This article was published in “Islamic Finance news” – Volume 10, Issue 7, dated the 20th February 2013.
Aviation is a growing global market and investment in aircraft leasing can form a valuable part of a balanced
portfolio for all investors. CHARLES F YETERIAN explores the market and discusses how well this asset class fits in with Shariah compliant finance.
No one today can ignore the reality of world air transport: be it for business, leisure, medical treatment, pilgrimage or cultural exchange, not to mention cargo transport. Never, in the history of humanity, have so many passengers taken commercial flights to visit faraway places.
According to the latest forecast by the International Air Transport Association (IATA), 3 billion passengers were transported by commercial airlines during 2012 and 46.5 million tonnes of freight was airlifted, representing 35% by value (US$2.2 trillion) of goods exported. On average, air traffic doubles every 15 years, despite occasional slowdowns. Over 1,200 aircraft are produced annually by aircraft manufacturers such as Airbus, Boeing, Embraer, Bombardier and ATR, at an estimated combined cost of over US$100 billion per annum; and planes of all types find a home in the more than 1,500 commercial airlines operating worldwide. Various studies estimate that there will be a need for an additional 28-30,000 aircraft to replace and augment airline fleets in the coming 20 years, calling for a global investment of US$4 trillion. They need financing.
How do airlines finance their aircraft?Of the above-mentioned annual US$100 billion investment, it is estimated that in 2013, 26% will be financed with the support of Export Credit Agencies (ECA) of producer/export home countries. Another 28% will be financed by bank debt directly to airlines and aircraft leasing companies; 25% will flow from cash/equity within airlines and aircraft leasing companies; 14% will be generated from the capital markets; and the remainder will be provided by a mix of manufacturer support, leasing company cash-flow and tax credits. Operating lessors are becoming a very important
source of aircraft financing, with an approximate 38% market share of the global fleet, and accounting for 36% of new aircraft orders outstanding.
ECA financing was, until now, generally the most economic form of financing, but new rules have imposed higher costs, making it less attractive than before. Commercial debt, on the other hand, has witnessed pricing pressures in recent years due to the financial crisis and the introduction of Basel III rules. The remaining method of aircraft financing is leasing, which comes in two forms: finance leasing or operating leasing.
Because of many factors aff ecting the evolution of the market in the last three decades, operating leasing has witnessed exponential growth. This segment now accounts for one aircraft flying out of three, and growing. In recent years, many capital providers entered the market and funding availability has been abundant despite the cyclicality of the market. Many factors affect this boom: including the current low cost of funding and an
anticipated infl ationary environment, especially following the last few years of flat economic growth in industrialized countries. Both capital and bank debt are available for good quality assets on lease to creditworthy airlines. Specialized asset-based lenders have been active in this market for decades.
Shariah compliant aircraft leasing
Several aircraft leasing and financing transactions (the number is estimated at over 55 transactions) in amounts exceeding US$5 billion have already used Shariah compliant structures and many international airlines are very familiar and comfortable with documentation involving Shariah compliant clauses related to maintenance, insurance and excluding any reference to Riba. Despite being Shariah compliant, the applicable law governing the lease agreement is normally an international one. Products used in aircraft financing include Ijarah wa Iktinaa’ and Mudarabah, among others. Some airlines in the GCC and Southeast Asia regions have issued Sukuk (estimated combined issues with a volume of US$12 billion) with aircraft as underlying assets to fund the airlines’ aircraft acquisition programs. This segment of the market is bound to grow significantly in coming years.
As a result, aircraft leasing has been cleared by many Shariah scholars who have developed an expertise in aviation financing structures from past transactions. Typically, Shariah compliant investment funds, solely dedicated to own aircraft assets have been launched to date by financial institutions, which were subsequently distributed to high net worth individuals in various countries. At Novus, we always take an equity stake in the leasing transactions we book. Figure 1 illustrates how it works, based upon an actual case. A dedicated fund (InvestCo) raises funds from Shariah compliant investors to finance aircraft transactions. With an aircraft costing US$100 million, InvestCo will use, say, US$30 million of its equity with the rest being financed from a third party lease financier, which may be conventional entity. In this structure, Investco capitalises LeaseCo with US$30 million which passes the money to FinCo. This enables Finco to obtain US$70 million of lease finance to facilitate the purchase of a US$100 million aircraft , on which LeaseCo takes a head lease. LeaseCo will then grant an operating lease to Airline Co for a term of anywhere between eight to 12 years. Airline Co pays monthly rentals to LeaseCo, part of which are paid on to FinCo to pay the Lease Financier; the surplus is paid to the investors, via InvestCo.
Risk factors in aircraft leasing and their mitigation
There are various risks involved in aircraft leasing. Chief among them is the potential failure of an airline lessee to honor its obligations under a lease contract triggering an event of default under a lease agreement. This risk is mitigated by careful selection of a counter party airline; relying on an airline’s financial history, whilst necessarily important, is not sufficient. Other factors have to be taken in consideration in determining an airline creditworthiness — ownership support, capable management, business model, competitive environment, strategy and vision, to name a few. Airlines do have an important role to play in the economic life and development in many countries, especially developing economies where land infrastructure is less developed. It is worth noting that the airline industry is very competitive and cyclical in nature. The industry is very exposed to economic slowdowns, natural disasters, increased cost related to aircraft taxes, environmental issues such as CO2 emissions, curfews at airports, etc. Moreover, most full service airlines (unlike low cost carriers) rely on premium travel to be profitable and that segment is vulnerable to general economic activity. Life is certainly very difficult for airlines’ management teams to keep profitable and satisfy their shareholders. The other main risk is the market value of the leased aircraft at the end of a lease term. Here, the mitigation is from careful selection of the aircraft types that investments will target; their fuel efficiency, their technological avantgarde, their sustainability via a wide user market (and after-market). It is not enough to look at market forces today, one must anticipate what the market will look like a few years down the line (when the current lease of an aircraft expires). What other aircraft types would have entered the market by then; the cause and effect of each move by an aircraft manufacturer or another participant in the supply chain (i.e. engine makers); any new entrants and introduction of competing aircraft types? Here, only professionals who are intimately familiar with the ‘metal’, manufacturing R&D and market receptivity, are best equipped to make judgments and analyze market forces and selection factors.
Exploring opportunities to invest in aviation assets
In the first instance, it must be decided whether to enter the market via senior lending, mezzanine lease financing or direct investment in aircraft assets. Obviously, depending on such determination, a potential financier will seek to team up with well established, active players in the market in order to participate or co-manage loan facilities to airlines, secured by aircraft assets, be they senior or junior tranches. This can be achieved by participating in syndicated loans or on a ‘club deal’ basis: the choice is wide. It can also involve the purchase of bonds in EETCs (Enhanced Equipment Trust Certificates), issued by airlines or leasing companies, primarily in the US capital market — although capital markets in other parts of the world like western Europe and Japan are also beginning to emerge. As to direct investments, the choice is also wide. An investor can purchase shares of any listed aircraft leasing company (and there are a number of them), or in hedge funds which have large diversified investment portfolios, including aviation assets, directly or indirectly (e.g. via aviation leasing platforms). Aircraft investment funds also float their shares on certain stock markets and investors can have direct access. These are the most ‘passive’ forms of investment in the sector. Such passive investment may lack visibility but it is liquid and may suit many smaller investors. It is worth noting that this investment does not include buying shares of airlines or aircraft manufacturers, another matter altogether. Another, more active, form of investing in aircraft assets is to team up with aviation platforms who have the knowhow and can custom-tailor an investment product that suits the desired riskreward profile, the time horizon of the investment and the exit strategy. Such investment can be in the form of a blind pool of aircraft assets (with clear pre-set selection criteria as to aircraft type, lessee profile and geographical diversification) involving amounts in the range of US$150-200 million, or can be carried out on an aircraft-by-aircraft basis, with an average investment amount of US$35-45 million per transaction. Such investments are generally leveraged two or three times to one (about 30% equity of the acquisition cost, and 70%of lease financing). Typically, such investment requires, in addition to aviation market expertise, structured fi nancing knowledge, depending on the jurisdictions involved — of both airline and leasing vehicle. Generally, the more sophisticated an airline is, the more it requires expertise in responding to its financing needs, lease documentation and technical interface. The investment can generally be made by buying shares in a to-benewly- established company (or fund), incorporated in a tax efficient jurisdiction. The company, generally a Special Purpose Vehicle, will buy an aircraft and place it on lease to a specific airline. All the parameters of the lease are known before the decision to invest is made — the aircraft type, airline involved, terms of lease, etc….and cash return on investment is almost immediate. In the current investment environment, investors look for transparent, real assets to hold on to, as opposed to financial products — fixed income or securities, which have tended to be quite volatile of late. Investment in leased aircraft assets is very suitable to most investors (i.e. pensions, insurance firms, high net worth individuals, financial institutions and governments). It should be considered as part of any investment portfolio, by way of good diversification. At Novus, we have worked with most, if not all, types of investors over the years.
In summary, the success factor in investing in aircraft assets is a good combination of capital provision with technical know-how. Aviation is a global market involving global players and sophisticated solutions to financing aircraft in an ever expanding market.