Chapter 3.3 – Financialization and Terminal Funding

Authors: Dr. Theo Notteboom, Dr. Athanasios Pallis and Dr. Jean-Paul Rodrigue

Port terminals are capital-intensive assets that require investments for their construction, expansion, and maintenance. This capital needs to be provided by financial mechanisms on which the port terminal industry relies. Complex relationships between port terminals and the finance industry have been established.

1. The Financialisation of the Terminal Industry

Conventionally, terminal ownership and operation were mainly assumed by the public sector through port authorities. The provision of capital for port infrastructure projects was the responsibility of the public sector. However, productivity levels tended to be low, and returns on public investments were limited. As privatization took shape, the dominant model shifted to port authorities being landlords, and the terminal operating business drastically changed. From a situation of fragmentation, the terminal and stevedoring industry expanded substantially with the emergence of global terminal operators controlling large multinational portfolios of terminal assets.

In the early 2000s, the terminal operation business reached a phase of rapid global expansion, on par with the rapid traffic growth supported by the shipping industry. Some corporate terminal networks were driven by strong demand and new greenfield terminal developments, and a series of large-scale acquisitions and multiple entries to boost expansion strategies, such as the take-over of CSX World Terminals and P&O Ports by DP World in 2004. This process was accelerated due to port reforms across the world and the evolving balance of power between shipping lines and terminal operators.

Simultaneously, the port and maritime industry has been subjected to increased financialization, implying that financial institutions play a growing role. Financial holdings such as investment banks, pension funds, and sovereign wealth funds, entered the market by providing large capital pools unavailable in the industry beforehand. The port terminal sector was seen as an attractive asset class having a potential for revenue generation. In more general terms, the financial sector provided capital for firms related to terminal operations and contributed to their remarkable expansion. For example, container terminal operators typically financially outperform container shipping lines, which are also strongly asset-based. An emerging class of terminal operators took the form of holdings backed by large pools of capital and using this capital to rapidly expand, particularly by acquiring terminal assets become part of a portfolio of port terminals.

Financialization refers to the increasing role of financial motives, financial markets, financial actors, and financial institutions in port terminals, ranging from the provision of capital to involvement in terminal operations.

When ports face terminal capacity constraints, financial holdings, independent terminal operators, and carrier-related terminal operators are willing to pay premium prices to acquire or develop terminal assets. The unintended consequence of financialization was that an increasing quantity of capital was chasing an asset class that could only be expanded at a slow pace, which resulted in asset inflation within the terminal industry during the 2000s. Financial bubbles have historically characterized sectorial investments such as real estate and high technology, and the terminal industry experienced such a process in the 2000s. The 2008-2009 financial crisis that resulted from cross-sectorial asset inflation and the resulting defaults led terminal operators and their financial actors to reassess risks and move away from previous aggressive expansion strategies.

After the financial crisis, financial institutions became more cautious and more demanding on terms and project characteristics. Terminal operators are also more prone to selling stakes in terminal assets for financial relief while keeping their role as operators. This commonly involves a financial holding seeking an opportunity to acquire terminal assets while leaving the existing terminal operator taking care of operations.

2. Risks and Terminal Investments

A. Port terminals as financial risk factors

The terminal operating sector has its own set of risk factors to be considered in capital investment, some of them related to the financial sector, but many related to its inherent business and operational conditions. The overall risks are:

  • Pure financial risks include such as capital and currency risks. There is a risk of losing the investment capital through devaluation or default, particularly since a terminal requires a large capital investment. The amortization of this capital takes at least a decade. The higher the margin taken on the asset, the higher is the risk of this asset becoming illiquid. Since terminals are used as co-laterals for capital investment, the capital risk is low if one expects that the value of this asset would rise and that a buyer could be found. However, there is a risk that the situation changes. Moreover, terminal operators generally face currency risks due to fluctuations in exchange rates, including the case of major currencies.
  • Market risks include unforeseen changes in demand and supply. This risk is strongly embedded within the regional economic and commercial geography of the terminal portfolio as well as the structure of maritime shipping networks. Intermediate hub ports with a strong focus on transshipment operations are particularly contestable and are among the riskiest terminal investment projects. With increasing competition for port hinterlands, the contestability of gateway traffic is also more acute. Thus, market risks may equally be considered as revenue or investment risks. They compound capital risk in a terminal by impacting the length of the amortization and the intervening changes in demand due to traffic fluctuations and contestability. Market risks are very explicit in concession contracts. For example, terminal operating companies often face high throughput guarantees in concession agreements. Additional internal micro-level market risks affect a terminal’s position, such as energy cost risks. Energy is one of the main operating costs for shipping and terminal assets. Terminal operators have conventionally not applied energy costs hedging, compared with shipping lines that typically try to protect themselves through either hedging operations or bunker fuel surcharges.
  • Political and regulatory risks concern international trade and manufacturing issues. For terminals, these involve the risk of arbitrary changes in the commercial environment due to political expediency, favoritism to a carrier or operator, and even confiscation (nationalization). Even if the last decades have seen an environment more open to trade and liberalization, there are risks the countervailing forces such as protectionism can emerge. Entering the market at a specific point in time means that regulatory changes are unforeseen in the long run, particularly since terminal concessions can last over 20 years. Regulatory risks refer to unexpected changes in the competition, such as incumbents or changes in the market strategy of competitors. It can also involve regulatory changes and planning conditions or more expensive operational models. For terminal operators, the regulatory framework for concession renewal is increasing the risk of the committed investment during the early stages of operation.
  • Market concentration and specialization risks are common when a player focuses on a specific region or a type of service. Containerization and economies of scale in mega-ships have expanded specialization risks, as they assume the availability of large freight volumes. In contrast, concentration reduces port of call options. With better hinterland access, the traditional markets of many terminals are highly contestable. A concentration of a portfolio in a specific market may lead to high returns if economic prospects are better than expected but to negative multiplying effects if economic conditions are even slightly lower than expected.
  • Moral hazard risk. Many port terminals are either public or have strong relationships with the public sector since governments and sovereign wealth funds can be stakeholders. Several are perceived to be of national strategic interests. If they face financial difficulties, they have the opportunity to use their political embeddedness to access public capital or private capital guaranteed by the public sector. This can potentially lead to misallocations (“too big to fail”), enabling less performing operators to remain in business and who, otherwise, would have been forced to rationalize their assets. There is a link between moral hazard risk and political risk. Policymakers can have strategic reasons to protect a terminal operator from defaulting, such as maintaining operations at a port judged to be crucial for a national economy.

B. Port specific risks for terminal operators

The size of the infrastructure and superstructure for terminal development adds to investment risks. To develop a terminal, an operator might have to invest in developing or improving the infrastructure and the superstructure of a terminal, which is capital intensive. The larger these infrastructures, the higher the sunk costs into the facility. The risks associated with port or terminal investments vary depending on the nature of the market and the stage of the development of the port. Public actors decide about the terms of a concession, and terminal operators decide to bid and assume responsibilities of terminal operations for a period that commonly exceeds two decades.

The probability of occurrence of terminal-specific risks relates to the stage of development of the terminal site to be operated by a private actor, which might invest in:

  1. An undeveloped site where the operator will have to develop infrastructure.
  2. A greenfield site with infrastructure developed to the site boundary.
  3. An improved site with a quay line and paved yard but without buildings or handling equipment.
  4. A site with all civil works completed but the operator supplies quay cranes and yard handling equipment.
  5. A fully developed site including quay cranes but the operator supplies yard handling equipment.

This condition is closely related to the technical, as well as the financial and market risks assumed, with the first option (1) being the one associated with the highest technical risk, with a declining risk as we are heading towards the last option (5) whereas technical risk transfer is the lowest. Technical risks ultimately result in delays and cost overruns or both, include:

  • Application of innovative techniques and technologies.
  • Design changes, including terminal function.
  • Land acquisition and availability.
  • Delays in project approvals and permits.
  • Change in construction legislation and default from the contractor.
  • Archaeological findings.
  • Construction contract variations or default from one of the contractors.
  • Availability of finance (cash flow) and force majeure such as a natural disaster.

Market risks may depend on the size of the investment. Still, their level also reflects the uncertainty in predicted traffic volumes, transport demand, and the willingness of users to call at a particular terminal and pay for services rendered. Demand predictions and forecasts are sensitive to uncertainties and strategic or optimism bias facilitated by less established markets. Due to underestimated traffic volumes, terminals in these markets are very sensitive to income, industrial production, economic growth, and disruptions due to economic shocks, such as the financial crisis of 2008/2009 or the COVID-19 pandemic.

The probability of risk exposure depends on the nature of the market for the particular port or terminal and results from the presence of alternative conditions:

  1. No established regional trade with projections based on unproven market expectations, such as those associated with a new free trade zone.
  2. Established regional trade with substantial transshipment.
  3. Established hinterland general cargo trade but with a low market penetration factor.
  4. Established regional and national trade but open to competition from other terminal operators within the same or nearby port.
  5. Established container trade and need for facilities upgrade.

The probability of market risk, in general, varies from highest in the first case (1) to lowest in case 5. Given the intervening changes in demand due to traffic fluctuations, and contestability on the supply side (intermediate hubs are particularly contestable), market risk is directly connected to investment risk in a terminal due to the amortization length. In recent years this risk was abated by the surge in transshipment throughput as maritime shipping companies organized the networks to cope with the growth in long-distance trade and economies of scale. With emerging hinterland access regimes, the contestability of gateway traffic is also more acute.

An environmental component of risks is also present in all terminal investments, though not unique to the industry. Project design, environmental impacts assessments, and respective approvals and permits are the norm. The risk associated with prerequisites in securing construction, maintenance, and expansion of a terminal is common in all transport projects. Addressing environmental risks might be costly and, perhaps more importantly, result in unnecessary delays in terminal operators’ strategies. Also, growing environmental concerns increase the risks of new environmental legislation, which may influence the operation and maintenance of a terminal. Environmental risks are related to the size of the terminal, with the more complex the operation, the greater the risks. At the same time, they are associated with the location, which is connected with the country and its respective national and international obligations.

C. Implications for concessions

All risks are fairly well known to the industry and embedded in their business strategies. As a risk minimization strategy, it has become common practice to launch large terminal projects in phases, following developments in port services demand. These phases can be timed with expected volume growth, and financial support can be secured accordingly. While capital could not have been readily secured for a large terminal capacity development project, such capital can be made available on an incremental basis and based on realized outcomes from investments in prior phases.

Global terminal operators follow a careful and selective approach when bidding for new terminal concessions, acquiring terminal assets, and selecting partnerships. They are also hedging risks by opting for more complex ownership and partnership structures with shipping lines, financial holdings, and other organizations.

3. Funding and Financing of Terminal Development

Terminal capacity investments are very costly given their capital-intensive nature. Because of the costs involved, port managers and terminal operators typically are inclined to first stretch existing capacity via measures leading to better terminal planning and more optimized port operations. It is easier to provide superstructures such as better equipment improving the stacking density than expand the terminal footprint. Only when capacity stretching has been exhausted that additional capacity should be made available. Such projects require large sums of capital from various public and private sources through funding and financing mechanisms.

Funding entails the provision of money at no interest for developing the port project (e.g. state grants, internal reserves). The capital is not necessarily expected to be recovered.

Financing implies that the money lent is regarded as an investment and comes at an interest rate (e.g. commercial and investment banks, bond financing) or required rate of return for the investor. The capital is expected to be recovered.

In practice, matching demand and supply is not an easy task given the long lead time to plan, construct, and start up new port and terminal infrastructure. Finding a suitable timing to initiate the planning and implementation phases of new port infrastructure is, therefore, a challenge prone to risks. There is always the imminent risk of creating overcapacity in cases where a port extension project does not induce growth in port demand. The timing of capacity expansion and a good assessment of future demand is crucial to position the port for sustained growth and secure suitable funding sources for capacity extensions.

Funding strategies for costly port investments are primarily constrained by a port’s institutional position. Pure public or tool ports, for example, are limited to funding sources obtained from national funds. Developing countries face increased constraints on the level of public funding sources available to develop port infrastructure due to other national infrastructural and social priorities. In these circumstances, the port must compete in the political arena to secure capital against other projects and where political interest groups influence priorities.

There are essentially five major sources of funding and finance available for port terminal infrastructure development:

  • Debt can comprise conventional loans, debentures (loan certificates), bonds, and convertible preference shares. Interest payments (the cost of debt) can be expensive, and defaulting on contractual repayment obligations can result in the forfeiture of assets, depending on the terms of the debt agreement. In general, banks or other lenders are susceptible to the project assets and their potential market value. In evaluating an investment project, they assess the extent to which the project assets remain within the operating authority or company. Banks and other lenders are also strict when it comes to risk distribution. They favor a setting where all risks associated with the port infrastructure project are assumed and passed on to the appropriate actor. For example, lenders might insist on passing the risk to the other project participants through contracts, such as a construction, operation, and maintenance contract.
  • Shareholder funds in the form of ordinary shares or preference shares. They are similar to debt but with equity characteristics or shareholder reserves that are re-invested retained earnings. A diverse shareholding dilutes ownership relinquishing control to majority shareholders. The cost of a share is essentially measured as the required rate of return on the investment from shareholders. However, in the case of retained earnings, these funds are not a free source of finance, and the required rate of return is essentially the cost of equity because funds belong to equity investors, not the firm.
  • New equity issues, in the form of initial public offering (IPO; the first issuance of shares on a stock exchange) or a seasoned public offering (SPO) or a general public offering (GPO). Methods of issuing seasoned equity include the private placement of shares to a single or small group of investors, employee options, or a rights offering (a right to purchase shares with a price concession). A GPO is similar to an IPO but with generally lower underwriting costs. A most noteworthy feature of a GPO is that generally, the market identifies a GPO as a signal that management thinks the firm is overvalued. The required rate of return is lower than the correct rate of return, implying a cheap source of funds or the market has overestimated the firm’s future free cash flows. Risks for shareholders associated with shares as a finance source resides in how value is affected (gain/loss value) on the share trading market.
  • Lease agreements comprise pure operating leases, finance leases (in substance a loan), or sale and leaseback agreements. Terminal operation concession agreements are essentially long-term operational leases used extensively for private participation in ports. The government or a public authority holds the property rights of the facilities throughout the concession period and receives lease payments on the assets. The private partner bears the production and commercial risks, so it has an incentive to innovate, optimize, and improve its services. Terminal concession and lease-operate arrangements are common in landlord ports. The financial side of a concession agreement remains a balancing act. High concession fees, royalty payments, and revenue sharing stipulations are detrimental to returns on investment. They could decrease the investment potential of the incumbent terminal operator and deter future investors. Low payments could negatively affect the revenue base of the public (port) authority, so it can no longer support its landlord functions. Finance leases are becoming more difficult to justify due to increased focus on substance over form accounting treatment and vigilance against tax avoidance. The accounting treatment and favorable tax concessions are less evident with the adoption of international financial reporting standards.
  • Mergers and acquisitions. These comprise horizontal integration mergers with firms in the same line of business and vertical integration mergers with firms higher or lower in the value chain, such as between suppliers and customers. Besides, there are also conglomerate mergers whereby a merger occurs with a completely unrelated firm to realize diversification benefits and management buyouts. This can also involve a management buyout (MBO). MBOs are an extreme form of divestiture. The overriding objective of a merger is to create synergy, where the sum of the merged firm is greater than the sum of the individual (firm) parts. Economic value is generated through efficiencies, increased expertise, and greater access to funding. Notably, mergers and acquisitions have come under increased scrutiny because of anti-competitive and antitrust legislation.

In an MBO, incumbent management acquires a significant, if not majority, equity stake in the company for which they work. This refers to a transaction whereby executive managers of a business individually or jointly with financing institutions (mostly private equity or venture capital firms) buy the business from the entity which currently owns it.

Excluded from the above five sources of port terminal finance are fiscal and government funds associated with public policy and national commercial strategic objectives.

The last decades have seen a substantial expansion of terminal facilities that required the injection of capital coming from various public and private sources. The port terminal industry has privatized and internationalized to cope with this demand, establishing partnerships with financial institutions. As global trade matures, investment priorities are likely to shift towards upgrading existing facilities, particularly automation and digitalization.


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References

  • Rodrigue, J-P, T. Notteboom and A. Pallis (2011) “The Financialization of the Terminal and Port Industry: Revisiting Risk and Embeddedness”, Maritime Policy and Management. Vol 38, No. 2, pp. 191-213.
  • Roumboutsos, A. and Pallis A.A. (2010). Risks in Port Concessions: A Contextual Analysis and Allocation Methodology. 12th World Conference on Transport Research (WCTR), Lisbon, Portugal, July.
  • Theys C., Notteboom T.E., Pallis A.A., de Langen P.W. (2010). The economics behind the awarding of terminals in seaports: A research agenda. Research in Transportation Economics, 27, 10-18.
  • Further references to be added.