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OPERATING LEASING OPERATING LEASING

Optimism prevails in the aviation industry of late. New entrants are plentiful and the demand for debt is high.

For operating leasing, however, there may be the faintest of clouds forming.

Lease rates, in general, are softening as a result of a glut of bidders on deals with no shortage of liquidity. Extensions are creeping up and so are suspicions of troubled operators. Despite the low oil price, spring in the northern hemisphere sees the return of both blossom and cash

flow problems for airlines within oil- or currency-sensitive countries desperately looking to make it to the summer season, while US domestic operators continue to reap the benefits. Lessors face many challenges not least in the decisions they are required to take on a daily basis.

IN-HOUSE OR OUTSOURCE?A lessor with hundreds of aircraft under management might decide the management of their fleet is best handled internally. However, in many instances, the skills associated with fleet

management and transition are better outsourced to specialist teams with years of operating lease experience as the cost of ill-informed decisions or errors can be substantial.

While there is a general trend for the larger lessors to manage fleets in-house, some lessors with large fleets have deliberately followed an outsourced model with the aim of in-house resource being 100% focused on front-office activities in order to build and sell a leaner operation.

When outsourcing, a lessor needs to decide if they are hiring a full-service operation or if they are cherry-picking skilled individuals. Both approaches have their respective advantages in relation to costs, flexibility and consistency. The full-service model combines the best mix of skills and costs but it also eliminates the risk of having to pay more if outside help needs to be drafted in at short notice to take over from a small team that has struggled. In such a scenario, the lessor essentially pays double as the second team needs to get up to speed with issues.

Whichever option is selected, lessors need to ensure that the team has skills across technical, remarketing, finance and project management and agree in advance whether outsourced help are there in a tactical capacity, ensuring tasks are completed; or in an advisory capacity where they are selecting aircraft, setting goals and establishing timetables.

CONTRACT LANGUAGELease contract wording should never be ambiguous. There is a common misconception that indistinct terms permit more room for future negotiation or manoeuvres. This is rarely a successful strategy and serves only to both lengthen negotiations and increase the likelihood of pushback or misinterpretation. The market seems to have realised this as there is a growing trend for lease to agree on “plain English” documents ahead of a return specifically to avoid ambiguity and debate at the point of return.

In particular, lessors need to pay attention to:

• Engine Performance Restoration. This is often the cause of confusion as to what exactly this should be and is critical in terms of what will be offered to the next lessee. Clearly there is a conflict when shop visits are being performed at, or just prior to, redelivery with the lessee wanting to minimise costs and the lessor wanting to have the best possible engine condition.

• PMA parts/DER repairs. Establishing what can and cannot be done should not wait for the redelivery when it will be far too late to make corrections.

Ideally the lease should include the process to be followed at redelivery from the initial planning meeting some 12 to 15 months prior to redelivery through to the presence of lessor’s representatives at the end of lease check.

EXTEND OR RETURN?If the airline is a decent credit, lease extension is frequently the best scenario.

Where rates and credit permit, lessees are advised to extend leases as rates are softening a little as a result of copious supply and competitive pricing. IBA estimates that 85% of transitions we currently advise on result in extensions.

The main caveat to any extension is the airline’s current performance. If there is an increase in credit risk, it may be more prudent to enforce a return. Years ago, much more effort was made to exploit regional demand shifts but that happens much less today. There are a number of interesting geographies

Aircraft Leasing Challenges Phil Seymour, chief executive of IBA, shares some advice for lessors dealing with the daily challenges of aircraft operating leasing.

“There is a general trend for the larger lessors to manage fleets in-house, some lessors with large fleets have deliberately followed an outsourced model with the aim of in-house resource being 100% focused on front-office activities.”Phil Seymour, CEO, IBA

The 787-9 is now being delivered by lessors

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OPERATING LEASING OPERATING LEASING

currently worth considering. Iran is on the map of more adventurous lessors. India is showing strong signs of recovery and China remains attractive despite the increasingly clear signals that growth is slowing.

The economic environment and credit worthiness of an airline can change rapidly, which means lessors need to ensure that their airline credits are reviewed, not just at the outset, but throughout the lease. Such due diligence has to be balanced against the lessee’s rights to quiet enjoyment but there have been instances where airlines initially have OEM support programmes in place with maintenance outsourced to a major, very capable facility only to find that a few years later the airline has reverted to lower-cost options for support. Assessing the practical capabilities of the airline management, and not just the financial reports, is essential. This can only be done by properly using the inspection rights contained in the lease and using the visit as an opportunity to meet the lessee team and build a robust rapport.

Within analysis of the likelihood of re-lease, the variety of criteria that impact demand, including aircraft type, age restrictions and regional demand, must be evaluated.

As in most businesses, investing in a relationship will bear fruit. Many airlines and lessors that have excellent reputations for “doing the right thing” and this allows them access to the best deals as both sides are trusted not to cut corners.

There are examples of sharp practice across operating leasing, both by lessors and by operators looking for a short-term gain. New and less experienced lessors are unfortunately most at risk from practices such as: discrimination by the lessee in respect of engine shop visit workscopes, SB incorporation and AD compliance, repeat inspections on structural repairs and a number of other issues, all of which may impact remarketability and long-term value.

REDELIVERIESRedeliveries are a hugely labour intensive exercise with high cost of making mistakes. In 2015, IBA estimated that inefficient redeliveries

and concerns around cashflow. Long-term forecasts for air traffic are strong and 2015-16 financials for airlines are generally upbeat, driven in no small part by the low price.

It is not just the assets themselves that provide early warning signs and critically, lessors do not want to hear of bad news from the operator first, which will likely be too late to act to salvage the situation. Other areas to monitor, or to have monitored, include:

• Financial reporting, business plans• Press articles• Peer networks, other lessors and

financiers• Key staff changes• Route changes and cancellations• Records & maintenance systems

issues• Economic & regulatory changes• Order deferrals

REPOSSESSION, THE NUCLEAR OPTIONAviation asset management, like all investments, is not without risk and should the prospect of recovering an aircraft emerge, there are some very important steps to take.

For lessors already be in the throes of an aggressive repossession, it is perhaps unhelpful to hear that the easiest way to smooth the path is to plan contingency measures well in advance and map and manage risk carefully. Key strategic factors to consider include:

• Does the Cape Town Convention apply?

• Where would the lessor fly the aircraft to? How secure will that be in terms of storage while the lessor, for example, paint it or conduct basic maintenance.

• What type of aircraft is being moved? A single-aisle aircraft is far easier and more practical to remove than a twin-aisle aircraft, especially one with four engines.

• What is the influence of unions and/or the likelihood of corruption?

• How robust is the legal system and does the lessor have links to local law firms that can ratify judgements?

Every repossession is different. The quickest one IBA has been involved in is

cost airlines an average of $1.7 million per narrowbody. While costs are often borne by the airline, botched redeliveries also negatively impact lessors, by tying up cash, frustrating the next customer or missing an opportunity to remarket. When remarketing, a large network of potential buyers is clearly required to be maintained to maximising chances of a sale.

Planning for redelivery and discussing whether an extension is preferable to a transition should start in earnest 12 months out from the return date. The sooner lessors speak to airlines about the transition the better.

Transition costs are inescapably high. Once you have prepared an aircraft for its next operator it is not unusual, on a twin-engine widebody aircraft, to spend up to $15 million on maintenance, fit out and paint.

The lack of engagement by the lessee until only a few months away from redelivery remains the primary cause of delays, frustrations and additional costs for the lessee and lessor at such a critical time.

This stage of an aircraft life cycle is not always negative. A lease expiry may be an opportunity to enhance value by performing weight and thrust upgrades plus other OEM configuration enhancements and even interior layout changes that improve the long-term value of the aircraft.

WHEN THINGS GO BADThere are four states of operating leasing:

48 hours, the longest was over 18 months as we played cat and mouse with union staff as they kept moving the aircraft to a different hangar slot to that stated on the court papers, denying us access to the asset.

Geography can be a large determinant of progress but it important not to generalise. IBA has pulled aircraft out of jurisdictions with high-profile corruption and union concerns in three days and had planes stuck on tarmac for weeks in seemingly friendly jurisdictions.

In practical terms, the steps to typically take are:

1. Agree with advisers that repossession, rather than alternatives such as payment holidays or lease renegotiation, is truly the best option. It is always expensive, often difficult and frequently laborious. While emotionally it can be immensely satisfying to go and grab the asset, lessors must consider if it is the best allocation of spend – depending on due maintenance, repossession and return to service costs can vary considerably from $1.5 million upwards – and where the aircraft will be placed next.

2. Where is the aircraft and are the titled engines on it?

3. At the first sign of trouble, a delayed payment for example, get eyes on the asset and the records scanned.

4. Access to the airway can be challenging. One technique deployed successfully is to book a flight on the contested assets and serve papers once passengers have disembarked. Have sympathy for the crew, on more than one occasion, negotiations with the pilot have been tense over ramifications of the seizure back home.

5. Mitigate union and airport staff influence. Whether it is criminals looking to steal components or union reps keeping records as leverage to recover three months salaries for their staff, it is vital to secure the aircraft and records.

6. Records are a key focus. While it is not quite true that an aircraft without back-to-birth records are

1. Lessor getting paid and the aircraft being looked after: clearly the ideal state one that requires the least monitoring though one should remain alert for danger signs between regular inspection visits, such as falling utilisation and removals of serviceable engines.

2. Lessor getting paid but aircraft maintenance ignored or grounded: When this is happening, send a team to monitor the fleet and records and consider putting an ongoing presence on the ground to monitor any attempt to create a “Christmas Tree”.

3. Lessor not getting paid but aircraft looked after: This happens when an operator has enough cash to fly and generate revenue, but is not paying you. Get on top of the issue; are there reserves? Might some short-term arrangement on deferrals stabilise the situation?

4. Lessor not getting paid and aircraft at technical risk: Red alerts all round. Implement some of the options above and also begin to explore the logistics of repossession.

The anticipated and planned for return of aircraft is complex, time consuming and often expensive. When lessors are facing unplanned returns or a hit on residuals as assets are grounded, mistreated or damaged, the ability to respond quickly is essential.

Much more likely than deliberate corner cutting are operational challenges

worthless, it can be enormously time consuming to reconstruct records. As mentioned above – have records scanned or digitised where possible.

7. Check that there is an umbrella contingency insurance policy in place.

In summary, here are IBA’s best practices for fleet management:

1. Implement an appropriate asset management programme.

2. Base the level of oversight on the specific transaction and the risk/reward profile, BUT continuously reassess and stay pro-active and flexible.

3. Obtain all the data possible, and read it, analyse it, ask the lessee questions about it. Always be looking over the horizon.

4. Always have a contingency and remarketing plan in place, but understand the costs involved with transition and remember that a repossession will not always give the best outcome

5. Be proactive. If a potential problem arises the best place to be is on the ground with the lessee.

6. Be prepared to play the long game, and sometimes to throw away the rule book to advance the situation.

7. Relationships built in country and with the lessee’s key personnel will pay off. Get the best advice in country.