Airlines appear unworried by the domination of Gecas and ILFC but manufacturers certainly are. Doug Cameron assesses current developments in the rapidly maturing operating lease sector.

You don't need brains in a bull market. Developments in the operating lease sector over the last year bring, for some, uncomfortable echoes of the late 1980s. Massive orders by Gecas and International Lease Finance Corp have been matched by the return of Japanese trading houses, speculative forays by smaller players and a tight market in most equipment types.

But this is no return to the crazy days. There is more caution about, particularly over residual value assumptions. Market evidence suggests that established lessors have learned the lessons of the last recession and are, more than anything, preparing for the next downturn.

General Electric's Gecas and ILFC have emerged to dictate the market leaving a shrunken GPA and Awas to manage their portfolios at a distant third and fourth place (see table). Amid signs of consolidation in the second tier of the market the task for other lessors remains to develop a competitive or niche strategy. 'The differences between Gecas, ILFC and the rest of us have always been there,' says Steve Layne, head of aircraft leasing at PLM Transportation. 'The mergers and acquisitions of the past five years have just made them more distinct. Airlines have had to define themselves as megacarriers or discount feeders and operating lessors have had to do the same.'

The operating lease business is quickly reaching maturity. In 1985 leases accounted for less than 200 units and just 2.5 per cent of the global jet fleet, according to Airclaims. By 1990 this share had climbed to 8.3 per cent and at the end of 1995 the figure stood at 12.6 per cent - representing more than 1,500 aircraft. In aircraft value terms the 1995 share is closer to 25 per cent.

The $5 billion orders from Gecas and ILFC have taken lessors' share of the manufacturers' backlog close to 30 per cent and it is the aircraft makers which appear least comfortable with the market's development. 'We need a more broadly based operating lease industry,' says a senior Airbus executive. 'There are two sharks and 500 minnows; we need a few more carp. I don't think we have come to terms with the dominance of Gecas and ILFC and we are cutting our own throats.'

The side effects of the megalessors' power were first highlighted in 1992 when Airbus found itself in competition with GPA to supply United with 50 A320s. The Irish lessor was the largest A320 customer with 100 of the type on order. Though Airbus won that battle it was at the expense of granting walkaway leases. Significantly, Gecas and ILFC now have 182 B737s on firm order between them.

The lessors have already started to divide along product lines. As a general rule of thumb Airbus enjoys a closer relationship with ILFC, while Gecas has assumed what some see as an almost dominant role with Boeing. The division is even clearer in the engine market. 'If you were Pratt & Whitney, or more so, Rolls-Royce you would be sensitive to Gecas becoming more and more an arm of GE,' says one lessor.

The response of the airline community is more sanguine. Competition between Gecas and ILFC has brought lower funding costs and a diversity of product. 'For a small-to-medium-size airline the presence of Gecas and ILFC is positive,' says one airline finance director. 'If ILFC was not that size we could not have seven new B767-300ERs configured as we want them - I would have to go to a couple or more lessors.' But the impact of the tight market for weaker credits is less benign. 'What we're seeing for the airlines is a take-it-or-leave-it situation from the lessors,' says another airline executive. 'If you don't want it someone else will. We haven't seen that for six years.'

The recovery in lease rates and aircraft values has been led by the Stage 3 narrowbody sector. Average monthly rates for a B737-300 have climbed 18 per cent to $260,000 over the past year, while an A320 for delivery early next year will cost you $340,000 - a rise of 36 per cent. In the B757-200 market rates have climbed from $350,000 to $450,000.

It is a similar story for Stage 2 aircraft. Rates for a late model B737-200Adv have climbed more than 25 per cent to around $130,000 over the past three years. The disappointing recovery of the widebody market is also starting to turn for most types with a shortage of DC-10-30s and J-powered B747-200s. Lessors are also taking full advantage of the opportunity to catch up on shortfalls in, for example, maintenance reserves, which developed during the lean years.


Aggressive expansion

The structure of the Stage 3 market has changed little since the end of the last cycle: the aggressive expansion of Gecas has filled the role of GPA alongside ILFC, a subsidiary of the American Insurance Group (AIG).

The next two largest lessors - Awas and the remaining GPA portfolio of 129 aircraft - are likely to be absorbed by other players over the next five years. Gecas has until 2001 to exercise its purchase option on the remaining GPA assets. TNT and News Corp, which own 50 per cent each of Awas, have made no secret of their desire to sell.

With $18 billion in owned and managed assets, Gecas has taken three years to assert its authority after the difficult process of integrating the portfolios and management of Polaris and GPA. The sheer scale of its order book generates generous discounts while GE's AAA credit rating gives it the lowest cost of capital in the industry. A clear policy of supporting GE engine products provides additional marketing leads.

ILFC, with a $14 billion portfolio, has seen the advantage it built up during GPA's turmoil eroded by Gecas. In the last cycle, ILFC had access to cheaper funding and accounting rule differences which allowed it to offer a rental advantage over GPA. But with the second largest order book ILFC can demand similar discounts to Gecas and, as GE's second-largest engine customer, the company will not be prejudiced by the relationship with Gecas.

Gecas retains a slight cost of funds advantage but, while ILFC uses its own A rating in the bank market, it can achieve AA- or A+ for its medium term note programme and, by using the same dealers as AIG for commercial paper issues, receives a AAA rating.

No third force is expected to emerge and the key battleground for the megalessors is management. Gecas president Jim Johnson is the third to fill the post and has witnessed a steady drift of former GPA and Polaris executives, including most of the hard-core marketing staff. 'On the surface Gecas has the [cost] advantage, but this is compensated by the better management at ILFC,' argues one financier.

Moreover, it is easier to place new aircraft than old ones, and airlines will begin to return today's new aircraft placements after a few years. Some doubt the preparedness of Gecas for this and the next downturn, a situation which Johnson's new team has yet to experience.

ILFC, like Awas, has retained the same core management through a recession and the start of a new cycle and, under president Steve Udvar-Hazy, ILFC is widely regarded as having the best marketing team in the business.

While Gecas can profit from a larger margin from its cheap finance the pressure is on the lessor to push rates higher to meet corporate return criteria running as high as 25 per cent a year. But promoting new GE engine sales may limit the lessor's scope. GE Capital made its returns from the trading of aircraft and straight leasing generates a lower return. 'They have got to start looking downmarket and trade old aircraft to make that sort of return,' says one financier.

Downmarket is not where either lessor is looking. The adoption of a core fleet strategy by top-tier carriers has led to more multi-aircraft deals with better credits such as ILFC's deals with KLM and Swissair. Gecas is known to be following a similar path.

With Awas and GPA in a holding pattern, the two players making a push into third place have been Boullioun Aviation and GATX Capital. Both have substantial order books which will take their fleets above 100 aircraft and both have followed a joint venture approach to expansion. 'Anyone that's going to be a leader and profitable in new aircraft leasing is going to be compelled to make these big orders,' comments Al Oliver, vice-president at CIT Group, the leasing arm of Dai-Ichi Kangyo Bank.

San Francisco-based GATX has been the keenest exponent of joint ventures with trading houses such as Nichimen Corp and has announced another with an order for 10 737-800s plus 10 options. Partners in the new venture include Heller Financial, owned by Fuji Bank, and the Kanematsu Corp, with one or two more to be added.

'A company our size needs partners to leverage up to meet the financial strength of Gecas,' says Glenn Hickerson, president of the Air Group at GATX. 'What you don't want in the market is a duopoly,' he says. 'But with few exceptions there have not been people positioned in the business to buy aircraft. Other lessors have to ask if we are doing things today which will allow us to compete with Gecas and ILFC in the future.'

Seattle-based Boullioun Aviation, a subsidiary of Sumitomo Trust & Banking, has followed a similar path, building up its own $450 million portfolio and setting up Singapore Aircraft Leasing Enterprise (Sale) in partnership with Singapore Airlines.

The company has ordered 12 B737-300/400s for delivery from next year and Bob Genise, president of Boullioun, points to the attractive pricing achieved for pre-delivery financing as evidence that it can emerge as a viable third force. 'A $5 billion portfolio of 100 aircraft or so is pretty manageable,' he says. 'But beyond that the economies of scale start to diminish and can lead to a case of indigestion.'

Sale has moved on from its initial aim of targeting widebody customers in the Asia-Pacific region with an order for eight A320s and four A321s, as well as six B777-200s. John Willingham, Sale's general manager, points to the synergies created by using Boullioun's marketing and technical support and SIA's status and maintenance support as means of carving a long-term presence in the market.

But while joint ventures ease financial barriers to entry the consolidation of the business creates new problems as partners may find portfolios competing with each other. This was first demonstrated by the income funds set up by Polaris, among others, in the 1980s. 'Conflicts of interest are a major problem,' says a former Polaris executive. 'We had to be purer than pure, even if it meant giving up an opportunity for our own portfolio. We bent over backwards, even by prejudicing ourselves, to preserve the credibility of the income funds.'

Willingham concedes there will be some overlap in the portfolios of Sale and Boullioun when the new orders arrive. 'We obviously make sure we're not ordering in competition with each other,' he says. 'And though there may be some campaigns where we coincide, this happens relatively little and we will manage these on a case-by-case basis.'


Speculative buying

While some Japanese investors have taken the joint venture path, the Gecas and ILFC orders have tempted existing players back into speculative buying on their own. This echoes the unhappy experience of companies such as Orix and Kawasaki, which lost heavily when they ran into the recession and a lack of management and technical support in the late 1980s. However, lessors are making more conservative residual value assumptions and have strengthened asset management systems.

Takeshi Kurokawa, vice-president at Nichimen Corp, says the dominance of the megalessors leads senior management to ask whether this is the right time to increase its presence. Nichimen is looking to establish a Dublin-based subsidiary with an order for 10 B737s. But he says that while the trading houses have become more aware of the inherent risks, the reaction has been to improve management rather than avoid the market. 'The Gecas and ILFC orders are a big plus, . . . it is a comfort factor,' adds another Japanese lessor.

The tax breaks of Dublin's International Financial Services Centre have made it a haven for the tax-driven leasing activities of Japanese trading houses, including Orix, Nissho Iwai and the largest player, Itochu. Nick Miyamoto, vice president marketing at Itochu Airlease (Europe), says the company aims to expand its portfolio across the range with B737s, B757s, B767s, A319s and even B777s.

Mike Garland, vice-president at Sunrock Aviation, the aircraft division of Nissho Iwai, says the company is looking to add 10 to 12 new generation B737s to its existing portfolio of 11 aircraft. 'It's a big decision for any company to bring in aircraft on speculation,' he says. 'If we found an airline to make the order with then we would [order] today.' Garland's caution is shared by Tetsuro Sato, marketing director at Tombo Aviation. 'It has been very difficult to convince head office to move back into the market,' he says. 'But at least we can show that we survived, remained profitable and kept most the aircraft flying.'

Tombo, a subsidiary of Mitsui & Co, is the latest to consider setting up a Dublin operation. The company entered the market in 1987 with 10 MD-11s, but Sato says the sluggish widebody market has lead it to focus ahead on the narrowbody sector. Tombo is considering an order for 10-15 aircraft and is evaluating the B737, A320, MD-90 and MD-95.

With Dublin firmly established as a leasing centre the Singapore authorities have sought to expand by creating a tax regime favourable to operating lessors based in the state. Sale has already taken advantage of this and future funds for the sector from southeast Asia may take the same form.

Regionair has made a major push since starting with a couple of wet leases to Vietnam Airlines. Backed by Ong Beng Seng, a local property magnate who runs Asia's Planet Hollywood and Hard Rock Cafe chains, the company has set up a new subsidiary, Aerostar, and ordered 10 A320s for lease to Vietnam Airlines. Regionair's cautious strategy is based on Seng's contacts throughout the region rather than financial clout. State-owned Singapore Technologies is also considering an operating lease venture.


Dazzling returns

The Stage 2 sector has always been the most hostile and fluid part of the market with lower equipment prices making entry and exit easier. New entrants continue to arrive despite the perception that values have peaked. 'People will still be dazzled by the returns and pay too much for the aircraft,' says Oliver at CIT.

Opportunities are still being created in this sector by the disposal programmes of existing lessors, such as Whirlpool Financial Corp, Potomac Capital and a number of Scandinavian lessors, as well as airlines opting not to hush-kit equipment.

This third tier of the market displays more niche strategies than the new aircraft players. Dick Doust, executive vice-president at Pegasus, points out there is more demand from lessees to customise aircraft. 'Airlines are more demanding now and they're not just going to take any given aircraft,' he says. 'And there is a lot more maintenance required in the used market.' Pegasus has looked to meet this demand by acquiring its own maintenance company, Hamilton Aviation.

Steve Layne at PLM points to the creation of more aircraft pools as another direction for the lessors while CIT, although moving towards more pure operating leasing, retains a large capacity for tax-based leasing, which allows airlines to take equity participation as balance sheets improve. Miami-based International Air Leases has followed a successful path through freighter conversions, first with the DC-8 and now with the L.1011.

The future for the larger third tier players, such as IAL, Pegasus, PLM and CIT, is to place Stage 2 equipment where noise rules do not hurt and to move into Stage 3 equipment. Doust says Pegasus is looking at the MD-80 and A320 markets and PLM is planning a similar move.


No secure future

The funding of the operating lease business has, like the airlines, remained concentrated in the bank debt market. Securitisation structures targeting the deeper capital markets have developed at a disappointing pace, though GPA has completed almost $5 billion in such deals. Citibank has dumped its plan for a $1 billion lease portfolio but a number of other banks - notably Crédit Lyonnais and NatWest Markets - continue to push the concept.

The complexity and high cost of these structures has deterred their expansion; ILFC has rejected a number of approaches on these grounds, preferring to recycle its portfolio and use established capital market products. The signs are that future securitised portfolios will focus on finance lease structures rather than operating leases. 'Any banks that go down [the operating lease] path will regret it,' says one financier.

While the lessors themselves have effectively divided up the market, the last piece in the industry jigsaw remains the future role of the manufacturers. While they clearly have an interest in seeking to control the aftermarket the experience of British Aerospace, forced to take a £1.2 billion provision for its lease portfolio, illustrates their reluctance to remain long-term players.

With the exception of Boeing, all retain captive leasing vehicles such as McDonnell Douglas Finance Corporation and Airbus AMO, though the Fokker portfolio was sold last year to Daimler Benz's debis Leasing. Manufacturers reluctantly admit they will have to remain in this business, avoiding head-to-head competition with true lessors and selling down their portfolios through the capital markets.

The increasing dominance of Gecas and ILFC has created a shift of power in the airline business from two manufacturers to two lessors. The owners of the latter are in more robust financial health than the former and enjoy cheaper funding. 'You have two major financial institutions taking a punt on the robustness of aircraft values and the efficiency of their management,' says one financier. The possibility of one of the lessors buying one of the manufacturers is not so far fetched.


Source: Airline Business