Aircraft Leasing Gains More Power, But Only At A Price
If there is one relationship in the leasing sector that symbolizes how difficult 2020 was, it is probably that of Norwegian and its lessors.
- Aircraft lessors expand market share
- Airlines request more sale-and-lease-back deals
- Customer bankruptcies force renegotiations and deferrals
- Pay-by-flight hour arrangements gain traction
Avolon CEO Domhnal Slattery describes it as a “black swan” event. Norwegian, with a large fleet of leased aircraft and 26 Boeing 787s among them, was facing collapse with the airline essentially grounded. Lenders agreed to swap debt for equity, temporarily making BOC Aviation and AerCap the airlines’s largest shareholders. Then Norwegian decided to exit the long-haul market. So the airline’s various lessors need to find new homes for 26 long-haul aircraft in a market best defined by, as Slattery puts it, “negative net demand.”
Norwegian may be an extreme case, given that it decided to exit its most important business altogether. But in various shapes, shades and forms, that is what the leasing industry has faced with a large number of its customers.
The leasing sector grew into a massive force over the past three decades, reaping the benefits of its business model, airline expansion and, for the past several years, low interest rates. Now, as the consequences of the COVID-19 pandemic continue to rattle through the air transport sector, the trend toward a bigger, even more powerful leasing industry continues at an accelerated pace, both in spite of and because of the pain inflicted upon it by the struggles of its customer base. Lease renegotiations come with a short-term hit, and popular mechanisms such as sale-and-lease-back (SLB) transactions are leading to an increased market share.
Controlling more than 40% of the in-service fleet, lessors will have even more leverage as customers of Boeing and Airbus regarding future orders, pricing and standardization requests, and they will want to have a bigger say in defining the next generation of aircraft.
Is this all good news? Maybe.
“The lessor share is becoming bigger, not because of careful planning but because of circumstances,” says Avitas Senior Vice President Adam Pilarski. In the current environment, airline requests for financing help, lease deferrals and SLB deals that airlines use for short-term cash generation are omnipresent. “It is not that [the lessors] suddenly became stronger—everybody else became weaker,” Pilarski notes.
Last year was brutal. “A significant percentage of our customer base requested some form of support during 2020,” Slattery says. Many continue to require some support. The most common conversations lessors have been having are about deferring lease payments, and generally they have been accommodating. Relief has often come in “moving payments to the right by some months with an interest rate” attached, as Dubai Aerospace Enterprise (DAE) Leasing CEO Firoz Tarapore says. These cases are relatively easy to handle, however, since they involve airlines that are in reasonable financial shape because of traffic volume, their own cost cuts, government support or a combination.
But not all cases are that simple.
“A fair number of clients’ cash flow did not support repayments,” Tarapore notes, even if DAE had agreed to a deferral schedule of several months. Until the third quarter of 2020, for 12 DAE customers representing 7% of revenues, “other ways to think about it were needed,” Tarapore says. These other ways included lease-rate relief now, in return for extended overall lease periods.
Airline bankruptcies, on the other hand, require “fundamental renegotiation,” Tarapore says, and give carriers more leverage in negotiating terms. One of the most painful effects of this for lessors has been airlines requesting and often getting power-by-the-hour deals. Slattery says such deals are now “typical” for aircraft coming off lease either through bankruptcies or because the regular lease term has ended.
“There are very few options for lessors” to avoid these arrangements, Slattery concedes, as the COVID-19 crisis has affected the industry globally, and aircraft cannot be shifted around easily to other operators. Generally, in Chapter 11 bankruptcy protection situations, Avolon is trying to “encourage airlines to keep aircraft,” Slattery says, essentially hoping for better times.
Although high-profile, Norwegian’s moves—exiting an entire business segment and cutting the size of the airline by two-thirds—are not even the biggest problem lessors are facing. That distinction belongs to HNA Group, the Chinese conglomerate of 14 airlines, including the original core of the concern, Hainan Airlines. GECAS has more than 40 aircraft placed with several of the carriers, Avolon has 37 and many other lessors have less, though still significant, exposure. One executive at an involved lessor says there may well be “pain in the middle,” meaning renegotiation, changed leases and deferrals. But he ultimately expects the aircraft to stay in China, given the current level of demand and the growth expected in the coming years.
Beyond dealing with customer requests, lessors themselves have significantly changed their tactics and behavior, both in terms of planned and actual direct deliveries from manufacturers and in the SLB market. In short, lessors were taking fewer aircraft than planned from the OEMs, but some became very active in SLBs.
In 2020, a total of 14 lessors took delivery of 176 aircraft from Boeing and Airbus (see graph). That is equivalent to about 24% of overall deliveries and well below the lessor market share of the in-service fleet. On the Boeing side, the numbers are heavily influenced by the long grounding of the 737 MAX: Only four aircraft were handed over to Avolon, and three to SMBC Aviation Capital.
The Airbus side shows more clearly how lessors reacted to the pandemic. Only eight lessors accepted more than 10 aircraft each. AerCap led deliveries with 29 A320neo family aircraft (plus three Boeing 787-9s). Air Lease Corp. (ALC), Avolon, China Aircraft Leasing Group (Calc), GECAS and Aviation Capital Group (ACG) were very active, too, at least in the context of much-depressed demand.
However, lessors deferred many 2020 deliveries. Avolon, for example, took 20 aircraft from Airbus and Boeing last year; it was due to receive 48 in 2020 prior to the pandemic. The numbers do not include SLB transactions. The changed schedules are confidential for many other lessors, but the rest of the industry was also active. “Pretty much everybody renegotiated their skyline,” says Slattery, who also commends Boeing and Airbus for having been very supportive. Aircraft that were already in production had to be taken regardless, but if work had not yet started, both manufacturers were open to negotiations.
Again, the 737 MAX was a special case and a unique opportunity for lessors to reduce their exposure. Boeing fell short of its own contractual obligations because of the global fleet grounding, giving lessors (and airlines) an opportunity for outright cancellations. Many of them opted to cancel: Avolon cut 75 aircraft from its orderbook, ACG took out 60, SMBC Capital 18, CDB Aviation seven and ALC six.
An important change has been visible in the SLB market. Before the pandemic, returns in the SLB market were often “uneconomic and structurally unsound for experienced lessors, driven by inexperienced players not pricing properly,” Slattery says. “They saw the channel as an opportunity to grow market share.” Slattery’s Avolon is one of the lessors that is active in both SLBs and the speculative order segment. But when Slattery observed that “gold rush that made no sense,” Avolon and other larger players became much less active.
There were some exceptions, however. DAE Capital has no direct orders; its portfolio is entirely SLB-focused. BOC Aviation, the world’s ninth-largest lessor by number of aircraft, has also historically been a major constituent in the field.
Now change is being driven by airline liquidity needs: In the absence of access to capital from banks or other lenders, airlines are turning to their leasing partners these days not only to renegotiate the terms of existing contracts, but also to sell owned aircraft (and lease them back) to generate urgently needed cash.
Such activity brought the bigger, better-financed lessors back into the SLB sector, while smaller players with less access to affordable financing have pulled back. Deals with airlines in distress are a challenge as well, even for the well-funded player. “It is risky, and you have to be selective, but it works with the right asset at an appropriate price,” Slattery says.
Avolon entered 2020 with 24 SLB deals planned; it ended up with 37.
DAE’s Tarapore notes that his company is the only one of the top 10 lessors with no direct orders from the manufacturers and is focused exclusively on SLBs. Then two things happened simultaneously because of the pandemic: Many major airlines canceled their own orders (in the case of the MAX, often simply because they could), and the terms and conditions of SLB deals improved as airlines’ reliance on them grew. Between March and October 2020 alone, DAE signed commitments for 55 aircraft, making it one of the most active lessors in the field. Customer profiles shifted, too. Even airlines such as Lufthansa, historically focused on owning rather than leasing aircraft, are seeking new investors for its fleet. DAE itself managed to sign an 18-aircraft deal with American Airlines, showing a move toward higher-quality customers.
Although “blind capital” was a distraction in boom times, in the current crisis, “it does not feel like in general people are buying market share,” Tarapore says. “We underwrite with the exact same criteria as before. Airlines remember now that having an established lessor makes a large difference on how they do in troubled times. Lessors can compete in a more rational way.”
“Lessors have become a huge source of cash for the airlines,” ALC CEO John Plueger said in a recent Air Finance Journal podcast. And lessors “generally have more leverage now that airlines need our help,” he noted. “Airlines that we did not think would do so are now turning toward the leasing community.”
Still, Pilarski wonders whether some deals are such a good idea. “Over the years, lessors were very good at pushing risk away,” he says. One example is maintenance guarantees defined in the leases. “The big question is: ‘Why are they doing it?’”
Lessors’ involvement with Norwegian, though not primarily an SLB problem, is “a good story of how not to do it,” Pilarski says. Another leasing executive says the only explanation for the sector’s involvement was the hope that Norwegian would somehow survive and retain a long-haul operation. Others thought the airline’s widebody growth has “lacked credibility” for years and saw the turn to short-haul-only flying as “the best business plan going forward,” Slattery says.
The fallout for lessors is immense. Rental levels for Rolls-Royce-powered Boeing 787s will “drop precipitously,” Slattery forecasts, because “there is no immediate solution and really no demand.”
While a number of major funding announcements indicate that credible lessors continue to have much easier access to financing than most airlines, cash and liquidity are not endless for lessors either. They do benefit from, among other things, a lower risk profile, however. “When you lend to a lessor, you effectively lend to a portfolio,” Plueger points out. ALC raises debt financing “primarily through the bond market, not loans,” he says.
“We estimate current liquidity levels of investment-grade lessors are sufficient to meet their cash outflows until mid-2022,” Moody’s Investors Service said in a report last fall. “By then, we expect the recovery in air travel will be sufficiently advanced that access to debt capital will strengthen, allowing the companies to refinance maturing debt and fund aircraft acquisitions. Resumed air travel will also improve aircraft trading volumes.”
To be sure, the major lessors will see decreased earnings and cash flow themselves this year, especially as renewed lockdowns emerge in global hotspots, Moody’s and Fitch Ratings credit analysts noted in separate reports. But lessors also have been reworking their own debt to expand their borrowing capacity. To that effect, all five major lessors—AerCap Holdings, Avolon, Aircastle, DAE Capital andACG—have so-called liquidity coverage equal to 1.6-2 times their estimated needs into October 2021.
ICF consultants predict large lessors will be even more important. “Larger, better-capitalized lessors will play a critical role in the survival of airlines judged to be acceptable post-COVID-19 credit risks,” they say.
Still, things will get harder before they get much better. “Lessors will see lower revenue, profit and cash generation for a number of years as airlines cut spending to survive until air travel substantially recovers, with 2020 cash generation cut by over 25%,” Bloomberg Intelligence analysts said last fall.
Tarapore expects that in terms of liquidity and refinancing, “the top 10 [lessors] are very secure,” and by and large the industry is capitalized well, though limited access to capital may “force the hands of some people.”
“The biggest and those with rich parents are not going under,” Pilarski predicts. “But I don’t think the changes are over. A lot of airlines and lessors will realize that their business is not as good as they thought.”
Then again, “BOC cannot fail—it is the Bank of China,” he says. Though he could imagine that smaller Chinese players might run into problems, they are not as high-profile and not “important” for the system.
“The share battle is likely to continue, as the largest lessors will likely survive the downturn, especially with many, such as SMBC, BOC Aviation and Jackson Square, being part of much larger entities,” the Bloomberg report states.
“This business is dependent on expertise and experience,” says CDB Aviation CEO Patrick Hannigan. “When you have to go through a year like , and you don’t have the quality and the depth of experience, it can be a very lonely, unpleasant and loss-making place to be.”
Hannigan believes structural change in the industry could occur but not rapidly. “People that came in to make a quick buck probably won’t reappear or will have difficulty getting access to funding to develop their businesses any further,” he predicts. “Will they then become available to buy at some stage in the future? Potentially, yes. But I think that won’t happen immediately.”
One reason change and disposals may take some time is that aircraft values have plunged, forcing asset holders to reassess their book values and make adjustments. That is likely to keep asset owners in the business for a while, even if they want to get out.
“They don’t want to sell, because you don’t sell at the bottom of the market,” Hannigan says. “If they’re forced to sell because they’re tripping covenants and folding or whatever, that may change the dynamic. However, as time goes by and the market comes back, airlines start operating again and airplanes get back on leases, that may change. They may decide to slowly but surely move out. In that environment, there is no doubt that the stronger players will take the opportunity to either buy portfolios of airplanes or buy businesses that are available.”
Slattery, too, believes the pandemic will trigger change. The current situation is a “clear demonstration that you must be investment-grade[-rated] to survive,” he says. “The bank market is shut down, the bond market is only available in scale to [lessors with] investment grade.” Therefore, he anticipates major consolidation moves among the top 10 lessors within the next year or two, leading to a “smaller number of bigger players.”
Ironically, Avolon itself, the world’s third-largest lessor, could play an active part in that process. Bohai Capital, a subsidiary of HNA Group, owns 70% of the lessor; the remaining 30% is held by Japanese lessor Orix Aviation. HNA’s Avolon stake may come up for sale as part of the group’s restructuring. Orix reportedly has a right of first refusal if a new investor is sought.
“We believe this will drive more consolidation among both lessors and airlines,” Moody’s says. “We expect a smaller number of global full-service lessors will emerge from the COVID-19 pandemic. Still, we also see the underpinnings of continued possible increases in the market share of operating leases as a percentage of total aircraft financing in force by the middle of the decade. The shakeout from the COVID-19 pandemic will result in fewer independent lessors. More of the industry will be controlled by large global banks, insurance companies and other financial institutions with less sensitive credit ratings and more diverse forms of capital access.”
Others are not convinced. “I don’t need another platform if I’m an investment-grade lessor,” says Credit Suisse analyst Moshe Orenbuch. “Unlike at an airline, there are only small additional benefits.” Orenbuch points to another issue for mergers and acquisitions, which is that big financial conglomerates are “not necessarily increasing their investment into this industry.”
Whether or not the top lessors become even bigger in the future, the industry’s role has strengthened materially over the last 20 years. In 2000, the share of operating leases of the in-service fleet was well below 30%; now it is approaching 50% and, by all expectations and as evidenced by recent moves of many airlines, will continue to rise. It is not only airlines that have become more dependent on lessors; manufacturers have, too, with huge implications for negotiating leverage and the design of future programs. “The strategic influence has moved from almost irrelevant to being a considered voice to becoming a key influence at the table as a next step,” Slattery says.
Lessors will invest where they believe returns are best and ignore segments where they are expected to be worst. Therefore, no OEM should expect any lessor activity in the widebody field for some time.
“There have been far too many widebody orders for far too long,” Slattery says. “There has been double-counting [of demand and on top of that the huge] Gulf carrier orders.” He predicts the twin-aisle market will be “very ugly” for some time, though the situation will “heal” through retirements of older aircraft, including Boeing 777 Classics and A330-200/-300s. Slattery believes it will take 3-4 years for the market to reach equilibrium. OEMs need to keep production rates “at a minimum” to achieve that, he stresses.
The leasing industry will continue to be active in the narrowbody segment and try to define the next moves—in particular, Boeing’s long-awaited response in the large single-aisle segment where Airbus dominates.
While times may be tough now, optimism is also slowly returning. “It will take some time, but I am more optimistic than I have been in 10 years,” Slattery says. “The cycle will start again, and there will be new winners.” He points to the substantial number of airline startups lined up in 2021 (AW&ST Feb. 8-21, 2021, p. 22).
Referring to the renewed lockdowns and the stalled recovery, Tarapore expects that January and February will be viewed as “an anomaly” in what is otherwise a “favorable” trend of a gradual return to normal demand. He believes some substantial improvement will be visible by June, not least because COVID-19 vaccines will be broadly available by then.
“Our summary today is that [recovery] is happening faster than most forecast,” Slattery says. “Assuming the vaccine rollout continues.”
—With Sean Broderick and
Michael Bruno in Washington