How do you view ‘transportation’ as an asset class?
Transportation assets are widely varied – we essentially define anything that moves as transportation, whether it’s containerships or planes or dry cargo vessels, making it a very global asset class. The opportunity to deploy capital in this asset class is equally diverse – including both opportunistic (distressed appreciation-oriented) and income generating strategies.
Today we manage approximately USD 2 billion in equity deployed in transportation assets for institutional investors, increasingly with a focus on income generation. In what has been a sustained and difficult low rate environment, institutional investors are seeking alternative sources of yield in less-correlated assets. We purchase transportation assets and then lease them to high-quality end users (similar to an investment grade single-tenant building in real estate) over long periods, creating long-duration income streams with the ability to deliver steady cash flows.
Who are the main investors in transportation assets?
Investors in transportation assets span the entire spectrum of institutional investors – pension funds, insurance companies, sovereign wealth funds, family offices and endowments & foundations.
Could you explain how investing in transportation can provide a differentiated source of income?
With transportation assets we use the same portfolio construction techniques found in traditional public assets, namely diversity by sector, asset type, counterparty and duration. We look to combine a variety of assets that will appeal to different end user counterparties, creating a mix of leases with varying duration.
The credit quality of end users comes into play. If we have five assets, we want to have five different kinds of ships assets, leased to five different types of end users for five different durations to avoid concentration risk. So diversifying the duration of leases and seeking out high quality end users to preserve credit quality are important characteristics.
To facilitate our focus on income, we concentrate on larger scale assets, enabling us to have a more institutionalized market (barriers to entry in larger assets are substantially higher) and to effectively deploy our capital in a more stable risk spectrum.
What is the regulatory landscape like for transportation assets?
Capital requirements implemented primarily in Europe, such as Basel III (regulatory framework on bank capital adequacy, stress testing and market liquidity risk), have put significant constraints on banks’ ability to deploy equity into assets. Historically large-ticket leasing had been a significant business for banks, but those banks have been pushed out of the market as the cost of holding equity on balance sheets has become loss-generating. We have seen the departure of bank lessors as a source of funding in the market and we are stepping into that space as a manager of third-party capital and as a fiduciary for our clients.
How sustainable are yields on transportation assets in a rising rates environment?
When interest rates rise, underwriting approaches evolve, in the sense that there is positive correlation historically between the lease rates achieved and the existence of an inflationary environment driven by positive economic growth.
While our borrowing costs increase as rates rise, we remove floating rate risk by fixing our rates. Meanwhile, lease rates will move in lock step with interest rates. In other words, while we may experience financing cost escalation, rising lease rates keep the margins consistent.
What kind of transportation investment opportunities are you seeing globally and particularly in Asia?
By definition our assets move around the world and the majority are U.S. dollar denominated. Because we seek to minimize foreign currency risks, 90% of our holdings are in USD, in terms of price as well as lease rates.
Our interest in Asia is a function of the extent to which the region is driving investment flows and commodity exporting activity – one day our assets may be in Asia, the next day they could be in Europe or South America.
It’s really about the counterparty, as such we try to seek out the strongest possible counterparties to manage credit risk. For example the majority of the companies leasing our assets are investment grade credit rated, with limited default risk.
How do commodity prices impact transportation assets?
We focus on very long term duration leases. If commodity imports decline, that may impact the credit ratings of our counterparties. Significant downgrades to companies leasing our assets would prompt us to revisit our exposure. It is critical to have high quality counterparties as the end users of assets to ensure certainty of cash flows.
Primarily, our focus as investors is on long duration leases, consistency of rates and quality of our counterparties. As the maturity of our leases are well diversified, which is important in mitigating re-leasing risk, we’re not overly exposed to repayment risk at any given time.
Historically rate volatility for larger scale assets is also fairly limited.
We anticipate asset depreciation in our underwriting standards. All of our return, not just capital return but also return on capital, comes from the income stream. If you think about it from an unleveraged perspective, generating an 8% yield would mean a 12% coupon flow – that extra 4% represents one’s return of capital. The typical useful lives of most transportation assets are around 25 years. So there is roughly a 4% depreciation component as part of the underwriting process, so we are de-risking the assets on a regular basis. We are getting our capital and our return on capital consistently throughout the income stream.
How has the recent trade tension impacted these assets?
It will be interesting to see how that plays out. If the dispute is limited to approximately USD 200 billion in terms of tariffs between China and US, the material impact may not be that significant. If tensions escalate, that may change the dynamics.
Our focus for investors remains on the users of our assets. To the extent that these users remain viable, then we have that certainty of utilization throughout the lease period. We have yet to see any material impact on leasing or strategic changes from our end users.
Take iron ore miners such as Rio Tinto, BHP Billiton and Vale, as an example, which are a big part of the dry cargo portion of the shipping market, they are exporting from Brazil, from South Africa, from Australia, but none of them export from the US.
Containers make up the majority of consumer trade activity, with total consumer demand driven imports into China at about USD 450 billion – a relatively small component of the USD 19 trillion US economy. As manufacturing costs have gone up in China in recent years, we’ve seen a migration of activities into secondary markets, in effect diversifying the risks for the container ships portion of our portfolio.
Trade wars typically create inefficiencies in shipping, which is actually good for shipowners because the distances for goods to travel often becomes longer, which tightens the market and moves rates up. In other words, artificial impediments such as tariffs can actually benefit shipping strategies.
Apart from trade, what do you view as the key risks for the transportation asset class?
Transportation assets age – they have a limited lifespan and ultimately need to be replaced. With an average asset lifespan of 25 years, assuming no growth in demand, owners experience an average annual replacement rate of approximately 4% of their total stock of transportation assets. Even if global growth demand is flat, which it’s not the case, transportation assets still have a significant capital requirement just to maintain existing global fleet levels.
We assume an overall 7% to 8% annual capital replacement requirement, a component of which is growth capital. One of the main drivers of our strategy is the constant demand for replacement and growth capital and where that capital will be sourced. So from a risk perspective, a trade-induced GDP slowdown might reduce capital required for the transportation asset class.
For us as investors, we continue to keep a close eye on the credit quality of our end users and any impact changes in global trade might have on them.
Global economic growth is also important for the movement of liquid energy, such as LNG, LPG, refined petroleum products and crude oil. Historically there is a positive correlation between global economic growth, demand for liquid energy and subsequently more transportation.
Finally, in order to stay abreast of technological change and manage the risk of falling behind new innovations, we constantly seek to acquire state of the art assets. For example, fuel consumption is an important area of technological advancement for ships and aircrafts.
When one of our lessees thinks about the type of asset they want to lease, a significant component of that decision making process is the energy efficiency of the asset. Older technologies are often enhanced, for example we saw new engine technology sweep across the shipping industry in 2013, creating new ships with lower energy consumption.
Another interesting example is incoming shipping industry regulations that will require owners to limit nitrogen oxide and sulfur oxide emissions. Having a fuel efficient ship is going to be more attractive as the cost of low sulfur fuel to meet that requirement goes up. In short, seeking to acquire the most fuels efficient assets will allow us to capture longer lease durations, as the lessees know the asset will perform better in the long run.
Similarly we’ve seen important technological advancements in the aviation market in recent years, with the development of lighter alloys adding incremental improvements to jet engine technology and effectively making aircraft fuselages lighter, resulting in better travelling ranges.
Does over-supply in shipping and/or aviation impact rates?
We tend to see much higher growth rates in planes than in traditional shipping assets. With effectively only two major manufacturers of aircrafts globally, the supply is much tighter and more controlled than in shipping.
On the shipping side, there certainly is a volatile supply cycle in the more speculative smaller end of the market. However, since we focus on larger ticket assets that are backed by long duration leases, we don’t see a lot of speculative commissioning. At the bigger ticker asset market ($50-100million asset), the investor normally requires a contract to secure the investment, making it much more stable.
Do you also invest in trains?
Our primary focus is on shipping, energy logistics and aviation assets, but we do consider investing in trains in developed markets, across Europe (primarily rolling stock leasing opportunities) and the U.S. (investment grade assets that can be combined into a long-duration lease portfolio).
We believe the U.S. train market is currently over supplied. Tank car construction in previous years in anticipation of more oil being transported out of North Dakota to the East Coast actually did not materialize. It is taking some time to work through this over-capacity with corresponding returns below our targets.
What other unique and interesting assets are you able to access with a transportation strategy?
We are able to access a number of unique assets, including for example wind farm maintenance vessels, which are maritime assets. These assets are driven by distinct underlying fundamentals, making them highly diversifying to a portfolio. High credit quality multinational companies operating these windfarms require these assets to service the facilities and provide electricity, making it a utility-like income stream over a decade or more.
Another interesting type of energy logistics assets in which we invest is related to transportation for liquid natural gas. These assets are leased to oil majors over very long periods, they tap into dedicated, well-established and consistent supply chains. These are high-quality industrial assets leased for many years – these assets match our focus on long-term income generation and attractive capital returns.