Financing Freighters

Understanding fundamentals of aircraft financing
helps in assessing present and future markets

Stephen Rimmer, Guggenheim Partners

To address freighter aircraft financing accurately, it is necessary to look at the broader aircraft financing market and focus on the issues affecting the freight sector particularly.

Before addressing present and future markets and the changing opportunities for the world's freighter fleet, I believe it's important to understand the fundamentals of aircraft financing as well as the specifics.

Aircraft financing comes in many forms - debt through public or private banks; finance lease; tax lease; and operating lease.

Debt, finance leases and tax leases were the preferred methods of financing aircraft in the past, and focused heavily on the creditworthiness of the borrower, primarily the airline. Many airlines were able to access money on both a secured and unsecured basis, relying on the strength of their balance sheets. The use of tax and finance leases was also centered on new aircraft with used equipment considered less attractive to the finance community. Those unable to access, or for fleet planning reasons, did not want to take on the full recourse fundamentals of these structures and liquidity sources were able to fund fleet expansion or replacement through operating leases. Operating leases focus fundamentally on the asset value rather than solely on the creditworthiness of the airline/operator.

In the 1980's, 10 percent of the world's fleet was financed by operating leases and grew to 20 percent in the 1990's.

Today, more than 25 percent of the world's fleet is financed through operating leases and that share is expected to increase to 50 percent in the not too distant future. This points to a very significant shift in the funding base away from the creditworthiness of the airline/operator towards asset-based funding.

We would argue that in today's market it is, and will be, the quality and attractiveness of the asset that will be the fundamental driver of financing aircraft acquisitions.

The question, then, is what does that mean for financing freighters?

If we consider the history of the air freight market, we see a sector that once consisted of smaller airlines and operators of older aircraft. This scenario made financing aircraft challenging. The liquidity from the aircraft financing market targeted newer equipment for more established, larger and creditworthy carriers. Hence, the freighter market struggled to find financing from this traditional debt, tax and finance lease liquidity sources.

The flip side was that the aircraft employed in the freight sector cost less because they were older. So airlines were able to - and in most instances had to - finance their equipment acquisitions from cash flow.

There was limited use of complex, highly structured tax enhanced and highly leveraged financing mechanisms in the freighter sector. Because of the older age of the equipment, and the uncertainty about residual asset values, the availability of asset-based funding or operating leases was very limited.

Today we see some very different forces coming together in the air freight industry, which has prompted financing alternatives of freighters.

The onset of the just-in-time supply chain brought with it high demand for reliability, efficiency (in terms of fuel and maintenance) and regulatory compliance for the aircraft used in air freight. The demands resulted in newer technology and aircraft of greater efficiency being deployed in the market. This development, along with the increased focus on the air freight sector by major airlines and integrators with strong balance sheets, opened the door for more financiers to consider financing freighter aircraft.

When considering the financing of new freighter aircraft (747-8, 777-200 extended-range and the A330-200) for top tier operators, we're seeing more "traditional" methods being employed, with debt a large component of the total requirement.

Operating leases reflecting the trends in the passenger market are financing a greater proportion of airlines' fleets. We anticipate the trend to continue. We're also seeing more financiers move towards financing new freighter aircraft because these assets have a longer life and therefore greater long-term protection against the cyclical aircraft market.

Financing new aircraft, however, involves dealing with the manufacturers' requirements for significant progress payments made before delivery.

In most instances, this requirement results in up to 60 percent of the delivered price of the aircraft being paid before delivery. Funding pre-delivery payments, or PDPs, is no easy task since no asset exists when payments are made to the manufacturer. Hence, PDP financing has become the domain of a few bank lenders which are able to find their way through the complexity of the risk issues involved.

Having financiers become comfortable with financing new assets is not going to answer all of the requirements of the air freight industry.

New aircraft are only part of the solution to the capacity demands of the air freight industry.

Passenger-to-freighter conversions will continue to provide the majority of replacement and growth capacity. Calls for efficiency, reliability and environmental constraints have prompted a move toward converting newer aircraft. This factor alone has helped the financing sector take a more positive view of financing converted aircraft.

If one can obtain feedstock aircraft for conversion - given the extended use of passenger aircraft due to new aircraft order backlogs and program delays - the challenge becomes finding available freighter conversion slots. Financing a used aircraft also is difficult because of the technical challenges associated with conversion and because it requires a change-of-use requirement.

The financing community typically doesn't like to see a change-of-use investment because it can represent between 70 percent 100 percent of the aircraft acquisition costs. Financiers are also wary of the technical risks that go with a passenger-to-cargo conversion.

Financing might be available for the acquisition of the passenger aircraft or for the converted freighter, but not during the conversion process because the aircraft is without a valid certificate of airworthiness because of the modification taking place.

Even seasoned aviation financiers and lessors don't fully understand the risks associated with conversion. Consequently, they might not want to participate in the funding process. This situation is exacerbated because the conversion provider requires payments before, during and at the end of the modification, increasing the cash liquidity demands of the airline operator or lessor.

The number of lenders and lessors that currently participate in the financing of freight conversions is limited. That means the liquidity tends to go to those operators and lessors perceived to be the best risks and to finance the most favored assets, including the 747, 767, 757 A300-600.

Financing the freighter fleet is becoming more commonplace among financiers and lessors. But in today's uncertain times, the mantra in the finance business is to keep things simple and choose the most attractive assets.

Stephen Rimmer is senior managing director of Guggenheim Partners. He also founded XS Aviation, an aircraft investment management and advisory company, and has been involved in aircraft and engine trading activities for over 29 years.