Following the success of our recent webinar on the Aircraft ABS market, and in response to demand, Phil Seymour, Company President, from IBA Group and Brendan Crowley, Director, from KPMG Ireland teamed up to assess the likely impact of the current crisis on both narrowbody and widebody aircraft finance models.
In this session, our experts discuss and address some of the most burning questions through scenario analysis and asset by asset modelling.
Key discussion topics
Phil and Brendan try to answer the following:
• How will possible early returns, rental holidays and repossessions impact on previously expected/modelled maintenance events and cashflow?
• What risks could lead to an unexpected Event of Default if not monitored?
• What are the outcomes and options available to various stakeholders?
• Will retirement trends change in the near term?
• What is the impact on current market values and lease rates now and in the longer term?
• How will models need to change to reflect the current climate and minimise the impact?
This session is a must for must for leasing companies, aviation investors and banks looking to further understand the potential impact on their portfolios, current leases and investments, and for those requiring further guidance on how to minimise and manage the impact.
Webinar Synopsis – How could the downturn in passenger demand impact finance modelling for ABS and other aircraft leasing models?
For those unfamiliar with IBA, we are an independent aviation consultancy which strives to maximise opportunity and minimise risk for our clients’ aviation assets. We do this using our advisory services, valuations, asset management and technical services and by providing data intelligence via our IBA.iQ platform.
Here, IBA’s President Phil Seymour joins with Brendan Crowley, director at KPMG Ireland’s Consulting group, to consider ABS and other leasing models against the backdrop of Covid-19. Both Phil and Brendan are expertly placed: IBA.iQ is preloaded with data relating to ABS transactions and Brendan’s team at KPMG has worked on the vast majority of ABS deals brought to fruition over the last decade.
2019 was a bumper year for ABS and 2020 looked set to be yet more successful. With the current global pandemic having arrested this anticipated growth, Phil and Brendan will together:
- Present an overview of today’s ABS market by aircraft activity status, aircraft class and unexpired lease length
- Consider how liquidity planning will need to be revised and assumptions challenged when dealing with events such as maintenance, retirements, returns and lease extensions
- Using China’s experiences and previous economic downturns as a guide, evaluate potential recovery speeds and assess how this crisis will influence aircraft and lease valuations
- Identify some portfolio watch metrics and drill down to examine contingency planning at the asset level
- Summarise their recommendations for effective management of high cost assets long term
Post-2015 ABS Structures
IBA.iQ records aircraft as parked when they’ve been ‘down’ for up to fourteen days, those inactive for longer described as being stored. Currently 60% of ABS aircraft are parked or stored globally and the lack of intercontinental and international travel has had a greater impact on widebodies than on other aircraft classes. The A330 features most prominently with about 80 aircraft overall. We would not rule out the downturn accelerating to levels where 80% of aircraft are ‘down’.
Whilst some specialist ABS transactions exist relating purely to freighters or to turboprops (such as the UX Capital Cargo 2017-1 and the Elix Aviation Capital Prop 17-1) most ABS fleets are heavily narrowbody-focused at 83%. The A320 ceo and Boeing 737-800 are particularly well represented numbering around 350 each.
Pre Covid-19, we were witnessing leases subject to extension and negotiation due in part to the Max’s grounding and delivery issues with the A320. Over the next four years including 2020, more than 600 lease expiries are scheduled and the key question to pose is how many of these leases will fail before their due end and, of the survivors, what numbers are likely to extend?
The unprecedented position we all now face presents unimagined complications for finance modelling. Stakeholders and investors will be forced to study factors previously considered outside their usual focus. Stresses formerly deemed to pose a threat to secondary rather than current leases will have to be rethought and maintenance issues will become a regular topic of discussion. Costs usually given scant attention like insurance and storage expenses will demand consideration.
With stakeholders unable to control current events and therefore ill equipped to make accurate predictions, we here attempt to present actionable advice for the short and medium term. Fundamental to ABS structures is the regularity of their debt outflows and expenses. Their framework is strictly arranged. A typical vehicle is responsible for setting aside funds to reimburse airlines for their maintenance expenses and, in a thriving economy, this factor is seen positively as it reduces investors’ exposure to the airline’s credit risk.
In an uncertain trading environment however, the requirement to keep reserves aside for maintenance liabilities is less attractive. The key message emanating from today’s turbulence is that maintenance funding will be unpredictable. Reports for the March collection period already show a significant decrease in rents received and we expect average 2-3 month rent deferral periods to be requested, 80-90% of aircraft having thus far asked for such delays. Since maintenance reserves make up around 30% of rental income, these funds may be insecure.
Short term, liquidity planning will prioritise satisfying the interests of senior interests and paying expenses by standard collections and reserve accounts to ensure avoidance of an indenture event of default. In the absence of major unexpected events, an ABS’s liquidity facility will provide for 9 month’s adequate funds. Crucially, the ability to bolster its provision accounts in the short term will now be restricted. Maintenance reserves having been refunded to airlines, an ABS could be exposed to subsequent maintenance expenses to cover which it has set aside only 50% of the returned amount and there will therefore be a shortfall.
Stakeholders and investors will need to inject some subjectivity into their forecasting, especially around transition and maintenance costs and their revenue projections. They should focus their attention on two main issues:
- Re-evaluating the cost assumptions on which they’ve traditionally relied
- Assessing the likely duration of the economic downturn
Historically, transition times would have been based on significant fleets over long periods of time. Thus, in a stable trading environment an ABS would expect assets returned either on schedule or following an airline default to be back or out on subsequent lease within one to two months. Anticipated costs would be around $250K – $350K for a narrowbody and $1M – $1.5M for a widebody. How will these expectations need to be revised?
Since China are two to three months ahead of the rest of the world, we can use their situation to anticipate how long the downturn’s effects are likely to be felt. Although modest improvements are trickling through with news that China Southern, Air China and China Eastern have added 10% more seat capacity over the last two weeks, volumes are still 50% down on already depressed mid- January levels and despite some aircraft returning to utilisation, their load factors will be low. Revenues will be far less than pre Covid-19 levels and we expect little improvement until at least June.
Lease rates and aircraft values
Historical economic downturns such as 9/11, SARS and the global financial crisis have equipped us with data to inform our understanding of how lease rates and aircraft values are likely to respond to Covid-19. Lease rates, more volatile than values, tend to rebound more quickly after a slump. So, a new build in 1998 would have attracted a monthly rental of $300K which, after 9/11 and SARS hit, softened to $200K before recovering. Market values can drop more than 60% and never recover to the same extent as lease values which is why base values are crucial. In periods of economic turbulence when most aircraft are grounded and unable to generate income, a long-term judgement of their economic value is imperative. The ISTAT definition of base value was developed as a measure appropriate for appraisers to use in even the most exceptional situations and is ‘the appraiser’s opinion of the underlying economic value of an aircraft in an open, unrestricted, stable market environment with a reasonable balance of supply and demand, and assumes full consideration of its “highest and best use.”’ This measure is the most reliable for high cost capital assets during a downturn. Focus must be on the relationship between base values and market values since previous crises have shown us that, whilst market values can fall away from base, long term they always track back.
What does this mean for ABS aircraft valuations in future? Traditionally, the average of three appraisers’ half-life-based values are taken and an absolute figure representing a maintenance adjustment for wear and tear is overlaid. Serious questions should be asked to ascertain this method’s efficacy today. Appraisers have themselves been wary of the methodology since they’ve had no influence over the maintenance figure used. Further, any market value determined mid crisis will necessarily be a distressed value. Whilst current trading peculiarities and their consequences for market values can’t be ignored, base values can be relied on as the most reasonable long-term indicators of economic values.
Watch-metrics and stress testing
Short term, liquidity will be a major issue for ABS structures as support options and the uses to which cash can be put are limited. As already highlighted, un- or inadequately funded maintenance expenses can drain liquidity reserves and threaten an ABS’s ability to withstand an event of indemnity default. We therefore advise careful scrutiny of reserve account funding and factoring into negotiations for rent payment holidays discussions about potential shortfalls in reserves to cover maintenance expenses.
Potential triggers for defaults in the medium term are likely to be related to transition events and concentration should be applied to lease ends over 2020-2021.
The quality of the relationship between an ABS and an airline is fundamental to successful navigation of the downturn. We anticipate scrutiny of security deposit reserves, exposure to end of lease payments and letters of credit or unfunded maintenance. Without effective interaction between the parties such that each understands the other’s expectations over route planning, however, extreme challenges are inevitable.
Longer term, the emphasis will shift to the asset’s value at creation or to depreciation so the question will be whether a depreciating asset has the potential to generate sufficient revenue to meet funding costs.
Actionable asset-level contingency planning
Typically, lessors and servicers will rely on pricing models to evaluate the viability of a lease and ensure it passes IRR thresholds. Future conversations between lessors, airlines and servicers will have to extend beyond normal parameters to include additional factors. Thorough contingency planning should be instigated now so investors can decide what they want to protect and their preferred work out scenarios.
Potential scenarios will stretch from the best-case, as-is situation where no action is required to abrupt redelivery should an airline fail and there are multiple variations in between. We anticipate 10% of aircraft will fall into the top category. Most ABS vehicles and investors are already dealing with payment holiday or rent reduction requests. We foresee longer term rent reductions being asked for which may come with lease extension proposals and future overpayment arrangements. Negotiations over maintenance reserves and redelivery conditions will demand new prominence. Due to the onerous costs transitions generate, the bleakest outcomes will be early redelivery or lease termination ahead of contract term with the Domesday conclusion being abrupt redelivery following airline failure.
Maintenance and transition costs
The significance of providing for maintenance cost events during periods of economic uncertainty is underlined in the charts presented here. They detail typical major maintenance episodes for a narrowbody and assume for simplicity’s sake that replacement of engine life limited parts will occur concurrently with an engine refurbishment. Potentially, an aircraft could be subject to maintenance events costing $16M over a 6-month period which maintenance reserves may or may not have kept pace with. It is relevant that reserves accrued from day one of a lease may be inaccessible immediately within an ABS structure and maintenance liabilities are not restricted in scope to major events.
We would strongly advise that ABS vehicles and investors exhaust all viable alternative options before accepting back control of an aircraft. Significant transition costs which will not have formed part of initial modelling or assessment work will accrue as will enormous extra workloads to deal with movement of the aircraft to storage, insurance premiums, collation of records, tracking down titled engines and continuous airworthiness management and compliance with directives to mention but a few. The global shutdown means the physical process of collecting a returned aircraft will be incredibly complicated.
We foresee pressure on rental incomes enduring throughout 2020 having failed to witness positive leading indicators from the Chinese data to date. The world is in the midst of very unusual circumstances, the severity of which strains modelling expertise to its limits. Based on such insecurity, our paramount recommendation for ABS vehicles must be that prompt, clear engagement with lessees is established so that the optimal solution for each party can be worked towards.
The data behind today’s session was provided by IBA.iQ, our unrivalled intelligence platform. Please make use of the system demonstration we’re offering by accessing this link. For further information about the subjects touched on today or to discuss the services we offer please get in touch with Philseymour@iba.aero