Airline Business looks at the state of finance markets as carriers continue to find innovative ways to keep aircraft liabilities off the balance sheet. A new survey also covers the world's major operating lease companies, including a ranking of the Top 40 groups by fleet value.
JACK SELLSBY LONDON Off-balance sheet aircraft financing structures such as the recently launched Japanese operating lease are likely to grow in popularity as airlines seek to reduce their exposure.Tax-based leasing dominated the industry for much of the 1990s, but with its demise, bankers and asset finance lawyers have been under pressure to find new structures which appeal to their clients. Support from European export credit agencies (ECAs) - comprising the UK's ECGD, France's Coface and Germany's Hermes - can be useful, as can support of the US Exim bank, but this form of sales support finance is sometimes considered to be too standard for many bankers.
"If we had to rely solely on booking export credit-backed deals, our credit committee would not want to know," says one experienced aircraft financier. "With the small-level margins on these deals and the intense competition for mandates, just to maintain relationships, we would not be able to justify our department. So we've been forced to look for more complicated structures to increase deal efficiencies and win the attention of some of the more creative airline finance departments."
The Japanese operating lease
The launch of the much-awaited Japanese operating lease (JOL) structure is perhaps one of the most fundamental developments of aircraft financing in recent years. It takes advantage of a large pool of equity investment from Japanese investors who are keen to plough their corporate profits into such deals. When the structure's forerunner, the Japanese leveraged lease (JLL), ceased in 1998 after rulings from the Japanese National Tax Authority (NTA), as much as $6 billion in annual equity investment was marooned with no access to the international aircraft finance markets.
The JOL was only established in the second half of 1999, but the level of deals is likely to leap in the first two quarters of this year, according to those bankers involved in the market. Even so. the level of equity investment is likely to take time to reach the staggering levels recorded by the JLL market in the boom years of the mid-1990s.
The number of quality airlines using JOLs as long-term finance options, and not as a short-to-medium term stopgap, reflects the widespread interest the structure is likely to have. Aer Lingus, Austrian Airlines, Emirates, Iberia, Korean Air and Scandinavian Airline System have all taken delivery of aircraft financed in this way, mostly on 10-year operating leases.
In line with its innovative approach to aircraft finance, SAS became the first carrier to sign a JOL last May. Nevertheless, many other carriers did not sign up until near the end of the year, in line with their delivery schedules. German bank WestLB arranged the $31 million deal for SAS and acted as initial lender. Orix, which is famous for its role in Japan's aircraft finance market, acted as equity arranger, sourcing investments from a number of Japanese companies with which it has long-standing relationships. Orix also set up a lessor special purpose company, which bought the aircraft with a long-term lease to SAS already attached, from Dublin-based leasing company Pembroke Capital.
"Our main focus was to bring the JOL in line with the underlying existing lease to SAS," says Michael Kramer, head of aircraft finance at WestLB in Tokyo. The financing is viewed as a pure long-term operating lease, in line with the NTA regulatory requirements. "Although the lender risk is mitigated through the transaction structure to a large extent, equity redemption - that is, no downside protection - is fully dependent on aircraft sales proceeds at lease maturity." In this case the lease is signed for 10 years, but WestLB has devised a number of structures covering short- to long-term leases.
The JOL structure allows the equity providers in the deal to claim equipment depreciation under Japan's double-declining (or double dip) balance method. The aircraft residual value at the maturity of the lease is based on relatively conservative estimates. Although future values generally create a murmur of discomfort in aircraft financing circles, for the reason that they are only estimates, market confidence in Boeing's new generation family of 737s in this case alleviates any major concerns.
The widespread and increasingly pertinent subject of residual value risk is taking hold in aircraft financing like never before. This is because the market is experiencing a distinct shift away from the traditional concept of only airlines taking the risk - except for familiar operating leasing deals where the traditional operating lease players accept the risk.
It would be remarkable if Japanese investors, for example, were persuaded to take a real economic risk on aircraft in a finance deal. "It probably won't come to investors taking a hit on a deal," says one Hong Kong banker. "Everyone doing JOLs has worked extremely hard with tax advisers and lawyers to work within Japanese tax guidelines without scaring the investors away."
Residual risk
With airlines keen to take delivery of some of their aircraft on off-balance sheet structures such as the JOL, the residual value risk is being placed on the shoulders of manufacturers, arrangers and even large leasing companies. Financial investors, however, would generally not accept the pressure of supporting such a risk, according to companies in the aircraft finance market.
Last year, Airbus agreed to provide Spanish flag carrier Iberia with asset value guarantees (AVGs) to help secure a deal for as many as 92 A320 family aircraft, due for delivery through to 2006. Of Iberia's 50 A320s ordered in June 1998, around half of them will feature the Airbus guarantee. This basically means that at a pre-determined time in the asset life, the manufacturer will commit to an agreed resale value.
Iberia was also one of the first airlines to head to a reviving Japanese market when it financed its first of four Boeing 757-200s last summer through JOLs. What made the transaction interesting was that leasing company ILFC, to which the aircraft will return after five years, provided an AVG on all of the 16 aircraft to be taken by the airline.
When Iberia first approached the JOL market, interest from equity investors was relatively limited, says Ignacio de Torres Zabala, finance manager at the airline. But when Iberia approached the market once again for the second batch of four 757-200s, the take-up was much better, he says, reflecting a quick comprehension by investors in the new product. So far, Iberia has completed JOLs for eight aircraft - more than any other airline.
While Airbus and Boeing do not view their activities to be primarily financial lessors, they are giving a clear message to the market that they are confident enough with the future values of their aircraft to offer customers attractive packages when they provide AVGs to help push through finance deals. With guarantees in place, it also instills a great deal of confidence in the finance community. If an off-balance sheet lease structure does not have to factor in concerns of future aircraft values, then financiers will only be concerned with cash-flow risk or the airline's ability to meet lease payments.
Iberia is a good example of an airline looking to free its capital for general operational purposes by not to tying it into long-term financings. "We would like to have the flexibility coming from typical operating leases, which at the end of the lease period you can forget about," explains Iberia finance director Enrique Dupuy. In a further move to increase the amount of off-balance sheet financing, Iberia is among a growing group of airlines keen to sign synthetic lease transactions. This type of lease - sometimes referred to as a tax ownership operating lease - is treated as an operating lease for accounting purposes and is held off-balance sheet, so the airline does not incur the usual liabilities on its accounts.
Off-balance sheet
With airlines around the world now looking to renew or increase the size of their fleets, on-balance sheet financing is not always an easy option, especially for those which are too cash-strapped or too young. While the latter can generally rely on operating lessors for fleet additions, a growing number of airlines are using finance structures to achieve a specific balance between placing aircraft finance on or off their balance sheet.
A common form of aircraft finance used in the USA is the enhanced equipment trust certificate (EETC). This looks set to take hold in Europe this year. While the debut deal, once again for financially innovative Iberia, received a lukewarm response in Europe, enough confidence has been generated for the addition of more deals in the pipeline. Tim Lintott, partner at London, UK-based law firm Freshfields, says that after the Iberia deal there will be more scope for such arrangement in certain European jurisdictions. The Iberia deal covered six A320-200s and is valued at $190 million, which is seen as a tester.
This relatively small figure compares with a typical deal of around $500 million to $600 million for the larger US carriers. Over the past five years the EETC market in the USA has been worth more than $16 billion in deal values. America West, Atlas Air, Continental, FedEx, Northwest Airlines, US Airways and United Airlines have all been active in this market.
The benefits from this form of non-balance sheet financing are the same in the USA as they are in Europe, but the latter has lagged in developing a market because of the more complicated and diverse bankruptcy laws that apply across the region. But the premise of the financing is not only that cash flow from a carrier will pay investors, but that asset residual value is maintained. This means that at the end of the structure, due fees can also be paid.
The concept works by creating a structure, backed by a portfolio of aircraft values, which is sufficiently secure to command the sort of A class credit ratings needed to tap into parts of the capital markets where airlines could seldom otherwise venture on their own account. It starts with a bank setting up the structure and adding in the aircraft values. Then certificates or securities are issued, usually in three or four classes of notes, typically starting with A.
A few airlines outside the USA, have looked to take advantage of this fresh source of funding, either through the EETC or similar structures based around securitisation of aircraft assets. Last year in Australia, Qantas arranged the former and Ansett the latter.
EETCs outside the USA
Although non-US airlines have been waiting for this kind of access to capital markets for some time, not everyone involved in the process is ready to accept them into the fold. Philip Baggaley of credit rating agency Standard & Poor's, says the issue of rating non-US airlines - which are mostly unrated - which may want to sell EETCs, could cause headaches. "If the corporate rating is acceptable [to an airline], the aircraft collateral, structure or legal analysis applied might be less favourable than anticipated," he says. "This is more likely in the case of non-US EETCs where new legal jurisdictions and new structures need to be explored."
Iberia's Dupuy says the airline is focusing on another European EETC later this year, estimated around $500 million. Legal eyes are firmly fixed on a number of other jurisdictions in Europe, with the Netherlands and the UK as the most likely contenders.
However, EETCs do not necessarily thrive in the USA just because of Chapter 11 bankruptcy proceedings; other variables matter. In the case of the recent Air Tran EETC for Boeing 717s, there was a degree of dissent from participating in the structure. A consensus of investment professionals believed that the asset was too young and its market presence too limited. If the airline launching an EETC goes bankrupt, then an 18-month built-in liquidity facility is generally sufficient for the arranging bank to remarket the aircraft. However, because the recently launched 717 is used by a handful of operators, the chances of successfully placing the aircraft become lower.
Aircraft finance is not a faddish activity, even if the image of whole banking communities taking to the wings after an economic crisis may sometimes instill this impression. What it boils down to is the ability to meet economic expectation and efficiencies within the realm of regulatory control. But as financial regulation has increased dramatically in recent years, the number of feasible outlets for financing aircraft has dropped.
Leveraged leases
While a limited number of leveraged lease deals were completed last year, the trend is not likely to increase. A handful of US tax-based leases have been signed in the second half of 1999, notably Ownership FSCs for British Airways and Cargolux. There has been a small amount of activity in the German market where grandfathered deals were allowed by the Ministry of Finance and the French tax lease market has seen a smattering of deals. But the mainstay of business has by far been booked through the export credit-supported deals.
Last year will set a record for Exim-covered deals, more than doubling the 1998 total of $2.7 billion. The year included a $1.9 billion deal for Saudi Arabian Airlines in late November for the airline's Boeing and McDonnell Douglas deliveries and a $278 million loan package for 11 Garuda new generation 737s signed in mid-December. ECGD, Coface and Hermes all expect record cover years for their activities in 1999. Earlier in the year the European ECAs completed a $4.3 billion package for ILFC, which saw a boom in the three agencies' cover of Airbus products.
While there is a certain symbiosis between export credit agencies, bankers and airlines, there is also the expectation that the commercial sector will take the strain in financing new aircraft.
Without the introduction of new products such as the JOL - soon expected to be followed up by a German equivalent - the whole market would stagnate. But the financial creativity continues. The home-country ruling prevents airlines registered in France, Germany, the UK and the USA from tapping these kind of export credit-backed of funds. The ILFC deal was an exception because the lessor proved the aircraft would be placed on lease to airlines domiciled elsewhere.
Owning aircraft used to be the vogue. Then operating leasing got bigger. Now some airlines want the flexibility of the operating leases, but also require the aircraft to fit into their own specific delivery charts. In the next phase, which has just begun, airlines are ordering aircraft and then finding others who are willing to take the finance risk.
Source: Airline Business
