Financing mix for container lines
Whilst there is reasonably reliable data available for the container ship sector this is not the case for the two large commodity shipping sectors of dry bulk and tanker. However, it is safe to assume that the lease penetration rate for dry bulk and tanker is significantly lower than for the container sector. The main reason for this lower lease penetration rate is that dry bulk and tanker shipping companies have historically derived a significant portion of their investment return from the timely purchase and sale of the vessel itself, whereas container lines earn their return from operating a network, somewhat similar to the airline industry. One of the disadvantages of leasing in that context is that the leasing structure always entails a restriction in asset disposal flexibility, hence impeding the return potential for the operator through a timely asset sale.
14.2 Leasing Motivations
14.2.1 Lessee’s Perspective
Why do companies generally and ship operators specifically enter into leasing transactions when presumably they could purchase or own the assets instead? The motivation for entering into a leasing transaction could be based on any single or combination of the below factors:
18.104.22.168 Cash Management
Especially for very capital intensive industries, such as shipping, cash management is the single most important motivator to enter into leasing transactions. Leasing effectively provides 100 % financing for an asset. On the other hand, the mainstay ship finance tool, the first priority ship mortgage, has typically provided financing for 60–80 % of a vessel’s value. The balance would normally come from the operator’s equity, which adds up to significant absolute investment amounts, especially in the context of multi-vessel newbuilding orders. Clearly the “incremental cash flow” value, which leasing provides, is greatest at times when conventional bank finance is constrained and limited to low leverage ratios on the asset’s value.
22.214.171.124 Funding Diversification
The financially more sophisticated companies attribute value to funding diversification and consider leasing an integral part of that funding mix. In shipping this is most evident with the container liner companies. As we are witnessing right now during the financial crisis, bank funding sources can dry up very quickly and in such situations it is of great value to have access to different sources of capital, be it bank finance, capital markets or leasing.
Whether leasing is perceived to be cost competitive compared to ownership by a potential lessee, depends entirely on the comparison that is employed. In shipping there is still significant confusion over what the correct comparison is. If one compares the cost of a lease with the cost of debt finance, it is not a like for like exercise because it assumes that the cost of the operator’s equity in the bank finance scenario is zero. The correct comparison is between the cost of the lease (IRR calculation taking into account the cost of the asset, rental stream and residual value) and the weighted-average cost of capital (WACC)1 of the lessee company. It is interesting to note that in shipping, the great majority of companies, particularly but not only private ones have either never considered their cost of equity or have simply determined it at a level that is not commensurate with the risks and cyclicality of the industry. As such, ship lessors are still facing a great challenge in winning the cost argument when marketing transactions.
Historically, accounting treatment of leases has been a significant motivation to consider leasing as opposed to ownership. Below, we describe the differences between a capital and operating lease and the lease accounting requirements by a lessee and lessor.
For financial accounting purposes, a lease must be classified, at its inception, as a capital lease or an operating lease. The classification criteria differ under various lease accounting standards. In general, a lease is considered a finance lease if it transfers substantially all the risks and rewards incidental to ownership. All other leases are classified as operating leases.
Capital lease criteria under U.S. GAAP and IFRS
U.S. GAAP (FAS 13)
IFRS (IAS 17)
1. The lease transfers ownership of the vessel to the lessee by the end of the lease term
2. The lessee has the option to purchase the asset at a price which is sufficiently lower than the fair market value such that it is almost certain that the option will be exercised
3. The lease term is ≥ 75 % of the estimated economic life of the asset
3. The lease term is for the major part of the economic life of the asset even if the title is not transferred
4. At inception of the lease, the present value of the minimum lease payments is ≥ 90 % of fair market value of the asset
4. At inception of the lease, the present value of the minimum lease payments amounts to at least substantially all of the fair value of the asset
Additional criteria for lessors:
(a) Collectibility of the minimum lease payments is reasonably predictable
(b) No important uncertainties surround the amount of unreimbursable costs yet to be incurred by the lessor under the lease
5. The assets are of a specialized nature such that only the lessee can use them without major modifications being made
6. If the lessee is entitled to cancel the lease, the lessor’s losses associated with the cancellation are borne by the lessee
7. Gains or losses from fluctuations in the fair market value of the residual fall to the lessee
8. The lessee has the ability to continue to lease for a secondary period at a rent that is substantially lower than market rent
Table 14.1 describes the capital lease criteria established under currently applicable main accounting regimes, U.S. Generally Accepted Accounting Principles (U.S. GAAP) and International Financial Reporting Standards (IFRS).
If a lease, at its inception, meets any one of the four criteria listed under U.S. GAAP (FAS 13), it should be classified as a capital lease; otherwise the lease is considered an operating lease. Additionally for lessors, two other criteria must be met in order for a lease to be classified as a capital lease.
Under IFRS, a lease will be classified as a capital lease if it exhibits one or more of the situations listed under IAS 17 para 10 and IAS 17 para 11. Otherwise, the lease is considered an operating lease.
If a lease is classified as a capital lease, the lessee records the lease payments as liability and leased property as an asset on its balance sheet. The lessor, on the other hand, recognizes lease rentals and the unguaranteed residual value as a receivable in the balance sheet. Over the lease term, rentals are apportioned between a reduction in the receivable and finance income.
For an operating lease, the vessel cost is capitalized in the lessor’s balance sheet and lease rentals are recorded as income during the period they are earned. For the lessee, rental payment is recognized as an expense in the income statement over the lease term.
Under U.S. GAAP and IFRS, even long-term leases for ships (up to 12 years for newbuildings) if structured correctly qualify as operating leases for accounting purposes. In other words, the transaction can stay “off-balance sheet”. Only the annual rental payment is charged to the profit and loss account whereas the balance sheet will typically only contain a footnote disclosure setting out some detail of the future liabilities connected to the lease. To the superficial student of financial statements, the lessee company will appear less leveraged and likely more profitable than it actually is. More significantly, some loan agreements or bond indentures still exclude off-balance sheet obligations from their covenant test calculations. However, it is very important to note that experienced credit analysts will always capitalize off-balance sheet obligations back onto the balance sheet of the companies which they analyze, so as to get a true picture of risk and profitability. Financial covenants for new financings are today almost exclusively designed to take into account off-balance sheet obligations. But finally and most importantly U.S. GAAP and IFRS are working on the introduction of new lease accounting standards2), which will have a significant impact on “lease buying behaviour”. Under the proposed changes to the lease accounting rules, all lease obligations will be capitalized on the balance sheets of the companies by calculating the net present value of the remaining contracted lease obligations. (Refer to Section 7 for more on the change in “buying behaviour”.)
126.96.36.199 Technological Obsolescence Risk Mitigation
In industries with a fast rate of technological change many companies prefer leasing to owning as they are concerned that the fixed assets might become outdated before the end of their anticipated useful economic lives. Leasing provides the option to allay the residual risk of these assets to a third party. In shipping, this is not a strong motivation to enter into a leasing transaction as technological change in the industry is only gradual and the premature obsolescence risk is therefore relatively small.
14.2.2 Lessor’s Perspective
The following are the main factors that lessors consider as they conduct their business:
Attractive Risk/Return Profile:
In many cyclical and capital-intensive businesses the risk-return profile of leasing companies is more attractive than that of the operators. The most prominent example in that respect is the relative financial success of aircraft leasing companies over several business cycles, which have far outperformed the airlines. The main advantage of the leasing business is that it typically has a diversified fixed revenue backlog and therefore is only via the credit risk of its customers—indirectly exposed to the cyclicality of the industry it serves. Even in the current shipping crisis we can observe that the few transparent ship leasing businesses are all financially outperforming the operators.
Capacity for Significant Financial Leverage:
In view of the more secure revenue base, leasing companies are typically able to achieve higher financial leverage in the debt markets than most operators. That can drive returns on equity (ROEs) to attractive levels.
Residual Value Speculation:
Some lessors hope or expect to derive significant “extra-return” through residual value realizations. The lessor’s estimate of residual value naturally has a very significant impact on the lease pricing process (see discussion below).
Tax benefits have historically played a very significant role for the leasing business. For most lessors in most jurisdictions, debt finance costs and equipment depreciation are tax deductible items. In some jurisdictions, accelerated tax depreciations have been permitted or even encouraged (to boost investment) resulting in significant tax losses in the early years of a lease. These same tax losses could then be offset against accounting income from other operations, hence lowering the near term tax burden of the lessor group. Over the years, these tax benefits have lured many institutions into the leasing business, although their core business had no connection whatsoever with the industry the leasing business was serving. In shipping, the most prominent tax leasing market was the UK in the years 2002–2004. Since then, the tax leasing business in shipping has almost vanished as tax authorities in the UK and elsewhere have clarified that to claim the significant tax benefits associated with the leasing activity, the lessor has to be “substantially at risk”. In other words, the lessor has to assume significant residual risk in the transaction to claim the tax benefits. Bank lessors, especially those in the UK, have left the field as concerns over ownership connected liability, residual value and remarketing exposure, as well as the need to shrink balance sheets in light of the Basel III regulations, have taken center stage. On the other hand, the specialist ship lessors have all been established in low tax or no-tax jurisdictions and have no use for tax depreciation benefits. Shipping is unique in this aspect, as most lessors and operators are only marginally taxed on their profits.
14.3 Ship Lease Contract and Structure
14.3.1 Time Charter
Fundamentally, ship leasing activities can be either based on a bareboat charter or a time charter contract. Time charters, which might also be called full service leases or to use an aviation term wet leases,3 are significantly more widespread than bareboat charters. Under a time charter the lessor provides the lessee the vessel “ready to trade” and all that is left for the lessee to decide is the direction of the vessel. Hence, the lessor provides for the operation of the vessel, including crewing, maintenance, insurance, docking etc. From the lessor’s perspective the advantage of a time charter is the full operational control over the vessel which is particularly significant in a customer default scenario allowing the lessor to redeploy the vessel without having first to repossess it (as under the bareboat charter). This has to be weighed against the operational and technical performance risk that the lessor carries under such transactions. The lessor has priced into the lease structure the estimated vessel operating expenses. If the actual operating expenses overrun, there is no contractual basis for demanding a higher lease rate from the lessee. Hence, the return of the lessor might become negatively impacted. This is particularly significant in the case of very long term time charters (10 years or more) as it has been historically difficult to accurately determine operating cost inflation over such long time periods and there are many cases of lessors having become “squeezed” especially in the years 2006–2008 when operating costs increased sharply as shown in Fig. 14.2 (Drewry Maritime Research 2012, p. 2).
Total operating costs
Also, under the time charter the lessor provides for certain performance warranties in relation to the ship’s abilities, such as cargo carrying capacity as well as speed and consumption. Should the vessel not be able to perform in line with these warranties for whatever reason, then the lessee might lodge performance claims against the lessor or declare the vessel off-hire ceasing the payment of charter hire. The long term time charter as contractual basis for a lease has proved to be particularly popular in the container liner industry as the liner companies have been very content to focus on their “network challenges” whilst the lessors were charged with running the ships and solving ship operational challenges, including sourcing for increasingly difficult to find ship officers. The time charter is typically documented on generally accepted industry form contracts such as New York Produce Exchange—for dry bulk vessels, Boxtime—for containerships or ShellTime—for tankers (Tiberias Management Consultants 2009).
14.3.2 Bareboat Charter
The alternative ship lease contract to the time charter is the bareboat charter. Under the bareboat charter the lessee is fully responsible for the operation of the vessel. The aviation equivalent is the dry lease which is by far the dominant leasing contract in aviation leasing. The advantages and disadvantages of this contract from the lessor’s perspective are the mirror image of those under the time charter. Under the bareboat charter the lessor does not carry the operational cost and vessel performance risk, resulting in a more predictable and stable cash flow. However, in the case of a customer default the lessor has to first secure repossession of the vessel. This could be time consuming depending on the maritime jurisdictions that are involved. Also, a customer default oftentimes goes hand in hand with a vessel that has not been maintained to an appropriate standard, such that the lessor upon repossession could face significant maintenance capital expenditures to get the vessel back into a “lease-ready” status. The bareboat charter has proven to be the lease contract of choice for the tanker industry as it is important for tanker operators to have control over the vessel because this is the service that they sell to their customers: the oil companies and traders. The background to this is that the tanker industry is facing the highest environmental and regulatory scrutiny within shipping, hence outsourcing ship operations to a lessor via a long term time charter is not an option for many operators. The industry accepted contract form for bareboat charters is the Barecon (see also Fig. 14.3).
Various costs associated to a ship-owner under different types of charters
14.3.3 “Hell and High Water” Bareboat Charter
The “hell and high water” contract is a sub-form of the Bareboat Charter and generally a higher contractual standard from the lessor’s perspective than the standard bareboat charter. The concept literally applied says: Come hell and/or high water the lessee has to pay. This contract has emanated from the tax leasing industry where non-industry lessors wanted to make it contractually clear beyond any doubt that they do not carry any operational risks. The aim is twofold: To remove the lessor from any liability risk connected to the ownership of the vessel and to ensure the highest predictability of rental stream for the lessor. There is no standard industry form for “hell and high water” contracts. Lessors use either proprietary lease documentation, which is built around the “hell and high water” concept, or they insert an expansive “hell and high water” clause into the Barecon contract. A comparative analysis of some risks and parameters highlighting the differences between leasing and Barecon are available in Table 14.2.