Private equity, boatless contractors, and Carillion… The future is in the east…

The death of private equity has been predicted many times before and this recent article is no exception. What is also not in question is that more people than ever are throwing money at private equity and alternative asset providers and that thay are expecting less from them:

“The investors have accepted the idea of lower returns as OK,” said the head of a private equity group. “It used to be that investors would earn 20 per cent net internal rate of returns. Now they are happy with 14 per cent or 15 per cent net internal rate of returns.”

What is not in question as well is that with ever more private equity money looking for returns the risk meter is being dialled up, which in offshore may present opportunities on the services side of the business, but with vessels and rigs, private equity money  will end up leaving the industry I think. An inability to get debt, lack of asset price inflation, and no other buyers for exit will be the core reasons.

Saying the offshore vessel industry is in chronic oversupply is really the same thing as saying there is too much capital in the industry. To rebalance some of this capital will leave via scrapping vessels, but some will also leave as investors can no longer justify holding their positions that require new equity to keep funding operating losses, or they realise they hold something unsellable. The question for the private equity firms in offshore is how they get out of investments where they are long on vessels? First Reserve are clearly doing all they can to get out of DOF Subsea and they have been some of the smartest energy investors around.

At the other end of the spectrum are York Capital and Hitecvision. Both initially backed start-up contracting companies looking to go long on vessels, then the market turned and they changed strategy to be vessel light, and now York have doubled down by buying more vesssels via Bibby. Hitecvision on the other hand have renogtiated with Solstad to reduce their exposure, closed out on Reef Subsea, and have tried to sell OI to MDR but failed.

The link here is how do these companies get out from these investments? The deeply related question is do you need a boat to a contractor? I mean obviously you need a vessel to deliver work offshore, but do you need a vessel under your control 365 via ownership or a time charter to be a contractor? The answer of course is that it depends… but if Asia is any clue to how the North Sea will go, in a situation where construction vessels are commodities, then things will be increasingly difficult for these two investors even as the market picks up. In Asia the reason margins have been structurally lower than the North Sea for years is solely because there were more competitors, and there were more competitors because there was a bigger choice of vessels, and therefore a relatively larger number of project managers who would charter one for a one off project.

But it is clearly the case is that a “boatless” contractor is more a lifestyle business than a serious economic or investable proposition. Without a vessel barriers to entry are low and all the business is really is a project management house charging 10-15% on the PM & Engineering, and then, when the market is good, some margin on the vessel. Such a company has only intangible assets, no intellectual property, can borrow virtually nothing, and its growth options are limited to how many engineers and project resource it is committed to hire. This is what is called a constant returns to scale business: no matter how much capital you throw at it you get back a 10-15% operating profit on the output which increases marginally to scale as the business becomes huge. There is also a fair bit of risk as when the market is weak, like now, and you have to bid lump sum and it runs over, the cost of the vessel is way beyond any margin you made elsewhere. It is exactly the business model of Carillion.

Now that the vessel market for OSVs is oversupplied, once pricing on certain projects gets above a certain level, any number of project management houses are likely to enter the market. In the old days when this wasn’t the case the rewards for going long on chartered (or owned) vessels was immense: as days rates increased annually those on long terms charters got an uptick in the charter rate but still only made 10-15% margin on the PM & Engineering. Now, if you are lucky, you get a 10% markup on the vessel and some operators are askling for direct pricing of the vessel or direct procurement.

There is no better example of this business model than Cecon Contracting (“Cecon”). Now don’t get me wrong Cecon is a great little business, but it is a lifestyle business. By that I mean it is a collection of guys in a shed at Arundel (a lovely shed btw I have been to a few times and they do a nice lunch) who meet at the office, and annually, if they are lucky, do a project in Angola, Tunisia, or some other exotic location. It is a lot like a boys golf weekend with a lot of pre-meets at the pub for planning, followed by the actual trip.  But there is nothing replicable or scaleable about this, and there is no forward order to book so to speak of. There is therefore nothing of value to sell. It’s a great little business for the guys involved, I wish I owned it (although being from NZ I don’t play golf), but it will be a lifestyle business forever. It is worth noting that one of the two projects they did last year one was the seafastening calculations for their own (or really Revers’) partially built vessel to get to cold stack, a project that on the open market would rank in the few tens of thousands (and maybe pay for the golf weekend). But Cecon has no operational shipping assets to speak of in its current incarnation (whereas Rever appears to have an asset in warm stack in Malaysia… like a lot of other people).

The entire asset base according to the Cecon website is a tensioner and stinger. In 2013 when  no one had one you may have been able to profit from the lack of supply with this asset base on the back of a Maersk R class, but the fact Cecon are offering it out for hire now should tell you where the market is at.  The Cecon vessels, ordered by Cecon AS (the original Cecon that went bankrupt), are so far from completion that at current rates of progress they will serve as a replacement for the Polaris when she retires in 10 years

So talk of merging it with Bibby Offshore to “enhance capabilities”, from Bcon to Cecon, just aren’t serious. I haven’t seen the “merger” documents (obviously), but I am assuming the legal form is the Norwegian company buying the assets of the UK Bibby Offshore (maybe it’s the other way I don’t know why though?). The only reason for doing this are either tax (yawn), to engineer some sort of default on creditors of the Bibby Offshore UK company (potentially the T&T tax authorities and US offices), or to obsfucate the investment value in Bibby Offshore (or some combination of all three) as the investors in the transaction work out how to get out of this. Based on Cecon’s published projects for last year in 2014 and 2016 the boys didn’t go golfing at all, and in 2017 a small marginal development (flowline 1 mile, moorings, a buoy, and a riser and one of the larger jobs they have done historically) was the only project. In the low single millions given the client and location I expect. There is no “industrial logic” for such a combination. If you need to merge with 5 guys in a shed in Arundel, with an asset base that consists of a stinger and tensioner, to enhance your capabilities, then you have a big problem.

Hitec’s position with Ocean Installer (“OI”) is no less easy. When it was set-up the relationship with Solstad, and OI’s willingness and ability to go long on vessels, but also the flexible lay systems on these vessels which were also in short supply, was a differentiator. But in addition to the growth in vessel numbers since 2012 there has been a boom in the associated supply of ancillary equipment for vessels, and that includes lay equipment. Companies such as Aquatic and MDL supply systems that were unavailable only a few years ago, and can be mobbed cost effectively on chartered tonnage. I am not saying they are suitable for every job, but the problem is lay spreads used to be used to make a ton of money of some jobs and more marginal money of others, now the some of more marginal jobs have gone for those committed to lay spreads 365 and therefore it is just not as profitable to have lay capability. Hitec/OI took some real equity risk here, and as happens sometimes, it didn’t work out.

Hitec/OI, like DOF Subsea, is a clear tier 2 contractor in every market it operates in, where procurement is all done regionally, and there is no economic benefit to being in all the markets it operates. It needs to pull out of everywhere apart from Norway/UKCS where Statoils’ desire to not get fleeced by Subsea7 and Technip has led it to favour smaller contractors, and just charter its 2 remaining vessels out when not working for OI in the North Sea. Because in every other market it is basically a Cecon without the golf but with a corporate overhead (and Stavanger just doesn’t have the views of Arundel).

The OI problem is the Cecon problem simply of greater scale and potentially of greater losses over the years. The price any rational buyer for OI would pay is surely capped at the cost of assembling a similar group of people, chartering similar assets, and winning some backlog. The “vessel premium” for having gone long assets at the right time is gone and the replacement cost is well below the original assembly cost. Hitecvision’s apparent insistence that OI must stand on its own financially now marks the understanding that this investment is about limiting the loss here rather than a realistic proposition of making money on the deal. Hitecvision had a great business model, where they took smart Norwegian companies international and they picked up an increase in both the multiple on sale and the quantum it was based on, but there is nothing in OI that allows them to do this.

I wouldn’t be surprised to see some combination between OI and BeCon at some point. The problem for Hitec will be taking on the operating losses of BeCon but no doubt the respective owners can convince themselves that two loss-making donkeys can make a thoroughbred… for a short time anyway.

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