Aviation Finance
Week 2: Asset Finance
I - Introduction
Aviation Finance is the business of providing financing, usually in the form of
loans, to airlines and operating lessors to help them
purchase aircraft. You are most likely familiar with airline
brands around the world; and operating lessors are large
corporations whose business is to rent out aircraft to airlines,
not unlike large car rental companies, save that the rental tenor
is usually 5 to 12 years.
Between the rise of commercial aviation in the 1960s, and the
Covid crisis in 2020, world annual traffic doubled every 15 years and had
proven resilient to external shocks. While the Covid crisis has impacted the
industry, growth will recover and it is estimated that over 43,000 new aircraft
are to be delivered in the next 20 years, with a value of roughly 7.2 trillion US
dollars.
II - Basics of aviation finance
Let’s imagine you are the CEO of an airline, and you need to add new aircraft
to your fleet to meet rising passenger or cargo demand. The
key question that you need to ask yourself is:
do I want to own or rent the new aircraft?
To simplify, try to think of it a little bit like the decision to buy
or to rent your own house or apartment.
- If you want to rent or as we say lease your aircraft, you will enter into a
contract known as an “operating lease” with an operating lessor.
- If you want to own the new aircraft, you will turn to an international bank
active in aviation finance, of which Société Générale, who will arrange what is
known as a “finance lease”.
The critical difference between an “operating lease” and a “finance lease” is
what happens at the end of the transaction:
- in an operating lease, the airline is obligated to hand the aircraft back
to the operating lessor, who will look to lease it to another airline as
quickly as possible.
- In a “finance lease”, the airline keeps the aircraft in its fleet,
without any financial liabilities attached to it any longer.
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The buy vs. rent decision has many consequences for the airline
and there is no “right decision” in absolute terms. It all depends
on the specifics of the airline such as its business model,
markets, strategy, as well as the aircraft type under
consideration.
Most airlines operate a mix of owned and leased aircraft with
some airlines having 100% percent of either owned or leased
aircraft in fleet.
III - What does a “finance lease” transaction look like from the bank’s
perspective
From the bank’s perspective, a finance lease is fundamentally a
long-term corporate loan secured by an aircraft.
What differs from other structured finance businesses (such as
project finance) is that the repayment of the loan does not
depend upon the revenues directly generated by the aircraft
under consideration but from the revenues from an airline’s
global operations.
Therefore the risk analysis is centered around the airline’s general
creditworthiness, meaning its ability to meet in the long run its financial
payment obligations.
A thorough credit risk assessment is therefore a major step in the process of
extending a loan, including creditworthiness elements you may expect for any
corporate, such as: evaluation of business and strategy, analysis of past
financial performance and key ratios as well as cash flow projections, but also
industry specific information such as operational metrics,
business model specificities: legacy vs low cost, routes
competition and possible consolidation.
However, the credit analysis can only take us so far as it is
quite often difficult to have a clear view on the credit standing
of a corporate beyond 5 to 7 years whereas finance leases
have a long tenor, typically between 10 and 15 years.
This is where the reliance on the collateral, namely the aircraft, comes into
play. Should the airline fail to meet its repayment obligations, the bank will aim
to physically repossess the aircraft from the defaulting airline, sell it (or lease
it) to a third party and repay the outstanding loan with the proceeds from such
sale (or lease).
The beauty of aircraft when used as collateral, as opposed to many other
tangible assets, is that it is an object which is relatively standardized and can
be easily moved across the globe.
However, all aircraft types are not equally desirable as collateral.
Financiers will always favor aircraft for which there exists a liquid
second-hand market. An expert view on each aircraft type and
specifications (such as engine type and variants, maximum
take-off weight, etc) is required to ensure the collateral
presents maximum second-hand value potential.
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In a typical “finance lease” transaction, a special purpose
company is created. Its objective is to:
1. borrow the money from the bank,
2. aggregate it with cash contributed by the airline and
3. acquire the aircraft from the manufacturer.
Immediately upon its acquisition, the aircraft is leased under a
long-term lease to the airline, who operates it.
The airline pays periodic rents under the lease, which enable the
special purpose company to progressively repay the loan according to a pre-
agreed reimbursement schedule.
The loan is fully repaid upon payment of the last rent.
The ownership of the aircraft is then transferred by the special purpose
company to the airline.
Many add-on features can be bolted on to the standard
structure I just described and in aviation finance, our goal is to
structure the right combination of solutions to address our
clients’ needs.
IV - Impact of the ESG shift on the air transport industry
Today the global Aviation industry produces 2 to 2.5% of all
human-induced carbon dioxide emissions.
Actually, while traffic has overall doubled every 15 years since the 1960s, fuel
burn per seat has decreased by 80% over the same period.
In 2020, the International Air Transport Association (IATA) announced a
resolution for the global air transport industry to achieve net-zero carbon
emissions by 2050 (in line with the Paris Agreement).
To achieve this goal, the aviation industry has short, medium
and long-term levers they can action. Let’s take a closer look at
those:
In the short term, the industry can act on:
- Fleet renewal: indeed new-generation aircraft currently
available can reduce CO2 emissions by up to 25% compared to
the aircraft they replace.
- Operating efficiency combining technology, operations and
load factor, which already contributed to 54% improvement in CO2 emissions
since 1990; and
- Carbon Offsets
In the medium term, Sustainable Aviation Fuels or “SAF” will be an
alternative to conventional jet fuel:
It is produced from sustainable feedstocks and is very similar in its
chemistry to traditional fossil jet fuel, meaning it can be used in current
engines up to 50% and within a few years’ time up to 100%.
Using SAF results in a reduction in carbon emissions of up to
80% compared to conventional jet fuel. IATA estimates that SAF
is the most important lever to reach net-zero target by
2050.
SAF production is currently very limited but will increase
along with demand as operators will progressively be
pushed by governments to use SAF.
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In the long term, CO2 reductions will be achieved through
disruptive technologies: From 2035 onward, manufacturers
are expected to start building aircraft powered by
hydrogen and electricity allowing further CO2 reductions
(or even zero-emission flights).
V – Conclusion
The key take home messages:
· There are 2 ways to finance aircraft: operating and
finance leases
· The decision to lend relies on the creditworthiness of
the airline
· The aircraft acts as a collateral
Whether it be in the short, medium or long term, massive CAPEX will be
required by industry players for their ESG shift and banks will have a key role
in financing the industry needs in this respect.
This concludes this short insight into the world and opportunities of the
Aviation Finance industry.
I hope you found it interesting and thank you for your
attention.
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