Challenges face the aviation industry but its economic fundamentals remain strong, argues Walkers partner Matt Hedigan, in this thought leadership piece originally published in Legal Business' Ireland Report.
In the article, Matt, who has attended and spoken at Airline Economics events New York, London and Singapore in the last few months, explores the current issues, changes over the last 12 months, and the forecast for the months and years ahead.
The commercial aviation sector has proved to be remarkably resilient, having weathered monumental periods of disruption in close succession with the grounding of the Max, and then the worldwide fleet as a result of the pandemic as well as the ongoing Ukrainian conflict. The effects of these crises are still with us, but air traffic numbers have been recovering quicker than many predicted, with airlines struggling to cope with passenger demand over the summer (something readers in Dublin will be all too familiar with).
However, there are undoubtedly additional headwinds facing the industry with rising interest rates, increasing fuel prices, the impact of inflation and recessionary fears likely to erode demand for travel this winter. These were some of the themes discussed at the Airline Economics Growth Frontiers London conference this September where I chaired the Banking Panel to discuss challenges, opportunities and risks for aviation banks in the current market.
There is still significant capital available and competing for assets, keeping lease rate factors low. With the costs of funding rising though as a result of inflation and rising interest rates, it looks like current loan margins and lease rate factors are mispriced. Undoubtedly there will be a correction to align lease rate factors with rising funding costs, putting additional pressure on airlines facing a period of downward pressure on demand, impacting cash flows needed to meet debt service costs.
Lessors, particularly those large lessors that have achieved investment grade ratings over the past decade, have been able to rely on low cost, unsecured capital markets funding to finance their portfolios. However with reduced capital markets activity due to interest rate and macro-economic uncertainties, a shift toward increased secured bank funding is creating opportunities for aviation banks to come back into the market in a stronger way. While European aviation banks are certainly re-engaging with customers and pursuing new mandates, the market remains deeply segmented between the haves and the have-nots, with banks having a continued focus on lending to the best quality credits and collateral, leaving mid-tier lessors and airlines struggling to access such funding.
Banks still have concerns about the risk profile of the aviation sector given the significant recent challenges faced by the industry and the additional macro-economic pressures now affecting airlines. While there will inevitably be further bankruptcies, there remains confidence that airlines and lessors that have made it through the last few years have streamlined their operations and will be able to capitalise on increasing passenger numbers in the medium to long term. The reports of the death of business travel have been greatly exaggerated in my view! I think this has been borne out over the last year where we have all seen people chomping at the bit to get back into the skies to meet colleagues and clients. Anyone in business who sees their competitors meeting their clients in person, knows that Zoom calls are not going to cut the mustard.
With many of the mid-tier lessors and airlines unable to access bank funding to modernise their fleets and finance order books, aviation-focused alternative lenders and credit funds have become increasingly big players in the commercial aviation lending market. Lenders like Ashland Place, Muzinich, Castlelake and Volofin have been carving out a strong niche in the non-recourse lending market. These funds can be nimble and often more flexible in terms of financing older assets as they are not subject to the same regulatory requirements as traditional banks. While banks may be able to offer lower margins given their lower funding costs, this is not the whole picture. Looking at the overall structure of a deal, alternative lenders can often offer more compelling terms with more flexibility to offer larger balloon repayments than banks, thereby giving borrowers more cash flow during the term of the financing.
The alternative lenders are currently providing fast and flexible capital solutions and much needed liquidity to the market. These funds have large amounts of institutional capital they are keen to deploy on sizeable transactions often competing directly with traditional aviation banks. This is to be welcomed and clearly demonstrates the confidence that investors have with respect to opportunities for real long-term value in the commercial aviation sector.
In terms of bank lending, Walkers’ Irish Asset Finance team recently advised Citigroup Global Markets Asia Limited and New Zealand Banking Group Limited as Joint Global Coordinators to a syndicate of Asia-Pacific, European and North American lenders in a US$1.7bn facility to Irish headquartered SMBC Aviation Capital. The financing generated strong interest across the global banking market. The quantum of the facility and level of interest again demonstrates, not only the strength of SMBC’s business but also the long-term confidence in the strong fundamentals of the sector.
We have been fortunate through the global reach of our asset finance practice, and our ability to offer a combined package of legal and corporate administration services, to advise on these and similar important mandates. While challenges remain, the industry has come a very long way in the last 12 months. The optimistic industry outlook is that demand for aircraft, particularly with the gradual re-opening of the Chinese market, will to a certain extent, offset challenges presented by increased interest rates and the inflationary environment.
