The Japanese leveraged lease looks certain to stabilise into a more mature product, helped by cautious equity investors. Report by Tom Ballantyne. When aircraft deliveries finally begin to pick up speed over the coming years the Japanese leveraged lease should have evolved into a stable, more mature product.

But if airline treasurers are counting on the phenomenal benefits available in recent months to lessees on the JLL continuing, they are in for a disappointment. Japanese banks are reining in the net present value benefits (NPV) on offer to lessees after pushing them to unheard of levels - above 10 per cent - during 1994.

Considering that the NPV began the year at 4-5 per cent, it is no wonder that this aggressive attack on the air finance market by JLL arrangers had the industry buzzing with talk that Japanese finance was returning with a bang. The market may be back in business and growing, but it is far from matching the boom days of the late 1980s, when JLLs were financing some US$9 billion worth of aircraft every year.

In Japan's fiscal year ending March 31, 1994 JLL financings rose to an estimated $3.5 billion and the latest year has seen a surge in the market's activity to around $6 billion. That's a big improvement over 1992, which saw JLL financings plummet to $2.6 billion after the downturn brought the cancellation and deferral of dozens of aircraft orders.

JLLs are now responsible for financing around 40 per cent of all new aircraft deliveries, up from 23.4 per cent two years ago, although questions remain about the depth of the market. Full recovery and a return to the 'good old days' can only come with a lift in aircraft deliveries, which remain stubbornly static.

While there are signs the coming year will see the beginnings of a revival in orders, a significant increase in actual deliveries - the key component - is not expected until late 1996-7 (see box). Even then, JLL salesmen face fierce competition from another high flying tax efficient product, the US commission FSC.

There were several key elements to last year's surge in JLL deals. First, a strong yen and poor domestic growth have drastically reduced the value of the Japanese banks' dollar assets, and lead the banks to seek out JLLs as a means to rebuild those assets. Coincidentally, a large number of small investors who put money into JLLs in the late 1980s, and whose tax benefits end after the first 5 or 6 years, were in the market again looking for new deals.

But the dearth in deliveries and the fact that FSC financings were grabbing much of the business - even Japan Airlines opted for a FSC on a Boeing 747-400 - meant the banks had to compete to win their share. The problem was that in their eagerness to beat off competition from FSCs they pushed the NPV up so high that investors, seeing their cut of the JLL cake shrink, cooled towards the deals.

The brakes have already been applied. The market, says Takaaki Kato, senior manager international aircraft finance for Fuji Bank, simply overheated as asset hungry banks tendered over-aggressively to capture the small number of deals available.

Nevertheless, there has been an improvement in the market, he adds. In 1992 Fuji's JLL business totalled $280 million, while in the first half to September 30 1994-5, it put together JLL financings worth $320 million. Fuji expects second half financings to be bigger. However 1995-6 promises to remain tough, with aircraft deliveries remaining low and competition for business from other finance sources high.

Both banks and equity investors are reassessing their position: airlines seeking finance for new aircraft won't get the sort of attractive JLL deals which were being put on the table in 1994, says Kato.

That's hardly surprising. Last August, when Qantas sought $180 million for two new Boeing 767s, the Japanese were hungry for a big role. 'The Japanese lease rates they were quoting for Qantas were the best I had seen for a number of years . . . they were very keen to get some high quality airline assets onto their books,' says Qantas treasurer Peter Greggs.

In the end, however, the Australian flag opted for a FSC and Japanese money funded only part of the deal. The Japanese did succeed in securing a package to refinance three Boeing 747-400s for British Airways, an eminent client for the country's underwriters.

Interestingly, the JLL market also departed from traditional practice in providing financing for a number of second tier carriers. These included El Salvador's Taca, LTU of Germany, Korea's Asiana and Crossair of Switzerland. Historically, the JLL has almost exclusively been used by prominent flag carriers.

Airlines whose financing needs coincided with the JLL mini-boom got the best deals, though some missed out through no fault of their own. Malaysia Airlines was scheduled to take delivery of the first of 10 Airbus A330s late last year when the market was red hot, but their arrival was delayed due to unforeseen problems with engines. Now the aircraft will be delivered this year at a time when the Japanese are taking a more measured approach. As a result, analysts believe MAS is unlikely to do a JLL, and will opt instead for European export credit funding.

According to Steve Lyons, a senior vice president with Spectrum Capital, the NPV will level out at 7-8 per cent during the first half of 1995-6. 'I think the Japanese market is going through a readjustment [and] will definitely stabilise in the latter part of this year. The last thing the market needs is this seesawing,' he says.

Merrick Howes, director of Sydney-based Macquarie Corporate Finance, believes that after completing a rash of aggressive deals last year Japanese banks have realised that while the pricing was very good for the lessee, the deals were growing less attractive to individual investors. 'The fees and the benefit to the lessor had been squeezed and the lessee portion got bigger - all because of their enthusiasm to get the deal,' he says.

According to Howes the market generally is now taking a cautious approach, making it difficult to place an aircraft in the market. 'There's this overhang, this feeling among the Japanese that "oops, we went out and we probably made a few too many commitments and therefore we need to be careful in the economics that we commit to in the future."'

Equity investors in particular are becoming choosier and demanding better returns, say financiers. 'I think it is becoming harder for them [the underwriters] to sell down to investors. You're finding that whereas before one equity underwriter would underwrite a whole B767 by themselves, now there will be three leasing companies or equity underwriters, each taking a third, so they are splitting the workload of selling down that equity portion,' says Howes.

However the apparent levelling off in the market is taking place at quite a high level. 'If potential clients are being offered a NPV benefit of 10 per cent, there's a lot of people interested. If it comes back from there I think the market will still be very good.'

One bright spot this year will be the first deliveries of Boeing's new B777, beginning in May. Analysts say there is keen interest over their financing although they expect the majority will be purchased through FSC transactions.

There is also some disagreement over whether JLLs will continue to attract second tier carriers. Fuji Bank's Kato believes the trend will continue and there will be room for new airlines which haven't previously been in the market. James Mori, a manager at Chase Manhattan Bank's Tokyo office, agrees: 'Where prominent names were there last year like Thai, MAS, BA and others, I think we will see more newcomers in the market, given the proper structure. We did a deal recently with Taca, the El Salvador airline. If you were to talk about Taca last year they simply wouldn't have been there.'

But according to Spectrum's Lyons, Taca 'was able to slip in on the basis there was this sort of perceived glut of equity and lack of deliveries.' He adds that there will be interest in good, well managed airlines which provide added security.

Macquarie's Howes takes a more pessimistic view:'I think that happened last year when the market was running hot. Suddenly all these airlines thought they could do a JLL and, even after paying some extra guarantee fees because their credit was not so good, were still able to get a good benefit.' He believes more cautious equity investors will want to focus on the BA, JAL and ANA type of deal. 'At the end of the day the equity investors, to whom they have to sell the transaction, know JAL, ANA and BA because they can go out to Tokyo's Narita airport, get on the aeroplane, see the carrier's flag and feel comfortable.'

Other factors will help sustain the growth. For several years now, Japanese investors have shied away from US carriers because of their disastrous financial performance. That is likely to change as US operators climb back to profitability. 'I think now that restructuring is well underway and the aviation recession has lifted, the US carriers will also benefit,' says Chase Manhattan's Mori.

There have been other shifts in the nature of JLLs. The share injected by small companies has been steadily increasing, from about 20 per cent of all deals two years ago to 30 per cent today.

JLLs attract cash from wealthy individuals and small family-owned companies attracted by the permitted deferral of tax in proportion to their share in the aircraft's depreciation. At the same time the size of individual investments has been shrinking, down from about ´200 million to approximately ´100 million ($1 million) today.

But the crucial factor for the airline industry is that the level of Japanese investor interest in JLLs now seems certain to stabilise and result in an increasingly mature product. When at last aircraft deliveries pick up speed, the market should be able to shed its roller-coaster reputation.

Aircraft manufacturers hope a lift in the leasing market - and particularly a revival of the JLL - will help kick start the slow pace of recovery in new aircraft orders.

Despite increasing industry confidence and rising profits as recession lifts, many carriers remain reluctant to commit to purchases as they strive to keep debt under control.

However, there is evidence that airlines are prepared to move away from outright purchase and lease aircraft to fill capacity gaps on key routes.

A survey of carriers in the Asia-Pacific revealed an overall 9 per cent rise in the number of leased aircraft during the June and September quarters last year, and there are indications that the trend is continuing.

Conducted by Sydney-based BDW Aviation Services among the region's major operators, the survey showed that in the 350-plus seat class the rise in leasing was a substantial 16 per cent. 'It doesn't matter to us who buys the aircraft,' says Seddik Belyamani, Boeing's vice-president international sales. 'I think it is good news that the Japanese are investing in aircraft again. It shows a restored confidence in this industry, it's helpful and we need it.'

A spokesman for Airbus Industries, which has recently formed its own Leasing Marketing Division, said he believed Japanese money would 'help kick-start a pickup of new orders.'

Boeing forecasts 230 deliveries this year, down from 270 in 1994. Airbus expects 130 deliveries, up from 123 last year. 'I think we are going to see more orders this year but it's not going to reflect in deliveries until 1997 or so,' says Belyamani.

Source: Airline Business