Asset Risk Assessment, Analysis and Forecasting in Asset Backed Finance

5.2 Types of Debt Financing

5.2.1 Standard Loan Facility Events of Default

Th e loan agreement sets out a list of events and circumstances, the occurrence of which will release the lender from its obligations and entitle it to pursue the remedies granted to it under the loan agreement or by law. A borrower’s default will trigger the acceleration of the loan (usually upon service of a notice from the lender to the borrower) and allow the lender to declare the loan amount and all accrued interest and expenses immediately due and payable.

A standard event of default clause will include the following:

(a) breach of payment obligations;

(b) breach of representations and warranties;

(c) breach of covenants;

(d) cross-default (a default arising under any other agreements which may be entered into by the borrower, a guarantor or any other security party);

(e) insolvency/bankruptcy of the borrower, a guarantor or any other security party or other similar event such as the appointment of an administrator or the entry into any form of payment moratorium with creditors;

(f ) depreciation in the value of the ship (resulting in the breach of the minimum asset cover requirement which is not rectifi ed within the contractually agreed period);

(g) material adverse change;

(h) change of control;

(i) invalidity of governmental authorization or consent;

(j) invalidity of any of the loan documents;

(k) unlawfulness.

Th e events of default may be distinguished between those which will have an immediate eff ect and others which will entitle the lender to accelerate the loan only if they are not remedied within a certain grace period. Payment defaults always fall in the fi rst category (even though certain borrowers who are considered by lenders to be particularly strong credits may be granted a short grace period for payment defaults). Fees

Th e borrower undertakes to reimburse the lender for all administrative, legal, enforcement costs and expenses to be incurred by the lender in relation to the loan agreement. It is also required to pay certain fees to the lender, set out in the loan agreement or in a separate fee agreement, which will include:

(a) an arrangement fee in a fi xed amount in respect of the structuring of the facility;

(b) a commitment fee, being a percentage per annum of the undrawn amount of the facility for the period during which the lender is committed to advance the facility to the borrower;

(c) in the case of a syndicated facility, an agency fee payable to the facility agent for conducting its agency tasks and certain other fees may be pay-able for the structuring, underwriting and syndication of the facility.

5.2.2 Leasing

An alternative method of fi nancing the acquisition of a ship (by a shipping company) may be through a lease, usually in the form of a bareboat charter or a long-term time charter. In structures of this type, the fi nancial institution involved acquires title to the ship and further enters into a lease agreement with the shipping company, pursuant to which the latter has the right to use and operate the ship. Instead of relying on security in the form of a mortgage to mitigate its risks, a fi nancial institution acting as lessor becomes the owner of the ship, acquiring in this way the increased protection owners are aff orded by law. Th e lessor’s position may be further enhanced by way of the lessee

assigning in its favor any rights the lessee has under the insurance policies regarding the ship and/or any contracts of employment to be entered into by the lessee. Th e lessor may in turn off er the ship and title to it as security to a lender in order to obtain fi nancing itself. Th is will be the case if the lessor is a subsidiary or affi liate of a major lender formed for the purpose of acting as the leasing arm of such lender, and it is therefore dependent on its holding company or affi liate when it comes to the availability of funding.

To fi nance a leasing acquisition involving newbuildings, the contract for the construction of the ship is usually novated or transferred from the original buyer, which is usually the “true” shipping company, to the fi nancial insti-tution, which is acting through a subsidiary formed for this purpose. Th at subsidiary assumes the obligation to pay the contract price due under the shipbuilding contract and becomes entitled to register the ship in its owner-ship. In order for the shipping company to be able to make use of the ship, it and the lessor, simultaneously with the acquisition of the ship by the lessor, enter into a bareboat or time charter or other leasing agreement which usually contains the standard rights and obligations of owners and bareboat/time charterers (or lessor and lessees) and also contains provisions as to the payment of hire or lease payments on certain agreed dates. Th e aggregate amount of the installments of hire or the lease payments are often calculated so as to be equal to the cost initially paid by the SPC (as lessor) to the shipbuilder and the amount of interest to be charged by the lessor’s lender to the lessor. Th e lessor will then use the hire to repay the debt fi nancing it will have received to fi nance the acquisition of the ship.

In a leasing transaction the risks arising from the ownership and operation of the ship are undertaken by the lessee, which fi nds itself in a similar position to that of a borrower under a standard debt fi nancing. Once all hire payments have been paid, the lessor is under an obligation to transfer title to the ship to the lessee, since the intention is for the operator of the ship to receive the benefi t of the residual value of the ship. It is not uncommon for a lessee to have the option to purchase the ship for a fi xed price at certain times during the currency of the lease. Th e amount of the purchase option usually equates to the aggregate amount of the hire or lease payments payable from the date of exercise of the option until the end of the term of the lease.

5.2.3 Bonds

Th e section above dealing with syndicated debt fi nancing provided a sum-mary of the manner in which more than one lender may participate in a debt fi nancing. An alternative to arranging such a syndication is for a borrower to

issue bonds, which usually incorporate only the key terms applicable to the bonds such as the principal amount, the applicable interest rate and their maturity, whilst the remaining detailed provisions in respect of the obliga-tions undertaken by the issuer are set out in a master document, such as an indenture or (in Greece) a program. Th e master agreement does not require that it be entered into by each of the bondholders and therefore the structure ensures that the bonds and therefore the rights they carry are easily transfer-able. At the same time a variety of corporate information and fi nancial and other covenants can be included in the indenture or the program.

Bonds share certain common characteristics with shares as they may both be traded on an organized exchange or market and are considered to be liquid instruments. One advantage of issuing bonds (as compared to issuing shares) is that certain limitations of corporate law, which sets out the basic charac-teristics of each instrument, do not apply to bonds to the same extent as they apply to shares, as a bond remains a debt instrument. Th e issuing company may however structure the bonds in many diff erent ways depending on the particulars of the transaction and the characteristics of the investor or inves-tors being targeted by the issuer.

One advantage, which bondholders hold over shareholders, is that, as a creditor of a company, a bondholder has, in an insolvency or dissolution of a company, priority over the shareholders when it comes to the assets of the company (or the proceeds from the disposition of those assets). Bonds may be subordinated to other forms of debt incurred by the issuer making the bonds akin in this respect to shares, where the shareholder only has a residual claim ranking after all creditors of the issuer. Such types of bonds are attractive to investors seeking to invest primarily in equity, but who are not content with the basic or “plain vanilla” nature of traditional shares. Th ese instruments grant to their holders the right to share in the profi ts of the issuing company although they off er less certainty as to recovery given that they are unsecured and dependent upon the issuing company’s assets exceeding its liabilities to creditors. Since holders of this type of structured bonds agree to be subordi-nated to other creditors of the company, such as lenders under loan facilities, they are usually able to negotiate a higher interest rate and a more favorable return on their investment than that applying to the senior loan facilities. In certain cases, bonds issued by shipping companies are secured, thus off ering the bondholders signifi cant priority over the shareholders or other unsecured creditors of the same company. Th e proceeds from the enforcement of the collateral asset(s) will fi rst be applied against repayment of the secured credi-tors (being the secured bondholders) and only then will they be available to unsecured creditors.

Th ere was a large number of shipping companies which issued bonds in the late 1990s in the US capital markets. Many of the issuers ended up buy-ing back their bonds at a discount (in certain cases signifi cant) either because they were unable to pay the coupon applicable to the bonds (being the agreed interest payments) or because they claimed they would be unable to meet future coupon payments. However, the issuance of these bonds resulted in the creation of a tracking market for analysts in the capital markets, particularly in the USA and Norway. Th is development, in turn, set the stage by 2003 for the return of shipping companies to the capital markets in the form of equity issuances.

Following the signifi cant reduction in the availability of debt fi nancing after 2008, shipping companies looked again to the capital markets for addi-tional sources of capital. With the bond market off ering low interest rates, the opportunity for bond issuances arose again and shipping companies issued bonds in the US and Norwegian capital markets. Bonds are attractive to investors where the issuer can show, through the long-term employment of its assets, that it has the required cash fl ow to meet all its coupon payments. Th is is why companies, which operate in those sectors of the shipping industry where it is customary for the assets to be subject to long-term employment arrangements, such as the off shore, LNG, oil and gas and container sectors, have looked closely at issuing bonds or have in fact done so.

5.2.4 Mezzanine Financing

Mezzanine fi nance represents a combination of the characteristics of debt and equity (in many cases it is viewed as representing “quasi-equity”). Financial institutions providing this type of fi nancing agree with the borrower, its share-holders and its senior lenders that the fi nancing provided by the latter will take priority in terms of repayment and security. Mezzanine lenders will enter into a junior or subordinated fi nancing agreement which regulates the lender’s ability to be repaid, usually only from the surplus income which may be gen-erated by the borrower after the senior loan has been serviced and operating expenses have been paid. In the absence of such a surplus, there will be no payment to the mezzanine lenders under the subordinated fi nancing agree-ment. Mezzanine lenders, who rank between the senior lenders and the share-holders, are rewarded for assuming a signifi cantly greater level of risk—as compared to the senior lenders—with a higher return in the form of a higher interest margin, a fee or “promote” (an agreed percentage of the profi ts or income of the borrower, usually above a certain threshold) or even the right to

convert their debt into shares of the borrower. Any such fee or promote will be payable on the condition that certain targets (set by reference to the inter-nal rate of return, net positions, income, etc.) are achieved and will allow the mezzanine lender to share in the profi ts of the borrower or to receive shares in the borrower (or a right to buy shares at a pre-agreed price within a specifi ed period, in the form of a warrant).

As explained above, the position of a mezzanine lender is similar to that of an equity holder, as the lender has the right to participate in the profi ts of the borrower even though, strictly speaking, the lender is a creditor who expects its debt to be repaid in full, subject to the usual risks of insolvency of the bor-rower. While the senior lenders are also exposed to the risk of insolvency of their borrower, their exposure is less because they will always rank ahead (both in terms of rights to the borrower’s cash fl ow and security) of the mezzanine lenders. Th e safer position assumed by the senior lenders (who will almost always provide the large majority of the debt) is refl ected in the amount of their return (usually signifi cantly lower than that of the mezzanine lenders) and also by the fact they will not usually have a right to participate in any of the borrower’s profi ts. While there are some specialist providers of mezzanine debt to shipping companies, in many cases the same syndicate of lenders will provide both the senior debt and the mezzanine debt, whilst the extent of the participation of each bank in the senior or the mezzanine debt will vary and depend on its risk appetite.

In document Manolis G. Kavussanos, Ilias D. Visvikis (Eds.)-The International Handbook of Shipping Finance_ Theory and Practice-Palgrave Macmillan UK (2016) (Page 172-177)