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1 1 of :14 by Bert van Leeuwen, DVB Bank S.E. When visiting London Heathrow, New York JFK or Tokyo Narita, very few people realise that a significant part of the commercial jets operating in and out of these airports are not owned by the airline of which the logo is so prominently painted on the jet s tail. Actually, from the total fleet of ca. 24,000 commercial jets that are in service with civil operators all over the world, about 38% is actually controlled by operating lease companies. As lessors generally stay away from the more specialised and hence less liquid aircraft types, their share in the fleets of the popular work-horse aircraft, such as Boeing s B737 or Airbus A320, is even significantly higher. For the entire range of Boeing B737s, as of early 2016, the lessor s share in the global civil fleet was 45%. The Airbus A320 family is even more popular, with a lessor s share of over 51%. The asset class Commercial jets are long-lived big-ticket assets. Most of the aircraft in the lessor s fleets are built by Airbus, Boeing, Embraer, Bombardier and in the future potentially Mitsubishi. Once famous names like Lockheed, Fokker or McDonnell Douglas are no longer active and their products are rapidly disappearing from the active fleet. Jet engines are produced by separate companies, in particular General Electric, Pratt & Whitney and Rolls Royce, or one of their joint venture partnerships.

2 2 of :14 Purchase prices for new aircraft range from around US$20m for a smaller 70-seat regional jet to US$200m for a big 500-seat Jumbo. Single-aisle 150-seat work-horses like the Boeing B737 or Airbus A320 go for between US$35m and US$50m. The installed engines are included in these numbers but if taken separately, would represent values between US$5m and US$25m, depending on their thrust level. Aircraft list- or sticker- prices are significantly higher compared to the numbers mentioned, but generally an airline or lessor can negotiate purchase price discount percentages of up to 30%-40%. In those cases, where an aircraft can be equipped with different engine types, discounting of the engine purchase price can even exceed these levels as the engine manufacturers tend to rely on the anticipated profitability of spare-part sales ( razor-blade model) over many years.

3 3 of :14 Generally, the economic life of a modern jet is estimated to be around 25 years. In the past, aircraft were sometimes retired earlier, because they could not meet increasingly stringent environmental requirements, in particular regarding emission and noise-levels. Today, this rarely is a reason for retirement anymore. Aircraft are now taken out of service because a more efficient new aircraft type is available, or because of expected high maintenance expenses. Aircraft and their engines have to undergo heavy maintenance according to a highly detailed schedule, based on flight hours, flight cycles (one take-off and landing) and/or calendar time. These so-called shop visits are very costly and the aircraft owner has to decide if it is worthwhile to spend this money on e.g. a 20-year-old aircraft. The commercial jet market is red hot at the moment. In contrast to ships, containers, rail cars, etc., global aircraft production capacity is limited, due to a highly complex supply industry. Due to strong demand for air transport, abundant equity made available for investment in aircraft and record profitability of the global airlines, aircraft orders reached record levels in 2013 and This resulted in a backlog equal to about nine years of production at 2015 production level. Probably because of long lead times and the lack of new aircraft (type) introductions, order levels for new aircraft in 2015 were down on Lessors It is not entirely clear who invented aircraft leasing. Some claim that George E. Batchelor, an aviation professional based in California (and later Miami) was the first entrepreneur who leased surplus Douglas DC-3 propeller driven warplanes to the airlines in the 1950s. The industry standard Ascend database indicates that the first commercial jets managed by leasing companies date back to 1965, with General Electric Capital Corp. and especially FINOVA (formerly Greyhound Capital) leasing a handful of Boeing B727s to Eastern Airlines in the US.

4 4 of :14 Aircraft leasing only became a serious business around the year 1973 when the worldwide leased fleet began to approach the 100 aircraft. Established in 1975, GPA (Guinness Peat Aviation) was probably the first mega-lessor. The company was based in Ireland, still the home of many leasing companies. Unfortunately, during the aviation industry downturn following the 1991 Gulf War, GPA went under. Even before GPA, in 1973, another leasing company named ILFC (International Lease Finance Company) had been established by Leslie and Louis Gonda along with Hungarian American entrepreneur Steven F. Udvar-Hazy.

5 5 of :14 Steve Hazy today is generally known as the Godfather of the aircraft leasing industry. After building a small initial fleet of leased aircraft, ILFC was acquired by the insurance company AIG in This not only protected ILFC from the impact of the Gulf War crisis, but allowed the company to expand and to reach a fleet-size of well over a thousand jets by Due to problems within AIG, unrelated to aircraft leasing, Steve Hazy decided to leave ILFC and established ALC (Air Lease Corporation) in In 2014, AIG sold its stake in ILFC to fellow lessor AerCap Holdings N.V. It is difficult to exactly rank the operating lessors as several criteria can be applied, such as fleet size, fleet value, fleet capacity, etc. In addition, lessors are not always the legal owners of the aircraft in their fleet, as ownership is often with SPCs (special-purpose companies). Generally, the industry measures the size of the leased fleets by the number of aircraft under management. In a set-up like this, the lessee/airline would be the operator, the SPC the owner and the leasing company the manager. There are over 150 lessors in the world, but just under two-thirds of the leased fleet is managed by the top 15 lessors. Many leasing companies are owned by financial institutions or private equity investors. General Electric s GECAS is the world s biggest lessor, managing over 1,500 jets. GECAS is followed by Aercap, managing close to 1,250 planes after the take-over of the ILFC fleet. The gap between number two and three is significant. Number three, BBAM, manages less than a third of the size of the Aercap fleet. Steve Hazy s new company, ALC, had already reached number seven in the ranking. The past decade has seen a dramatic increase in the number of Asian (Japan, China) controlled lessors, including SMBC, BOCA, ICBC and Avalon. Apart from the expected returns investing in always dollar-denominated aircraft offers, protection against currency

6 6 of :14 movements, especially devaluation of some of the Asian currencies. Obviously, investing in aircraft has also been stimulated by the global search for yield resulting from the abundant liquidity and low interest rate environment that is the consequence of quantitative easing. As illustrated by the take-over of ILFC by Aercap, there is still some consolidation going on. Irish lessor Avalon was merged with Hong Kong Aircraft Leasing to achieve economies of scale. Apart from mergers and acquisitions of entire lessors, individual aircraft and even portfolios of aircraft change hands on a regular basis. Effectively during the past three to five years, the majority of transactions involving secondhand aircraft, was between financial owners/investors without the aircraft moving to any other operator. To the outside world, these transactions are virtually invisible. In a number of cases, while ownership of the planes changed, the management of the aircraft including monitoring the payment of lease rentals and maintenance reserves by the lessee operator stayed with the same team. A recent phenomenon has been the creation of so-called side-cars. These are specialpurpose companies managed by a professional leasing company but with the ownership split between this leasing company and a financial investor, such as a private equity or a pension fund. Generally, the lessor only takes a minority stake in the side-car. For the leasing company side-cars represent the best of all worlds. They divest a significant part of the residual value risk to the side-car investor, but retain the management fees, market presence and usually a share in the upside value of the aircraft. Another instrument that was often used is the Asset Based Securitisation (ABS) of aircraft portfolios. Lessors and other intermediaries bundle a group of aircraft together, obtain a rating from one of the rating agencies and subsequently sell the various (A, B, C, E) notes to investors. The benefit of an ABS is that usually the new investors are slightly more risk tolerant or are prepared to accept a lower yield. In addition, the ABS structure allows the sponsor to include a few less attractive assets in the portfolio as the so-called portfolio effect (risk diversification) blends away this risk. With lead time for new aircraft now several years, lessors are focusing on SLBs (saleand-leaseback transactions) to grow their fleets. The lessors share in the current jet order-book is only 19% and just to maintain the 38% share lessors have of the global in-service fleet requires a significant SLB volume. Interestingly enough several airlines have placed huge orders for new generation aircraft types, speculating that will be able to enter into profitable SLBs. In some cases, airlines have flown jets for five years and after this period they were able to do a SLB, selling the (five-year-old aircraft) for an amount equal to the original purchase price. Other airlines are planning to become quasi lessors themselves, by leasing out their surplus planes. The jury is still out if this business model will be successful long term. Lease terms and maintenance reserves Typical operating lease terms include a tenor of up to 12 years, a fixed or variable rental (in US dollars) paid monthly in advance and a security deposit paid up front. The lessee is responsible for insuring the aircraft for any liabilities arising out of the operation of the aircraft. The lessee is also responsible for removing all liens against the aircraft, such as mechanics or air traffic control liens. Points of negotiation include issues like extension or early termination options, purchase options and the right to sublease the aircraft. The negotiations about the aircraft maintenance and return conditions are amongst the most important of the entire leasing process. While lessors used to focus on relatively new aircraft, as a result of the scarcity of new or young aircraft, several start-up lessors have shifted their focus to older mid-life or even very old end-of-life aircraft. These lessors essentially rely for their returns on the remaining lease

7 7 of :14 income stream ( stub lease ) plus the proceeds of parting out the aircraft and/or the monetary return compensation paid by the lessee airline. Lease contracts always stipulate how the lessor will be compensated for the loss of value due to the use of the aircraft. Second and third tier lessees often have to pay maintenance reserves for every flight hour and cycle. The lessor collects these on a separate account and if at the end of the lease it is decided to scrap or part-out the aircraft the lessor can pocket the reserves. Top-tier lessees will generally negotiate return conditions. These specify the condition in which the plane will be returned at the end of the lease. This means that the lessor takes a credit-risk. If as an example the aircraft is returned at age 20, neither the lessor nor the lessee has an interest in spending money on maintenance in case it is unlikely the aircraft can be leased out again. In such a situation, the lessor and lessee will negotiate an amount of compensation paid to the lessor in return for accepting the aircraft in as is, where is state. In the past, airlines have sometimes accepted onerous return conditions and the return compensations added up to a huge amount, sometimes well exceeding the US$10m. This number has to be seen against the background, that the difference in market value between a half-life (hypothetical average maintenance condition) large wide-body jet and a full-life plane (aircraft and engines entirely fresh from overhaul with many new parts) can be between US$20m and US$30m! Why lease a jet? Until around 1990, many airlines considered leasing a jet the poor man s way of building a fleet. At an aircraft finance conference, the former treasurer of now defunct Swissair proudly stated his airline pays cash for its aircraft. Times have changed and today most of the world s airlines lease-in at least a part of their fleet. Leasing is certainly no longer a sign of financial weakness. Leasing an aircraft is no longer a taboo for top tier airlines and flag carriers. Leasing obviously has its pros and cons. Pros and cons of leasing Pro Con Transfer residual value risk No benefit from favourable residual value Efficient way to maintain a young fleet Operating lease cost higher vs. straight debt 100% financing, no equity required Less operational freedom (incl. maintenance) Lessor equity cheaper vs. airline equity Airline may not be able to use tax shelters Off-balance sheet (this may change) Potentially expensive return conditions Earlier access to delivery slots Clearly, in an optimal fleet structure there is a place for leased as well as owned aircraft. Everything depends on the individual characteristics of the airline s financials and operations and the characteristics of the fleet, the aircraft types and indeed the individual aircraft. It may be smart for an airline to engage in a sale-and-leaseback for a new aircraft that will be out of production soon (the infamous last-of-the-line planes) while maintaining a new technology aircraft on the balance sheet. Given the many uncertainties about the future market environment, any lease vs. buy decision is by definition complex and multi-disciplinary. The future After many years of strong growth, the lessor s share in the (fast growing) global fleet reached a plateau in It is expected that in the coming years growth will resume at a modest pace. As mentioned, not all aircraft types are suitable for leasing. Highly specialised, illiquid aircraft and aircraft with high transition cost (e.g. changing a Lufthansa passenger interior to an Air India interior) will not find too much popularity with the leasing community. Much will depend on the outcome of the current large-scale generation change the industry

8 8 of :14 is going through, in terms of equipment technology. In almost all aircraft classes the in-production aircraft types are being replaced by new technology products, with significantly better fuel burn and consequently production cost per passenger mile. If the new generation of investors will not be too disappointed by the residual value performance of their ageing aircraft assets during this transition phase, aircraft leasing will probably become a mature mainstream industry and not the specialised niche market that it has been for many years. With a projected annual need for over US$170bn in delivery finance for new commercial jets alone by 2020, the industry will need all the funding sources it can get, with operating leases definitely one of the most important. Author: Bert van Leeuwen, Managing Director Head of Aviation Research DVB Bank S.E. Tel: bert.van.leeuwen@dvbbank.com Website: Tel: +44 (0) Copyright 2014 Capital Markets Intelligence Ltd