European banks are seen as the most likely source of financing for the aviation industry, but the global credit crunch is affecting the amount of available funding for the sector
When it comes down to who will finance the upcoming needs of the aviation market, all fingers point to the European banks. But can these banks, which are under pressure due to the fallout in the financial markets, really fund the aviation industry's enormous financing bill going forward? That was the question delegates tried to answer at Airline Business sister publication Commercial Aviation Online's recent Inside Air Finance conference in London.
"There are two things that this industry needs: fuel and banks, and there is turmoil in both those areas," says Christian McCormick, head of aviation finance at Natixis Transport Finance. "There is going to be a crunch for liquidity in this market that will lead to significant increases in margins. Combined with the increase in the cost of fuel, it is evident that the industry is about to change quite dramatically." However, McCormick also believes stress in other assets, notably real estate, has caused a flight to quality to aviation financing. European banks are being identified as the most likely source of financing by the aircraft manufacturers for their order books, but this comes at a time when the global banks are battling a credit crunch which is limiting the amount of financing on offer.
"The banking industry is not able to lend capital between each other let alone to third parties," says British Airways group treasurer and head of investor relations, George Stinnes. In addition, the capital markets, which have traditionally funded many lessors and US airlines, are off-limits for the foreseeable future.
"There are two things this industry needs: fuel and banks, and there is turmoil in both areas"
Martin Webb, head of aviation finance at Alliance & Leicester, stresses that departments within banks are also competing internally with each other for capital allocation. "These pressures are evidenced by the large number of banks in the market looking to raise additional capital to bolster their balance sheets.
"For example, there are some banks that still have significant overhang on deals they underwrote for mergers and acquisitions in 2007," he says.
"Now under pressure to move this debt, some deals are being offered to the market at between 80-90% of par. It is tough to try and compete for capital allocation when your colleagues can acquire these discounted debt deals with commensurately higher returns."
He also expresses concern over future aircraft values, which he says remain uncertain. "If we are lending at 70% today and values fall 30%, the bank is effectively an equity player suddenly with 100% exposure to asset security, whilst only getting a senior debt return," says Webb.
DVB Bank board member Bertrand Grabowski questions why operating lessors are singled out by the manufacturers as an additional source of funding when it is the banks, again mostly European, that are providing their capital, or the capital markets when open. "Yes, lessors add liquidity to the market, but this liquidity is on the asset, bought, sold, rented, and not much for their funding which comes from third parties. In a sense, for financing, they are essentially conduits," says Grabowski, adding: "Of course, one may debate whether the big boys, GECAS and ILFC, come into that category, and probably not, but they are exceptions."
Bankers at the conference agreed tighter credit markets have led to higher pricing due to increased cost of funds, less financial involvement from the hedge fund and private equity community and weaker underwriting appetite from the banks. Monarch Airlines managing director Tim Jeans confirms the new pricing environment, revealing the airline is now paying increased financing costs of London Interbank Offered Rate (Libor) plus 180 basis points. This means that effectively the cost of borrowing to a second-tier carrier like Monarch has doubled. In a more normal market it would expect to pay Libor plus 80-100 basis points, with first tier carriers paying 50-60 basis points.
"European banks won't be able to increase their contribution to fund the industry's new delivery needs," says Grabowski. "Gross industry exposure, liquidity and a challenging industry cycle will probably entail only modest growth of European banks' exposure to this industry."
He believes consolidation among airlines will add constraints due to banks' single borrower lending limits which will further weaken bank participation in aviation financing deals. A London-based banker says the industry needs new investors and new liquidity because "banks will get full". He warns: "Capacity is finite. Banks can write deals, but ultimately who is going to end up holding the paper? This is a big issue." A financier agrees: "In today's environment, it doesn't take much to be at or near your concentration limits. Sure, banks are lending, but the syndication market is very limited."
A US-based financier says financiers are already pulling back on financing. He points to a deal he is currently assessing because the financing is stalled at the credit committee of a bank that said it would fund the deal: "I have a deal sitting in front of me in which the aircraft is ready for delivery, but the bank is still waiting for credit approval." Now, the same airline is facing a situation where it will have to pay double for its all-in cost of funding just to get a bridge financing away.
Asian banks and sovereign funds are often touted as another source of financing for the industry. However, Boeing's managing director of capital markets Kostya Zolotusky notes that Chinese banks have been "scaling back" their involvement in recent aviation financings. Grabowski discounts Asia as a secure source of financing going forward because of "problems due to US dollar exposure and an immature funding structure". However, he believes "large Asian/Chinese banks will continue to absorb low risk, low reward deals far away from asset-based lending structures".
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Boeing's Zolotusky sees consolidation among banks as a concern for the aviation finance market: "Now there are 30 banks [in aviation finance] compared with some 60 banks 10 years ago."
Bankers at the conference were unusually quiet about financial support from the export credit agencies, which provide guarantees, insurance and reinsurance against loss for entities that conduct business abroad, and changes brought about under the new Aircraft Sector Understanding, which is intended to build a level playing field for the world's major exporters of aircraft.
However, Zolotusky notes that fewer banks appear to be participating in these deals. One conference delegate said weaker bank appetite for Export Credit Agency financings stems from these deals being "too much hassle for too little money". However, tighter liquidity will likely lead to an increase in ECA financings going forward. Bankers also pointed out that structured tax deals are fading out due to a lack of capacity in the French market, but also in the Japanese equity market.
Another potential source of financing for the aviation market could be from the German Kommanditgesellschaft (KG) market. The KG finance structure has long been a common arrangement in the German investment fund market in many asset classes including ships, real estate, renewable energy projects and now aviation. Diverse names such as Engine Lease Finance, Babcock & Brown, Virgin America and Emirates have all tapped this market during the past year for financing. But it was the Airbus sale of five A380s on lease to Singapore Airlines into the KG market that drew attention to this new source of funds.
Many are hopeful that the KG market, which is said to be made up of money from wealthy German dentists and doctors, could prove a vital market for lessors that are locked out of the capital markets, but need to sell aircraft to make room for new deliveries and to increase capital. However, because this is a new source of funding, it is hard to know how deep the market will be for aviation finance going forward. "This retail market is very sensitive to headline industry news and, as such, with all the bad press around aviation today, we may see some significant slowdown in the market and a flight to perceived quality deals," says Grabowski.
Also, certain KG financings have been questioned by financiers due to their assumption of future aircraft values and overall structures. Bankers at the conference echoed this concern. One conference delegate noted that "unhappy KG investors from the first round of aircraft financings may not return", which could limit the potential involvement of KG funds in aviation. Olaf Sachau, head of aviation transportation finance at HSH Nordbank, says: "This market has been there for other assets. I hope we are careful in this market, so it will be there for the next 20 years."
An increase in pre-delivery payment financing during the past two years has prompted Airbus to revisit and revise this type of financing to allow the manufacturer to be made whole on any risk of "clawback" under the new structure. Clawback, which calls for the refund of equity to the airline by the financier in the event of bankruptcy or default, creates risk that certain financiers are not inclined to take. They also say the revised PDP means bankers can no longer rely on the aircraft value as security in PDP financing.
Certain big ticket banks have voiced concern about the revised PDP structure and have quietly said they will not participate in financings due to the new clawback clause. Talks between banks and Airbus on an industry wide solution have taken place. "We have reached agreement with most parties, but not all," says Christophe Million-Rousseau, senior vice-president of customer finance at Airbus. The uncertainty surrounding PDP could pose a risk for Airbus, which will see increased aircraft deliveries during the next couple of years. However, talks between the banks and the manufacturer appear to have progressed since February.
Since then several Airbus PDP financings have closed, but it is also true that certain banks which have traditionally funded PDPs are missing on these deals. Airbus says the new PDP structure avoids speculative transactions by financiers, particularly operating lessors, which have taken advantage of airline defaults in the past.
Going forward, all signs suggest there will be pressure on the availability of financing, which means further financial participation from the manufacturers and the ECAs is needed to keep aircraft moving out of the production plants and into the skies.