The sums involved in aviation finance are mind-boggling. During 2015 alone the airlines and aircraft lessors took advantage of low interest rates and strong capital availability to raise more than $45 billion (€43 billion) in secured and unsecured debt.The outlook for 2017 is the same, if not better, according to most commentators.
The big question for the airlines is how they decide to fund their fleet purchases. Leasing remains very popular with close to 50 per cent of the world's commercial aircraft fleet expected to be leased under operating leases by 2020, according to Pieter Burger, lead tax partner, aircraft leasing and finance, with Deloitte.
“The choice and availability of aircraft finance ultimately depends, of course, on the airline in question. For some, such as recently established airlines and certain low-cost carriers, leasing an aircraft under an operating lease will be the favoured or sometimes the only option,” Burger says.
“Other airlines with strong credit ratings may prefer to raise cheaper loan finance available from the capital markets or the commercial banks and use this to acquire aircraft outright. Even in the latter cases, however, it is common to see airlines adopt a diversified funding strategy with at least a portion of the total fleet leased under operating leases.”
KPMG’s head of aviation finance and leasing Tom Woods says the aviation finance market has gone through some changes in recent years.
“During the financial crisis, the export credit agencies were being relied on to fund aircraft deliveries for a number of years,” he says. “They kept the market open to a certain extent and accounted for over 20 per cent of the market at one point. As the economy picked up the banks and the capital markets have stepped back in, with the capital markets being the largest funding source in 2016.”
According to Woods, about 36 per cent of aircraft deals were financed by the capital markets during 2016. Cash made up 24 per cent and bank debt was 27 per cent, while the share of export credit agencies had declined to 11 per cent.
“There is a strong appetite for aviation finance from investors across the globe, with increasing interest from investors in Asia and Korea, in particular,” Woods says.
Significant lender
Former
GPA
chief executive and current chair of the UCD Smurfit School of Aviation Finance Patrick Blaney says that every available funding market is being tapped.
“Korea is now a big player in this space,” he says. “Five years ago, it wasn’t in the market at all but it is now a very significant lender. New sources of capital are always being explored by the industry.”
A major feature of the year was the re-entry of the banks to the market. “Aviation finance came back into fashion with the banks in 2016,” says Blaney. “But there was also a lot of capital markets activity with a lot of securitisation activity towards the end of the year.”
This saw the aircraft lessors getting involved in the creation of asset-backed securities. This involves aircraft leases being bundled into a product which is then sold on to investors. These allow the lessors to refinance borrowings in order to use that credit for further purchases and can be very attractive to investors.
“They put very good aircraft and top-tier carriers into them. They put good customers and good aircraft into the package. They structurally enhance that by putting in a guarantee facility,” Blaney says.
“This reduces the risk for AA-rated bondholders. These structured products command high ratings and high prices. They are highly complex products and have to be rated by the agencies. Their upfront cost can be significant and they require a lot of ongoing administration, but this is justified by the returns and margin over the life of the product.”
BDO partner Peter Carroll agrees. "With a well-managed fleet of narrow-bodied aircraft, good customers and good maintenance programmes, it's easy to show an income. It's an industry that's very well managed and focused on residual values and so on. They can go to investors and show strong cash flows and so on and that's very attractive to people," he says.
Private equity
This is just one source of finance being explored by the industry. “They need exposure to every market,” Blaney says. “Every company is out in every market. They pick and choose what they will do at any given time, but they keep them all warm. If you are trying to raise a lot of money, it helps to keep all potential sources involved and informed.”
Private equity is another significant source of funding for the sector, according to Carroll.
“Private equity is a big fan of the aviation sector. Private equity has enjoyed very good returns from the sector, particularly those invested in narrow-bodied aircraft,” he says.
“Some of them had their fingers burnt in the wide body area which are much more difficult assets to move if things stop in one market. I see no reason why strong private equity investment in aviation won’t continue.”
Timing and choosing the right type of finance are absolutely crucial, according to Blaney. He mentions the salutary tale of one lessor which was a wholly-owned subsidiary of a global insurance company. It was mainly funded by short-term debt but the mismatch with its long-term assets could be deemed acceptable as long as its parent remained healthy.
However, when the global financial crash came, it wasn’t able to refinance and ended up being sold off for a fraction of its pre-crash value.
“That’s a lesson which was well learned by the aviation finance industry,” says Blaney. “It’s a truism about borrowing that you only borrow when don’t need to. The lessors are borrowing long before they need it. What they typically do is refinance borrowing with an asset-backed security and then move the borrowing to something else.”
The enhanced equipment trust certificate option
There are other options for airlines wishing to fund aircraft purchases, including enhanced equipment trust certificates (EETCs). These are seen by many as the next generation of debt financing for airlines.
EETCs are corporate debt securities usually issued by an airline. They are secured on the aircraft and are enhanced by elements such as debt tranching, availability of liquidity facilities and over-collateralisation.
The main advantage EETCs offer to airlines is a lower cost of finance, while the attraction for investors is the same as with other asset-backed securities.
However, they are mainly used in the US due to certain tax advantages there. The bankruptcy regulations in the US, which make it quite easy to recover assets, also add to the attractiveness of EETCs in that market.
“New financing sources will likely continue to emerge driven by ongoing strong airline fundamentals such as strong global passenger traffic and low oil prices, and a better understanding in the investment community of commercial aircraft as an asset class,” says Deloitte’s Pieter Burger.
“The recent increase in non-US investor interest in public EETCs should continue and increase into 2017.”