PUBLISHED BY: Islamic Finance news
Using effective risk management techniques can help to avoid losses on aircraft financings provided by Islamic and conventional financiers, arising from airlines encountering economic turbulence. WESLEY POLLARD and CHARLES YETERIAN explore these opportunities.
Industry risk potential
The airline industry has been attracting secured lenders, both conventional and Shariah compliant, for almost a century; despite the fact that it is notoriously unprofitable aside from a relatively small number of standout performers. This trait primarily arises from the capital- and labor-intensive nature of the industry and its vulnerability to economic shocks that particularly impact traffic demand and fuel prices. Further complications are added from the largest operating cost components (fuel and aircraft acquisition) historically being denominated in US currency introducing foreign exchange risk to the mix. Political, technological and evolving competitive pressures add complexity to the credit risk assessment of airlines for those entities prepared to enter into transactions and become financially exposed to them.
On the plus side, airlines are highly cash generative as virtually all tickets are sold in advance of the service being provided. This feature allows airlines to cover most, if not all, of their day-today working capital requirements from this, effectively, ‘no cost’ temporary loan advance received from consumers. Consequently, most on and off-balance sheet debt has been utilized in the acquisition of expensive aircraft-related fixed assets giving the secured lender a potentially valuable ‘cushion’ in the process.
However, fixed debt service obligations on this capital expenditure require airlines to generate revenues and profitability over the long-term in order to survive and prosper as a going concern business. When economic shocks or an overly intensive competitive environment result in surging costs and diminished revenues, an airline’s fixed costs (debt and labor) can relatively quickly erode cash reserves (‘cash burn’) and force the airline into re-organization or insolvency. In this regard, the majority of airlines recognize the overriding importance of having significant cash resources available to tide them over during periods when the operating environment is unfavorable and the airline is reporting losses. Airlines can often sustain losses for a number of years, depending on their size and equity base and shareholders’ support, but, eventually, the absence of a turnaround in profitability will usually require a cash injection (debt or equity) sooner or later in order to maintain operations. Therefore, a key risk alert for analysts is the existing cash position of an airline, its development and knowledge of any access the airline has to further cash which can best determine whether the airline can meet its financial obligations over the short to mediumterm.
The starting point for an Islamic secured financier looking to transact in the commercial aircraft sector should be the risk assessment of the proposed borrower. In this venture, an overriding priority is normally the full repayment of the funds invested before focusing on returns. In the event that the planned repayment of funds is delayed or terminated, the recovery of these funds by realizing the security (aircraft) value is a key risk safety feature. With the dual advantages of an airline’s proven ability to cover its costs by generating cash advances and the good value retention characteristics of commercial aircraft as an asset class, it is still quite rare for lenders to lose money on aircraft financing transactions as long as they follow a structured risk policy and act or react in an appropriate and timely manner. Islamic equity financiers have an exposure to the residual value of the aircraft after a lease expires. But this risk is essentially the same as for Islamic investments in real estate or shipping or project finance.
The caveat to this is that the airline also needs to be operating in an owner/lessor/lender friendly jurisdiction which will not place burdensome hurdles to impede the orderly repossession of the aircraft. This can be a particularly sensitive issue if the ailing airline is a major player or the flag-carrier of a country, employs a sizable workforce and generates significant revenue inflows to the national economy. Although the Cape Town Convention (CTC) seeks to alleviate concerns of this nature, it remains a significant risk factor and the legal practices adopted by a nation in the event of an airline bankruptcy should feature in any risk assessment for a secured financing. Governments from several Islamic nations including Malaysia, Indonesia, Pakistan, Saudi Arabia and Bangladesh were some of the very first to sign-up to the CTC. Despite the generally positive attributes, airlines can and do go out of business often owing significant amounts of money to external stakeholders including lenders. New mainline commercial aircraft can cost between US$40 million and US$300 million each so even a small fleet can add up to a major exposure if it’s relatively young. The ability to quickly move aircraft to other operators depends on timing and market liquidity for that particular aircraft type. The risks are considerably reduced for an in-demand aircraft that is first to the market given that a major airline failure can suddenly swamp demand if there are too many aircraft looking for a new home at the same time. The recent (2008) industry downturn caused by the global financial crisis resulted in a fairly high number of airline bankruptcies overall at the outset but very few major collapses then or since. In fact, the relentless growth of the air transport industry over the past five decades has supported a long run trend
of more airline start-ups than failures.
However, the large airlines that do fail can result in substantial losses to lenders. Two relatively recent collapses involved Mexicana in 2010, which reportedly owed banks US$800 million, and Kingfisher Airlines (India) in 2012 which had reported total debts outstanding at that time of US$2.5 billion. These debts were compounded by the fact that some banks and aircraft lessors (including Islamic institutions) were prevented from repossessing the underlying aircraft that were owned or pledged as security. Although aircraft in both cases were eventually released, values had depreciated over time thereby diminishing the recovery amounts whether by sale or onward lease. The fact that both airlines were losing money over an extended period should perhaps have prompted interested parties to negotiate an early return of the aircraft in order to circumvent later (and costly) bankruptcy-related challenges.
Risk management
The focus of this article is on utilizing good practice to offset the risks faced by banks and other Islamic financial institutions in lending to airlines for the purpose of acquiring commercial aircraft. In this context, the responsibility of the risk assessment function is to: 1) establish the long-term probability of the default or bankruptcy event prior to entering into a financial arrangement and within its time-horizon; 2) monitor the operating and financial performance of the airline during the financial exposure period; and 3) enact appropriate measures to minimize the potential for economic loss arising out of an airline default by recovering the asset.
Virtually all commercial and Islamic financial institution lenders will have a procedure for assessing and formally approving financial transactions in accordance with item 1) above which is industry standard practice and vital in order to correctly ‘price in’ the perceived risk. As identified in the case of some major airline bankruptcies, there is less certainty that items 2) and 3) are given sufficient attention that would give lenders a better chance of avoiding the sort of losses that have been witnessed. Nonetheless, the relatively small additional costs involved in employing, outsourcing or associating with suitably qualified and experienced personnel to monitor airline financial exposures and consequently enact recovery procedures (when required) could easily pay for itself many times over.
At Novus Aviation Capital, the activities undertaken to cover the monitoring of airline exposures are fairly comprehensive and considered appropriate for the company’s business model as an aircraft operating lessor but could be adapted to fit most lenders and investors’ modus operandi:
• Constant monitoring (cash and information flows);
• Formal credit review (individual airline and portfolio basis at least annually with rating review);
• Technical summaries provided by airline (monthly);
• Covenant compliance;
• Intensive monitoring/watch-list (as required);
• Risk ratings track record and database;
• Asset value monitoring (individual aircraft and portfolio);
• Shortfall alert where residual risk or watch-list case;
• Periodic market soundings for vulnerable assets.
• In an event of default, take necessary action to re-market aircraft.
Most of the information required for monitoring is supplied by the airline or specialist third parties to Islamic and conventional financiers, as part of the contracted or compliance obligations under the various financing documents, although a lot of useful intelligence can be gathered from differing sources including internet news providers. Indeed, one of the crucial aspects of sound risk assessment is the ability to interpret information and foresee issues arising which contribute to a ‘big picture’ analysis. Fully informed monitoring and assessment can trigger an advance warning of financial distress giving reasonable time for mutually beneficial proactive rather than reactive solutions to be reached.
In the worst case scenario of a payment default, the safety net of having a highly mobile and valuable asset as security helps in a restructuring or return negotiation, although the political jurisdiction is also an important factor as the lessors to Kingfisher Airlines who had to put their aircraft back together before they could fly them away after lengthy bureaucratic delays were left counting the cost.
Lessons learned
History shows that airlines very rarely collapse overnight and there are generally many months and sometimes years of a downward spiral before the end (usually) inevitably arrives. This becomes truer the larger the airline as it can have many tangible (aircraft, buildings) and intangible (airport slots, route rights, gate access) assets that can be sold and converted into life preserving cash. An airline tactic for overcoming short term liquidity ‘squeezes’ is also to be selective in who is paid out of scarce cash resources and this is usually decided by the airline assessing which creditor is most likely to act rather than ‘wait and see’.
The best advice to Islamic financiers is, therefore, stay awake, be at the front of the queue to question airline executives and at least be seen to be prepared to pull the plug, as most Ijarah contracts can allow you to. The aware lender that is not content with ‘a head in the sand’ approach but has a proactive thrust to its risk management philosophy is more likely to encounter the tailwind of a successful financing recovery whilst its competitors are fighting the headwind of increasing losses.
Wesley Pollard is the vice president of market research and risk management at Novus Aviation Capital — Dubai while Charles Yeterian is the executive vice president of Novus Aviation Capital Geneva, Switzerland. They can be contacted at wesley.pollard@novus.aero and charles.yeterian@novus.aero.
