Financing Shipping Companies and Shipping Operations

V O LU M E 2 3 | N U M B E R 4 | FAL L 2 0 1 1

Journal of

APPLIED CORPORATE FINANCE A MO RG A N S TA N L E Y P U B L I C AT I O N

In This Issue: Private Equity and Capital Structure Morgan Stanley Roundtable on The State of Global Private Equity

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Panelists: Steve Kaplan, University of Chicago; Carl Ferenbach, Berkshire Partners; Mike Bingle, Silver Lake Partners; Marc Lipschultz, KKR; Phil Canfield, GTCR. Moderated by Alan Jones, Morgan Stanley.

An Empirical Model of Optimal Capital Structure

34

Jules H. van Binsbergen, Northwestern University, John R. Graham, Duke University, and Jie Yang, Georgetown University

The Evolution of Private Equity in Emerging Markets: The Case of Poland

60

Darek Klonowski, Brandon University

Financing Shipping Companies and Shipping Operations: A Risk-Management Perspective

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Stefan Albertijn, Alfred C. Toepfer International GmbH, Wolfgang Bessler, Justus-Liebig-University Giessen, and Wolfgang Drobetz, University of Hamburg

Creating Value at the Intersection of Sourcing, Hedging, and Trading

83

Blaine Finley and Justin Pettit, IHS

Spin-offs: Tackling the Conglomerate Discount

90

Ajay Khorana, Anil Shivdasani, Carsten Stendevad, Sergey Sanzhar, Citi

Pre-Issuance Hedging of Fixed-Rate Debt

102

James Adams, J.P. Morgan Securities LLC, and Donald J. Smith, Boston University

Market Interest in Nonfinancial Information

113

Robert G. Eccles and George Serafeim, Harvard Business School, and Michael P. Krzus, Mike Krzus Consulting

Financing Shipping Companies and Shipping Operations: A Risk-Management Perspective by Stefan Albertijn, Alfred C. Toepfer International GmbH, Wolfgang Bessler, Justus-Liebig-University Giessen, and Wolfgang Drobetz, University of Hamburg

he shipping business is both big and important. Thanks in part to low-cost maritime transport that has helped make possible the shift of industrial production to emerging countries, ships are now involved in roughly 90% of global trade. Modern vessels are sophisticated assets that often require more than $150 million to build. And the global shipping industry generates an annual income of almost $500 billion in freight rates, representing approximately 5% of the total global economy.1 Shipping has also always been a volatile business, one that is tightly linked to the general business cycle. Shipping industry revenues followed booming world trade fairly closely up until mid-2008, with the Clarksea index of freight rates reaching a peak of 47,567 at the end of 2007.2 But as the global financial crisis spread and deepened in 2008, the index dropped almost 85% from its peak to a low of 8,025 in April 2009. And the market value of ships followed freight rates down, with the Clarkson Second Hand Price Index falling roughly 40% from a peak of almost 350 to below 200. Such extreme changes in revenues, operating cash flows, and asset values have upset the usual means of financing shipping companies. In the past, the industry raised as much as 75% of its external funding from banks,3 while bonds and public equity provided only about 5%. But the financial crisis also created capital, credit, and bailout problems for banks that specialize in shipping. In 2009, for example, the volume of syndicated shipping loans (see panel A of Figure 1), which once accounted for over 40% of total ship finance, fell by more than 60%. The number of active shipping banks has fallen sharply, and the banks that are still in the business are spending more time restructuring existing loans than making new ones. To the extent that new loans are granted at all, the volumes are lower, and the maturities—now five years at most—are considerably shorter than those that characterized the pre-crisis period. As shipping loans have become less available and more expensive for borrowers, they will also be less profitable for banks for three reasons. First, listed shipping companies need to comply with fair value accounting standards, which make

the high volatility of vessel prices and collateral values more visible. Second, new capital adequacy and liquidity standards under the Basel III framework will require shipping banks to allocate substantially more equity to shipping loans. Third, the recent crisis made it clear to shipping banks that many single-vessel companies had insufficient collateral. But even as its sources of bank funding are shrinking, the shipping industry will require more capital in the near future because of aging fleets, higher safety standards, loan rescheduling, and increasing global trade. Financing ships, shipping companies, and shipping operations—what Moody’s calls “exotic” finance—will be a key challenge in the maritime industry, given the new regulatory constraints on bank lending. What this means is that much of the risks involved in the shipping industry will have to be transferred from bank balance sheets to capital markets through the issuance of bonds and public equity. And as part of this transition, many shipping banks are likely to change from risk-bearing lending institutions (that is, commercial banks) to institutions that function more like investment banks and provide a variety of capital market solutions, including the use of risk management instruments such as freight derivatives. Recognizing that the shipping industry must consider new approaches to funding capital budgeting projects, this study analyzes the financing alternatives and risk management activities of companies that own, lease, charter, or operate ships. In their attempt to optimize financing decisions, the managers of such companies should recognize that risk management involves simultaneous decisions about shipping operations, the use of derivative instruments, and the firm’s capital structure. When managing the risks associated with changes in their operating cash flow and asset values, the companies must decide whether it is better to retain and manage the risks internally or transfer them to the capital markets. And as discussed in this study, when determining how much and what forms of outside capital to raise, shipping company managements should go through the following four steps: 1. Understand the risks involved in owning and/or operating commercial vessels.

1. See International Maritime Organization, 2006; http://www.marisec.org/worldtradeflyer.pdf. 2. The Clarksea index is a weighted average index of freight earnings for the three major vessel types, i.e., bulker, tanker, and container vessels.

3. See ABN AMRO, 2011, Shipping Finance and Investment: Current Trends in Ship Finance, Istanbul: 3rd Mare Forum in Ship Finance.

B T

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Journal of Applied Corporate Finance • Volume 24 Number 4

A Morgan Stanley Publication • Fall 2011

Figure 1 Sources of Ship Finance Panel A: Syndicated Shipping Loans

Panel B: Shipping Bond Issues 12

100 90

10

80 70

8

60 50

6

40

4

30 20

2

10 0

0 2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

1993

1995

1997

1999

2001

2003

2005

2007

2009

Panel D: Shipping Equity Issues

Panel C: Yield Premium on the Shipping High Yield Bond Index 18

30

16

25

14 12

20

10

15

8 6

10

4

5

2 0

0 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

BB Corporate Bonds

B Corporate Bonds

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

Shipping High Yield Bonds

The numbers in panels A, B, and D show issuing volumes in $bn. Panel C shows the yield premiums for the Bank of America Shipping High-Yield Bond Index and the Barclays B- and BB-rated corporate bond indexes (in percentage points measured against the Barclays U.S. government bond index). The data are from Marine Money and Thomson Reuters Datastream.

2. Evaluate the benefits and costs of the relevant risk management techniques and instruments. 3. Weigh the benefits and costs of debt and equity capital. 4. Choose the value-maximizing combination of financing vehicles and risk management tools.

of vessels, which have become more visible due to the recent requirement to comply with fair value accounting standards, are of immense importance in the shipping industry. The risks of fluctuations of vessel prices not only affect individual shipping companies and their financing banks, but have the potential to set off a downward price spiral and magnify shocks to the economy.4

Operating Cash Flows, Asset Values, and Industry Risks Business risk is usually defined as the potential decline in the value of a shipping company caused by changes in the major sources of uncertainty that affect its profitability. However, any risk management process starts with identifying the different sources of business risk. We classify the risks of a shipping company into two main sources: risks from changes in operating cash flows and risks from changes in the market value of assets. Such changes affect shipowners, operators, and financiers alike. One important lesson from the current shipping crisis is that, even without significant changes in expected operating cash flows, the risks from declines in the market value

Risks to Operating Cash Flows The risk of changes in operating cash flows, or operating exposure, refers to variations in a company’s cash flows that are caused by changes in output or input prices as well as a lower level of capacity utilization. Examples for shipping companies include freight rate risk, operating cost risks, such as bunker price risk, interest rate risk, and exchange rate risk, among others, as well as counterparty risk.5 Freight rate risk. Freight rates are the main source of income for a shipping company, and therefore the variability in earnings due to changes in freight rates constitutes the most important operating exposure. As a consequence, the volatility of freight rates has a direct impact on a shipping company’s

4. See “Bankruptcy and the Collateral Channel” by Benmelech and Bergman in the Journal of Finance 66, 337-378; 2011.

5. For a survey of operating risks, see “Shipping Derivatives and Risk Management,” by Alizadeh and Nomikos, London: Palgrave-McMillan; 2009.

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A Morgan Stanley Publication • Fall 2011

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Table 1 Descriptive Statistics of Shipping-Related Time Series Mean

Sample period: # Obs.

Volatility Skewness

Kurtosis

Normality

(S.D.)

(S)

(K)

(JB-test)

Autocorrelation 1st

12th

ARCH effects 1st

12th

Clarksea Index

256

-1.19

34.68

-0.48

5.39

70.1

***

23.0

27.5

19.4

57.0

Baltic Dry Index (BDI)

256

-0.83

53.09

-1.16

14.38

1483.3

***

41.3

75.4

47.1

84.9

Baltic Dirty Tanker Index (BDTI)

152

-0.46

62.00

0.13

4.41

13.0

***

2.7

14.6

0.9

14.1

Baltic Clean Tanker Index (BCTI)

152

2.08

59.33

0.18

3.69

3.8

4.3

25.6

0.2

8.1

MDO Bunker Prices Index, Rotterdam

256

8.17

29.10

-0.16

6.39

123.4

***

24.7

49.1

7.8

58.8

Bulker Second Hand Price Index

256

4.35

31.98

-1.90

19.87

3188.6

***

1.0

55.7

16.7

21.7

Tanker Second Hand Price Index

256

1.87

13.20

0.26

16.05

1819.5

***

15.2

35.8

1.4

5.7

Container Second Hand Price Index

174

0.15

17.39

-1.13

9.65

358.1

***

19.7

94.1

0.2

17.9

Bulker Newbuilding Price Index

256

0.40

7.54

-0.71

6.25

134.5

***

45.9

154.3

16.5

47.4

Tanker Newbuilding Price Index

256

0.53

7.31

-1.40

10.77

728.4

***

37.3

101.1

0.1

3.3

Container Newbuilding Price Index

174

-0.35

9.23

-2.10

14.74

1125.6

***

42.5

83.6

40.6

44.2 4.5

1990.01-2011.04, monthly data

Bulker (Capesize) Scrap Index

256

3.29

30.93

-5.09

59.15

34325.4

***

0.7

9.2

3.9

Tanker Scrap Index

256

3.71

28.41

-3.47

37.28

14049.6

***

0.1

5.9

1.8

2.3

ShipInx (30 largest listed shipping companies)

103

18.63

30.22

-1.33

7.46

115.7

***

4.4

15.4

19.3

23.3

BOFA High Yield Shipping Bond Index

179

8.37

10.19

-1.74

16.98

1547.9

***

24.5

50.2

16.2

29.9

MSCI World Stock Market Index

256

6.37

15.73

-0.88

4.97

74.1

***

3.7

9.8

16.9

33.9

J.P. Morgan Global Government Bond Index

256

7.02

6.59

0.00

3.34

1.2

4.5

32.8

2.0

23.0

All indexes are based on monthly log-changes over the sample period from January 1990 to April 2011 (ending date of all series). The data are from Clarkson Shipping Intelligence and Thomson Reuters Datastream. Mean and volatility (S.D.) are reported as annualized percentages. JB-test is the test statistic of a Jarque-Bera (1980) test for the null hypothesis of normality. ***/**/* denote significance at the 1%/5%/10% level. The columns for autocorrelation report the Ljung-Box (1978) test for first- and twelfth-order autocorrelation; the null hypothesis is that there is no autocorrelation up to order one (twelve). The columns for ARCH effects contain Engle’s (1982) LM test statistic for test for first- and twelfth-order autoregressive conditional heteroscedasticity; the null hypothesis is that there is no ARCH effect up to order one (twelve).

profitability. Freight contracts come in two main forms: spot (voyage) charter contracts and time-charter contracts. Under a spot charter contract, the ship owner agrees to transport a specified amount of cargo from a designated loading port to a designated discharging port in return for a sum of money that is known as “freight” and is typically stated on a U.S. dollars/metric ton basis. In contrast, under a time-charter contract, the charterer agrees to hire the vessel from the ship owner for a specified period of time (anything from a round trip to several years) and under certain conditions defined in the charter-party. In this case, freight rates are paid on a U.S. dollar/day basis. The volatility of freight rates is comparatively high—or at least considerably higher than the volatility of equity and bond indexes. As reported in Table 1, during the period from January 1990 to April 2011, the MSCI World Stock Market Index and the J.P. Morgan Global Government Bond Index had annual standard deviations of 15.7% and 6.6%, respectively. By comparison, the Clarksea index of freight rates had an annualized standard deviation of 34.7%. And the volatility of the Baltic Dry Index (BDI), which tracks the worldwide international shipping prices of

various dry bulk cargoes, such as coal, iron ore, and grain, was even higher, at 53%. The high volatility of freight rates is a major issue for all participants in the shipping industry. One explanation for the high volatility is that the demand for freight services is a “derived” demand”—that is, a demand not for the vessel itself but for the services it provides. This demand depends on factors such as global economic activity, global seaborne trade, cyclical and temporal changes for commodities transported by sea, the distance between sources of production, and the consumption of commodities. The compounded variability of all these factors is reflected in highly volatile prices for freight services. In addition to having a high standard deviation, the return distribution of freight prices also exhibits “fat tails” (or kurtosis) and negative skewness. During the recent financial crisis the volatility of freight rates shot up dramatically. As can be seen in Figure 2, the annual standard deviation of the Clarksea index and the BDI almost doubled to 60.9% and 109.4%, respectively, during the period from January 2008 to April 2011.6 Freight rate volatility is also affected by vessel size and

6. Because freight is a non-storable commodity and the opportunities for substitution are limited, it is not surprising to find that spot freight rates are also autocorrelated (see table 1). For background on serial correlation in freight rates see “Forecasting Spot and Forward Prices in the International Freight Market” by Batchelor, Alizadeh, and Visvikis

in the International Journal of Forecasting 23, 101-114; 2007; and “Ship Funds as a New Asset Class: An Empirical Analysis of the Relationship between Spot and Forward Prices in Freight Markets” by Bessler, Drobetz, and Seidel in the Journal of Asset Management 9, 102-120; 2008.

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Figure 2 Freight Rates and the Global Stock and Bond Markets 700 600

Clarksea Index Baltic Dry Index MSCI World Stock J.P. Morgan Global Bond

500 400 300 200 100 0 1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

Data sources: Clarkson Shipping Intelligence and Thomson Reuters Datastream.

charter contract maturity.7 Freight rates for larger vessels are more volatile than for smaller vessels, in part because larger vessels are less flexible and there is less demand for them in depressed shipping markets. And spot rates are more volatile than time-charter rates, which presumably represent weighted averages—and hence smoothed estimates—of expected spot rates over the maturity of a long-term contract. Freight rate variations also have cyclical, seasonal, and random components.8 Bulker freight rates increase in the first quarter and decrease during the summer months, whereas tanker freight rates are usually higher in early winter than in other months of the year. The magnitude of seasonal changes increases for larger vessels and decreases for longer-term contracts. Also worth noting, there is evidence of “volatility clustering” in freight rates—that is, a tendency for large changes in freight rates to be followed by more large changes (of either sign) and for small changes to be followed by small changes.9 Operating costs. The volatility of operating costs also affects a shipping company’s cash flow and profitability. Operating costs in a narrower sense include manning, repairs and maintenance, stores and lubes, insurance, and administration. Such costs are thought to be relatively constant and to rise with inflation. If the ship is operated in the spot (voyage) market, the ship owner also must bear all voyage costs. Most important, the cost of fuel oil (or “bunker”) typically accounts for 20-25% of the total voyage costs; and because it is linked to world oil prices, the cost of bunker fuel is quite volatile and

hence a major source of risk. As shown in Table 1, the annual volatility of bunker prices is 29.10%. Finally, the costs of shipping companies can also be influenced by changes in interest rates and currencies. Given that most vessel acquisitions are financed through floating-rate U.S. dollar term loans, changes in interest rates can not only impose higher costs, but also cause cash flow and liquidity problems for distressed shipping firms. And because the U.S. dollar is the denomination currency in the shipping industry, companies from outside the U.S. are also exposed to currency risk. The currency risk arises if the company borrows in a currency other than the U.S. dollar but uses the U.S. dollardenominated freight income to repay its debt. However, when a shipping company arranges its financing in U.S. dollars and both freight revenues and operating costs are denominated in dollars, the firm has created a “natural” hedge and foreign exchange exposure is limited. Counterparty risk. Counterparty risk refers to the uncertainty about whether a counterparty to a shipping transaction will perform its obligations in full and on time. The fact that most trades and contracts in the shipping industry are negotiated directly between the counterparties implies that the partners have to rely on each other’s willingness and ability to fulfill the contract. The agreement can relate to a charter contract between a ship owner and a charterer (charter-party), a freight derivative transaction between two investors, or a bunker transaction between a ship owner and a bunker supplier. In all these cases, counterparty risk is

7. On how rates vary for different types of vessels see “Comparisons of Volatility in the Dry-Cargo Ship Sector” by Kavussanos in the Journal of Transport Economics and Policy 30, 67-82; 1996; “Price Risk Modeling of Different Size Vessels in the Tanker Industry using Autoregressive Conditional Heteroskedasticity (ARCH) models” by Kavussanos in the Logistics and Transportation Review 32, 161-176; 1996; and “Shipping Derivatives and Risk Management” by Alizadeh and Nomikos, London: Palgrave-McMillan; 2009. 8. See “Seasonality Patterns in Dry Bulk Shipping Spot and Time Charter Freight Rates” by Kavussanos and Alizadeh in the Transportation Research Part E: Logistics and Transportation Review 37, 443-467; 2001; and “Seasonality Patterns in Tanker Spot

Freight Rate Markets “by Kavussanos and Alizadeh in Economic Modelling 19, 747782; 2002. 9. Regarding autoregressive conditional heteroscedasticity in freight rates see “Comparisons of Volatility in the Dry-Cargo Ship Sector” by Kavussanos in the Journal of Transport Economics and Policy 30, 67-82; 1996; “The Empirical Evidence of the Leverage Effect on Volatility in International Bulk Shipping Market” by Chen and Wang in the Maritime Policy and Management 31, 109-124; 2004; and “Dynamics of the Term Structure and Volatility of Shipping Freight Rates” by Alizadeh and Nomikos in the Journal of Transport Economics and Policy 45, 105-128; 2011.

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attributable to the extreme volatility of freight rates, vessel prices, and cash flows in the shipping industry (among other influences). Simple remedies to reduce the counterparty risk are the posting of collateral or bank guarantees as a security in the event of default.10 As a general rule, the larger a firm’s counterparty risk, the greater its reliance on equity rather than debt in its own capital structure. Risks from Changes in the Market Values of Assets As the recent financial crisis made clear, changes in the market value of vessels are second only to freight rate volatility in importance. Given that listed shipping companies now have to use fair-value accounting for the vessels on their balance sheets, asset value fluctuations have become more visible than in the past. To illustrate this volatility, during the over 20-year period from January 1990 to April 2011, the annual volatility of the Bulk Carrier Second Hand Price Index provided by Clarkson Securities (and reported in Table 1) was 32.0%, while the volatility of the Container Second Hand Price Index was a somewhat lower, though still material 17.4%. But during the recent crisis period from January 2008 to April 2011, these two standard deviations increased to 42.8% and 26.7%, respectively. Vessel prices and their volatility affect all market participants. Shipping banks have to analyze vessel prices to set the terms for loans and monitor collateral values, asset players monitor vessel prices for portfolio management and investment decisions, and shipyards need to examine the conditions in the second-hand market to adjust their production capacities or the terms of their contracts. As we saw with the volatility of freight rates, the prices of larger ships exhibit more volatility than prices for smaller ships and for the same reason: the larger ships’ more limited operating flexibility (and usefulness during a downturn in demand). At the same time, the prices for second-hand ships are more volatile than those of newly built vessels, presumably because the former are available for immediate delivery at the prevailing market conditions. Vessel scrap prices are also volatile, at roughly 30% per year (see Table 1). They are more related to world scrap steel prices than shipping fundamentals. Because listed shipping companies use fair-value accounting for the ships on their balance-sheets, such asset value fluctuations have become material. U.S.-listed shipping companies must follow U.S. GAAP. According to SFAS 144, any listed shipping company’s long-lived assets must be reviewed periodically for impairment. SFAS 157 defines fair value as the price that would be received in a sale or paid to 10. In the case of charter-party risk management, shipowners generally rely on questionnaires with a set of qualitative criteria (e.g., prior black-listings of the charterer, ship maintenance standards, previous experience with the counterparty, information gathering from the handling shipbroker) to avoid ships or contract partners which may be unsuitable for the voyage. 11. See “Ship Valuation using Cross-Sectional Sales Data: A Multivariate Non-Parametric Approach” by Adland and Koekebakker in the Maritime Economics and Logistics 9, 105-118; 2007.

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transfer a liability in an orderly transaction between market participants on some date (i.e., not a forced liquidation or sold under duress). Impairment losses must be recognized when the carrying amount of long-lived assets are not recoverable and exceed their fair value. Impairment losses, which are calculated using estimates of the fair values of the assets that are provided by (at least two) independent ship brokers, reduce reported values to market prices. In theory, the market values of vessels should reflect not just their current operations, but the present value of cash flows expected over all future periods. In practice, however, market prices and fundamental values can diverge significantly, especially during crisis conditions when many ships are for sale. Regression analysis has identified three factors—vessel size, vessel age, and the state of the freight market—as major determinants of comparability, which are related to fair vessel value assessments. In other words, these factors are related to future expected operating cash flows or to discount rates.11 For shipping companies and their investors, the biggest challenge caused by the new fair value accounting requirement is likely to come from the effect of impairment losses that are disproportionate to reductions in operating cash flows on banks’ collateral and required regulatory equity capital. With the aim of limiting such disparities between market and fundamental values, as well as their effects on shipping banks, the Hamburg Shipbrokers’ Association recently proposed a long-term asset valuation (LTAV) approach in which the fundamental price of a vessel is the sum of the discounted operating earnings and eventual resale value.12 The market for second-hand ships tends to become highly illiquid during crisis conditions (often dominated by only a few forced liquidations), limiting the usefulness of valuation by comparables. Therefore, the main impetus for formulating and adopting the LTAV approach has been to reduce defaults during the crisis stemming from loan-to-value covenant violations.13 But the ability of LTAV to prevent such defaults could be limited by the approach’s conflict with the Basel II/III requirements and with shipping banks’ agreements with regulators that require the use of minimum collateral values. For as we just noted, impairment losses increase risks for shipping banks by reducing the collateral value of ships, which in turn increases the bank equity capital required by regulators. To the extent that mark-to-market accounting and Basel II/III capital adequacy requirements restrict bank lending, we expect shipping banks to shift these risks from their balance sheets to capital markets through vehicles such as loan securitization. 12. See “The Expectations Hypothesis of the Term Structure and Risk Premiums in Dry Bulk Shipping Freight Markets” by Kavussanos and Alizadeh in the Journal of Transport Economics and Policy 36, 267-304; 2002. 13. See “Vereinigung Hamburger Schiffsmakler und Schiffsagenten e.V. (VHSS): Valuing Ships” by Esty and Sheen, Case Study, Harvard Business School; 2011.

A Morgan Stanley Publication • Fall 2011

Besides restricting bank lending, Basel II regulations are likely to amplify industry cycles.14 High vessel price volatility reduces collateral values, potentially leading to financial distress and “fire-sales” during industry downturns.15 Vessel price risk can end up affecting the entire industry through the “collateral channel.” In illustrating this effect, a study of the secured debt tranches of U.S. airlines showed the potential for one firm’s bankruptcy to reduce the collateral values of other industry participants, particularly when the market for assets was relatively illiquid.16 This effect also explains why shipping banks were reluctant to liquidate their collateral from non-performing loans during the crisis, even though almost all loan-to-value covenants were broken. Some banks were forced to allocate additional equity capital according to Basel II regulations. One consequence is that lenders have become less willing to make long-maturity loans even if they perceive little change in the fundamental value of assets.17 Because a vessel’s operating lifetime averages 15 to 25 years, syndicated shipping loan maturities of over ten years were common in the pre-crisis period. But during the financial crisis, the maturities dropped to just five years.18 Pure risk. Pure risk is the possibility of a reduction in vessel values from physical damage, accidents, and losses due to force majeure. In a wider sense, pure risk also covers the risk of loss due to physical risks, technical failure, and human error in the operation of the assets of a company, as well as the risk of legal liability for damages. Examples include the risk of a collision, accidents, liabilities from oil or chemical spillage, and piracy. Pure risks are usually managed by purchasing insurance contracts such as protection and indemnity, hull and machinery, and off-hire insurance for shipowners, and operators or mortgagees interest insurance for shipping banks.19 Risk Management Tools in the Shipping Industry Having discussed the major risks confronting shipping companies, we now turn to the management of such risks. In an article published in this journal in 2002, Lisa Meulbroek described an “integrated approach” to risk management that combines three different ways that companies implement their risk management objectives:20 1. modifying operations, 2. employing financial derivatives, and 3. adjusting capital structure. 14. See “Cyclical Implications of the Basel II Capital Standards” by Kashyap and Stein in the Federal Reserve Bank of Chicago Economic Perspectives 28, 18-31; 2004. 15. See “Do Asset Fire Sales Exist? An Empirical Investigation of Commercial Aircraft Transactions” by Pulvino in the Journal of Finance 53, 939-978; 1998. 16. See “Bankruptcy and the Collateral Channel” by Benmelech and Bergman in the Journal of Finance 66, 337-378; 2011. 17. The study of the asset-backed commercial paper market during the financial crisis “Rollover Risk and Market Freezes” by Acharya, Gale, and Yorulmazer in the Journal of Finance 66, 1177-1209; 2011 explains why lenders may sharply reduce the maturity of debt they are willing to hold, even if the arrival of bad news signals only a small change in the fundamental value of assets.

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Integrated risk management involves the search for the optimal, or value-maximizing, combination of these three basic methods. Or to put this another way, the goal of corporate risk management is to aggregate all the risks presented by the firm’s business and investment strategy, and then to use some combination of derivatives and capital structure adjustments to limit all “residual” risks that cannot be managed more effectively through minor operating adjustments. Let’s start with a brief mention of some of the strategic or operating levers for managing the risk of shipping companies. Because expected risks and returns vary with the type and size of vessels, shipping companies can diversify risk simply by owning different types and sizes.21 Smaller vessels are less risky than larger ones, both in terms of freight rates and vessel prices because of their operational flexibility. Shipping companies can also partly hedge their revenues by chartering their vessels for longer terms at fixed prices instead of relying on the volatile spot market. But if such operating strategies have the potential to reduce risk, they may also be inflexible and costly to implement. For example, it is expensive and time-consuming to buy and sell vessels and to move in and out of freight contracts. In addition, it is often hard to find charterers seeking long-term contracts during market declines. And even if a long-term charterer can be found, in the event of further declines counterparty risk is likely to become a major concern, given the charterer’s increased incentive to walk away from the contract. What’s more, putting a large portion of the fleet on a long-term fixed rate contract with other ship operators instead of employing the vessels on the spot market could mean the loss of valuable specific knowledge about and relationships with customers. And on top of these reservations, there is at least one more compelling argument against fleet diversification: the tendency of many of the most successful shipowners to specialize in those segments of the market where they have the most operating expertise. As the past 30 years should have made clear, diversification away from a company’s core competencies is rarely a value-maximizing strategy. Managing Cash Flow Risks Using Freight Rate Derivatives For reasons like the above, then, the introduction of shipping derivatives and the increased liquidity of these markets have provided some shipping companies with a more flexible and cost-effective means of managing risk. As an example, 18. See ABN AMRO, 2011, Shipping Finance and Investment: Current Trends in Ship Finance, Istanbul: 3rd Mare Forum in Ship Finance. 19. See “Shipping Derivatives and Risk Management,” by Alizadeh and Nomikos, London: Palgrave-McMillan; 2009. 20. See “A Senior Manager’s Guide to Integrated Risk Management” by Meulbroek in the Journal of Applied Corporate Finance 14, 56-70; 2002. 21. See “Derivatives and Risk Management in Shipping” by Kavussanos and Visvikis; London: Witherby Publishing; 2006; and “Shipping Derivatives and Risk Management,” by Alizadeh and Nomikos, London: Palgrave-McMillan; 2009.

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take the case of freight rate futures contracts. Thanks to the standardization process the freight market has undergone in recent years, freight rates can now be bought and sold in a derivatives market, despite the fact that such rates are not a tangible commodity but represent the cost of providing seaborne transportation services. Participants in this market include two main groups: (1) players in the physical segment—shipowners, operators, and some trading houses— that are looking mainly to hedge their risks; and (2) investors with no physical positions—investment banks, hedge funds, and other traders—who bet on the future direction of the freight markets. And as we now discuss, participants in freight derivatives markets have two basic choices: forward freight agreements and freight options. Forward freight agreement (FFA). A forward freight agreement is a contract between two parties to financially settle a freight rate, for a specified quantity of cargo or type of vessel, and for one of the major shipping routes at a certain date in the future. The underlying on an FFA contract can be any route or basket of routes represented by the set of Baltic Exchange indexes. The Baltic Exchange offers a wide range of shipping indexes for different vessel sizes in the bulker and tanker sector. These indexes are calculated based on a panel of independent ship brokers who provide their professional assessments of the prevailing open-market level at their time of reporting on each publication date. FFAs, which are traded on these underlying assets, are settled in cash at the difference between the forward price and the settlement price. In most cases, the settlement price is the average of the index for the underlying route over the settlement month. This averaging rule is used to prevent the possibility of settlement rates being influenced by fluctuations or trading manipulations on a single trading day. To serve as the underlying for an efficient derivatives market, a shipping index must be standardized and liquid—and this in turn means the index must be grounded in the physical markets with sufficient transactions on a given route (based on a predefined reference vessel), supported by a large number of freight market participants, offered on a regular basis, easy to understand, and balanced between the Basins (Atlantic versus Pacific). There are two generic types of FFA trades. First, shipowners and ship operators want to minimize the exposure and transfer the risk of an unexpected decline in freight rates, and they can hedge their freight income by selling FFAs (or going “short” FFA). Second, the charterer of a vessel wants to protect himself against unexpected increases in freight rates, and buying FFAs limits the charter payments that must be made. In spite of some problems with the practical implementa-

tion of both these simple hedging as well as more advanced trading strategies, 22 the volume of trades in the FFA market, as shown in panel A of Figure 3, has increased sharply during the recent years. One main reason for this increase in trading activity is the strong interest of sophisticated investors who are not active in the physical shipping markets. The sharp increase in freight volatility during the recent crisis attracted volatility traders with no interest in taking physical positions to the FFA market, thus fulfilling the important function of liquidity provision. As can be seen in panels B and C of Figure 3, there were two price peaks in 2007 and 2008, when both spot and forward rates rose to unprecedented levels, followed by a dramatic drop in rates in the course of the global shipping crisis.23 Although trading volume dropped during this period, trading activity in the FFA market is expected to revive along with the industry. One major impetus for the expected increase in FFA market trading and liquidity is the market’s ongoing transformation from a broker-driven over-the-counter (OTC) market into a fully regulated market with a central trading platform. To mitigate counterparty risks in OTC contracts, most trades were cleared through one of several clearing houses. For example, according to the Baltic Exchange, more than 90% of all FFA trades were cleared in 2010. As part of the international regulatory trend to make OTC markets more transparent, the Baltic Exchange, which has the authority to enforce more standardized trading practices and arbitrate disputes in the market, launched its Multilateral Trading Facility (MTF) called “Baltex” in June 2011. The assumption behind the creation of Baltex is that the increase in price transparency will make natural hedgers and investors more confident to enter the market, leading eventually to greater liquidity, smaller market impact of individual trades, and greater price efficiency. Freight Options. Options on freight offer a flexible way to manage freight rate risk, but one that requires payment of option premiums. Freight options are settled as average Asian price options, in which final settlement is based on average prices over time. These facilities give industry participants many new choices. Take the case of a charterer with a large fleet of owned or leased vessels whose main business strategy is to achieve reliable, but low-cost transport of goods. In general, the duration of the charterer’s cargo book will be shorter than the duration of the time-chartered fleet, leaving the charterer long on freight. For example, the charterer will have cargoes up to nine months in the future, whereas his chartered fleet of vessels extends well beyond that, leaving the charterer with

22. Kavussanos and Visvikis (2006) and Alizadeh and Nomikos (2009) discuss the practical problems involved with the implementation of FFA trading, such as basis risk and timing mismatch between paper and physical contracts (FFAs are settled at the end of each month, whereas fixtures in the physical market can be concluded any time during that period). Kavussanos and Visvikis (2006) and Alizadeh and Nomikos (2009) op. cit.

23. Panels B and C of Figure 3 show the spot and FFA rates for the first three quarters (+Q1, +Q2, and +Q3) and the front year (+1Y) for the average of the four trip-charter routes contained in the Baltic Panamax Index (BPI) and the Baltic Capesize Index (BCI), respectively.

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Figure 3 Trade Volumes and FFA Rates Panel A: Volume of Trade in the Dry FFA Market 2,500,000 2,000,000 1,500,000 1,000,000 500,000 0 2002

2003

2004

2005

2006

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Panel B: FFA Rates for BCI 4TC (Spot, +1Q, +2Q, +3Q, +1Y) 25,000

20,000

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0 Jan 05 Jul 05

Jan 06 Jul 06

Jan 07 Jul 07 Spot

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Jan 09 Jul 09 +3Q

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Panel C: FFA Rates for BPI 4TC (Spot, +1Q, +2Q, +3Q, +1Y)

9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 Jan 05 Jul 05

Jan 06 Jul 06

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+1Y

The trading volume in Panel A is given in lots, where each lot refers to either 1.000 tons of dry cargo or one day of time charter hire. Freight rates (in $/day) in Panels B and C are the spot and FFA rates for the first three quarters (+Q1, +Q2 and +Q3) and the front year (+1Y) for the average of the four trip-charter routes contained in the Baltic Panamax Index (BPI) and the Baltic Capesize Index (BCI), respectively. Data are from the Baltic Exchange.

more carrying capacity than cargo. In this case, freight derivatives such as freight rate options or basket FFAs can be used to limit the risk that the long position turns. For example, by buying freight rate put options, the charterer can offset losses from the vessels during falling markets with income generated by the put option. One disadvantage of this strategy, however, is that the Journal of Applied Corporate Finance • Volume 24 Number 4

option premium must be paid up front, which can tie up substantial amounts of corporate liquidity. To avoid this problem, the charterer could instead sell call options. If freight markets rise above the agreed strike price, the charterer has to pass on all profits that are generated from employing the physical vessel, which he still controls and can use. While the profit cap represents an opportunity loss, the premium A Morgan Stanley Publication • Fall 2011

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Figure 4 Leverage of Listed Shipping Companies 60% Shipping Companies (Book) 50%

G7 Benchmark (Book)

Shipping Companies (Market) G7 Benchmark (Market)

40%

30%

20%

10%

0% 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Mean leverage ratios are shown for 108 listed shipping companies over the 1992-2010 sample period. Leverage is defined as total (interest bearing) debt divided by total assets. Market leverage refers to quasi-market leverage ratios, using market values of equity and book levels of debt. The control group consists of all companies from the G7 countries which are contained in the Compustat Global database (excluding financial and utility firms). The figure is based on the results in “Capital Structure Decisions of Listed Shipping Companies” by Drobetz, Gounopoulos, and Merikas. Working paper, University of Hamburg; 2011.

collected for the option provides a “subsidy” for the vessel that effectively makes it cheaper than its time-charter rate. Accordingly, it takes a large drop in freight rates before the charterer will incur a loss on his position. Still another alternative for the charterer is to sell plain vanilla FFAs against a long position in freight. In a falling market he will receive payouts that offset potential losses from the operation of his time-charter fleet. In rising markets, his time-charter fleet will generate higher income, which will have to be passed on to the FFA counterparty. But this amounts mainly to an opportunity loss; the charterer still has full control over the vessel and can carry the goods at market rates. The superiority of each particular strategy depends on the ship owner’s attitude toward risk, but also on other factors that we discuss later. Managing Asset Value Risks Using Vessel Price and Scrap Derivatives Physical vessel owners did not have short-selling opportunities before the introduction of derivative contracts. With the help of such derivatives, shippers can now hedge freight rates as well as vessel prices. One such derivative is a Forward Ship Value Agreement (FOSVA), which is a cash-settled forward contract24 based on the Baltic Sale and Purchase Assessments (BSPA), a bi-monthly vessel value index based on assessed prices for standard vessels. Ship owners can hedge their ship values by selling FOSVAs and can adjust or rebalance their vessel portfolios without physical transactions. The FOSVA 24. See “The Pricing of Forward Ship Value Agreements and the Unbiasedness of Implied Forward Prices in the Second-Hand Market for Ships” by Adland, Jia, and Koekebakker in Maritime Economics and Logistics 6, 109-121; 2004. They discuss the pricing of forward vessel values based on cost-of-carry relationships and no-arbitrage conditions for physical vessels and examine the empirical relationships between forward

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market, however, is not yet as liquid as the FFA market, and some investors may be better off using FFAs (despite the basis risk involved in such a strategy).25 In addition to the BSPA, the Baltic Exchange offers assessments of demolition prices of different types of vessels at the end of their lifetime. The Baltic Exchange Demolition Assessments (BDA) is quoted in U.S. dollars per light displacement tonnage (LDT) of the ship. Light displacement refers to the weight of the ship with no cargo or fuel on board and, as such, it essentially represents the steel scrap of a vessel. Accordingly, while supply and demand for scrap vessels may also have some impact on prices, vessel demolition prices are primarily linked with steel prices.26 For shipowners, the value of the vessel can be compared to demolition prices to decide whether to further operate the vessel or scrap it. When the value of the vessel falls below the scrap value, the vessel should be scrapped, and hence demolition prices provide a floor for second-hand prices. Although there are as yet no derivatives trading on ship scrap, the Baltic Exchange may consider the possibility of creating a derivative instrument with its BDA index as the underlying asset. Interaction Between Risk Management and Capital Structure As just discussed, then, the total risk of shipping companies can be managed through strategic operating decisions, such as the use of long-term charter contracts and leasing of (instead of owning) ships, or through the use of derivative prices, implied forward vessel values, and future spot values. 25. See “Ship Finance: Hedging Ship Price Risk Using Freight Derivatives” by Alizadeh and Nomikos, forthcoming in: Talley, W. (ed.), Companion to Maritime Economics, Blackwell; 2011. 26. See Alizaded and Nomikos, (2009) op. cit.

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instruments. But after the companies adjust operations or use derivative instruments to manage risk, there will always be remaining risks, sources of uncertainty that are either difficult to anticipate or measure, or for which no suitable derivative instruments are available. In cases where this residual risk is still large, the required protection is generally provided by more equity capital. Thus, in addition to the risk management choices on the asset side of a shipping company’s balance sheet, its capital structure constitutes another layer of risk management. But let’s consider the converse of this argument: namely, that effective risk management using derivatives can function as a substitute for equity capital. To the extent that derivative contracts provide a new, more efficient way of reducing risk, companies may no longer need as much equity as in the past. Or to put the same thought differently, risk management has the potential to increase a shipping company’s debt capacity. Consistent with this idea, a recent study involving one of the present authors reports that shipping companies with larger operating exposures (as indicated by a high degree of spot rather than longer-term, time-charter employment of vessels) operate with significantly lower leverage and lower financial risk.27 Moreover, to the extent that risk management and equity capital are in fact economic substitutes, companies that already use considerable amounts of debt may have much to gain from hedging operating exposures with derivatives. In fact, shipping companies have traditionally operated with fairly leveraged capital structures. During the period 1992-2010, for example, the average book leverage ratio of 108 listed shipping companies varied between 0.40 and 0.45—a level that, as can be seen in Figure 4, was significantly higher than the mean book leverage of companies from the G7 countries which are contained in the Compustat Global database (excluding financial and utility firms). As we suggest below, some shipping companies, given their comparatively high levels of leverage, may choose to pursue hedging strategies using the new shipping derivatives markets that will allow them to maintain or maybe even increase their leverage. Capital Structure and Financing Decisions Having discussed the link between capital structure and risk management, we now explore the financing alternatives of shipping companies, first by discussing the determinants of the capital structure of listed shipping companies, and then by analyzing the characteristics of shipping bonds and shipping equity in more detail.

The choice of comparatively high levels of financial leverage in the shipping industry can be explained by the fact that most commercial vessels are fairly standardized assets, which are divided into vessel sizes and classes. Because such assets are also tangible and liquid (often bought and sold) at least under normal circumstances, they generally provide good collateral for loans.28 And because liquid assets are less costly to monitor and liquidate for debtholders, they reduce the expected costs of financial distress.29 In addition to the tangibility and liquidity of their largest assets, another argument in favor of high leverage for shipping companies centers on their founder-dominated ownership structures. Using a sample of 107 shipping IPOs, one recent study reports an average ownership of the largest shareholders of 36%. Reinforcing the case for concentrated ownership as a source of value, the study also finds a strong positive association between the ownership concentration and stock price performance of those IPOs.30 One important role of high leverage in such cases is to make possible the concentration of ownership—not to mention the better control opportunities for (founder) blockholders—that appears to be associated with superior performance. Having commented on the capital structure of shipping companies, let’s now consider their financing alternatives. Shipping companies today have more financing choices than a decade ago. Debt capital possibilities include shipping bonds, convertible bonds, and export credits provided by development banks. The sources of equity capital include private and public equity, venture capital, and sovereign wealth funds. Shipping bonds. While the shipping industry is seen as relatively risky, it nevertheless features low technology risk and low regulatory risk. For each of these reasons, along with the factors mentioned earlier, debt capital will continue to play a large role in the industry. Sea Containers Ltd. was the first shipping company to issue public debt when it sold $125 million of subordinated debentures in 1992. Since then, approximately $50 billion of shipping bonds have been issued. The annual issuance volumes of shipping bonds are shown in Panel B of Figure 1. Shipping bonds often provide borrowers with easier terms than loans from shipping banks. Whereas the banks generally insisted on floating rates, a mortgage on the ship, and positive covenants in the loan agreement,31 the terms of a typical highyield shipping bond include: • A fixed coupon; • No principal repayment until maturity (typically 6-10 years);

27. See “The Shipping Corporate Risk Trade-Off Hypothesis” by Merikas, Sigalas, and Drobetz in Marine Money, 40-44; (October) 2011. 28. See “Capital Structure Decisions: Which Factors Are Reliably Important?” by Frank and Goyal in Financial Management 38, 1-37; 2009. 29. See “Corporate Finance and Corporate Governance” by Williamson in the Journal of Finance 43, 567-591; 1988; and “Liquidation Values and Debt Capacity: A Market Equilibrium Approach” by Shleifer and Vishny in the Journal of Finance 47, 1343-

1366; 1992. 30. See “Concentrated Ownership and Corporate Performance Revisited: The Case of Shipping” by Tsionis, Merikas, and Merikas, Working paper, University of Piraeus; 2011. 31. See “Revisiting Credit Risk, Analysis and Policy in Bank Shipping Finance” by Grammenos in The Handbook of Maritime Economics and Business, Informa Law, 777810; 2010.

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• No mortgage on the issuer’s assets (most of the time); • Negative incurrence-based covenants, allowing the issuer to take on additional debt provided it is in compliance; • No maintenance covenants, such as loan-to-value clauses; and • Permission to prepay principal only after a predefined period of time (after which prepayment is permitted at a premium). While shipping bonds offer borrowers more flexibility than bank debt, public debt borrowers could face higher financial distress costs because it is easier to rewrite debt contracts with banks than with bondholders (except under Chapter 11).32 Such flexibility is likely to be important since a significant number of shipping firms have defaulted on their bonds. A study of 50 shipping bonds (mostly rated doubleB, with a few single-Bs) issued during the period 1992-2004 reported that 13 shipping firms (or 26%) had defaulted on their bonds by the end of 2004. The remaining 37 bonds were still trading or had been retired. After analyzing the performance of the different rating classes, the study also reported that 8.82% of the double-B rated bonds (BB+, BB and BB− ratings) and 53.30% of single-B rated bonds (B+, B and B− ratings) in their sample defaulted.33 As can be seen in Panel C of Figure 1, there was a spike in yields during the financial crisis from mid-2008 to end-2009, when shipping markets were particularly affected by the global financial crisis. During that time, the sharp drop in shipping bond prices caused the yield premium to jump to almost 25%. Whether investing in shipping bonds is an attractive investment alternative for institutional or private investors thus remains an open question. The answer will depend on the sophistication of the investor, whether he or she can properly analyze the default and liquidity risks of high-yield issuances, and whether the yield spreads accurately reflect and compensate the investor for the underlying risks of shipping bonds. As we discuss below, asset-backed securities that contain shipping loans are a potential alternative for investors. In fact, to the extent that banks have a comparative advantage in accessing and processing information, investing in securitized bank loans is likely to be the superior alternative for some investors.

Shipping equity. Small firms usually lack access to public equity markets, and the shipping industry is highly fragmented with many small firms characterized by concentrated ownership.34 Family owners tend to be reluctant to dilute company control and to disclose sensitive information. For that reason, most equity financing for shipping companies in the past has come from private investors and retained earnings. In fact, capital markets provided little public equity for shipping companies until 2004. Since then, equity issues— IPOs as well as seasoned equity offerings—have increased significantly (as can be seen in Panel D of Figure 1). Perhaps the most important factor underlying this increased issuance activity was the sharp increase in the level of freight rates during the mid-2000s, which was interpreted by many market participants as creating attractive investment opportunities. And in one early study of shipping IPOs, the authors reported that the main motive for shipping companies going public was to raise capital for vessel acquisitions.35 Shipping IPOs can be roughly classified as either “regular” IPOs or trust models. Regular IPOs are like most publicly held corporations in other markets. That is, there are often conflicts of interest between the old family owners and new shareholders.36 Outside investors frequently worry about high administrative costs and the limited control rights they have as dispersed investors. Moreover, because public investors have imperfect knowledge about the firm’s underlying assets to go along with their limited control, the market values of shipping companies often trade at a discount to their assessed net asset values (NAVs), which reflect the market values of vessels held by a shipping company. In this respect, public shipping companies are somewhat similar to closed-end funds and REITs, although shipping investors have relatively more information through the international vessel sales and purchase markets.37 In response to these challenges, new financing instruments have been designed to be more attractive to institutional investors. These new forms are based on trust structures, such as the U.S. Master-Limited-Partnership (MLP) or the Singapore Shipping Trust. Shipping trusts or MLPs combine the tradability of common stocks with the legal structure of partnerships. Economically speaking, they are a hybrid security with characteristics of debt as well as equity. The

32. See “Equity, Bonds and Bank Debt: Capital Structure and Financial Market Equilibrium under Asymmetric Information” by Bolton and Freixas in the Journal of Political Economy 108, 324-351; 2000. 33. See “Estimating the Probability of Default for Shipping High Yield Bond Issues” by Grammenos, Nomikos, and Papapostolou in Transportation Research: Part E 44, 11231138; 2008. As a comparison, Standard & Poors (2009 Annual Global Corporate Default Study and Rating Transitions; 2010) reports weighted mean annual corporate default rates of 0.97% for BB-rated bonds and 4.93% for B-rated bonds over the sample period from 1981 to 2009 (ignoring vintage effects). Looking at a 5-year time horizon (which roughly corresponds to the average lifetime of the shipping high yield bonds in Grammenos et al.’s (2008) sample), the average cumulative default rates were 9.51% and 22.30% for BB-rated and B-rated bonds, respectively. 34. See Maritime Economics by Stopford, Taylor & Francis, London; 2009; and Tsionis et al.; 2011; op. cit.

35. Other frequently stated reasons were asset-play strategies and debt repayment. See “The Long-Run Performance of Shipping Initial Public Offerings” by Grammenos and Arkoulis in Journal of Maritime Economic 1, 71-93; 1999. 36. See “Corporate Governance and Board Effectiveness in Maritime Firms” by Randoy, Down, and Jenssen in Maritime Economics and Logistics 5, 40-54; 2003; and “Ownership Structure and Operating Performance: Evidence from the European Maritime Industry” by Lambertides and Louca in Maritime Policy and Management 35, 395-409; 2008. 37. See “The Role of the Underpricing Real Asset Market in REIT IPOs” by Hartzell, Kallberg, and Liu in Real Estate Economics 33, 27-50; 2005; “The Marketing of ClosedEnd Fund IPOs: Evidence from Transactions Data” by Heanly, Lee, and Seguin in the Journal of Financial Intermediation 5, 127-159; 1996; and “REITs, IPO Waves and Long-Run Performance” by Buttimer, Hyland, and Sanders in Real Estate Economics 33, 51-67; 2005.

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trustee manager, or general partner, uses the funds committed by its trustholders or limited partners to acquire and build up a diversified portfolio of ships and then charters them out with the aim of achieving a stable stream of profits for the shareholders (or limited partners). Separate entities serve as commercial and technical vessel managers. Because trusts and MLPs are partnerships, they do not pay corporate income taxes, although their investors must report any distributions as income. Trusts and MLPs are required by tax law or contract to distribute a significant fraction of their operating cash flow, thus effectively forcing them to return to the markets for new capital. As a result, the shareholders’ or limited partners’ returns come more from cash distributions than capital gains, potentially resulting in lower stock price volatility and stable, but lower growth potential. At the same time, however, trust and MLP companies are better structured than corporate firms to profit from pursing active asset-play strategies that involve buying and selling vessels. The rates of return to equity investors in listed shipping companies (in the different organizational vehicles just described) have historically been quite high. As reported in Table 1, from September 2002 to April 2011, the ShipInx, a value-weighted index of the 30 largest listed shipping companies, had an annual mean return of 18.6% and a standard deviation of 30.2%. Moreover, in a detailed analysis of 48 shipping stocks over the 1999-2007 period, a study involving one of the present authors found—perhaps surprisingly—that the highly cyclical shipping industry had an equity beta of less than 1.0,38 suggesting that investments in shipping equity may offer substantial diversification benefits for investors. Nevertheless, it is still an open question what types of shipping risk public equity investors prefer to hold. For example, it is not clear whether the majority of equity investors prefer a transformed and reduced (through hedging) risk exposure to an unhedged exposure. In fact, some diversified investors may be seeking unhedged exposure to shipping. A Capital Market Perspective on Risk Management As we have seen, then, the business risks in the shipping industry are substantial. Moreover, the effects of such risks have been compounded by the adoption of fair value accounting, which has made vessel price changes not only more transparent, but also more difficult for regulated banks that lend to the shipping industry. The Basel III standards supervise liquidity risks and limit maturity transformation. For example, a net stable funding ratio for structural liquidity on the balance sheet weighs available funds with regard to 38. See “Common Risk Factors in the Returns of Shipping Stocks” by Drobetz, Tegtmeier, and Schilling in Maritime Policy and Management 37; 2010. Market betas around one are clearly surprising for the highly cyclical shipping industry with its high financial leverage, provided that these risks add up and reinforce covariance risk. Additional asset pricing tests indicate that macroeconomic risk factors must be taken into consideration in order to capture the return-risk-profile of shipping stocks. This paper

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stability and compares that to refinancing needs of assets. Essentially, this requires shipping banks to refinance loans on a long-term basis through capital markets. During the current financial crisis, the market for funds with maturities of 5-10 years became highly illiquid, and banks’ borrowing conditions substantially deteriorated. In addition, banks will have to comply with higher equity capital requirements under the Basel III regulations. For example, a new (non-risk based) leverage ratio compares Tier 1 capital to unweighted total assets and off balance sheet items. The minimum (unweighted) leverage ratio is 3%. Taken together, the higher Basel III equity capital requirements mean that many banks will not be able to keep as many risky shipping loans on their balance sheets and will transfer some to the capital markets through securitizations. Although the structure of completed loan securitization transactions is similar to those in other industries, there are a few shipping-related peculiarities.39 Perhaps most important, shipping banks usually prefer a synthetic securitization structure that allows the originator to keep the loans on its balance sheets and under management. Under this structure, the entire servicing of securitized loans remains with the bank, thereby still maintaining the client relationship, which is essential in a relationship-banking environment. In addition, a cross-sectional representation of shipping loans should be selected from the bank’s entire loan portfolio. The selected loans should be diversified with respect to the vessel type, size, domicile and age of the vessels, thus offering the investor a well-diversified ship portfolio. Corporate Risk Management and the Equity Risk Exposure In a much-cited article in this journal called “Rethinking Risk Management,” Rene Stulz argued that the main goal of corporate risk management is to protect a company’s ability to carry out its business plan and exploit its comparative advantages in risk-bearing by limiting the possibility (and consequences) of catastrophic “lower-tail” outcomes.40 To illustrate the idea in the context of shipping, if the main core competence of a shipping company is the efficient acquisition, operation, and maintenance of its fleet, then the firm’s risk management policies and capital structure policies should be aimed at minimizing its cost of capital while ensuring its ability to make strategic investments, if possible by preserving continuous access to capital markets under most conditions. Now, as we have already seen, capital structure is likely to play an important role in shipping companies’ efforts to identifies the world stock market index, currency fluctuations against the U.S. dollar, changes in industrial production, and oil price changes as long-run systematic risk factors that drive expected stock returns of listed shipping companies. 39. See “Securitizations of Shipping Loans” by Kasten and Seil in The Handbook of Credit Portfolio Management, McGraw-Hill, 397-408; 2008. 40. See “Rethinking Risk Management” by Stulz in the Journal of Applied Corporate Finance 9, 8-24; 1996.

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maximize value. The presumably high cost of outside equity (given the small size of the companies and concentration of ownership) implies that, for most shipping companies, minimizing the cost of capital is likely to mean making aggressive (though not unreasonable) use of debt (even though many shipping companies do not pay corporate income taxes), while limiting to acceptable levels the possibility that financial distress will interfere with operations and the required investments in safety and maintenance. Moreover, the use of shipping derivatives can play an important role in this financing strategy. By reducing the volatility of the operating cash flows, hedging with derivatives can help reassure potential lenders or bondholders about the company’s ability to avoid financial distress, or comfortably service even higher levels of debt. Especially in cases where creditors and other outside investors find it difficult and costly to monitor the firm’s changing risk exposures, the more stable cash flow stream produced by an effective hedging program can effectively reduce the cost of capital, if not immediately then over time as the market experiences the results. In addition, the cash flow stability provided by hedging can also help preserve the firm’s access to capital under difficult market conditions. This may well be an important reason to hedge, since as reported in a study involving one of the authors, the greatest investment opportunities in the shipping business, as in many businesses, tend to appear when freight rates and operating cash flows are low and vessel prices are down.41 Hedging freight rates may help ensure the ability of asset players to acquire vessels at fire-sale prices during periods of industry weakness. The Case for “Selective Hedging” The discussion so far has presented major elements of the theory of how corporate hedging can work to increase value. But this account begs the question: What about those shipping companies that use derivatives not so much to hedge as to produce trading profits, a practice that is sometimes referred to as “selective hedging?” It is plausible that a shipping company with many physical freight contracts might know more about the general demand and supply for freight and therefore has a comparative advantage with this type of risk. Shipping companies may well have better information about freight rates than financial participants in opaque and sometimes illiquid freight (derivatives) markets. To the extent this is so, the companies could conceivably earn a consistent profit stream from hedging

41. In the sample of listed shipping companies from “Capital Structure Decisions of Listed Shipping Companies” by Drobetz, Gounopoulos, and Merikas. Working paper, University of Hamburg; 2011, their capital expenditures (scaled by total assets) are negatively correlated with changes in the Clarksea index during the 1992-2010 period. An annual correlation coefficient of −0.32 suggests that shipping companies’ investment opportunities and actual spending were greater during time periods with low or decreasing freight rates. See also “Does Hedging Affect Firm Value? Evidence from the U.S.

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“selectively”—that is, using derivatives to hedge only when the market is expected to move in the direction of the hedge. But for companies with outside investors who insist on understanding the firm’s source of profit, a strategy of selective hedging is likely to raise concerns that the firm’s trading activities will have the effect of amplifying instead of dampening the firm’s exposure to freight rate risks. And for this reason, a policy of selective hedging would likely require companies to maintain equity-heavy capital structures that demonstrate the firm’s ability to “self-insure” over a full business cycle. Investors will want the assurance that the potential trading losses are not large enough to endanger the solvency of the firm. In sum, if managers believe that they have informational advantages when they really do not, selective hedging will likely increase cash flow volatility and reduce shareholder value. In the absence of some informational advantage over other market participants, selective hedging will be hard to distinguish from speculation.42 Conclusions The shipping industry faces volatile operating cash flows and vessel prices as well as increasingly risk-averse banks. While bank debt will remain important in the future, the industry will increasingly look to capital markets for external funds. Shipping banks are likely to change from being commercial bank lending institutions to becoming more like investment banks that arrange a variety of financing solutions. Risk management will be central to shipping companies in this new environment. They must decide which risks to bear, which to manage internally, and which to transfer to the capital markets. These decisions require shipping financial managers to assess the effect of each risk on firm value, understand how each risk contributes to total risk, and determine the cost of reducing that risk given the specific circumstances of their companies. stefan albertijn is Global Head of Risk Management at Alfred C. Toepfer International GmbH, Hamburg.

wolfgang bessler is Professor of Finance and Banking at JustusLiebig-University Giessen.

wolfgang drobetz is Professor of Finance at the University of Hamburg.

Airline Industry” by Carter, Rogers, and Simkins in Financial Management (Spring), 5386; 2006. 42. On whether the gold mining and oil and gas industries have been successful in selective hedging see “Are Firms Successful at Selective Hedging?” by Brown, Crabb, and Haushalter in the Journal of Business 79, 2925-2949; 2006; and “Firm Value and Hedging: Evidence from U.S. Oil and Gas Producers” by Jin and Jorion in the Journal of Finance 61, 893-919; 2006.

A Morgan Stanley Publication • Fall 2011

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