According to the Federal Aviation Administration’s ? ‘FAA Aerospace Forecast (Fiscal Years 2011–2031),’ the commercial air carrier industry will grow by a remarkable 3.7% over the next five years. System capacity in available seat miles – the overall yardstick for how busy aviation is on a global scale – will increase 4.5% in 2011 and is expected by the FAA to grow thereafter at an average annual rate of 3.6% through 2031.
In light of the limitation of available funding by commercial banks, private equity and hedge funds maintain an important position in the aviation leasing market and provide a significant source of much needed equity, lending and leasing capital.
The types of assets that are suitable for private equity and hedge fund investments include:
- Aircraft and lease asset-backed securities
- Direct investment in aircraft and aircraft-owning entities
- Equity investment in aircraft leasing firms or joint ventures
- Secured and unsecured privately placed notes
- Loans secured by aircraft or aircraft-owning entities
- Co-investments with other investors/other funds in all of the above
Advantages of aircraft investments
Apart from this relatively broad range of assets that meet financial sponsors’ needs, there are additional characteristics that seem to attract private equity and hedge funds to the aircraft finance market. It is worth noting that significant amounts of capital can be put to work in aircraft-related transactions.
Business cycles, aircraft assets, particularly newer aircraft, have generally not been subject to heavy valuation fluctuations. From the U.S. tax point of view, aircraft investment can be structured in the form of asset-backed securities that qualify as debt with no U.S. withholding tax on the interest payments, thereby allowing a wide range of international entities to invest and participate.
In comparison to other alternative asset classes, which are subject to delayed repayments (the so-called ? ‘J Curve’ or ? ‘hockey stick’), aviation leasing assets from the start provide current lease income and certain tax benefits to investors. Aviation assets also are ? ‘hard assets’ with fairly ascertainable market and residual values to which investors tend to flock in turbulent times. Finally, the learning curve for the establishment of relationships, technical expertise as well as the documentation of operating leases and purchase transactions help protect the aviation investment and finance industry from complete market overrun and structurally provide a limit to competitors.
Opportunities for private equity and hedge funds
Aviation finance by its very nature is capital-intensive, taking into account the 2011 list prices for, e.g., a Boeing 787 Dreamliner at (US$185–218 million) or an Airbus A380-800 at (US$375 million) per aircraft. Financial sponsors can also benefit from the maturing of the aircraft market which leads to a standardisation of the documentation for the leasing and financing of aircraft. In the current economic climate, balance sheet commitments from large strategic sponsors need to be replaced and private equity and hedge funds stand ready to fill this gap. Finally, the fast growing emerging markets in Asia, the Middle East, Africa and Latin America add to the need for additional financing sources. The recent bankruptcy filing by American Airlines may also serve to move debt toward the aircraft leasing entities financed by hedge funds and private equity funds rather than directly to the airlines.
A private equity or hedge fund general partner would expect certain qualities from potential aircraft investments. Those would include synergies across aircraft-related investment platforms, opportunities based on market dislocations and illiquidity of financing availability, excess risk-adjusted returns and inflation protection in an asset that resets financial terms on a regular basis. Maximising the pass-through of available tax benefits to U.S. taxable investors from ownership of aircraft, and minimising tax and tax compliance burdens on non-U.S. and/or tax-exempt investors will also be a concern and will drive fund structure, as discussed below.
Tax-optimised fund structure
The attached chart shows a sample for a parallel fund structure that would cater to the needs of U.S. taxable investors, U.S. tax-exempt investors as well as non-U.S. investors.
The parallel non-U.S./offshore fund structure shown allows U.S. taxable investors to access depreciation and other deductions, while sheltering non-U.S. investors from the obligation to file a tax return in the United States and directly to pay U.S. tax on lease or sales income treated as derived from a U.S. trade or business (ECI), while avoiding U.S. tax to such investors on fund income that is not ECI, including certain interest income on aircraft-secured debt and non-U.S.-based sales and rental income. U.S. tax-exempt investors, who would otherwise be directly liable for U.S. income tax on rental income (and, in some cases, sales income), should also be able to avoid direct filing and tax payment obligations under this structure. Lease-in/lease-out structures using fund-owned special purpose vehicles to hold, lease and sublease aircraft may be able to be availed of to avoid non-U.S. withholding taxes on aircraft rental income.
Additional tax considerations
Use of a traded corporate fund domiciled in a treaty jurisdiction may minimise income and withholding tax if real operations are present in the treaty jurisdiction. Sales and use taxes and VAT on sales of aircraft based on the location of the aircraft at the time of sale must be considered and will vary among jurisdictions, with some exemptions available. Allowable tax depreciation will vary among jurisdictions and may depend upon where aircraft is used.
Exit strategies for aircraft investors include portfolio sales, portfolio (part-out) liquidations, the securitisation of portfolios and the issuance of asset-backed/secured notes. Several IPOs of aircraft-finance related vehicles like Aircastle, AerCap Holdings or Air Lease Corporation have occurred in the recent past. Financial sponsors regard an IPO as an important exit strategy that usually offers attractive returns. In addition, asset management firms such as Doric Asset Management have tapped the IPO market to fund new entities that purchase designated aircraft, and lease such aircraft to a specific airline, thereby bringing the investor directly into the ownership of a specific aircraft lessor. These financing structures have been utilised most recently to finance the purchase of A380 aircraft as well as large shipping vessels.
2012 — the outlook
This summary has so far highlighted that aircraft finance presents significant opportunities for financial sponsors. Still, some risks should be taken into consideration that may or may not materialise in the near future. For example, the base value appraisals supporting legacy secured debt capital markets transactions may be optimistic — especially with respect to older aircraft. Also, there is a potential book value problem lurking below the surface of some existing aircraft portfolios. The potential write-offs or write-downs could be material. Economic useful lives for new aircraft may be shorter than the historical averages due to the acceleration of new deliveries and new technologies in the aircraft market. New FASB and IFRS lease accounting rules will push debt attributable to operating leases back onto the balance sheet of airlines, which may negate some of the benefits of operating leasing transactions compared to debt financing of aircraft by airlines. The financial crisis, new financial regulations and in particular, new capital requirements on financial institutions are all putting pressure on the existing profitability of aircraft lenders, increasing the costs of borrowing, and again, favoring the ownership of aircraft by well-capitalised entities. Finally traded leasing companies may face difficult disclosure obligations relating to the implications of all the risks mentioned above — which may yet push the advantage in favor of the privately owned leasing firms.
In spite of the foregoing, 2012 should prove to be a year of opportunity for hedge funds and private equity funds to create investment vehicles specifically designed for large scale investment in aircraft portfolios to take advantage of current market pricing (for both used and new commercial aircraft) and capital needs of both leasing companies and airlines.
Michael C. Mulitz is a Finance Partner and head of the Aviation Finance and Leasing Group, based in New York. Daniel J. Hartnett is a Finance Partner based in the firm’s Chicago’s office. Willys H. Schneider is Tax Partner based in New York. Thomas A. Jesch is European Counsel (Tax) based in the firm’s Frankfurt office.
Kaye Scholer LLP provides strategic counsel and legal services to the Fortune 500, middle-market companies and government entities on a full range of US and international matters. Founded in New York in 1917, Kaye Scholer’s 450 lawyers regularly advise on matters across multiple legal jurisdictions, including the US, UK, EU and China. For more information, please visit www.kayescholer.com.
Zein El Hassan is a leading financial services and investment funds lawyer with over 20 years’ experience. He advises on all aspects of managed funds, superannuation, life insurance, structured and retirement products, product and entity rationalisation, as well as mergers, acquisitions and divestments within the financial services industry.
This article first appeared in Kaye Scholer LLP Investment Funds Group Newsletter (Winter 2011 - 2012).