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The aviation industry’s famously long benign period of growth, now referred to as a “supercycle”, is slowly coming to an end. Barring any exogeneous market shocks, the industry is expecting a softer rather than a hard landing, at least for now.

The aviation industry remains awash with liquidity as investors continue to search for yield as interest rates remain at ultra-low levels. However, nervousness remains. Airline bankruptcies have seen an uptick in 2019, demonstrating that airline credit risk is clearly increasing, with some airlines addressing capacity issues and reducing growth plans heading into 2020. 

The market picture today is much more complex than in previous years, primarily due to the distortion caused by the grounding of the Boeing 737MAX in March 2019 with still no firm date for its return to service. Aircraft lessors are enjoying a short-term bounce in demand due to the absence of the expected MAX capacity, with airlines seeking to extend leases and secure short-term lift. The experienced lessors are keeping a sharp eye on those building headwinds to ensure they benefit from opportunities both now and once the market turns in earnest. 

Macroeconomic and geopolitical factors

On a macroeconomic level, global economic growth in 2019 has been the weakest since the global financial crisis a decade ago. Global GDP growth was hovering around 2.9% in the fourth quarter of 2019. 

Rising trade barriers – trade wars between US and China, as well as the continuing fallout of Brexit in the UK – and the associated uncertainty has impacted business growth around the world. This has been coupled with country-specific weaknesses in large emerging market economies such as Brazil, India and Russia, as well as a stressed financial environment in Argentina, social unrest in Venezuela, and continuing geopolitical tensions in the Middle East. 

Trade wars and political disputes between the US and China have had a significant negative impact on the aviation industry, particularly on the air cargo market due to the slowdown in world trade. Figures from International Air Transport Association (IATA), in the December IATA Airline Industy Economic Performance report, track the impact on the airline industry. Passenger traffic growth reduced in 2019, down to 4.2% RPK growth, from 7.4% in 2018. Capacity growth was also down to 3.5% from 6.9% in 2018, which can certainly be attributed in part to the MAX impact. Global airline revenue growth rose by only 3.2% over 2018 figures, totalling $838bn; net profit however fell to $25.9bn from $27.3bn in 2018. Although fuel costs were largely static, non-fuel expenses increased. The impact of foreign exchange costs on non-dollarearning airlines has been a constant problem for the past few years, while the constraints on capacity from the grounding and other unrelated delivery delays, resulted in additional aircraft-related costs for airlines. 

Low interest rates have helped soften the general downturn in the world economy. Despite expectations at the start of 2019 that rates were likely to continue to rise, they in fact edged downwards. The US Federal Reserve Interest rate fell from 2.50% in January to 1.75% in December. The European Central Bank rate remains at zero, while the Bank of England has kept its 0.75% rate since the hike from 0.5% in July 2018. Japan’s interest rates also remain at zero. A significant rise or change in this low interest rate environment is not expected by economists, barring any black swan event. This ultra-low interest rate environment means that investors need to continue to look elsewhere for yield. Aviation has certainly benefitted in this respect over the past decade and there are no signs that this wall of liquidity is easing. This is distorting the macro picture for the aviation industry and is arguably shielding some of the weaker companies. 

Airlines have benefitted from stable oil prices over the course of 2019. Despite attacks on oil supply lines in Saudi Arabia, spikes have been shortlived. Although oil prices rose to $71 a barrel immediately after the attack, they then sank back down again faster than anyone anticipated. Oil prices lowered back to the $60-65bbl range – although they again spiked above $70bbl in early January 2020 after tensions escalated between the US and Iran. IATA reports that annual global airline fuel costs were $188bn in 2019, representing 23.7% of total airline operating costs. IATA expects this to fall back to 22.1% of expenses in 2020, with a total spend of $182bn. The decline, says IATA, is due to the delaying effect of hedging and the expected continuation of low oil prices. Moreover, concerns about the widening of the spread between oil and jet fuel prices, due to the impact of IMO 2020 environmental regulations, have “diminished”, says IATA. 

Despite the risks, the low oil price has the more prudent airlines seeking to hedge their fuel needs. “We try to manage the volatiliy of oil prices by hedging our future consumption for 12 months,” says Yassine Berrada, chief financial officer of Royal Air Maroc. “This is something we do annually. This cost we try to manage. The main difficulties we see in the future are more about the availability and cost of qualified labour, plus the threat of new taxes for the environment. A lot of countries are very innovative in terms of taxation. This creates some uncertainty, as not all taxes can be passed through to the customer.” 

Although oil remains the largest operating cost for airlines, over the past 12 months or so, the cost concern for most airlines has been the foreign exchange rate against the US dollar, which has negatively offset the low oil price. 

“The benefits of a low oil price have been felt more by US dollar denominated economies or currencies that haven’t weakened against the dollar,” says Aengus Kelly, chief executive officer of AerCap. “The reduction in oil price hasn’t really flowed through to the bottom line for some of the emerging market countries.” 

Despite the impact of FX, hedges are not as prevalent for currency as they are for oil. “We don’t hedge our foreign exchange exposure,” says Berrada. “We have natural hedge by having debt in euro, and the majority – 40% – of our revenues are in euro. We may use hedging products in the future. We are currently still looking at the market, the dollar may go down…” 

Another way to negate the impact of oil price fluctuations is by using less fuel – many airlines are in the process of renewing their fleets with more fuel-efficient aircraft, saving 6-7% on fuel consumption per flight, and are also answering to the call for more environmentally sound flights. 

For Evan Carruthers, chief investment officer at Castlelake, FX issues combined with jurisdictional weaknesses remain a headwind heading into 2020: “One macroeconomic headwind related to the trade disputes is some significant disruption in the currencies in the emerging markets. Those FX issues, in our opinion, combined with weakness in certain macro regions, have caused some disruption and have led to an uptick in defaults and credit risk in the global portfolio. Although a lot of those issues take time to materialise, we do see more stress in the system today than we did 12 months ago. So we’re quite cautious, and that’s the proven approach at this point in the cycle.” 

The market is more or less aligned to the notion that the aviation industry, like the global economy, has entered a downturn, but those market distortions discussed above – liquidity, new aircraft delays, low oil prices – are resulting in these early days of a possible downcycle having a softer impact. 

According to David Goring-Thomas, Global Head of Aviation at MUFG: “On a macro level, we are past the peak – passenger growth is decreasing, and air cargo is in negative territory. In the equipment market, the (used) twin aisle segment is under pressure, and single aisles may be at risk once the MAX and NEO deliveries gain momentum. On the airline side, the industry seems very competitive, but the reason we have not seen so many airlines suffer is a combination of still-manageable traffic growth alongside low capital cost, ample financing and fuel costs remaining low. Once these conditions change, expect a lot more marginal carriers to default.” 

John Slattery, chief executive officer of Embraer Commercial Airplanes, agrees that while the industry is probably well into the downcycle, the impact is being dulled by the overall health of airline profits. “We’re probably two-and-a-half years into the downcycle,” he says. “Some people are not feeling that yet because the return that airlines are generating is still above the weighted-average cost of capital. If we aggregate the numbers around the world, it’s now down to about 100 basis points above the weighted average cost of capital. The trajectory for the last two and a half years has been quite solidly down.”

We’re probably two and-a-half years into the downcycle. Some people are not feeling that yet because the return that airlines are generating is still above the weighted-average cost of capital. If we aggregate the numbers around the world, it’s now down to about 100 basis points above the weighted average cost of capital. The trajectory for the last two and a half years has been quite solidly down.

John Slattery, Embraer

He adds: “We’re seeing a correlation of OEM orders following the downcycle. We’re seeing a lot of bankruptcies, starting with the European Union environment, but not exclusively in Europe. So, these are all big indicators to us that we’re certainly into what I would describe as a relatively soft landing. It is hard to predict how much longer, but certainly I see another two or three years, at least two years of the downcycle, and then maybe a softer landing before the market takes off again. Our business is a cyclical business. Typically, the peak-to-peak or trough-to-trough has been about seven years. We’ve started to live a little bit of a double cycle this time around, but cyclicality is not bad. It helps the industry reset itself from a competitive perspective.”

Traffic growth is indeed expected to rebound in 2020, hence the expectation for a relatively soft landing. Global GDP growth is expected to recover to 3.4% over the next year. The International Monetary Fund and other bodies predict that next year’s growth will come from a more secure environment as trade tensions begin to ease, as well as an improvement in the emerging markets and an improving outlook in Europe. 

IATA suggests that this “combination of a moderate pick up in global growth and world trade, a modest reduction in fuel costs, tempered by an expected increase in capacity growth, should help bring some stability to airlines’ financial performance in 2020”. The industry body is forecasting a small rise in net post-tax profits to $29.3 billion and an EBIT or operating margin of 5.5% next year. Although these results are down from the peak years of 2015-2017, they reflect a better performance than that of earlier decades. IATA warns, however, that financial sustainability “remains narrowly based, concentrated in a relatively small number of airlines globally”. More positively, with stable fuel prices, passenger travel (measured in Revenue per Kilometres (RPKs)) is expected to grow on a par with 2019 at 4.1%. This is below the 20-year average pace of 5.5%, which IATA says shows that the industry has now entered a period of below-trend growth for air travel. Despite the expected rebound in international trade, IATA expects only moderate growth for air cargo, with Freight Tonnes per Kilometre (FTK) of 2.0% in 2020, compared to the estimated decline of 3.3% this year. 

Financiers tend to be more cautious and, despite passenger growth, the downcycle pressures will continue. 

“There will be headwinds, of course – the question is how strong they are. Everybody is waiting for a downturn in growth. But central banks are still helping with cheap-cheap money,” says Florian Maier, managing partner of EMP Structured Assets. 

His co-managing partner, Philipp Prior, agrees but says that the industryspecific challenges are creating their own problems. “We see too much capacity in the market in terms of equipment. We see too much money in the market, too much capital flying around with a lot of new investors from mainly Asia or private equity. The question is whether this fits together with the needs of the airlines. There’s still potential passenger growth, but we have too much equipment, and we have too much money. For us, now, in the finance industry, I think it’s getting really interesting how cheap rates will stay, how cheap banks will still lend money into this market, and how cheap the lessor will give the aircraft to the airlines.” 

Frank Wulf, global head of aircraft finance at NordLB, expects the tougher market conditions to continue well into the next decade. “The number of airline bankruptcies over the last two years is a clear indicator that the market environment is getting tougher. I am certain that this trend will continue for the next few years. Furthermore, airline profits are falling sharply across the board and with additional taxes or environmental charges to be imposed, this will even worsen. The situation is somewhat distorted by the 737 MAX grounding. Had all these aircraft been delivered as scheduled, I believe we would have had some serious excess capacity and lease rates (as well as values) would even be under even more pressure. As such, I fear that this will be the case in 2020 or 2021.” 

The impact of the MAX grounding on the aviation sector has been significant. It is discussed in a special section later in this report. 

The number of airline bankruptcies over the last two years is a clear indicator that the market environment is getting tougher. I am certain that this trend will continue for the next few years. Furthermore, airline profits are falling sharply across the board and with additional taxes or environmental charges to be imposed, this will even worsen.

Frank Wukf, NordLB

Aviation is a global industry and has benefitted enormously from globalisation – connecting people across oceans more efficiently than other forms of transport – but it is also a very noticeable polluter. Even though the Air Transport Action Group figures show that commercial flying accounts for about 2% of global carbon emissions and about 12% of transport emissions, the industry has been targeted by environmental activists in 2019. 

Concerns about the environment took centre stage in 2019, and aviation has been in the firing line. Protestors have glued themselves to aircraft roofs and airport floors in London, there have been countless marches in cities around the world in support of the Extinction Rebellion movement and Greta Thunberg, a teenage activist from Sweden, began a one-woman crusade by striking from school every week outside the Swedish parliament in the summer of 2018, which grew to a climate strike of 4 million people across 161 countries in 2019. Thunberg has addressed the United Nations, US Congress, and UK Parliament on climate issues and has now been named as Time Magazine’s 2019 person of the year. 

All of these pressures are contributing to the spread of the phenomenon of flygskam or ‘flight shame’, which is prevalent in Europe, especially Scandinavia. Although IATA and the major aircraft manufacturers are predicting that passenger numbers will continue to grow at around 4% per annum until 2035, other analysts – namely banks like UBS – have produced studies suggesting that such high-profile environmental awareness campaigns are beginning to trigger a change in flying habits in wealthier parts of the world, particularly in the US and Europe. After surveying more than 6,000 people in the US, Germany, France and the UK, UBS found that 21% had reduced the number of flights they took over the last year. UBS believes this trend may deepen and continue into developed markets. 

Environmental, Social and Governance (ESG) issues impacting the aviation industry are addressed throughout this report, but they are addressed in more detail in the final chapter.

Airline fundamentals

Fundamentally, air travel is growing – albeit more slowly – and is predicted to continue to do so for the next decade, despite the environmental lobby and prevalence of flight shaming. However, 2019 can be characterised as having seen a major spike in airline bankruptcies. Although the actual number of bankrupt airlines was not so far out of step with previous years, the size of the airline fleets involved has increased. Thomas Cook and Jet Airways are probably the largest airlines by fleet size to fold in recent years, while bankruptcies of well-known brands like WOW Air and Germania, and Avianca in South America, caused ripples throughout the aviation sector. 

“In 2019, we’ve probably seen more bankruptcies than the norm,” says John Plueger, chief executive officer of Air Lease Corporation (ALC). “Some of it is coincidental timing and many of these airlines weren’t going to make it anyway…. These failures happen because of the airline business models and those idiosyncrasies. I don’t think there is necessarily one fundamental thing that’s driving an increase in the [bankruptcy] rate. At this time, all these different airline models were finally reaching the end of their ropes, and so we saw a few more bankruptcies this year.” 

Plueger uses the Jet Airways bankrutcy as an example. Although many aircraft were on lease to Jet, those planes were soaked up by other Indian carriers that took advantage of the restrictive slot situation. “There wasn’t a fire sale,” he explains. “There wasn’t a crisis in aircraft supply. The value of those slots and gates is very high and several Indian carriers could only gain access to them by taking a number of Jet’s aircraft. Despite all these bankruptcies, Thomas Cook for example, we haven’t had difficulty placing our aircraft. Nobody likes these situations but it’s been a fairly orderly transition from these bankrupt situations.”

For most aircraft leasing executives, airline bankruptcies are a normal component of the business. “Bankruptcies are a fact of life,” says Aengus Kelly, chief executive officer of AerCap. “It’s the daily cut and thrust of our business. On average we repossess one airplane a month. I don’t see the long-term bankruptcy average changing – I think it will stay at normalised levels.” 

James Meyler, chief executive officer of ORIX Aviation, agrees: “Looking at the research, the number of airline bankruptcies hasn’t really spiked last year, but the number of aircraft available from those bankruptcies has hit the highest levels since after 9/11 – over 350 aircraft in 2019. So, in that sense, there has been a huge flush onto the market of aircraft from bankruptcies. However, they’ve definitely been soaked up by the market demand, partially because of the MAX grounding, but in general the passenger demand has continued. [For airlines] that have had a faster growth spurt than their original business plan, the only option they have to get aircraft in the short-term is in the leasing channel because of the manufacturer order backlog and delivery delays. But most of the very large lessors will tell you they’ve placed already almost all of their 2020 aircraft in, and a lot of their 2021 aircraft. Strong airlines and growing airlines have taken advantage of other airlines’ bankruptcies by taking extra lift.” 

Portfolio management in a choppier environment is essential, says Peter Barrett, chief executive officer of SMBC Aviation Capital. “[The number of bankruptcies in 2019] is a reflection of the environment, which is probably not as good overall as it was perhaps two years ago. Therefore, airlines with a strategic weakness that are overleveraged and have a poor strategy, are going to be exposed in an environment like we have today. Well-managed airlines, big or small, with good balance sheets, good strategies, are probably doing okay. We put a lot of focus on our portfolio management. The number of European airlines that have gone out of business this year, we have either avoided full stop or we have traded out of over the last number of years because we’ve had some concerns. We did have exposure to Jet, which is probably the most material one for us, and that’s actually worked out reasonably well and we got the airplanes back quickly. Generally, I think the experience of the aircraft leasing industry continues to be pretty good despite the fact that there have been a number of airlines going out of operation. Our ability to get the assets, redeploy them, and get them back to generating revenue has been effective. That shows the underlying strength of the leasing model, which has proven to be resilient even when there has been a little bit of a spike in bankruptcies.” 

Airlines that ceased operations in 2019

Airline

Country

Fleet size

Adria Airways

Slovenia

10

Aerolíneas de Antioquía

Colombia

4

Aigle Azur

France

10

Air Philip

South Korea

3

Al Naser Wings Airlines

Iraq

1

Asian Express Airlines

Tajikistan

3

Astra

Greece

1

AtlasGlobal

Turkey

BACK IN SERVICE

Avianca Argentina

Argentina

2

Avianca Brasil

Brazil

43

California Pacific

US

2

Far Eastern Transport

Taiwan

7

Fly Jamaica Airways

Jamaica

1

Flybmi

UK

17

Germania

Germany

31

Insel Air

Curacao

3

Jet Airways

India

99

New Gen Airways

THAILAND

3

Peruvian Airlines

Peru

6

Silverstone Air

Kenya

11

Tajik Air

Tajikistan

7

TAM Bolivia

BOLIVIA

6 (ONLY 3 OPERATIONAL)

Taron Avia

Armenia

1

Thomas Cook

UK

34

Via Airlines

US

3

Wisdom Airways

Thailand

unclear

WOW

Iceland

15

XL Airways

France

4

While many lessors are benefitting from this uptick in short-term demand, some are still wary of the underlying issues that may affect the industry further into the downcycle. 

“It’s been a tough year,” says Tom Barrett, chief executive officer of Engine Lease Finance (ELF). “Although some days it’s been a normal year for the number of bankruptcies, there has been a lot of our engines. We’ve had 4% of our portfolio redeliver unexpectedly as a result of them this year. That’s unscheduled downtime. We’ve been protected in the current cycle because the demand has been so strong from the severe consequences of EIS issues. Were it not for the MAX issues, particularly the demand on the current technology that we provide, that would be quite a drag.”

Ali Ben Lmadani, chief executive officer of ABL Aviation, admits that the bankruptcies are a concern for smaller players. “Most of the returned aircraft are now flying because they are marketed very well but it’s still a fear for small players like us. When the price of oil is low, the cost of funds is low. The leasing community is willing to give very, very low lease rental factors to the airlines and we still have bankruptcies. The fact that airlines are going bankrupt when the markets cannot be better scares me a lot more than the MAX issues. Currently, it’s an amazing market; airlines should be making the highest profit levels of their lifetime. But airlines are going bankrupt, and that’s what scares me more than rising interest rates and the cost of fuel.” 

Over the past few years, more airlines have been filing for bankruptcy during the summer season, notably in Europe, which worries financiers. “The process started a couple of years ago and a significant number of airlines have gone bankrupt in Europe, namely Air Berlin, Monarch, Wow, Primera, and more recently Thomas Cook,” says Arnaud Fiscel, Head of Transportation at Bank of China (UK). “There have also been some players in promising and fast-growing Asia, such as Jet Airways. Some operators unfortunately start experiencing cash shortages immediately after the peak of the summer season, which is quite unusual, but evidencing deep structural financial weaknesses. From an air operator standpoint, the peak of the current cycle has most certainly been reached.”

[The number of bankruptcies in 2019] is a reflection of the environment, which is probably not as good overall as it was perhaps two years ago. Therefore, airlines with a strategic weakness that are over leveraged and have a poor strategy, are going to be exposed in an environment like we have today. Wellmanaged airlines, big or small, with good balance sheets, good strategies, are probably doing okay.

Peter Barrett, SMBC Aviation Capital

Taking a regional view

The airline industry is global but split by regions provide a more detailed picture of the general health of the sector. 

Every year as part of this study, Airline Economics asks participants to provide their optimism levels for the various regions on a range of 1-5, 1 being the most pessimistic and 5 being the most optimistic. The chart shows optimism levels rising in most parts of the world, except for Europe and the Middle East. 

Indeed, airline bankruptcies need to be considered within the jurisdiction or region in which those airline are operating. This section focuses on each region with an eye on expected performance, consolidation and operating environment. 

Europe

With the rise in bankruptcies and the weaker trading environment, further airline consolidation is expected in 2020, although this is restricted to certain regions. Most consider Europe to be overdue for more airline consolidation. In 2019, one of the largest deals was the acquisition of Air Europe by International Airlines Group (IAG), but there has also been a move to expand by some of the other large players – Ryanair, Aer Lingus, Wizz Air – to push for growth, making an already competitive market even more so for weaker players such as Norwegian.

Overall net airline profits for Europe are more subdued than other mature markets due to the highly competitive market and strength of the low-cost carriers. IATA reports European airline net profits were $6.2bn in 2019, caused by low yields. However, the industry body is predicting a better performance in 2020, with profit up to $7.2bn driven by a reduction in capacity expansion plans and subdued fuel costs. 

The US bankruptcy laws enabled the carriers to consolidate and fix their cost structures. Now, the top four or five airlines control 80% of the traffic. At the present time, you do not see a similar concentration or dynamic in Europe or in other places in the world.

Mike Inglese, Aircastle

Europe is a very mature market with arguably too many airlines in the region; however, the rise in bankruptcies and the move towards further consolidation seems to be generally welcomed by the major market players since it is clearing out weaker airlines and boosting profits for the strongest airlines that remain. “More consolidation is inevitable, but it’s healthy,” says one senior executive. “The fact that consolidation happens in a healthy environment is a good thing, because it keeps the market more productive. In Europe, there’s a lot more room for consolidation, just because of the number of players.” 

Europe is often compared to the US market, where the airlines have spent the past few years consolidating their cost bases, restoring their financial strength and employing greater capacity discipline. 

Mike Inglese, CEO of Aircastle, says: “The US bankruptcy laws enabled the carriers to consolidate and fix their cost structures. Now, the top four or five airlines control 80% of the traffic. At the present time, you do not see a similar concentration or dynamic in Europe or in other places in the world. Over time, airlines will see the benefits of more consolidation, like the IAG model where you let regional people run their airline with the scale benefits of managing a broader and bigger fleet along with the leverage it provides with OEMs and lessors.” 

James Meyler sees a similar trend: “The US really is a prime example of what can be achieved with consolidation. Europe definitely is in need of a similar process and there are signs it is starting with IAG taking on Air Europa, and it has considered Norwegian in the past. There is a move to that IAG Grouptype consolidation, similar with Ryanair expanding with Laudamotion. There is still some way to go though; the five largest carriers in the US control 70% of their market; Europe’s top 5 only 50% of theirs. Asia is further behind because its low-cost carrier growth is still in its infancy and the legacy government stateowned carriers are only just starting to become independent and profitable airlines on their own right rather than being a traditional flag carrier, an offshoot of the state. I think that’s going to be slower to happen but ultimately, they will follow the same trend.” 

Aside from the group approach to consolidation, certain airlines have also been taking equity stakes in other airlines as a first step. In Europe, Air France-KLM, Delta Air Lines and Virgin Atlantic signed a joint venture agreement where Air France-KLM would acquire a 31% stake in Virgin Atlantic for £220 million. However, the two-year planned stake sale was abandoned by Richard Branson, who opted to retain control and expand the airline he founded by securing more operating slots at an expanded London Heathrow airport to establish Virgin Atlantic as a second UK flag-carrier to rival British Airways. 

For Cowen analyst Helane Becker, the stark reality is that there are simply too many European airlines with too many hubs. “The problem in Europe is every country wants an airline and it’s so important for national pride to have an airline and to provide jobs. In the US, we had industry consolidation and we had hubs shut down. In Europe, you don’t have that. IAG is a holding company for five or six different airlines and they still have hubs in Ireland, Spain, the UK. Likewise, Air France-KLM has hubs in Paris, Amsterdam; Lufthansa has hubs in Frankfurt and Munich. Do they really need so many hubs? The answer is absolutely not, especially with more efficient aircraft that can over fly the hubs.” 

Becker recalls the exponential growth of the large gulf carriers, which were overflying Europe into the United States and connecting people in the Middle East, thus cutting out the main European hubs. “Today, though, you can fly non-stop from San Francisco to Tel Aviv, for example. All these airlines are overflying all those hubs and it’s an increasing trend.” 

The US really is a prime example of what can be achieved with consolidation. Europe definitely is in need of a similar process and there are signs it is starting with IAG taking on Air Europa, and it has considered Norwegian in the past.

James Meyler, ORIX Aviation

Using the US airline success as an example for European carriers is reasonable but there is a question mark over whether European airlines could initiate a similar restructuring of the market in the absence of US Chapter 11 bankruptcy protection laws, which enabled financially weak airlines in the US to restructure while continuing to operate. 

After Thomas Cook filed for insolvency following several months of attempting to secure further sources of funding, the company had little choice but to halt operations. The UK Civil Aviation Authority, effectively and efficiently, quickly launched the largest emergency repatriation programme – dubbed “Operation Matterhorn” – to return 150,000 passengers to the UK over a period of 14 days. Similar programmes  were launched after the collapse of Monarch and XL Airways, which provoked a government review into airline insolvencies. Recommendations issued in the final report in May 2019, suggested that the UK consider reforming the insolvency regime for airlines to allow the CAA to use that airline’s own aircraft to fly passengers home. The new Airline Insolvency legislation was set out in a little more detail during the Queen’s Speech that marked the opening of the UK Parliament on 19 December 2019. The main elements of the proposed legislation include the introduction of a special administration regime for airlines to support passengers’ needs post-insolvency and to keep aircraft fleet flying long enough for passengers to be repatriated. It will also enhance the CAA’s regulatory powers to improve their oversight of airlines in distress, and mitigate the impacts of a future airline failure, and extend the CAA’s remit to apply for the repatriation of both ATOL and non-ATOL protected passengers. ATOL, or Air Travel Organiser’s Licence, is a UK financial protection scheme that protects most air package holidays sold by travel businesses that are based in the UK. (Currently the CAA does not have to repatriate non-ATOL passengers.) The new legislation will also establish what the government describes as a repatriation “toolkit of mechanisms for companies and passengers”, including measures to make it easier for the CAA to grant a Temporary Airline Operating Licence so that an airline can continue repatriating passengers following insolvency. 

Meanwhile, the UK continues to be unsure about the impact of Brexit, which will now be executed on 31 January 2020. Although, since the UK election in December, the uncertainty around whether Brexit will happen at all has lifted, uncertainty remains regarding the impact on the country and the European Union (EU) more broadly in terms of the aviation industry. The UK and the EU still need to reach some sort of agreement that will allow operations to continue between the two regions to continue. One industry observer suggests that large UK carriers, such as easyJet, Virgin Atlantic, and British Airways, will need to find alternatives to compensate potential outbound traffic due to the relative weakness of the pound against the euro. 

The problem in Europe is every country wants an airline and it’s so important for national pride to have an airline and to provide jobs. In the US, we had industry consolidation and we had hubs shut down. In Europe, you don’t have that.

Helane Becker, Cowen

North America

North America is the region with the highest optimism level from among the report participants, which is unsurprising due to the very strong airline market. Net post-tax profits for 2019 rose to $16.9bn, according to IATA year-to-date estimates, up from $14.5bn in 2018. In 2020, profits are expected to be $16.5bn with a net margin of 6%, impacted only slightly by the expected decline in yield as capacity rises. IATA expects consolidation to continue to help sustain load factors, although it is difficult to see how much further the region can consolidate. The US airlines in particular have demonstrated over the past few years how adept they have become at managing costs, fleet and route networks. 

“The airlines in North America have become more disciplined with regards to optimising networks, reducing costs, and identifying those routes that are profitable and where they can be competitive,” says Karl Griffin, chief executive officer of the Dublin-based, full-service commercial aircraft leasing company. “North American carriers have provided a blueprint for many other regions and operators. The key for operators outside of the US is to understand where their market space is with a focus also on reducing costs.”

There has been some consolidation in Canada, with Air Transat acquired by Air Canada and WestJet acquired by private equity firm Onex. However, true consolidation in the US airline sector is restricted by the large homogenous market; that said, some observers fully expect the entrance of new competitors. “The US will see new airlines,” says Peter Barret, SMBC Aviation Capital. “This is part of the story that doesn’t get told. There continues to be competition in the US, there continues to be new airlines that have grown up over the last five or 10 years that are cutting out a niche for themselves. It’s going to be a continually evolving market. However, the type of consolidation and the scale that they’ve achieved in the United States is going to be much harder to achieve in other markets.” 

North American carriers have provided a blueprint for many other regions and other operators. The key thing really for operators in or outside of the US is to really understand where their marketplace is rather than focusing on market share.

Karl Griffin, Genesis

There may be some further consolidation in the US market, but this will be limited to the smaller airlines. The major US airlines are now too large to acquire other US airlines without triggering serious anti-trust rules. However, US airlines are looking outside of the region to expand their networks using equity acquisitions. Delta Air Lines is preparing to acquire a 20% stake in LATAM Airlines for $1.9bn, and was also seeking to expand its share in Virgin Atlantic before the deal was pulled at the last minute. Moreover, Delta has also acquired a 10% stake in Haijin-KAL, the largest shareholder of Korean Air. American Airlines has tried a similar strategy, buying into China Southern in 2017, but has not expanded further. United Airlines owns a small share in Brazilian carrier Azul, as well as a minority stake in US regional carrier Express Jet, and intended to launch a joint venture initiative with fellow Star Alliance members Avianca and Copa to better compete against Delta in the South American region, although these plans were curtailed by the former’s financial difficulties. 

“Over the course of the last 15 or 20 years, the South American market is of increasing relevance to the North American market and to the Western Continental European Market,” says Embraer’s Slattery. “Equity investments are being made by European and North American airlines into the Latin American airlines to effectively hardwire their partnership for the next cycle. You’re also seeing equity investments changing, companies divesting an equity investment, and new players are replacing them. South America is a robust market where we’re starting to see good growth. It’s a market that’s going to continue to be in demand, particularly by the North American airlines and by the European airlines.” 

Although US airlines have shown solid profits for more than five years, sustained by a strong market due to past consolidation and a strong US economy, in 2019, the on-and-off trade war with China has put pressure on imports costs and private consumption from 2020. The threat of an escalating trade war has dimmed in recent months, but still remains. 

“The issue I am most worried about is the US-China trade war,” said Declan Kelly, chief operating officer of GECAS, speaking on camera in Hong Kong at the beginning of November 2019. “It is so important for everybody that it is resolved quickly.” 

Earlier in the year, ORIX Aviation’s James Meyler was concerned that the slowing passenger growth due to the trade wars might impact the leasing business, but this not materialise. “There was a concern that the trade wars between China and the US would affect the airlines’ demand, but actually what we’ve seen is that all of our aircraft that were due to come off lease, not just in 2019 but actually through 2020, have now all been either extended, placed on a new lease or sold. So again, the concerns of the softening haven’t materialised.” 

For others, the trade dispute becomes a more significant threat if it impacts interest rates further: “Presently, the US economy is pretty robust because interest rates are low,” says Stephen Hannahs, chief executive officer of Wings Capital. “The manufacturing sectors are not performing as well as the consumer sector because of tariffs and global economic uncertainty. It is my view that it is unlikely that the Federal Reserve cuts rates much further. They will try to keep some dry powder to ensure that the economy keeps going. I am concerned about the low rates because I’ve seen significant evidence of people chasing yields, paying excessive prices for assets and doing things that are commercially mistakes. Eventually, this will be a problem. So, it’s a challenging environment.” 

Despite the concern, most believe the trade disputes will eventually die down. “There clearly has been some negative impact – especially on airfreight from and to China,” says NordLB’s Wulf. “We can only hope that, despite all the sabrerattling, a certain sense of rationalism prevails and there is a strong intention on all sides to find amicable solutions to avoid a further escalation of the situation. If that is not the case and the spiral of slamming punitive tariffs on goods continues, this will definitely have a noticeable longer-term impact on the aviation industry.” 

There was a concern that the trade wars between China and the US would affect the airlines’ demand, but actually what we’ve seen is that all of our aircraft that were due to come off lease, not just in 2019 but actually through 2020, have now all been either extended, placed on a new lease or sold. So again, the concerns of the softening haven’t materialised.

James Meyler, ORIX Aviation

South America

South America is a mixed picture. Overall, the market seems more positive about Brazil, which has weathered its own challenges and is improving – this is a major positive, because it is a quarter of the whole Latin American market. In fact, the demise of Avianca Brasil is viewed as a positive since it helped stabilise the market for other players. Elsewhere in the continent, conditions are much more challenging. 

“We’re seeing signs of recovery in Brazil,” says AerCap’s Kelly. “Although the Real hit an all-time low in [early December] at R4.26 to the dollar but the finance minister did not seem too concerned about it. We saw Brazil recover more, certainly over the course of 2019, which was encouraging because that’s really driving the rest of South America.” 

The political instability issues in certain jurisdictions such as Argentina, Venezuela and Chile are a source of concern, although there is some hope that the new administration in Argentina will help improve the situation there. Foreign exchange issues have hit Latin American countries particularly hard. “It’s a more challenging macroeconomic situation in Central and South America, which is evident in some of the defaults and some of the what I would categorise as stress deal activity in those regions,” says ELF’s Barrett. 

The low performance of Latin Americas economies as a whole, the depreciation of local currencies in emerging markets, and the lower volume of commodities trades (excluding Brazil) have a negative impact on airlines, especially on domestic airlines with no hard currency revenues. 

Despite these stresses, participants in this report are in general “cautiously optimistic” about Latin America, and fully expect the region to recover heading into 2020. IATA also expects some restructuring in the airline sector to improve the overall performance, with net profits estimated at $0.1million, an increase over the $400,000 loss posted in 2019. 

Asia-Pacific and China

Airlines in the Asia-Pacific region were most exposed to the trade war between China and the US, which is reflected in the fall in passenger and cargo traffic figures as well as net profits. IATA notes that net profit in 2019 for APAC airlines was $4.9bn – a fall from $6.1bn in 2018, which is where it is expected to return to in 2020 as world trade recovers and if fuel remains at lower levels. 

It’s a more challenging macroeconomic situation in Central and South America, which is evident in some of the defaults and some of the what I would categorise as stress deal activity in those regions.

Tom Barrett, Engine Lease Finance

Although international travel has been impacted by the trade disputes, domestic travel in China has been very strong. China has a large domestic market driven by a growing middle-class, which could support long-term air traffic growth even if part of the international traffic is slowing down; hence optimism levels remain relatively high. 

“China continues to grow and our expectation is that the government will continue to ensure that it grows for the foreseeable future although there are other issues that are more idiosyncratic to China,” notes Castlelake’s Carruthers. “There is an abundance of leverage in the system, clearly, and there are some issues with the smaller airlines and with the HNA-related airlines in China, which has been a challenge for all of the lessors that have been exposed to that region. This is a different issue than what you see in Europe where you’ve got a lot of fragmentation and high competition. China’s issue is more about idiosyncratic debt issues at the corporate level and we’re having that stress work its way through the system – that will resolve itself over time, possibly, through some insolvencies and some M&A activity, where some of the smaller less stable airlines will get rolled into the larger more stable players.” 

Outside of China, the Asia-Pacific market yields are under pressure; this has only been exaccerbated by the protests in Hong Kong, which have caused traffic to fall dramatically. However, many regard this as a short-term issue that will be resolved, and remain optimistic regarding the broader region due to the strong underlying market fundamentals. 

“Over the past five years or even longer, the larger growth has come, and will come, from Asia,” observes Khanh Tran, chief executive officer of Aviation Capital Group (ACG). “When you’re talking about the dynamics and demographics of that market, many people are gaining more wealth and are willing to spend more to travel for leisure or for business. There are infrastructures issues in certain countries with big populations like Indonesia, and you have big population countries like India. There have been airline failures in India and the infrastructure is not very conducive for travel. That will change; the demand for traveling abroad remains.” 

Indonesian traffic shrunk in 2019, and there have also been some issues in Thailand. However, as Tran states, the overall Asian market still wants to travel, and traffic has risen regionally . “Next year, it will probably be closer to double-digit growth, which is more like the emerging market that Asia is. But if that was a down ycle, I think we would all take it.” 

Hani Kuzbari, managing director of Novus Aviation Capital says that although further bankruptcies are likely, new airlines will emerge to fill the gap: “Airline failures are an inconvenient way for new carriers to acquire resources, such as more pilots, aircraft, landing slots, for example. Startup airlines or airlines requiring capacity will emerge to fill up the gap in the market from the failures of some of the incumbent or exploit fast-going markets demand in countries or regions. Some markets in Asia are a good example, where airlines have been inducting a number of aircraft that came out of some of the European operators that went out of business.” 

Regardless of the fall of Jet Airways in India, the optimism levels for the airline industry in that country are increasing. 

“India is a billion people. Aside from China, other countries are significantly smaller but with higher traffic numbers – that shows the potential,” says Cowen’s Becker. “As India’s economy continues to improve, more people will want to travel. The Indian aviation market has been oversaturated with start-ups that have failed – Kingfisher, Jet – which put a lot of aircraft on the ground at one time and and there’s still too much capacity, which means airlines suffer the same thing that US markets suffered 20 years ago; over capacity. But if they grow in a measured way, you don’t have those issues. We’re certainly expecting improvement from where we were with the Jet bankruptcy, but we’re not expecting the robust growth we saw earlier in the decade, which is a good thing.” 

Lessors have had issues repossessing aircraft from India – especially with Kingfisher – but those painful jurisdictional legal tanglings were not quite so painful during the Jet bankruptcy. “Lessors have managed it very well,” says Austin Wiley, chief executive officer of SKY Leasing. “India, as well as Brazil, are tricky markets to repossess aircraft, there have been stumbling blocks there before. On the whole, it was a pretty efficient process this time. Lessors have learned lessons from the past. No question the lessors benefitted from manufacturer production delays. Sometimes it’s better to be lucky than good, but on the whole, it’s been very impressive in terms of the re-deployment of assets.” 

Positive experience is returning lessors to India. “India has been a growth market for us,” says Aircastle’s Inglese, “and over the past few years, we’ve expanded our Asian relationships with the likes of AirAsia, Lion Air, and IndiGo in India. We were also able to quickly and seamlessly transition seven aircraft from Jet Airways to SpiceJet in 2019.” 

Lessors have managed it very well, India, as well as Brazil, are tricky markets to repossess aircraft, there have been stumbling blocks there before. On the whole, it was a pretty efficient process this time. Lessors have learned lessons from the past. No question the lessors benefitted from manufacturer production delays. Sometimes it’s better to be lucky than good, but on the whole, it’s been very impressive in terms of the re-deployment of assets.

Austin Wiley, SKY Leasing

Middle East

While the Middle East market has encountered some challenges over recent years, the ongoing restructuring efforts on networks, schedules and fleet capacity are resulting in a slowdown of capacity growth in the region, to the benefit of all airlines. The closure of the Dubai runway for a month also impacted schedules. The general consensus is that the restructuring has put the main airlines back onto a growth footing, albeit one of slower growth than seen in the past, which is viewed as a heathier growth path for the region. This positive trajectory has prompted IATA to predict a reduction in net profits for the Middle East in 2020 to a loss of $1bn, down from a $1.5bn loss in 2019. 

Africa

Optimism levels are rising for the Africa region, although the overall level remains muted compared to the rest of the world. In aviation, Africa has always been the weakest region, although breakeven load factors are low (as yields are above average) and costs are also low. That said, few airlines can achieve those breakeven load factors, and growth remains slow. IATA is predicting an improved performance for the region but net profits will still post a loss in 2020. 

Royal Air Maroc (RAM) is bullish on the region, which could be revolutionised with an Open Skies agreement. “There is a high potential in terms of traffic to Africa and from Africa and OpenSky will definitely have an impact,” says CFO Berrada. “We have seen that just between Morocco and Europe, for example, when we started with OpenSky in 2004 and it was fixed in 2006, traffic grew between Morocco and Europe by double digits for 10 years. So, there is a potential within Africa, especially due to the lack of road or rail infrastructure.” 

Most RAM traffic is international, connecting passengers to and from Africa to Europe and the Americas. “We don’t have much traffic between Morocco and Africa as an origin and destination but it has grown. We have a lot of more new Africans living in Morocco now, and Morocco investing in West Africa banks and insurers, so there’s a lot of traffic between them. We are advocating more OpenSky in the African skies. There is a lot of potential; we are trying to invest in that potential, especially in West Africa.” 

Lessor Fundamentals

The leasing market is awash with liquidity, and investors unable to find yield in more traditional markets are still exploring more “esoteric” avenues to secure a better return on their investments. This is not a new phenomenon; investors have been attracted to the stable returns enjoyed by aircraft leasing for some time since the global financial crisis ushered in a new ultra-low interest rate environment. And although the “gold rush” age where investors piled into leasing vehicles at a significant rate has passed in recent years, there is still enormous interest in the area. 

In 2019, the leased aircraft portfolio increased to 12,954 aircraft, according to analysis from Ascend by Cirium. 

Aviation has evolved significantly over the last five to 10 years in terms of its acceptability as an asset class to which people will provide capital. It used to be the case that for a lot of funds, capital that flowed into commercial real estate was going to fixed income instruments, or equity, or infrastructure, but the whole bucket of alternative investments has grown significantly post-financial crisis as money managers, insurance companies, and anybody with capital obviously is looking to put money to work.

Richard Moody, Deutsche Bank

Richard Moody, global head of transportation finance at Deutsche Bank, observes: “Aviation has evolved significantly over the last five to 10 years in terms of its acceptability as an asset class to which people will provide capital. It used to be the case that for a lot of funds, capital that flowed into commercial real estate was going to fixed income instruments, or equity, or infrastructure, but the whole bucket of alternative investments has grown significantly post-financial crisis as money managers, insurance companies, and anybody with capital obviously is looking to put money to work. Also, aviation return on investment value is impressive when you compare this to different asset classes. The interest in aviation has benefited from more transactions, which are bringing more liquidity, and increasing aviation’s relative value versus other asset classes.” 

Aviation’s value relative to other asset classes is critical. Many see it continuing for some years yet, considering aviation as no longer burdened with the ‘esoteric’ moniker and as more of a conventional investment avenue, while others remain less optimistic and more cautious about further, risky investment in this sector. 

“Aircraft as an asset class has become mainstream,” says Peter Barrett, CEO of SMBC Aviation Capital. “I think that will continue. I’m not an economist and I’m certainly not a soothsayer so I don’t know what’s going to happen in the future, but I do think that capital – the price of it, the availability and the liquidity of it – will ebb and flow; that’s the nature of the longterm economic cycle. At some point that will change for our industry, for aviation generally, but I don’t think it’s going to change just for aviation. I think it will change for everybody, but aviation will still remain as a meaningful and vibrant and attractive asset class, although there might be less liquidity so money might get more expensive or there might be less of it – and then when the cycle returns, it will broaden. So, aviation is here to stay, but I think it will wax and wane with the macroeconomic cycle.” 

New leasing companies have continued to emerge onto the scene over the past 12 months, with many more new joint ventures and sidecars being set up to capitalise on the continued healthy liquidity in the aviation industry in the leasing space.

Top 30 leasing companies

Ranked by number of aircraft

Rank

Company

Current Portfolio

Portfolio Value ($mn)

Firm Order Backlog

1

GECAS

1,144

22,938

351

2

AERCAP

1,019

33,492

306

3

AVOLON

529

19,627

362

4

BBAM

509

21,067

 

5

NORDIC AVIATION CAPITAL

487

6,021

62

6

SMBC AVIATION CAPITAL

416

15,681

254

7

ICBC LEASING

402

15,090

123

8

AIR LEASE CORPORATION

384

17,662

316

9

BOC AVIATION

356

15,590

151

10

DAE CAPITAL

354

10,102

 

11

AVIATION CAPITAL GROUP

318

9,465

153

12

AIRCASTLE

275

5,846

25

13

CDB AVIATION

227

7,875

185

14

CARLYLE AVIATION PARTNERS

225

3,246

 

15

ORIX AVIATION

223

7,036

 

16

BOCOMM LEASING

212

7,598

30

17

CASTLELAKE

210

3,552

 

18

MACQUARIE AIRFINANCE

195

4,081

60

19

BOEING CAPITAL CORP

193

1,813

29

20

GOSHAWK

177

6,816

40

21

JACKSON SQUARE AVIATION

174

6,937

30

22

AVMAX AIRCRAFT LEASING

149

443

 

23

AMCK AVIATION

145

4,396

20

24

CHINA AIRCRAFT LEASING COMPANY

137

4,495

190

25

STANDARD CHARTERED AVIATION FINANCE

129

4,159

 

26

AVIC INTERNATIONAL LEASING

123

3,834

 

27

FALKO

114

1,244

 

28

CARGO AIRCRAFT MANAGEMENT

99

1,293

 

29

GTLK - STATE TRANSPORT LEASING COMPANY

97

2,217

4

30

REGIONAL ONE

97

395

 

Aviation becomes an attractive asset class when there’s more liquidity. As the airline industry has grown and as leasing platforms have grown – with many of us now publicly traded and with many more different ABS vehicles – aircraft has been placed in the mainstream spotlight for investment. Despite all the capital inflows that have happened, aircraft continue to perform very well as assets and as asset classes.

John Plueger, Air Lease Corporation

John Plueger has observed this influx of new competition since starting ALC, and even previously during his long tenure at ILFC. “This has happened for two reasons: one is the abundance of liquidity, but the second is because aircraft have proven to be a very consistent and a high-yielding asset for decades,” he says. “Aviation becomes an attractive asset class when there’s more liquidity. As the airline industry has grown and as leasing platforms have grown – with many of us now publicly traded and with many more different ABS vehicles – aircraft has been placed in the mainstream spotlight for investment. Despite all the capital inflows that have happened, aircraft continue to perform very well as assets and as asset classes.” 

As a consequence of those new entrants seeking to build market share over the past decade, the capital inflow has been most influential on the aircraft sale-leaseback market, driving down lease rate factors and returns. Over the past year, however, there are signs that those falling returns have begun to cause those newer players to a pause their more aggressive bids. 

“You don’t quite see as many respondents to sale-leaseback proposals today as you did two years ago,” says Plueger. “Despite lowering interest rates, which is generally helpful to all capital-intensive industries, there are some players that are just putting on the brakes as the sale-leaseback market reaches levels that just don’t work for them anymore.” 

ORIX Aviation’s James Meyler agrees that there are signs of greater discipline returning: “Now that some new entrants have reached a certain scale, they are acting in a more rational manner, but you still have certain players that, for whatever reason, require a transaction at a certain time. They may be coming towards a quarter-end or year-end target, a stretched business plan, or whatever it may be. There’s usually somebody who has a real requirement to get a transaction done at a given point in time, and they’re the ones that pay up and win the deals… In terms of S&LBs, what we have seen is where maybe 18 months ago, we lost out in the first round, now, in the last six months, on those types of deals where we believed we’d be competitive, we’re now getting into the last two or three or winning bids.” 

“Bottom line, the evolution continues. The rush starts at the beginning, floods the market, depresses yields, people start to exit, etcetera. It’s just a natural part of the growth of the industry,” adds Plueger. 

Plueger further notes that the influx of Chinese leasing companies being formed has halted with some exiting the market altogether, selling their portfolios. Minsheng, for example, sold its portfolio to Castlelake in 2019, and there are others companies that have changed ownership. In December, Mizuho entered into a joint venture with an Ping An to form the newly named leasing company Clover Aviation Capital. 

Mike Poon, CEO of CALC Group, sees continued growth coming from China, however: “We established the Chinese platform 10 years ago as the first aircraft lessor in China. Then many more lessors started up in China. If you look at the track record, most of them are making quite good money. But the next liquidity opportunity in my view is in Hong Kong. Hong Kong has changed the aircraft leasing industry with their recent efforts. Now, the Hong Kong effective tax rate is sometimes even lower than in Dublin. Hong Kong has a lot of liquidity. As it becomes the gathering point for more leasing companies, more and more money will flow into this sector and we expect the leasing market in China to keep growing, especially in Hong Kong.” 

We established the Chinese platform 10 years ago as the first aircraft lessor in China. Then many more lessors started up in China. If you look at the track record, most of them are making quite good money. But the next liquidity opportunity in my view is in Hong Kong. Hong Kong has changed the aircraft leasing industry with their recent efforts. Now, the Hong Kong effective tax rate is sometimes even lower than in Dublin.

Mike Poon, CALC Group

Consolidation

Another natural part of the evolution process of the leasing industry is consolidation. 2019 was not a particularly standout year for consolidation in the leasing industry, but there were some significant deals. Tokyo Century took full control of Aviation Capital Group, while Aircastle was acquired by a newlyformed entity controlled by affiliates of Marubeni and Mizuho Leasing; moreover, Singapore’s GIC completed its investment in Nordic Aviation Capital. There was further aviation industry M&A activity – Bombardier completed its sale of the CRJ program to Mitsubishi Heavy Industries as well as its Q400 program to Longview, in order to focus on its corporate jet business. Apollo acquired PK Airfinance from GECAS and MUFG bought the aviation finance franchise from DVB. 

For ACG CEO, Khanh Tran, the full takeover by Tokyo Century from Pacific Life, has re-energised the company. “When we originally began having discussions with Tokyo Century investing in ACG we were excited to have an ideal, informed, institutional investor because they had already invested in this business on their own, in Tokyo, for quite a while. Having a shareholder and owner who understands the fundamentals of the business is important.” 

ACG has already tapped into Tokyo Century’s JOLCO expertise as well as enabled the company to diversify its services with the introduction of is financing arm, Aircraft Financing Solutions. “AFS is a model after the US Export-Import Bank guarantee and we recruited four members from the Eximbank. To my pleasant surprise, we were able to put business on the books within less than nine months. We don’t provide the loan ourselves, but we arrange ‘credit-enhanced lending opportunities’ where ACG is the credit enhancing party. This is version 1.0; we’re working now towards version 2.0 and 3.0.” (AFS is discussed in further detail in Chapter 2.) 

Castlelake’s Evan Carruthers expects those smaller-scale lessors that have been created in the past decade to be ripe for acquisition: “Some of the leasing businesses that are small and subscale that don’t grow into real sustainable businesses ultimately will be targets for consolidation. In addition to that, there are a few large leasing companies that will likely look for a different source of equity capital over the next call it 24 to 36 months.” 

Firoz Tarapore, CEO of DAE Capital, which acquired the AWAS platform in 2018, has been surprised at the relatively low levels of M&A activity in 2019. “In the last year or two, origination has become more difficult because pricing levels are low as a result of increased supply. A 20-aircraft fleet lessor hoping to increase to a 40-50 aircraft fleet, or for a 100-aircraft lessor hoping to get to 200, is now starting to realise that it is not going to get there. Such companies cannot maintain the status quo because they’re getting marginalised every single day, so they either need to make the decision to sell or do something completely drastic to keep their objectives alive. In our business, because the leases are so long, lessors are subsidised to put their heads in the sand for a longer period of time than an economic person would, but that runs out as well. In the next two to three years, there will be more rational decisions taken, and more of those smaller lessors will decide that selling is the right thing to do. It’s only the much stronger players that are able to use different channels to originate.” 

ORIX Aviation, which celebrated the one-year anniversary of acquiring a 30% share in Avolon in November 2019, can boast of having one of the longest-lasting constant shareholders in ORIX (although General Electric holds that crown with its ownership of GECAS). James Meyler says that such companies are rare and that there is a natural evolution in the turnover of lessor ownership: “Every five to ten years, there’s been quite a large turnover in ownership base and we’re going to see that continue,” he says. “What’s interesting though is that ten years ago the top 10 lessors controlled over 60% of the leasing market; today, the top 10 companies control only about 40%. The larger lessors’ share of the market has been eroded by new entrants pushing through. That will continue because a lessor needs scale – with the order backlog, you can’t grow from 100 to 300 or 400 aircraft within a three- or four-year period unless you acquire a company or a very large pool of aircraft, which is more difficult to do than people think.” 

Meyler adds that he expects the exit mechanism for some entrants to continue to be characterised by a portfolio sale, rather than a platform sale. 

Scale is all-important for lessors if they are to provide required services for customers as well as certainty of execution. It is also essential for progressing the company towards securing an investment grade corporate credit rating, which opens the door to more efficient and cheaper sources of funding. 

In the last year or two, origination has become more difficult because pricing levels are low as a result of increased supply. A 20-aircraft fleet lessor hoping to increase to a 40-50 aircraft fleet or for a 100-aircraft lessor hoping to get to 200, is now starting to realise that it is not going to get there. Such companies cannot maintain the status quo because they’re getting marginalised every single day, so they either need to make the decision to sell or do something completely drastic to keep their objectives alive.

Firoz Tarapore, DAE Capital

ORIX Aviation’s acquisition of a 30% stake in Avolon enabled the latter to reach that investment grade rating, which in turn has boosted ORIX Aviation’s profit share and equity value in the business, as well as opening up new relationships with airlines and investors. Joining these two businesses, which had little overlap – Avolon focuses on new aircraft, while ORIX Aviation is more an asset manager and trading company – has brought scale to both companies. “There was a very little overlap in our business models,” says Meyler. “We’ve been very complementary in terms of our investment. There’s been certain synergies in terms of trading aircraft into the Japanese market, but also in terms of being able to offer airline solutions at scale.” 

Meyler adds: “Because of the capital required for this business, 200-plus aircraft is at least the size an aircraft lessor needs to be, which tends to be at least an $8-20 billion balance sheet size. To do that without either being an investment-grade company or being owned by an investment-grade company is virtually impossible if you want to be competitive with other players that are.” 

Scale also tends to give customers confidence of execution. In the past, lessors have recounted stories of competitors that have won bids with ultra-low lease rates or few or light return conditions but then sought to renegotiate terms. This is also true for new entrants that are purchasing aircraft from competitors. James Meyler observes that certainty of execution is one of the main challenges for new lessors to overcome: “One of the challenges for the new entrants, even in the US market where you’re competing against reputable large lessors with certainty of execution and availability of funds, to be able to beat them in any bidding campaign, you have to pay a reasonable premium to allow the customer to take the risk on a new entrant. That has pushed up pricing for new entrants because they need to pay for execution risk. It’s been good for sellers, but it’s been definitely a challenge for many of the new entrants.” 

Cost of capital is king in aircraft leasing. For smaller lessors that have a 100 basis points spread between their funding costs, profit margins are greatly reduced at similar lease rates compared to the IG-rated competition. There are always niche players, however, which prove the exception to this rule. 

Novus Aviation Capital’s Kuzbari confirms that he always considers any M&A mandates that come to market, and would seriously consider any avenue to gain scale, for the right price. “We’re witnessing more parties seeking a potential exit to monetise their investments, because they are having difficulty finding relevance into the market due to continuous competitive pressures, because they are too small and finding difficulty growing or feeling a little jittery about the outlook particularly with increased airline bankruptcies,” he says. “On the other hand, we’re seeing continuous flow of liquidity coming to the space, despite the pressure on returns. M&A is a relevant avenue to create scale quickly, accessing a talent pool, widening customer base or gain access to an order book for instance…. M&A opportunities are something we monitor closely and at the right price, the right terms, it’s something we would consider. But we are in a good shape and hence not under pressure to do either.” 

Joint ventures and sidecars

One way to secure a lower cost of capital and growing in size at the same time is by entering into a joint venture (JV) or sidecar investment with new investors. 

Many participants in this report remark that sidecars, JVs and/or strategic alliances will be increasingly used as a primary channel of deploying new capital into the sector. Forming a new venture, by whatever means, is an efficient way for new money to step into owning aircraft with an experienced partner with an established platform at their side. This method should also be considerably cheaper than buying an entire leasing company, as it avoids any goodwill payments for a platform. For lessors, such vehicles enable them to avoid excessive lessee-concentrations by right-sizing their portfolios without eroding the relationships with their airline clients. And of course, there is a considerable fee-earning potential for the leasing company as the asset manager. 

We have our joint investment company with Sichuan Development Holdings, You will see more industry participants setting up joint investment companies as a good way for new entrants to the sector to participate, but also gain access to the capabilities of the industry experts through their marketing and technical expertise. This is also a way for some leasing companies to manage client and/or asset concentrations. It allows lessors to underwrite larger deals by transferring some of the risk to joint investment partners.

Kieran Corr, Standard Chartered

Kieran Corr, global head of Standard Chartered’s Aviation Finance business, agrees that sidecars make sound investments. “We have our joint investment company with Sichuan Development Holdings,” he says. “You will see more industry participants setting up joint investment companies as a good way for new entrants to the sector to participate, but also gain access to the capabilities of the industry experts through their marketing and technical expertise. This is also a way for some leasing companies to manage client and/or asset concentrations. It allows lessors to underwrite larger deals by transferring some of the risk to joint investment partners. Certainly, we are looking for similar opportunities in the future on a global basis, and you’ll also see many of our competitors establishing similar platforms.” 

Aircastle has also tested this model in the past. “It’s an interesting model,” says Inglese. “We’ve done it on a small scale in the past through a joint venture with Ontario Teachers’ Pension Plan, which was once a minority shareholder in our company. We had a joint venture which owned a number of aircraft. The Teachers’ investment team that worked on our deal moved on, and the people who inherited the investment had a different focus, so they exited our stock a few years ago. We recently sold off the remaining assets in that portfolio to one of the newer players from the hedge fund world. There are benefits to leveraging your platform and your skills to manage assets for other players. The difficult part in that equation is always managing the conflicts associated with placement cycles.” 

Our brand is our lifeblood, and we take that corporate fiduciary responsibility very seriously. Ultimately it’s the airlines that decide whether they want this aircraft or that aircraft, so there is rarely a situation where you have that same aircraft type available from two portfolios.

Austin Wiley, SKY Leasing

Managing conflicts of interest is essential for the success of any sidecar venture. Most lessors recognise the paramount importance of setting out clear investment criteria in legal documentation ahead of any new investment vehicle. But alongside the legal requirements, the leasing partner in any sidecar is equally protective of their reputation. 

“Our brand is our lifeblood, and we take that corporate fiduciary responsibility very seriously,” says SKY Leasing’s Wiley. “Ultimately, it’s the airlines that decide whether they want this aircraft or that aircraft, so there is rarely a situation where you have that same aircraft type available from two portfolios. This is where you have to have the right processes in place. It’s how you manage your team. You can’t take better care of the assets you own over a managed asset – that’s just a recipe for trouble. Ultimately, the investors speak with their wallet. They will go away if you do a poor job.” 

SMBC Aviation Capital’s Barrett agrees: “We are in this for the long game and we certainly plan to be here in 20 years’ time. If you don’t do the right thing for your investors, it will come back and bite you. So, we treat every aircraft in our business exactly the same, as whether it’s owned by us or owned by somebody else.” 

For ORIX Aviation’s Meyler, ensuring that joint ventures are in different market sectors is a good way of avoiding any conflict issues. “Obviously, documentation is key in terms of when you’re entering into the agreement and transparency is critical. Also it is important to be careful about which joint ventures you enter into in the first place. Typically, we will try not to have multiple joint ventures in the same space. So, one might be mid-life aircraft, one might be new aircraft, and one might be end-oflife product type.” 

In fact, Meyler adds that in reality having a certain amount of healthy conflict is a positive factor since it demonstrates your effectiveness as an asset manager. 

“If you’re not really active in the market, placing multiple aircraft every month, buying and selling aircraft, you’re actually not going to be a relevant and appropriate manager for the investors,” he says. “That’s one of the key differentiators that successful asset managers bring – they have so much activity that they’re able to marry up deals in portfolio trades or selling into ABS vehicles where they can pull aircraft from different investors, and indeed, with airlines in terms of lease requirements. Very rarely does an airline want just one aircraft. Airlines will typically give a premium for getting sistership aircraft or multiple aircraft from the same channel. Being able to put one of your own aircraft and one of your investors’ aircraft together into a two aircraft transaction will get better results for everybody.” 

For Investec’s Narayan, the investors in his funds are all professional investors that understand conflicts, and more importantly, understand how to manage them in a transparent manner. “Most of our investors are professional investors; they are not retail investors. Conflicts are discussed, managed with these professional investors in the transaction documents for those particular funds. They know what they are signing and they actually go through all of these issues and conflicts very, very carefully. No one just gives away the money.” 

However, even with the most stringent investment criteria and oversight, there are some industry players that remain deeply sceptical of any sidecar vehicles created by established leasing companies. 

Bank of China’s Arnaud Fiscel, for example, is much more cautious: “Sidecars and JVs present an inherent conflict of interest, willingly or not. It may prove difficult to properly assess the equity injection actually made by a leasing sponsor, and accordingly whether investors’ interests are fully aligned. In certain circumstances, it may appear slightly challenging to demonstrate a fair treatment of a sidecar portfolio with the operating lessor’s own portfolio of the exact same aircraft, leased to the exact same operators. One would similarly advise new, less experienced investors willing to join the aviation industry to focus on recourse transactions.” 

More and more lessors are becoming asset managers using these vehicles, or indeed through the prevalence of assetbacked securitisation vehicles that allow lessors to sell off their assets but remain as the servicer to the secured portfolio of aircraft. For ABL Aviation’s Ali Ben Lmadani, this trend is worrying. “Four or five years ago, there were very few asset managers. Today, we see more and more of the lessors becoming asset managers. They are not willing to invest their own equity, but they’re willing to manage assets. The conflicting issue is obvious. But when you see lessors moving out of investing their own equity to manage other assets, that tells you something about the market.” 

Sidecars and JVs present an inherent conflict of interest, willingly or not. It may prove difficult to properly assess the equity injection actually made by a leasing sponsor, and accordingly whether investors’ interests are fully aligned. In certain circumstances, it may appear slightly challenging to demonstrate a fair treatment of a sidecar portfolio with the operating lessor’s own portfolio of the exact same aircraft, leased to the exact same operators.

Arnaud Fiscel, Bank of China (UK)

Ben Lmadani explains that as a pure asset manager, his company charges each client the same advance fee, the same asset management fee, and the same marketing fee. “So, we have the same incentive for all aircraft under management. We also educate our investors as much as we can and, in some cases, we also put our money with their investment. We lose our money before we lose our investors’ money. However, we tell them not to expect very high double-digit returns, because we cannot achieve that. We are very honest about what we’re going to achieve. If a deal is conservative and makes sense, we will do it rather than go for an insane return that we don’t think we can achieve.” 

The leasing market remains ultracompetitive, despite some experts saying that some discipline is returning to the market, particularly in the sale-leaseback sector. The concern regarding such a crowded market where new investors are piling into the space, having only experienced a decade of growth and solid returns, is what happens when those building headwinds result in losses. 

“If some investors gets burned in this market, they will go away and it will affect all of us,” says Ben Lmadani. “Some of the deals on offer to equity investors scare me. If the markets have a bad reputation, it will not affect one company, it will affect all of us because nobody will trust us. We saw it in the past in the shipping market, for example. Our industry is all about trust. When the equity investors give us money, it’s because they trust us. If one of us, as an industry, betrays their trust, it will affect all of us.” 

For new entrants to the leasing market, the need to build market share quickly, resulted in some very tightly priced deals being closed some years ago. The worry is that those deals will mature in the coming years and that investors will start to lose out – a situation that may arrive even sooner if the market turns further downward and more airlines begin to return aircraft. 

“Dropping fares to sustain demand and fill excess capacity will prove uneconomical in the long run and airlines will naturally start returning less desirable aircraft which are under flexible operating lease,” explains Bank of China’s Fiscel. “As many airlines return aircraft, you could expect an even more acute drop of lease rates for certain aircraft type, which would incidentally have an impact on certain investors, financing less liquid assets with significant non-recourse balloons. In this context, I wouldn’t be surprised if latecomers in the leasing market start facing financial issues with the re-leasing of the asset at a significantly lower lease rate.” 

Robert Korn, CEO of Carlyle Aviation Partners, warns that in a harder downturn, some leasing platforms will begin to struggle to make promised returns and passive investors may pay the price: “There are now many more passive investors that allow others to manage their assets,” he says. “We’re already seeing some of those pools where capital was deployed two, three, four, five years ago not having the expected returns and being shut down, and those are kept very private. We don’t see that investor distress or frustration in our space. The airplanes continue to fly, the airlines continue to operate, the asset manager quietly moves on to the next investor, and the first investor’s left with an unpleasant experience of not making the profits that they expected. They either have to decide do I continue in the space and raise a different pool of capital, or lick their wounds and move on. Today, the alternatives to deploy capital are very challenged in today’s market. The ultimate come back is that aviation is very large, there are a lot of opportunities for capital that wants to be here.” 

Stephen Hannahs, CEO of Wings Capital, also predicts a harder fall in the coming years: “I felt a little bit uncomfortable about the airline industry during the last 12 months,” he says. “When we were completing our securitisation in September, many lenders and investors asked me about the state of the industry. I noted that I feel that a downturn is coming. I base this view on some of the recent airline failures, the length of the economic upcycle and our own experience with late payments. I’ve seen some cracks and some airlines are struggling. In the end, this is a cyclical industry. I don’t think airlines are struggling because they’re not selling seats. The yield for airlines has been difficult because of competition. It seems that there is an airline startup every month. There is over capacity in many markets. Some jurisdictions are having trouble, and they exist in all parts of the globe. They come from the Asian market. They come from Latin American markets. They come from the European markets. We’ve had some customers that historically haven’t been slow payers, become slow to payer. We’re working with each airline on a case-bycase basis as the airline sorts through their challenges. As people searched for yield, this brings in excess capital and some deals probably shouldn’t be done. I don’t think that there will be a recession in 2020, but I think it could happen in 2021.” 

There are now many more passive investors that allow others to manage their assets. We’re already seeing some of those pools where capital was deployed two, three, four, five years ago not having the expected returns and being shut down, and those are kept very private. We don’t see that investor distress or frustration in our space.

Robert Korn, Carlyle Aviation Partners

Aircraft trading

Despite the headwinds, 2019 has been a relatively good year for lessors, with good airline demand, and improving lease rates for the right products. Although the new entrants to the leasing space have resulted in increased competition, the situation has also provided a busy aircraft trading environment, as smaller lessors try to build up their portfolios for scale and more firms look to tip assets into ABS structures, an ever-more popular trend. All of these factors have inflated prices for certain product types. 

For Castlelake’s Carruthers, the increase in aircraft trading is a consequence more of the availability and low cost of capital than the supply and demand of aircraft. “On the front end of the market, although sale-leaseback trade is still at incredibly rich valuations, aggressive bids from Chinese leasing companies have subsided and so pricing is a little bit more sane today than it probably was 18 or 24 months ago. When you move to older airplanes, it’s influenced first and foremost by the fact that leverage is still readily available. When the capital structure of an airplane acquisition is still 75%-80% debt, if there is more debt available and if that cost of financing has gone down because interest rates are low, it has a significant influence on the pricing of that airplane. The second factor is simply the amount of equity capital that’s been raised around the sector over the last three to five years. A lot of smaller start-up leasing companies have been capitalised with equity and are pressured to acquire airplanes and substantiate their business plans. When you have that marginal equity capital flowing into the system, it is clearly going to create an environment where you have a lot of money chasing fewer and fewer opportunities, which has the tendency to inflate pricing.” 

This current situation is not expected to change in the short-term, barring a sharp economic shock that would weaken or close down the capital markets. “The capital markets, chiefly the ABS product, has been a large exit avenue for many of the large leasing companies that are looking to sell portfolios of airplanes into the market, and it has been an efficient financing vehicle for a lot of the smaller players that are trying to build up portfolios,” says Carruthers. “Whether it’s in the e-certificate market or it’s just the debt market, if there’s weakening there or if the cost in that financing goes up, there is going to be an adjustment to the pricing of airplanes that have been trading into that marketplace. The ABS market is one of those markets that is open until it isn’t. It’s likely going to be more dependent on the health of the overall capital markets than the health of the aviation industry and the aircraft leasing industry.” 

That being said, the more airline defaults there are, the more likely it is that new capital entering the aviation space will diminish. In such a scenario, long-term sustainable platforms that are ready to work their way through a downcycle where capital is less available and defaults are creeping up, will win over the much smaller, less experienced platforms that lack the capability to work their way through a more challenging market environment. 

GATS progress

In the meantime, high-volume aircraft trading is set to continue into 2020. The pain associated with novating aircraft, however, still remains. The Global Aircraft Trading System (GATS) promises to revolutionise aircraft trading between lessors – this will relieve both airlines and lessors from the increasing volume of lease novations, as well as bringing the archaic trading system for aircraft bang up to date. The aim is for the GATS platform for electronic trading, developed by the Aviation Working Group (AWG), to launch by the end of the first quarter of 2020. The programme is currently on schedule. 

The capital markets, chiefly the ABS product, has been a large exit avenue for many of the large leasing companies that are looking to sell portfolios of airplanes into the market, and it has been an efficient financing vehicle for a lot of the smaller players that are trying to build up portfolios.

Evan Carruthers, Castlelake

Leasing companies are for the most part convinced of the benefits of GATS and are starting to place aircraft into a GATS trusts. Moreover, all AWG members – specifically SMBC Aviation Capital, Avolon, GECAS and BOC Aviation – are very supportive of the platform and are expected to use the platform from its launch at the end of March 2020. Airlines, while initially more sceptical, are also starting to embrace GATS as an industrywide solution for making lease novations more efficient for everyone. GATS may also bring broader macroeconomic benefits, since the platform is expected to generate more liquidity in the market – more aircraft trading – which should theoretically translate to more supply and lower lease rate prices for airlines. 

SMBC’s Barrett confirmed in December that the lessor had signed its first GATS lease, which he describes as a landmark. “We’re very committed to the GATS platform but it is going to take time and it won’t be a panacea for everybody. But, if we stick at it collectively as an industry, and we begin to demonstrate the benefits of it, then we can make a progress, but it’s not going to happen overnight.” 

Barrett further notes that the main challenge is to demonstrate to their airline customers that it is also in their interest to support GATS. “Sometimes airlines view novations as an opportunity to renegotiate or engage with their supplier on some minor points, but when they see the benefits of the ease of doing GATS, the consistency, the protection of their position – because it isn’t always going to be that the airline is going to be in the stronger position, sometimes it’s the other way around – in that situation, having a fair and transparent process in terms of novation is a good thing.” 

There are reports of airlines requesting fees for novations, which is understandable given the amount that some are asked to complete and the consequent strain on their resources. “Some airlines are asking to put transaction fees into their leases,” says Robert Korn, CEO of Carlyle Aviation Partners. “This phenomena of novations – the number of novations and the speed and the amount – is overwhelming to some airlines that have to put full-time people onto this. So, they’re asking for those fees to cover their direct and indirect costs. So, I have sensitivity for the airlines; at the same time, we have contracts that have a process of how you go through a novation.” 

Some participants in this study still require more clarity on how the GATS platform will work in practice, along with its limitations for certain jurisidictions. The AWG has held a series of events explaining how the GATS platform will work. Moreover, in March ahead of its go-live date, it is initiating a simulated testing period where users can generate fictional trusts and novate aircraft using the system, which should help alleviate these concerns. Meanwhile, Fexco, which is the IT service provider building the GATS platform, has created a video that provides a sneak peek of what the platform will look like. The video can be accessed here: http://aviationnewsonline.com/downloads/fexco.mp4 

All of the GATS documents and more are available from the AWG website: http://www.awg.aero/project/gats/

Further information