Private Credit

for Shipping:
Strategies for Borrowers, Lenders
and Limited Partners

DATE: AUGUST, 2021

AUTHOR: MATT McCLEERY - MANAGING DIRECTOR OF BLUE
SEA CAPITAL, INC. AND PRESIDENT OF MARINE MONEY.

If you would like to confidentially discuss a potential transaction, including LP investment in a

Direct Lender, secondary market purchase/sale or starting-up a Direct Lending platform, please
contact Matt at mmccleery@marinemoney.com
Executive Summary
The $175 billion per year credit market for shipping has changed dramatically in the past
10 years. These changes have created significant risks and opportunities for borrowers,
lenders, and investors. The most significant catalysts for this change were:
1. A net reduction of approximately 30% in the volume of total debt
provided to shipping by traditional commercial banks after the Great
Financial Crisis.

2. Increased allocation of capital into “Direct Lending” strategies by

institutional investors seeking to generate yield in the prolonged low
interest rate environment.

The market for Direct Lending to shipping has entered a new phase. As new platforms
enter the shipping market, existing platforms raise additional capital, and cashflow
positive shipowners repay their loans, competition is increasing among Direct Lenders.
At the same time, Sustainability considerations are changing the behavior of key
stakeholders, including commercial banks, Limited Partners, charterers, and shippers.

It is more important than ever for borrowers, investors, and Direct Lenders to remain
current on conditions in the Direct Lending market, to ensure they are achieving the
most attractive terms available.

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The Background: Commercial Banks Reduce Exposure
The most significant reasons why traditional commercial banks exited the shipping
industry, or reduced exposure to shipping, include:

• Substantial losses on shipping loans made during the “China Boom” of 2003-2009
• Banks moving away from asset-backed lending
• New capital adequacy requirements that make ship lending less profitable
• ESG-related policies that dissuade lending related to fossil-fuel dependent assets

In reducing lending volume, traditional shipping lenders tightened underwriting

standards, lowered transaction sizes, and moved away from syndicated loans. This
widespread change in strategy resulted in fierce competition among banks to directly
serve the limited number of qualified borrowers, such as those with “corporate” legal
structures, healthy balance sheets, modern assets, and larger fee-generating
relationships with the lender.

Unfortunately, a significant portion of shipping borrowers

are no longer being served by commercial banks.

For example, owners of older vessels, niche vessels, non-recourse borrowers such as
JVs, “projects” sponsored by private equity funds, borrowers in less desirable
jurisdictions and those with small and more highly leveraged balance sheets are unable
to access today’s bank market. It is important to note that 40-60% of the global fleet is
controlled by “small” owners of less than 20 vessels and many ships are still held in
Special Purpose Companies with different shareholding structures and therefore no
corporate guarantees.

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What is Direct Lending?
The capital void created by the withdrawal of traditional shipping banks coincided with the
broader trend of increasing “Direct Lending,” a phenomenon which has resulted in
response to chronically low interest rates. Direct Lending has proven to be an attractive
product for borrowers, lenders, and investors.

Also known as “alternative lending” and “non-bank lending,” Direct Lending involves a
lender that is not a regulated bank (e.g., a credit fund), providing debt capital directly to a
borrower on a bilateral basis, without the use of an intermediary such as an investment
bank, broker, or private equity fund. Publicly listed Business Development Corporations
(“BDCs”) are another form of Direct Lending platform but focus primarily on leveraging
domestic (U.S.) investments controlled by financial sponsors.

Unlike traditional debt “investors” who buy leveraged loans and high yield bonds, Direct
Lenders operate like banks, but enjoy more flexibility because they are primarily funded
by equity capital and therefore are not required to comply with banking regulations. Direct
Lenders originate, structure, document, execute and monitor transactions directly with
borrowers.

By offering so-called “bilateral” loans (one lender, one borrower), Direct Lenders can
exclusively control and closely monitor their investments from the initial funding to
maturity. In many cases, Direct Lenders choose to structure transactions as “finance
leases” so that they enjoy title to the vessels in the event of default.

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Increased Allocation for Direct Lenders
Direct Lending in Europe (across all asset classes) grew from around $10 billion of
Assets Under Management (“AUM”) in 2012 to close to $100 billion of AUM in 2020,
according to Ares Management. The United States and Asia also experienced robust
increases in AUM. Allocation of capital into Direct Lending strategies has grown at a
faster rate than traditional opportunistic credit strategies such as distressed debt and
“special situations.” Direct Lenders have become increasingly active in the shipping and
offshore industries due to their capital and asset intensity and lack of adequate sources
of debt funding.

Why it Works – For Institutional Investors

Direct Lending to shipping is appealing to institutional investors, the so-called “Limited
Partners” who provide the capital to alternative asset managers, because it offers risk-
adjusted returns that are attractive relative to (i) equity investments in shipping, and (ii)
other fixed income investment opportunities such as corporate and sovereign and term
loans.

This is especially true in today’s low interest rate environment because the returns
generated by Direct Lending and operating leasing are significantly higher than the risk-
free return of Treasury bills. In other words, the lower the risk-free interest rate, the more
attractive the absolute returns generated by Direct Lending. Moreover, Direct Lending is
not correlated with broader equity markets with respect to asset allocation.

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 The unleveraged cost of capital charged by Direct Lenders is approximately 8%-10%,
but can range from 6%-15%, depending on the funding cost of the lender and the risk
characteristics of the individual transaction.

Generally speaking, alternative asset managers that form JVs to invest in Direct Lenders
may have a higher hurdle rate since there is an additional layer of management fees
between the Limited Partners and the shipowner. If the Limited Partners are passive, such
as insurance companies and pension funds, then the hurdle rates and cost of capital may be
lower.

Why it Works – For Alternative Asset Managers

Direct Lending is well suited to ship finance for several reasons. First off, ship finance is “big
ticket” and highly scalable, which provides operating leverage for managers of Direct
Lending platforms. Therefore, managers can generate adequate management fees (1-2% of
AUM annually) and potentially significant carried interest due to the high volatility associated
and large volume associated with international shipping markets. Carried interest hurdle
rates for Direct Lenders range from about 5-8%, depending on the source of capital.
Second, ships are a form of collateral, and they generate revenue, allowing Direct Lenders
to estimate their recovery in the event of default in various market conditions.

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Why it Works – For Borrowers and Lessees
Despite its higher cost, Direct Lending can be a useful tool for shipowners and
industrial companies with ocean transportation needs for the following reasons:

1. Direct Lenders can lend money to smaller and highly leveraged borrowers who do
not have access to the inexpensive capital provided by commercial banks or bond
markets.
2. Although the nominal interest rate is generally higher than a bank loan, Direct
Lenders can provide higher loan-to-value (LTV) ratios and longer amortization
profiles. This flexibility in terms and structures can allow Direct Lenders to offer
borrowers financing that may have a lower cash break-even despite the higher
nominal interest rate.
3. Direct Lenders can offer a combination of fixed coupon plus a profit-sharing kicker
on the earnings and asset value appreciation of the financed vessels. For
example, we are increasingly seeing Direct Lenders provide borrowers with an
“equity tranche” to meet their return requirements.
4. Although Direct Lending was initially associated with smaller borrowers and
smaller transaction sizes, today we are seeing some of the largest bilateral
transactions in the market offered by Direct Lenders. This would have been
considered unthinkable just a few years ago.
5. Direct Lenders can finance older vessels, which means that even the biggest
shipowners periodically have a need for Direct Lending.
6. Direct Lenders are very good at execution thanks to their good understanding of
the shipping industry. This means that they understand the commercial and
technical aspects of the specific vessels as well as the unique features of
international shipping and maritime law. As a result, Direct Lenders are able to
close transactions quickly, which is extremely valuable to borrowers in both high
and low markets.

Challenges for Direct Lenders - Increasing Competition

Today’s abundance of liquidity and chronic low yields are driving ever more capital into
the Direct Lending market. As a result of the success of Direct Lenders, both in terms of
attractive returns, adequate volumes and modest loan losses, new Direct Lending
platforms continue to enter the shipping and offshore industries. We are also seeing
increased competition from the commercial bank market, particularly among an
emerging class of “niche” shipping lenders that can offer products comparable to the
some of the products offered by Direct Lenders.

We are currently tracking approximately 30 Direct Lenders and operating leasing

companies who are specifically focused on the international shipping and offshore
assets.

As a result of this increased competition and greater liquidity, we have observed a

continuous improvement in terms for borrowers doing business with Direct Lenders and
operating lessors.

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To remain competitive, Direct Lenders and operating lessors are now using low-cost
leverage (both on a portfolio basis and on individual loans) in order to offer borrowers a
lower cost of capital. For example, Direct Lenders and lessors can enter into conservative,
secured loan facilities (30-40% LTV) from traditional banks at very low cost (around LIBOR
+ 250) and then use the blended cost of capital to offer borrowers lower interest rates.
Traditional commercial banks receive favorable regulatory capital treatment because
leveraging Direct Lenders and operating lessors is deemed to be “structured finance”
rather than “asset finance.”

Challenges for Direct Lenders – Decarbonization, ESG & Asset

Obsolescence
The growing trend of Sustainability Investing may have both positive and negative
consequences for Direct Lenders to the shipping industry. Although the economics of
Direct Lending are attractive, the strategy faces increasing risks associated with investors
choosing to allocate less capital to industries associated with fossil fuels. According to
Preqin, 36% of the $10 trillion of capital allocated to alternative investments are managed
by funds committed to ESG. This commitment takes the form of having a stated ESG
policy or being an active member of an association such as GRESB, PRI or SASB.

Moreover, to the extent that they finance older vessels with greater Carbon Intensity,
Direct Lenders run the risk that their vessels might become economically impaired when
shippers and charterers assign a price to carbon emissions. None of the Direct Lenders
that we track have become signatories to the Poseidon Principles.

As a counterbalance, the most substantial commercial banks that lend to the shipping
industry are reducing their exposure to vessels that do not meet certain criteria with
respect to emissions, which should push even more lending demand to Direct Lenders.

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Challenges for Direct Lenders – Strong Shipping Markets
With container ship and dry bulk vessel values and rates at high levels, the overall “balance sheet”
of the $1 trillion global fleet is getting stronger. As a result, borrowers are pre-paying their most
expensive loans and need less net capital from third parties, including Direct Lenders.

Strong markets pose an additional risk for lenders who may be forced to assume increased
counterparty risk from charterers at high rates and greater residual value risk when vessels
potentially revert to mean valuations levels in the coming years.

The Future
Although more capital is flowing into this market, Direct Lending to shipping has significant
barriers to entry. To be successful, Direct Lenders must have a robust knowledge and experience
and a full platform of support services, including “back office” capabilities such as technical
expertise of vessel operation and maintenance, a view on asset values and charter rates, legal
execution resources, portfolio monitoring systems, Know Your Customer (KYC) compliance and,
increasingly, ESG evaluation. We have seen very little loan volume achieved by Direct Lenders
who are not exclusively dedicated to the shipping industry.

In the past eight years, Direct Lending and operating leasing have gone from being a
“marginal” source of ship finance to a major feature of the landscape.

As Direct Lenders and lessors continue engineering their own capital structures to lower their
rates, and as their strong performance continues to attract more AUM, we believe they will
continue to provide a valuable service for borrowers and attractive returns to shareholders, but
success will rely on adapting to a changing market.

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 Matt McCleery, President, Marine Money
Managing Director, Blue Sea Capital, Inc.

For Questions or Inquiries about this report, please contact:

mmccleery@marinemoney.com