FARNBOROUGH: The cost of cash

Sydney
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A year ago, the talk of the aircraft finance industry was the "funding gap", as airlines, financiers and airframers wondered whether, as they faced the fiercest days of the credit crisis, they would come up with the $68 billion needed to pay for the airliners scheduled for 2009 delivery.

As it happens, the money materialised, with much help from government-guaranteed loans channelled through export credit agencies (ECA). So, halfway through a 2010 with its $62 billion aircraft financing bill but confidence restored, fears of the funding gap have virtually disappeared.


ICBC showed China's financial muscle with an Emirates A380 deal through Doric. Picture: Airbus 

However, the cost of financing that $62 billion is set to remain higher than many players are comfortable with, owing to market volatility and changes to the ECA regime.

No doubt uncertainty surrounding new financial regulations, including recent moves by the UK and the US Congress - which has proposed a sweeping overhaul of the banking system - along with the Federal Reserve's decision to keep interest rates steady due to sustained market woes, is only contributing to an already fragile market sentiment and making financial decisions extremely difficult for aviation customers and their financiers.

Even cash-rich and operationally stable BOC Aviation, the aircraft leasing business owned by Bank of China, says it is carefully watching what chief executive Robert Martin calls extremely "uncertain" market conditions this year before embarking on the next phase of growth.

"Last year was an easy year to read because it was so bad," says Martin, whereas "mixed signals" from the various regions in terms of the shape of the recovery, the volatility of fuel prices, new entrants into the leasing market and the availability of financing make predicting market conditions tough.

Kostya Zolotusky, managing director of capital markets development at Boeing Capital (BCC), says that "while the number of [financial] participants remains steady and improving", the cost of financing is rising. Key factors pushing up the price of money are the advent of sovereign debt risk in Europe, as markets start to price in the possibility of default by the Greek and other governments, and China's monetary tightening, which has raised the cost of funds for banks there.

However, Zolotusky notes that while commercial debt today "is a bit more expensive" it is still "very reasonably priced" given the "very low" levels of the so-called London Interbank Offered Rate (Libor), which stands as a benchmark for much lending between banks.

He adds: "We remain on track with our earlier forecast that we expected to do less direct financing this year, due to lower industry deliveries and improving market conditions. As manufacturers, we are now more focused on deal-specific challenges rather than systemic market concerns."

Airbus and Boeing expect to contribute less than $500 million each in customer financing this year, compared with just under $2 billion each last year.

In May, operating lessor AWAS successfully closed a $530 million senior secured term loan in the US capital markets to refinance 30 Airbus and Boeing aircraft at a conservative 65% loan-to-value ratio. But chief executive Frank Pray admits market volatility affected the transaction: "When we started this process it was a very different environment, the markets weren't even talking about [the sovereign debt crisis in] Greece. Timing is everything."

COST OF CHANGE
Government support on both sides of the Atlantic in the form of export credit agency loan guarantees is widely credited with keeping aviation financing on track in 2009 during the depths of the liquidity crisis. ECA-backed money has been available for as little as 30-40 basis points (0.3-0.4%) above Libor for the US Export Import (Ex-Im) Bank, and less than 50 basis points for European export credit transactions - compared with the three-figure margins that prevailed before the economic crisis.

But while ECA intervention may have been the key ingredient that kept airliner deliveries rolling last year, that cheap money comes with a price. For banks, lending at the low interest rates that have prevailed since the ECAs took a heavy chunk of the market is not good business. Last year, the US Ex-Im deals put around $8-9 billion into the market, with a similar amount supported by its European counterparts, totalling around a quarter of the $68 billion civil aviation market. Percentage-wise, this year is worse from the commercial banks' perspective, with ECA-backed money expected to come to the same total, while overall demand shrinks to around $62 billion.

According to a European banker, the availability of "favourably" priced ECA-backed financing is limiting the amount of commercial aircraft deals in the market. "Appetite for aviation financing is being killed by the ECAs," says the banker. "There is more [bank] appetite out there than what is obviously available, but this supply is being killed off because the ECAs are pricing us out of the market."

However, by 1 January, the cost of those guarantees could as much as double as aviation industry financial players, acting through the Aircraft Sector Understanding (ASU), a pact agreed in 2007 through the Organisation for Economic Cooperation and Development in Paris, look to ween airlines off ECA money by limiting the amount of the funding on offer. Airbus's senior vice-president of structured finance, Nigel Taylor, believes export credit financing support is likely to be "twice as costly" under the new regime.

But Airbus and Boeing welcome the changes. Says Zolotusky: "We recognise export credit financing is not sustainable at current levels. We are committed to dialling down ECA support, so the commercial markets can do as much as they can stand.


Avolon Aerospace was founded by long-term aviation financier and RBS Aviation founder Domhnal Slattery. Picture: Avolon 

"We believe the markets are getting healthier and regaining strength, and we anticipate that next year, ECA support will start coming down."

Airlines which have relied on ECA funds may find the changes particularly difficult, but draining some ECA money out of the system should at least make the market fairer, if more expensive. For carriers such as British Airways and Lufthansa, which have been ineligible for ECA-backed money under the so-called home country rule - Airbus and Boeing agree not to support sales to airlines in their home countries - government-backed financial support for rivals has been a sore point. Next year they may pay more, but they will have less to complain about.

THE LEASING FACTOR
As the financial crisis unfolded, many financiers feared that operating lessors, which did so much to facilitate airline fleet growth during the boom years, were heading for a crash as lease rates fell and many of their airline customers wobbled financially and sought to cut seat capacity.

The lessor crunch, however, did not happen. Frank Pray of lessor AWAS notes: "There were no distressed sellers; portfolios weren't sold for a song and this provided investors with confidence in the leasing community.

"There were also no unsold white tails produced by Airbus and Boeing."

Boeing's Zolotusky adds that, compared with last year, "the lessor landscape is looking a lot more robust".

And, instead of the widely anticipated lessors' consolidation, there are actually more of these players today than last year, largely due to an inflow of private equity money during the past six month. Zolotusky describes this development as positive and notes that even though private equity investors can not "access the kind of [borrowing] leverage" they were once accustomed to, these funds have helped establish a number of new lessor platforms with "capital structures that will allow them to do significant business in the second half of this year and beyond".

Earlier this year, International Lease Finance founder Steven Udvar-Hazy came to market with Air Lease Corporation with nearly $3 billion of capital: $250 million secured from private equity firm, Leonard Green & Partners, $1 billion from investors through a private placement in May and $1.5 billion through a secured revolving credit facility from UBS.

Avolon Aerospace, founded by long-term aviation financier and RBS Aviation founder Domhnal Slattery, also entered the market - with a $750 million equity contribution from Oak Hill, Cinven Group and CVC Capital Partners. Avolon also secured a $400 million warehouse debt facility arranged by UBS, with Crédit Agricole-Corporate Investment Bank, Deutsche Bank and Frankfurt-based bank KfW. A second, $215 million facility has been signed with DVB Bank to help finance acquisitions from operating lessor AerCap.

Separately, another ex-RBS aviation financier, John Slattery (Domhnal's brother), formed Greenstone Aviation with a $100 million equity contribution from investment group Jefferies.

Jackson Square Aviation also came to market, with $500 million equity from investment funds managed by Oaktree Capital Management. The lessor has already entered into transactions with two customers, Avianca and Air Berlin, for the sale and leaseback of 10 Boeing 737 Next Generation and Airbus A320 family aircraft. NordLB provided long-term financing on the two Avianca aircraft deliveries.

Also founded on private equity, Lionhart Aviation, a Canada-based company, has entered the aviation finance sector this year. The lessor purchased four A320-200s from Air Berlin in March. Lionhart Aviation is leasing two of these aircraft to Virgin America and two to Azerbaijan Airlines.

In addition, former Allco Aviation employees have started Sydney-based KV Aviation with $200 million in private equity funding. Meanwhile, the Carlyle Group has joined existing player RPK Capital to invest $600 million into the aviation sector.

While the addition of fresh blood to the market has been welcome, a downside to this new money is that, with the exception of Carlyle and RPK, these lessors are primarily interested in brand new or newer A320 or 737 models with better credit airlines. That is a space in the market which, says Pray, "never really lacks access to funds".

Older aircraft have a harder time attracting investment finance, especially if they are attached to less than favourable airline credits. And this situation could get worse.

According to Gary Liebowitz, senior analyst at Wells Fargo Securities, more older aircraft could become available upon the "consolidation of US legacy carriers", which could lead to falling values and therefore further hinder financing appetite for these assets. Financing for older aircraft, "if available at all", tends to "requires higher equity contributions", he explains.

OVERCROWDING?
Are there too many players chasing after the same market segment?

As Greenstone chief executive Ruth Kelly puts it, the difference between 2000-03 and 2010-13 is that the number of new-build deliveries will be twice what it was, but there are no new big players like RBS, ILFC or CIT to do the big deals. So, she says, there is plenty of space for companies like hers to put equity into the market.

And, new lessors looking for a foothold in the market may also find that today, unlike at any time in the past decade or so, their path is not being blocked by the industry's long-term heavyweight, ILFC.

ILFC has been under scrutiny, and for sale, since its parent company, the insurance giant AIG, was bailed out by the US Treasury and effectively nationalised early in the credit crisis. Kelly sees no appetite for spending US taxpayer money on ILFC. So, far from ordering any new aircraft, the way forward for the world's second-largest lessor will be a "managed phase down".

Donal Boylan, however, warns against dismissing ILFC's impact on the market. Some sort of break-up may well be on the cards, he says, but ILFC accounts for a quarter of the leasing industry and it is well funded for legacy reasons, so it is not going to go away.

VALUE TALKS
Pray sees the influx of private equity capital as good for AWAS, as it is making its parent company, private equity firm, Terra Firma, "comfortable" with further investment in the aviation space. However a potential hiccup, says Pray, is that lessors are no longer capital providers, but rather they draw funds from the same source as the airlines.

"It is a problem when you are borrowing in the same space as your customers. As a lessor, you need to have a good value proposition to differentiate yourself in the market," he says. He explains that in addition to its normal leasing activities, another service AWAS provides is the trade-in of aircraft from airline fleets as well as supplying assets, which helps to "differentiate" its business.

As BCC's Zolotusky sees it, money is chasing lessors as a direct result of an "extraordinary performance of aircraft portfolios through the worst economic and financial crises of our time. I cannot think of any other asset class that has done as well."