Prepare for take-off: aviation leasing

It is no secret that institutions are broadening their horizons searching for new alpha generating opportunities. Airline finance may not be the first stop on their journey but it is becoming more than just a blip on the radar screen. Like many other alternative investments, though, it requires a deep understanding of the dynamics, direction and fundamentals of the industry.

“[There is a] low correlation to equities, an attractive dividend rate and strong income generation from aircraft lease. But you must ensure that you have the right combination of aircraft and airline.”

Shantanu Tandon

This is particularly the case with aviation, which has had a bumpy ride over the past few years. Research from advisory firm Ascend, part of Flightglobal and Reed Business Information, shows around 136 airlines have had their wings clipped during 2007 to 2012 while three major airlines – Japan Airlines, AMR and Kingfisher – underwent bankruptcies and re-organisations.

The recession, increased regulatory costs and fuel price volatility are partly to blame, but the other culprit is the longer term trends that have plagued the industry over the past decade. These include excess capacity, intense competition and the proliferation of low-cost carriers, according to a recent report from PwC Aviation Finance, Fasten Your Seatbelts. These challenges combined with unusual external events such as 9/11, SARS and swine flu outbreaks and volcanic eruptions have wreaked havoc on balance sheets as well the returns on equity.

Today, the sector is leaner, with engines revved up on the back of the burgeoning middle and upper classes of the emerging markets who have acquired a taste for travel. Research from Airbus, the world’s largestmanufacturer of passenger jets shows that although over 60% of air travel will continue to take place in the developed countries, traffic growth between advanced and emerging air transport markets is estimated to grow at an average annual rate of 5.1%. This is above the world figure of 4.7% and not far off the 6.6% annual growth rate prediction between emerging markets.

Demand is flying high

The increased demand has translated into larger orders for aircrafts. Last year, Airbus raised its 20-year industry forecast for aircraft deliveries by about 5% to 28,200, valued at over $4trn. Rival US-based Boeing also increased its predicted order book to 35,280 airplanes for airlines, leasing companies and freight firms from its previous projection of 34,000 over the same period. This is more than doubling the global fleet with the price tag coming at over $4.8trn.

Although this is welcome news for the industry, finding the funding will not be easy. “The banks are pulling back as they de-leverage,” says Shamshad Ali, a partner at PwC Financial Services in the UK and co-author of the recent report Aviation Finance, Fasten Your Seatbelts.

“Many banks are moving away from financing big assets that require dollar funding, on their own balance sheets. The key challenge for airlines, which have record orders in place, is to find financing at attractive rate in a tougher economic environment.”

The same patterns have taken place in the real estate and infrastructure space where the banks have also retreated and institutions are stepping in to fill the funding gap. The picture, of course, was different before the financial crisis. Aircraft finance transactions under Basel II typically required low levels of capital because they were asset-based, fully secured by the aircraft and operating lease rental stream.

The regulatory screws have been tightened with Basel III which has a 3% capital requirement regardless of the quality of the assets and a new net stable funding ratio which requires funding to match lending maturities. The PwC report notes that this will impact future loan conditions for long term borrowing, including for aviation finance. For airlines, the effect of Basel III could translate into higher loan pricing as banks pass on extra liquidity costs. Although it is hard to quantify the exact impact as lending rates are an interplay of bank risk and liquidity costs as well as currency exposure but it is likely that loan pricing will rise.

The banks are not the only ones being squeezed. Export credit agencies, which have played a vital role in providing finance since 2008, have their own set of rules to grapple with. For example, the new Aircraft Sector Understanding (ASU) is likely to result in a considerable increase in premiums.

“What we are seeing now is capital markets are financing close to 30% of all deals with ECAs at 20%,” says David Treitel, managing director of Apollo Aviation, US-based aviation asset manager. “However, it is becoming more expensive and we are seeing institutional money come in particularly on the private equity side.”

No shortage of funding

To date, private equity funds such as Cinven, CVC, Oak Hill Capital as well as Singapore’s sovereign wealth fund, GIC Singapore, have been the most active investors. Japanese banks, on the other hand, have been at the forefront of some of the larger deals. These include, the Sumitomo Mitsui Financial Group’s $1.2bn acquisition of Royal Bank of Scotland‘s plane-leasing unit, the sale of DVB’s 60% share in TES Holdings to Development Bank of Japan and Mitsubishi UFJ Lease & Finance Co’s $1.3bn purchase of Jackson Square Aviation from Oaktree Capital.

There is no shortage of prospects. In the next two years alone, Ascend expects aircraft leasing companies to purchase a total of aroundrequire around $20bn of equity capital to be pumped in. The market is dominated by the so called ‘big two’, GECAS and ILFC, who both have fleets larger than Delta Air Lines, the world’s largest airline by number of aircraft. Smaller upshots such as HKAC, Avolon and Jackson Square are hot on their heels, but they are all in pursuit of insurance companies, pension funds, private equity firms and other long term investors.

The main selling point is relatively predictable and higher than average returns in a low interest rate environment. In addition, the underlying asset – the aircraft – is global, plus it is highly mobile and can easily be reclaimed or redeployed in the case of a default. “There are great opportunities but there are barriers to entry in that it is a less well understood sector,” says Ali. “It is not like equities or other alternatives, there is a dearth of coverage and there are very few dedicated funds to invest in.”