There are numerous players, both old and new and including hedge funds, active in aircraft financing at the moment as investors clamour to take their share of a buoyant market
There is one word more then any other to describe today's aircraft financing market - liquid. Banks and capital markets are taking a very favourable view of a sector that many shunned in the aftermath of 9/11.
And there are plenty of new entrants. Mostafiz ShahMohammed, head of transportation asset-backed securities at investment bank UBS, estimates there are around 100 hedge funds active in the aviation sector, as well as about 25 private equity firms. "This is something very different from pre-9/11," he says.
Jose Abramovici, global head of aviation group at French bank Calyon, notes that "hedge funds have become key players for buying sub-tranches in aircraft finance or securitisation deals".
There are already some signs hedge funds and private equity investors are looking for an exit strategy, particularly in the leasing sector (see page 45). Pegasus and Q Aviation are up for sale, while AerCap and AirCastle have undergone initial public offerings (IPOs). The three-to-four year timeframe in which many hedge funds like to operate is in many cases coming up.
It is not just hedge funds that have been active in IPOs. Leasing giant GECAS carried out a successful IPO late last year through its Irish affiliate Genesis. ShahMohammed sees this deal, whereby GECAS raised around $640 million, with an initial portfolio of 41 GECAS aircraft, as a sign of things to come. "Others are looking to create similar vehicles," he says, adding that GE Aviation had previously carried out an exercise of this type last year focused on spare engines.
Steve Udvar-Hazy, chairman of lessor ILFC, says he too is looking at a Genesis-type deal. "It is a way to unload part of your portfolio into a separate package," he says. "We're looking to package up some older aircraft and are thinking along similar lines." The aircraft in question are Airbus A310s, Boeing 757s, older 767s and 737 Classics, which have already been substantially written down from a tax point of view. "We are currently looking at the tax structure and implications," says Udvar-Hazy, adding that ILFC too may look at Ireland, with its favourable tax regime. There is already a subsidiary there, ILFC Ireland.
Managed assets
ShahMohammed says there are other strategic reasons for these type of semi-detached arrangements than tax. "In the past, you sold aircraft to other investors and to leasing companies," he says. "This way you still have the asset and are still managing it - you keep control." He adds: "Another advantage is that you are not taking 100% of the risk. Some risk is shared with shareholders."
Rob Martin, chief executive of lessor Singapore Aircraft Leasing Enterprise (SALE), predicts Australian bank Macquarie may also be looking to package together aircraft following its takeover of the GATX fleet. "The likes of Macquarie are looking to buy assets and repackage them in securitisations where they don't hold the residual. They are going to be volume-driven," he predicts.
Meanwhile, the banks that stayed in the industry are often taking a different tack, says Abramovici. "After 9/11, many banks changed their approach towards aircraft financing from a corporate credit approach to an asset-based or asset-backed approach. Generally, banks were not prepared to repossess aircraft and become lessors against their will."
He says there have been significant changes in the main financial players over the last decade. "In the early 1990s, the aircraft finance market was dominated by Japanese banks that could underwrite and keep large tickets and were leading the Japanese leverage lease market." He says after the Japanese credit crunch started in the late 1990s, German state-backed landesbanks took over, due to their very low cost of funds and ability to structure German leveraged leases.
"After 9/11, a number of German banks slowed down their lending activities because of involvement in the bankruptcies of Swissair, Sabena, United Airlines and Air Canada, and the disappearance of state guarantees for the landesbanks, which had a negative impact on their credit ratings," says Abramovici.
With the move towards asset-based lending, Abramovici says some banks shut down their aviation teams. "In 2007, we consider that approximately 20 banks are capable of arranging aircraft cross-border transactions worldwide, while another 20 are participating in aviation deals, from time to time."
Even so, observers note that many banks that went quiet on aviation on 9/11 are now back in strength. Christian McCormick, chief executive of Natixis Transport Finance, notes that Islamic finance is also on the increase.
This, of course, has all contributed to the liquid market conditions. The question is how long they will last. The feeling is, while the near-term still looks positive, some tightening is inevitable, depending on when the next downturn arrives. "Some think the next cycle will begin in 2011, some in 2009, and some pessimists think sooner," says ShahMohammed. "In general, people are optimistic about the near future. You will probably see a continuous exit rather than a sudden rush."
One market that many have doubts about is India. Abramovici warns: "We need to watch the situation in India where $30 billion of aircraft have been ordered while the infrastructure has yet to be improved." Indian start-ups have been active on the IPO front over the last year or two. However, McCormick notes that these have raised from $80 million to $400 million. "When you consider the size of the aircraft orders, it becomes clear the amounts raised will only provide the company with enough to cover working capital, and not leave much to finance the actual aircraft assets."
Abramovici believes the Chinese market too may be one to watch. "Two out of the top three airlines are losing money after having been forced to acquire weaker domestic airlines." He adds that the Middle East "has also to be monitored carefully because of the huge ordered capacity, especially of widebodies, which represents some potential capacity excess".
The financial health of US carriers has improved substantially. The Air Transport Association of America believes its members will earn from $2 billion to $3 billion when last year's figures are finalised (see page 28), with a net profit of $4 billion in 2007.
"All of the airlines have made good progress on cost," notes Phillip Baggaley, chief financial analyst at ratings agency Standard & Poor's. "However, they have used up pretty well all their collateral. The big US carriers don't have as much cash to absorb a shock as they did in the last downturn."
The merger wild card
Don Schenk, president of Airline Capital Associates, asks: "If a downturn came now would they survive? Probably not. If a downturn is several years away, probably yes." In any case, Baggaley notes, there is one major wild card - mergers.
Standard & Poor's has US Airways, which is making a bid for Delta Air Lines that would partly be funded by $4 billion of debt, on credit watch with developing implications. Baggaley says a possible United Airlines bid for Continental could be negative for the former in terms of ratings. "Much will depend on how they finance it and integration."
On the possibility of consolidation in the USA, he says: "Certainly it is an added risk, but airlines see a window of opportunity, given the way banks perceive airlines at the moment, combined with a US administration likely to be more favourable than the next."
The financial community certainly seems to see plenty of positives from the possible merger deals. ShahMohammed says: "It would provide better access to the capital markets, and pull forward the replacement of older aircraft." There will certainly be plenty of work for financiers. "In the USA alone, if US Airways and Delta went ahead, along with a couple of similar deals, you could be talking about 1,000 aircraft being involved. This, of course, also means more demand for manufacturers."
Leasing companies in particular are waiting to see what American will do with its fleet of Boeing MD-80s, with Delta and Continental also facing similar decisions. In the past, US carriers have made less use of operating leases than other regions, but as lessors are quick to point out, their financing choices this time round may be more limited.
There are other reasons why the US market may be more open to the idea of operational leases. Steve Rimmer, executive officer at lessor Guggenheim Aviation Partners, notes that there has been a decline in tax lessors in the US market. The leverage lease has fallen out of favour in the USA, partly due to hits investors have taken when airlines go into Chapter 11 bankruptcy protection.
Japanese surge
Worldwide, however, the tax lease is still alive and well, with the Japanese operating lease set to come back into favour. McCormick notes: "There were not many Japanese operating leases around last year as the Japanese tax authorities were in the process of amending their tax laws." However, when the Japanese tax authorities finally published the new rules, the initial fears of changes proved unfounded. "As a result, the Japanese lease is already making a stronger come back," says McCormick.
McCormick notes that the French banks, including Natixis, have recently had success in the Chinese market with the optimised French leases that make use of the different treatment of withholding taxes in different countries. Other tax products such as the US leveraged lease, the South African and Polish leveraged lease have fallen out of favour. The latter is due to the weakness of flag carrier LOT Polish Airlines.
In the meantime, debt markets are proving airline-friendly at the moment. "The airline industry has benefited over history from an ability to get interest rates that are more attractive than any other cyclical industry of this type," notes Schenk, putting this down in part to the fact the sector has in the past been heavily regulated, meaning the banks rarely lost money, plus the ability of the industry to offer collateral. "Interest rates and advance rates are very attractive at the moment," he says.
McCormick says European majors are able to get debt finance on the open market close to the 50 basis points above LIBOR (the London interbank interest rate) offered by export credit agencies once the export credit insurance premium has been taken into account. ShahMohammed says: "The debt markets are pretty strong for the strongest names. There is not much capital market activity for airlines at present. There is also a lack of supply of airline structured products - the credit market is better. Senior secured debt for airlines is trading at extremely tight levels. That is a good indicator."
Schenk, however, predicts the public markets will soon see a pick-up in activity. "The price of debt in the secondary markets is improving all the time," he says.
In Europe, there has been a spate of IPOs in the low-cost and start-up sector, the most notable last year being Air Berlin. "Equity is there," notes Mark Long, at DVB. "It's just relatively expensive."
Alongside the favourable financial climate, there are some signs of irrational exuberance. "Certain areas are looking frothy," says ShahMohammed. "I suspect some banks will soon run out of capacity, which will mean turning off the taps for certain aircraft types and certain credits. They will show a little bit of caution." He adds, however, that the sophisticated use of synthetic risk programmes may keep things ticking on for longer than would be expected.
Irrational pricing
ShahMohammed sees signs of overpaying in the Boeing 767 market. "There is some irrational pricing with the 767. It has good range and there is a shortage, which is driving up rates and values. But it does face risk from the 787," he warns. He adds, however, that the demand for freighter conversions may alleviate this issue. Rimmer at Guggenheim says that the lessor is interested in buying passenger-configured 767s and A330s and then leasing them back to operators until they take delivery of 787s or A350s, at which time Guggenheim will convert them to freighters.
ShahMohammed says concerns he had about the 747-400 market have largely been alleviated by the need for interim lift caused by delays to the airbus A380. Rimmer argues that some of the prices for young 737NGs and A320s has been driven up by publicly quoted companies and securitisation vehicles whose portfolio content needs to satisfy ratings agencies. ShahMohammed argues, however, that the absence of near-term replacements, combined with their fuel efficiency and a strong backlog, is supportive of both types.
As the good times roll on, the issue of when they will end moves up the agenda. Some argue that investors are more savvy this time round. "The debt markets are a lot more knowledgeable, and so are leasing companies," says Shah Mohammed. Schenck says: "We believe carriers are showing a lot of restraint." But there are signs of irrational behaviour. "You are seeing the return of some silliness," notes McCormick. But perhaps this time the industry has learnt some of the lessons from previous cycles.
Source: Airline Business
