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.