In Germany, a Shipping Industry Bubble Drifts Toward a Scary End

NEW YORK (The Deal) -- It is a saying that Germans love: better a scary ending than a scare that never ends.

Unfortunately, Germany's water-logged shipping industry, based around the northern port city of Hamburg, has been one long scare since the 2008 credit crunch sunk its bright future. And there is no end -- scary or otherwise -- in sight.

For several years, restructuring specialists and investors have been predicting a major industry crash amid over-capacity, growing competition and weak prices as lenders shoulder huge amounts of shipping debt.

State-backed HSH Nordbank, a Hamburg-based bank that is the world's second-large ship financier, for example, has €21 billion ($22.9 billion) in ship financing on its books, about half of which it sees as non-performing. And Frankfurt's Commerzbank, the country's second-biggest ship financier, has just under €17 billion, though its non-performing loans are in the single digits.

But despite expectations that lenders will run out of patience, banks are so far playing a waiting game.

Although over-capacity is affecting shipping around the world, Germany is a special case because of a unique funding model and favorable tax treatment that allowed a boom in shipping at the turn of the millennium. The country now has the largest container fleet in the world and is the fourth-largest seafaring country.

Hamburg is synonymous with the industry as home to Germany's biggest port and Europe's largest container facility after Rotterdam, The Netherlands.

"Vessel values still suffer from overcapacity. A reduction may help to return to realistic market prices," said Sven-Holger Undritz, a Hamburg partner with White & Case.

"There's a lot of uncertainty right now," he said.

The root of the problem is twofold: Germany's tonnage tax bases tax payments on the capacity of German ships rather than their actual income (a similar taxation scheme is used in India, the Netherlands and the United States). The effective flat tax creates the potential for skyrocketing returns in booming markets.

In addition, in the early 2000s, shipping companies began touting a special financing model unique to Germany known as the single ship KG, an abbreviation of the German Komanditengesellschaft, a sort of limited partnership. The legal form allowed investors to become partners in a single ship with no liability -- all the returns and none of the risk.

The promise of foamy profits brought in a perfect wave of money as an overheating global economy kept full ships ferrying goods across the world's oceans in the early 2000's.

Between 2006 and 2008, KGs accounted for 26% of all new ship tonnage around the globe, according to statistics from German law firm Kravets & Kravets.

At the same time, German lenders such as Commerzbank and HSH Nordbank were also shelling out to finance the building boom, much in the same way that mortgage lenders in the United States backed the housing bubble.

The profits were so heady that they even attracted financier J. Christopher Flowers and his J.C. Flowers, which bought a 26% HSH Nordbank stake in 2006.

Then came Lehman Brothers Holdings in 2008. As economies collapsed, so did shipping volumes and the once-white-capped returns of German KGs went out with the tide.

The KG market dried up. By 2013 KGs were only responsible for 2% of new tonnage, and single-ship bankruptcies began to become near-daily occurrences.

An estimated 450 have gone belly up since the crisis, often leaving banks owning the ships.

"It will be a very slow process," said White & Case Hamburg partner Riaz Janjuah.

"The whole shift to Asia is also a factor. It remains to be seen how German shipping companies can regain access to financing after the KG market has broken down in Germany," Janjuah said.

Although there is plenty of doom hanging over Hamburg's once-thriving shipping sector, the looming debts and bankruptcies have yet to lead to a swift restructuring. Hamburg's 150 or so shipping companies are hoping that the problem will go away and lenders such as Commerzbank and HSH Nordbank continue to extend maturities and offer concessions on the loans.

A recovery after the Lehman crisis even had the potential to get Germany's vessels profitable again but new, record-capacity boats from Asia curtailed that upturn.

The industry's woes have attracted the interest of international financial investors, eager to take on the debt at as much as a 50% discount and swap the liabilities for ownership.

However, attorneys involved in recent deals said that banks are hesitant to accept the offers, still hoping for better times.

One of the most visible is Oaktree Capital Management, which has bought about 45 ships from around the world and has partnered with Hamburg shipping company Rickmers Holding GmbH & Cie. KG to run many of the vessels.

"There should be a lot of investment opportunities, but there aren't," said a former banker who now helps private equity with shipping investments. "This is a different business than private equity is used to."

In at least one case, Oaktree Capital Management has taken a different tack to finding money amid the misery. The company in 2011 bundled together its specialist heavy transport ships into Hamburg-based Hansa Heavylift.

At least some of the ships were curried from one of the few bankruptcies of a German shipping company: Bremen-based Beluga. Oaktree Capital Management bought the company and pushed it into insolvency.

"Beluga was a diversified company operating 10 different ship types with an inefficient organization," said Hansa Chief Financial Officer Alex Karakassis.

"Hansa Heavy Lift is a strategically focused and operationally streamlined company operating two different vessel types. We have a clear focus on the higher end heavy-lift transport and transport and installation markets," Karakassis said.

Oaktree Capital Management isn't the only buyer of distressed German shipping debt.

Santa Monica, Calif.-based TCP Capital two years ago teamed up with Delos Shipping of Dallas to take over KG fund specialist König & Cie, and Commerzbank has sold €440 million in shipping loans to both Oaktree Capital Management and KKR (KKR). Banks love the solution of selling off packages of shipping loans, but analysts warn that the vessels themselves aren't restructured, as the risk is simply shifted to the new owners, often supported by acquisition financing from the selling banks.

Not everyone thinks that the situation is so dire.

Karakassis, for example, insisted that the German shipping industry isn't in the poor shape many would have outsiders believe, but it is also not as healthy as it once was.

"This is the new normal. People are learning how to deal with the new situation," said Erik Kravets, an attorney who focuses on shipping from his office in the northern German city of Cuxhaven.

"People are learning to be profitable in this," he said.

The ship owners and banks are quite right to be patient and weather a storm that may frustrate financial investors out for a quick buck, Kravets said.

"The owners of these companies in Germany are often heavily invested with their own equity. Most of these companies are family-run," Kravets said.

"They're going to be the last ones standing," he said.

That may explain why private-equity investors of late have begun loosening purse strings in an attempt to get aboard troubled ships.

Attorneys said that private-equity investors, spurred by the interest in German shipping from the likes of KKR and Oaktree Capital Management, have begun raising their bids.

But some German shipping experts say the private-equity interest is doing more harm than good.

One shipping broker said that the appearance of new capital is pumping extra capacity into a market that needs to see less.

Financial investors have created fleets by combining distressed assets with new tonnage.

In April, an attempt by listed financial investor Lloyds Fonds to jump-start a consolidation by buying out 18,000 owners of 11 KG funds failed.

Lloyds Fonds had hoped to hand the shareholders new shares in itself in exchange for their tanker and container ships, offering valuations between 20% and 140% of the initial investment, according to Lloyds Fonds.

The 11 funds were worth a total €325 million, excluding related liabilities of €163 million. But the investors voted down the plan, likely because the exchange rate that Lloyds Fonds offered was based on its own shares being worth €3.54 each.

At the time, the stock changed hands at about €1.75, meaning that investors would be taking an additional haircut by accepting the stock.

Although internal impetus to restructure may be lacking, Germany's shipping industry is beginning to feel external pressure to shape up. The state of Hamburg is in talks to end its exposure to HSH Nordbank.

The city-state holds 85% of HSH Nordbank together with the neighboring state of Schleswig-Holstein, and the duo were forced to bail out the lender in 2009 with a €3 billion injection and a €10 billion guarantee. That rescue watered down J.C. Flowers' stake to just under 10%.

Hamburg and its mayor, Olaf Scholz, are afraid that the European Commission is going to take a dislike to the €21 billion in ship debt on HSH Nordbank's books and force a liquidation, leading to losses that could exceed the €10 billion guarantee.

The bank returned some of its state guarantees in 2011 when it thought it was doing better but then went back cap in hand to its state backers to return guarantees to the original £10 billion figure when its fortunes worsened. The EC still has to rule on that new tranche of state aid.

Scholz wants HSH to roll the questionable loans into a bad bank while retaining its healthy activities. The city and rural Schleswig-Holstein would be willing to inject several billion to support the bad bank and then step away from further responsibility.

The local governments have refused to comment on the plans, but Scholz made an oblique reference during a recent state of the city-state address.

"Let's not kid ourselves. The Hamburg and Schleswig-Holstein budgets have yet to completely cover the bill for the bank's egotistical expansion strategy," Scholz said.

That bill could be the scary end that Germany's shipping sector needs.

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