After the demise of the Japanese leveraged lease, the markets for tax based aircraft leasing are being shut down one by one. What other sources of funding will replace tax leasing and will they be as cost effective?
All good things must come to an end and that time has arrived for aircraft financing. At least for tax-based finance. Interest rates around the world are making leveraged leasing deals unattractive and, as various economies start to retract into zero growth or even recession, their governments are no longer accepting the wholesale export of tax benefits to third countries through complicated lessor vehicles. It is time to reassess how commercial aircraft are being financed, a stiff challenge in a high-level delivery year like 1999.
The roller coaster financings of the mid-1990s, with very fine debt margins yet an abundant supply of investors willing to plough billions of dollars into aircraft finance, have come to the end of the ride. It will be some time before banks and financial institutions are again willing to offer margins as low as 30 basis points over Libor and probably even longer before equity placement firms will have an over-eager and ever-active supply of wealthy individuals and companies who are willing and able to defer their tax bills in this way.
Market estimates suggest that tax-based financing has accounted for just 30% of all deals this year in a clear sign that other forms of finance are increasingly being used.
The end of an era started in mid-1998 when the Japanese banks finally realised that no amount of lobbying would prevent the mighty Japanese National Tax Authority and the Ministry of Finance from closing down the Japanese leveraged lease (JLL) market. After all, Japanese investors had been able to defer their tax bills for more than 10 years of the structure's existence. The final blow may have caused many gloomy faces in Tokyo, London and New York when the market closed in October but the Japanese Government's move was nothing new.
Plugging the loopholesThe Internal Revenue Service in the US and the Inland Revenue, the UK's equivalent, were already hot on the heels of financiers trying to find loopholes in tax legislation to structure attractive aircraft finance deals. Determination on behalf of the British had already reduced the UK tax lease market to little more than a marginal option for some UK-based carriers.
Until very recently, German tax leases, although complicated, offered a viable alternative to airlines with an appetite to fill their finance portfolios with leveraged lease deals. But a blow was dealt to the German market in early December when the Ministry of Finance, of the recently elected Schroeder administration, announced it may also be closing tax loopholes. A multi-billion dollar market was shattered overnight as arranger and investor confidence evaporated. Some conservative arrangers even believe the government may take retroactive action and scupper some of the deals closed in the last three years of the German tax lease market. The change was fully expected from the outset of the German elections. Even if Chancellor Kohl had won another term, many financiers in Germany were aware that their business was earmarked for change.
Some German investors, typically the fraternity of Germany's rich dentists, doctors and lawyers, were able to generate after-tax yield of as much as 18-19% on aircraft finance deals. Most, however, only benefited to the tune of around 15% - still a very good return on the average DM100,000 ($60,000) investment. The German Ministry of Finance's proposed draft would hit investor yields and, in turn, airline costs. "People are nervous and everyone is waiting to see the outcome," says Michael Trentzsch, at Hypobank in Munich. "But the big investors are not as nervous as the small investors. With these changes, [small investors] will start to invest in other areas like pension funds and the stock markets."
Like many other tax authorities around the world faced with the same challenges, the Germans will be focusing on depreciation and amortisation. At present, the German tax lease structure is enhanced by a 12-year amortisation schedule for wide body aircraft such as Airbus A330-200s. But this is set to change. "The new amortisation levels will be increased to 20 years, which will have a serious impact on deals," explains Henryk Wuppermann, of recently formed East Merchant - comprising the West Merchant Bank leasing team and majority capital from Saxon LB - in Düsseldorf.
Tax deferrals for Germany's rich investors are also likely to be hit by the draft proposals. Up to now, just 50% of an investor's tax rate would be applied to the residual value of the aircraft in their investment portfolio. The Ministry of Finance wants this to be scrapped and the full tax rate to be applied. In theory, investors will lose 50% of their tax deferral benefit in a further blow to the appeal for German tax leases. Investors staking as much as DM400,000 are likely to suffer from the net gain/loss ratios factored into German tax leases. Although this may be the top end of investors - in terms of investment levels - many deals have been signed which feature such equity stakes. In fact, one German equity investor came up with 30% of the equipment cost of an Airbus A340-300 in one deal - a figure considerably higher than DM400,000.
Estimates from German arrangers suggest that as much as DM3 billion in equity alone was injected into German tax leases in 1998, some 25% more than in 1997. These figures, although impossible to verify precisely, suggest the German tax lease market has reached the heights of the Japanese leveraged lease market which, in its better years, used to notch up as much as $5.5 billion in deals a year. If the German market financed as much as $6 billion in debt and equity for aircraft last year, it gives a clear idea of just how much the clamp down means to the Ministry of Finance. It also gives an indication about how airlines may have to search elsewhere in 1999 for appealing deals.
Germany's NPV issueWhile the risk-taking has been postponed in Germany, and deals remain on the back burner, some German arrangers still have faith in the future of the German tax lease market. One of the key indicators of a structure's appeal is the net present value (NPV) - the discounted net value of future net revenues, cash flows or rental streams, allowing for inflation. The higher the NPV, the more attractive a deal will be to airlines. In most leveraged lease markets an 8% NPV would be very attractive, but this is normally only for better credit airlines. "NPV benefits are strongly linked to interest rates. They are not as high [for German tax leases] as they have been in the past - 5% is about the best the market has seen recently," says Wuppermann. Germany's low interest rates have reduced the appeal of the German tax lease but, with the implementation of the Ministry of Finance's draft proposals - if and when they become legislation - the NPV is likely to be reduced to around 3%. Not such a problem, say some financiers.
Others disagree completely. One London-based banker who scans global finance markets for the best deal for his clients, says the German tax lease will no longer have any attraction. "A 3% NPV benefit on an Airbus A320-200 would translate into about $1.5 million in benefits. Then the legal fees would have to come out of this. It wouldn't seem worthwhile," he says. It is in cases like this where airlines will have to examine carefully whether the more traditional debt markets are more favourable to finance their equipment. Combine this with a drop in investor willingness to participate in German tax leases and this market could be facing some tough months ahead - at least for leveraged deals. There has to be a cut-off point for any party involved in a transaction, beyond which the benefits become marginal.
Some financiers find inherent difficulties in some structures. "I've never been involved in a German tax lease which hasn't faced some problem or hassle along the way," says the banker.
Nevertheless, finding that all-important loophole in the law is the domain of the highly paid and meticulous tax lawyers - and lawyers in Germany are no exception. Many of them probably spent Christmas intent on finding ways of circumventing the government's plans. If anyone has found a way of getting around the proposed draft, it will certainly remain proprietary for as long as possible to avoid further scrutiny by the Ministry of Finance.
As with any aircraft finance structure, there will always be airline finance departments which favour one tax lease over another. Swissair, for example, has been a German tax lease faithful from the structure's incarnation. Its comfort with the structure - and practice at the legal documentation - has helped the carrier yield NPV benefits this year of over 6% - the best the market has seen. But other airlines have not been so lucky. Some arrangers canned deals last December because of the Ministry of Finance announcements. No-one is willing to give confirmation of individual deals even though an official ruling has yet to make these legally unacceptable.
Some market sources say there may be special attention given to deals which do not feature any German content - in other words Boeing aircraft - not destined for a German lessee.
Other alternatives are also fading fast. Finance for wide body cross-border deals has been available in the US market, mostly through the Lease in-Lease out (Lilo) structure. Transnet, the holding company for South African Airlines, completed a US Lilo in late November in a repeat transaction for a Boeing 747-400. Standard Bank, HSBC and Nationsbank arranged the $150 million deal. Cathay Pacific - ever keen to broaden its portfolio of finance structures - signed a US lease for one Boeing 777-200 in September, arranged by Bank of America.
With the exception of an oshore transaction arranged by The Transportation Group for one Austrian Airlines 777-200, also signed in September, there were no other prominent cross-border US leases for aircraft signed in the latter part of 1998. Internal Revenue Service investigations into US lease structures have scared the Lilo market into silence.
An Internal Revenue Service official in Texas confirmed on 18 December that no ruling had been given on the infamous Section 467. The tax authority has been mulling over Section 467 regulation changes, which would affect the viability of the Lilo structure, for the past two years. But confidence has dropped out of the market, in anticipation of an announcement. "We are aware of counsel in the USA who will not take 24h risk on these deals at the moment," says an aircraft finance arranger in London. So, with counsel in the USA expecting imminent rulings from the Internal Revenue Service, it is not surprising that the tax authority refuses comment on whether it will soon issue a declaration.
Although the US market has only been available to a select group of top-notch profitable airlines and government-backed flag carriers, its sidelining is yet another blow to leveraged leasing possibilities.
Continued low interest rates in the USA are one of the main reasons why so few US leases have been signed. US investors also require deals to feature new widebody aircraft operated in and out of acceptable or safe jurisdictions. US leases of a more traditional kind will no doubt continue for second-tier and regional carriers in the USA. Most of the equity for the 30 to 40 deals a year seen over the past two years has typically come from US banks, insurance companies and mutual and pension funds.
Although the Lilo structure was probably the best option for non-US airlines to tap the US equity markets, other options still remain open. Financiers do not see any largescale exodus to the US foreign sales company (FSC) options. But one banker in New York says that Boeing's appetite for FSC transactions will keep some life in the market.
Although the Pickle Dole lease, named after two US senators, has enjoyed some prominence in a handful of Airbus equipment deals for Air Canada over the last two years, its general application to aircraft finance is poor because it requires a tenure of about 20-25 years, which is far more suited to the rolling stock market.
French alternativesNiche jurisdictions offer very few alternatives for airlines and the ones which have available tax capacity are tending to look at carriers in their domestic markets. France is perhaps an exception. The French tax lease market has always been limited and has relied on equity injections based on the tax capacity of French banks. In the past this market has been limited to French mainland carriers and airlines in the French overseas territories, with very few others. United Airlines has managed to tap this market for its A319 deliveries over the past two years. Its French tax lease for two A319s, arranged by Crédit Agricole Indosuez in October, is a perfect example. But other carriers may be sneaking in. Emmanuel Leblanc of Banque Nationale de Paris expects to see British Airways add French tax leases to its finance portfolio in 1999, either through the main airline or through one of its subsidiaries. But this market is very limited and it is doubtful if any other carriers will get a substantial piece of the action.
Bad news for Sweden and Spain has come in the form of government probes into aircraft deals in both jurisdictions over the last couple of years. While Sweden may have offered a small cross-border option to some airlines, the future looks bleak. Such probes have left companies confused over how to account for leasing deals, says one arranger. Spain's mainly domestic users will also need to look elsewhere following negative investigations into Spanish tax leases.
In the UK, legislation passed in November 1996 made the depreciation rules on UK tax leases on aircraft assets relatively unattractive. But in a smart move in January, BA invited UK institutions to fund a tax lease on two 747-400s ordered before the changes in the rules were made law.
Traditional borrowingTax-based financing seems to have run its course. But most of the intervention by governments was expected and the finance markets are relatively confident that other, though perhaps financially less favourable options, will be found during 1999.
Estimates on how expensive traditional debt pricing will be over the next year average at about 70 basis points to 90 basis points over Libor. But while there is a general consensus that airlines will have to pay more for any type of aircraft finance in 1999, there are exceptions. Mandated by Cargolux, the Luxembourg-based cargo carrier, Commerzbank has shown its relative market strength by lending to the carrier at 40 basis points over Libor for a 747-400 delivery in December.
Even though the German lease market may have closed temporarily, the Germans and especially the landebanks, are still firmly in the game and willing to lend extensively on aircraft.
Japanese banks will be out of the lending parade for some time as the Japanese premium is still high and means their cost of borrowing is set at around 75 basis points over Libor, making their role in aircraft finance prohibitively expensive for airlines. In fact, the majority of the Japanese banks, once famed for their blank chequebook approach, are in the process of asset stripping to rid their balance sheets of long-term, non-core business liabilities. Some bankers also complain that they are being left in the dark by their Tokyo head offices over the direction of future policy.
But good news could be on the horizon. One Japanese bank in London has been authorised to book new business around April. This will most likely take the form of higher-risk and higher-return deals for the bank. This is a noticeable trend in the market which is reinforced by the presence of other banks, such as the recently-formed team at the National Bank of Kuwait in London and MeesPierson, in this area. As most Japanese banks are trying to restore some balance sheet health, the German, French and some UK banks are taking assets off their hands, including many JLL deals.
Even the hotly contested British Airways $2.5 billion debt umbrella facility is being sold off by the Japanese. While the airline had used the facility for the last time by the start of December, some Japanese banks, including agents in the deal, were looking to sell more of their underwritten stakes. And at an average of 60 basis points, many banks were getting a good deal on the British Airways credit.
New Japanese productsOptions for airlines financing narrow body aircraft in 1999 could also be taken up by a developing product in the Japanese market. With few investment options open to them, traditional JLL equity investors are being lured into the Japanese operating lease (JOL) market. But such transactions, being promoted by trading houses like Itochu, Marubeni, Nichimen and Sumitomo, will take on a difference from the JLL. Awaiting guidelines from the National Tax Authority in Tokyo, one Japanese banker says, "the authorities will want investors to take more of a residual risk in the aircraft with JOLs than the rather more cosmetic risk taken with JLLs."
As bankers the world over suggest more residual risk deals - at least for investors - as the path ahead, there is likely to be an increase in the level of residual value insurance. "There are now more banks looking at asset-backed deals but they will be charging less than banks which did the same some years ago," says a New York-based financier.
Manufacturer supportAs the cycle of fortunes in the airline industry revolves, financiers, bankers and manufacturers will rely on their unwritten code of conduct and expect others to take up the finance slack. As talk of looking to residual value-orientated financing becomes the current buzzword, manufacturers can be assured that the finance community will expect them to raise their level of activity in the finance markets.
With talk of repossessions and the need for manufacturers to maintain aircraft values, the manufacturers will no doubt react - albeit reluctantly. "When bad times return for the airlines, the banks and financial institutions may again experience a rapid loss of appetite for aircraft financing, forcing the manufacturers to take up the slack. And if that happens at a time when aircraft deliveries are at high levels, the potential need for financing from manufacturers will be all the greater," summarises Tassos Philippakos, aviation customer finance expert at Moody's Investor Service in New York.
Every airline with a delivery in 1999 will most likely find a willing financier. But while a US carrier like Continental can rely on one of its preferred structures - the enhanced equipment trust certificate which still remains beyond the reach of European and Asian carriers - others will face higher financing costs.
The more financial institutions there are in the market, the better the deal for airlines. In 1999 there will, without a doubt, be considerably less competition as banking markets tighten.
The upward trend on margins therefore looks set to remain, but the financing possibilities will still be there - just different.
Source: Airline Business
