Since the early 1970s there has been an increasing trend for airlines around the world to rely on operating leasing as an alternate means to managing their financing and fleet requirements for commercial aircraft.
Under an operating lease structure, the airline commits to a long-term lease agreement for the aircraft from a lessor (typically between six to 12 years), with all related operating expenses borne by the airline. At the end of the lease term, the aircraft lease can either be extended for a further period, or the aircraft is returned to the lessor in compliance with the provisions in the lease agreement, which typically relate to the aircraft’s maintenance condition. In the latter case, the lessor will transition the aircraft to another operator, or when the aircraft has reached the end of its useful life, sell it for parts in the spares market.
Given the prevalence of operating leasing, the benefits over aircraft ownership have been clearly recognised by airlines
Given the prevalence of operating leasing, the benefits over aircraft ownership have been clearly recognised by airlines. Operating lessors control a large portion of the Airbus and Boeing original equipment manufacturer (OEM) order books. Sometimes airlines have difficulty purchasing directly from the OEMs as the order backlog means they are sold out for many years. Airlines will also often approach lessors with regards to leasing solutions. In addition, operating leasing provides attractive fleet flexibility to airlines since aircraft are leased for fixed terms resulting in no residual value asset risk for airlines. Operating leasing is also attractive to bank lenders as it reduces the lending risk profile for them with the operating lessor ‘sandwiched’ between themselves and the operator. Operating leases also improve cash flows for airlines, in that pre-delivery payments to OEMs for lessor orders are borne by the lessor. Security deposits during the lease term are smaller than the equity contributions required for a financing. Given that most lessors are able to draw financings cheaper and from a more diversified pool of debt sources than many airlines, it is no surprise that the percentage of commercial aircraft under operating leases amounts to almost 50 percent of the worlds total commercial aircraft fleet today (see Figs. 1 and 2).
Private equity investors have long been attracted to the investment rationales of operating lessors. For example, Cerberus Capital Management, a US based private equity firm, invested in Dutch-based commercial aircraft lessor AerCap, which it took public in 2006. AerCap has subsequently grown to be the largest aircraft lessor in the world through the acquisition of International Lease Finance Corporation (ILFC) from AIG. Cerberus successfully completed its exit from the investment in 2012. Aircastle, another publicly traded commercial aircraft lessor, was founded by private equity firm Fortress Investment Group in 2004 and taken public in 2006. In 2006 Terra Firma, a UK based private equity firm, acquired AWAS for $2.5bn in cash plus the assumption of liabilities from Morgan Stanley. In 2007 Terra Firma then further agreed to purchase Pegasus Aviation from the US private equity firm Oaktree Capital Management, and combined AWAS and Pegasus to create the new AWAS, then the world’s third-largest aircraft leasing business. More recently, Avolon Aerospace Leasing, a lessor founded in 2010, backed by private equity firms Cinven, CVC Capital Partners and Oak Hill Capital Partners, successfully took the business public in December 2014.
So why is private equity so enamoured with investing in this space? One of the principal attractions for the aircraft leasing space is that the sector serves a growing airline industry with an attractive aircraft capacity supply and demand dynamic. Air traffic has historically doubled every 15 years and is, according to research by The Airline Monitor, projected to have an average annual growth rate of 4.8 percent for the next 20 years, thereby doubling traffic again over the next 15 years. Air traffic has exceeded GDP growth by approximately 1.9 times over the past 40 years and the sector has been very resilient to external shocks.
World air traffic recovered to a long-term trend only a year after a drop in 2009 and it took only three years for traffic to recover from the events in 2001. The reasons that have contributed to this traffic growth have been the expansion of urban populations, the rise of a global middle class, the rise of low cost carriers and greater globalisation and cross-border economic activity. This increase in travel demand has continuously increased the demand for aircraft capacity.
What is also attractive to private equity is that from a supply side perspective, the industry is dominated by only two major established players, Airbus and Boeing, with smaller players like Brazil’s Embraer, Canada’s Bombardier and France’s ATR competing in the market for turboprop aircraft and smaller jets. Suppliers such as Russia’s Sukhoi, China’s COMAC and Japan’s Mitsubishi have entered the market with small jet offerings but are expected to take several decades before becoming serious competitors to the established players on a global scale.
Growth within growth
Investors are investing in a growth industry within a growth industry. Driven by air travel demand, the latest Boeing and Airbus forecasts show that the commercial aircraft fleet is expected to more than double over the next two decades from its current level of roughly 20,000 commercial aircraft. Retirements of aircraft at the end of their economic lives (approximately 25 to 30 years) and their replacement by more fuel-efficient types further drives the demand for new aircraft production.
In a rising fuel price environment, replacement demand for fuel inefficient aircraft is strong. Whereas fuel cost as a share of total operating expenses was in the mid teens in the years 2003/2004, it has now risen to a stable 30 percent share, further driving replacement demand for older aircraft. Even in an environment with lower fuel prices, this trend is expected to continue. The introduction of more fuel-efficient new technology aircraft will de-risk the negative effects on airlines’ operations in the event of a fuel price spike.
Another attraction from an investor’s perspective in this space is that the two largest suppliers to the industry are relatively constrained in terms of their production capacity. Changes to production, whether it is an increase or decrease, is difficult given the long lead times involved and their supply chain capacity constraints. Extensive production backlogs on the most popular models allow Boeing and Airbus to manage their production levels as regional or individual customer demand shocks can be evened out by reallocation of order slots to other customers.
Private equity investors haven taken into account what are significant hurdles to entry into the aircraft leasing space, given that the businesses are very capital intensive with acceptable returns only provided on a levered basis. Private equity investors are familiar with different leverage options making them natural investors in the aircraft leasing space. They often apply a diversified debt funding mix to the lessor with funding ranging from the standard bank financings to export credit supported loans or even the US capital markets.
Investors are also drawn to this industry by the fact that investments in operating lessors are in long-lived assets. The value of these assets is relatively predictable. It is also supported by the solid fundamentals given the attractive supply/demand dynamic around aircraft capacity. Relatively predictable new aircraft production levels and a steady outlook in terms of growth and aircraft replacement demand drives such a dynamic. There is volatility in aircraft values, driven by supply/demand and competitive factors. However that volatility is mitigated when looking at aircraft values on a lease encumbered basis, where the lease cash flows and aircraft residual values mitigate a pure asset value view.
Similar to investments in real estate, large chunks of equity from investors can be deployed efficiently and quickly, with the most prevalent narrow body aircraft costing upwards to $50m and widebody aircraft prices starting from the low $100m per aircraft. However security lies in the fact that the assets can be moved from one operator to the next, should that be required at the end of a lease be it scheduled or unscheduled. The worldwide mobility of aircraft to different airlines around the world provides tremendous risk mitigation to the investor.
Aircraft leasing businesses are capital-intensive operations and the forward orders with Airbus and Boeing carry significant cash drag through the associated pre-delivery payments. In addition, there is placement risk for the aircraft, interest rate risk and financing risk that need to be managed. For that reason, many lessors tend to focus on sale-lease back transactions or trades from other lessors where all of these risks can be mitigated since the aircraft are already on lease to an operator and financing requirements are near term with very limited interest rate risk exposure.
Even though the investor focus draws comfort from the underlying asset values, private equity investors tend to invest in businesses and management teams rather than pools of assets themselves. This approach is largely based on the realisation that the aircraft leasing business is a relationship business, where airline and supplier relationships allow for the best realisation of value in transactions.
Private equity firms have now branched out into other aviation leasing areas, such as helicopters, as shown by the $375m of equity capital that funds associated with MSD Capital, Soros and Cartesian Capital Group have committed to helicopter lessor Waypoint Leasing. The attraction for private equity investors to the aircraft leasing business will likely remain strong given the solid fundamentals around asset values, the favourable and predictable supply and demand characteristics of aircraft assets and the long-term steady returns that lessors have provided throughout various industry cycles.
Most importantly, a positive track record by private equity investments in the aircraft leasing space has been established with several successful investment liquidations, whether private or into the public space. Private equity certainly has an important role to play to capitalise the aircraft lessors that are playing the economic cycles and investments in diverse aircraft assets in various ways. We should certainly be looking for more activity by private equity in the space.