The Covid-19 pandemic has caused turmoil to the global economy, with the aviation sector being hit harder than most. With countries quickly imposing travel restrictions to combat the spread of the virus, airline cashflows were immediately and severely reduced causing the largest economic shock to the aviation sector in decades. Aviation participants, including airlines, lessors and financiers, have quickly sought to adapt and consolidate their position, often seeking alternative sources of financing and investment. As such, there has been growing interest and investment from private equity in the aviation sector.
WHAT DO WE MEAN BY PRIVATE EQUITY?
We are not referring to the private equity asset class but rather the investment management companies that raise funds from institutions and individuals and then invest that money, by equity and debt, into businesses. For our purposes, this will also include hedge funds, venture capital funds and distressed debt funds. Generally, we are referring to any form of private capital that exists outside of general banking or the capital markets.
PRIVATE EQUITY AND AVIATION
Private equity is not a new entrant to the aviation sector. Private equity firms were early investors into aircraft leasing and many of today’s aircraft lessors are, or were once, owned by private equity funds. For example, Cinven, CVC, GIC and Oak Hill’s investment in Avolon; Carlyle’s investment in RPK and Apollo Aviation Group (now Carlyle Aviation Partners); Cerberus’ investment in AerCap; Oaktree’s investment in Pegasus, Jackson Square and Elix; Terra Firma’s investment in AWAS (acquired by DAE); EQT Partner’s investment in NAC; Fortress’ investment in Aircastle and Falko; and KKR’s investment in Altavair. Similarly, private equity firms have long-been investors in privately-owned and part state-owned airlines.
PRIVATE EQUITY AND IRR
Private equity firms are focussed on achieving a high internal rate of return (“IRR”) on their investors’ capital. For example, Apollo Global Management (not to be confused with Apollo Aviation Group) has maintained a cumulative gross IRR of 39% since 2009 and KKR, since its inception in 1976, has maintained a cumulative gross IRR of 25.6%. As a result, private equity funds do not normally seek to compete with the traditional aviation investors, such as banks or the capital markets, due to their differing investment strategies and target IRRs. However, the current market presents potential opportunities attuned to their IRR requirements.
Distressed markets are a key focus for private equity firms and represent a common investment strategy. Investment into a distressed market will often have a higher risk profile which can deter mainstream investors but increased risk is often coupled with increased potential returns. The modified risk/return profiles in the aviation sector, since the effects of the Covid-19 pandemic, are more attractive to private equity firms.
PRIVATE EQUITY AND THE SHIPPING INDUSTRY: DISTRESSED ASSETS
In 2012/2013, the shipping industry was (i) still feeling the effects of the 2009 global financial crisis, (ii) facing serious issues of over supply due to a large backlog of ship building contracts and (iii) characterised by a large number of small disparate ship owners. The traditional lenders had retreated from the market due to over exposure, stricter capital adequacy requirements and a general policy steer away from non-core assets. Private equity firms stepped-in to fill the investment gap. In 2013, according to Marine Money, private equity investment in shipping jumped 2.5-fold to US$8bn.
Since 2013, private equity has found a home in the shipping industry and has continued to invest (up to US$20bn since 2013). While not all investments have been successful, private equity is now considered a major and consistent player in the market. There are some parallels that can be drawn between the shipping sector in 2012/2013 and the current issues facing the aviation sector, with its (i) large aircraft order book, (ii) a number of smaller and/or new entrant aircraft lessors and (iii) the potential tightening of traditional funding sources. However, it should be noted that, while there might be a current oversupply of aircraft for today’s needs, it is generally accepted that it will not take long for the aviation sector to correct itself with the International Air Transport Association (IATA), in 2018, predicting a 3.5% compound annual growth rate for aircraft travel over the next 20 years, meaning a doubling in passenger numbers from 2018 levels.
POTENTIAL AREAS OF INVESTMENT FOR PRIVATE EQUITY
1. Airline restructurings
Covid-19 has had an immediate effect on airlines, with revenue and cashflow being severely impacted. It is common for airlines to rely on strong summer revenues to survive leaner winters, and with those in the northern hemisphere having lost much of their summer business, it is likely that the short-term economic shock will also cause mid to long-term issues for many airlines. Most airlines will require new investment, with some needing restructuring, to survive. New capital is often necessary to convince creditors of a proposed restructuring. While private equity firms will consider investment into airlines that do not require restructuring, it is likely that investment in the context of a restructuring will provide more attractive IRRs.
a) Asset-backed debt
Airlines typically raise financing secured against their most valuable assets, their owned aircraft fleet, while also raising unsecured debt by way of bond issuances and revolving credit facilities. Commonly, this leaves a number of unsecured assets on the balance sheet – the equity value in owned aircraft, various receivables, portfolios of airport take-off and landing slots, frequent flyer programmes, intellectual property, inventory and equipment and, potentially, real estate.
For private equity funds, this presents an opportunity to provide rescue financing secured against either a specific asset or the airline’s assets as a whole.
It has been reported that a number of private equity firms, including Davidson Kempner, Centerbridge Partners, Elliot Management and Greybull Capital competed to provide Virgin Atlantic rescue financing.
b) Equity investment
With significantly more flexible investment strategies than traditional banks and lenders to the aviation industry, private equity funds are, in contrast, able to invest in airlines by way of equity and take an active role in their management. Often the funds' strategy will involve increasing the operational efficiency or business model of the company, divesting of assets, further capital raises and/or mergers and acquisitions.
Virgin Australia’s creditors recently approved its purchase out of administration by Bain Capital, whose restructuring plan includes rationalising the airline’s fleet around 737s and streamlining operations. Interestingly, this deal was reportedly challenged by an alternative proposal from Virgin Australia’s bondholders, led by private equity (Broad Peak Investments Advisers and Tor Investment Management). The counter-plan was to re-list the airline and maintain the current management. One of the bondholders’ main motivators in proposing the counter-plan was the, now approved, less than 10 cent on the dollar offer on the nearly US$2bn worth of unsecured bonds they provided to Virgin Australia. This scenario demonstrates both the risks and rewards for private equity in equity and debt investments in the airline industry.
c) Debtor in possession financing
In the US Chapter 11 context, we have also seen private equity stepping-in to provide debtor in possession (“DIP”) financing. DIP financing is provided to companies in Chapter 11 to assist with financing the company’s reorganisation and usually has priority over existing debt, equity and other claims. DIP financing provides a good opportunity for private equity to invest in airlines on favourable terms and gain preferential security. Oaktree Capital reportedly offered to provide US$1.3bn of a total proposed US$2.45bn in DIP financing to LATAM, which recently entered Chapter 11. This deal was challenged by current creditors as it was calculated Oaktree would have an option to convert their debt to equity at an implied 32% discount when LATAM emerges from bankruptcy. When considering whether to approve the proposed DIP, the US Bankruptcy Court for the Southern District of New York noted that Oaktree’s proposal was “entirely fair”. Ultimately, however, the proposed financing arrangement was rejected by the court for unrelated reasons.
2. Aircraft lessors
A recent study by Airfinance Journal, looking at lessor exposure to certain distressed airlines, found that of the US$276.8bn of total lessor assets, 5% were distressed at the beginning of June.
For the most part, the lessors with large exposures, some which stood at 100%, were smaller or niche lessors. AerCap was reported to have a 10% exposure to distressed assets but, due to its size, has been able to draw large sums of cash from the capital markets to fund itself through the current crisis. The general market view is that the larger lessors have the available cash flow to see out the crisis but the smaller or more niche lessors are in a tighter situation. For the larger lessors, this situation is perhaps more likely to impact on profitability than to give rise to more significant issues.
Opportunities may arise for private equity investment in smaller or more niche lessors that (i) have asset and lessee diversification challenges, (ii) are highly leveraged and/or (iii) are unlikely to be able to source new investment from their existing shareholders. These opportunities could include (i) equity investment, (ii) refinancing existing financing with more flexible payment terms and/or (iii) the provision of debt with an option to convert to equity.
3. Distressed debt
Another option for private equity would be to invest in portfolios of non-performing loans held by existing lenders looking to de-risk or pivot away from aviation, which is an area that private equity has dominated in the shipping industry since 2012/13.
a) “Sunny day” investors
With consistent growth in the aviation industry and stable returns over many years, the aviation industry has attracted many “sunny day” investors into ABS, EETC, private placements, portfolio financings and even more vanilla aircraft debt. These investors have been passive and content with the safe, consistent and predictable returns that aviation offered. Since the Covid-19 crisis, these “givens” are no longer the case and there are a number of investors who will inevitably seek to exit the market as it no longer correlates with their risk profile or they are unwilling, or lack the necessary expertise, to manage the distressed debt effectively.
We expect to see a number of banks looking to sell non-performing aviation loans, either on an individual or portfolio basis. This may be necessary where the bank’s internal credit controls or capital adequacy requirements necessitate the off-loading of non-performing loans or where the bank’s investment strategy, following the impact of Covid-19, no longer treats aviation as a core business area.
Both types of investor might present opportunities to private equity investors looking to take on distressed debt and work on extracting value. A key differentiator for aviation, when compared to shipping in this context, is that the aircraft underlying the NPLs can be considered fairly homogeneous. The value of the aircraft, and therefore the security value, has fewer impacting factors, whereas there is often considerable variation between assets and their value drivers in the shipping industry.
4. Aircraft portfolios
The larger lessors have routinely sold leased aircraft portfolios, as part of their general business and risk management strategy, to a seemingly endless supply of investors. More recently, such lessors have been reluctant to tender the sale of leased aircraft portfolios as, in the context of Covid-19, the potential pool of buyers is reduced and those that remain inevitably expect more attractive pricing, particularly where relevant lessees are in financial difficulty. However, to manage diversification risk and free up much-needed capital, some lessors will be forced to sell leased aircraft portfolios in this “buyer’s market” and private equity funds may prove to be willing investors.
Aircraft will inevitably be returned to lessors in the context of the myriad airline restructurings, and some of these aircraft will be difficult to remarket, particularly older or less in-demand types. Private equity often thrives in extracting value from difficult assets and so may look to exploit such opportunities.
HOW WFW CAN HELP?
Our aviation practice is at the forefront of the industry. With over 35 years’ experience in the aviation sector, we have advised on many of the most innovative, complex and high-profile transactions and restructurings in the aviation market. In addition, our market-leading maritime practice has advised on every recent maritime restructuring and so has much to offer by way of a blueprint for extracting or preserving value in the context of restructuring and distressed assets. For further information on aviation restructuring, please read our acclaimed Aviation Restructuring Report.