Aircraft leasing: Waiting for take-off

As the airline travel industry continues to grow, there is potentially more opportunity in aircraft leasing. However, there are risk factors to be considered.

The airline industry has grown on the back of robust demand for overseas travel, with the Asia Pacific region, in particular, benefitting.

According to the latest data from the International Air Transport Association, 33.7 percent of total revenue passenger kilometers, a measurement of the profitability of the industry in percentage terms, came from Asia Pacific in 2016.

Leasing companies estimate that the demand for outbound travel will grow further due to market liberalisation and a rising middle class, both key economic growth drivers in the region.

Will Gramolt, chief financial officer of CDB Aviation, the leasing arm of Chinese policy bank, China Development Bank, speaking at the Credit Suisse Asian Investment Forum 2018 in March, estimated the profitability of the region “will rise 40 percent over the next 20 years or so”.

Despite this rosy outlook for the industry, however, the leasing segment is providing constraints to further growth. Former chairman, president and CEO of GE Capital Aviation Service, Norman Liu, said: “The industry is lacking lending platforms.”

He pointed out that it has been only a few years since large institutional investors started investing in aircraft leasing platforms.

In June 2017, Caisse de Dépôt et Placement du Québec, a Québec-headquartered Canadian pension fund, announced the formation of a $2 billion-sized global leasing platform, Einn Volant Aircraft Leasing, with GE Capital Aviation Services, an Irish-American aviation financing firm.

Sichuan Development Holding, the largest state-owned enterprise in Sichuan province, also formed a joint venture with Pembroke, Standard Chartered Bank’s aviation finance arm, in March 2017.

The limited talent pool to manage these assets is another factor, Liu added. PDI data has tracked six managers which have raised over $5.6 billion across nine aircraft leasing vehicles since 2010. Managers such as Castlelake, BBAM, and VX Capital Partners have launched aircraft leasing-specific funds in the last 24 months.

Up until now, banks have been the primary source of funding for lessors as part of their overall backing of the growth of airlines’ operations. Shailesh Deshpande, a New York-based head of securitized products finance – transportation at Credit Suisse told industry participants at the conference that “leasing has been taking almost 50 percent of this segment [airline financing] and there are new assets coming onto the landscape.”

Over 30 percent of entire aircraft leasing finance has been bank debt, according to Gramolt. Leasing companies typically buy aircraft with cash, obtain bank debt, use tax-driven structures or securitise hard assets.

Beijing wings in

“Now the real trend is with Chinese participants leading the leasing industry,” Gramolt said, adding that Chinese banks fund about 35 percent of total aircraft leasing activities and Chinese lessors with strong parent companies are now prominent.

Other banks in the region are also increasing their exposure to these assets, while traditional lenders such as US and European banks have retreated from the segment, according to Gramolt. For instance, Japanese banks now account for 20 percent of the total funding in dollar terms, followed by Australian banks with 10 percent of the overall aircraft leasing market.

However, the strategy still remains niche for many institutional investors. Jin-Woo Kim, a Seoul-based managing director of the alternative investment department at the Military Mutual Aid Association (MMAA), said the current risk-adjusted return levels for aircraft leasing are not attractive.

The Korean pension fund, with $9.8 billion in assets, committed around $58.5 million across three aircraft financing funds in February 2017. This included a $40.4 million commitment across two aircraft funds with underlying Emirates and China Airlines assets.

“Now we are questioning what will be a reasonable risk-adjusted return level for the aircraft leasing strategy,” said Kim, adding that the pension fund is not planning to gain further exposure to aircraft leasing funds.

The pension fund stated a required return rate of 5.5 percent for the aircraft funds. PDI understands that the MMAA is looking at shipping financing strategies to obtain higher returns.

“We see more transactions involving collateral and ABS (asset-backed securitisation)…but yields have been tightening,” said Gramolt.

Increasing turbulence

Geopolitical risks are also playing a crucial role, affecting the entire airline industry, according to Liu.

With China having hit back with plans to tax $50 billion of US products, including small aircraft, after the US announced its plan to impose tariffs on Chinese imports in April, the industry is in the firing line of the trade dispute.

“There will be sudden headwinds that the industry will face,” Liu added. For instance, there are issues with airport infrastructure, pilot constraints and historical downturns such as the global financial crisis and 9-11. “They are the big risk factors,” he said.

Stanley Hui Hon Chung, president of Hong Kong Aircraft Leasing and Aviation Finance Association, agreed with Liu that the geopolitical backdrop is crucial. Chung also argued that lessors will be challenged and industry consolidation will happen as he sees more new participants entering. “The bigger you are, the more it gets competitive,” he added.

Despite this backdrop, he estimated the current level of demand for airline passengers and freight will rise further in the long term.

Industry participants project the number of airline passengers to grow as much as 3.8 billion, globally, from 2017 to 2036, which is double the current figure, Deshpande said.

“In terms of the total number of travelers in China, by 2020 there will be 700 million [people] who will travel overseas for the first time. These are the numbers that we are looking at and this is definitely a better demographic,” said Chung.

Regional initiatives are also in place, aiming to boost the growth of the industry. Hong Kong has stated ambitions to become the hub of the aircraft leasing market. Its single corporate tax system used to be 16.5 percent fixed for corporates. Now it has come down to 8.5 percent, with an effective tax rate as low as 3 percent, according to Chung. “This is great stuff,” he said.

Aircraft can be a sensible addition to institutions’ investment strategies as an affordable and liquid asset compared to the likes of real estate or power plants. But investors would do well to take account of the tightening yields and various risk factors.