Private Equity and Maritime Industry

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1 Private Equity and Maritime Industry Private Equity (PE) is a catchall phrase that encompasses a number of distinct investment styles. Irrespective of taxonomies, investors in maritime companies have scored outsized successes across the spectrum of tanker, drybulk and container sectors. Buyouts of public companies, or divisions of listed entities, represent the biggest subset; others include venture capital, mezzanine, distressed, and fund of funds. In a remarkably short time, these direct investment vehicles have grown into a dominant force in the world s financial markets. They have done so primarily by fueling an acquisitions boom that dwarfs the takeover frenzy of the 1980s. Investments made by private equity funds are transforming the capital structures of a wide spectrum of companies across many industries. Those transport companies with high contract coverage and steady revenues, necessary to support repayment of the leverage that supports the buyouts, have come within the PE cross-hairs. In the broader transport section, Australian national airline Qantas; travel services leader Sabre Holdings have been the subject of buyouts this year. In 2006, natural gas and oil pipeline operator Kinder Morgan, also an owner of tanker terminals, was the subject of a $15 Billion buyout (including $7 Billion of debt)- the largest since the 1989 $25 Billion Nabisco deal described in the book Barbarians at the Gate. The current record size buyout is $45 billion, agreed to by Kohlberg, Kravis, Roberts & Co. (KKR) and TPG in their acquisition of power generation utility TXU, this past February. In such deals, an investment fund, often structured as a privately held limited partnership, owns equity in the acquired company. The largest PE groups have their fingers in many pies. Blackstone Group, with $88 billion under management as of May 1, is best known for high-profile buyouts, but also operates real estate funds, hedge funds, mezzanine, debt, and closed-end mutual funds. In July, it put forth a proposal to take Hilton Hotels private for $26 Billion. Carlyle Group, with about $60 billion under management, runs 51 funds embracing buyouts, venture and growth capital, real estate and leveraged finance. Other PE behemoths include KKR, a leader in the buyout game since the 1980s which has now filed to raise public money; Bain Capital; and Cerberus Capital Management, which led the group that paid $7.4 Billion for a 51% of General Motors financing arm last year and is slated to acquire a majority of Chrysler this year. The TXU acquirer,

2 TPG (once Texas Pacific Group ), with $30 Billion under management, once invested in failed maritime transaction site Levelseas.com. The overall market size is huge. All told, PE firms participated in deals valued at $308 billion in the U.S. from January through late June, according to Thomson Financial. The figure is already within striking distance of last year s record $395 billion, which was nearly triple the 2005 tally. According to Dealogic, PE deals accounted for 35% of worldwide merger activity through mid-june 2007, up from 21% last year. On a global basis, the year-to-date PE buyouts totaled $568.7 billion in the first half, comprising 20% of all global M&A. That compares with 14% last year and 11% four years ago. The frenetic pace of activity is fed by a deluge of cash pouring in from insurance companies, pension funds and other institutional investors seeking higher returns. U.S. PE and venture capital fundraising hit a record $215.4 billion in 2006, according to Private Equity Analyst, published by Dow Jones, up 33% from 2005, and a nearly fivefold increase from 2003 s cyclical low of $44 billion. What s more, the record U.S. inflow was less than half the worldwide total of $453 billion raised by 722 funds that finished taking new money last year, according to a different source, London-based PE Intelligence. The scale of PE transactions has exploded over the past two years, a reflection of both surging capital inflows from institutional investors, plus easy access to credit for even the riskiest deals. The current upswing reflects a variety of cyclical and secular forces. Along with expanding global economies and buoyant equity markets, institutional allocations to PE funds in 2006 were swelled by reinvestment of abnormally large distributions that many funds had returned to their investors after liquidating successful investments, during the previous year. When they cash out, funds may sell shares to the public, in an IPO, or they may sell out to another PE fund. On the debt side, a flat yield curve, skin-tight credit spreads, and record low corporate default rates all encouraged banks and bond investors to seek higher yields by financing leveraged buyouts. PE buyers have been able to load up on debt for financing acquisitions at a historically slight rate premium over investment-grade debt, sometimes in an increasingly covenant light format. Horizon Lines, now listed on the New York Stock Exchange, has provided one of the shipping industry s best known encounters with PE, resulting in successes for all concerned. In the late 1990 s, CSX Corporation, in moving out of SeaLand, its container shipping investment, sold the lion s share- its non U.S. business, to Maersk, for roughly $800 Million, and held on to its U.S. business- then called CSX Lines. In early 2003, CSX Lines was then sold to the Carlyle Group, for a price of approximately $315 Million (including convertible securities and debt), and renamed Horizon Lines. As is customary, the old management was retained.

3 Though Horizon was a mature business, running vessels in U.S. Jones Act trades (mainly to Alaska, Puerto Rico and the Pacific islands) ongoing investment was required well beyond the normal maintenance capital expenditures. In 2002, Horizon had only recently begun its Florida to Puerto Rico service, and it was investing heavily in technology and equipment in owned terminals. Valuation is the surest sign of value added. Another well known PE shop, then came in, with Castle Harlan Fund IV (CHP IV) buying Horizon from Carlyle in July, 2004 for $663 Million (including debt). Carlyle s return was reportedly more than 5 x invested equity, implying that high leverage figured in this private transaction. According to a Horizon regulatory filing: CHP IV and its associates and affiliates invested approximately $157.0 million in Horizon Lines, Inc., of which approximately $87.0 million was in the form of common shares and Series A redeemable preferred shares, or Series A preferred shares, and $70.0 million was in the form of 13% promissory notes, which were convertible into shares of Horizon Lines, Inc. The company was then on its way to a recapitalization through the public equity markets, starting with a September 2005 IPO. In three subsequent secondary offerings, in June, September and November, 2006, Castle Harlan investors were able to monetize their gains. Proceeds of the offerings were approximately $170 Million (more than double the $87 Million share component). During its ownership in the Castle Harlan stable, and afterward, Horizon has been paying down debt- indeed, in late June 2007, its credit rating was increased to BB- (from B ) by rating agency S & P. Proceeds from its September 2005 IPO went towards paydown of preferred stock and two debt issues: $53 Million of a $250 Million 9% Senior notes due Nov 2012 (issued July 2004) and $56 Million (principal amount) of $160 Million (principal amount) 11% Senior discount notes that had been issued in Dec At the time of a Dec $25 Million prepayment on a term loan, Horizon s CFO stated: Going forward, reducing our leverage will continue to be a key component of our overall business strategy." S & P noted that We believe that the company's fleet renewal program and cost-cutting initiatives will lead to improved credit metrics over the near to intermediate term, despite an increase in lease-adjusted debt related to the delivery of five new ships." In 2006, Horizon entered into a lease of five newbuilding vessels from Ship Finance Ltd., where the assets will remain off Horizon s balance sheet. Around the same time of Carlyle s Horizon investment, in 2002, an investment fund organized by Sterling Partners LP, a Connecticut investment boutique specializing in buyouts of well performing divisions from industrial companies, was investigating the maritime space. At the time, Sterling, which already owned a barge company (serving the U.S. Western river system) and a tank truck operation (operating in the Midwestern states), approached Amerada Hess Corporation about selling its fleet of six integrated

4 tug barges (ITB s), serving the U.S. Jones Act trades. Sterling teamed up with Paul Gridley (an ex Lehman Brothers banker who had, in turn, led a highly successful leveraged buyout of Marine Transport Lines in the late 1980 s). The result was a new entity, United States Shipping LLC- which bought the ITB s, using $40 Million of equity raised from management and a group of fund investors. The leverage consisted of a $130 Million term loan (put together by CIBC), a $10 Million revolving credit, and roughly $30 Million of Sellers Credit- in the form of a senior subordinated note. Members invested a further $6 Million in 2003 to expand the fleet. The investment paid off in a big way two years later, at the beginning of shipping s IPO boom, in November 2004, with the liquidity event, in this case, the public flotation of Limited Partner (LP) units in a new entity, U.S. Shipping Partners, L.P., trading with stock symbol USS. Prospectus calculations show that new LP investors received a 42.6% interest in USS in return for their $133.5 Million, providing a firm valuation of $313 Million. Conversely, the original investors $46 Million stake was now worth $179.9 Million, in the space of two years. Carlyle had also been involved in a U.S. flag shipping investment, investing in Seabulk International, the re-named Hvide International. In the mid 1990 s, Hvide had built up a sizable business in the OSV sector, as well as building up a fleet of U.S. flag tankers for the coastal trades in refined petroleum products and chemicals. Overbuilding of the service vessel fleet, as oil prices slumped, led Hvide down the path to a voluntary bankruptcy in late Under a reorganization plan where Hvide continued to operate normally, $300 Million of high yield notes (8.375%) were de-leveraged, converted into 98% of the firm s equity. In 2002, a PE Consortium including Carlyle s Riverstone Global Energy and Power Fund, and funds from DLJ/CSFB injected $100 Million for a 51% holding, in the form of newly issued company shares priced at $8.00/share. In conjunction with a transaction where shareholders (rather than the company) were paid out, the new investors held 73% of the Seabulk shares (on a fully diluted basis, with option exercises considered). The balance sheet was simultaneously bulked up with $180 Million of five year debt ($80 Million in a term loan, and the balance through a revolver), from a group led by Fortis and NIB. $95 Million of senior secured notes, priced at 12.5% (issued in 1999) was also repaid with the new bank debt. More than $200 Million of U.S. Government guaranteed Title XI debt was tied to the dozen U.S. flag deepsea product and chemical tankers, and

5 continued to be serviced as the ships generated cash in what proved to be a strengthening market (as evidenced by the USS IPO in late 2002). The exit for Carlyle and DLJ/CSFB came in mid 2005, in the form of a merger of Seabulk International into Seacor Inc., which paid the equivalent of $21.32 per share of Seabulk, effecting its purchase with a combination of cash and Seacor shares. According to a Carlyle announcement, the aggregate value of the consideration used to buy out Seabulk equity was $532 Million (with the PE share worth approximately $400 Million). For Seacor, serving the oil industry with boats and helicopters, a big attraction was Seabulk s OSV fleet, leaving analysts to speculate whether Seacor would finance its acquisition through a spin out its U.S. flag product and chemical tanker business. Blackstone s name also came up in connection with Great Lakes Dredge & Dock Company (GLDD), whose successful IPO in late 2006 provided the exit for an earlier investment by buyout shop Madison Dearborn Partners, which had acquired the 120 year old dredging and waterfront infrastructure specialist in 2003 from a fund run by Citibank Venture Capital. The Citi entity (the same group that had nurtured what is now Navios Maritime Holdings, during the 1990 s) had, in turn bought out Blackstone in In the GLDD IPO, Aldabra Acquisitions, a blank check company launched by a New York money manager, invested $50 Million to gain a 28% stake in GLDD. Madison Dearborn retains a majority holding in the recapitalized entity, which now has requisite liquidity for the PE investors to value and monetize their investment. The funding mix also includes $175 Million of publicly traded 7.75% Senior Subordinated Notes, maturing December 2013, issued in conjunction with Madison Dearborn s 2003 acquisition and infusion of nearly $100 Million (with bond proceeds also refinancing an earlier debt issue). GLDD s enterprise value has grown from $171 Million, at the time of Blackstone s 1993 investment, to more than $450 Million. It is not a coincidence that PE investors have rallied around Jones Act companies such as Seabulk, US Shipping Partners, Horizon and even GLDD- whose big customer is the U.S. Government, in the form of U.S. Army Corps of Engineers which must continually maintain ports, rivers and locks. Unlike more commodity shipping plays which are at the

6 mercy of spot market vagaries, these Jones Act players forward book reveals a preponderance of contract business that can bring predictable revenues to comfortably service debt. Of paramount importance is the protected nature of the Jones Act trades- the U.S. build requirement provides a barrier to entry not present in the international flag shipping business. PE investors having a familiarity with the energy space have been able to get comfortable with tankers. GLDD s story is closely aligned to the infrastructure sector, where big gains have also attracted funds managers in recent years. Branded business, whether hotels or cruise ships, create customer followings that are also attractive to PE players. A variant of pure PE is the purchase of shares in private companies. Apollo Management, whose latest vehicle, Fund VI, raised $12 Billion, entered the maritime space earlier this year when it gained control of privately held Oceania Cruises- which was created in 2002 out of the ashes of the failed Renaissance Cruises. Equity in the five year old Oceania, including shares still held by Cruiseinvest - the syndicate of Renaissance creditors and equity investors who initially leased three vessels to Oceania, was worth around US $475 Million, based on the announced transaction value of $850 Million and an existing debt facility of $400 Million (consisting of $375 Million in term loans with six and seven year tenor, plus a $25 Million credit line that was not drawn upon). Though details are guarded, market sources have pegged the initial equity investment in Cruiseinvest at under $50 Million, suggesting a fabulous payday. For a small company, PE can provide the capital to support large investments in vessels. Though Oceania had created a highly regarded position with its ships of under 700 passengers, expansion was the way to build on its successes. Within weeks of the announcement of its acquisition by Apollo, Oceania announced a $1.1 Billion order for two 1200 pax vessels to be built at Fincantieri (if an option for a third vessel is exercised the total price-tag would be $1.6 Billion). A hypothetical future for Oceania would be its own IPO, or possibly an acquisition by one of the dominant cruise players, Carnival Corporation or RCCL, after the newbuildings begin generating cash flow. Alternatively, following the Horizon precedent, another PE fund could buy out the Apollo interests. Oceania would be valued based on an EBITDA multiple in a business combination with a strategic player, or another financial player. Cruising stalwarts have worried whether Oceania s EBITDA growth would come from cost cutting. Apollo s founder, Leon Black, who once worked at Drexel Burnham Lambert under high yield debt impresario Michael Milken, is known for his sharp pencil. But Apollo s winning deals have included consumer franchises in the hospitality business, a great similarity to cruise shipping- and its brands such as Harrah s or Vail Resorts have remained intact. Blackstone, whose founding partners came out of Lehman Brothers, made its own foray into the shipping business in 2006 with an investment alongside U.S. Shipping Partners in the construction of nine U.S. flag product tankers to be built at the NASSCO yard and

7 chartered to major oil companies under long-term deals. Vessel construction will expenses will severely impede an MLP s ability to grow cash distributions, so, typically, newbuildings are warehoused in related companies. Thus, Capital Products Partners will purchase ships from Capital Ship Management and Teekay Gas Partners will buy vessels constructed by other Teekay entities. A creative approach to financial warehousing was the USS linkage with a Blackstone, and other investors, who will be providing $105 Million for a 60% equity stake a joint venture company- USS Product Investor LLC (USSPI), which can sell the vessels to USS at a profit, or operate them. Steel cutting on the first vessel (for 2009 delivery) is expected in August As with each company described in this article, substantial debt accompanies the equity investment. In this case, Blackstone and Lehman Brothers have agreed to provide $325 Million of debt to the joint venture. USS also issued $100 Million of high yield debt (13% coupon), partly to fund its equity contribution. Commodity shipping companies have also benefited from PE investment styles. In a spot market tanker shipping template not unlike that of traditional PE, Oaktree Capital was an early backer of General Maritime prior to its 2001 IPO. In the late 1990 s, the company was acquiring surplus oil company ships en bloc (rather than a corporate division)- usually without charters. Investors in Oaktree funds had profited handsomely in the 2001 flotation, and have sold their shares back to the company in early Other variants on the PE story include investments by financial sponsors in commodity shipping companies that have been able to exploit the higher valuations possible with an IPO. After sponsoring the companies, PE funds have sold shares in the IPO and afterwards, benefiting from meteoric rises in the sector. Sponsor Kelso & Company, a New York buyout shop (that says it has invested several $Billions in deals over the past three decades), backed Eagle Bulk Shipping in late 2004, and profited from the mid 2005 IPO. A listing of Eagle insider sales transactions shows that investors tied to Kelso have been selective sellers since the IPO, culminating in gains from one of Eagle s two secondary shares offering in January 2007, including an offering netting $121 Million to the share sellers. In February 2007, the FR X Offshore fund, a PE fund with Quintana Maritime backer First Reserve, specializing in the energy sector, sold its big block of shares, netting nearly $24 Million. In a Genco Shipping and Trading $148 Million secondary offering earlier this year, the Oaktree Principal Opportunities Fund (a large holder in the selling shareholder seller Fleet Acquisition LLC) scored further gains, along with backers that company Chairman Peter Georgiopoulos. Most recently, in another variant on the PE theme, shareholders in drybulk owner Paragon Shipping who had participated in a $109 Million private placement last Autumn are now selling their shares to outside investors who can trade the dividend paying stock over the counter. In this form of exit, where shareholder stakes are re-jiggered, the company will not receive any money- much like many of the recent secondary offerings in the sector. J.F. Lehman & Company, a private investment fund, has participated in two private transactions, the purchase of Atlantic Marine (the owner of shipyards in Jacksonville, Fla

8 and Mobile, Ala.) and a $70 Million investment into a new project, Hawaiian Super Ferry (which has secured $140 Million of Title XI guarantees on debt placed with institutions). At some point in the future, an exit, with sales to U.S. investors, will enable Lehman investors to realize their return. Until June 2007, nothing seemed to stand in the way of the PE juggernaut. Today the picture is considerably cloudier. Credit conditions are suddenly less friendly, thanks to contagion from the subprime mortgage arena. Ship financiers watched, in late June, as investment grade rates MISC Bhd postponed a $750 Million bond issue (for funding a big newbuilding orderbook, not linked to a buyout) A number of buyout-related bond offerings related to leveraged buyout got the cold shoulder from investors. Several smaller deals also were postponed, while others were scaled back or repriced. A recent ironic twist is the public money raising now underway by the public equity companies. Fortress Investment Group, which does sizable PE business but is perhaps better known for its hedge funds, kicked off the trend by completing a highly successful IPO in February this year. Fortress has been well known to LSE readers since 2004, when the management of Stelmar attempted to bring Fortress in an as a White Knight after company founder Stelios Haji-Ioannou had lined up OMI Corporation as an acquirer. After an acrimonious battle with management, Haji-Ioannou was eventually able to improve upon the Fortress offer with Stelmar s late 2004 sale to OSG for $842 Million, or $1.3 Billion enterprise value. Fortress was rumoured to have been the catalyst for OMI s self imposed sale earlier in the year; OMI filings indicated that an un-named PE investor made an unsolicited $25/ share bid that began OMI s sales process, well below the eventual $29.25/ share price paid by the Teekay and Torm consortium. The filings also reveal that at least five PE players were among the bidders looking closely at OMI. Recently, market rumblings had the Abu Dhabi Investment Authority talking to Apollo about taking a small equity position, at a time that Apollo was also looking its own public offering. Such a deal would be analogous to a Chinese investment in Blackstone, earlier in the year, several months prior to its IPO, bringing in a cornerstone investor and setting parameters for valuation in an upcoming offering. Reports suggest that a 10% stake in Apollo could be worth $1.5 Billion and that Apollo had returned 35% annually to investors since its formation in the early 1990 s. Blackstone made a huge splash when it began trading on June 22, giving the firm an initial market value of $33.6 billion. KKR has filed registration documents for a $1.25 Billion public offering. Because of differing ownership tranches, a valuation is imprecise, but some analysts suggested an overall value of around $ 25 Billion. One of KKR s funds began trading independently in the Amsterdam market in May. Success in lucrative PE deals rests heavily on leverage, and recent fears of higher interest rates sent further shock waves around the PE community- higher rates for LBO debt will inevitably cut into returns. Still, PE investing has been so stunningly profitable in recent years, that the sector s returns could remain attractive despite reduced margins as spreads

9 and overall rates rise. A more serious threat is if the supply of credit for these risky deals suddenly constricts, triggered potentially by one or more high-profile defaults of corporate bonds or by problems at a major bank or hedge fund. A second potential threat is taking shape in Washington, in the form of proposals to deny capital gains tax treatment to PE firms share of portfolio profits more than doubling the effective tax rate that would apply to the general partners of these U.S. based firms. Provisions in the bills could apply to PE and hedge funds, venture capital and also real estate funds. But, in the meantime, the champagne is flowing among those PE players who have invested in maritime business over the past few years. ALSO WORTH READING FROM bdp1- SEACASTLE IPO, Fortress Investments bags two container lessors Carlisle (private to private) and Interpool (public company taken private) soon to be launched into an IPO, along with a fleet on vessels. Submitted to Janes Transport Finance

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