Doubling Down as an Exit Strategy?

The present state of the dry bulk market has caught many people in shipping by surprise; the wave of the orderbook getting delivered in 2015 onwards was expected, but several macro factors – and primarily China’s slowdown – were not properly factored in; as a result, dry bulk rates are close to thirty-year lows. Other sectors in shipping such as tankers and containerships – although markedly with cash flow positive numbers – have not been doing exceptionally well either. And now, with the collapse of the price of oil, the offshore industry is also under the watchful eye of creditors and value-oriented investors.

The weak state of the market definitely has ripple effects in every aspect of the maritime universe from shipowners with quickly diminishing cash reserves, to the deteriorating condition of shipping loans and their impact on the shipping banks and their capital ratios, to the collapsing prices for scrap metal and ships. One thought that has been in the mind of shipping people is the behavior of the institutional investors having entered shipping between 2010 and early 2014, when the markets were at higher levels – primarily in terms of asset prices. Most of these investments in hindsight turned out to be poorly timed and investors ended up catching a ‘falling knife.’ Hindsight is perfect, as they say, but most of the concern is with future action and reaction in reference to the underwater investments.

Private equity funds and institutional investors were never expected to be long partners and capital providers in shipping, just opportunistic investors exploiting the crisis and benefiting along with their strategic and limited partners from the recovery phase of the cycle. Thus, an exit strategy was expected sooner or later, and some people were concerned from the possible waves of said exit strategy. The most likely scenario of an exit strategy would have been an IPO whereby companies, businesses and ships could be sold at a profit to retail investors and hedge funds – constrained by mandates to invest small amounts or in liquid investments – but still aiming at an ever growing shipping market. The present state of the market with fairly weak asset prices is definitely not conducive to IPOs in an industry where shipping companies are valued at NAV of their long-term assets (ships) instead at a premium to that for management expertise or multiple of cash flows. One can easily realize that the damage done by ‘falling knives’ has cut too much into pricing that even in the tanker sector – where freight rates are strong enough to be suitable for an IPO, shipowners cannot dare go for an IPO; asset prices are well below the cost basis.

Typically, institutional investors have approximately five to seven years as an investment horizon, implying that for investments taking place in 2010, the window is not fully open any more.  Based on anecdotal evidence during our travels, whether from envy or misinformation, some shipowners are expecting that institutional investors will be forced to sell their ships to meet such deadlines, thus creating ripples in the market and also a buying opportunity; such an outcome is not likely to happen, at least not any time soon; there is still time for the funds to play for time and also deadlines to liquidate a fund and return proceeds to investors are not set in stone as there are provisions for extensions; and of course, unfavorable positions could be rolled over in future funds and  be given even more time to wait out the cycle and hopefully come to fruition.

There may be an alternative scenario on how institutional investors could react to the present unfavorable shipping market conditions and also better position themselves for an IPO – the dream exit strategy. Commodity prices for iron ore, coal, copper, etc. and also prices for oil and petroleum products, etc are at cycle lows whether it has been caused by excess investment and capacity (i.e. iron ore, oil, etc) or diminishing demand primarily from China. The corollary of this is that prices for newbuilding contracts can now be more favorable; the direct material cost is at least 10% lower than this time last year, all being equal, and thus the shipbuilders have room to lower prices. Also, most of the outstanding orderbook is maturing by the end of 2016, less than eighteen months away. It’s a scary thought, but the shipbuilders may decide to get aggressive later this year in attracting new orders and building their backlog once again. Given that commodity prices have been declining, many shipbuilders may decide to pass the savings to the buyers of newbuildings rather than go for thicker margins.  Besides lower newbuilding prices, likely ‘new and improved’ vessel designs may be developed by the end of the year, higher fuel efficiency, higher cargo capacity, bigger…better… why not a new ‘eco eco design’ to completely kill vessels of fifteen years of age and make hell the trading life of new, just ‘eco design’ vessels?

One may get tempted to question whether such line of thinking makes sense at all, when the freight market is at a thirty-year low (for the dry bulk vessels, at least,) the outstanding orderbook overall is more than 20% of the world fleet, and the majority of the vessels on the water at present are newer than five years old. It’s a fair prayer to have that buyers and investors will show restrain and self-discipline and will not follow up with a new wave of newbuildings trying to undercut the competition and double-down on their investments.  But as previously mentioned, shipowners are their own worst enemies and ‘shipping is not a team sport’, thus self-discipline is in the eye (or judgment) of the beholder, and each potential investor can decide their own course.  Furthermore, legendary investor Warren Buffett is happy to see share prices of stocks he owns to go down as that gives him the opportunity to buy whole companies at a lower cost; if doubling down is good enough for Mr Buffett, why then not good enough for the garden variety institutional investor with shipping interests?  And as an exhibit, another legendary investor, Wilbur Ross, ordered a series of Suezmaxes at $70 million per vessel in 2010; in the fall of 2014, it has been reported that his funds have sponsored the newbuilding contracts of four additional Suezmax tankers at $60 million apiece, bringing his overall cost basis to $67 million per vessel overall. If they were a good investment at $70 mil apiece, then they make an even better investment at $60 mil apiece.

It’s hard to predict how the present owners and institutional investors will react to the weak shipping market; there are many variables that can change fast, including the freight market itself. On the other hand, there are too many contributing factors that favor a new wave of newbuilding contracts and going for a ‘doubling down’ strategy: low commodity prices that drive lower newbuilding costs, comparatively low interest rates that make newbuildings a fair game, excess shipbuilding capacity and a diminishing orderbook by the end of this year - plenty of money to be invested, whether in shipping or other industries, whether by funds with shipping exposure or funds still looking for optimal timing to get invested in shipping…whether the freight market moves up or down, it will stimulate more orders, too.

Possibly doubling down may provide the best way out… sometimes one has to wonder…or wander…