Investing in aviation: Due diligence

Aviation leasing platforms

Performing due diligence on a leasing platform can be done by using the commonly applied metrics of Loss Given Default (LGD) and Loss in the Event of Default (LED). In our opinion, however, this is not sufficient to understand the bigger picture. You need to comprehend the role a lessor plays. 

Lessors have two roles: as a financier and as an asset manager.  As a financier, the lessor is evaluated on how well it earns money from its assets and how well it can protect it. Performance in this sense needs to be assessed alongside what type of credit package is assembled to ensure proper coverage. 

Technical awareness

To accurately model investment returns from an aircraft or portfolio, you need to understand the technical variances of the specific aircraft, engines, ongoing maintenance requirements in the lease agreement and end of lease return conditions. Short of an on-site inspection of all assets and their associated records, technical due diligence should never be overlooked. 

The approach to this depends on the aircraft's age profile:

• For most newer aircraft remaining on lease as a going concern with a lessee for the foreseeable future, a high-level review of crucial digitally available records will get you part of the way, and these aircraft can always be inspected at a later date, usually in conjunction with customary rights under the lease.  However, as it stands today, in our view, nothing will replace being on-site with the asset, and its records, never mind the critical importance of establishing your relationship with the operator on this aspect of your deal.
• For older aircraft, with more established legacy operators, historical digital records might not be readily available. It is always recommended to have a full on-site review, primarily to ensure that the aircraft is being properly maintained and repaired correctly per manufacturer requirements. If an extensive portfolio of aircraft is being considered, and if all aircraft and records cannot be inspected, a weighted matrix should be considered to prioritise which aircraft should be examined, at a minimum.

Precise awareness as to exactly what you're buying, the current metal condition, future metal condition, and the rights and obligations over the duration of the lease will allow you to quantify an accurate value for your investment from the outset. Accurate due diligence should also reduce the risk of unforeseen running costs or maintenance time, as well as protecting against a diminished exit value which may disrupt expected returns. 

Conversely, the lessor's role as an asset manager is intrinsic to its success. Key performance indicators for aviation asset management include the length of time an aircraft has between leases, the efficiency of default remediation, aircraft remarketing and trading, and control of recovery costs. In addition, a lessor that can effectively navigate the technical necessities of aircraft maintenance and transition also speaks to its understanding of the importance.

Tax

Tax due diligence is an essential consideration when investing in aviation. The mobility of the aircraft leasing industry, complex structuring requirements and "big ticket asset" values all contribute to tax risk with sales or acquisitions and physical asset movements potentially falling within the scope of numerous taxing authorities. 

The tax landscape is changing dramatically both on a unilateral and multilateral stage. Consider a lessee jurisdiction where the lessor is not a local taxpayer. Do you know the local tax attributes of the lease and allocation of risks between the lessee and lessor? Commercially, lessors may point to clauses which attribute tax risks for future changes of law to the lessee, however, ultimately passing such liabilities to lessees may severely damage customer relationships in this ever increasing competitive commercial landscape. If tax requirements are not satisfied, what is the contractual remedy? Can a foreign tax authority make an assessment against you, or worse yet, seize your asset? Is the structure that you plan to use sustainable?

These are all vital questions to consider in an aviation transaction (via direct aircraft acquisition). Additionally, if you are buying shares in an aircraft owning entity, consider yourself "stepping into the shoes" of the target. Now you need to think about the tax risks attributable to an unfamiliar entity; domestic tax, transfer pricing across potentially multiple jurisdictions, foreign permanent establishments, structural sustainability and more. Ultimately, whether the acquisition is by way of "share" or "metal" transfer, ambivalence of underlying tax risks can lead to a dilution of expected investment returns either during the income life of the investment, or on exit when latent exposures are subsequently discovered by a knowledgeable buyer. 

Terms and conditions

The due diligence of a lease is critical. Lease construction has evolved exponentially over the past 10-15 years whereby terms, conditions and lessor remedies have been so acutely defined that if misread or misunderstood, significant financial implications could arise. In addition to the above, the prolific use of maintenance reserves, return conditions and complex end of lease compensation calculations, can also implicitly affect the financial benefits of a lease structure.   

Simple nuances in language over how reserves are accrued and accounted for and subsequently expanded, are vital elements of ancillary rent and can cause for both a benefit and possibly an obligation for the lessor. Additionally, do you understand the financing that is attached to the lease, is there a swap in place, what are the breakage costs, what are the financing considerations? These are all questions that should be asked when investing in on-lease aircraft as costly answers can handcuff your ability to benefit from the fungible nature of your asset. 

Credit

Airlines come in all shapes and sizes. Understanding the operator, their financials and market position is all commensurate with proper credit analysis. As always, with any credit analysis, the "five Cs" apply: Character, Capital, Capacity, Collateral and Conditions. In addition to high GDP elasticity, there are a multitude of endogenous (load factors, wages, RPK, order book) and exogenous variables (fuel costs, macroeconomic shocks, geopolitical shocks) which can tip an airline into an insolvent position.

When considering a more substantial portfolio opportunity, some of the lesser-known, weaker credit operators can easily be overlooked. A well-balanced risk profile will always have a mixture of solid pillars that should not be a major concern, a mid-tier of operators that require a bit of monitoring and a bottom tier of airlines that should remain front and centre when it comes to risk monitoring and asset preservation – and the latter category should generally be minimally represented.

Currently, however, with stronger markets and prolific access to capital, airlines have been more successful, even the bottom credit tier, effectively negotiating away some of the more onerous, lessor-friendly terms. As such, current leases can be seen to be limited in terms of securing remedies that would offer higher levels of comfort. What does this mean for investors? For buyers who will not be servicing their own portfolios, a full understanding of the servicer-lessee relationship must be further investigated, including how that servicer intends to deal with any possible defaults or accelerated lease redeliveries. 

Additionally, what, if any, fungible securities might be on account, and if minimal, do options exist to remediate should an operator start to breach its covenants. Jurisdictional awareness of self-help, tax structuring and ease of de-registration are also critical opinions to seek. If you don't learn how to protect your investment, a small problem could turn into a more significant uncontained cost event with limited recourse.

Diligence by a trusted partner is essential

Currently, the competitive market is ripe with opportunities. Those looking for the right piece of the puzzle need to know what types of questions to ask, to understand the real risks behind the proposition while having an appreciation of how aggressively they want to enter the market. There is no "one size fits all" approach to aviation assets. 

While the baseline due diligence might sometimes look the same, knowing what other mitigating factors to identify and what questions to ask are only the first stepping stones for success. This could include incorporating technical modelling of cash flows of reserves and maintenance expense, along with the critical analysis of the end of lease compensation and return conditions.

The premise that there is always a premium associated with a leased aircraft when incorporating a collateralised value is misleading at best, and some sellers/arrangers may anticipate that investors do not do their homework. If assets support a transaction, then a technical analysis of the asset must be made to breakdown the position in a default situation as when compared to similar assets. If the investment is in a going concern, then further consideration must be given to the ability of the lessor to effectively transition aircraft, manage defaults and realise returns on investment through an efficient trading platform. In most cases, the intangibles can be the real determinant of investment realisation.

As the saying goes – you can have a bad asset in a good deal and conversely, a good asset in a bad deal. It is vital you have a trusted advisor who can recognise the issues from the onset and can construct a decision making framework from which to build upon, will aid in credibility and confirmation of platform durability.