The following article first appeared in its original form in the 31 December 2009 investment newsletter of Lighthouse Advisors. It provided some background on the nature of shipping trusts, and discussed three of them in some detail. Subsequent events have materially changed the situation for all three trusts, and the case studies have been updated to reflect this. Those who wish to investigate further should refer to the individual shipping trusts’ announcements for relevant information.
No part of this foreword or the article below is to be construed as investment advice. The article is reproduced for informational purposes only, and the author accepts no responsibility for any inferences drawn or actions taken as a result of the article. Any opinions expressed therein are the personal views of the author and do not constitute a professional opinion for any purposes whatsoever. At the time of writing, Lighthouse Advisors is a “long-only” fund manager and holds no long or short interest in any of the trusts discussed.
Benjamin Koh
Investment Manager
Lighthouse Advisors
12 July 2010.
Benjamin Koh, Investment Manager, Lighthouse Advisors
SHIPPING TRUSTS are “alternative” methods of ship financing. Ships are usually financed by owner-operators via a combination of debt and equity. The creation of shipping trusts has allowed the separation of ownership from operation, and financial investors have since become significant owners of ships.
Shipping trusts have traditionally been private investment vehicles. Popular structures include the Norwegian kommandittselskap (KS) and the German Kommanditgesellschaft (KG) partnerships. In recent years, some shipping trusts have been publicly listed. Are these trusts valid investments?
The answer: it depends. As usual, the devil is in the details. The biggest question is whether the trust is structured as a going concern or a self-liquidating vehicle.
As a going concern, cash must be set aside for fleet renewal. It is a reality that ships age and must eventually be scrapped. Therefore the cash generated from depreciation cannot be returned to investors, but must be retained to finance replacement ships.
As a self-liquidating vehicle, there is no need to retain cash to renew the fleet, and therefore all the cash can be paid out. KS and KG vehicles fall into this category – at the end of the charters, the ships are sold or scrapped.
As long as investors understand the intent of the trust, and the trust managers behave accordingly, there is no problem.
The problem arises when the trust managers market the trust as a going concern, but then pay out cash as if the trust were self-liquidating i.e. 100% cash payout. This misleads investors who think that the high payouts are sustainable and do not realize that part of the cash received is a return of capital.
What happens eventually? The ships are scrapped, and the trust is wound up. Can the trust managers extend the life of the trust? Yes – by raising fresh funds. In other words, the ability of such a shipping trust to survive as a going concern depends on the whims of the capital markets. If capital markets are strong, funds can be raised to renew or even expand the fleet. But if capital markets are poor, no money can be raised, and the trust liquidates.
This is clearly a defective business model because survival as a going concern depends not on operations, but on public sentiment. For a shipping trust to operate as a bona fide going concern, it must retain cash generated from depreciation to renew the fleet. If there is debt, the debt must also be paid down. Otherwise, eventually the debt will exceed the value of the ships. Long before that, the bank would have seized and sold the ships.
A shipping trust that claims to be a going concern, but returns capital to investors as “income”, can only survive by regularly selling new units to raise fresh capital. Investors in such a trust must be prepared to come up with fresh money to keep the trust going. In the worst-case scenario, the cash calls may exceed the payouts to investors, leaving them with a negative yield on a net basis.
There are 3 shipping trusts actively traded on the Singapore Exchange. A comparative study yields some interesting insights.
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Case 1: Pacific Shipping Trust (PST) is an owner of container ships. 70% of its revenue comes from Pacific International Lines (PIL), PST’s listing sponsor. The rest comes from CSAV, a South American ship operator.
PST’s payouts are based on cash available after repaying debt. So as the ships depreciate, the debt is paid down. Also, PST currently pays out only 70% of the cash left after repaying debt. The 30% cash retention approximates the cash generated from depreciation. Thus, PST currently appears to be operating as a going concern, and it should be able to renew its fleet on its own when the time comes.
Still, PST has its challenges: it is negotiating with CSAV over the latter’s desire for reduced charter rates due to the poor freight rate environment. Should PST acquiesce to CSAV’s demands for fear of losing the charter entirely, PIL may demand the same treatment. Obviously, this would not be a pleasant turn of events for PST unitholders. Counterparty risk is clearly a problem for PST.
Update: Recent events have since changed the picture substantially. On 25 June 2010, PST committed to buying two dry bulk carriers, to be chartered to China’s Jiangsu Shagang group (or its nominee). This will diversify PST’s fleet away from containerships, and will reduce revenue dependence on PIL and CSAV to 53% and 24% respectively.
However, these twin beneficial effects come at a price. The current shipping finance market will only support a loan of about 60% of the vessels’ purchase cost, which means PST must fork out the balance in cash. PST does not have enough money on hand to pay the full 40%, which means it will probably have to raise funds from the equity markets when the bill comes due. This effectively puts it at the mercy of the capital markets.
If PST’s unit price is too low when capital-raising is needed, the deal may be yield-negative, and it may not garner enough support from unitholders to raise the funds, which might force it to cancel the acquisition of one or both of the vessels. That would in turn risk a lawsuit for breach of contract. It could be messy for all involved. Unitholders could be forced to support a yield-negative rights issue in order to avoid an expensive lawsuit, a no-win situation.
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Case 2: First Ship Lease Trust (FSLT) is an owner of a diversified fleet, comprising container vessels, oil tankers, chemical tankers, product tankers and dry bulk carriers. Until recently, FSLT paid out 100% of cash generated and did not pay down its debt. This essentially made the trust behave like a self-liquidating vehicle, regardless of any management claims to the contrary.
The current downturn has caused the value of FSLT’s ships to plummet, and it has been forced to renegotiate its loans with the banks to waive loan-to-value covenants. FSLT has placed out new units to raise cash, and it has also finally begun to pay down debt, albeit very slowly. This has of course impacted cash distributions, and investors who invested on the basis of the high yield are now stuck with much lower yields.
Also, there is significant debt due in 2012, which FSLT has no chance of repaying on its own. If the banks do not refinance the debt, FSLT must sell ships, raise equity or do both – but the shipping or capital markets may not be strong when FSLT needs to sell.
To make things worse, when the shipping market recovers, FSLT may lose ships: it agreed to buyout clauses in several of its charters, in order to raise the charter rates.
Should the shipping market be strong at renewal time, the customers will buy the ships cheaply, forcing FSLT to replace the ships at a high price. But if the market is weak, FSLT will have to renew the charters at a low price. So heads the customers win, tails FSLT loses.
FSLT’s past decisions helped to maximize the short-term cash flow and distributions to unitholders, but there were some tradeoffs in terms of risk. Investors will need to decide for themselves whether such risks are acceptable.
Update: FSLT has suffered a charterer default: it announced on 4 May 2010 that two of its ships, Verona I and Nika I, would be returned by Groda, more than three years ahead of the official lease expiry. The ships were subsequently arrested in Japan and China by bunker supplier Daxin Petroleum for unpaid fuel bills. FSLT has since posted a security deposit to secure the release of Verona I and is still negotiating the release of Nika I.
The vessels will be redeployed in the spot market and will earn substantially less than under the original charter terms. Shortfalls will be compensated out of Groda’s deposit, but that deposit will not last very long if current spot rates persist. If the deposit runs out, FSLT’s cash flow and thus distributions to unitholders will be adversely affected.
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Case 3: Rickmers Maritime Trust (RMT) owns a fleet of container ships. It originally paid out 75% of cash generated, but did not pay down debt.
As with FSLT, the downturn has caused a downward revision of RMT’s fleet value, triggering a negotiation of loan-to-value covenant waivers with its banks. Cash distributions have also been drastically reduced in an attempt to pay down debt, so those who invested for the high yield have received a rude shock.
Unlike FSLT, RMT also had huge future commitments: four 13,100 TEU ships were ordered without having arranged the financing. If the capital markets had remained strong, RMT units might have traded at a price high enough to allow equity fundraising. The current downturn has made this unfeasible, and the decline in the existing fleet’s market value has also ruled out the use of additional debt.
Reflecting the challenges facing RMT, its auditors Pricewaterhouse Coopers issued a disclaimer of opinion on RMT’s FY2009 financial statements, on the basis that if RMT was unable to deal with its short-term bank borrowings and capital commitments, the “going concern” assumption used to prepare the statements would not be valid.
Update: On 9 June 2010, RMT signed agreements with its banks to extend one of its loans for five years, and to waive the loan-to-value covenants for up to three years. On the same day, RMT also signed an agreement with its parent Rickmers Maritime Group to discharge RMT from its obligation to purchase seven vessels, including the four 13,100 TEU ships, in exchange for a penalty of US$15m in cash and US$49m in a convertible loan. These agreements clearly give RMT some much-needed breathing room, though it remains to be seen if distributions to unitholders will return to historical levels.
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