Private Equity Made Bad Bet on Ships, Hit by Collapse in China Trade

Private equity clearly has more money than it can deploy sensibly.

One sign was its enthusiasm for energy plays. It’s hard to imagine an investment more out of synch with the classic private equity formula of steady cash flows and solid customer franchises. Fracking, one of PE’s recent targets, is highly capital intensive, and the sellers are at the mercy of price swings in a highly volatile end market.

Apparently the private equity crowd fell for the sales pitch of the oil & gas crowd, and convinced themselves that energy prices had nowhere to go but up. Oops.

Similarly, some private equity firms seem to have believed the China hype, that the emerging superpower’s trajectory was inevitable Yet as we’ve stressed, no major economy has made a smooth transition from being export-led to consumer-driven. And for those who were watching China, there were signs in addition to the commodity price declines that all was not well. For instance, about 24 months ago, imports of almonds, a favorite of the emerging middle classes in China, fell abruptly, a sign of consumer retrenchment.

The Financial Times discuses today how charter prices have collapsed, particularly for “dry bulk” ships, and the Baltic Dry index is at the lowest level since it started to be published, in 1985. Needless to say, the news of the day, that manufacturing indexes in China have weakened for the 10th straight months. Stock prices fell over 7%, enough to trigger a trading halt for the balance of the day under new circuit breaker rules.

Mind you, even by the standards of the highly cyclical shipping business, the current state of affairs is dire. From the Financial Times:

China’s slowing growth and a glut of ships have hit earnings for vessels carrying coal and other dry bulk commodities so hard that owners face forced sales, emergency capital raisings and possible bankruptcy.

Charter fees are not covering vessels’ operating costs, let alone their financing, in the latest bad news for the many private equity firms that have invested in the sector.

Short-term charter rates for Capesize ships — the largest kind — were as low as $4,897 a day on December 23, down from more than $20,000 a day in August. Vessels typically cost around $13,000 a day to operate and finance.

And private equity made this debacle even worse than it had to be by adding to capacity at the peak:

The slide partly reflected growth in the dry bulk fleet as vessels ordered in late 2013 and early 2014, many with private equity funding, were delivered. The net capacity of the world dry bulk fleet grew 3 per cent in the first 10 months of 2015, despite a spike in the number of older vessels being scrapped following the slump in rates.

And it was not as if this problem was not foreseeable. The Financial Times warned early last year that the private equity strategy was wrongheaded, that if it were to invest in tankers at all, investing in older ones rather than new capacity would have been sounder. Since the shipping industry is not a major beat for the pink paper, it’s not hard to imagine that insiders had been giving warnings privately even earlier. From the 2015 story:

One of Greece’s highest-profile shipowners has warned private equity firms they risk “destroying” markets if they continue to finance new vessels, after excessive deliveries have driven down cargo rates.

Private equity, which until the past few years was only a minor contributor to shipping finance, has invested at least $5bn in shipping every year since 2010 and funded about 10 per cent of deals.

The cash rescued many companies after the collapse in rates and banks’ growing caution towards shipping lending after the financial crisis.

However, much of the new capital was used to order new vessels at cut rates from desperate shipyards, rather than buying existing vessels from other shipowners.

And as the new story details, low oil prices have further whacked charter rates by reducing transit times and hence lease terms:

The crisis has been made worse by the low oil price. As the price of fuel has fallen, charterers have ordered many shipowners to speed ships up instead of operating them slowly to save fuel. Michael Bodouroglou, chief executive of Paragon Shipping, an Athens-based, New York-listed dry bulk shipowner, said the increased speed was making the oversupply problem worse by increasing the fleet’s carrying capacity.

Conditions are so lousy that major players, including public companies, are selling ships at distressed prices to raise cash. Monarch Alternative Capital and Oak Tree Capital have large stakes in two of the public companies that are under duress. And given that these deals were levered, you can expect the related debt, which probably at least in part wound up in private equity credit funds, will also show losses.

Mind you, these tanker losses are chump change in term of the total capital deployed by the private equity industry. But the fact that the funds invested on a continued basis, as opposed to a brief fling at bottom-fishing, strongly points to underestimation of the risks (as in a naive belief that they could rise a rising market and get out in time) or sheer cynicism (private equity makes money whether the deals work out or not). And more broadly, as the peak multiples paid in 2015 attest, it also shows too much money chasing too few deals can lead to a remarkable ability to rationalize questionable investments.

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  1. craazyboy

    It’s like Warren Buffet always says. “When the tide goes out, you find out which Chinamen have been swimming naked!”

  2. Marat

    Tanker (i.e. crude carrier) market is actually doing quite well currently driven by storage capacity requirement. Dry bulk is as you describe and container is sufferring too.

    1. rjs

      yes, i found the headline weird. i have been reading about a shortage of oil tankers, such that they can name their price, brought on the the contango trade, wherein they’re being used for oil storage as the planet is running out of land based storage…

      here’s bloomberg a few days ago:

      US exports (two ships from Texas to Italy already) may exacerbate that..

      and yes, the bulk dry carriers of grain, coal and ore are in trouble, as witness by the recent Baltic dry record lows

      1. Yves Smith Post author

        Grr, I was pushing to get this launched by the 7:00 AM cut for e-mails, and got it done with one minute to spare. Didn’t catch that the headline was off. The perils of AM drafting. Thanks for the correction. I hate it when I am not buzzword compatible.

        1. Paul Tioxon

          The US Navy Yard dry docks were left to the city of Philadelphia when the Navy said buh bye. Big time ship building came back to the dry docks based mostly on the Jones Act requiring American shipping to use American made ships for bulk as well as crude oil or gas cargo transport to American destination, meaning Puerto Rico, Hawaii, Guam, etc or LA to NYC. The most recent deals were ordered this past summer from Kinder-Morgan which seems to need added capacity for Jones Act cargo and storage. It looks like the fix was in for rescinding the export ban on American crude, but the Jones Act still stands.

          Exxon-Mobil has also been a customer. Of course, the amount of taxpayer subsidies to first set them up then keep them in business during the nadir of shipping during the Great Recession has totaled about $500Mil. It would seem that crude oil is doing well, needs ships for the new American export opportunity as well as for storage.

          “Kinder Morgan Inc. announced Monday it will buy four product tankers in design and construction at Aker Philadelphia Shipyard in South Philadelphia for $568 million.

          Two ships used to transport petroleum products and crude oil will be delivered in late 2016 and early 2017. Two other tankers will be finished by late 2017, the Houston-based company said. Aker is building the vessels in a joint venture with American Shipping Co. called Philly Tankers L.L.C.”

          A brief history of the shipyard renewal at the following link.

  3. ck

    Well written, except for the ship class.

    To be correct – dirty tankers – the ones that carry unprocessed crude oil from places like the Arabian Gulf or the coast of West Africa are doing the best in years. With oil being so cheap it seems that there is a constant demand for unprocessed oil.

    Clean tankers – the ones that carry processed products like gasoline and diesel, are not doing as well.

    Bulk carriers – transporting mainstay commodities like iron ore, coal and agricultural products are suffering one of the worst slumps in history primarily due to the slowdown in China and of course as the article says due to over investment over the ZIRP years. The private equity unlimited supply of
    money seeking yield at any cost has seriously unbalanced this sector.

    1. Steve Gunderson

      Dirty tankers are being used for storage because of contango conditions from this past summer/fall.

  4. Rajesh

    Noted that a smooth transition from an export led economy to a consumption led economy has never happened so far. Why is the converse possible?

    1. susan the other

      because it is the logical progression of trade that you trade your surplus goods; you don’t create an economy based on trade; or you trade your natural advantages. Indicating that first you consume and grow prosperous enough to trade the rest. No? Creating an economy for trade is like eating your seed corn in a way.

      1. Rajesh

        Thanks Susan the Other, I was thinking that its because wrt China it was about trade based on low cost labor which leaves workers poor and unable to consume as opposed to say Germany where trade based on technological superiority (or at least the perception of it).

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