The end of the mega-lessors may not be as close as you think as GECAS continues to be a significantly larger player than any other competitor, and ILFC adopts a business plan of expansion. That's according to Angela Behrend-Görnemann, Global Head of Aviation at HSH Nordbank AG, Hamburg and Kiel, who speaks exclusively to CAPA about American carriers' dependence on capital markets, export credit agencies and the effect emerging companies are having on the leasing sector.
What sparked your interest in aviation and how did that lead to your career?
Before I started my “aviation career”, I worked in the shipping industry and joined the ship finance department of Hamburgische Landesbank (one of the predecessors of HSH Nordbank AG). After the Iran-Iraq war in the early 1990s, the bank decided to start their aviation activities – when the market was down and the majority of the banks were leaving the aviation industry. This trully counter-cyclical approach sparked my interest and that’s how it all started. Since then I have always found aviation an exciting industry with many wonderful people to work with.
Do you believe American carriers are too dependent on capital markets?
No. American carriers are fortunate to be able to take advantage of the deep and liquid capital markets in the United States which increase their options for financing aircraft. American carriers generally do a good job of trying to assess what works best for them in terms of a capital and financing structure. All airlines seek to balance the desire for debt financing at the lowest cost with preserving access to as wide a variety of debt sources as possible to ensure they do not become too dependent on any one source. I would expect US carriers to continue to take advantage of the deep, liquid capital markets in the US while also affording commercial banks such as ourselves opportunities to provide financing.
Is the end in sight for the mega-lessors? How are the emerging leasing companies affecting the sector?
The evolution of the leasing industry is an interesting topic since there have been a number of changes in the leasing sector recently. While it is true several lessors lost access to the strong credit of their parent during the recent financial crisis and were no longer able to execute on what was essentially a credit arbitrage model of competition, it is not clear that existing mega-lessors will somehow become significantly smaller. For example, let’s consider GECAS. GECAS is likely to remain a very large player – significantly larger than the competition – largely because GE is likely to continue to support GECAS which appears to be a useful player in the parent’s overall aviation strategy. Turning to ILFC, while many predicted ILFC would be sold in pieces, it appears now to be adopting a business plan that will allow it to expand. ILFC has proven it has access to capital and does not appear to be under any immediate pressure to downsize. So, it does not appear likely that either GECAS or ILFC will become substantially smaller in the near term.
So, what will the make-up of the leasing sector look like going forward? The recent financial crisis appears to have leveled the playing field somewhat since many players that relied on a parent with a strong credit rating now have to finance aircraft on their own terms. Most lessors are concerned that they not be too dependent on any one financing source and appear to be trying to diversify their access to debt capital as much as possible. It is probably reasonable to conclude that, for most lessors, there is a maximum size where they have enough economies of scale without exhausting their access to the commercial bank markets. This maximum size is probably in the range of 400-600 aircraft depending on fleet value and age. So, it is reasonable to assume that, in the future, there will be a stronger second tier of lessors behind GECAS and ILFC all with a similar fleet size of several hundred aircraft. The new emerging leasing companies are likely to drive a shift to a larger second tier of significant lessors since their private equity owners will be looking for exit strategies for their investments and mergers with other leasing companies may make for an attractive exit.
Otherwise, the emerging leasing companies appear to be affecting the leasing sector in a number of ways. With a need to build fleets quickly in order to grow and provide returns to the private equity investors largely backing the new lessors, it is possible that the new emerging lessors are bidding up aircraft pricing in the sale and leaseback market particularly for brand new aircraft. If so, it is possible the new lessors are lowering returns in the short run. However, over the longer term, the new lessors are simply validating the fact that the market increasingly appears to be demanding leasing solutions. Lessors have grown to about 35% market share in terms of aircraft owned today and over 50% for the most popular types. We expect that share to grow to about 50% for all types of aircraft in the coming years. After all, lessors provide two key benefits to the aircraft financing industry – they allow airlines to conserve cash while adding new equipment and the lessors take the residual value risk on the aircraft assets, transferring the risk from airline investors who are less focused on asset values to investors seeking the asset value risk and up-side potential.
The new entrant lessors may also be helping the leasing industry by increasing the visibility of the sector. For example, Air Lease Corporation’s recent IPO may increase the investment analyst community’s coverage of the sector which may help share prices of all public lessors over time.
2009/10 marked increased participation of ECAs in financing aircraft. What is your take on the current state of the aircraft financing market and the players in it?
The export credit agencies have essentially doubled their participation in the new aircraft financing market and now finance about one-third of Airbus and Boeing deliveries. During the financial crisis, this increased ECA activity was helpful in that it bolstered liquidity and avoided cuts in production when airlines continued to demand the latest generation aircraft as a hedge against rising fuel prices. However, the key question for the industry has been how should the ECAs disengage from the market without causing sudden dislocations? Today, the private sector financing market has largely recovered to the point where it can finance its historical share of new deliveries yet many participants feel they are being priced out of the market by what essentially amounts to government competition. For most of these competitors an early disengagement of the ECAs would be manageable. However, the manufacturers and airlines are less sure of the availability of private sector financing at reasonable prices and prefer a slower, more orderly disengagement. It now looks like the new Aircraft Sector Understanding will define when the ECAs disengage. With many deliveries effectively grandfathered under current ASU rules until 2013, it appears the ECAs will retain their larger than historic market share until 2013 when we would expect to see a fairly rapid disengagement of the ECAs.
Lessors are also becoming more active in the sale and leaseback market and will likely continue to ramp up their activity, eventually financing closer to 50% of new aircraft deliveries up from about 35% today. Capital markets have been slower to re-enter the aircraft financing market although some increased ABS activity is likely in the next year or two as lessors seek to tap an additional source of debt financing to maintain diversity of debt capital sources. The bank markets continue to slowly recover. At HSH Nordbank, we expect to become increasingly active in aviation finance now that we have restructured our operations. Over time, Chinese banks are likely to increase their participation in the global aircraft financing market.
While the overall availability of financing for the new aircraft market has been quite strong, we still see a lack of liquidity for used aircraft transactions. More used aircraft transactions are getting done this year than last so it appears liquidity is beginning to return to the used side of the market. HSH Nordbank is active in this niche and we expect the used aircraft market to fully recover over the next year or two as additional financing institutions begin to look at that market as a source of increased potential profitability.
Do you think the ECAs have the opportunity to further facilitate the evolution of the Cape Town Treaty?
Ex-Im bank has already taken the lead in trying to provide an impetus for the expansion of the Cape Town Treaty. Nevertheless, even with additional efforts from the European ECAs, the Cape Town Treaty will really only be truly successful when enough countries have adopted local laws fully implementing the treaty and investors feel confident the treaty will enable them to recover assets in a timely manner. The Cape Town treaty is really the first time treaty law has been used to try to govern local bankruptcy rules and there is bound to be some push-back in certain signatory countries as legislatures work to draft implementing legislation. Moreover, it is not clear whether bankruptcy courts will fully comprehend the implications of those new laws which are often starkly different from previous bankruptcy code. Eventually, countries will probably see the benefits of Cape Town. Indeed, the ECAs may be able to play a useful role in any period of confusion since, as governmental entities, they may be more persuasive than private sector financial institutions in getting the mechanisms of each country’s bankruptcy regime to see the intent and benefits of Cape Town.
Do you think the new Aviation Sector Understanding’s (ASU) higher prices and more restrictive terms will expand the demand for commercial aircraft finance? What effect will this have on lessors?
If the new ASU is implemented as drafted, the higher prices should certainly drive increased demand for private sector aircraft finance. What is less clear is whether the new ASU rules could be renegotiated in advance of full implementation in 2013 when the grandfathering period runs out. While no renegotiation is expected, it is possible that manufacturer and airline fears over higher pricing could lead to an adjustment of the ASU. However, if the ASU enters into force unchanged, we would expect the ECA market share to decline to closer to historical levels with commercial banks and lessors picking up most of the difference.
From a lessor perspective, an increase in pricing on the part of the ECAs should make their product more competitive. Nevertheless, while the lessors are affected by the ECAs, demand for aircraft leasing is driven not only by cost considerations but also by the desire of airlines to preserve cash and to transfer asset risk. So it is not clear that availability of cheaper ECA financing is affecting lessors as much as it might if price were the only factor. It should also be noted that lessors also use ECAs as part of their arsenal to finance aircraft. So lessors will also be affected on their cost side to a degree if ECA financing becomes more expensive. However, since ECA financing is not a primary financing tool of lessors, the effect is expected to be easily manageable.
It is really for those negotiating the agreement to determine what is fair. My sense is that the signatories to the new ASU probably expect that both China and Russia will ultimately find it to their advantage to sign up to the ASU regime or to a future renegotiated ASU regime. In the meantime, it will take some time for the Chinese and Russian manufacturers to begin to develop market acceptance of their products so that not having Russia and China in the ASU probably will not be too distortive in the short to medium term.
Can you comment on the controversy surrounding the home country rule?
It was interesting that the new ASU regime did not specifically address the home country rule. As you know, airlines located in home countries resent what they see as the distortive affects of cheap ECA financing that is available to their competitors located outside of home countries but not to them. The new ASU appears to limit the effect of any distortion by increasing the cost of ECA financing for good credits to where it is hoped competitors of home country airlines would no longer avail themselves of ECA financing to the degree they have in the past. It remains to be seen if this will quell the controversy or not but the issue is likely to become less pronounced as ECA market share declines.
We strive to have a balanced portfolio by region in line with demand and our internal credit and portfolio requirements. Airbus and Boeing expect the Asia Pacific region to account for the largest share of deliveries at around 35% of total deliveries with Europe and the Americas accounting for smaller shares of about 26% and 29% respectively. Our regional footprint and solid customer relationships in Europe are likely to keep the European region slightly dominant in our portfolio.
How does your portfolio strategy differ from that of a regular aircraft lessor?
As a bank with a long-standing focus on asset knowledge, our overall portfolio is not significantly different from that of an operating lessor and is dominated by in-production liquid aircraft (ie, aircraft with a large user base) such as the A320 and B737NG families. While we put a strong focus on understanding the assets we finance, we do have more flexibility than our lessor friends in terms of what we finance since our assets serve merely as collateral for the loans we have – that is, we do not expect to become owners of the assets. As a result, while we prefer liquid in-demand assets, we have been able to finance less liquid but strong assets such as for example the A380. Having said that, in these cases we put strong emphasis on the credit quality of the borrower in order to limit the risk that we would ever need to rely on the residual value of the collateral.