Shipping’s false idols of equity and debt

Shipping’s false idols of equity and debt

A colleague’s piece I read recently mixed up some of his financial terms in an obvious market shorthand manner that reminded me how seasoned investors fudge their numbers such that they can side with momentum (‘Mr Market’) when they please, but only through passing risk-returns onto others.

If we go back to what got shipowners in their mess post-2008, it was cheap capital and over-ordering of ships. We are not going back to the exact same problems because banks this time are holding back loan capital from shipowners, even good shipowners. And this has forced on a new problem.

When we look at the cost of capital we need to remember that the cost components of debt and equity are completely different. In short, long term we want a balance of financing between debt and equity based on an optimum capital structure. We all remember the 70-80% ranges for asset level debt finance. At a corporate level this figure might be higher or lower, depending on corporate quality and risk taking.

But what we have now is a pear-shaped mess. On the one hand we have high leverage players either hanging on by a thread or working through the mess of assets they got in at recent cycle highs.

And then we have a combination of new capital and survivors financing principally through equity cash raises.

Recently, we saw quite a few 9% type structured equity (ie, cumulative preferred shares).

And all through the post-crisis periods we have also seen share placements with large discounts or share sales that effectively kill off share prices, most recently Nordic American Tankers and Diana Shipping. But also others.

Often, these have been opportunistic placements just at a time of a small recovery in shares, followed by irresponsible banker and shipowner behaviour killing off their shares.

What these owners and bankers have often missed, or more likely wholesale ignored, is that there is a cost to equity, which is far higher than debt.

We need to focus on the new capital raises from these old and new ship investors. The older guard is made up of established fund or private equity type investors. And many of these are using 100% equity finance.

When we look at WACC, the weighted average cost of capital, equity is usually a far more costly component – and yet many in the market behave as if it is free. Including the long-term tested investors.

Charles de Trenck

Charles de Trenck began his study of China in 1980 and eventually got in on the ground floor in China's equities boom of the early 1990s through work in Hong Kong and China shares. By the mid-90s he shifted to containerised trade, ports and shipping, eventually leading Citi to #1 rankings in Asia transport equities.

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4 Comments

  1. Skipper
    March 28, 2018 at 6:17 pm

    In reality, by introducing any levels of debt, the cost of equity increases in long term to offset short term advantages and leave WACC unchanged!

    Secondly, debt is preferred where there are tax advantages, but since levels of profitability are low, tax advantages might be close to nil. Therefore, why accept any level of debt that brings pressure on cashflows, potentially handing over control of the business operations to the debt holders(ie. to the banks!), nevermind conflict of interests between debt-equity holders?!
    So, high levels of debt are definitely a false idol!

  2. charles detrenck
    March 28, 2018 at 9:15 pm

    Skipper: Thanks for the comments.

    This piece was part of a longer set of articles, which began as a dialogue with a long time investor, and is a little simplified here.

    But you raise a good point on the advantages of debt historically versus current perception.

    There was a time when debt was a great tool. And then it was massively abused, with the help of German banks, KG, Japan finance structures, etc. Some of these structures are still available, especially for Japan yards, which are taking full of advantage of these features.

    Perhaps now what is being abused is the concept that equity is free!

    I would want to sit down and run through debt, equity as components of WACC, and then take that against target returns in the form of ROIC and ROE. … And eventually come back to a discussion on ship rental returns and store of value relative to vessel supply and long term inflation/deflation of manufacturing costs.

    Thanks and best

  3. Shipping Finance
    March 29, 2018 at 12:16 am

    I would have to agree with the previous above. I think author needs to distinguish between the different types of investments that can be made within shipping.

    1) In an opportunistic asset play type situation, cash is king. Asset prices are cheap only when charter rates are low. So best time to invest is usually a time where charter rates are at/below OPEX hence not generating enough cash to satisfy any sort of debt obligations. But these investments are made with the hope to give double digit returns when/if market recovers. So these sort of investments tend to be all equity just to manage the cash breakeven levels. when market recovers and charter rates increase, only then debt starts getting introduced into the picture.

    2) But if you are looking at a yield play investment within shipping i.e. asset with relatively long term charter attached, then yes the typical capital structure to maximise profitability by taking on debt can be applied.

    1. Andrew Craig-Bennett
      April 3, 2018 at 2:07 am

      The seasoned asset player will want to move fast, both in and out, and secured debt, even where there is an excellent relationship with the creditor, takes a little time.

      In a long term deal, one can put in a suitable level of debt at any time.

      As Charles says, we all know that equity is expensive, and many people forget that “in the heat of the moment”.