Aviation Finance: 2021 and beyond has been saved
Aviation Finance: 2021 and beyond
The aviation finance and leasing industry has been in the midst of unprecedented market conditions for almost a year. The onset of the COVID-19 pandemic and the associated lockdowns and other containment measures effectively grounded much of the global fleet and slowed air travel and airline revenues to a trickle. IATA forecasts an USD118bn net loss for the airline industry in 2020 and it is expected to roll into 2021 as airlines are faced with more regular and restrictive lockdowns as variants of the virus increase in frequency and ease of transmission.
2020 was dominated by airline bankruptcies and restructurings, rental deferrals, government bailouts, debt raising and an aircraft trading market that effectively stalled.
Against that backdrop there have been some green shoots of positivity. Regional and domestic travel is expected to rebound this year and the flight data from domestic travel in China for 2020 has been positive. Furthermore there has been no shortage of available funding. In the first few weeks of 2021 a number of major lessors have been able to tap the bond market at extraordinary low rates. The capital markets represent a vital source of funding given the withdrawal of many banks from the space. Similarly Castlelake have recently launched a new (and oversubscribed) ABS – something not many commentators were anticipating 6 months ago. Airlines too have been accessing the capital markets to a significant level. This demonstrates pent up investor appetite for any sort of yield. However this debt will ultimately need to be repaid. The eventual impact of the high levels of debt on airlines and lessors remains to be seen but it is likely to tighten margins and considerably impact profitability. The silver lining from a lessor perspective is that the borrowing levels of airlines are likely to significantly curtail airlines ability to incur capital expenditure meaning that the percentage of leased aircraft is only going to increase.
Many industry commentators are still waiting for a significant ramp-up in M&A activity amongst lessors. Perhaps the availability of funding has deferred this for a time as potential investors wait to see how that plays out with one eye on the financial impact of impairments as more and more financial information for 2020 becomes available.
Despite some uncertainties 2020 and early 2021 has seen continued investor interest as a number of managers have established dedicated aircraft leasing funds and platforms looking to take advantage of potential value in distressed assets. It is likely we will see more of this as 2021 progresses.
We intend on bringing our clients additional thought leadership focussing on specific aspects of the industry in this time of immense challenge. We will look to discuss topics such as what restructuring options are available to lessors and airlines? What has been the business and operational impact on lessors? What has the impact been from an accounting and tax perspective? What should an investor consider if looking at the industry for the first time? Has the ESG agenda taken a back seat? M&A prospects particularly for well-backed lessors? How do mid-sized lessors (non-investment grade) raise debt and at what price?
While we touch on some of those topics below, these are some of the key questions we will endeavour to answer throughout this series in more granular detail starting with the opportunity for a wall of cash.
A Wall of Cash
Bond investors have sought investment into aircraft leasing companies with seven bond issuance in January 2021 alone. The total combined bond issuance of USD 6.3 billion for ACG, AerCap, Bank of China, Avolon, Aircastle, Air Lease and DAE have an average of five year terms with varying coupons between as low as 0.72% (Air Lease 3 years) and 3.38% (DAE 750 million 7 years) . The returns on the aircraft leasing bond issuances are historically low but are comparatively favourable to the rest of the market. Why?
Well, the current crisis is affecting the outlook for the market in the short term. However, global RPKs are expected to recover to reach 2019 levels by late 2024. There is expected continued growth in the aircraft leasing market. The industry expects to see an increase in sales and leaseback transactions, given the continuing liquidity issues facing lessees. Airlines have progressively shifted towards aircraft leasing to reduce the financial burden as well as increased flexibility to change their fleet profile and operating model which is now all the more relevant.
Furthermore, other lessors have an opportunity to bolster their balance sheets at this time. In a period of record low Treasury bond yields, there is a wall of money seeking alpha. There is cheap cash available at a time when Directors have a requirement under the Companies Act in Ireland (and other jurisdictions) to ensure that the company is a going concern. Therefore, there is a window of opportunity in the coming 12 months to improve the financial position of the company. It may also open up the opportunity for those investors seeking to enter the industry at a time of distress.
The Potential to Restructure
The USD 173 billion of financial support provided by governments has been a lifeline for many airlines. However, significant cash burn is expected to continue and IATA have called for continued support to stabilize the industry. The industry’s debt burden has increased by over 50% to $651 billion.
Consolidation of aircraft lessors is expected to be driven by small and mid-sized lessors with midlife assets coming under funding pressure and who may not be able to access unsecured debt markets without strong credit ratings or funding from parent banks. Also, lessors with large debt maturities may find themselves forced into restructuring with their lenders which in-turn may lead to consolidation in the market. It is clear new investors are looking to sidecar transactions with successful lessors as an opportunity to earn returns and gain a foothold in the industry with limited exposure to establishing a platform.
For many mid market lessors, restructuring will become a necessity due to debt covenants and repayment obligations. Smaller lessors may be in the shop window as well as an exit strategy. With this in mind, Ireland has become a favoured location to enter into restructuring arrangements.
Historically, the aviation leasing industry has taken a long term view of investment and has been able to ride out turbulent times. There has been, however, always been risks to be managed. According to Phil Bolger, (Strategic Adviser to Deloitte and former Deputy CEO of GPA) since the establishment of GPA in 1975, there has been inherent risk in the aircraft leasing business. These risks include weakness in global macroeconomic conditions, e.g. recession, unemployment and inflation that may affect the demand for air travel. A lack of liquidity and interest rate fluctuations that may affect the airline’s ability to raise capital for the purchase of aircraft and other factors such as the risk of terrorism, war, geo-political conflicts may also negatively impact the cash generating capacity of airline customers. In addition, the supply of new aircraft for example the launch of new generation models and the re-entry of BA 737 MAX is likely to affect the market value of aircraft. For example, China's three major state-owned airlines put off delivery of over 100 aircraft from Boeing and Airbus last year but kept every single order from Commercial Aircraft Corp. of China (COMAC), in a show of support for the domestic manufacturer during the coronavirus pandemic. Variations in the price of oil may affect the operating costs of airline customers and their cashflow generating capacity. A change or introduction of new local and international regulatory controls, e.g. permitted airport capacity, noise regulations, airworthiness certification, climate change related regulations, may result in grounding of aircraft and subsequent ability of airline customers to meet their lease payment obligations.
However, with the global pandemic, operational risks are now more acute for investors. The composition of aircraft fleet type is a key consideration for lessors, given potential impairment and re-marketing risk linked to different aircraft types. Lessors should have a diverse geographic customer base to reduce risks from any one region. The diversification of client base leads to a reduction of concentration risk with a limited number of lessees.
In addition, a diversification in revenue streams enhances the liquidity and resilience of lessor. We will also delve into these risk factors in more detail in an upcoming article.
Avolon’s Jim Morrison predicts that two-thirds of new passenger aircraft deliveries will be financed by lessors and the recovery will be quicker than anticipated. According to the report, the recovery will be driven by vaccines, fiscal stimulus and monetary easing.
A key success factor for investors in the aircraft leasing market includes high frequency transactions providing strong market insight. However, this may not be possible until the market stabilizes after the pandemic. Access to cheap capital will always provide a competitive advantage. The opportunity will be for investors and lessors to restructure their balance sheets with refinancing in the capital markets or private investment. All lessors hope rates will increase over time as airlines run out of options and are forced to lease. Conversely there is a risk that too many lessors will be chasing every deal and driving down yields. We expect ESG will become a major issues for airlines beyond 2021 once again (which we will analysis further in a separate article). However, without an experienced management team with long term industry involvement and a selective and deliberate aircraft purchase strategy, investors will not prosper in the new world.