Why do we need ship valuations? A summary of the discussion so far on the LinkedIn “Ship Valuation” group.
My experience of valuations is mainly the first three situations, when a bank is serious about providing finance for the purchase (or re-finance) of a ship and negotiating the terms of the loan, when the loan is about to be drawn down (shipowner gets access to the funds) and as part of the ongoing assessment of the collateral used as security for the loans and client facilities.
In each of the three instances, the bank is testing its security of the loan through the Minimum Value Covenant (MVC). This harks back to the first rule one of banking – don’t lose money. If the owner can’t pay back the bank, the bank can legally take over the ship and other ships put up as collateral for the loan. The MVC is a ratio of the value of the ship to the loan outstanding, expressed as a percentage. That is, an MVC of 135% means if the loan is for $100 million, the ship must be valued at $135 million or more. As the loan matures and repayments made, the ship value limit should become easier to reach. But as we know, the shipping cycle isn’t always that generous.
1. Banking – Independent appraisal for loan application.
The term sheet lays out the terms of the loan, and terms are negotiable. The Relationship Manager (RM) needs an independent value for the ship the bank is considering financing. This could be a formal certified valuation or a phone call to a broker for an opinion of the value. From this the RM and from current market practice, the RM can judge the level of MVC to pitch on the indicative term sheet. In times of easy credit in the run up to October 2008, banks competed hard on MVC. Rumour has it some loans were negotiated down to 100% MVC. In eras of tighter credit, like at the moment, a bank is likely to stipulate the MVC to be 135%. In the 1990’s the MVC was regularly 150% and 200% for mezzanine finance.
At this stage a formal certificate is not always required, and unless the RM is very sure the deal is going ahead, it is a wasted expense. This is where the online tools are very useful. The oldest is Price Guidance, which is part of shipvalue.net from Clarksons Valuation Services, which first appeared as part of the original SIN (Shipping Intelligence Network). This allows a quick search of the ship and a current value. New entrant VesselsValue is targeting this aspect of the loan appraisal process, too. VesselsValue’s USP is that certificates are issued online, too.
2. Banking – Loan drawdown.
Once the loan is agreed the MVC is tested again at drawdown, the time when the funds are released by the bank. If it is a secondhand purchase weeks or months could have passed between the signing of the loan and the release of the funds. In the case of a newbuilding it could be years. If the value of the ship has fallen and MVC cannot be met, the loan terms will have to be renegotiated. The bank will usually know up to two weeks in advance the actual delivery date, and that is when to let the valuers know a valuation is needed. A panicked phone call from bank to valuer on the eve of delivery helps no one, especially if the market is moving fast.
3. Independent Appraisal during the loan review.
Every loan facility is subject to an annual or twice yearly review. Those facilities on “Special Watch” may be subject to quarterly or even shorter review periods. The MVC is tested during the review. The loan documentation will state the borrower must provide two certified valuations from a panel of six (the number depends on the ship type) shipbrokers or valuers. The two valuations must be within 10% of each other. If not, another valuation from another member of the panel is required. The average of the two valuations is used to test the MVC.
It will also state in the documentation that the client must pay for the valuation. This gives rise to an interesting situation. It is the client that instructs the valuer, signs the service contract and pays. The relationship is between the borrower and the valuer. However, the borrower will almost certainly have another relationship with a broker or brokers within the same shop, and will try to apply pressure for the value to be the “correct” one. Valuers need to have strong personalities to withstand these internal and external forces, and give the valuation they can prove through methodology and due diligence. The test is who has signed the valuation. Is there more than one signature, has a company Director put his name and reputation to the valuation?
Another interesting facet is the contract between client and valuer. This usually states the certificate is for the private use of the client. But everyone knows this is being passed onto the bank for the use of the bank.
Because loans have started on different dates in the year these valuations are not ideal for checking the quality of security in the bank’s shipping portfolio. Most banks arrange to have the whole portfolio valued as at the start of the year and at the mid-point. The introduction of online services like shipvalue.net and VesselsValue.com have made this process quicker and cheaper.
A valuation is needed to give an indication of the likely amount the ship will raise in an auction sale. The valuer will be asked to give a reserve price. The creditors, which includes the port whose berth the vessel is occupying, will want a quick sale, so the reserve price must not be too high. Here the valuer needs to have specialist knowledge of the auction process and costs, and be aware of rate of deterioration of value a ship no longer active suffers. Payment for the valuation comes out the proceeds from the sale.
5. Insurance or general average.
I have no direct experience of valuations for insurance purposes, so I reached via LinkedIn for some expert advice on why the marine insurance industry needs ship valuations. The reply I received is; “We insure ships on an agreed value basis. This means what the underwriter insures the ship for is what he pays in the event of a total loss whatever the market value of the ship. Therefore the underwriter needs to appraise the insured value in relation to the market value. If it is too low then the probability of constructive total loss is greater, however if it is insured too high the moral hazard increases. Although the owner puts forward a value often reflecting the earning capacity and the residual value, the owner is often pushed by the bank. In the loan covenant it may stipulate the minimum sum insured. On top of the standard hull policy there is an “increased value” policy which only pays out in the event of a total loss. This value is generally limited to 25% of the hull value. So if the hull value is usd20m the increased value would be usdusd5m. Obviously the rate on the increased value is lower because it is only covering the total loss risk. Basically the logic goes along that if the vessel loss reaches say, usd20m then the vessel will be a total loss.” I would like to thank Jon Chaplin of Tradewinds for sourcing this explanation.
6. Investment prospectus: valuation of assets for ipo or for bond issues.
In most shipping companies the only assets are the ships. Therefore, to float part or all of a shipping company on a stock exchange the investors need to know the value of the assets they are “buying”. Shipbrokers are very aware of the pitfalls of dealing with financial investors. First, they are not shipping people, and expect to be able to apply the same criteria used to value any other enterprise to a shipping company and its ships. Therefore, a lot of management time is spent in education and marketing. Second, the rewards are relatively small. Although a premium is placed on the service to cover the costs, it is nothing compared to the rewards of the banks and lawyers running the ipo process. Third, and most importantly, the risks are huge. When the shipping cycle turns downwards (as it always will at some point), investors will look to get their money out, and maximise the cents on the dollar. These can be mitigated by showing the methodology and due diligence paper trial, but lawsuits do occur. After the boom in shipping junk bonds several brokers were hauled into court. Some cases were settled out of court, but there was considerably reputation damage. Damages in a US court could wipe out profits, or even bankrupt a small broking house. It begs the question; is it worthwhile providing valuations for raising finance?
7. Annual accounts and audits.
This is fairly straightforward, and the annual accounts of public shipping companies often list the brokers providing the valuation of the vessels at fair market value.
8. Accounting for vessels under shared or family ownership.
Many shipping companies are family owned, but not all of the family will be active in the day to day running of the company. Nonetheless, they need to know return on their investment in the business and the current value of their share of the assets. Shared ownership is more common than supposed. For example, three owners may feel strongly that the timing is right to invest in a particular sector. All three focus on one ship, and risk driving bidding beyond what the see as a reasonable level. They agree to co-invest in the ship, through the single purpose company that owns the ship. No one outside the agreement will be aware of the arrangement, and the registries will record the vessel as being operated and beneficially owned by one party. Therefore, the co-investors will require independent valuations of the current market value of the ship. But on an operational level all three co-investors are rivals and compete for business.
9. Legal disputes
Legal disputes over valuations are not uncommon, and many valuers also work as expert witness in court. In the 1990s shipping companies issued a series of junk bonds, of which around 90% defaulted. There have also been court cases where valuations have been a feature, but not the main issue. These go to show that a clear paper and electronic trial must be kept of all valuations.
So far the only specific government regulation I have come across is a German regulation detailing how ships are to be valued. Under Section 24, paragraph 1 to 3 of the Pfandbrief Act there are exact rules for the determination of the Mortgage Lending Value of Ships (MLV). This entered force in July 2008, and upon examination is essentially “Last Done”. This will be discussed under when we look at how valuations are made.
Size of the Valuation Market?
Given that there are ten possible instances for the need for valuations, this gives rise to the question of what is the size of the valuation market? There is no central register of valuations completed, or the billings. To estimate demand I use a proxy of the number of deliveries combined with the number of ships sales each year. In 2012 there were 4325 deliveries and sales. Each certified valuation costs $1500, giving a potential market of just under $6.5 million. Although this sounds a lot, it is less than 0.01% of the value of ship sales in 2012 ($84.7 billion – source: CRS).