One of the sectors most adversely affected by the covid-19 pandemic is transportation, in particular, airlines. With many countries around the world closing their borders in March 2020 and implementing severe restrictions on international travel, aviation was one of the fastest and hardest hit industries. It has also suffered from a slow recovery as many restrictions have so far only been partially eased, with ongoing travel bans between selected countries and an increased burden of testing on passengers putting many off getting on a plane.

The scale of the crisis facing the aviation industry is something few could have predicted at the end of 2019. According to analysis by the Airports Council International, an industry body representing global airports, passenger traffic in 2020 declined 64.6 percent compared with pre-covid forecasts and in 2021 is projected to be down by 47.5 percent.

As a result of airlines going out of business, or cutting back to try to survive, total capacity is thought to have decreased by more than 10 percent. To put this in context, the largest previous decrease in capacity was in the wake of the global financial crisis, at just 2 percent of the total.

“Pre-covid, airline balance sheets were in good shape,” says Evan Carruthers, chief investment officer and managing partner at private investment manager Castlelake. “Airlines have a lot of fixed costs and the severity of this crisis saw revenues for many drop to zero and a sharp decline in credit quality.”

A loss of revenue of this magnitude has created two major problems for airlines going forward. First, a need for more financing to both help them survive and recover their business as the impact of the pandemic eases. Second, many of the industry’s traditional finance providers, such as banks, are pulling back from the market.

ACC Aviation, an aviation leasing, charter and asset management provider, surveyed airlines to find out how they would seek financing to fund fleet updates and network expansion in the post-covid era and found 46 percent believe capital market funding, including private debt and equity funds, would dominate aircraft finance in the future. A further 28 percent believe export credit financing will increase.

“Bank debt is available (primarily) for Tier 1 airlines. As the market recovers, however, we can expect to see increased availability for debt finance with debt capital markets remaining strong,” says ACC’s vice-president of aircraft finance advisory, Viktor Berta.

Carruthers believes banks operating in the aviation space are likely to face similar issues to banks in broader corporate lending, where a mixture of regulatory and economic issues will make it more challenging for them to lend, all of which has been exacerbated by the events of the past 18 months.

“It’s less profitable today for banks to lend to aviation. Regulatory pressure and covid risks mean banks are going to move away from lending to transportation operators,” says Carruthers.

Overheated market

According to Berta, a mix of high demand for asset-backed security bonds and good supply of bank debt to finance aircraft meant the market was already overheated and margins had begun to thin. Demand was so high that up to 50 entities were bidding on some RFPs.

“Pre-pandemic, lessors and appraisers were already reassessing certain assumptions on their pricing models in preparation for the adjustment to values of older vintages as new technology alternatives continued to gain ground,” explains Berta.

“The expected return of the Boeing 737 MAX was seen by many as the event to trigger the realignment in values in this segment of the market. The investment and financing community, however, was not expecting an imminent correction.”

The pandemic has not simply been a correction but a catastrophe for aviation and simply to survive the unprecedented period of disruption to their business, airlines have built up a considerable pile of debt, according to Carruthers.

“The aviation industry has seen a huge spike in leverage, with more than $250 billion of debt raised since covid hit, and it’s going to take five to 10 years to manage down balance sheets, so they need refinancing capital to help them get through this,” he adds.

The picture looks bleak, but alternative lenders have to some extent been able to plug financing gaps and provide solutions to help the aviation sector begin to recover. In fact, for private debt lenders in aviation, this could represent a major opportunity, one which Castlelake has been keen to grasp, having launched a new business to provide further financing to aviation beyond its usual aircraft leasing capability.

“We saw an opportunity to set up a direct lending business focused on aviation and have hired into our platform to make that happen. Initially it was a short-term reaction to what was going on in the market, but we think this will be a long-term sustainable business model for us for years to come,” says Carruthers.

Direct lending opportunity

The crisis has also allowed lessors to acquire aircraft assets at attractive prices as airlines have become more willing to put up collateral in order to help them survive the period of disruption.

“Pre-covid, the sale-and-leaseback market had largely dried up,” says Greg Byrnes, chief financial officer at White Oak Aviation, a lessor and specialist aviation lender.

“The balance of power at that time was really with the airlines and aircraft prices were high and this drove down yields, especially for smaller players in the sale-and-leaseback market. Almost immediately when covid hit, the sale-and-leaseback market opened up again as airlines looked for liquidity and we were able to complete several deals.”

Like Castlelake, White Oak Aviation has also sought to pursue direct lending into the aviation sector as banks have withdrawn from the market, providing capital for aircraft acquisition or other general growth and liquidity needs.

For this line of business Byrnes sees particular promise in the air freight business. “We’re looking at a lot of freight opportunities right now due to a big premium in demand for air freight and those operators are looking to expand their capacity,” he says.

With the worst of the pandemic hopefully behind us, what does the future look like for the aviation sector? Carruthers believes there will be a recovery, but it will be a challenging one.

“Our expectation is for a rocky recovery,” he says. “The industry is still very disrupted, particularly by jurisdiction-specific restrictions, which are difficult for aviation which relies on global traffic and open borders.

“We won’t see a robust snap-back in demand but different parts of the industry have seen a strong rebound, such as domestic travel in the US, but international traffic is still down on where it was pre-pandemic.”

Byrnes is more optimistic, believing demand for air travel will result in an improvement in 2022 and beyond.

“We’ve felt for some time that 2023 is when we will see demand return to pre-pandemic levels but there’s a lot of uncertainty around economic recovery in different regions and the potential for covid variants to cause further disruption, but we think things are heading in the right direction.”

While the pandemic has created exceptionally challenging circumstances for the aviation industry, it looks set to be an opportunity for alternative lenders. Not only can they claim market share from banks that are pulling away from the market, but the correction to asset values and cooling of the market has enabled them to pick up assets at attractive valuations and develop new relationships to build on in the future.