Who’s Who Legal brings together three of the leading aviation finance practitioners in the world to discuss key issues facing lawyers today.
Conyers Dill & Pearman Limited
Order backlogs for new aircraft are at a record high, but at a time when the traditional aviation banks are still under pressure. Have you seen an increase in the number of players from the East? Which types of investors are attracted to the aviation finance market?
Julie McLean: There has recently been a strong trend towards operating leasing of aircraft and an increase in sale and leaseback activity by airlines. Taking aircraft on operating leasing appears the preferred route for many airlines. Consequently, there has been much activity in the operating lessor space in terms of acqusitions and the emergence of new players. Much of this activity has involved Asian institutions – particularly from China, Japan and the Middle East. Asian (in particular) banks and leasing companies have entered the aviation market in recent years, both in terms of direct involvement in transactions and by the acquisition of aircraft portfolios and operating lessors, including the (now long-standing) position taken by Bank of China, via BOC Aviation, in the market; the acquisition of RBS Aviation by Sumitomo Mitsui; and Mitsubishi UJF’s purchase of Jackson Square Aviation. New players in the operating lessor market have also emerged, for example, Jackson Square and Avolon and, in Asia, HKAC, ICBC Leasing, China Development Bank Leasing and, in the Gulf region, Alafco in Kuwait.
The rising cost of traditional capital is bringing about more innovative financing structures – and the increasing use of the capital markets – as well as private equity and sovereign wealth interest and involvement. Examples of private equity investment into aircraft lessors are Cerberus Capital into Aercap (now exited); Terra Firma into Awas; and Oaktree into Jackson Square (now sold to Mitsubishi). With Exim and ECA financing getting more expensive, there are opportunities for investors. We have had queries about establishing segregated account companies as a fund vehicle for investors in aircraft but none that have proceeded to fruition yet.
As a firm, Conyers frequently acts, across our jurisdictions, for a number of the world’s leading leasing companies, airlines, financial institutions, investment funds and private equity firms engaged in the aviation market.
Berend Crans: It would indeed appear that a number of players from Asia, and in particular China, are increasingly active in the market. Leasing companies like Dragon Aviation Leasing (which is owned by China Aviation Supplies Holding Company (50 per cent), Aercap B.V. (20.5 per cent), CA-CIB Airfinance S.A (20.5 per cent) and East Epoch Limited (99 per cent)), China Financial Leasing Group, Bank of Communications Finance Leasing (BOCOM) and Hong Kong-based China Aircraft Leasing Company Limited (CALC), which in January 2013 signed a purchase agreement with Airbus for 28 A320 and eight A321 aircraft are showing their strength. In February 2013 CALC announced its intention to obtain a listing in Hong Kong to “cater for our bold expansion plans”. Although CALC’s current customers are primarily Chinese carriers, such expansion may entail that CALC will also look for customers in other regions. In 2011 BOCOM signed a purchase agreement for 30 C919 aircraft with the Commercial Aircraft Corporation of China. BOCOM also recently acquired aircraft on lease to European carriers from other lessors. Following the entry into force of the 2011 Aircraft Sector Understanding and the inherent substantially increased costs of ECA supported transactions, commercial lenders may be in a position to offer funding at better margins. Their lending capacity may, however, be restricted because of Basle III requirements and other solvency rules. This may open the door to new structures, with funds provided by pensions funds, insurers or through debt capital market instruments.
Edward Gross: Backlogs for business jet original equipment manufacturers (OEMs) have fallen across the industry from the highs of 2008. Cessna’s backlog, for example, has gone from $16 billion in June 2007 to less than $1 billion now. Larger aircraft OEMs have slightly better backlog circumstances. OEM backlogs have been impacted by, among other things, the slow market recovery as well as a reduced level of production by certain OEMs. It is unlikely that the business jet market will reach pre-recession levels any time soon. The North American market continues to be the strongest market by a wide measure.
In business aircraft financing markets, there has been an increase in participation from Chinese banks, including Bank of China and Minsheng, but primarily to support in-country sales into China.
In North America, various groupings of financing providers, money centre banks and independents that have been traditional market participants include BofAML, RBSAF, JPMC, Wells, Citi and PNC (all bank affiliates) as well as CIT, GE Cap and Guggenheim (independents). Citi, CIT and Guggenheim focus on opportunities outside of the US. PNC, GE Cap and Guggenheim are somewhat unique for their focus on the asset. Newer entrants and regionals that are staffing up, often buyers in syndication transactions, and in some cases focus on medium-size and smaller aircraft, include CapOne, BMOH, BB&T and Regions (bank affiliates) and Element and Synovus (independents).
Some banks, including many newer entrants, are participating in the aircraft financing segment to serve the needs of their existing customers, some of whom are looking for 1-stop shopping. This is especially the case for their ultra-high net worth customers. Some banks are hoping that the aircraft financing will facilitate the sale of other banking products to a newer customer.
Helicopter lessors that are generating significant volume include Milestone, Macquarie and Element.
There are concerns that the growing demand for new aircraft will have implications for the residual pricing of current aircraft. Do you expect this to have an adverse impact or to provide opportunities for investors to pick up mid-life to older aircraft?
Berend Crans: A growing demand for new aircraft does not necessarily mean that values of current aircraft will be adversely affected. Much will depend on the traffic growth and the speed with which new aircraft deliveries can be effected. Boeing’s 2013 forecast indicates that by 2032, 85 per cent of the global fleet will consist of new aircraft, ie, aircraft delivered after 2013. Obviously, factors like higher operating costs and customer preferences will also play a role in out phasing older aircraft and may expedite the putting in operation of new, more economic, cleaner and more appealing aircraft. Still, mid-life to older aircraft could be attractive to investors and operators in regions where low-cost-carriers are yet to gain market share.
Edward Gross: investors to pick up mid-life to older aircraft?
Business jet OEMs frequently introduce new models, and financing providers to this market to anticipate this. Some consider it an advantage because this dynamic can stimulate demand. Some examples include the Pilatus PC-24, Falcon 5X, Challenger 350, Legacy 450 and 500, and Citation Latitude and Longitude, as well as the G650 which has been delivering for the past year.
However, some business jet financiers believe that the flow of new jet deliveries from the OEMs, along with the already-large installed base, exerts too much pressure on pricing for new and one-to-five-year-old jets. Although the volume of aircraft transactions and related financings has picked up since the recession, pricing is not improving. Pricing is declining due to declining asset values.
The demand for jets aged 10 years or older is and could remain poor. This supply/demand imbalance is driving much faster diminution of value than our industry has experienced in the recent past. When levels of pre-owned inventory for sale swell, diminished trade-in values are likely to impact the buying power of a new aircraft purchaser.
Growing demand for new aircraft will have implications to residual value pricing of current aircraft, which is a big concern for lessors. Lease financing has become very desirable to customers, but very few financing providers can confidently prognosticate accurate residual estimates. Many were way too optimistic prior to the recession, and there is some hangover given that experience.
Because age matters to traditional market participants, regional financing providers might find an opportunity to support customers who desire financing of mid-life to older aircraft. And although the residual risk will impact a financing provider’s willingness to do leases and take residual risks, there could be lending opportunities. Lenders can protect themselves better with deal terms and conditions, including shorter terms, loan-to-value pre-payments and requiring additional collateral.
OEMs that can provide acquisition financing will have a significant advantage. Some general aviation customers acquiring new aircraft, whether for business or personal use, are less likely to find multiple funding sources among the banks and independent financing providers. OEMs of very light jets and other lighter aircraft would likely facilitate sales by establishing a captive financing provider or a financing program with an experienced funding source. By way of example, Honda is establishing a captive that will provide financing to customers purchasing the new HondaJets when deliveries commence in the near future.
Further to the commercial versus business market distinctions, aged commercial aircraft might be more easily redeployed than business aircraft. Commercial aircraft are revenue-generating assets, and in many cases can be profitably returned to service assuming fuel prices are reasonable and expensive maintenance events are not due. If a business aircraft has unique specifications and features that are desirable to the original operator, but not necessarily to other operators, the trade-in or resale value could be impacted.
Outside of the two largest leasing entities, GECAS and ILFC, have you seen an increase in new entrants? Why is leasing so attractive? Do you expect to see more deal activity in this area in the coming year?
Julie McLean: The majority of our work in Bermuda tends to involve financing and leasing of aircraft by Russian operators. Historically the leasing companies involved were the likes of GECAS and ILFC, but lately we have seen the Russian leasing companies (VTB Leasing and VEB Leasing) involved in more transactions. From a general persepective, I read somewhere that 35 per cent of the world’s airline fleet are leased, and that this figure is set to rise to 50 per cent by 2020 – so it is likely that you will see even more activity from the smaller leasing companies. Lessors have numerous important roles. To manufacturers, they are customers, offering a crucial distribution channel to airlines. To airlines, they supply an essential means to acquire aircraft with less overall risk and (potentially) better economic value. So yes, I would expect more deal activity involving leasing companies in the coming year.
Berend Crans: We have indeed seen new entrants in the Netherlands, including Jetscape, CALC and the Bank of Communications Finance Leasing. Julie McLean’s numbers regarding the growth of the operating leasing market are correct and were published by Boeing in their most recent forecast. On this basis one would indeed expect that operating lessors are active in a growth market. For airlines operating leases allow for flexibility, eg, to cover seasonal volatility in capacity requirements. In addition operating leases do not absorb liquidity and can be relatively short-term. Financial leasing structures provide a good alternative to plain vanilla financing. Given the Boeing and Airbus forecasts, indicating a demand for approximately 35,000 new aircraft over the next 20 years, one cannot but expect a lot of deal activity in the coming years.
Edward Gross: Unlike commercial aviation, there are very few operating lessors of business aviation assets, other than helicopters. The majority of business jet customers, even in the US, are paying cash. However, many of the business jets being financed are lease financed (ie, a true “lease” for tax, accounting and commercial law purposes). Some attribute the desire for this product to the reluctance to invest in business aircraft by new owners or owners whose aircraft suffered drastic losses of value as a result of the recession. However, residual value can be a very dangerous variable for lessors who have inadequate in-house resources or who make competitive bets on future value in this uncertain market.
Helicopter leasing is a recent, but expanding market. Over the past three years, a number of participants have entered the helicopter operating lease market. Examples include private equity-backed companies like Milestone and Waypoint, and commercial leasing companies like the Lease Corporation International and Macquarie. These participants seem to view investment in rotary assets to be better opportunities than those available in commercial aircraft leasing.
Helicopters have long economic lives and, historically, have stronger residual values. The credit analysis typically includes reliance on the lessee’s very strong end-user customers, including energy companies and governmental entities. Helicopter values suffered less than business jets during and after the recession because they were operated for purposes and by businesses that were less impacted by the recession, including as air ambulances, and in service of utility companies and in oil and gas exploration.
The market has seen a significant amount of consolidation in recent years. Following the scrutiny of the American /US Airways proposed merger, do you think airlines will opt for more alliances?
Berend Crans: Obviously a distinction should be made between mergers, which are much more likely to directly affect competition, and alliances like SkyTeam, One World and Star Alliance. I do believe that cartel authorities will look even more closely at mergers, now that the number of players is decreasing. It may follow that cartel authorities scrutinise the effect of mergers at micro level and assess for instance whether a contemplated merger could impair competition on certain routes. Today one could even argue that competition is virtually non-existent on a number of European routes, where only two carriers operate. If one compares prices on routes where only two airlines operate, eg, to popular holiday destinations such as Alicante or Valencia, one can hardly escape the thought that there is some form of concerted practice between those two carriers. The same may hold true for routes in the USA and in other countries or regions. Further consolidation will most certainly adversely affect competition and one can only hope that cartel authorities will properly assess the implications of any proposed merger and will only give their consent when competition is safeguarded. Nevertheless, we must expect further consolidation as carriers – like Alitalia – may no longer be able to independently survive.
Airport privatisations are on the rise throughout the world as governments look to cut their budget deficits and transfer the burden of financing, development and operational costs to the private sector. Has this been an active area of work for you and your firm? Do you expect this trend to continue?
Berend Crans: In the Netherlands, privatisation of Schiphol Airport has been intensely discussed for many years. NV, Luchthaven Schiphol (also known as Schiphol Group NV) – the owner of Schiphol Airport, Rotterdam Airport and Lelystad Airport – is owned by the Dutch state (69.8 per cent), the municipality of Amsterdam (20 per cent), Aeroports de Paris (8 per cent) and the municipality of Rotterdam (2.2 per cent). The interest currently held by Aeroports de Paris is the result of a cross-participation transaction. Schiphol Group NV has a 51 per cent interest in Eindhoven Airport NV with the municipality of Eindhoven and the province of Noord-Brabant each holding a 24.5 per cent interest. Similarly Eelde Airport in the north of the country is owned by provinces and municipalities.
In 2006 privatisation of Schiphol was seriously considered by the Dutch government, but the Municipality of Amsterdam raised strong objections. In addition, airlines opposed the contemplated privatisation as they feared that rates would be increased. In 2007 the (new) government shelved the plan. This year the Dutch government announced in its Policy on State Participations, which was published on 18 October 2013, that Schiphol is one of the current state participations which serve the public interest and are of strategic importance, just like TenneT, the national grid manager, Gasunie, the manager of the national high-pressure natural gas grid, and the Port of Rotterdam. It was concluded that these state participations will be maintained and will not be privatised. Things may of course change in the future but the current political trend would appear to be against privatisation in any case where it concerns airports and other infrastructure serving a public interest and having strategic importance. Obviously, Schiphol Airport, which is the main airport of the Netherlands, is not to be compared with much smaller airports, like Eindhoven, which has a more regional role, and Eelde, from which primarily low-cost carriers serve popular holiday destinations. Privatisation of these airports may not be excluded on the basis of public interest or strategic considerations only. Given that over the last decade Eindhoven Airport has been consistently profitable whilst Eelde has been consistently lossmaking, commercial considerations could still trigger privatisation of this type of airport. Given the current political climate it is, however, not expected that this will occur in the near future.
Edward Gross: It seems logical that this trend will continue. However, the pertinent governmental authorities are still likely to play a meaningful role, including with respect to matters of defence, national security, environment, safety and emergencies. The business air industry is also concerned that private airport operators could shift the cost-allocation to business aviation operators, and could also be less even-handed as most aviation authorities have been when deciding cost allocations between commercial and general aviation. Other lawyers in our firm have been involved in this practice area.