Aviation finance managers give lift to debt-heavy industry

Managers that offer aviation financing are finding a silver lining in the pandemic, as airlines are more likely to lease or enter into sale-leaseback agreements rather than buy the aircraft outright, industry sources say.

Such arrangements help airlines avoid adding more debt to their already burdened balance sheets.

As banks pull back from aviation financing, private equity groups are stepping in, buying the new planes that airlines had ordered as they are being delivered and then leasing them back to the airlines. The sale-leaseback business is growing as manufacturers work through a huge backlog of aircraft orders, managers said. What's more, during the pandemic, some managers launched direct lending businesses to help airlines repay billions in government loans by replacing them with private debt.

Private equity firms are bulking up their capabilities in order to capitalize on these trends.

In 2021, Ares Management Corp. financed the launch of a leasing company, Vmo Aircraft Leasing LP. Eight months later Vmo doubled its assets with investments from Oaktree Capital Management LP and Diameter Capital.

Apollo Global Management Inc. also invests in aviation finance through funds including Navigator Aviation Fund I, as well as through its business development company, Apollo Investment Corp., which owns Merx Aviation Finance LLC, a global aircraft leasing, management and finance company. Meanwhile, its insurance subsidiary, Athene Holding, owns PK AirFinance, an aviation-focused lender.

Managers like aviation finance for its cash flow, and so do some investors. In February, aircraft leasing company BBAM Aircraft Leasing & Management closed its latest flagship aircraft leasing fund, the $1.5 billion Incline Aviation II.

The $48.6 billion Arizona State Retirement System, Phoenix, has a fund of one investing in aviation finance with hedge fund Sculptor Capital Management Inc. Both the $246.3 billion New York State Common Retirement Fund, Albany, and $180 billion Florida Retirement System, Tallahassee, are investors in Carlyle Group Inc.’s new aviation fund, Carlyle Aviation Leasing Fund. Both have committed $200 million to the fund.

Carlye acquired an aviation business then known as Apollo Aviation Group in 2018, when the firm had $5.6 billion in assets under management. Carlyle’s aviation group now has 419 commercial aircraft on lease to 106 airlines in 59 countries, making it the sixth-largest lessor by fleet count, said Bill Hoffman, Miami-based chairman of Carlyle Aviation Partners. It had $11.7 billion in AUM as of June 30.

What started as a niche investment opportunity is now more broadly recognized by institutional asset owners and investment consultants, Mr. Hoffman said in an emailed response to questions.

The business has evolved from when Apollo Aviation launched in 2002, at the time predicated on selling engines and airframe parts of aircraft prematurely retired due to a reduction in demand following the Sept. 11 attacks. Today, the renamed Carlyle Aviation’s investment strategies span airplanes’ life cycles, offering financing for everything from pre-delivery payment loans to when the planes near the end of their useful life, Mr. Hoffman said.

“COVID presented a unique opportunity to test the viability of the strategy,” he said. “Despite the effects of COVID, coupled with aircraft seizures in Russia and followed by the recent spike in financing costs, we continue to see indications of interest in the sector.”

Carlyle executives believe that what had been a lull in deal activity since the start of the pandemic, with the exception of transactions driven by consolidation in the industry, “has started to change,” Mr. Hoffman said.

“In recent months we have seen our own pipeline of deals expand materially,” he said.

Aircraft leasing is a variation on investing in infrastructure and real assets, said Evan Carruthers, Minneapolis-based managing partner and CIO of private debt firm Castlelake LP. The firm raised its first aircraft leasing fund about 17 years ago, when there were no other institutional funds making such investments, Mr. Carruthers said.

Aviation leasing firms’ primary customers are airlines, which are “incredibly capital-intensive businesses” with episodic and volatile cash flow, Mr. Carruthers said. Airlines can solve for this with debt, which ballooned as a result of the pandemic.

The International Air Transport Association estimates that airline industry debt levels have increased by more than $220 billion to more than $650 billion during the pandemic, including loans extended by governments to aid the industry at the start of the COVID-19 crisis. McKinsey & Co. expects that the airline industry could accumulate between $870 billion and $1.1 trillion of debt by 2024, which is when air travel is expected to recover fully.

Increasingly, airlines are leasing newer aircraft rather than buying, which would load the airline up with even more debt, Mr. Carruthers said.

Prior to the pandemic, most airlines had aging fleets and when their businesses dropped to zero because of the pandemic, many took the opportunity to retire older airplanes en masse, which are inefficient and more expensive to maintain, Mr. Carruthers said.

Rebuilding their fleets by leasing newer airplanes gave airlines the opportunity to demonstrate they were making progress around fuel efficiencies and carbon footprinting, Mr. Carruthers said.

But buying newer airplanes is a drain on their already debt-ladened balance sheets and so, Mr. Carruthers said, more airlines are selling the new airplanes and leasing them back to reduce their debt. This is a big opportunity set for aviation finance firms as it will require $125 billion to $140 billion of capital per year over the next five years to pay for the new airplanes on order, he said.

“There’s an argument to be made that more than 50% of that will be leased,” Mr. Carruthers said.

That is especially the case since airlines are still recovering from 2020, which was the worst year in airline history, Matthew Elwood, New Haven, Conn.-based head of aviation, private equity/real assets at Barings LLC, said in a written response to questions.

Aviation financing managers and airplane lessors worked with their main customer, airlines, during the beginning of the COVID-19 crisis when air travel ground to a halt.

“Leasing companies, including our own, Genesis, worked with many of their airline customers to defer lease payments through the worst of the pandemic,” Mr. Elwood said. Barings formed Genesis in 2014 and four years later, in September 2018, the €14.5 billion ($14.6 billion) Ireland Strategic Investment Fund invested in Genesis.

“For the most part, the airlines have repaid the deferred amounts and are back to paying their lease payments on time and in full,” Mr. Elwood said.

But they have not completely recovered and Barings executives believe that airlines will lease more than they purchase airplanes as a percentage of their fleets, he said.

“Almost certainly leasing will becoming more dominant as airlines have seen the value of flexibility in fleet planning,” Mr. Elwood said.

As for the returns, they are similar to private credit in that it depends on where in the capital stack you invest, according to Mr. Elwood.

In 2020, 47% of airplanes were leased, up from 36% in 2010, data from IATA and aviation data provider Cirium shows. There were 31 aviation-focused funds on the market with a combined fundraising target of $20.8 billion as of Aug. 24, according to Preqin data.

Barings expects this to be the case “despite the fact that lease rates will need to rise due to increased appreciation of risks, such as pandemics and nationalization, as well as the increase in the cost of capital,” Mr. Elwood said.

What’s more, chastened by their experience during the war in Ukraine, “from now on, airlines operating from, or within, nations with less than friendly governments will have to pay higher lease rates (if leasing companies will even lease them planes) to compensate for the risk,” he said.