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Due Diligence - What Is Your Deal Really Worth? April 2018

There was a great deal of activity concerning aircraft lease portfolios during the first few months of 2018. IBA has been advising various investors, with a broad range of investment objectives, with surprising results. Whereas typically investors are seeking at least a 7% return, in some deals the returns were much leaner than anticipated, in others break-even was the optimistic outcome. Both market share and an eagerness to develop a relationship with a particular operator were highlighted as objectives in these cases. With such lean returns, one theme is common to all; robust due diligence (DD) ahead of purchase and a focus on expert ongoing servicing is essential to maximise the opportunity to realise target returns.

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The majority of investors base their decisions on the combination of the expected lease income and the gain from the sale of the aircraft. While the key risks to return are still operator/credit and asset risk, the jurisdiction is a third parameter to monitor. Additionally, there have been significant differences between theoretical future values as provided by appraiser websites and publications versus actual negotiated return conditions. For example, it is unlikely that a twin-engine, twin-aisle aircraft on lease with a top tier airline will be in full life or even half-life condition at lease end. Compensation formulae regarding what the airline may have to pay at lease end are complex. The surrounding assumptions regarding engine swapping and build standard of engines can slash tens of millions of dollars off the assumed appraised value at lease end.


The term due diligence can confuse. Although not every deal needs the full spectrum of DD, it is useful to highlight the range of areas to assess beyond legal and financial diligence. The mix of critical quantitative and qualitative factors makes seeking expertise both prudent and highly likely to improve investment decision-making.


Commercial DD

Assessing the market, the stage of the cycle and the strategy of the target is central to investment and acquisition activity. IBA is typically engaged to conduct commercial due diligence (CDD), or to add additional sector insight to an existing CDD. Areas where challenges or concerns may arise include:


• Growth estimates. What are the base assumptions and are they realistic? While overall growth predictions remain robust, there are some deals where market growth rates are unrealistic, lease rates are unrealistically high - especially for extensions, and insufficient notice of the competition has been taken.

• Strategy. What is the strategy? Is it clear? If it isn't that is an immediate red flag. If it is clear, has it been done before and what was the outcome? Although it is preferable for the unconventional to succeed, the truth is aviation is littered with failed ventures. If it has previously failed, examine what has changed this time? For example, there have been five low-cost, long-haul (LCLH) business models that are currently using old aircraft, new aircraft, widebodies and narrowbodies using secondary airports, primary airports or obligatory waypoints. Not all will succeed.

• The competitive landscape is also frequently underestimated. Look very closely at competitors, their positioning and sources of differentiation. Examining the relative strength of marketing strategies, the use of technology and the introduction of a premium offering to a very price-sensitive market, can be illuminating.


Operator DD

To truly assess the credit risk, investors need to visit the airline and meet the management team. The most successful lessors invariably have great links to both their lessees and other key stakeholders - often the government in trickier jurisdictions. Investors don't always have such access and there are some specific areas where investors should focus their research or seeking additional advice. These areas are typically split into two - credit or an airline's operational performance and its ability to maintain and return assets.


These areas can be broken down into the following:


• Robust backing from markets, states, or large shareholders familiar with aviation. In the last 12 months the strength of backing and access to credit has overtaken financial performance as the primary quantitative focus, for second, third and fourth-tier airlines. Although such backing isn't a substitute for the fundamental strength of the customer.

• Strong financial track record. Across the typical analysis around revenue, efficiency profitability and liquidity, investors should focus on: inconsistent and seasonal earnings, reliance on exceptionals, weak FX position, leverage and poor margins. Jet fuel has nearly halved over the last three years. Most operators are turning a profit in these relatively benign trading conditions so if margins are lean now, investor need to be wary as both fuel and maintenance have plenty of scope to increase. On occasion, too much faith can be placed in financial statements, which may be dated or less reflective of current operating conditions.

• Established and understood strategy. As discussed under CDD, at the operator level it is important to be able to understand the strategy and management's ability to execute. One airline IBA analysed last year shifted from a focused low-cost carrier (LCC) pure play, to diversification across three new areas - with very mixed results.

• Track record of management. Assessment again mixes quantitative and qualitative research to build a picture of the operator's ability to: win and retain business, manage and expand a fleet, juggle outsource and inhouse resource, maintain records and certificates (in English) and operate safely. The operator coming up short on any of these will impact your investment.

• Related to the above - understand how long the management team have been in place and where there might be disruptive movement. For any airline it is helpful to understand the direct and indirect influence of unions and if it is a subsidiary, feeder or sovereign-linked airline. Investors need to understand who is really in charge.

• Redeliveries continue to deserve a mention in terms of impacting value. IBA has updated its transitions research recently and overspends are increasing. A poorly planned or handled redelivery can easily cost $2 million per narrowbody or $5m per widebody, which could wipe out a typical profit.



Linked to both commercial and operator is the jurisdiction. This is important to assess in terms of economic performance, political shifts and interference, ease of doing business, exchange controls and the legal environment in relation to disputes and repossession


• Economic performance is clearly important given the close, albeit shifting parallel between GDP and traffic. It is also useful to assess the importance of aviation to the economy and the impact on the economy of external shocks. Air travel is exceptionally robust, witness the recovery in Turkey as one recent example, and Kenya recovers from the drop in traffic following terrorism concerns. Linked to economic growth is infrastructure, which needs to keep up with, or get in front of, GDP and traffic growth. India is a textbook example of impressive growth seemingly outstripping existing infrastructure.

• Political stability, the likelihood of regime change and the perceived level of government intervention are also important to understand. In the last two years, countries including Egypt, Qatar and the Maldives - where a state of emergency currently impacts tourism - can be dramatically impacted by instability. The robustness of local courts and speed of litigation are key to understanding the chances of success and ease of asset recovery where necessary. This needs to be conducted on a country by country basis. In some developing countries repossessions have been exceptionally smooth whereas similar actions in G7 countries were tied up in red tape for months. Repossessions are never inexpensive. IBA research estimates a narrowbody repossession to cost a minimum of £300k and a widebody will be £650k, excluding reconfiguration, remarketing and necessary maintenance to transition.


Asset DD

For asset due diligence, alongside the textbook considerations, investors should look to have many aircraft with many operators.

• At a higher level - decide which aircraft pose the best investment for the investor. A narrowbody aircraft with a decent airline credit will return 4-5% per annum, so for investors seeking higher returns may wish to invest in narrowbodies placed with more challenged credits and/or a mix of aircraft types. Turboprops and Regional Jets can offer greater returns, balanced against relatively fixed deal costs and increased volatility. Widebody aircraft too, offer greater returns, often to seemingly stronger credits - but they can deliver very nasty surprises in relation to liquidity, transition or reconfiguration costs.


In general terms, IBA advocates investors consider the following: Indeed, as the IBA.iQ charts below highlight, the value profiles of the various aircraft types can vary widely. The charts compare the percentage of original value retained at 12 years for 2006 deliveries.


The market characteristics of an aircraft type give a good indication of how residual values will perform in the secondary market. Aircraft types with high fleet concentration amongst a small number of operators limit the opportunities when it comes to remarketing. Lessees have greater negotiating power when it comes to extensions.


In the charts, IBA compares three aircraft models with stark variances in their market characteristics. The Boeing 737-800 is a highly liquid and sought after aircraft. The aircraft has achieved strong sales over a 20-year period and is operated globally, in all world regions and across a base of around 200 carriers. As such the aircraft exhibits strong value performance, with around 45% of its original delivery value retained at year 12.


The widebody Boeing 777-200LR has much weaker market characteristics. The aircraft has always been viewed as a niche product given that the ultra-longrange business model was not widely adopted. As such, the current passenger fleet stands at fewer than 60 aircraft. The operator base is only 14 strong, restricting the potential customer base. Value retention at 12 years is unsurprisingly weak at close to 30%.


An extreme example would be the Airbus A340-600. IBA is aware of sub-US$6 million trades recently, highlighting the poor market conditions for this model. Less than 100 units were sold, more than a third of the fleet is parked and there are only eight active operators worldwide. In ISTAT Market Value defined circumstances, assuming a single sale and highest best use, the aircraft may achieve a higher value than displayed in the graphs, however IBA has seen aircraft trading in the US$4 -6 million range.


The key to understanding the likely future value of aircraft assets is the appraisal. Appraisers and appraisals take various forms. IBA advocates securing a specific appraisal for the aircraft under consideration. Generic values have their place, but a full appreciation of the following is recommended to correctly value the assets:


• Age
• Utilisation
• Maintenance record and status
• Internal and external condition
• Lease quality and length
• Reserves and return conditions
• Specification
• Current or planned modifications
• While not a formal DD exercise, to build a rounded picture of opportunity and risks, more clients are conducting lease reviews to support negotiations and minimise shocks. Areas to focus on include the 3R - Rentals, Reserves and Return Conditions.


Technical DD

Connected to the asset is the technical DD. This area of due diligence is likely to be outsourced to experts and on occasion investors may wish to:


• Physically inspect aircraft to ensure they are in the condition stated. Undeclared damage or repairs can knock millions of dollars off the value.

• Assess storage and maintenance facilities to determine whether the aircraft have been maintained appropriately and to inform status for calculations in relation to future values and expenditure. If an operator is receiving new equipment having run an ageing fleet, you might wish to ensure the facilities can manage new - generation aircraft.

• Inspect maintenance and records. Investors may choose to check records and maintenance independently. Both are great indicators of an operators competence.





For more information contact: Mike Yeomans

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