Ship Building Finance
It is crucial for the sale and purchase (S&P) shipbroker to understand the problems ship buyer has to face in finding the money for financing ship. Major ship-owning companies finance their new ships from their own resources or by increasing their share capital.
A common method of financing the purchase of a ship is via a bank loan secured by a mortgage. A prudent ship buyer enters into preliminary negotiations with a bank so that the general principles are covered.
Preliminary negotiations mainly involve the bank satisfying itself that the ship buyer will be able to earn enough with the ship to repay the loan and the interest.
It might cause delays in concluding negotiations and takes time for the ship buyer’s bank (lender) to ensure that the proposed ship complies with the business plan originally agreed between the lender and borrower.
It is customary for Progress Payments to be made by lender bank for newbuilding ships. There may be five (5) progress payments to shipyards:
- Signing the newbuilding ship contract
- Steel cutting
- Lay the keel
- Launch from slipway
- After successful sea trials
Newbuilding Ship Credit
In some cases, loans for the purchase of newbuilding ships can be negotiated with the banks through the shipyards and/or shipyards act as financiers.
Generally, newbuilding ship credit arrangements have followed international agreements which lays down that up to 80% of the ship purchase price may be advanced at a rate of interest below the general market levels with the buyer finding the 20% out of his own resources.
Elaborate finance devices have been employed to provide front end finance and to grant periods of grace during which time the shipowner does not have to make any repayments. Such schemes which meant the shipowner not having to risk any of his own money seemed fine at the time but they were without doubt a major contributor to the deep recession in shipping after 2008.
In shipping business, no single cause is wholly responsible for the surplus in tonnage. However, shipyards understandably were prepared to go to almost any lengths to keep their shipyards working. Governments are more concerned with the short-term electoral effect of the unemployment caused by shipyard closures.
Many shipowners tend to work by instinct. If lenders were prepared to accept the shipowners’ business plans this simply fed their natural optimism so the providers of soft credit must shoulder the burden. After the latest shipping recession, many shipyards are closed and the search for the cheapest labor force moves relentlessly round the world so that there are now some countries with no history of shipbuilding replacing the traditional centers of shipbuilding excellence.
Nowadays, most newbuilding ship deals are negotiated directly between the buyer and shipyard, it is relatively rare for sale and purchase (S&P) shipbrokers to be involved although some specialists in newbuilding ship contracting do exist.
How to Finance Shipbuilding?
Shipbuilding is a capital-intensive industry that requires substantial financing to complete projects. The process of securing funds for the construction and acquisition of ships is known as shipbuilding finance. This specialized area of finance involves many parties, including shipbuilders, shipping companies, financial institutions, and sometimes government entities.
There are several ways to finance shipbuilding, including:
- Self-Financing: Some shipping companies or shipbuilders may have enough cash reserves or retained earnings to fund new shipbuilding projects. However, given the high cost of building new vessels, this is not always a feasible option for most companies.
- Bank Loans: This is the most traditional and common form of shipbuilding finance. Loans are provided by banks with the ship itself usually serving as the collateral. In this arrangement, the shipping company will repay the loan over time, typically from the revenues generated by the ship.
- Leasing: Under a lease arrangement, a financial institution or leasing company purchases the ship from the shipbuilder and then leases it to the shipping company. The shipping company pays periodic lease payments and often has the option to purchase the ship at the end of the lease term.
- Export Credit Agencies (ECAs): These are government or quasi-government agencies that provide guarantees, insurance, or direct loans to facilitate export transactions. For shipbuilding, ECAs can provide guarantees to commercial lenders to encourage them to finance shipbuilding projects.
- Public Equity and Debt: Shipping companies may raise capital by issuing shares or bonds in the public markets. This option, however, is typically available only to larger shipping companies that are publicly traded.
- Private Equity and Venture Capital: These sources of funding involve selling an ownership stake in the company or project to investors. These investors often expect a high return on their investment due to the risk involved.
- Joint Ventures and Partnerships: These are agreements between multiple parties to share the costs and benefits of shipbuilding projects. This can help spread risk and leverage the strengths of each partner.
Securing finance for shipbuilding requires careful planning, as the high costs and long project timelines carry significant financial risks. It is also a complex process involving multiple legal, regulatory, and market factors. Shipping companies often work with financial advisors or brokers to help navigate this process and secure the best financing arrangements.
While discussing shipbuilding finance, it is also important to mention various key considerations and challenges involved in the process.
- Risk Assessment: This is a significant step in shipbuilding finance. All parties involved need to assess risks such as market risks, technological risks, environmental risks, and political risks. Accurate risk assessment helps in structuring the financing deal and mitigating potential losses.
- Creditworthiness: Before extending loans or financial assistance, lenders assess the creditworthiness of the borrower, which is determined by financial health, operational efficiency, and market reputation.
- Regulations and Compliance: Various national and international regulations govern the shipbuilding and shipping industry. Compliance with these regulations is essential to secure financing.
- Valuation: The valuation of the ship and the projected earnings capacity are key considerations in shipbuilding finance. Lenders need to be confident that the ship can generate sufficient returns to repay the loan.
- Economic Conditions: The global economic climate plays a significant role in shipbuilding finance. Economic downturns can reduce demand for shipping, making it harder for shipping companies to repay loans.
- Technological Advancements: Rapid technological changes can render new ships obsolete before they even hit the water. This poses a considerable risk for lenders and investors.
- Environmental Considerations: Increasingly strict environmental regulations can add to the cost and complexity of building and operating ships. The transition to cleaner fuels and technologies is a significant challenge facing the industry.
- Political Risks: Political instability or changes in trade policies can impact global shipping routes and demand, affecting the financial viability of shipbuilding projects.
Shipbuilding finance is a complex process with many considerations and challenges. Given the high stakes and potential risks, many shipping companies and shipbuilders turn to financial experts to help them navigate this landscape. While the methods of financing may vary, the ultimate goal remains the same – to successfully construct and operate vessels that meet global demand for maritime transportation in a financially sustainable manner.
Finance for Ship Building
With the perpetual, dynamic flow of global trade, commercial shipping remains an indispensable component of our contemporary worldwide economy. Regardless of a nation’s inclination towards isolationism or jingoism, no country can claim complete self-sufficiency. Despite any liquidity crisis, the fundamental principles of economics, namely supply and demand, ensure the continuation of international trade and its primary physical conduit—commercial shipping.
From the most rudimentary raw materials and minerals to essential foodstuffs, energy resources, and manufactured goods, all commodities are incessantly imported and exported. The intricate network of trade routes facilitated by shipping forms the arteries and veins of this global exchange. It is an undeniable truth that the vast majority of trade, in terms of volume, is transported by ships. Recent reports from the International Maritime Organization (IMO) even suggest that this figure reaches as high as 90%. This fundamental dynamic shows no signs of shifting. Equally undeniable is the fact that the pivotal assets enabling this trade, be they humble coastal bulk carriers or sophisticated LNG tankers, all have a finite commercial lifespan.
Hence, irrespective of any decline in a vessel’s inherent value or the perceived scarcity of easily accessible liquid funds to finance its replacement, all such vessels will inevitably require replacement. This necessity arises from their either becoming economically inviable or physically unsuitable for operation. Furthermore, a significant portion of these new construction projects will depend on third-party financing.
It is important to acknowledge early on that it is imprudent to speak of the international shipping industry as a homogenous entity. This industry is incredibly diverse and intricate. The range of vessel types is only matched by the diversity of their owners. These owners span from colossal corporate conglomerates to modest coastal trading entities and individual owner-operators. Similarly, while this article discusses many aspects of ship finance, it omits the intricacies of corporate bonds and other financial instruments.
Hence, it should come as no surprise that no single approach can adequately encapsulate or cater to the needs of such a vast and diverse industry and its financing requirements.
Nevertheless, what follows is a concise and high-level overview of the various types of financing available—both those with traditional roots and those currently in use. As the global economy evolves and expands, certain components of these traditional financing methods fall in and out of favor, while others emerge. Factors such as fundamental functionality and appeal continuously transform and progress in accordance with the demands of end users, the global economy itself, and overarching financial trends.
To comprehend the present state of this diverse global industry, it is imperative to retrospect and delve into the fundamental economic constituents of its financial structure.
For instance, primary components encompass:
1- Traditional Lenders
While several of the conventional British and German banks have withdrawn from this lending market, certain American banks still persist. Most notably, Citigroup and BoA continue to possess and are open, under suitable circumstances, to expanding their substantial conventional debt in this industry. Other European lenders, like ABN Amro and Rabobank, remain active. The Nordic regions should not be disregarded, with active participants such as Nord/LB, nor should emerging debt frameworks like the Norwegian Limited Partnership (KS). Undoubtedly, there will be more developments.
2- Shipyard Debt Financing
The subsequent option entails engaging the subsequent most interested party. In order to generate profits, the ship owners need to acquire debt to raise capital for funding replacement vessels. To maximize their earnings, the lenders must continue to allocate their funds. However, if these two principal parties fail to reach a satisfactory agreement regarding price, level of risk, and security provisions, the other subsequent most interested party comes into play: the vessel builders themselves. Simply stated, to amass their wealth, the ship builder must persist in constructing and delivering their vessels. To finance this enterprise, the shipbuilder requires not only new orders but also timely payment for existing ones. This enables timely delivery and opens up new construction slots, thus initiating the entire process anew. When you combine this fundamental reality of cash flow with the customary payment terms of a standard shipbuilding contract (i.e., five installments during the construction phase, with the fifth installment often ranging from 70% to 90% and being due upon delivery), these two factors merge to create a predicament for both the prospective owner and the builder in the event of insufficient funds at the delivery stage.
3- Chinese Investment Banks
The China Development Bank or the China Construction Bank can serve as sources for conventional debt finance deals, albeit limited to Chinese construction projects exclusively. For non-Chinese contractors, national export credit agencies in established commercial shipping countries such as the Netherlands, South Korea, Norway, Japan, and the Scandinavian nations may potentially provide assistance. These Export Credit Agencies (ECA) themselves have recently shown more openness towards adopting innovative debt structures and associated security packages for suitable parties. However, it is important to note that there are no guarantees with Export Credit Agencies (ECA). Export Credit Agencies (ECA) are entities that not only respond to economic conditions but also consider significant internal and variable policy factors.
4- Corporate Debt Financing Models
As equity levels or “skin the game” are often specific to the deal (i.e., vessel), the subsequent logical progression (if those figures are insufficient to facilitate the flow of debt) is to introduce additional collateral into the arrangement. As mentioned earlier, relying solely on recourse financing for the asset is no longer deemed acceptable by many financiers. The subsequent logical step for borrowers/owners who possess other assets is to incorporate them into the mix. These assets can include, as long as they are not already encumbered, other affiliated vessels within the owner/borrower group. Nonetheless, although secondary security is feasible, as explained in the builder credit section below, it is not ideal nor widely favored. However, if relying solely on additional vessel security does not suffice from a combined unencumbered asset valuation perspective, and/or is deemed unfavorable from a commercial fleet management standpoint, other group assets are commonly taken into consideration. Subsidiary shares, group revenue streams, land, buildings, and tangible facilities can all be included in the security package. To delve deeper into this point, these assets may extend beyond those belonging solely to the borrower and encompass those of the borrower group.
Consequently, the outcome is a facility and security package that is much more recognizable to a corporate financier than to a traditional shipping lender. While various combinations of the aforementioned three factors can secure many deals in the post-2008 financial crisis era, they all depend on the presence of a potential traditional debt provider in the equation. As numerous interested parties are aware, this is not always the case. Frequently, despite the greater depth and breadth of a specific security package on offer, there is no sole lender who is willing to provide 100% of the required debt, even considering the genuine possibility of post-drawdown syndication. In such instances, the resulting complexities of an inter-creditor arrangement, even in a three-party deal, may be perceived as excessively intricate and burdensome.
The conventional practice of financing new constructions with a single recourse and loan-to-value ratios ranging from 60% to 70% has become obsolete for the majority of ship owners. The extent of equity that owners or other stakeholders are now expected to contribute has undergone significant changes compared to just a few years ago. At the very minimum, most lenders anticipate a considerably larger contribution in the form of direct investment from the borrowers themselves in each new financing endeavor. The most apparent source for this investment lies in the augmented owner equity within the borrowing vehicle itself. Although seemingly equitable and straightforward, accessing a substantial pool of liquidity is often challenging for owners/borrowers due to the recent decline in bulk and day charter rates within an already competitive market.
6- Increased Loan-to-Value (LTV) Ratios
Loan-to-Value (LTV) Ratios serve as a logical solution to the scarcity of debt capital and naturally arise from borrowers having made substantial equity investments in new deals. A reduced percentage in this headline figure is favorable to credit committees and risk management heads in numerous financial institutions. However, it is essential to acknowledge that while comforting, this approach does not, in any manner, alter the inherent volatility of both the asset class and its underlying market. Such volatility is an undeniable reality that potential borrowers are frequently reminded of.
What are the different types of Ship Financing?
There are several types of ship financing options available to individuals or corporations involved in the maritime industry. They offer the necessary capital for shipbuilding, purchasing, or repairing vessels. Here are the major types:
- Bank Loans: These are the most traditional form of ship financing. In this case, a bank or financial institution provides a loan to the ship owner, which is typically secured against the vessel itself. The vessel acts as collateral, and the loan is repaid over a certain period with interest.
- Bonds: Shipping companies can raise capital by issuing bonds to investors. These bonds represent a debt that the shipping company is obligated to repay with a certain interest rate. The shipping company may use the funds raised from the bond issuance to finance new vessels.
- Private Equity: In private equity financing, private investors or equity firms invest in a shipping company in return for a stake in the business. This is a popular method of ship financing, especially for larger projects, because it doesn’t require the company to take on debt.
- Leasing: In a lease arrangement, the ship owner doesn’t actually own the ship but rents it from a leasing company. There are several types of leases, including bareboat charter (where the lessor provides only the ship), and time charter (where the lessor provides the ship and crew).
- Export Credits: Some governments offer export credits to domestic shipbuilders to incentivize shipbuilding in their own country. This method of financing is generally only available for new builds.
- Joint Ventures: In a joint venture, two or more companies pool their resources to finance a ship. This helps spread the risk and cost of the project.
- Public Equity: Some shipping companies are publicly traded, meaning they can raise capital by issuing shares to the public. Shareholders in the company have a claim to a part of the company’s profits.
- Ship Mortgages: A ship mortgage is a loan taken out on a ship where the ship is used as collateral. If the borrower fails to make payments, the lender can seize the ship to recoup their losses.
- Structured Financing: This involves complex arrangements that typically combine various forms of debt and equity financing, along with financial instruments like derivatives, to achieve a specific financial objective.
The appropriate type of ship financing will depend on the specific needs and circumstances of the shipping company or individual. Factors that may be considered include the company’s financial health, the type and age of the ship, and market conditions.
Maritime Mortgage on Newbuilding Ship
A maritime mortgage is a legal instrument that enables the owner of a ship to secure a loan or other obligation with the ship itself as collateral. This is similar to a real estate mortgage where the property can be foreclosed and sold to repay the debt if the borrower defaults.
In the case of a newbuilding ship, a maritime mortgage could be used to secure the financing necessary for the construction of the ship. This would typically involve a number of steps:
- Pre-Approval Phase: In this initial stage, the prospective shipowner creates a business plan and approaches lenders (usually banks or other financial institutions that specialize in maritime financing) to secure preliminary approval for the loan.
- Loan Agreement: Once pre-approval has been granted, a loan agreement will be drawn up. This will detail the terms and conditions of the loan, including the repayment schedule, interest rates, and what constitutes a default.
- Shipbuilding Contract: Alongside the loan agreement, a shipbuilding contract will be signed with a shipyard. This contract outlines the specifications of the ship to be built, the price, and the building schedule.
- Registration of the Mortgage: Once the loan agreement has been finalized and the shipbuilding contract signed, the mortgage can be registered. In many jurisdictions, this involves registering the mortgage with a public registry, often part of a country’s maritime or shipping authority. The registry ensures that the mortgage is enforceable and that the lender has a recognized interest in the ship.
- Drawdown and Construction: With the mortgage registered, the funds can be drawn down to pay the shipyard in accordance with the construction schedule. Regular inspections and valuations may take place to ensure the build is proceeding as planned.
- Delivery and Repayment: Upon completion of the ship, it is delivered to the owner. At this point, the repayment phase of the mortgage begins, typically involving regular repayments over a number of years.
- Release of Mortgage: Once the loan has been repaid in full, the lender will release the mortgage, effectively ending their claim to the ship.
It’s important to note that each of these steps involves a number of complexities and legal considerations, and therefore it’s essential to engage competent legal counsel experienced in maritime law and ship financing to navigate this process. Each jurisdiction may also have its own particular laws and regulations governing maritime mortgages, so local legal advice is also crucial.
What are the risks in Ship Building Finance?
Shipbuilding finance refers to the process of financing the construction of ships, typically via a mixture of debt and equity financing. This sector presents several unique risks, which are outlined below:
- Market Risk: The shipping industry is known for its cyclical nature with booms and busts. The demand for new ships is closely tied to global economic conditions and international trade volumes. If there is a downturn in these markets, then the demand for new ships may decrease, putting financial pressure on shipbuilders and their lenders.
- Construction Risk: Building a ship is a complex, lengthy, and expensive process. There can be cost overruns, delays, or quality issues. In some cases, a shipbuilder may even go bankrupt before the ship is finished, leaving the financier with an incomplete asset that may be difficult to sell.
- Technological Risk: The shipping industry is subject to changes in technology and environmental regulations. For example, new emission standards may require ships to be fitted with expensive new technology. If a ship is being financed over a long period, there is a risk that it may become technologically obsolete before it is completed.
- Counterparty Risk: This is the risk that the other party in a contract will default on their contractual obligations. For example, a shipyard may fail to deliver a ship on time, or a buyer may fail to make the agreed payments. This risk is particularly high in the shipbuilding industry due to its capital-intensive nature and the long duration of shipbuilding contracts.
- Regulatory Risk: The shipping industry is heavily regulated and subject to international, national, and local laws. Changes in these regulations can have a significant impact on the cost and feasibility of building new ships.
- Exchange Rate Risk: Since shipbuilding often involves parties from different countries, there’s a risk associated with currency exchange rates. If the currency of the country where the shipyard is located appreciates significantly compared to the currency in which the financing was arranged, the cost of the project in the financing currency can significantly increase.
- Resale Risk: This relates to the risk of the financed ship not achieving the expected sale price upon resale in the secondary market. The resale value of a vessel can be influenced by many factors, including global economic conditions, the age and condition of the vessel, and changes in shipping regulations.
Mitigating these risks often involves a combination of careful due diligence, contractual safeguards, and the use of various financial instruments such as currency hedging and insurance.
Risks of Ship Financing
Shipowners engage in such actions to fulfill their specific trading requirements or capitalize on more advantageous credit and tax opportunities, while others seek to transition to novel fuels and technologies. They aim to exploit market rates that continually reach unprecedented highs, expand their operations, diversify their activities, or pursue a combination of these objectives. From cruise ships to containerships, tankers, bulk carriers, and offshore vessels, shipowners are perpetually in search of financial partners to assist with the capital requirements linked to newbuilds. Forecasts indicate that the shipbuilding market will experience growth in the coming years, driven by the industry’s commitment to green shipping and the growing demand for seaborne trade.
Financial institutions will have opportunities to offer short or long-term financing to support these projects. Nevertheless, the risks associated with shipbuilding may dissuade some potential financiers. Indeed, our conventional asset finance instincts face challenges as there is no immediate cash flow to leverage (at least for a certain period) and often no asset to mortgage (although exceptions exist), thereby limiting or securing the financier’s exposure. Hence, whether serving as a mere bridge financier for part of the shipbuilding installments or for those willing to provide full-term pre-delivery financing for the vessel, how can financiers find reassurance when funding the construction installments of a vessel?
Risks typically associated with Financing Newbuilding Ship
Investors engaged in the financing of vessel construction often encounter the primary risks of insolvency. On one hand, there is the risk of shipyard insolvency, and on the other hand, the risk of shipowner insolvency. Additionally, there is the risk of the shipyard failing to construct a vessel that adheres to the specified requirements within the agreed-upon timeframe.
The occurrence of shipyard insolvencies is not merely a theoretical concern; in fact, shipyard insolvencies are quite prevalent. Recent instances of shipyards flirting dangerously with insolvency have involved both prominent state-supported shipyards and smaller private entities, spanning Asia and Europe. As a financier, it is far from ideal to face the possibility of a halt in the construction of the vessel, especially when partial funding of the installments has already commenced. This poses a genuine risk that the vessel may never reach completion. Fortunately, this risk can be mitigated through thorough due diligence on the shipyard, careful consideration of the terms outlined in the shipbuilding contract, and the inclusion of refund guarantees in an appropriately drafted manner. The risks may be amplified in cases where the shipyard is newly established or when the design and technology remain untested.
The pivotal document in these transactions shall be the shipbuilding agreement. Shipowners understandably hesitate to involve their potential financiers in the negotiations of the shipbuilding agreement. It is a matter of expertise, timing, and overall sensitivity. After all, shipowners face significant pressure to secure slots at shipyards in an intensely competitive environment. Nonetheless, any financier will require thorough due diligence on the shipbuilding agreement, and a prudent shipowner often assigns its advisors to ensure its “finance-friendly” nature prior to engaging any financier. Special attention should be given to assignment restrictions, cancellation and refund rights, the provision of a refund guarantee, insurance coverage requirements, and the general schedule and mechanics of payments. These factors will, among other things, determine the drawdown schedule under the facility agreement. Additionally, the shipowner will typically enter into a supervision agreement, either internally or externally when lacking this capability, and the financier will seek assurance regarding the supervisor’s abilities, especially if they also provide post-delivery financing. The financier will also have an interest in identifying who assumes any design/technology risk.
Furthermore, financiers involved in the financing of newly constructed vessels would ideally pursue a provision known as “step-in rights,” which would empower them to assume the responsibilities of the shipowner who is failing, essentially taking over their payment obligations. This objective can be easily accomplished through a meticulously crafted English law assignment and acknowledgement or through a bespoke “direct agreement” among the shipowner, financier, and shipyard. Admittedly, this situation is far from ideal, as the effectiveness of this remedy ultimately depends on finding a new buyer for the vessel upon its delivery, introducing a certain level of uncertainty. As experienced project financiers understand, however, seeing the project through to its completion is often the most financially prudent strategy to navigate out of a default scenario.
Guarantee of Refunds in Newbuilding Ship
To mitigate the risks associated with potential insolvency at the shipyard level, it is customary for a prospective shipowner to seek a guarantee that ensures reimbursement of their payments if the shipyard fails to fulfill its obligations, leading to the shipowner’s right to terminate the shipbuilding contract or in the case of insolvency proceedings. Typically, this guarantee is provided by the shipyard’s bank, utilizing their own standardized template, and the shipyard is obligated to pay a fee for this service. It is important for financiers to avail themselves of the advantages offered by this refund guarantee, either as direct beneficiaries or through assignment. It is advisable to seek the guidance of relevant legal counsel to ensure that the guarantee achieves its intended purpose in accordance with the governing law and the jurisdiction where it is likely to be enforced.
Nonetheless, it is in the mutual interest of both shipowners and their financiers to advocate for this assurance under favorable conditions. In essence, the shipowners bear the inherent risk, while the financiers may possess suitable alternative safeguards in place, such as creditworthy corporate guarantees from a shipowner’s holding company and/or cross-collateralization with other vessels that are already constructed and utilized. In any scenario, reimbursement guarantees typically conform to established norms and form an integral part of the shipyard’s contractual proposal.
Mortgage on a Ship Under Construction
At what point does an assemblage of steel cease to be merely that and transform into a vessel? This question holds practical significance for financiers when a vessel is being fabricated in a jurisdiction that acknowledges mortgages prior to delivery. It is important to note that this situation does not apply to the three shipbuilding superpowers: Korea, China, and Japan. Therefore, it represents a more distant possibility. Indeed, this possibility primarily exists within countries with a civil law background, such as France, Belgium, and Germany, where ship registries may consent to the registration of vessels under construction. Consequently, this opens the pathway for granting mortgages on such vessels. The mortgage may either be extended by the shipyard itself which would be uncommon, if they retain ownership of the vessel under construction until delivery—whether because they seek their own financing or as part of the negotiations in the shipbuilding contract—or by the shipowner if the title to the vessel is gradually transferred to the buyers through a continuous incorporation of new materials during the construction process. Firstly, the registration of the vessel under construction will only be feasible once the vessel attains a certain degree of “completeness” (for example, the keel-laying date in Belgium, France, and Germany). This implies that certain initial payments would have already been made at this stage, prior to the implementation of any mortgagee protection. Secondly, asserting rights over a vessel under construction will yield limited value if there is no avenue to ensure the completion of the construction or the reimbursement of the payments. A judicial sale of a vessel under construction is generally not the most lucrative recourse in such circumstances, as evidenced by a recent case in Germany where the vessel was disposed of at scrap value due to the shipyard’s insolvency. Ultimately, having a mortgage is generally advantageous in the realm of asset finance. However, acquiring a mortgage over the vessel under construction may not be as effective in cases where the vessel is being constructed in a different jurisdiction. It is essential to verify the local position in such situations.
Long-Term Charter Backed Newbuilding Ship Finance
Frequently, when a shipowner enters into a shipbuilding agreement, they often do so after securing a long-term charter. Gas companies and oil majors, for instance, frequently participate in such transactions. These charterers are also actively engaged in the construction process, ensuring that the vessel aligns with their specific requirements. These charterers, however, prefer not to assume ownership of the vessel or act as direct purchasers under the shipbuilding agreement, due to liability management or simple business planning considerations. Instead, they delegate these responsibilities to the shipowners. At times, charterers may contribute to funding the cost of the shipbuilding agreement, which significantly enhances the financier’s prospects of recouping their investment in the event of a defaulting shipowner.
Ship Financiers and Charterers shall engage in negotiations pertaining to the occurrences in those circumstances, either by means of an acknowledgment of the notice of assignment under an English law agreement or by means of a separate direct agreement between them where the law of another jurisdiction is applicable. Ideally, financiers and charterers would mutually consent that, in the event of the shipowner or ship manager’s failure pertaining to the intended vessel, the ship financier or its nominee shall assume responsibility for overseeing the construction process with the shipyard, while the charter agreement shall remain in effect, and the vessel’s management shall undergo a change. For example, by referring to a pre-agreed list of acceptable alternative ship management companies, or by simply deferring the appointment of managers to a later stage in the construction process.
How Ship Financing Deals Work
Ship financing deals are complex financial transactions that involve several parties and multiple steps. These deals can involve significant sums of money, given the high costs of buying and operating ships. Here’s an overview of how a typical ship financing deal might work:
- Identification of the Ship: The first step in ship financing is for the ship owner (or prospective owner) to identify a vessel they want to buy. This could be a new ship being built at a shipyard or a used ship that’s already in service.
- Preliminary Negotiations: Once the ship has been identified, the prospective buyer will negotiate a purchase price with the seller or shipyard. This price will depend on the type of ship, its age, its condition, and other factors.
- Financing Application: The buyer will then apply for financing. This could be from a bank, a specialized ship financing company, or other financial institutions. The institution will assess the creditworthiness of the borrower, the value of the ship, and the income the ship is expected to generate.
- Due Diligence: The lender will conduct a due diligence process. This involves assessing the technical condition of the vessel (if it’s a used one), the business plan for the vessel (including the potential profitability of the routes it will sail), and the financial health of the borrower.
- Loan Approval and Terms: If the lender is satisfied with the results of the due diligence, they will approve the loan. The terms of the loan (including the interest rate and the repayment schedule) will be determined by the risk assessment of the borrower and the value of the ship.
- Security and Insurances: As part of the loan agreement, the lender will typically require the borrower to provide security for the loan. This is usually in the form of a mortgage on the ship, which gives the lender the right to take possession of the ship if the borrower defaults on the loan. The lender will also require the borrower to have insurance on the ship, to cover potential damages or losses.
- Closing the Deal: Once the terms of the loan are agreed, the buyer will close the deal with the seller or shipyard. The lender will pay the agreed purchase price, and the seller will transfer ownership of the ship to the buyer. The buyer begins to repay the loan according to the agreed schedule.
- Operations and Repayment: The buyer, now the ship owner, will begin operations with the ship to generate revenue. The revenue will be used to maintain the ship, pay operational expenses, and repay the loan.
- Detailed Due Diligence: During this phase, the lender will inspect the potential borrower’s financial records to determine the creditworthiness and financial health of the company. The due diligence process may also include an inspection of the ship to ensure it’s in good condition, as well as an appraisal to determine its value. The lender may also review the shipping market conditions and trends to ensure the investment is sound.
- Risk Management: The risk for the lender in ship financing deals is significant, as it involves a large sum of money and the ship industry is cyclical and volatile. Therefore, risk management is a critical aspect of ship financing. The lenders use different methods to manage risk, such as diversification of portfolio, capping the loan-to-value ratio, requiring strong financial covenants, and keeping track of the secondary market for ships.
- Loan Structuring: Once the due diligence process is complete and the lender is satisfied with the level of risk, they will structure the loan. The structure will include the total amount of the loan, the interest rate, the repayment schedule, and the terms and conditions of the loan. The structure will also detail the collateral or security against the loan, which is often the ship itself.
- Legal Documentation: Once the terms of the deal are agreed upon, the legal documentation phase begins. This involves drawing up the contracts for the loan agreement, the mortgage on the ship, and any other necessary documents. These documents need to be carefully reviewed by both parties before they are signed to ensure they accurately reflect the agreed-upon terms.
- Disbursement of Funds and Transfer of Ownership: After all the necessary documents are signed and all conditions are met, the lender will disburse the funds for the purchase. The seller or shipyard will receive the money, and the title of the ship will be transferred to the buyer. The ship is then registered in the name of the buyer, and a mortgage is registered in favor of the lender.
- Operational Phase and Loan Repayment: Once the ship is operational, it starts generating revenue. The ship owner uses this revenue to repay the loan as per the agreed repayment schedule. The owner is also responsible for the operational expenses of the ship including crew wages, maintenance, insurance, and fuel costs.
- Default and Foreclosure: If the ship owner defaults on the loan repayment, the lender has the right to take possession of the ship, sell it, and recover the loan amount. The process of taking possession and selling the ship is governed by the laws of the country where the ship is registered.
- Loan Exit or Refinancing: At the end of the loan term, the ship owner can choose to sell the ship, pay off the remaining loan balance, and exit the loan. Alternatively, if the ship owner wants to keep the ship, they can seek to refinance the loan.
Each ship financing deal is unique and can be quite complex, involving multiple parties and several stages. These are just some of the steps involved in a typical deal. In practice, the process may involve additional steps or complexities, depending on the specific circumstances.
This is a simplified overview and the exact process can vary depending on the specifics of the deal and the regulations in the jurisdictions involved. Furthermore, other forms of ship financing, like leasing and joint ventures, might involve different processes.
Benefits of Sale-and-Leaseback Arrangements in Ship Finance
Sale-and-leaseback arrangements have gained significant traction in recent times. In a sale-and-leaseback arrangement, the original company that owns the ship sells the vessel to another company and subsequently leases it back from them. Consequently, the original ship owner assumes the role of a lessee, while the new buyer becomes the lessor. In some instances, these transactions may also incorporate a purchase option, granting the lessee the right of first refusal to repurchase the vessel at the conclusion of the lease term. Recognizing the growing popularity of sale-and-leaseback arrangements in 2020, BIMCO introduced SHIPLEASE, a standardized term sheet designed for utilization in sale and leaseback transactions.
Sale-and-leaseback arrangements offer advantages to both the lessor and lessee. They provide the lessee, the original owner of the ship, with an opportunity to generate cash flow and enhance capital, thereby augmenting liquidity upon selling their vessels. The funds obtained by the lessee can be allocated towards alternative ventures or utilized to cover operational expenses. In the case of acquiring newly constructed or pre-owned vessels, shipping companies can employ such arrangements to facilitate delivery without the need for the lessee to amplify the company’s indebtedness or dilute its equity. The benefits for the lessor extend to heightened asset security as they assume ownership. Unlike traditional bank financing, which necessitates initiating legal proceedings to recover the asset in the event of non-payment or default, the lessor, as the vessel’s proprietor, has the authority to promptly terminate the lease or charter and reclaim possession of the vessel, thus expediting the process compared to enforcing a mortgage.
Chinese leasing institutions, in particular, have played a significant role in the substantial growth of sale-and-leaseback transactions, which have witnessed exponential expansion in recent years. While these leasing institutions were primarily focused on the new-build market in the past, they are increasingly venturing into the second-hand market as well.
Japanese Operating Leases with Call Option (JOLCO) in Ship Finance
In recent years, there has been a notable increase in the utilization of Japanese Operating Leases with Call Option (JOLCO) transactions. While JOLCOs have historically been prevalent in financing arrangements within the aviation sector, we have observed their growing prominence in the shipping industry. These operating lease agreements involve an equity investment from Japanese investors and senior debt financing provided by financial institutions to a special purpose vehicle (SPV). The SPV, in turn, utilizes these funds to cover the costs of acquiring the vessels. Simultaneously, the SPV and the shipping company enter into a bareboat charter. Such arrangements offer shipping companies access to competitive lease rates and off-balance-sheet financing, making them an appealing choice in Japan due to specific provisions in Japanese tax law. JOLCOs signify a shift towards alternative sources of financing within the shipping industry.
What is JOLCO?
Japanese Operating Leases with Call Option (JOLCO) is an innovative and popular form of aircraft and ship financing that originates from Japan. This financing structure has gained significant traction in the international shipping and aviation sectors due to its potential tax advantages and its flexibility in terms of the lease’s structure.
In a JOLCO, a Japanese investor, typically a company or a group of individuals, purchases an asset (in this case a ship), and then leases it back to the operator, typically an airline or shipping company. The operator makes regular lease payments to the Japanese investor, who benefits from depreciation tax allowances in Japan.
The “call option” in Japanese Operating Leases with Call Option (JOLCO) allows the lessee (the operator) to buy the asset (ship) at a predetermined price, which can be exercised at a specific point during or at the end of the lease term. This optionality can be an important financial planning tool for the operator.
Japanese Operating Leases with Call Option (JOLCO) transactions are typically arranged by specialized Japanese leasing companies, who act as intermediaries between the investors and the operators. These leasing companies also work with banks to provide non-recourse debt financing as part of the transaction.
Here’s a step-by-step breakdown of a typical JOLCO transaction in ship finance:
- A shipping company identifies a need for a new ship but may not want to, or cannot, finance the ship’s full cost upfront.
- The shipping company negotiates a sale and leaseback deal with a Japanese investor, who agrees to purchase the ship and lease it back to the shipping company.
- The Japanese investor obtains non-recourse debt financing from a bank and uses this to cover a portion of the ship’s purchase price.
- The investor purchases the ship from the manufacturer or existing owner, utilizing both the debt financing and their own equity.
- The investor then leases the ship back to the shipping company under an operating lease agreement. The shipping company makes regular lease payments to the investor.
- The investor benefits from depreciation tax allowances on the ship in Japan, which can make the transaction highly attractive from a tax perspective.
- At a certain point during the lease, or at its end, the shipping company has the option to purchase the ship from the investor at a predetermined price.
Japanese Operating Leases with Call Option (JOLCO) structures are quite complex and involve a number of legal, tax, and financial considerations. They require careful structuring and management to ensure that they are compliant with tax laws in Japan and in the operator’s home country. However, if properly managed, they can provide significant benefits to all parties involved.