The aviation financing industry has undergone a monumental shift in the past decade. As traditional bank lenders have come under increasing regulatory pressure, by virtue of their systemic importance in a decade of low interest rates and a search for yield, private capital (private equity, hedge funds, distressed debt funds, etc.) has been attracted to the relative stability of cash flows and value retention of aviation assets. It is no secret that private equity and other alternative funds have long been accumulating capital, waiting for the opportune moment.
The COVID-19 Pandemic (the "Pandemic") has wreaked havoc on the aviation and travel sectors. As difficult as this has been to be involved in, distress is attractive to private equity. As airlines restructure and revisit their global fleet compositions, the market reprices distressed assets to reflect evolving operating conditions. In this relatively illiquid market, therefore, there are unprecedented opportunities for longer term investors with experience in distressed assets.
Prior to the onset of the Pandemic there had been a sustained long-term growth in traffic and Revenue Passenger Kilometres ("RPK") were forecast to grow 4.3% p.a. between 2018-20331. However, the sharp falls in RPK recorded in the initial months of the Pandemic have created a favourable market for specialist investors. For instance, like many industries, airlines rely on cash flows to pay lease rentals, service debt and cover operating expenses. The combination of having to reimburse ticket prices and the evaporation of future bookings has meant that cash flows ground to a halt. However, private equity and specialist distressed funds are able to finance struggling operators at reduced prices as they are forced to restructure. With this comes the potential for substantial gain in the long term when capacity and load factors pick up. While the sharp falls recorded in the initial months of the Pandemic have started to recover, some key markets are still below pre-Pandemic levels due to countries swinging back and forth between new measures/lockdowns, as shown below.
The promising developments on the vaccine front, as well as the implementation of new lockdown measures aimed at reducing the 'R' rate, means that some operators are expecting activity to rebound by spring 20211, but the opening of borders and consumer confidence will obviously be critical to this. In the meantime, however, they are increasingly looking to their strategic partners and new alternative financing to survive the storm.
Private equity is by no means a new entrant in the aviation market. Indeed, some of the largest lessors have had some association to private equity at one point or another. However, 2020 has seen momentum and involvement increasing – for example, private equity and hedge funds have been key drivers behind major industry developments such as the rescue financing for Virgin Atlantic and the bid for Virgin Australia2. This will likely form part of a growing trend as non-performing aviation loans and distressed airlines will need to be refinanced or restructured over the coming years, and as banks may seek to exit these positions. Private equity and other funds which are not constrained by traditional regulatory oversight are well placed to partner their deep pockets and expertise from other sectors with the technical know-how of the current players, making informed bets through flexible investment strategies involving debt, equity and an active management role.
One of the inevitable outcomes of the Pandemic will be consolidation throughout the industry. As alluded to above, we have already seen a number of high profile airline insolvencies, and most lessors are also feeling the pain. On both sides of the fence, the top tier credits will likely benefit.
The surviving airlines should emerge from the Pandemic leaner and stronger. Well placed to take advantage of the rebound and potentially reduced competition (for a period of time, at any rate). We are continuing to see purchase and leaseback opportunities, and are seeing more portfolios of aircraft being offered for sale by struggling lessors. Whilst pricing remains an issue, it seems likely that well capitalised lessors will ultimately be able to take advantage of attractive purchase prices, which will pay dividends in the coming years.
2020 has brought unprecedented challenges to the aviation industry, but has also brought opportunities. In combination with continuing low oil prices, high asset maintenance and safety standards, and the increasingly familiar benefits of the Cape Town Convention for financiers, it is likely the momentum for private equity will continue to build in aviation as these opportunities continue to be presented. With no viable alternative to air transportation, we are generally optimistic about the future and feel that the industry will emerge from the Pandemic bruised, but by no means broken!
1 Airbus Global Market Forecast 2019-2038, p. 7.
Originally Published by Reed Smith, November 2020
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