Airlines, lessors and banks all navigated through a transitory period following the financial crisis, which changed the landscape for aviation finance. Despite a tricky few years, banks and leasing companies became proficient at tapping into the new sources of liquidity that flooded into the sector seeking yield that was reduced or nonexistent in more traditional channels. That liquidity remains today as investors from private equity and insurance firms, fund managers and the capital markets, are attracted to the aviation sector by its fundamentally strong growth rate and long-term, real asset-based returns.
DVB’s Vincente Alava-Pons opines that such interest is driven by the lack of growth or stagnation in other industries, pointing to shipping as one obvious example. “Some industries are not performing as expected so money is shifting away from other industries, such as shipping and real estate, which have probably peaked,” he says. “But banks and investors are entering the aviation industry because assets have become more mainstream – recognized as steady, stable and liquid assets. They’re probably the most movable assets you can imagine but the industry is also attractive having experienced the longest positive cycle.” Despite signs that the positive cycle has tipped into a downcycle – albeit more of a slow correction than a fall – Boeing anticipates that stable growth and broad, diversified funding will continue to support efficient aircraft financing in the next year.
“The aircraft financing market remains healthy, with adequate commercial liquidity, providing a wide range of efficient options available for our customers,” said Tim Myers, president of Boeing Capital Corporation. “We expect another year of balanced funding for commercial airplane deliveries in 2019, mirroring the broader industry, primarily split between bank debt, capital markets and cash.”
According to its annual Current Aircraft Finance Market Outlook (CAFMO) report, released in December 2018, Boeing forecasts continued strong demand for new commercial airplanes in 2019, resulting in about $143 billion in deliveries by major manufacturers, which has the potential to grow to more than $180 billion by 2023. In addition to new aircraft delivery financing, Boeing estimates the secondary aircraft market will drive refinancing requirements in the range of $43bn per year.
‘In 2018, the market for used aircraft remained exceptionally resilient, with demand exceeding supply. The cargo market recovery has further stimulated the demand for freighter conversions, bolstering residual values. These factors should help support continued strength in the secondary financing market.’
“Driven by a growing understanding of aviation’s strong growth potential and the industry’s attractive returns, we continue to see innovations and first-time entrants into the market, providing increased capacity for funding new deliveries as well as pre-delivery payments, mezzanine debt financing and the secondary aircraft market,” Myers adds.
Boeing expects the funding mix for deliveries to be balanced between commercial bank debt and capital markets and cash. It adds that strong industry fundamentals are attracting more participants and investment in both new deliveries and the used aircraft market. Boeing predicts airlines and lessors to experience some of their lowest historical financing costs. The manufacturer also expects the capital markets to continue to grow, bolstered by unsecured borrowing.
Commercial bank funding for new aircraft deliveries reached $50bn in 2018. According to Boeing, the slowing pace of regulatory changes, combined with attractive risk-adjusted returns, has encouraged banks to deploy capital into the aviation sector. Statistics from Boeing suggest that the aviation banking market continues to spread out beyond the traditional confines of North America and Europe, with Asian banks now accounting for a major source of liquidity. ‘China and Japan accounts for more than 40 percent of all bank debt for new aircraft deliveries. This trend is expected to continue, with nearly 17,000 aircraft to be delivered into Asia over the next 20 years.’
Japanese banks are very active in this sector, specifically utilizing efficient equity financing structures such as JOLs and JOLCOs. Korean investors are also becoming more involved in the sector, attracted by dollar assets and structured products.
The entrance of new money into the sector has been positive for airlines and leasing companies, as well as banks in the beginning of the post-crisis period. There are a few signs that some of this money is beginning to consider a move back to more traditional channels but there is little evidence of a wholesale exit from the market at this point in time. Investors and new banks are making returns, have invested over the long term and are happy to stay. Airlines and leasing companies continue to benefit from this interest in the sector but some banks are feeling the pressure from such sustained investment.
“We have worked with some insurance companies as lenders into commercial loans, and we have also structured secured private placements sold to institutional investors,” says one banker who asked not to be identified. “The main issue today is the over-liquidity in the bank markets that drives the spread downward below the minimum level required by the institutional investor.”
Alava-Pons agrees to an extent that competition is impacting yields but states that the growth rate of the industry is feeding interest. “The perceived impression is that the risk-adjusted returns are still attractive but there is the realisation for credit transactions that yields are being compressed,” he says. “We are in a situation where new players have entered the market, realised the situation and have taken up a small part of the pie or pieces of pie. Whenever I speak to my competitors, they will say that they are really struggling to get any deals. The pie overall is increasing but the amount of players that want to eat from the pie is increasing faster.”
The impact of more restrictive capital requirements legislation on the aviation banking market has been debated in the industry for many years. The delay in the finalization and implementation of the Basel IV changes has allowed banks to continue lending without significant impediment to their business models. But that is still set to change.
Based on guidance issued late last year, secured aviation finance may be considered specialised finance. If this is the case, banks can continue to apply the Foundation and Advance Internal Ratings Based approach (A-IRB) for the calculation of credit risk for such loans, i.e. no change to the bank’s capital requirement calculation. For unsecured loans, however, banks will be required to allocate more capital to the loans thereby driving up the cost of those loans. The implementation date is January 1, 2022.
Banks – specifically European banks that followed A-IRB for their capital requirements -- have been preparing for big changes to their business model. This may not be as severe, however, if indeed banks can continue to use A-IRB for secured aviation loans.
If banks have to move away from AMA and allocate more capital to their aviation loans, NordLB’s Frank Wulf states the regulatory changes will make long-term lending “almost impossible”, resulting in an emphasis for the bank to focus more on short-term financing solutions as well as taking more originating and structuring roles for bank financing deals and preferring agent, security trustee and service agent roles to generate fee income.
He says: “It is alarming that in a world where politicians are telling us that there is not enough lending, that they take initiatives which could almost make it impossible to at least do what is actually required for the industry. You can argue and say leasing companies trade more these days, so for them a six-year loan could work on a narrowbody aircraft, but there are still a number of airlines that like certainty and want 12-year or even longer financing, which could see such financing becoming increasingly difficult [if A-IRB cannot be applied].”
“Change is inevitable,” says Dehouck. “You adapt to regulation. BNP Paribas is extremely well prepared in the sense that not only are we a big capital provider using our own balance sheet to the aviation sector for airlines as a resource, at the same time, we’re a big capital provider in arranging and structuring and distributing capital market products. We have one of the leading European US dollar distribution houses, which we believe is an advantage for us.”
Dehouck says that there is still some debate within the bank on how Basel IV will affect its book. “I think those questions just define the fact that Basel IV is unclear and has not been repriced in the market at all, for the time being,” he adds. “Furthermore, there is still enough liquidity, so it will be crazy to stop being active and/or to reprice at this juncture in this cycle. The worst scenario for the market, for our clients and for the manufacturers, would be that banks are forced to apply [Basel IV repricing] into a downturn market which would be disastrous. Unfortunately very negative unattended consequences are the byproducts of regulation.”
Natixis’ Bedaine-Renault agrees that there will be some changes: “Natixis is preparing for the change. Speaking more broadly, it is expected that Basel III may materialise in an increase of margins in order to compensate for the additional capital,” she says. “We don’t see it yet, and maybe it’s because it is considered as far away or maybe because some banks are not computing it today, but I think it’s worth inquiring what the impact is going to be here.”
DVB’s Alava-Pons says that banks should be increasing pricing but the over-liquidity in the market is creating a difficult environment.
“We’re trying to prepare for it and we should, by definition, increase pricing since we need to reserve more capital but it’s completely overcompensated in a negative way by the liquidity in the market,” he says. “We cannot overcompensate for the amount of excess liquidity in the market. It doesn’t mean that we’re not going to deal with it. Normally, every transaction DVB is subject to the same review, but then depending on how competitive priced it is, we may then take a smaller or a larger slice in the transaction.”
DVB has an advantage in certain transactions due to its experience and reputation for managing older assets. However, Alava-Pons admits that other lenders have adopted this strategy in such a crowded market “There’s only so much you can earn if the pricing is going down,” he explains. “It’s almost like a linear function – the lower the pricing goes, the more you have to distribute to the right parties. We take our banking relationships as seriously as our aviation relationships to make this work.”
He adds that the future of commercial banking could be certain companies becoming more like asset managers. That has been a trend in the recent past of course, when many bank owned aviation portfolios were effectively leasing companies that were subsequently spun off. Banks will undoubtedly need to readdress their long-term strategies for aviation investment.
“We are moving towards a strategy that is not just lending, but which provides more solutions to our clients, which is notably investment banking, but we are trying to work on more optimised solutions with our teams looking at the whole capital structure right up to the equity,” says Bedaine- Renault of Natixis. We are looking at the value-add, this is notably dictated by Basel III, but also by the fact that technology is changing our work environment. If you are not changing the way you approach business, then eventually, you may have some issues. Natixis’ latest Strategic Plan focuses on deepening client relationships, and also digitalizing its way of working in order to optimize not only the client experience but also the value-add that we are trying to build.”
NordLB’s Wulf points out that even without the full implementation of Basel IV, banks are struggling to be competitive in the long-term financing space. “In this current funding environment, banks are actually less competitive on long-term financing, so we’re trying to be more competitive also by using more innovative structures on the shorter end of the market, and that usually then channels again into portfolio transactions and into warehouses. We’re quite active on the PDP side and on some bridge facilities, which is where we will still be of value for our partners.”
The changing strategies being introduced gradually by advanced Basel banks are being viewed by other non-Basel banks as an opportunity to attract more business. Bank of China and Korean Development Bank, spoken to for this report, both highlighted the availability of their balance sheets for short and long-term aviation finance.
“The first impact of Basel IV will presumably be a widening of pricing conditions for unsecured loans and secured loans in the event they were not exempted,” says Bank of China’s Fiscel. “Most banks would likely be required to set more equity aside when providing long-term financing, which would have a direct impact on debt margins. The most impacted banks would be those that have been using the advanced internal ratings-based methodology as opposed to banks that have been using the more conservative, standard methodology, who are expected to be less impacted. The question is when the advanced-methodology banks will begin pressing back and absorbing or passing on those extra costs resulting from the implementation in 2022 of the new regulation [if the loans are not exempted].”
Another prominent banker at a large European bank states confidently that long-term secured financing will be affected following the implementation of Basel IV where more capital is required against those loans. “The banks will need to distribute more widely their loans to new channels, such as insurance companies, asset managers and pension funds, and some new structures will be developed such as the structured/secured private placements,” they say. “ECA and US Ex-Im Bank may come back sooner rather than later if commercial bank financing becomes much more expensive and if the export credit agencies re-open their business. The new structures, such as AFIC, Balthazar and CRI will supplement commercial loans and the capital markets will continue to grow.”
For now, the bank market remains fully open for airlines and leasing companies, with tough competition keeping margins compressed. Airlines specifically are capitalising on the liquid market to finance their deliveries but also to rationalise their funding mix. One airline executive reports that the company is taking bank debt while it can get it, since the offers are flooding in – more so since they have posted solid profits over three years: “When you hit a speed bump, all the offers can suddenly disappear, so you have to take bank financing when it is offered because the leasing companies will always be there,” he says.
Leasing companies are being used for financing more than ever before. DVB’s Alava-Pons observes that airlines have so much choice that they are making serious demands, specifically in saleleaseback transactions: “Airlines can now actually say that they are only going to award a mandate if we take a minimum of five aircraft and provide PDP,” he says. “We want to provide PDP financing but it’s almost a must to win certain business. Leasing companies can only provide PDP if they have a strong parent or if they have strong banking relationships. And lessors can only offer five to six aircraft in one go if you have the capital muscle to do so. An airline will only look at you seriously if you can offer scale but also competitively price the lease. Capital/equity, banking relationships and access to funding (e.g. capital markets) is absolutely key.”
The competitive nature of the sale-leaseback market driving ultra-low lease rate factors has grown so fierce that pricing is only one of the many sets of demands from airlines pressing their advantage in the current environment. PDP funding is attractive since purchase agreements are so expensive – 30% of the final purchase price of an aircraft – and financing can cover all of that cost, freeing equity and lowering weighted average cost of capital. However, PDP financing can be difficult to attain, even under normal market conditions. While most airlines use cash to secure their delivery slots, some airlines seem to be pushing from a position of strength to secure PDP financing.
AerCap’s Kelly warns that rising interest rates may result in less liquidity for certain airlines, particularly those with PDPs. “PDPs are a huge bill,” he says. “Airlines have been complacent about PDPs. When the market turns, PDP funding is the hardest thing to secure. If things keep going the way they are, some airlines will struggle a bit with PDPs.”
Bank of China’s Fiscel sees PDP funding as largely now being addressed by the leasing companies. GECAS has been a regular provider of PDP financing for its clients. In January 2018, GECAS arranged a sale-leaseback along with PDP financing for Viva Air in a transaction for ten A320ceo aircraft. CALC too has provided PDP financing for Viva Air in January in another purchase and leaseback agreement for five Airbus A320-200ceo series aircraft. And in July, GECAS signed another contract with Okay Airways for the purchase-and-leaseback with PDP financing of two 737 MAX 8s. These are only examples of public deals; the true level of lessor support is much higher.
PDP financing is a simple concept but a relatively complex instrument, according to Fiscel. “It’s a fairly simple short-term financing tool. From a security standpoint, however, this complex instrument demands a careful analysis; the lending to an airline willing to secure a delivery slot significantly differs from a more traditional aircraft financing solution with an asset security. Although usually full recourse to the obligor, a PDP facility is only secured by a partial assignment of the Purchase Agreement, entitling creditors to take delivery of the aircraft should the airline default.
The structure therefore calls for caution: banks – which are not as equipped as operating lessors with dedicated technical and marketing teams – will wish to avoid having to take delivery of an aircraft. As consequence, lenders will focus on the transferability of the purchase contract to another operator, hence careful assessing the value of the assignable price at which they may be able to step in.”
Fiscel further explains that the purchase price of an aircraft with similar specifications can vary widely between airlines depending on the order size or indeed the relationship between the airline and the manufacturer.
“For a financier, it is often difficult to get clarity on the net purchase price which was agreed to be paid by the airline. An airline may manage to negotiate more competitive terms and contractually agree to pay less than other operators for an aircraft with similar specifications. However, the manufacturer will be reluctant to assign to lenders the full benefit of the purchase agreement, setting the price – at which the lender may be able to step in post airline default – at a value significantly greater than the actual net price negotiated by the airline.”
He adds: “The concept of a different step-in price somewhat limits the ability of banks to quickly remarket the aircraft position, and may reduce the incentive for the manufacturer to exercise the call option that is often requested. This does make PDP funding challenging as lenders have to be comfortable with both the step-in price agreed with manufacturer and the level of equity paid by the airline which is essentially the bank’s protection in a default situation, while assessing the value of that particular delivery slot a number of years out.”
PDP financing is therefore rather unappealing for banks and is usually reserved for strong banking relationships or those with balance sheets and the ability to attract new clients. “From that perspective, it may be simpler to fulfil PDP with unsecured financing, albeit at higher margins,” says Fiscel. “Interestingly, we have recently seen many operators fulfilling their PDP needs through revolving credit facilities secured by unencumbered aircraft or engines.”
Lessors, however, are equipped both to take delivery of aircraft and to assess the value of a slot and the manufacturer views the lessor as a client so the lessor would be able to secure a lower sellable price akin to an airline. Equally, for lessors seeking to build market share and which have not placed direct aircraft orders, PDP financings are a way to build a relationship with an airline, attract business away from a competitor and a way to secure earlier delivery slots.
“Up to mid- 2000s, with major manufacturers’ support, the banking market was very supportive of the PDP financing; the interest has slightly faded away since, as a result of the conditions imposed by manufacturers and several years of airlines’ record profits,” says Fiscel. “Most airlines still use cash for their PDP obligations but as cash reserves will most likely shrink, I foresee an increased need for PDP financing support.”
Some banks are trying to become more innovative when it comes to PDP financing. As mentioned above, NordLB has been quite active in PDP finance. In May 2018, the bank’s Singapore branch acted as mandated lead arranger (MLA), lender, security trustee and facility agent for a working capital loan of approximately £300 million to PAAL Cetus Company – a subsidiary of Ping An – to finance PDP payments for nine aircraft on lease to Aeromexico. Industrial and Commercial Bank of China acted as the initial lender and MLA. This deal adopted a specific structure that balances between a conventional PDP finance and a working capital loan, which sits on top of a lessor PDP financing to the lessee. Such alternative structures – including options to transfer to special purpose vehicles or the lender can make PDP financing attractive and reduce risk for lenders.
Export credit agency (ECA)-supported transactions continue to be well below historical levels. At first sight, this is not that unusual since the industry is awash with liquidity and airlines are accessing cheap financing elsewhere. However, the levels are much lower than in previous upcycles since both major aircraft manufacturers still do not have full access to their domestic ECAs.
The European ECAs, although open for business, are curtailed in supporting large ticket Airbus assets unless they can be absolutely sure and provide evidence that the sale contract was in no way connected to the ongoing fraud investigation by the UK Serious Fraud Office (SFO). UK Export Finance (UKEF), however, has been actively supporting Rolls-Royce engines fitted onto Boeing aircraft. In October, 2017, Norwegian Air Shuttle (NAS) closed a Japanese Operation Lease with Call Option (JOLCO) financing of one new 787-9, powered by Rolls-Royce Trent engines. Due to the Rolls-Royce engine component, UKEF guaranteed the debt portion of the deal. More recently, in September 2018, EL AL Israel Airlines funded one Rolls-Royce-powered 787 with a $125 million loan from Citibank with support from UK Export Finance (UKEF). UKEF fully intends to continue with an extension of such support for Rolls-Royce-powered Boeing aircraft.
SACE, the Italian export credit agency, has also begun to support some aviation assets, guaranteeing financing for one Boeing aircraft delivered to SunExpress in late 2017.
The US has been without a fully functioning ECA for nearly four years, which is as long as the US Export-Import (Ex-Im) Bank has lacked a quorum for its Board of Directors. Although the US President’s four nominees for the Board have been awaiting Senate confirmation since 2017, no action has been taken, despite strong bipartisan support. The US Government shutdown over the holiday period makes it unlikely that this issue will be resolved until further into 2019.
In 2014, Ex-Im Bank support for Boeing accounted for 40% of all of its transactions. Today that figure is below 1%. Aircraft Finance Insurance Consortium (AFIC)-backed sources of finance have emerged during that time to fill this vacuum. AFIC, which is a syndicate of insurance companies, has financed more than 30 aircraft in 2018, twice the volume of its initial year of operations.
In 2018, AFIC closed its largest portfolio financing to date for Ethiopian Airlines, which comprised eight aircraft – five Boeing 737MAX-8s and three Boeing 777F cargo aircraft. The deal also represented AFIC’s largest amount of financing for an airline in 2018, utilizing over $600 million of AFIC supported senior debt financing. The transaction was funded by Societe Generale, ING and SMBC. The AFIC supported financing of the five 737MAX aircraft was combined with a junior loan financing furnished by Investec to provide Ethiopian Airlines with 95% financing for the aircraft at an attractive all-in cost. The first aircraft was delivered on June 30, 2018 and the last aircraft was delivered on December 29, 2018.
No doubt buoyed by the success of the AFIC product, Marsh S.A.S – a different team from Marsh LLC which is the broker for all AFIC deals, which has separate reporting lines and appropriate Chinese walls in place -- is working with Airbus and another insurance syndicate, dubbed Project Balthazar, which will assist some airlines with backing for Airbus assets. The first deal is reported to be close to finalization.
Despite the success and the volume the insurance-backed sources are providing to the market, Boeing states that the new supported sources of finance are “not a satisfactory replacement for the U.S. Export-Import Bank, which remains a critical tool, particularly in the event that commercial financing conditions decline”.
Boeing suggests that export credit agency funding will continue to account for a “small share” of aircraft financing in 2019 because “markets are anticipated to remain healthy and resilient”. However, should the market take a deeper downturn, however, as some industry players predict that the ECAs will once again become more in demand. This is, of course, their raison d’être: namely, to be a counter-cyclical source of finance.
Since only very few rated airlines are able to access the public bond markets, most aircraft will be financed with secured loans, AFIC supported debt or other efficient equity products. The most popular and available low-cost equity structures in the aviation market today are JOLs and French Tax Leases. The latter are only available for the very few airlines that capitalise on the Sino-French double tax treaty. A standout deal from 2018 that incorporated the French lease for two 777 Freighter aircraft on lease to Turkish Airlines, with debt that was supported by AFIC.
By contrast, the JOL and JOLCO products, have been used effectively by many airlines for many years. The past year has seen a significant uptick in transactions as the Japanese equity market ramps up its investment into aviation assets.
One of the most impressive deals in 2018 was a repeat deal from British Airways (BA), which was the $608 million debt financing of 11 new aircraft – two 787-8s, two 787-9s and seven A320neos – using an enhanced equipment trust certificate (EETC) structure that incorporated Japanese equity in a dual JOLCO structure.
The ramp-up in liquidity from Japanese investors through newly active Japanese banks has caused changes in the market relative to how it was viewed twenty years ago during its last boom time.
“In the late 1990s and 2000s, Japanese equity investors would target the very best credits, focusing on new equipment and the most liquid aircraft, usually narrowbodies” says Fiscel. “Working alongside Japanese equity would ensure a stringent pre-screening process by the Japanese arrangers and investors. Adding to good quality credits and assets, a healthy equity buffer usually set around 25-30% would ensure risk-remote debt opportunity. Today, with increased investors’ appetite, the Japanese market remains a very active resource; Japanese structures have become more widely available, including for second-tier credits and/or on less liquid second-hand widebody aircraft. Interestingly, we note that JOL-based offers increasing compete against more traditional leasing solutions in sale and lease back transactions.”
FPG Amentum and ORIX Aviation have already stated that they are heavy JOLCO users, and many more leasing companies that have the relationships with Japanese banks – ACG for example – also are taking advantage of the renewed equity interest from Japan. As a result, this product will remain popular even though it is limited to Japanese banks and certain jurisdictions.
ABL Aviation has recently partnered with SBI Group – one of the largest financial companies in Japan – to focus on opportunities in this space. According to Ali Ben Lmadani, chief executive officer of ABL Aviation: “Recent large JOLCO transactions with high-quality airlines like Vietjet, Ethiopian, Emirates and SAS demonstrate the insatiable equity appetite in the Japanese tax lease market. The JOL market, too, remains robust and more and more players are entering this market. We look forward to expand our JOL and JOLCOs investments with the help of the SBI network of banks.”
Bank loans remain prevalent for airlines and lessors, with pricing remaining at historically low levels and covenants being loosened in response to market demands and competition.
Leasing companies are becoming attuned to securing debt at very low levels in revolving credit facilities and in more conventional but large scale financing. On the secured debt side in 2018, some of the stand out deals came from leasing companies in Asia. Vermillion, the aircraft leasing joint venture between CK Asset Holdings and MC Aviation Partners, refinanced a $950 million secured loan facility. CDB Aviation also successfully closed a $700 million seven-year secured financing facility that covered a fleet of 19 Airbus and Boeing aircraft.
In June, BBAM closed a $1.3bn non-recourse aircraft secured financing to support its acquisition of a pool of 65 aircraft from AirAsia. This deal – split into two facilities: a two tranche $574.5million facility taken by Fly and a two-tranche $695.7 million facility for BBAM subsidiary, Incline – was the largest secured aircraft term loan in Asia, which was syndicated to 19 banks. In the US, Wings Capital closed a $500 million secured loan facility that has the option of being upsized to $750 million with a syndicate of six banks.
In one of the largest deals of the year, in May 2018, Macquarie AirFinance closed a $3 billion non-recourse aircraft secured term loan facility, using a pool of 133 aircraft and two engines as collateral, coupled with a $1 billion unsecured revolver in a wide-ranging restructuring of its entire financing arrangements that succeeded in diversifying its funding sources and optimizing its unencumbered and encumbered asset pool. The deal refinanced and upsized a previous $1.8bn Spitfire term loan used to acquire a portfolio of aircraft from AWAS in 2016.
There is an observed trend for warehouse facilities as new lessors and investors build up aircraft portfolios to refinance into the very popular aviation asset backed securitisation (ABS) market.
Most of the large leasing companies capitalised on the buoyant financing markets in 2018 to expand or upside existing or indeed sign new revolving credit facilities, many of which were unsecured.
BOC Aviation upsized an oversubscribed unsecured syndicated loan from a launch amount of $500 million to $750 million, with a syndicate of 19 banks.
In March 2018, AerCap increased its $600 million unsecured revolver to $950million and extended it for four years. In May, ALC extended its unsecured revolver to 2022 and amended the total revolving commitments to $4.5 billion from $3.9 billion, priced at LIBOR plus 105 basis points with a 20 basis point facility fee. Later in the year, DAE signed a new unsecured $750 million five-year revolver with a group of nine international banks, while Aircastle upsized its revolver to $800 million from $675 million and extended its tenor by two years.
The move to unsecured financing is very attractive for leasing companies in particular since having unencumbered assets is viewed favourably by the rating agencies when considering enhancements to ratings, especially to investment grade, as it allows them to access much more favourable pricing in the capital markets.
The capital markets financed almost 28% of new aircraft deliveries in 2018, with most of that financing accessed by lessors. Since there are only very few airlines that are rated today, it is only a very few that regularly enter the capital markets. The US carriers are however prolific issuers, specifically to tap the EETC market, while other European carriers and some Chinese airlines have issued senior bonds for working capital and to finance their aircraft deliveries. Access to the capital markets for leasing companies, however, has also exploded in recent years as lessors have found more ways to raise money in this capital intensive business.
Many lessors issue senior secured, and increasingly, unsecured bonds, with most of the largest lessors tapping the markets in 2018 in large amounts. AerCap and ALC regularly tap the senior unsecured bond market with issuances of over $1bn. ALC has also initiated a $15bn medium term note (MTN) programme to issue unsecured, fixed and floating rate notes more efficiently. Aircastle, SMBC Aviation Capital, ACG and DAE have all issued unsecured notes in 2018.
An advantage these particular leasing companies have when they are raising debt is that they are rated as investment grade by the corporate rating agencies (DAE is not yet rated investment grade by all agencies but it is a stated goal). This is a major achievement for a leasing company and gives them access to much cheaper funding.
NordLB’s Wulf observes that it is “absolutely right” that there has been a lot of unsecured capital markets action because “it’s easier and simpler, structures have been well-developed, documentation has been wellestablished, so it’s an easy process,” he says. “Lessors are also seeking to have 50% to 70% of their capital requirements in the unsecured space.”
DAE is on the path to becoming investment grade rated by all the credit rating agencies. DAE has set as a goal becoming investment grade rated by all the credit rating agencies. “At our current scale and the scale at which we want to be, we need the access of investment grade rated pools of capital,” says Tarapore. “Our metrics are already very strong on just about every dimension with one exception – the percentage of unsecured funding. In 2018, we dramatically increased our unsecured funding percentage and in 2019 we are scheduled to increase it further.”
The conventional wisdom is that rating agencies, among other requirements, like to see lessors ensure no more than 30% of their assets are encumbered to be considered for an investment grade rating. The reality, however, is more nuanced.
“We look at each case individually – many larger lessors are way more than that,” says S&P’s Snyder. “Obviously we do like to see a lot of unencumbered assets because historically what happened with ILFC during the financial crisis, when they had a substantial amount of shortterm debt maturities, but they had a lot of unencumbered aircraft, they were able to refinance those assets using them as collateral.”
Kroll Bond Rating Agency also has no hard and fast rules for awarding investment grade ratings when observing secured versus unsecured debt. “Such ratios don’t apply to all leasing companies because it is very much dependent on the structure of their leases,” says Marjan Riggi. “We take the view that if a lessor is an orderbook player that they should have almost all of their assets unencumbered because they need money to finance PDPs and they need much more flexibility around the aircraft because delivery dates may vary from plan. But if a leasing company was more sale-leaseback focused, it is healthier to have a higher level of secured aircraft financing because those deals are amortising and match-funded.”
Riggi adds that raising debt in the unsecured bond markets with three, five or seven-year money, is typically not going to match the lessor’s debt liabilities. “For orderbook lessors, one of the major ratios we assess is their average remaining lease term and debt maturity buckets,” she adds, “because the longer they both are, the closer they are to match funding.”
Rating agencies also ensure that they examine lessors debt maturities versus their financing needs to ensure they are spread out and are manageable, even during periods of stress.
“Lessors who tend to access the unsecured capital markets do spread out their maturities between shorter and longer-term debt,” adds Snyder. “They are very conscious of how to spread out three, five, seven and even 10-year notes when they access the capital markets.”
AerCap’s Kelly says that whether the split between encumbered and unencumbered assets makes sense is irrelevant. For him what is important is having the ability to tap into the biggest market in the world – the US unsecured bond market. “You should naturally have a bigger proportion of your debt in that market than other markets,” he says, stressing however the vital importance of maintaining relationships with other lenders and playing in more markets. “It’s crucial to have diversified funding sources but you can only have alternative sources if you’re active in other markets,” Kelly adds. “You can’t just show up in Tokyo or Taipei for the first time in several years, never having done a deal and ask for money. That discussion is only going to go one way.
I believe that there’s a real benefit to having a significant amount of secured debt. I also believe that you have to have those relationships and they have to be active. But for a balance sheet of our size where we’re spending $6 billion a year on capex, and $3 to $4 billion a year of refinancing, it’s not feasible to have the majority of the funding coming from $100, $200, $300 million dollar deals. You have to be able to hit the market where you can do a billion in an afternoon.”
ORIX Aviation’s James Meyler agrees that the split ratio is largely irrelevant and the focus should be more on the tenor. “The term of the debt available is more important than just the percentage because that clearly is going to give the ability to withstand a prolonged period of correction,” he says. “Having multiple capital sources with good tenor, which is well-staggered, I believe is more important than a hard 70/30 split on unsecured/secured.”
Meyler believes that lessors should issue debt closer to five years to be able to withstand a potential cycle downturn. “For a three-year issuance, by the time you’ve absorbed your costs on issuing those bonds and the various structuring/ investment banking and legal fees, the amortisation of those costs over the short period of three years doesn’t make it particularly attractive. Having said that, as part of a programme where you have varying maturities, you cannot have them all five years. If you’re issuing every six months, you probably want some variances in that.”
Matched funding is deemed to be preferable to ensure a steady return on long-dated assets. However, industry sources state that some players – mostly new entrants – are not learning from past mistakes made by the great Guinness Peat Aviation (GPA) and later ILFC, and have succeeded in raising very low priced debt over short three, or five years to finance 12-year leases.
“When those loans need to be rolled over, interest rates have gone up and the lease margin has been squeezed,” says Robert Martin, CEO of BOC Aviation. “Only now are some lessors realising that they’re either loss making or very marginal in profit making. This is the same mistake that was made in 2008 by ILFC and CIT, and before them by GPA in 1990, when they had relied on either short-term commercial paper or had big debt balloons mature at once. The risk depends on what mix of tenors people are using to issue in debt securities, so we’re very careful. We’ve bonds spread across the whole curve up to 10 years. Some of our competitors are just doing three-year deals, and even with call options at year one.”
Generally though, banks and rating agencies seem confident with the ability of leasing companies to get their funding mix right.
When asked about a potential risk related to aircraft leasing companies that fund themselves with debt maturing significantly earlier than the useful life of their financed assets, BNP Paribas’s Dehouck says: “Overall, we’re not worried. “When we look at how the lessors are matching their financing with their liabilities, there are certainties, which attach to their aircraft. So, we are not looking at the fact that aircraft have 25 years of useful life. We’re looking at cashflows that are committed and those tend to be five, six, seven years in that range. It seems to us to be fair and relevant for the lessors to fund themselves on those type of maturities. [With] a mix of three, of five, of seven and 10 years, the average funding maturities gets to where the lease maturities are.”
Enhanced Equipment Trust Certificates (EETC) remain a popular way to finance large new aircraft portfolios but in 2018, only four noteworthy deals came to market (totalling $1.8bn – less than half the 2017 issuance) – United Airlines in January, American Airlines and Spirit Airlines both offered privately-placed EETCs in 2018, as well as BA in March in the first non-US EETC deal brought to market in some time.
The trend for EETC transactions to be issued with a AA senior tranche continued in 2018, achieving superior pricing on the notes as well as satisfying investor demand for more secure paper. Airlines are tapping into the private placed market more so than in other years in an attempt to diversify their investor base and capture demand for paper secured on vintage aircraft – as in the case of American Airlines, but also to capture demand for less senior paper as in the case of Spirit Airlines who added two C tranches of notes to two older EETC transactions. The American and Sprit transactions were both reported as oversubscribed and achieving a very satisfactory blended yield.
Leasing companies have become more and more attuned to the use of the ABS product. Issuance has blossomed since the markets restarted around 2014. In 2018, 14 separate deals totalling $7.583bn in volume were closed successfully. This can be compared to 12 deals totalling $6.602bn in 2017, seven deals totalling $4.151bn in 2016, five deals worth $3.659bn in 2015 and six deals, totalling $3.362bn, in 2014.
“Over the last couple of years, there’s been much more investment into the aircraft ABS space,” says Anthony Nocera, senior managing director of ABS commercial, Kroll Bond Rating Agency. “Part of this is because investors are looking for yield relative to the rating, the single-A and triple-B rating. Aircraft ABS is a very unique asset class – it incorporates complicated assets overlaid with a somewhat complicated structure – which takes a lot of diligence and education to become comfortable with this type of risk.”
At present, those investors that have examined it and invested already consider it to be a very attractive product to buy into, especially on the A-notes, which have an excellent performance history over many years. “It certainly seems a reasonable alternative to what else is available and whatever else is going to be available,” says Meyler, adding that if the pricing structure does change in a rising interest rate environment, those same investors will need to decide “whether or not they want to get paid more for that risk”.
ABS paper – particularly the A notes – are pricing much more tightly at approximately one percent over US treasuries, which gives rise to the question as to whether investors are being adequately rewarded for a relatively illiquid investment.
For Dehouck, the pricing is a result of the current market dynamics and the search for alternative investments. “The reality is, if interest rates do increase, ABS pricing should increase. At some point, bond investors will see other alternative classes of assets that might be better priced or priced at the same level but with better risk adjustments. But as of October 2018, we didn’t see any pullback.”
ABS structures are also being utilised for aero engines as well as aircraft. In 2018, Willis Lease Finance closed West IV, its fifth ABS transaction. “WEST IV was very heavily oversubscribed,” says Dan Coulcher, SVP and chief commercial officer for EMEA at Willis Lease Finance. “We expect ABS structures to be a financing option for Willis for many years to come. The fact that we’ve managed to do five in what is considered quite a niche industry shows that the market has good appetite for it and we believe the residuals of engines are stronger than aircraft; they just require a lot more management. That will continue. The low interest rate environment has driven a lot of funding into aviation assets for people searching for yield. If interest rates went up enough, maybe that means savers will start pulling out, but we haven’t seen that.”
The vast majority of those interviewed for this report believe that the aviation ABS market will remain active into 2019 despite rising interest rates and increased volatility that may impact pricing. As a proportion of the whole, approximately $200bn ABS market, aviation notes comprises a very small fraction of that with only $7.6bn issued in 2018, which was a record year. “This is a drop in the ocean,” says Mizhuo’s Srinivasan, “there is a lot of room to grow.”
Robert Korn, CEO of Carlyle Aviation Partners, which has issued many ABS deals over the past few years, sees that interest rates are rising and impacting prices of each tranche of debt but states confidently that “there is no lack of investor interest or capital”.
The aviation ABS product has evolved over the past year to introduce tradable equity or E note sales – initiated by the GECAS STARR and ALC Thunderbolt II deals, followed by Castlelake’s two CLAS transactions and BBAM’s inaugural Horizon ABS deal. The idea is to create more liquidity in E notes and the secondary paper but this development is at the very beginning of its evolution, and more tradable deals are required before a substantial market can be created.
“We are just at the tip of the iceberg here,” adds Srinivasan. “There have only been three deals on the tradable equity side, with maybe 20 investors on each equity deal. As that market grows and some of the efforts by lessors to become more transparent are proven, people will understand more of what goes into the model, what are we looking for in terms of IRR, and they will be able to effectively opine on lease rate renewals.
They will be able to haircut sale prices. They’re going in with their eyes wide open. They will understand the potential downside and the potential upside. Investors are beginning to appreciate the fact that this is a longer term investment and the fact that it’s tradable means they can get out of it if they want to, which wasn’t possible in the past with traditional E note sales to single investors because they had to either find a single buyer of the e note or sell the planes.”
John Plueger, CEO of ALC, is confident that having a tradable equity product will attract more investors to the aviation ABS market. “Although it is easier to get debt investors than equity investors, it is clear to me that this is an untapped source of capital. The best way to attract investors to any market is to show more liquidity, a larger marketplace, a tradeable instrument that they can get in and get out of. I think we’ve created that with Thunderbolt II. We’re very bullish on this product and we held a special investor day session where we talked about the importance of transparency. That session was very well-attended, with a high degree of interest. We think we’ve unlocked and opened the door here. And I do believe we’ll continue to see a good, robust ABS market community next year.”
Not everyone is convinced that the tradable E-note market is feasible as a working market. “It is possible to trade E notes technically, but it is really illiquid and these notes barely trade. Some dealers send runs but they tend to be axes rather than real markets,” says Bedaine-Renault from Natixis.
The key to the success of this secondary market is transparency. This is a significant debate in the industry due to the obscurity of certain details in aircraft transactions. These range from aircraft purchase prices for new aircraft deliveries for PDP finance right down to the secondary purchase prices for aircraft in secured vehicles such as ABS structures. Although there is general agreement that there is a lack of transparency on aircraft values that are subject to actual trades, there is also a general acceptance that this will not be made public soon. That could be starting to change in the ABS market at least.
In the Thunderbolt I transaction, which closed in 2017, ALC added a revolutionary earn-out structure, where equity partners buy-in at a certain level where they would expect to generate a return of the FlightAscend forward curve of both lease rates and sales values. This means that if ALC outperformed these market lease rates and betterthan- market sales prices, the investors and ALC would share in the upside. The bondholders in TBOLT I also had a similar benefit since at the point of most risk in any ABS transaction – when leases expire – the servicer, ALC, was incentivised to perform well. This structure relies on ALC disclosing the lease and/or sale price to its investors. Thunderbolt II built on this structure to enhance transparency further for equity investors as well.
The aviation industry has traditionally shrouded its deals in secrecy; airlines and operators rarely if ever publicise the purchase price of their aircraft, whether from manufacturers nor in the secondary market, or disclose the pricing of their financing agreements or lease rates. For ALC, the only piece of information they agreed to be kept secret is the individual lease rate with an individual airline, which is a private contract.
The Thunderbolt II deal team designed a financial model that discloses information, including lease expiration dates, maintenance cashflows, top-up liabilities at lease expiry, and even lease rates on a pooled basis. Moreover, the model tells the investor exactly how much equity sits behind the bonds as well as exactly how much the servicer makes and how much the equity holders make for their different roles in this structure. This information allows investors to sensitise the model to assess any scenarios that they want to run to track predicted performance.
MUFG’s Olivier Trauchessec sees the e note market as very promising. “I like the structure but overall I like the broader theme, which is to try to be more transparent. That’s what investors are looking for; they want to be able to trade in and out of securities if and when they need to, but they need transparency on future performance to be able to do so. The more trading there is, the more investors you’ll see.”
Despite the shallow, fledgling market, some trading is picking up.
“We are seeing an increase in activity in the sale of E notes,” says Standard Chartered’s Corr. “Historically, it has not been a very deep market, but it is deepening with innovations such as distributed equity structures. That will continue particularly as new investors come into the sector – there is certainly renewed interest from Asia for this paper.”
Chinese lessor, CALC, launched its own debut ABS vehicle in January 2018, which was also China’s first ABS denominated and settled in foreign currency, and listed on the Shanghai Stock Exchange.
“CALC was able to bring in a lot of new ABS buyers,” says CEO Mike Poon. “Although the interest rates have risen, the ABS product in the aviation market is still very attractive, especially for this long term pension money extension. Compared to other alternative investments, compared to other products in terms of the security and cash flow certainty, the aviation ABS aircraft product is still the most reliable and robust income stream they’re looking for. So, I’m still very optimistic for more ABS players in this market. Of course, the pricing may be slightly different year by year, but the ABS buyers find this product really attractive compared to alternatives.”
For GECAS’ Declan Kelly, although he expects interest rates to have an impact on ABS pricing in future deals, for him the greater concern at the moment is the quality of the asset pool in some ABS transactions. “The growth of the ABS market has been phenomenal,” he says. “But interest rates are going to have a major impact on it. There is still a large investment pool coming in but on the flip side, can people find the right aircraft? I’m more worried about the quality of the assets being put into them. A slight premium is being paid to source assets to go into those products, which is what you need to be careful of.”
There is general agreement in the marketplace that the popularity of the ABS market and the ways in which the assets in the portfolios are appraised are driving up valuations of aircraft. “Finance drives asset values in any asset class,” says Wings Capital’s Hannahs, “If finance is easy and liquidity is broad, people find it easier to pay more.”
Leasing companies have been capitalising on the wall of liquidity to expand beyond their balance sheets and set up new joint venture companies, or sidecars, with new partners to invest and finance aviation assets. Notable deals this year include CALC’s China Aircraft Global (CAG), a $1.25bn CALC-sponsored sidecar formed with four institutional co-investors, which plans to invest over six years in a portfolio of new commercial aircraft on lease to global airlines. Poon described CAG as the “perfect structure for a lessor to maximise its capital efficiency” whilst retaining client relationships and securing management fees.
In 2018, Avolon set up a new joint venture agreement with Cinda Financial Leasing called Jade Aviation, which acquired seven aircraft from Avolon for $337 million. Avolon retained 20% equity in Jade Aviation and has committed $17.2 million in equity to help grow the portfolio. Standard Chartered set up SDH Wings International in 2017, which Kieran Corr says has been very successful to date: “This is an exciting development because it allowed new capital to come into the sector and partner with people with proven leasing capabilities – it’s almost a transfer of industry know-how. It’s a way for new entrants to learn about the leasing sector and develop their own infrastructure in time.”
SMBC Aviation Capital’s Peter Barrett is more stoic: “They’re a good thing if they work,” he says. “There have been many over the years and some frankly haven’t played out well at all. You need to have an aligned interest between the leasing company and the investor. If you have a leasing company who wants to do XYZ and an investor that wants to achieve ABC, keeping those two interests together for a long period of time doesn’t happen that often. Sometimes it does but it often tends to diverge. It depends on the individual circumstances.”
There is also the risk of conflicting interests with sidecars since leasing companies will manage products it owns on its own balance sheet and assets it manages for its shareholders. The challenge for the manager is to define the split between the allocations of assets to the company portfolio and the managed sidecar. “You need to avoid adverse selection,” says Hannahs, who has managed several sidecars during his career. “Wings managed portfolios were created to allow us to expand our capital base as our shareholders own the sidecar and we manage it. If you have an independent party that you are managing assets for, there can be tension to be managed.”
As an asset manager and lessor, ORIX Aviation has been successfully managing co-investment, or so-called sidecar investments for over 15 years, having set up its first JV with Carlyle in 2003. “We did multiple portfolio JVs throughout the 2000s with Cargill, Magnetar and most recently with Merx,” says Meyler. “For us, certainly, it’s part of our business model as an asset manager but an asset manager with a balance sheet. Clearly, we want equity in the deals and we want to be getting the return of our investment above just fees. That works very well for us.
If I was an investor coming into the market, I would be very happy to pay a management fee to a platform such as ORIX Aviation to have huge resources available to see it through a cycle and share the equity risk. That makes an awful lot more sense and that will continue because people will always want to invest in leasing.”