On Aircraft Lessors

In March 2020, when the world was immersed in the lockdown nightmare, it looked like Aircraft lessors were the ones who were most exposed. Airlines did not have money to pay - they could declare default on leases or dive into insolvency. OEMs may have had some difficulties, but they were in a way protected by the predelivery payments from lessors and airlines. Aircraft lessors, being in the middle between airlines and OEMs, had to take the toughest hit. However, looking at today’s position, it seems that the lessors managed to navigate through these dire times with minimum losses. I believe the root cause of lessors’ performance is in their complex business model; capability to facilitate the needs and interests of aircraft owners, investors, OEMs, and airlines. In regular times, lessors are exposed to various risks and conflicts of interests that inevitably accompany their gains; however, lessors manage to mitigate these risks quite successfully.?

The pandemic drastically changed the lessors’ risk landscape and exposure. Despite that, lessors did not become too conservative or rejective; on the contrary, they demonstrated their ability to build bridges and cooperation chains with other stakeholders; sometimes even compromising (temporarily) their interests. Perhaps in the middle of the pandemic, it is too early to look at lessors’ actions and moves and make judgments. It’s also too early to conclude what could be done better. In this article, we study and discuss key competencies of lessors in regular times; their roles in fleet and capacity management, mitigation of risks for stakeholders, and new products diversifying lessors’ proposition and extending aircraft’s useful life.

Fleet and capacity management

An airline’s fleet is one of its key success factors. Often airlines are unable to reach their revenue targets, satisfy demand, or able to cope with the competition due to the age, capacity, or composition of their fleets. Whilst demand can be affected by the passengers’ perception of airplanes and the appearance of cabins. Even if the airline makes large investments in the interior of the passenger cabins, it still cannot offer the features and amenities which passengers experience onboard competitors’ airplanes. It causes a loss of the competitive edge and erodes customers’ loyalty.

The pressure can be caused by restrictions imposed by the local and interstate authorities (like aircraft age restrictions, noise and emission limitations, etc.). Airline realizes that the capability of its fleet is undermined and crippled by these restrictions. Older fleets are not allowed to operate in particular destinations or such operations are associated with heavy penalties. Again, the airline may try to comply with these restrictions through large investments in the aircraft. Sometimes it helps; sometimes even large investments do not help overcome the restrictions.

Underperformance can be caused by economic reasons. The airline may realize that operation of current fleets is no longer in its favor – with less fuel-efficient and heavier fleets it loses in competition. Sometimes it is feasible to exit the competition rather than continuing loss-making operations with non-competitive aircraft. The airline cannot change its fleet overnight - and loses to competitors operating younger and more efficient fleets.

In all of the described scenarios, the operation of obsolete fleets has no future. The aircraft should be retired or moved to the emerging markets with weaker competition, where they can successfully respond to unsatisfied demand.

Another bundle of reasons which may push the airline to change fleets is related to the mismatch of the market potential and fleet capacity. The reasons may be different. Shifts in foreign policies, closing or opening borders, mistakes in market growth assumptions, popping up or disappearing transit opportunities may create imbalances between the capacity and increased or decreased demand. The most obvious response to such changes could be in the increase or decrease in frequencies of operation. This solution works to a certain extent. In the case of demand growth, the increase in frequencies can be limited by the number of allocated airport slots. In the case of a drop in demand, a reduction in frequencies may affect flight connections and cause an outflow of passengers to the competitors or their shift to other modes of transport. The airline has aircraft but cannot operate them efficiently. As time flows, airline exposure grows. The airline either loses revenue due to unsatisfied demand or, on the contrary, accumulates losses when demand is thinner than planned.

Airlines face similar difficulties when, as a result of poor fleet decisions or a merger with another airline, it has to operate a mix of different aircraft types. Such stretch in the number of fleet types affects the economic performance of operations. The airline has to keep an extended inventory of parts and components, support training and rating for crew and engineers for multiple types, etc. Eventually, the airline realizes the necessity to narrow down the number of aircraft types in operation.?

In each of the above examples, the airline has a fleet that does not match the market demand, conditions, and growth potential. The airline has to make serious changes in the fleet to adapt to the market demand and capacity. Lessors can help the airline with this. Lessors can arrange it as a planned and systematic process of fleet renewal when the airline returns older fleets and takes on lease the new ones. Or it can be done as a trade-off – the airline sells older fleets to the lessor and leases or purchases newer fleets from the lessor.???

Lessors have the necessary skills and resources to arrange the placement of the aircraft returned by airlines with other customers or sell them to the other lessors. Returned aircraft can be placed in the countries that have lax fleet age restrictions; shifted to a region with less stringent certification requirements; reconfigured and placed with other operators.? In this regard, lessors are great allies of the airlines, taking over all the troubles of reconfiguration, conversion, and remarketing of the aircraft.

Lessors help stakeholders in risk mitigation

Let’s assume an airline places a large airplane order with an OEM. The OEM is then exposed to significant risk. If the airline (even the strongest and the most reputable one) orders hundreds of aircraft, such an order, from the OEM perspective,? creates a significant concentration of risks. Even if deliveries of aircraft are distributed over several years, any adverse circumstance affecting the airline shall disrupt deliveries and affect the OEM. Various reasons and circumstances (which are beyond the creditworthiness or the airline risk profile) can affect the airline’s performance. Abrupt growth of political tension between the airline’s home country and the major country of its operation (up to the ultimate termination of flights) can be one of the reasons. It can be economic and political turbulence in the home country which affects the capability of passengers to travel. It can be the closing of multiple markets due to force majeure circumstances (which we observed on a global scale).?

Of course, the OEM and airline can work out solutions and reschedule deliveries until better times. However, any cancellation of orders can seriously affect the OEM.?

Even before that happens, lessors step in between the OEM and the airline, purchase part of the ordered fleets and lease them to the airline. The latter allows the reduction of the OEMs’ risks. It also gives additional comfort to the airline since it diversifies the sources of fleets and, with the Lessor in the game, has more room for maneuvering in the deliveries schedule or any required changes in the types of the aircraft. With the lessor in the picture, it also reduces the airline leverage. The airline does not need to attract an enormous amount of debt to acquire the same number of aircraft.

Lessors also help airlines address their liquidity challenges. In their dialogue with lenders, the airlines have to demonstrate three things: sound cash flow which allows them to repay borrowed amounts; significant equity contribution (skin in the game) and satisfactory security (liquid assets with the appraised value higher than the amount of attracted debt). Quite often the airline has two things in place; the situation when it has all three is unique. Without having all three, it is quite difficult to attract financing and implement fleet growth plans. The combination of purchasing and leasing the aircraft enables airlines to improve their liquidity. Improved liquidity helps the airline attract additional debt financing.

Lessors can assist airlines in resolving an intrinsic controversy between the operating company and its shareholders. Operating companies strive for growth - to do this, they need to attract more capital and use it to grow their fleet. The shareholders are balancing between reaping the rewards of such growth from the company (through the dividends) and reinvesting profits with the hope that the increased market capitalization will increase the value of their investment. The situation gets even more challenging when the airline approaches the shareholders with the request for additional capital to address its liquidity issues. Such additional investment increases the potential exposure of shareholders (even if the risk level does not change). Leasing aircraft from lessors allows airlines to boost their capacity without putting an additional burden on the shareholders.

Lessors’ risks and diversification of product portfolio

Lessors are exposed to various risks in their business activity and they dedicate a lot of effort to analyzing and mitigating these risks. Traditionally, lessors assess their external risks in two major dimensions: country-wise risk and airline-wise risk. For each country and each airline, lessors establish a certain threshold of exposure that should not be exceeded. If a lessor is approaching this threshold, it can reduce exposure by selling the aircraft with the lease attached.?

Large lessors have to deal with country risks when they lease aircraft to countries with relatively small airline sectors. A large share of lessor assets in the entire aircraft fleet in the country can become a subject of attention for anti-trust regulators. To comply with these anti-trust regulations, lessors have to reduce their share through the sale of some aircraft placed in this country to the other lessors.

Lessors can use sale and purchase transactions for entering new markets and gaining new customers. They can purchase aircraft or a fleet of aircraft operated by a certain airline or in a particular country. The latter allows them a seamless entry into a new market or the gain of a new airline customer.

Buying and selling assets help lessors maintain their fleet age policy. If the lessor is primarily specialized in new Aircraft, it usually sells the aircraft with the lease attached as soon as the aircraft reaches a certain age. The buyer of such aircraft is usually a lessor that is specialized in mid-life assets. This lessor takes redelivery of the Aircraft from the first lease and places it in the second lease. When the aircraft reaches its age limit for passenger operation, the lessor sells the Aircraft for cargo conversion or tear down.

Lessors can easily diversify their line of products through mergers with other lessors specialized in other market segments or through investments in the adjacent market segments.

For example, a pure aircraft lessor can acquire a fleet of engines with leases attached from an engine lessor and enter the segment of engine leasing. The lessor can invest in the development of freighter conversion STC and take a lead in the segment of freighter aircraft leasing. The lessor can also choose to tear down the end-of-life assets from its fleet and enter the market of spare parts and components trading.

Some lessors take another step forward and create strategic units for consulting services. Such units assist airlines in articulating their strategy and making coherent fleet decisions. Furthermore, these consulting units help lessors understand the risks of their airline clients and assure that airlines make the right decisions regarding their fleets. Active participation of lessors in formulating strategy and fleet policy of their lessees reduces lessors’ risks.

In this article, we looked at some aspects of Aircraft lessors’ business and concluded that it is not just purchasing aircraft and putting it on lease with airlines. The scope of products and solutions which lessors offer creates a complex and exciting landscape.? Lessors are key players in renewing, expanding, and evolving fleets of airlines. They play an important role in shaping and re-distributing risks between stakeholders in the aviation community. Lessors have tools for mitigating and redistributing the risks within their own (Lessors’) community. Finally, Lessors’ business model allows them to diversify their range of products, add, combine and vary leasing, trading, and consulting services. With more than 50 % of the world’s fleets of aircraft on lease from lessors, their contribution to the sustainability and growth of the aviation industry is vitally important. The role of lessors, thus, cannot go unnoticed in this rapidly changing landscape of the aviation and airline industry.