Your firm has raised billions of capital. Now it needs a new way to put it to work. Your boss has heard that aircraft leasing is a neglected source of stable returns. Your job is to develop the business plan. But where do you even start? Kevin Butler, TMF Group's air finance specialist, explains.
Aircraft leasing has been growing dramatically. Airlines now lease almost half the aircraft they fly, up from 10 to 15 per cent 30 years ago. Over the next 20 years a doubling of the commercial fleet is expected to add 20,000 aircraft. With a commercial jet costing between $85 million and $450 million, the total capital required will surely exceed $5 trillion.
But aircraft leasing is also a highly technical business. Investment returns come wrapped in a web of legal, fiscal, technical and marketing risks, many of them peculiar to the industry and hard to manage.
- Airline economics are precarious and peculiarly vulnerable to global uncertainties like the price of oil, the health of world trade, and international tensions.
- A technically sophisticated, highly mobile and very expensive asset creates a host of multi-jurisdictional tax and legal risks.
- Active asset management is crucial but requires deep, specialist knowledge of the market and the technology.
- And then there's the great unknown: second-hand values, or 'residuals'. The rate at which an aircraft's value on the secondary market declines is fundamental to overall investment returns but the risks are hard to manage.
So this is a market in which new investors, with limited in-house aircraft leasing expertise and a restricted network of industry connections, often find themselves at a disadvantage. And the only way to level the playing field is to seek the support of industry experts.
Right from the start, make sure your legal advisors are highly experienced specialists in the aviation sector.
The standing of a lease is not primarily a function of the airline's solvency. It is determined by how easy it is for you to repossess your asset – whether at the end of the lease or after an insolvency – and then how promptly you can return it to service.
The profitable airline is a relatively young phenomenon. Airline insolvency risks remain real. The industry's decade of consistent profit growth has been concentrated in just 30 airlines, with a long tail of marginal performers and loss-makers. Many countries will see your aircraft as part of their critical infrastructure. Local courts, including in the US, can be particularly reluctant to ground an airline.
It is vital, then, that all legal documents and agreements are prepared to aviation market standards and leases contain industry-standard return conditions.
Equally, it takes specialists in aviation leasing to create ownership and leasing structures whose efficiency, compliance and sustainability can be relied upon over the full term of a lease.
Leasing structures depend on a jurisdiction's network of double-tax treaties and the tax treatment granted to the special purpose vehicles (SPVs) that own the aircraft. With less than half a dozen suitable jurisdictions to choose from worldwide – each boasting its own local legal, fiscal and regulatory particularities – the choice of a 'home' jurisdiction is crucial.
Take Ireland. Half the world's commercial aircraft are managed or leased out of Ireland. Decisions about tax structure have profound legal, fiscal and practical consequences. 'Trading structures' must meet economic substance criteria to secure the necessary advanced capital allowances. Without sufficient substance, a non-trading structure – or section 110 regime SPV – must be used, but that will rule out deals with certain countries.
In recent years 'multi-stop' tax structures – combining several jurisdictions into a single leasing arrangement – have become more common. For example, the aircraft might be owned in Ireland, sublet to a LILO (lease in/lease out) intermediary in France, before finally being leased to an airline in Indonesia. Each financial centre adds some tax, accounting or regulatory value or efficiency – plus a layer of jurisdictional complexity.
Since the key objective of the OECD's work to tackle 'base erosion and profit shifting'(BEPS) is to end the misuse of double-tax treaties and token business structures in international tax planning, BEPS is an important and evolving risk for airline leasing structures, requiring expert management.
Aircraft residuals (the value of an aircraft on the second-hand market) are fundamental to overall portfolio returns, but they are also immensely difficult to forecast and tricky to mitigate.
Countless factors help determine an aircraft's value on the secondary market: regulatory change – emissions, take-off weights, new technologies; age and history; whether an aircraft is nearing the end of its development cycle; changing airline preferences and attitudes – cabin configurations, engine choices, perceptions of reliability, narrow versus wide body airframes, and many more besides.
Even if you have new or long leases in place, don't be tempted to sit back and take a passive approach to managing residuals. Monitor the secondary market constantly from day one. Assess the competing opportunities and alternatives. Track trends in airline preferences and aircraft (re)configuration. And be ready to trade if its prospects begin to deteriorate even if an aircraft is still in-lease.
The aircraft industry is highly regulated for safety reasons (which also helps protect values) but an airline in financial trouble can be tempted to cut corners with its maintenance and airworthiness documentation. Make sure you always know the condition of your aircraft by inspecting it regularly throughout the life of the lease.
Residuals risks are a fact of life. You should build room into your financial model to accommodate the potential losses. But ultimately only deep airline industry knowledge can minimise them. If you don't have the appropriate expertise in-house, hire specialists with the necessary experience, systems and network and let them manage your aircraft and monitor your leases.
Choosing a portfolio – to bid or to buy?
Whether you buy your aircraft new from the manufacturer or bid for an existing portfolio, assembling your fleet is a highly technical piece of strategic risk management.
Successful aircraft choices, even when buying new, are always rooted in a solid understanding of the markets for aircraft and air travel. Consider focusing on a particular market segment to build your understanding and grow your own network of trusted contacts and service providers.
Generally speaking, only two types of portfolio can offer investors any real protection against being left holding an expensive asset that nobody wants: young portfolios of new technology are always easier to re-lease; old portfolios of old technology already have rock-bottom residuals.
Buying box-fresh lets you choose the most popular aircraft and make sure the associated contracts and leases are optimised right from the start. The supporting contracts and documentation will need to be negotiated promptly. Do you have the expertise to do that yourself? Once those aircraft are yours, any delay placing them will mean heavy financing costs but no lease income.
Buying new aircraft won't automatically protect you from the consequences of poor choices. A portfolio of very young aircraft containing old technology – perhaps inefficient engines – will age very quickly as better technology enters the market. Over-reliance on a single model, even a popular one, could leave you vulnerable to the unexpected – think 737-MAX. And avoid specialist, wide-bodied models designed for very particular markets – think Airbus A-350. Very few airlines have the capability to operate them successfully and they could face an uncertain future in the aftermarket.
Most new investors purchase existing portfolios. This enables them to deploy capital quickly and generate income immediately. It's important to be cautious about residuals at the bidding stage. Assumptions about future values will influence the returns predicted by your portfolio pricing model, which in turn will influence your bidding. Don't let unrealistic residuals forecasts push you into paying too much.
Existing leases also mean existing contracts and terms (requiring specialist legal expertise to risk-assess properly) and at least some aircraft you'd prefer not to own. All the points made above regarding risky aircraft choices also apply when bidding for an existing portfolio. But now you should also be thinking about potential overexposure to particular regions, markets, high risk jurisdictions and airlines?
Managing the metal
It can be tempting to view an aircraft lease purely as a financial matter. Success in aircraft leasing begins with never losing sight of the astonishing machines at the heart of the transaction.
Managing the metal is all about minimising the time aircraft spend stationary and unproductive while you look for a suitable new lessor. When a lease ends or a lessee calls time, any delays, whatever the cause, will cost thousands a day and quickly make a big hole in returns.
Even when a lease runs quietly to the end of its term – as most do – a standard, scheduled close will still involve a time-consuming, costly and technically challenging return processes, working with the airline and possibly the manufacturer as they prepare the plane for return in line with the terms of the lease.
Even a fresh lease doesn't guarantee plenty of time to prepare for what happens next. To think so can be a costly mistake. There is always a risk that an airline will get into financial difficulties. If they are forced to return the aircraft early, you are left with a non-performing asset for as long as it takes to find a new lessor.
Even a 'routine' repossession can be time-consuming and technically challenging. Specialists will need to visit the aircraft on your behalf wherever it landed last. There may be technical inspections, re-registrations and probably airworthiness documentation to renew. Permits will be needed for the flight 'home'. All before the aircraft can finally be shepherd back into service. And if the airline had been in difficulty for some time it may have been tempted to cut corners with maintenance and airworthiness, neglect which could take many months and millions (including the lost profits) to correct.
The airline leasing market is indeed dynamic, with a recent history of strong and stable returns.
But it isn't a place in which inexperienced investors, however talented, are likely to thrive without expert professional support. It is a highly technical business, combining industry-specific legal and fiscal complexity with some very particular (physical) asset-based risks, all of which demands deep industry knowledge and technical expertise to navigate profitably.
So, if there is a 'first rule' of negotiating the aircraft leasing market profitably, it is this: take your time, proceed with care, and always seek to build a team that collectively really knows the industry.
TMF Group is one of the world's leading providers of business support services to the airline finance industry. Our large, dedicated aviation finance team, located in all the significant aviation jurisdictions, manage hundreds of aircraft leases all over the world. We work with a wide range of aircraft lessors, including new entrants and established players, airlines, private equity, hedge funds and banks. Our capital markets, aviation finance and regulatory compliance teams tailor their services to the particular needs of the industry, helping clients create efficient structures, acquire appropriate assets and negotiate effective relationships with lessees.
TMF Group's aviation services are an integrated part of a €2 billion independent global multinational with 7,800 in-house experts in 80-plus jurisdictions. We deliver a broad portfolio of consistent, integrated but localised services in accounting, tax, HR, payroll, corporate secretarial, regulatory compliance, capital markets transactions and alternative investments. Whether you operate across one border or many, with a handful of staff or several thousand, we have all the flexible, coordinated, business-critical support you need to open up new opportunities, build strong businesses, invest globally and stay nimble, efficient and in good standing everywhere.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.