The aviation sector has witnessed a succession of well-publicised difficulties since the onset of the Covid-19 pandemic in 2020, which brought to an abrupt end a golden period for lessors. Beyond the lockdowns and travel restrictions, there are now issues with capacity at airports as the world opens back up and demand for air travel resumes. Furthermore, with ever-increasing emphasis on ESG, the industry needs to boost the efficiency and environmental performance of aircraft fleets. And all of this is occurring against the backdrop of a rampant inflationary environment, the war in Ukraine and the knock-on effects for leased aircraft operated out of Russia.
Asset pricing uncertainty during this turbulent period has hampered the aviation industry’s access to financing, with investors being very strategic with regard to the transactions they are willing to invest in. This has brought about fundamental changes in the aviation lending market. There has been a decrease in financing from traditional sources such as large banks, as they focus on assets they perceive to be less conflicted or affected by the current landscape. With some lenders leaving the market and the banks that remain focusing on specific transactions, it begs the question: How will the industry tap into new financing? In this article, we explore investment fund-based aircraft financing solutions and pose the question of whether aviation funds are the way of the future.
Private equity in the aviation industry
The good news is that the industry has a history of resilience, having come through the oil crisis, 9/11, and the global financial crisis. It has weathered these and other setbacks over the past decades and returned to the growth path each time. Although the role of traditional banking finance has reduced, this arguably creates significant opportunities for alternative finance providers. Airlines, lessors and financiers have all sought to adapt their positions during the Covid-19 era and the aviation industry as a whole has always been willing to seek alternative sources of financing. Pre-2020 there had been growing interest and investment from the private equity world into the aviation industry.
Private equity (PE) is not new to the aviation industry, of course, and indeed has already played a significant part in its history. PE investments have been made in some of the large lessors we know today, such as AerCap’s funding by Cerberus and Oaktree’s investment in Pegasus. PE houses have also invested into airlines and airports over the years and some have hired experts from the aviation sector to ensure that they have the asset class expertise internally. Private equity is, however, a step away from the traditional route to finance though banks and the capital markets.
For a number of years, PE firms have not only been financing lessors and other infrastructure around the fringes but they have also been acquiring existing aircraft platforms. Such firms are focused on delivering returns for their investors and the key is a high internal rate of return (IRR). Since 2008, PE funds have been filling the financing holes left by the consolidation of many of the major banks after the financial crash. As they have grown more successful over the intervening period, PE firms have sought out new investment opportunities. Although it is fair to say that PE money had retracted from the aviation industry before Covid-19 struck, the recent issues affecting the industry have caught the eye of some firms that are focusing on distressed markets and IRR. It is not all one-way traffic, either: PE firms have proven to be attractive to the aviation industry due to their dynamic nature and speed of execution on transactions. The financial instrument of choice for many PE firms are funds.
The advantages of aviation funds
In order to understand the reasons behind using aviation fund structures, it is important to appreciate the advantages they offer both PE funds and lessors looking to create a fund of their own. There are also benefits to attracting new investors by using regulated funds, which would not previously have had the same degree of access to the industry through banks or capital markets. In addition, there’s the ever-changing tax environment, which may affect how finance is structured in the years ahead.
From a PE manager’s point of view, the benefits of using a regulated fund structure revolve around accessing a larger pool of investor capital. Some regulated investors, such as pension funds and large insurance companies, cannot invest through non-regulated vehicles, such as special purpose vehicles (SPVs), directly. They can, however, invest in a regulated fund, which in turn can acquire aircraft or platforms. By using a regulated fund, the manager is not required to have any ‘skin in the game’ – as compared to an asset backed security (ABS), for example. What’s more, the rise in interest rates will not impact the ability to raise capital through a fund. Investors into the fund will invest at par and would not be receiving a predefined percentage with a spread versus a corporate bond issuance.
From an investor’s point of view, the use of funds provides a superior level of protection due to the fully regulated status of the fund, for example under the EU’s Alternative Investment Fund Managers Directive (AIFMD). The very nature of a regulated fund means that it is safer than an unsecured loan that may be provided to an aircraft lessor. Due to its regulation, investors are less constrained in the amount that they can allocate to the structure.
Spotlight on the ICAV
Staying with European examples, the Irish collective asset-management vehicle (ICAV) has been used by the aviation industry in the past. The ICAV is a corporate legal entity specifically designed for investment funds. It is authorised and regulated by the Central Bank of Ireland and offers a number of attractive features as a fund-raising vehicle. An ICAV is trusted and recognised by institutional investors as a robustly regulated investment product subject to independent depositary oversight. An ICAV can be structured to avail of the AIFMD marketing ‘passport’, by which it may be distributed to professional investors across the European Economic Area (EEA) without the need for additional local Member State approvals. A fund such as the ICAV, which outlines investment strategy within the offering documents, is not subject to any legal or regulatory limits on liquidity, asset diversification or leverage – which can also be an advantage.
From a tax perspective, an ICAV can also provide tax neutrality for the fund and its investors. The fund will not be subject to local taxes, which allows for efficient pooling of investments. In addition, an ICAV is eligible to ‘check the box’ for US federal tax purposes. Another interesting trait of ICAVs is that they can be structured as umbrella platforms comprising separate legally ring-fenced sub-funds holding different portfolios of assets. In the aviation space, this facilitates sponsors to house each asset in a segregated sub-fund (potentially with different financing counterparties) and offer investors exposure to various combinations of underlying assets.
Funds are another alternative that allow jurisdictions like Ireland to be recognised as a global hub for aircraft leasing. At IQ-EQ, we are seeing increasing interest in the regulated aviation fund route, whether this is through our Irish, Singapore, Hong Kong or Cayman offices. Fund structures can be used to develop a leasing company, or to allow investors to gain access to aviation assets a manager or lessor has created, which can in turn be sold or refinanced within the capital markets.
Aviation funds, ready for take off
Transportable assets are clearly an in-demand asset type for managers and investors alike, with aircraft arguably taking the number-one spot. By increasing access to the market through regulated funds and the investors who use them, the industry can benefit from a further capital injection to help it face the headwinds that increasing oil prices, inflation and economisation of fleets pose. The industry has faced many challenges in the course of its existence and none more so than in the last two years, but it continues to bounce back. Fund-based structures present an efficient means for those wishing to invest in the space, with potentially attractive returns for those who do.
IQ-EQ’s global Aviation team are experts in the structuring and establishment of these funds and related SPV platforms and can offer fund administration, managing agent and SPV administration services across the globe. To find out more, please contact me or Joanne McEnteggart.
This article was originally published by Airline Economics.