in Lessors & Asset managers , Airline trends & analysis , Ishka insights

Thursday 27 October 2016

Lucia Cebotaru

at Ishka

lucia@ishkaglobal.com

Investor guide to aircraft finance: an overview

It has been around for a while and burned a few fingers in its time, but aviation finance seems to be enjoying a renaissance.   As commercial airlines gyrated wildly from profitability to value-destruction in the 1980s and 1990s, returns for the investors in aviation have acquired the reputation of being notoriously volatile, driven by an unrelenting business cycle and sensitivity to macroeconomic and geopolitical shocks.   In the aftermath of the financial crisis of 2008, the industry braced for the double whammy of a significant hit on the profitability of airlines and of scarcer, more expensive financing.  Those concerns softened as the industry showed resilience and delivered healthy risk-adjusted returns, while lower availability of some traditional capital sources such as bank debt was supplemented by export credit agencies (ECAs) and capital markets.  

In the years that followed, airlines’ and lessors’ anxiety about securing enough liquidity to meet aviation’s increasingly enormous financing requirements has been met with a deepening pool of capital from banks, capital markets, and internal industry sources.  This is because aircraft are hard, globally mobile assets underlying a global industry with relatively predictable supply-demand dynamics, which despite a set of unique characteristics and risks, consistently outperform other asset classes. Institutions and individuals have become better educated about the nature of aircraft assets and the attractive yields they can typically generate, especially in a persistently low-interest rate environment, and aircraft finance is now in a position of being able to attract new investors. 

Aviation finance offers them a significant array of opportunities, each structured to cater to a different combination of investors’ requirements for returns, risk, volatility and duration. 

Why aircraft finance?

An oft-heard adage is that aircraft finance is a “growth industry within a growth industry.”  The use—and therefore need for financing—of commercial aircraft is a function of air traffic, both in passengers and cargo, which has been shown to double, albeit with some volatility, approximately every 15 years.  Industry data show that despite pockets of weakness, worldwide air traffic continues to grow above long-term trends, airplane utilisation (percentage of time an airplane is in flight per day) and load factors (the measure of how much of an aircraft’s load capacity is used for revenue generation) continue to rise. 

The number of orders for new aircraft—currently, the price tag for Airbus’s and Boeing’s combined order book is estimated to be worth $3.5 trillion over the next 20 years — reflect both those trends and a significant need to replace aging aircraft, especially the types with high fuel consumption.  New deliveries alone will require an estimated $120 billion-$170 billion per annum in financing in the medium to long term.  This comes on top of requirements for financing—and therefore investment opportunities— at various other points in the lifecycle of the aircraft, such as midway through the economic life and prior to or at the conclusion of it.

In considering whether aircraft finance is an attractive opportunity, an investor must consider the unique qualities of the aircraft as the underlying asset.  An aircraft is a fungible, hard, wasting asset which depreciates steadily over its life span to a certain value (known as the “residual value”).  Current industry practice is to depreciate aircraft over 25 years to 10% of the original value (although there is debate over the potential shortening of useful economic life, with some observers claiming it should be as low as 15 years).  Aircraft are denominated in US dollars, global in their recognition and highly mobile.  The value of the aircraft is generally predictable through the cycle but is more sensitive to economic shocks and other common risk factors than some other asset types (such as infrastructure or real estate).  Because the value of the aircraft declines with time, the cash flows associated with it also decline.  As an investment, aircraft generally generate returns higher than infrastructure over longer horizons, partially because higher initial leverage (required to ensure attractive equity returns) is mitigated through strong investor protections.

Debt or equity?

Traditionally, a distinction has been made between aviation investors who invest, in some way or another, into actual aircraft (or “metal,” in the aviation parlance) and financial investors, who limit their investments to publicly-traded or privately-placed financial instruments (“paper”). For financial investors, participation in aircraft finance is possible directly, through privately placed secured or unsecured bank loan or notes (on the debt side), or through ownership in aircraft-owning entities (on the equity side). 

Typical equity investors on the metal side include lessors, private equity funds, hedge funds, and banks. Their investment strategy calls for high risk-adjusted returns and often have a strong asset management platform.  An equity holder in aviation will be exposed to the residual value risk — aircraft are a wasting asset, and its final value may fluctuate dramatically depending on the prevailing market conditions and its technical condition.  

On the equity side, available platforms include managed funds for high-yield investors; these often require a significant equity stake and target higher cash yields at the expense of lower absolute returns.  Such specialised funds may rely on strategies which their asset managers believe to be filling in the gaps unserved by more traditional investment vehicles; they may, for example, offer financing structures that are viewed as too risky by conventional lenders.  Other vehicles for equity participation include:

- shares in listed companies (lessors or airlines)

- ownership of aircraft-owning entities (such as, for example, private equity firms purchasing operating lessors)

- hedge funds and private equity firms with active trading strategies and a focus on riskier segments with possibility of higher returns (e.g. end-of-life segment where aircraft are acquired for partout (for parts).

For investors whose risk appetite does not extend to equity positions, aviation finance offers multiple opportunities in the debt space. Where the debt space, especially in the West, was previously heavily dominated by commercial banks, private equity firms, pension funds, insurance companies and asset management funds have been showing appetite for senior secured and unsecured notes, pre-delivery- payments financing and other forms of aircraft funding.  

Debt providers, by definition, are protected by seniority over equity in a bankruptcy situation; senior debt providers also often benefit from strong protections built into the financing structures (these may include bankruptcy remoteness for the investment vehicle, collateral, external guarantees, coverage and other structural triggers, cash traps, provisions for early repayment, etc). 

By way of explaining how pricing is determined in the debt space, investment instruments with higher returns have relatively simple structures and rely principally on the performance of the issuer rather than on recourse to its assets (i.e. collateral and security). Investments with lower returns are structured to provide investors recourse to specified assets in a distressed scenario. The exact nature of the recourse is critical to assessing risk and, therefore, the pricing.

A brief summary of investment needs

Investment vehicles exist on both equity and debt sides for pre-delivery financing (PDP), new aircraft deliveries, mid-life aircraft and end-of-life.  Each of these is associated with its own potential upsides and risks.

PDP financing
 

Production of an aircraft can take several years and involves significant outlays by the manufacturer; to offset some of the costs OEMs (original equipment manufacturers) require the aircraft purchaser to make regular payments, usually amounting to 30%-40% of the list price, during the production period.  The purchaser—whether an airline or an operating lessor—will normally require short or medium-term financing to effect such payments, and a loan facility from an experienced aircraft finance bank has been the traditional PDP format.  
 

The fundamental feature and source of risk for an investor in a traditional PDP structure is that no physical aircraft exists at the outset of the term of the facility that can be used as security, either by way of a mortgage or by way of assignment, and that the PDP financier therefore takes credit risk on the purchaser. Due to those risks and as a result of regulatory pressure in the West, institutional investor appetite for this kind of financing has been muted, despite delivering meaningfully higher returns than in conventional aircraft finance transactions.  For an investor with appropriate risk appetite and horizon, PDP financing offers shorter tenors and credit risk mitigation through credit enhancements (e.g. parent company guarantees).  Notably, there has been an uptick in interest from private equity and special funds in providing PDP financing to a wider range of purchasers.

New delivery financing
 

 New aircraft deliveries are the largest source of financing need in the industry, with airlines and operating lessors requiring a mix of commercial debt, export credit, internally-sourced equity and, indirectly, capital markets’ support.  This is perhaps the best understood segment of the aviation market for the investor community; it is also the most competitive, with risk-adjusted returns compressed relative to other aircraft-backed vehicles.  This is because for a wasting asset whose value declines steadily over its life, the entry-into-service point offers an investor exposure to an asset at its highest valuation and with the best potential for revenue generation. 
 

Importantly, the initial appraised value of a new aircraft and its depreciated value in the near term are more transparent and predictable at that point than any one later in the asset’s economic life, which provides investors with comfort.  Depending on the investment vehicle, investors in this space may also look through to the credit quality and technical expertise of the operator of the underlying aircraft; top-tier airlines and operating lessors with strong operational platforms and a track record of solid financial performance are often viewed as capable of maintaining the aircraft in an optimal condition (thus maintaining the aircraft’s value) and so are able to tap capital sources across the spectrum of instruments.   
 

Investment in new aircraft, especially if it is in high demand by operators due to desirable technology and fuel efficiency, is viewed as less risky and yet capable of generating consistent returns to both debt and equity holders.  Aviation assets at the beginning of their lifecycle may be particularly suited to investors with longer horizons, who seek ongoing long-term yield (and, in case of equity, possible residual value profit at exit). 

Financing mid-life and end-of-life aircraft
 

There has been consistent investor interest in mid-life aircraft.  The appeal of such assets lies in the relatively long remaining economic life, stable cashflows underpinned by high utilisation and, for equity investors, comparatively predictable residual values.  

Many of the transactions brought to the markets in recent years were targeted at liquid, in-demand, in-production aircraft at mid-life.  At the end-of-lifecycle inflection point, investing in any scheme involving aircraft nearing the conclusion of their economic life has always required intimate technical knowledge of the asset, as data requirements for pricing true residual value are difficult, if not impossible, for aspiring investors with no industry expertise.  Returns for an investor in this segment of the aviation market are normally higher, reflecting the riskiness of decision-making due to the opacity of market data.   

An additional factor driving the appeal of this segment is the rising number of aircraft considered to have reached their ‘end of useful life’, thus increasing the size of the overall end-of-life market segment.  This is because there are indications that abundant export credit support for new deliveries has allowed airlines that would have been previously forced to purchase second-hand aircraft to enter the primary market; older assets are now less likely to remain in operation and enter conversion or part-out markets earlier that previously thought.  The end of the investment spectrum is better suited to the vehicles with higher hurdle rates for investments, such as hedge funds.
 

Is aircraft finance for me?

Fundamentally, investing in aircraft is not dissimilar from investing in any other asset class, and an investor should begin the consideration process by determining its objectives and contrasting them with the opportunities that exist in the aviation space.  Some of the questions a potential investor in aircraft may ask themselves include:

• What is my investment horizon—short (up to 3 years), medium (4-7) or long (10-12 years)?
• Am I comfortable with the volatility of returns?
• What are my investment hurdle rates?
• What is my risk appetite: am I willing to take risk on the value of the underlying aircraft or the possibility of bankruptcy by the originator of the investment?
• Am I looking to maximize the upside or limit the downside for my investment?
• Do I understand the value of the underlying aircraft, its changes over the lifetime of the asset and the effect of those changes on the quality of my investment?  
• Do I understand how the value of the aircraft is retained on a technical level and have monitoring and technical capabilities to ensure such value retention? 
• Am I comfortable deferring the monitoring of asset value to a third party?  
• Do I understand my rights and responsibilities in relation to the underlying aircraft in a distressed scenario?

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