Economic and traffic growth are two of the key indicators of growth in commercial aviation globally. Economic growth in a region generally has a strong impact on the increase in demand for air service. While in aggregate this is true, the degree to which air service grows in relation to gross domestic product (GDP) is not consistent throughout the world. Typically, in developing countries, air service grows at a much higher rate than GDP. Historic experience in Western Europe and North America shows that air traffic growth in a developed country with a mature air service market is less responsive to GDP than in a developing country. By way of illustration, Boeing’s worldwide forecast for the ratio of air traffic demand growth to GDP growth over the next 20 years is approximately 1:5, albeit with regional variation. At any time and any place, few airlines have the internal cash available to self-finance acquisitions of new or used commercial aircraft, and most airlines seek financing from a variety of sources, including traditional bank debt, export credit guarantees, tax leases, capital markets and operating leases.
There has been much commentary in recent years relating to the enormous aviation potential of the economies of Brazil, Russia, India and China. Recently, Africa and the Asia-Pacific region have been regularly added to this list, and we may add Latin America and the Middle East to the regions already mentioned. In other words, heady growth (more than 6 per cent) is predicted in almost every region of the world with the exception of Western Europe, which may be considered to have reached saturation point.
To cite growth forecasts from one of the two major manufacturers, Boeing predicts demand for 41,030 new aircraft in the next 20 years, valued at US$6.1 trillion. Half of these aircraft will replace existing aircraft, such that by 2032 the world’s commercial aircraft fleet is expected to comprise 46,950 aircraft. And, after many years of an Airbus and Boeing duopoly, new aircraft types are entering the market: the Bombardier C Series (in 2016 the CS100 was delivered to launch customer Swiss and the CS300 to launch customer Air Baltic), the Comac ARJ21 regional jet, the Comac C919, the Sukhoi Superjet, the MC-21 and the Mitsubishi Regional Jet. Of all these 41,030 new aircraft, 40 per cent are predicted to be required in Asia-Pacific, 20 per cent in Europe and North America and 20 per cent in the Middle East, Latin America, the CIS and Africa. Boeing delivered more commercial aircraft in 2017 than any manufacturer for the sixth consecutive year and set an industry record with 763 deliveries in 2017, driven by high output of the 737 and 787. Boeing booked net orders for 912 aircraft and has an overall backlog of 5,864 orders. Airbus’s commercial aircraft deliveries in 2017 were up for the 15th year in a row, reaching a new company record of 718 aircraft delivered to 85 customers. The 2017 total comprised 558 single aisle A320 family (of which 181 were A320neo); 67 A330s; 78 A350 XWBs and 15 A380s. Airbus achieved 1,109 net orders from 44 customers in 2017 and at the end of 2017 Airbus’s overall backlog stood at 7,265 aircraft.
Global revenue passenger kilometres (RPKs) are expected to grow by an average of 4.7 percent over the next 20 years. The average passenger load factor has reached a record high of over 80 per cent. The top 15 airlines account for about half of world RPK growth. American, Delta and United topped the table, with Emirates jumping above Air France-KLM. The International Monetary Fund estimates that the world’s GDP rose by 3.1 per cent in 2016. So RPKs did better than the historic figure for air travel, growing at twice GDP. The International Air Transport Association estimates that the world’s airlines made a profit of US$34.5 billion in 2017, helped for another year by the fall in fuel prices and low interest rates. IATA expects that strong demand, efficiency and reduced interest payments will help airlines improve net profitability in 2018 despite rising costs. 2018 is expected to be the fourth consecutive year of sustainable profits with a return on invested capital (9.4 per cent) exceeding the industry’s average cost of capital (7.4 per cent). Thus, compared with previous years, these are heady times. The level of finance required to sustain this expansion is astonishing. The commercial aircraft finance market is already a market valued annually in excess of US$100 billion for the financing of new deliveries. (This is in addition to the secondary aircraft market, the business jets world, spare engine leasing or finance and the engine aftermarket.) Deliveries of new aircraft will require an average of US$125 billion of finance annually over the coming decade.
The purpose of this short introduction to the aviation finance world is not to predict how aviation finance will meet the challenge, but to take a snapshot of where we are now and to identify which threads are likely to be picked up going forwards. Given this context, we will examine:
- the main financing products currently available: commercial bank finance, leasing, export credit, the capital markets and now insurance;
- developments in the emerging markets; and
- the progress of the Cape Town Convention.
Commercial banks, lessors and export credit agencies account for the majority of aircraft financing, and the use of capital markets has expanded considerably over the past decade. Following the credit crunch of 2008, the availability of traditional debt was severely constrained, but has seen a resurgence over the past few years. To fill the subsequent funding gap, the export credit agencies (and, indeed, the manufacturers themselves) stepped up to the plate. However, it is expected that it is the areas of capital markets and operating leasing that will see the most financing activity in terms of volume. The emergence of a new insurance market in 2017 has enhanced the diversity of financing options. As the global aviation industry updates its fleet and adds capacity to meet growing demand, Boeing expects the funding requirement for new aircraft deliveries to increase from US$122 billion in 2017 to US$189 billion in 2022.
According to Boeing, the sources of US$139 billion worth of finance for the purchase of aircraft in 2018 are expected to be as follows:
- bank debt: 35 per cent;
- capital markets: 29 per cent;
- cash: 26 per cent;
- export credit: 5 per cent; and
- insurance: 5 per cent.
In this overview we shall look at:
- enhanced equipment trust certificates (EETCs);
- asset-backed securities (ABS);
- export credit agency (ECA) financing;
- commercial bank finance;
- leasing; and
An EETC is a publicly (but sometimes privately) issued, rated security that relies on the credit of a single issuer and is secured by aircraft. This is usually in the form of a special-purpose company or SPV, which is created with the sole purpose of owning the aircraft. While EETCs have traditionally been issued by United States airlines, because of the availability of section 1110 of the US Bankruptcy Code, the product should now be increasingly available to airlines in countries that have adopted the Cape Town ‘Alternative A’ insolvency regime (eg, recently, Air Canada, British Airways and Virgin Australia).
EETCs were effectively closed during the financial crisis, and re-opened in 2009. There is strong evidence that in 2016 and 2017, airlines, especially US airlines, looked increasingly to the debt capital markets as a source of funding. During the past 12 months or so, near-record levels of financing were completed in the primary securities markets accessed by airlines (and aircraft lessors) compared with prior periods. Airlines have been issuing EETCs and unsecured bonds, while lessors have been issuing unsecured bonds and sponsoring aircraft and engine ABSs.
EETCs are well suited to repeat issuances, and carriers with established histories in the market can achieve very competitive rates. One of the key developments of recent years has been a growing cadre of non-US investors in EETCs. According to Boeing, the growth in international EETC investors over the past several years is being driven by ‘healthy airline fundamentals, a broader understanding of the strength of commercial aircraft as an asset class, and active outreach efforts by investment banks and manufacturers’. Between 2014 and 2016, investors from nine countries bought public EETC paper for the first time, with just two countries falling away. Over that same period, the overall allocation to international investors jumped from 5.8 per cent to 8.3 per cent, a rise of more than 40 per cent. As global EETC issuances gain further traction, and as non-US investors learn more about the aviation industry and the value of commercial aircraft, it is Boeing’s expectation that this positive trend will continue.
All that said, capital markets actually saw an overall decline in activity in 2017, according to Boeing ‘partly due to airlines deleveraging risk and greater access to bank debt’. Lessors accounted for 70 per cent of the volume as they accessed capital markets for unsecured debt and ABS issuances to finance their portfolios. Boeing anticipates that 2018 will see an upward trend in capital markets volume as lessors continue to use the space as their primary source of financing. Boeing expects new institutional investors entering the market to further stimulate the use of capital markets and EETCs.
ABS are issued in the private and capital markets, secured by aircraft or lease rental cash flows. The predominant forms of ABS are transactions structured as collateralised loan obligations and collateralised debt obligations (EETCs are not characterised as ABS since they are reliant on the single issuer). The newly reopened ABS market provides an efficient means for lessors to sell off portions of their portfolios.
ECA-guaranteed loan products covered only about 5 per cent of new aircraft financings in 2017, substantially down from previous years. This is a financing supported by an ECA, of which the primary ones are:
- Brazil: BNDES – supports Embraer;
- Canada: EDC – supports Bombardier;
- France: COFACE – supports Airbus and ATR;
- Germany: Euler Hermes – supports Airbus;
- UK: UK Export Finance – supports Airbus and Rolls-Royce; and
- US: US EX-IM – supports Boeing, CFM, IAE, GE and Pratt & Whitney.
ECA financings are currently regulated by the Organisation for Economic Co-operation and Development Aircraft Sector Understanding (ASU) arrangements; however, not all aircraft manufacturing countries are subject to the ASU rules (eg, China, Japan and Russia), which will be of increasing significance as these countries develop new aircraft types and develop products. By way of example, in 2017 China’s export credit agency CEXIM’s financed two Airbus A380 aircraft; the transaction was a US$450 million financing for Minsheng Financial Leasing as lessor of two A380-800 aircraft on finance lease to Korea’s Asiana Airlines.
Having been of critical importance when filling the funding gap during the downturn in availability of traditional debt finance during the recent prolonged recession, ECA financing is likely to reduce over time in the light of the ASU’s requirements to impose market-level fees and rates. The 2011 ASU requires each ECA to classify its borrowers into one of eight risk categories, based on these senior unsecured credit ratings. The new ASU thereby raises the export credit premium for all buyers and borrowers.
Both Airbus and Boeing lacked access to their domestic export credit agencies in 2017 for well-publicised reasons; however, 2018 should likely see renewed usage. That said, export credit financing is likely to remain marginal for the foreseeable future as the commercial financing markets remain healthy.
In April 2018 the US Ex-Im Bank agreed an innovative $1 billion risk sharing programme with 10 reinsurers that fulfils its 2015 Congressional reauthorisation mandate to engage in risk-sharing with the private sector to minimise its (and US taxpayers’) liabilities. The deal continues the process of de-risking subsequent to the hiatus that saw a newly Republican-dominated Congress withdraw its mandate from Ex-Im in 2015 for five months. Subsequently Boeing was a key initiator of the AFIC private insurance-linked initiative last year, followed by this latest programme.
A new market development is the provision of insurance risk capital to aircraft finance. Boeing and Marsh developed the Aircraft Finance Insurance Consortium (AFIC), which consists of four insurers that issue an AFIC non-payment insurance policy (ANPI) to cover a lender’s credit, residual value and jurisdiction risks. Marsh manages and administers the ANPI platform. More than US$1 billion of new aircraft deliveries were supported by AFIC in 2017.
Commercial bank finance
Commercial banks currently fund approximately 35 per cent of new aircraft deliveries in 2017, demonstrating recovery from the lean years of the credit crunch. The traditional Western European (mainly French and German) banks and US banks are now joined by new market entrants in Australia, Japan, the Middle East and (in the case of financing Chinese airlines) China. The adoption of Basel III is likely to raise the operational costs for banks, which will, of course, be passed on to customers in the form of higher margins: increased capital adequacy requirements and other changes such as the net stable funding ratio rate being phased through to 2019, and are expected to have a significant effect on the availability of commercial bank finance. Bank debt is the most prevalent source of financing in China.
As well as traditional mortgage finance, more specialised products that remain available to a greater or lesser extent are:
- French lease: a cross-border tax lease where the lessor is domiciled in France; this is traditionally the preserve of the French commercial banks;
- Japanese operating lease (JOL): Japanese investors put up equity and the balance of funding is provided by a bank loan. Since the debt must be booked in Japan to avoid withholding tax, this product has historically been the preserve of Japanese banks such as the Bank of Tokyo-Mitsubishi. (A JOLCO is a JOL with a call option allowing the airline to purchase the aircraft.); and
- Kommanditgesellschaft (KG): a product whereby the aircraft is acquired by a German limited partnership, financed by German investors and partly leveraged by bank loans from one of the banks specialising in this product (eg, NordLB).
Activity in the operating lease sector restored momentum lost in the aircraft finance sector during the liquidity crisis, and the subsequent downturn in the finance sector and in the wider economy. About 40 per cent of new aircraft deliveries are currently facilitated by way of operating lease, and most analysts suggest that this proportion will rise to 50 per cent by 2020. In addition to traditional investors in aircraft equity, such as operating leasing companies (eg, AerCap, GECAS and DAE), hedge and private equity funds have recently become increasingly significant in this market. The ABS market remains important for lessors to finance portfolios of aircraft.
Industry consolidation has continued, with DAE Capital acquiring AWAS in April 2017. DAE Capital was prepared to pay a significant premium for AWAS – bankers close to the deal say it paid a multiple of 1.15 times the portfolio’s value for the platform. The deal propels DAE into a top 10 aircraft leasing platform. AWAS adds 214 owned aircraft and has orders for 23 aircraft, giving DAE a committed fleet of 394 aircraft valued at more than US$14 billion.
As well as consolidation, there is a trend of new entrants into the market, especially in Asia and the Middle East, where traffic has been booming and plenty of capital is available. Of the top 25 aircraft lessors in the world in recent years, fewer than half were operating only a decade ago. Some are totally new, such as ICBC Leasing and CDB Leasing in China or DAE Aerospace in Dubai. Others are set up by serial entrepreneurs, such as Air Lease Corporation and Avolon (now owned by HNA Group). Some airlines with large order books have also set up leasing companies, such as Indonesia’s Lion Group, which has already leased out 737 NGs into the Chinese market. Regional concentration is continuing: for example, two-thirds of the Chinese lessor fleet is leased by Chinese carriers (the majority of Bohai Leasing’s aircraft are leased to carriers owned by HNA such as Hainan Airlines). The balance of lessor ownership continues to move eastwards following a natural expansion of the growth in commercial aviation in Far Eastern emerging markets, with lessors in the Asia-Pacific region now owning or managing 25 per cent of the global fleet.
Emerging market developments Africa
The strong level of growth predicted for the African aviation industry over the next 20 years (5.9 per cent per annum) is higher than the world average (4.7 per cent), and provides a major opportunity. The African Airlines Association estimates that its member airlines will double their combined fleet of 600 aircraft to 1,210 aircraft. In 2016 African airlines had their best growth performance since 2012, up 7.4 per cent. Growth is being underpinned by strong demand on routes to and from Asia and the Middle East. Capacity exactly matched demand, with the result that the load factor remained flat at 67.7 per cent.
Aviation in Africa is beset by hurdles to growth; the most notable relating to liberalisation, safety and infrastructure. With the exception of South Africa and, to some extent, Nigeria and Kenya, the banking system in much of sub-Saharan Africa is not well capitalised and local banks are not in a strong position to provide aircraft finance (with exceptions such as Investec, Nedbank and RMB in South Africa and FBN in Nigeria). The small size of most African airlines and the many difficulties in operating airlines means that many financial institutions are unwilling to invest in African airlines and charge higher rates, or will only do so if there is a government guarantee in place to cover default risk. The number of African airlines using finance or operating leases is still relatively low, at around 40 per cent, and tends to remain limited to top-tier airlines. The use of ECA financing has become common with development banks (Afrexim, Africa Development Bank, PTA Bank, Africa Finance Corporation) often used to fund the 15 per cent equity exposure.
Asia-Pacific and China
The increasing wealth and development of the region has created a burgeoning middle class, eager to travel. The increase in passenger demand has encouraged expansion, and to meet predicted passenger demand it is expected that China alone will need 7,420 new deliveries between 2017 and 2036; 60 per cent of these aircraft will be leased. Chinese airlines already have over 3,100 aircraft, which is roughly 14 per cent of the world’s fleet. The fleet has been growing at a rate of 11 per cent per year since 2010. Low-cost carriers now account for over 50 per cent of total seat capacity in the region.
In 2016, Asia-Pacific carriers recorded a demand increase of 8.3 per cent compared to 2015, which was the second-fastest increase among the regions. This pace is considerably ahead of the five-year growth average of 6.9 per cent. Capacity rose 7.7 per cent, pushing up the load factor 0.4 percentage points to 78.6 per cent.
Increasingly, Asian banks are becoming more involved in aviation finance transactions, not just in the region but across the world, filling the gap where European and US banks are restricting their lending. There is also a shift in the traditional use of US dollars to finance transactions. BOC Aviation has completed its first aviation financial transaction in Chinese yuan, with more than 50 per cent of the funds coming from private banks. China’s financiers have been active in the leasing market since 2008, when five major finance leasing companies were established, sponsored by the largest state-owned banks.
The Asia-Pacific region will be the dominant region in terms of passenger numbers, having overtaken the US market with 40 per cent global passenger kilometres.
India’s commercial aviation industry is rapidly expanding, with the Ministry of Civil Aviation predicting that by 2020 India will be the third-largest aviation market in the world, and by 2030 the largest. Aviation accounts for 1.5 per cent of India’s GDP and serves around 150 million passengers per annum, with 90 million alone passing through Delhi.
Despite the growing demand for commercial flights and increasing passenger demand, commercial carriers are still suffering owing to heavy taxation and strict government regulations. In addition, after the default of Kingfisher Airlines in 2013 and Spice Jet in 2014, foreign financiers have become more reluctant to lease aircraft to Indian airlines, as strict regulation makes it increasingly difficult to repossess aircraft, with some financiers withdrawing from the Indian market altogether. Although India is a signatory to the Cape Town Convention, the experience of Kingfisher and Spice Jet has been far from encouraging, although the government has moved quickly to address the shortcomings in, for example, recognition of irrevocable deregistration and export request authorisations (IDERAs), and a number of the difficult Kingfisher and Spice Jet repossession cases related to aircraft that were leased prior to India’s ratification of the Cape Town Convention. This may have an effect on other airlines that rely on financing from foreign banks as it is becoming more commonplace for them to charge higher lease rentals or even require advance payments, which adds to the financial burden already on carriers.
The Middle East is another region currently outpacing the global rate of growth of the aviation industry. In 2016, Middle East carriers had the strongest regional annual traffic growth for the fifth year in a row. RPKs expanded 11.8 per cent, consolidating the region’s position as the third-largest market for international passengers. Capacity growth (13.7 per cent) continued to outstrip demand, with the result that the load factor fell 1.3 percentage points to 74.7 per cent. The geographical position of the Gulf, acting as a bridge between the rapidly developing Eastern markets and the more established markets in the West, continues to support the growth of locally based airlines. As the established European finance providers find their exposure to the region at capacity, and their levels of liquidity are also squeezed, local Middle Eastern banks have increasingly been entering the market, viewing the airline industry as an attractive opportunity to diversify their loan books. The big state-owned airlines, viewed as strong credits, have been able to demand very reasonable pricing in the commercial debt market.
Iran is, in theory, now open for deals. Aviation is one of the five markets where US sanctions are being lifted first. In January 2016, the Joint Comprehensive Plan of Action came into force, followed by General Licence J in July 2016. But it is not simple. Deals involving US-origin aircraft (ie, typically those that include 10 per cent or greater US-origin content by value) still require an OFAC licence, sanctions can snap back, and about 200 individuals or organisations remain on OFAC’s Specially Designated Nationals (SDN) list, including Mahan Air. In January 2016, Iran Air signed an order with Airbus for 118 aircraft, including 21 A320ceo family, 24 A320neo family, 27 A330ceo family, 18 A330neo (-900), 16 A350-1000 and 12 A380; the first delivery under this order took place in January 2017.
The Cape Town Convention
One of the most significant legal developments in the past decade has been the introduction of the Cape Town Convention, which established a system of recognising international rights in aircraft and certain aviation assets. It came into force in 2006 and at this time, depending on whether a particular jurisdiction has ratified the relevant sections and absorbed the principle into local law, it gives genuine rights and the ability to give effective notice to third parties of ownership and security interests. This has, in certain circumstances, provided encouragement for prospective lessors and financiers considering the financing of aircraft and engines in jurisdictions that may hitherto have been viewed as difficult. An immense debt is due to the Aviation Working Group, and to all of those who have worked on the Convention over the past decade.
The Convention has been ratified by 76 contracting states and the Aircraft Protocol has been ratified by 71 contracting states (the Convention also applies to rolling stock and satellites and its applicability to aviation is governed by ratification of the Protocol). The Convention will become increasingly important in international aviation finance as it gains more universal coverage, and a crucial tipping point may well be imminent ratification by all of the EU member states. It is highly likely that within the next few years the Convention will be the standard reference point for the creation, recognition and enforcement of aircraft security interests in the vast majority of countries with any relevance to aviation (which, to a greater or lesser extent, means all countries in the world).
Bombardier Business Aircraft predicts up to 8,300 new business jet deliveries representing approximately US$250 billion in industry revenues from 2016 to 2025 in the segments in which it competes. Bombardier Business Aircraft expects North America will account for the greatest number of new business jet deliveries between 2016 and 2025, with 3,930 aircraft, followed by Europe, which remains the second largest market with 1,530 deliveries expected between 2016 and 2025. Business jet finance is a niche field where private wealth banks (eg, Credit Suisse, UBS, Bank of America and Citibank) and specialist asset financiers (such as Global Jet Capital) tend to predominate, though export credit is also available.
An annual financing requirement of US$125 billion is a daunting target by any standard, but the aviation finance community has proved itself capable of meeting the challenge in the past, and will no doubt do so again, especially with new entrant capital. This is a robust, innovative and entrepreneurial part of the global finance community, working in a fast-changing sector, and can look forward with confidence to the next 20 years. Each chapter of this book will examine the legal context within which this community works.