital, as the budget for replacing the overage fleet can be as huge as an amount οf between 15-18 bn USD.2
1 Nautemporiki, June 1998 2 Fairplay, May 1998
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Private investments, banks or the traditional financing methods cannot cover that amount.
New ideas and a variety of new financing methods have to be used.
But which are the new methods and are they suitable for the shipping industry?
Will the shipping industry be able to adapt them in order to benefit from their advantages?
1.3 PURPOSE
The purpose of our dissertation is to find out new methods of financing in the shipping industry in order to create the equity for new investments.
We will analyze the various methods and we shall assess the advantages in comparison with disadvantages for the shipping companies and the shipping industry in general.
Because of the international nature of shipping, we will find the different aspects prevailing in different markets around the said problem and its solution.
Finally, we will attempt to set out a pattern for companies without a department of finance, clarify these methods for them so that they can manage this sensitive area of shipping.
1.4 LIMITATIONS
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As shipping is an international business, we decided to concentrate our research in the European financial market, as cities like London, Piraeus and Oslo are three of the biggest shipping centers in the world. Greece is rated first among shipping countries worldwide as the Greek owned fleet counts up to 2.996 units representing 17% of the world fleet and 51% of the E.U. fleet. Norway comes third worldwide as their fleet counts up to 7,2 % of the world fleet and Norweigian shiping companies operate arround 15% of the worldtonnage3. As we can understand these two countries represent the European market.
Another reason for our decision was the immediate access to these centers as the supply of information that we could obtain was much more substantial in comparison with companies in other continents.
Another limitation has been the engagement only with the trampmarket. That has been due to the importance of that market in the world economy as it is responsible for the majority of the transportation of goods by sea.
Additionally, that market needs immediate support in order to renew the overaged fleet.
Finally, a demarcation has been made in our financial analysis due to the special characteristics and the different mentality of the markets with which we have been working.
Furthermore, our effort has been concentrated in giving a pattern for the shipping
3 Svensk sjöfartstidning – December 1999, pp. 25- 26
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company, describing what will be necessary on their part in order to raise capital from the financial markets. It has not been our aim to analyze in depth the financial situations of different companies.
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2. METHODOLOGICAL ISSUES
Subsequently, the procedure of how the research has been completed will be described. First, we will describe the various scientific methods available for writing an essay followed by a description of the type of the essay and the perspective that has been chosen.
Then there is an overview of the structure of the thesis, followed by a discussion of the sources and the type of interviews that we used.
2.1 SCIENTIFIC APPROACHES
In the end of the 1800´s, two methods were dominating: positivism and hermeneutics4.
Positivism assumes that one should concentrate on what is real and can be verified with empirical data. There is an objective, complex reality that can be studied by breaking it in pieces. This reality must be reproduced without any influence from the scientist’s sentimental, political or religious status. The aim is to try to create laws that will be generally valid based on observations which in their turn should be independent of time and place, precise and assured.
Hermeneutics is analyzing the object by placing it into a wider context. The approach is qualitative. Facts and values are not always easy to part. The scientist’s personal experience and interpretation is often very important in order to achieve scientific results.
4 Lundahl & Skärvad, Utredningsmetodik för samhällsvetare och ekonomer
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We don’t believe our thesis should follow strictly either positivism or hermeneutics, but a combination of both would be more appropriate.
We want to make an objective presentation of the situation where facts should be more important. At the same time we know that our own personal values will come forward during the interviews.
Another parallel to hermeneutics is that what is valid for the industry today may not be valid tomorrow. We accept that the reality is complex and that is the reason why we have tried to place our subject into a wider context by taking the international accepted methods of finance under consideration.
Even if we want to hold on to positivism’s objective view and analysis method, we believe that our approach stands closer to hermeneutics.
2.2 QUANTITATIVE AND QUALITATIVE METHODS
Quantitative methods are grounded in positivism. The researcher is collecting data by measuring and analyzing phenomena. Hypotheses, based on well-defined theories and laws, are tested with statistical methods.
Qualitative methods are grounded in hermeneutics. They begin with concrete observations of the reality in order to build models for expounding the researcher’s view of the situation.
In our essay we use the qualitative method. Interview questionnaires consist only of qualitative data. In some part of the essay statistical data has been used but these are not result of our own survey.
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2.3 TYPE OF ESSAY
The thesis can be defined as a combination of two different types of research or studies. Firstly it can be described as descriptive, meaning that it is trying to describe the traditional financial methods of shipping. Furthermore it can be defined as an explorative study as it tries to gather and analyze information about the future methods of shipping finance.
The perspective used in the thesis is from the shipowner’s point of view as it is up to him to decide whether he will chose a specific financing form or not. Although the shipowner is playing a crucial role in the choice of the financial method it is the investors who offer the financing possibilities. Therefore an analysis from the investors point of view is made as well in order to assess the demands they have in order to offer financial services to the shipowners.
2.4 STRUCTURE OF THE ESSAY
The third chapter of this essay is a description of the shipping industry in order to provide the reader with sufficient information in understanding the mechanisms behind demand and supply. In the fourth chapter, there is a description of the traditional as well as the new financial methods and how these apply on the market. Thereafter, there is a financial approach and analysis. Of course, the analysis should give answers to the research question. After that follows a chapter with conclusions and finally, in the last chapter there is a critical examination
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where the essay’s validity (lack of systematic errors) and reliability (absence of random measuring errors) is evaluated followed by suggestions for further studies.
2.5 TREATMENT OF THE INFORMATION
2.5.1 Sources of information and their critique
The collected information for this essay has come from both primary and secondary sources.
For the market view, information provided from books, reports from shipping magazines and newspapers were used. The information for the presentation of the traditional financing forms came mainly from books. Some books were provided from the library of Maritime Law at the University of Stockholm but in general, the collection of books in Sweden has been limited. Since shipping is a sector that constantly undergoes structural changes, literature becomes quickly obsolete. The material we have used was sufficiently up to date in order for us to be able to deal with the latest developments in the subject. Information from the internet, regarding various articles written in shipping journals and newspapers, assisted us many times in staying up to date.
The new sources of finance were presented after various interviews with shipping companies and shipowners, both in Sweden and Greece, as well as banks in
Greece.
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2.5.2 Interviews
There are different types of interviews: Standard and non-standardized interviews5.
The advantage with a non-standardized interview is that the interviewer has the opportunity to choose the way in which questions are formulated and the order that the questions appear more freely and in an unbiased way. The main point is to ask questions and get answers that provide the information needed. The interview in this case can become considerably more flexible and adjusted to the situation.
Since non-standardized interviews need skills and great amount of knowledge in the field while standardized interviews draw less information, we have used a form of semi-standardized interviews. The questionnaires that we present in the end of our essay (appendix 1 & 2) were used as a guideline in the discussion but the meaning was that the respondent should talk freely and spontaneously.
When it comes to the interview objects we have interviewed experts and directly interested parties.6 Expert means a person that is knowledgeable and well familiar with the topic in question and thus can give valuable information. The directly interested parties are those that have a direct linkage to the topic. We interviewed financial experts from different banks in order to gather information regarding the requirements that the financial world has for investing to a shipping company.
These people are acquainted with evaluating shipping companies and taking financial investment decisions. The directly interested were the representatives
5 Lundahl & Skärvad, Utredningsmetodik för samhällsvetare och ekonomer, p. 72 6 Lundahl & Skärvad, Utredningsmetodik för samhällsvetare och ekonomer, p. 74
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from various shipping companies who have a directly interest on the financing methods that we are focusing on in this essay.
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3. DEFINITION OF A SHIPPING COMPANY
A shipping company can be anything from a captain with a small ship up to an organization with a fleet of vessels. Some of the companies manage the whole operation of their ships on their own while others choose to buy some or all of the services for managing the operation.
Actually there are two basic methods of vessel’s operation for the shipping company.
A ship can be employed as a LINER, i.e. it runs on a regular line between two ports or series of ports. A LINER has a regular schedule of sailing and an agreed list of tariffs or prices.
Alternatively a ship can be employed as a TRAMP. In this case the ship is chartered or hired out at the best price the owner can obtain. Such a ship may go anywhere with anything for remuneration called the freight, which fluctuates depending on the international economic climate.
That shows that the shipping market, despite some imperfections, is closely related with the model of perfect competition.
In the market we have the shipowners and the shippers who are provided the services from the charterers.
There is a status without barriers in the market - free entry and exit - with information provided freely in the shipping world.
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That situation creates the condition for free competition, giving the law of supply and demand its crucial role.
3.1 THE DEMAND FUNCTION
Demand for transport results from demand for goods. The demand for shipping services and consequently for ships is a result of several factors such as the size and structure of international trade, the distance of transport, the productivity of ships, political events, the world economy and so further.
Freight rates accounts only for a small portion of material costs and as a result they do not significantly influence the demand. That makes the demand function to be inelastic.7
The dominant feature of the shipping model is the volatility of demand as it is unpredictable and quick to change, in contrast with supply function which is predictable and shows unwillingness to changes.
The model that describes best this relation is the "COBWEB ".8
In this model we can observe a time delay between the supply can satisfy the demand increase. That depends on the time that a new ship needs from the time of ordering until delivery, which can stretch up to two years.
7 Ignacy Chrzanowski, An introduction to shipping economics, 1989, page 52
8 Hardwick P. Khan, An introduction to modern economics, 1986
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On the other hand the supply is fixed in the short run while demand falls as the market needs some time to realize that some old vessels have to be scrapped and some others to be laid-up in order for the demand to match supply.
Freight rates
C. A 15% increase in demand from D 2 produces a 270% increase in freight rates. D 3 F3 B. A 50% increase in demand from D1 pro- A. Low demand duces only a small in- and low freight crease in freight rates, rates. F2 D 1 D 2
F1
Sea transport supply (Thousand btm/annum) S1 S2 S3
Figure 3.1:DEMAND FOR SHIPPING SERVICES
Source: Stopford M. “Maritime economics” 1988
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3.2 THE SUPPLY FUNCTION
The size and structure of the fleet in service, average time of operation and productivity of shipping determine the supply of shipping services.
Freight rates will be affected in case of a shortage in the transport capacity or in excess of transport tonnage.
In the former occasion freight rates will rise and that will make even older vessels profitable and continue to operate until the market is stabilized and the whole of the operational fleet is at sea. Additionally, vessels will operate at a speed which will not be optimal but the high running costs will be covered from the higher freight rates and the efficient time saving.
Later occasion - excess of tonnage- shall drive down the freight rates making revenues fall below the cost of running for the least efficient ships of the fleet.
These ships might be withdrawn from operation or be scraped.
This will drive supply to contract and meet demand, a restoration of the equilibrium.
In this case operating costs will make companies operate their vessels with optimum speed thus saving fuels.
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Cost/freight $ per thousand ton miles
D. PREMIUM FREIGHT RATE No further sea transport available until new ships delivered.
C. HIGH FREIGHT RATE All ships operational & running at full speed. A. LOW FREIGHT RATE Least efficent ships B. RISING FREIGHT RATE laidup and active All ships in service & fleet fleet slow steaming. starts to speed up.
Sea transport supply ( thousand btm per annum)
Figure 3.2: SUPPLY FOR SHIPPING SERVICES
Source: Stopford M. “Maritime economics” 1988
3.3 FLUCTUATIONS ON THE FREIGHT MARKET
Prices fixed in the course of a confrontation between supply and demand for shipping services have an unstable character. They often fluctuate.
Fluctuations of freight rates may take a form of cyclical fluctuation9 which means that business cycles (long, medium or short term) are periodically repeated oscillations of basic economic variables, such as production, employment credit and prices. The theory of business cycles distinguishes three basic cycles.
9 Ignacy Chrzanowski , An introduction to shipping economics, 1989, p.62
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--- Long terms cycle of a 50-year period also called the Kondriatiev’s cycle.
It distinguishes 20 years of expansion, a 10-year plateau and 20 years of recession,
--- Juglar's cycle of a 10- year period also called the investment cycle, and
--- Kitchin's cycle which is of a 3-4 year period, is considered as a commercial cycle.
The theory in sea transport analyzes cyclical changes of the freight market as well as other elements of maritime economy, such as shipbuilding industry.
The economic situations that generate these cycles are summarized by Hampton as follows: “Starting with a growing economy and a depressed shipping market, freight rates rise with an increase in transport demand. Rising freight rates increase the earnings of shipowners who respond to a more favorable investment climate by building up the price of second hand ships and by ordering new ships. The orderbook builds until crest. At the peak, there is a slowing of economic growth and freight rates decline. The delivery of the vessels into a falling market helps to depress rates further. Low freight rates discourage ordering and encourage lay-up and demolition of ships. Eventually, the excess supply reduces until it approaches a balance with demand. Then the cycle is ready to begin again. An entire regular cycle of this type might take about three to four years from through to through”.10
10 Ignacy Chrzanowski , An introduction to shipping economics, 1989, p. 78
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4. THE SHIPPING FINANCIAL METHODS
Shipping by sea continues to provide the lowest unit transportation cost. As it is the principal form of transportation in international trade, it is by definition international in scope.
In a capital intensive business as ship ownership, it comes as no great surprise that financing terms can make or break any given transaction.
For the above reason we will assess the traditional financing methods and the results in the shipping industry while we will to point out the mistakes and benefits from these in shipping.
Finally we are going to explore the new finance sources, how these affect the shipping industry and by which method these can be applied to different shipping companies. Furthermore, we are going to pay great attention to the benefits that the owner and the company in general are going to have if they decide to apply these new methods.
4.1 THE TRADITIONAL WAY
4.1.1 BANKS
The typical form of commercial bank finance for vessel is project finance: the employment of the vessel is expected to be adequate to cover operating expenses
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and repay the debt. Security takes the form of a mortgage over the vessel, assignments of the vessel's earnings and insurance and finally the corporate guarantee of the parent company.
The extend of their involvement (commercial banks) has varied considerably in the past. During the 60's, government guarantees gave the possibility to shipping yards to offer cheap fixed interest credits.
When the market was blooming in the earlier 70's, commercial banks came into the picture. They granted loans with very competitive terms to the point that in some cases no guarantees were taken.
Good economic prospects and optimism for the future gave the excuse for the above movement.
Shipowners ordered new vessels but unfortunately oil crises erupted in 1973. This and the war situation in Yom Kippur the same year resulted in the collapse of the tanker market. Freight rates dropped dramatically, with a similar impact on the price for a second hand vessel, creating serious financial problems for shipping companies. The situation became even more critical because of the orders for new vessels which had been made few years back.
That created the big tonnage surplus that market faced up to middle 80's.
As the banking world experienced that unpleasant situation, they were forced to reconsider their attitude towards shipping investments.
The crises drove some shipowners without financial background to terminate their activities. That made the banks suffer great losses, creating a general skepticism
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over the shipping sector, and making bankers ask for greater securities.
In order to lend a substantial amount of money now, bank must be secured for the overall cost binding the owner on personal securities or on other vessels of the fleet if there are any.
With a new order for a vessel, a long timecharter has to be provided giving the bank the possibility of amortization of the hole outstanding debt plus the interest.
Usually the time in which the bank has the right to collect profits from the ship operation is nearly half of the useful life of a vessel (assuming a vessel's life to be between 15-20 years).
That means that the shipowner can yield the profits from the remaining of the vessel’s useful life, giving him the possibility for profitable trade plus the possibility to sell the ship in a good, profitable market, earning by that way a higher amount in comparison with a simple operation.
The economical situation today has caused some banks to be highly selective as regards shipping, lending mostly to well established companies with a good reputation and a strong financial basis. Even in this case the normal finance ratio in their ship financing does not exceed the 70 % of a vessel price 11. But at the same time some other banks, realizing that shipping is still a profitable market, tried to adapt shipping finance in their portfolio by taking equity positions enabling them to participate in profits.
11 Paine, The financing of Ship Acquisitions, 1989
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4.1.2 PRIVATE EQUITY
Private equity was the major source of shipping finance especially in the early 60's
More traditional owners, inexperienced with financial activities, preferred the private investments, to avoid debt, and any relation with bank institutes was not seen positively.
In the 70's started an exposure to financial debt due to the increased need for greater amount of money in order to cover newbuildings activity.
4.1.3 SHIPYARDS
In the occasion of newbuildings, the official export credit agencies have an important role in the financial market.
There are basically three types of export credit programs12: a) The first type involves direct finance form the local export financing agency to the buyer of the vessel. b) In other cases the credit takes the form of notes issued by the buyer to the shipyard under the construction contract. The shipyard then sells the notes to the export credit agency, or borrows against them. c) The third is that export credit agencies package a group of export credits, and
12
Paine, The financing of Ship Acquisitions, 1989, p. 6
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sells them on a discounted basis, with or without recourse, to syndicates of international commercial banks.
However, a few of the programs are done on an interest subsidy basis, under which an official export credit agency merely guarantees to commercial banks, actually providing finance, that their yield on the transaction will be at least some specified spread over LIBOR (London Interbank Offered Rate), even though the rate to the borrower is fixed at 7-9 %. In other words, the export credit agency makes up the difference, but takes no credit risk and is not responsible for providing any funding13.
The big difference with an ordinary term-loan, is a grace period of 1-2 years, which means that the borrower does not have to start paying his amortization before this time.
The terms of the official credits are in most cases as follows:
Amount: 80 % of contract price; Tenor or Term: 8 years; Interest rate: 9% fixed;
Amortization: equal semi - annual installments of principal.
There are, however, some notable variations with respect to the security required and the currency of the financing.
4.2 THE NEW ENVIRONMENT
13 Paine, The financing of Ship Acquisitions, 1989, p. 6
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Shipowners need a modern and effective financing method in order to be able to restore the stability in the shipping industry.
Old ships must be scrapped or be laid up as new environmental regulations by
IMO (International Maritime Organization) make the operation of old fleet inefficient.
But the construction of new vessels is a highly capital intensive matter which need new finance sources in order to create a positive environment for the shipowners who will accept the risk and the financial debt.
4.2.1 PRIVATE PLACEMENT
"The private placement is a private sale of a new issue of equity and / or debt securities to a limited number of investors. "14
Private placement is the least expensive method of issue.
The people investing in a public placement are people related with the shipping industry such as other shipowners, captains,people with previous engagement in the area - or financial institutions closely related to shipping.
This method has benefits such as the reduction of financial risk and positive cash- flow streams with better prospects as the company will expand in the future.
On the other hand, the greatest disadvantages, in an area in which family companies are a majority, are the loss of privacy and the loss of control.
14 Paine, The financing of Ship Acquisitions, 1989, p. 6
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4.2.2 PUBLIC OFFERING
"New issues of equity and / or debt securities made available publicly by already listed companies or companies going to be listed on the stock exchange".
A shipping company can increase its equity capital by retaining earnings or by selling new common stock.
Banks usually, take the responsibility of issuing the stocks, providing the company with all the necessary information before a company goes public.
The main underwriter will be the bank which will undertake the risk of price fluctuations during the period of issuing in return of a fee.
As the shipping industry acts in the world market, it will not be a problem to raise funds in different markets.
Apart from the project’s attractiveness to investors, the general perception of the shipping market, its earnings and appreciation potential will be the deciding factors for investing in the shipping industry. Due to the high risk of investment, shipping companies usually offer a higher dividend payout.
Since shipping is an industry with certain peculiarities, companies wishing to be listed have to show certain standards features such as proven earning capability, liquidity , competent management and transparency.
Investors expect companies to be structured defensively, i.e. to have a degree of tolerance of short - term loss built in15.
15 Mr Chiliadakis Interview 1997
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Benefits with public offering: 16
Greater company image: A company will be exposed to the public. Investors will be familiar with the company and its possibilities as daily listing in stock market tables and press releases will create a positive climate for that company.
Better financial basis:
The cash - flow stream that public offering is bringing, will strengthen the equity basis of the company allowing them to borrow funds with more attractive interest rates.
Disadvantages:
- Loss of privacy: When a company shifts to public status, it is required to reveal highly sensitive information, such as compensation paid to key executives, special incentives for management, and many of the plans and strategies that underline the company's operations. While this need not include every detail of the company's operation, information that could significantly affect investors' decisions must be disclosed; and it will have to be updated on a continuing and timely basis thereafter.
A more bureaucratic decision - making progress which to a certain degree limits management freedom to act. Furthermore, shareholders generally judge management performance in terms of profit, dividends and stock prices and apply pressure to increase earnings per share and dividends.
This may cause management to emphasize short-term strategies instead of longer-
16 Grammenos, City University 1996
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term plans.
4.2.3 JUNK BONDS
Junk-Bonds are similar to other kinds of fixed-income securities in that they promise to make specified payments at specified times and provide legal remedies in the event of default17. Bonds are more attractive in raising funds than common stocks as the cost of underwriting and distributing debt is lower.
A very important factor is the bond rate. Is it a fixed or a floating interest rate?
The decision depends on the company's project.
A company must consider the fees, the coupon, the average size of the issue and finally the level of interest rates in the economy.
In comparison with term loans, a bond issue usually has lower cost and greater maturity (up to 20 years) but can be more inflexible due to its greater maturity period.
Recently, great importance has been given to junk bonds which are bonds of high risk. Usually these bonds are issued by companies that have been rated low from international credit institutions like standard “Poor's” or “Moody's” giving them a credit ratio of BBB - or Baa 18. Shipping companies belong to that group and just for the Greek shipping industry last year bonds were issued for a value of 115bn
17 Ross, Westerfield, Jaffe, Corporate Finance, p.286 18
Nautemporiki june 1997
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USD, represented mostly by two companies, the Global Ocean Carriers and the
Eguimar Holdings.19
Shipowners have realized that bond issuing is a faster development way in comparison with traditional bank lending as they can channel investment money in new orders until the maturity day instead of amortizing the bank loan.
4.2.4 LIMITED PARTNERSHIP
The above method is a tax beneficial way of attracting capital from the public into the shipping industry.
The method is applied mostly in countries with high taxation and a typical example in the shipping world is Norway.
The company under Limited Partnership is a single purpose company with an unlimited liability for the principal and limited liability for the general partners.
Benefits of the above method are concentrated in the individual taxation in relation to the company taxation.
By that, funds and capital can be re-invested in similar projects, avoiding to be taxed twice.
A typical ratio for a Limited Partnership is 20/8020. That means that investors subscribe to approximately 20 % of equity against 80 % of bank lending,
The investor will have a financial commitment exceeding his share of the equity
19 Nautemporiki june 1997 20 Svejn Ung Debdahl, Interview june 1998
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by an "uncalled capital commitment " which will be normally up to 2 times the amount already paid. 21
Disadvantages with Limited Partnership have been criticised as being an indirect way for subsidising the Norwegian shipping industry, especially in light of the competitive environment of the European market.
Finally, when a vessel is sold, the profits will be distributed to the investors according to their share.
21 Den Norske Bank 1997
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5. ANALYSIS OF THE FINANCIAL METHODS
As shipping is a capital intensive business with high risk, expectations from financial investors are related to their risk.
But as any other investment, shipping area follows rules that are accepted by the international finance theory, and we are going to look at these in order to set out a pattern for future investors.
Due to shipping peculiarities, investors must always be well informed and in constant communication with that area.
According to Mr. Chiliadakis C.E.O. of Midland Bank in Greece, investors believe in companies with a modern corporate structure and competent management.
Companies must follow a strategy in order to achieve: i) High returns on the investment capital ii) Efficiency iii) Economical stability
As we said above, investors seek a "clear" view in corporate structure for companies in which to invest money. Transparency is a key concept in the shipping industry as shipping companies are organised in a network of holding companies, one for each vessel.
That creates a confused situation for the investor who does not have a complete view, the result being avoiding to invest in such a project. For the above reason, a clear picture of the company structure will make the investor recognise a dynamic
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management with good prospects.
5.1 OPERATIONAL VIEW
The economic environment create fluctuations which affect earnings making investors to be unsure for their returns.
For that reason shipping companies have to use methods in order to reduce volatility and to stabilise returns.
These methods have been analysed below.
Operations
Good operation will result in cost reduction and higher profits. A strategic planning in vessels, chartering with a balance between them chartered on a time - charter basis and vessels operating on the spot market, will result to a stable cash - flow stream, which is enough to cover the main costs and attain a good position in order to take advantage of a sudden upturn in the market.
Of course that depends on the charterer who is providing the cargo and negotiating the freight rates.
A good and close relation with different charterers will result in stable cash flow, which is a necessity for the prosperity of the company.
5.2 HEDGING RISK
Hedging will offset the firm's risk by a set of transactions in the financial markets.
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Financial instruments such as future contracts or forward contracts will hedge the financial risk of the investor and at the same time will secure the company against market risk as also risk against fluctuations of fuel prices22.
Financial risk can be divided in two kinds:
The interest rate risk and the currency risk.
Since shipping is a capital intensive business, a fluctuation in interest and exchange rate will affect the company and its expected return and for that reason a hedging strategy will benefit the company in a distress situation.
Our subject is not to analyze hedging strategies; we are just going to mention that hedging instruments for the above occasion can vary from future of forward contracts to the multi - currency options.
With market risk we mean hedging against freight rates. Biffex23 is the tool we use to hedge against fluctuations in the freight market.
The concept is future exchange trading units based on a shipping index and that a shipowner can on the Biffex offset a "loss" in the freight markets by a gain in the future market.
Fuel prices depend on the fluctuations in the oil market. These fluctuations affect the fuel costs for vessels and the effect can be off set by a forward contract to a known price that depends on speculations for the future oil price.
22 Kokinis Christos, Interview 1998 23 Tsakkos A., Interview 1998
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5.3 FINANCIAL THEORY
A closer view of the investment can be succeeded by a disclosure of the financial ratios of the companies.
Based on that, an investor can take his positions and make critical decisions for the future of his investment.
But some necessary knowledge must be cleared in order to understand the idea behind a decision.
An investor will aim at a high return similar to the risk he is taking, as a compensation to that risk. There are actually more than one financial models that can give the relation between risk and return. Two of them are the Arbitrage
Pricing theory and the Capital Asset Prising Model (CAPM )24. We chose the later to explain the above mentioned relation and this model is set up as follows:
E ( Ri ) = Rf + [ E (Rm) - Rf ] * i
Where : E ( Ri ) = The expected return on a risky asset ( i ).
Rf = The return on a long term government bond.
E ( Rm ) = The expected return on the market.
i = A measure of risk for the asset ( i ).
[ E ( Rm ) - Rf ] = The risk premium the left hand side of the equation, that is Rf, incorporates the expected real return, expected inflation and liquidity premium, while the right hand side accounts for
24 Ross, Westerfield, Jaffe, Corporate Finance, p 238
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the risk premium required on this particular asset ( i ).
The risk premium has on average been 8.5 % 25 . Shipping companies have been commanding premiums of up to 18 % 26, depending on the individual characteristics of the particular company. If a risk - free investment stands at 8 %, the return of the shipping stock will be between 25-30 % 27The most important financial ratios for shipping that investors look at are the following : 28
5.3.1 Liquidity ratio :
Current Assets / Current Liabilities
Liquidity refers to the ability of a firm to meet its short - term financial obligations when and as they fall due. Shipping companies should have a high ratio.
5.3.2 Solvence ratios:
Total Debt / Total Assets
Total Debt / Equity ( Gearing )
Long Term Debt / Equity ( Leaverage )
These ratios provide insight into the extent to which non equity capital is used to finance the assets of the firm. Capital from debt and other creditor sources is more risky for a company than equity capital. All of the respondents stressed the
25 Ross, Westerfield, Jaffe, Corporate Finance, p.238 26 Midland Bank july 1997 27 Midland Bank july 1997 28 Royal Carribean annual report 1997
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importance of keeping these in moderate limits. The gearing should for most of the
29 time not exceed 25 % .
Time interest earned ( EBIT / Interest Charges )
This ratio measures the extent to which earnings can decline without causing financial embarrassment to the company because of inability to meet annual interest costs.
Capitalisation rate E/P
These reflects the rate at which the market is capitalising the value of current earnings. The higher the likeness that the projected earnings will be realised,the lower the applied capitalisation must be. Since the shipping business is considered highly risky, the capitalisation rate must be high.
5.3.3 Leverage
An investor has to be informed about the debt in relation to equity that the firm has. At the same time, it is of great importance to know the size of the company's operating fixed costs (insurance, rent ) as opposed to its variable (labor)ones.
The two models which can describe the above situations are given below :
Degree of Financial Leverage ( DFL ) is measured as DFL = % change in net income ( WI ) / % change in EBIT
29 Fairplay june 1997
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Degree of operating leverage ( DOL ) is measured as
DOL = % change in earnings before interest and Tax ( EBIT ) /
% change in revenue
In the shipping industry, fixed costs are relatively high. That means that a shipping company's break - even point will be higher than for a company which is less capital intensive.
But as the break - even point has been reached, it's profit will rise more rapidly than those of less capital intensive company.30
A combination of a high degree of operating and financial leverage will mean that even small changes in the level of revenues will produce wide fluctuations in net income, return on equity and earnings per share ( EPS ).
The model that measures the degree of combined leverage is given below:
DCL = DOL * DFL
In our case, shipping companies must keep financial leverage in certain limits as they cannot avoid high operating leverage.
That will help a company to survive in the occasion of a downturn in the market.
5.4 INVESTORS SIGHT
30 Ross, Westerfield, Jaffe, Corporate Finance, p. 286
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As we mentioned before, investors must have a clear view in order to evaluate investment methods that have been used by shipping companies.
Some basic factors in help of evaluation will be the following:
5.4.1 Operational view
By operational view companies can reduce the volatility of the market and at the same time stabilize cash-flow streams.
That can be achieved with good co-operation between first class charterers and shipping companies in order to close Long - term Contracts of Affreightment and long term timecharters.
The above cooperation will help the company retain its financial health, having the possibility of maintaining the fleet as modern as possible and becoming as efficient as it can get.
Additionally dynamic management will be ready to hedge against currency fluctuations as well as against prices of fuel oils and interest rates.
5.4.2 Financial Ratio Disclosure
Good information exchange between companies and their financial institutions will create a confidence between the two parts. That will help in the event that the company will need to raise additional finance.
5.4.3 Competent management and well corporate structured
The ability of management to be in contact with the market and the constant development of financial instruments is a necessity in a prosperous shipping
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company.
5.4.4 Rationalization in strategy and thinking
Companies should have strategies both for the long - term and the short - term and be aware of different scenarios that can happen and be able to respond to them in a rational way.
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6. CONCLUSIONS
At the end of our dissertation we will point out the results from our analysis.
With these in mind, conclusions can be drawn and a possible pattern for future shipping finance can be given.
6.1 FINANCING METHODS
As we realised, a strong financial base is the most important factor in a capital intensive business such as shipping.
Investors look for companies with competent management, a well structured organisation and a solid equity base. Leverage must be kept in reasonable grade, keeping debt under certain limits . That will encourage potential investors to take the risk and put money in the risky area of shipping.
It will also enable companies to be financial stronger providing them with the necessary equity base to be enable them to withstand a period of low freight rates and hard harsh competitiveness.
The traditional bank financing in form of loans will still be the method chosen by most shipowners to finance their projects. Their close relation with bank institutions and the possibility of tailor- made financing based on their needs will prompt traditional shipowners rely on their bank operators.At the same time it will be much easier to persuade them about something that they already know and have already used.
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This has been the opinion the people who have been interviewed have held with regard to the majority of shipping companies in the future.
Additionally, banks today have much more experience than previous years with special sectors just for shipping finance. Their executives are experienced staff, with knowledge about shipping peculiarities, who are ready to give immediate support to shipowners without the bureaucratic situation of the past.
Large financial institutions such as MIDLAND BANK are willing to underwrite public offerings, to take equity positions and to offer advanced financial services simulated to the shipping industry such as corporate advice and cash management.
In case of newbuildings export credit agencies have the main role through the shipyards’ financing. Even in that case, banks are the financial source with the difference that their profits will be a higher yield based on a larger spread over the
LIBOR.
A crucial detail in shipyards finance is that the shipping company will have the benefit of a grace period up to 2 years before they start amortize their loan debt.
Under that period, shipping company will have the opportunity to strength its equity base due to cash inflows from its trading activity. `
Evaluation from the above is that in the case of newbuildings shipyard finance will be in favor as the grace period seems to be very attractive for the companies.
Among new financing methods, junk bonds is the one which, offering substantial benefits such as pay - back of maturity day, is most preferred in our days as an
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attractive alternative method in order to raise finance.
Most of the Greek shipping companies, as we found out during our interviews, advocating that method, just in last year issued bonds for an amount of 150 bn
USD.
As new orders are coming all the time, we believe that bond issuing will take the biggest share in the near future, as the market is mature in bond financing and the
LIBOR is rating in very good levels.
Public offering is the second most common method to raise finance.
It was mostly in Scandinavia that this method gained acceptance. The choice of stock market mainly and sponsoring and underwriting afterwards contributed to the success of the issues. The Oslo stock exchange is the stock market where shipping has a great share among the whole trade as 30% of listings worldwide can be found in that.
Worldwide investors who seek shipping shares can find in Oslo the market that is specialized in the shipping industry.
In addition, as the domestic capital seems to be insufficient in order to cover the amount that the shipping industry seeks, foreign investors have the opportunity to trade expecting high returns.
On the other hand, the Greek market, being mainly dominated by family companies, seems to be unwilling to raise capital through public offerings.
Loss of ownership and privacy makes Greek shipping companies avoid the above
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method. At the same time, the need for a big amount of equity presses the companies to find solutions in order to raise capital. According to the people who have been interviewed, the market conditions will play a crucial role in the decision of shipowners on whether to go public or not, depending on their financial status.
Finally limited partnership has been explored mainly in Norway thanks to the legal and financial environment.
But as conditions are changing constantly, it will be quite unpredictable if limited partnership will be attractive in the near future.
The higher ship value - in comparison wish some years ago - and the constant changes in the taxation method make limited - partnership an investment with high risk but without promising returns.
6.2 FINAL EVALUATION
Our final conclusions are summarized as follows:
The majority of the traditional shipping companies will continue to use the old and more widely used financial methods in order to finance their operation.
As most of them are family dominated, the idea of losing control discourages possible ideas of raising funds through stock markets.
When companies want to choose an alternative financing method, mainly junk bonds and public offering afterwards seems to be the most attractive finance
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method in order to raise capital.
Irrespective of what method a company will choose, stock markets and new financial instruments will play a crucial role in the future as the shipping industry will need big amounts of funds in order to cover the needs of such an important industry.
At the same time, from the investor’s side a clear view of the company’s operation and managerial capacity will affect the final investment decision. Companies, that have very few possibilities to adopt the new ideas but can present a strong equity base, are going to be the first to benefit from the future effect of an outside financial investment.
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7. CRITICAL EXAMINATION
As a big part of the fleet has been overaged, its renewal is of great importance for the shipping industry. For that reason, we consider our thesis as actual, particularly now when various shipping companies enter a period of large investments. We believe that even in the near future this thesis will be actual even though new development might take place and new ideas that can be applied in shipping might emerge. Nevertheless, a shipping company will already have past experiences to draw from and take the final investment decision. At the same time, studies like this which attempt to throw light on the financial methods problems, will always contribute towards a better understanding of such issues.
7.1 THE ESSAY’S VALIDITY
Validity is characterized by the absence of systematic errors31, meaning how good are the indications we have received on the investigated problem from the instruments made available to us.
The collected information for this essay has come from annual reports, interviews and books or articles. Annual reports have a high validity since all the companies have to follow certain rules and regulations, especially in the case of the financial information. Regarding the interviews, we have first of all, chosen people that
31 Lundahl & Skärvad, Utredningsmetodik för samhällsvetare och ekonomer, p. 67
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have great knowledge of the topic. We can not guarantee that they have answered in total objectivity but we think that the questions put to them during the interviews were well structured in order to support a systematic search through the areas that the respondents had knowledge in and the questions were relevant to our investigation.
As it comes to the theoretical part of the essay it is constructed on literature which would give it a high validity rate.
7.2 THE ESSAY’S RELIABILITY
Reliability means the absence of random measuring errors32. Who is doing the investigation should not influence the outcome. We have tried in this essay to stay as objective as possible and even if some influence have been introduced; it has been done unconsciously.
7.3 SUGGESTION FOR RELATED STUDY AREAS
In the course of preparing our dissertation, we came in contact with a variety of problems related to shipping but we knew that they were not relevant to our purpose.
Actually, we thought that it has been a great experience for us to get involved with
32 Lundahl & Skärvad, Utredningsmetodik för samhällsvetare och ekonomer, p. 69
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the industry of shipping and although we felt many times the temptation to expand, we realized that we have to limit ourselves to the topic of our investigation.
But now that we have reached the end, we think that it would be interesting to expose some of the problems related with shipping area, giving the possibility to future researchers to get involved.
First of all, we think it would be interesting to make a study on how the new financial sources we focused on in our essay have developed. It will also be interested to see how the shipping companies have adopted these financial methods.
Another interesting subject would be to find out how the shipping world is going to change. Will the countries using traditional shipping methods maintain their positions in the world of the shipping market? Or, will they, in adapting to a global and changing environment, be requested to make due adjustment?
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BIBLIOGRAPHY
BOOKS
. Hardwick P. Khan – An introduction to modern economics London, 1986 . Ignacy Chrzanowski - An introduction to Shipping Economics Fairplay Publications, London 1989 . Lindgren Christer – Metodkompendium för uppsatsarbetet på C-nivå, Stockholms Universitet, Företagsekonomiska institutionen, 1994 . Lundahl U., Skärvad P. – Utredningsmetodik för samhällsvetare och ekonomer, Studentlitteratur Lund, 1982 . Ross S, Westerfield R, & Jaffe J – Corporate finance Boston 1990 . Paine Francis – The financing of Ship Acquisitions Fairplay publications Ltd, Cambridge 1989 . Stopford Martin – Maritime Economics Unwin Hymay Ltd, London 1988
ARTICLES
. Fairplay, May 1998 . Fairplay, June 1998 . Fairplay, July 1998 . Nautemporiki June 1998 . Svensk Sjöfartstidning December1998
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ANNUAL REPORTS
. Cool Carriers Annual Report 1997 . Global Ocean Carriers Annual Report 1997 . Leif Höegh & CO. ASA Annual Report 1997 . Ocean Bulk Annual Report 1997 . Royal Carribean Annual Report 1997
INTERVIEWS
. Chiliadakis Lefteris, Shipping Direktor – Midland Bank, Greece . Kokinis Christos, Vice President – ABN AMRO, Greece . Tsakkos A.- Tsakkos Shipping, Greece . Svante Hellberg, Cool Carriers, Stockholm . Michaela Dahlman – ATC Shipping, Stockholm . Hans Ost Hejberg – Financial officer, Ocean Bulk . Svejn Ung Debdahl – Financial Manager, Grindlays Bank, Piraeus
ESSAYS
Triantafyllakis N.S. “The stock market as a source of Equity Fund Rising for shipping companies” City University Business School, December 1989
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APPENDIX 1
SHIPPING COMPANIES INTERVIEWS
Questionnaires used when interviewing shipping companies
1) What's the situation in shipping industry today?
2) What do you think will be the best way to raise finance according the investment knowledge that you have already.
3) Would you ever think to go public and if so why?
4) What advantages - disadvantages can you possible realize for the present.
5) What is your opinion about new sources of finance?
6) What will be - according to your opinion - the best way to raise finance in shipping industry? a) Bank loan b) Junk bonds c) Different forms of equity d) Private placements e) Shipyards f) Something else?
7) Do you believe that something must to change in corporate structure in order to attract investors?
8) By which methods can a shipping company reduce its operating costs resulting to a better view for the investors?
Hedging or Diversification?
In what areas is hedging more appropriate and why?
9) What do you think for the effects of the new financing methods as they can affect the established profile in shipping industry?
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10) How can you accept the loss of privacy and the loss of control in the new corporate structure, in order to raise capital?
11) Do you really believe that a shipping company can survive without help from the international financial market?
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APPENDIX 2
BANK INTERVIEWS
1) Which is the role of banks in today’s shipping market?
2) What are the financing methods that you believe as most attractive in the future? a a) Bank Loans b) Bond Issues b c) Public offerings c d) Private placements d e) Limited Partnership
3) What is your opinion for the above methods?
4) What is the bank terms in order to finance a shipping company?
5) What are the demands, from the organisation of a shipping company, for granting a loan?
6) What is the most basic criteria, that you expect to be fulfilled from a small shipping company, in order to raise capital?
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APPENDIX 3
Abbreviations
BIFFEX Baltic International Freight Futures Exchange
CAPM Capital Asset Pricing Model
DFL Degree of Financial Leverage
DOL Degree of Operating Leverage
EBIT Earnings Before Interest and Tax
IMO International Maritime Organization
LIBOR London Inter Bank Offered Rate
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