Aircraft Finance and Asset Protection – Operators Adding Value                                 By Aoife O’Sullivan, Partne...
Increased price competition will characterize the long range business jet       market as OEMs look to capitalize on deman...
noted the effect good operation can have on the credit profile of a transactiontowards protecting the current life of the ...
undertaken a full conversion course on the aircraft and will be willing to undergoregular refresher training plus the mand...
save for the purposes of maintenance. In the event of a default under the loan   agreements, the operator can become the m...
local Aviation Authorities. Regardless of the small print in the loan documents   and the fact that the bank has a first c...
borrower to pay large sums of money he may not have anticipated. Support       programs act as a type of savings policy ag...
earn revenue income against finance: it is also about ensuring the asset is protectedto the best extent possible.Contact d...
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Aircraft Finance, Asset Protection And Operators.May 2011


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Showing how private and corporate jet operators can add value in terms of asset protection

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Aircraft Finance, Asset Protection And Operators.May 2011

  1. 1. Aircraft Finance and Asset Protection – Operators Adding Value By Aoife O’Sullivan, Partner, Gates and PartnersIntroductionThe general feeling of manufacturers at EBACE this year appeared to be one ofcautious optimism. For the 20-year period from 2011 to 2030, the BombardierBusiness Aircraft Market Forecast predicts a return to sustained growth in businessaviation, with business jet manufacturers delivering a total of 24,000 business jets inall segments in which Bombardier competes, representing total revenues ofapproximately $626bn for the industry. For the 10-year period spanning 2011 to2020, 10,000 deliveries worth $260bn are anticipated, and 14,000 deliveries worth$366bn are anticipated in the 10-year period from 2021 to 2030.Embraer have stated that they believe the market for business jets will not begin torecover from its post-financial crisis slump until 2012 at the earliest. Almost 14% ofthe global business jet fleet - around 2,500 aircraft - is up for sale, up from 12%before the crisis, as key reasons for the apparent delivery lag. Smaller aircraft havebeen hardest hit and as a result, manufacturers will reduce production in 2011 tocope; for example Embraer will cut the output of its Phenom 100 and 300 businessjets to 100, down from 126 in 2010.While industry deliveries are not expected to improve significantly in 2011, keyindicators are showing an upward trend, and it is expected that business aircraftdeliveries will continue to grow in 2012. In addition, with a widening customer basefor business aircraft - especially in high-growth economies - Bombardier anticipatesthat North America, Europe and China will be the three most active markets goingforward and will generate the most revenues over the next 20 years.Gulfstream President Joe Lombardo echoed this forecast at EBACE, saying thatGulfstream continues to see strong and growing demand from countries outsideNorth America, even as its home market in the U.S. recovers. “Although about 70 percent of sales in the last quarter were international, with about half of those comingfrom Asia, corporate customers in the U.S. are returning to the market as well,” hesaid. “Additionally, we are seeing positive market indicators, including Gulfstreamfleet hours, which have just about returned to 2008, pre-recession levels. We remainoptimistic and are committed to our investment plans, which will position us well forthe future.”Summary of Zenith Jet Business Aviation 10 Year Market Forecast (2011-2020) Total deliveries over forecast period (2011-2020): 11,103 units Total billings (revenues): $240 billion Expected compounded annual growth of new aircraft deliveries, 2011-2016: 15% A notable increase in demand for long range and large business jets will continue from emerging markets
  2. 2. Increased price competition will characterize the long range business jet market as OEMs look to capitalize on demand Order backlog levels likely to decline in short-term as manufacturers manage the alignment of their order intake and production rates Demand for light and mid-size business jets remains weak, but production levels will ramp up quickly as market recovers Opportunities exist for OEMs to develop new clean sheet designs as existing airframe platforms are increasingly unlikely to yield successful derivativesZenith Jet believes the fiercest competition between the manufacturers is mounted inthe Super Midsize segment. “Virtually every single competitor has a particular valueproposition it successfully leverages to secure market share. All six aircraft OEMs willhave a product in this segment as of 2017. The segment is arguably the moststrategic in business aviation as it occupies a “sweet-spot” where manufacturersdraw on the installed bases of several segments (up and down the segment scale) tosecure orders. In terms of unit delivery and revenue performance for the SuperMidsize segment over the forecast period, it will secure over 1,300 units andapproximately $30 billion in revenues”.Zenith Jet sees discernable regional trends taking shape over the next 10 years. “Forexample, the international market will favour primarily a wide body profile. In terms ofnarrow body demand internationally, it will be predominantly split between Cessnaand Embraer. Also, the percentage of new customers to business aviation (primarilycoming from emerging markets) will be unprecedented over the next 10 years.Regarding regional unit delivery performance, the trend of emerging marketscontributing to growth and favouring the international market for orders over theNorth American installed base will continue. Latin America, Asia, the US, Russia andAfrica will be significant drivers for growth while Europe and the Middle East deal withindigenous issues that may prevent them from realizing their true demand potential”.The Financing RequirementClearly not all buyers are cash buyers and the ability of the industry to be supportedby bank finance is essential to keep order books open and encourage secondary andsubsequent sales. Reluctance on the part of major banks and financiers to re-enterthe market has eased and we are seeing a lot of the major players open theirbalance sheets to aircraft finance again. All the major players (e.g. Credit Suisse,SocGen, Barclays, BAML, GE) were at EBACE this year and all say they are verymuch back. Some indeed, never left the market, but all in all the approach to aircraftas a credit risk was and has been very cautious and this looks set to continue. 100%non recourse financing is very much a thing of the past (and that’s no bad thing). Thetrend of private wealth banks has been to insist on the borrower placing funds withthe investment bank as a condition of lending. Leasing companies such as Milestoneare offering alternative finance structures (e.g. operating leases) and we expect moreto enter the market offering genuine finance leases (i.e. lease with a purchase option)which can have the added attraction of tax benefits and allowances.Up to recently, financiers have tended to look at aircraft finance from a repossessionor loss risk: “what happens if the lessee defaults / what if the asset is destroyed”. Theknock on effect of lessons learned through the recession is that the banks andfinanciers are taking (or should take) a lot more interest in the operation of theaircraft, training of crew, application of correct safety procedures etc. They have
  3. 3. noted the effect good operation can have on the credit profile of a transactiontowards protecting the current life of the asset through to residual value. So, goodnews for operators, you are back in demand. A respectful and on-going workingrelationship between the borrower, operator and bank should assist all three if anyissues arise and in many cases, may help to prevent such issues arising at all.What is an Operator?The operation of private and business jets tends to be divided into three separatecategories: 1. Business Aviation Commercial - aircraft flown for business purposes by an operator having a commercial operating certificate under public transport regulations and an air operators certificate (“AOC”); 2. Corporate Private - non-commercial operations by professional crews employed to fly the aircraft; and 3. Owner operated - Aircraft flown for business or private purposes by the owner of the business.The commercial decision behind the choice of the owner tends to fall on cost but alsoon regulatory restrictions. Private aircraft do not have the same restrictions as thoseflown for public transport (most notably in respect to flight time limitations and runwaylength).In terms of financing risk, there is a very real difference between all three. A validAOC and operating license is mandatory for companies offering charter flights inEurope. Similar legislation, Part 135, is issued by the Federal Aviation Administration(FAA) for operators doing business in the United States. The licenses certifycompliance with regulations, the competence of personnel and flight safety. Anoperating licence is granted if the operator shows, not only sufficient financialstrength, but also that it meets all legal requirements put in place including adequateinsurance coverage. Aircraft placed « on an AOC » will be subject to an operation ormanagement agreement, an essential term of which will be passing all responsibilityfor operational, maintenance and regulatory compliance to the AOC holder and awayfrom the owner.In all other cases, the responsibility for operation of the aircraft rests with the ownerto varying degrees. It is possible to contract the services of a private managementcompany but they will rarely take full operational risk and responsibility – they tend toact as subcontractors for various aspects of the operation of the aircraft. The owneroperated category is exactly that – the owner takes on operational responsibilityhimself and does not assign or novate that responsibility to anyone else.A genuine concern in recent times has been a trend for public transport flights beingcarried out by unscrupulous operators or owners who do not hold AOCs, contrary toregulation. The resurgence of this type of illegal charter flight caused EBAArepresentatives to issue warnings about the dangers for passengers. The EBAApublicaiton « Is my flight legal » urges passengers to thoroughly check the licensingand other information related to their flight and the company they have chosen andremind them that in the case of non compliance with the legislation by the operator,the passenger can be taking the risk of flying without insurance coverage.It is fair to say that operation of aircraft by AOC holders is not necessarily at a higherstandard. Some owner operators and private management companies will have
  4. 4. undertaken a full conversion course on the aircraft and will be willing to undergoregular refresher training plus the mandatory checks in accordance with regulation.The problem for the financiers however is that they are usually not well equipped togauge the professionalism of the owner operator and the private manager – takingthe aircraft to the AOC holder tends to be a way of relying instead on the regulatorswho issue them their licence to operate and keep them under regular audit. Bankswho lease instead of finance through loans in legal terms remain the owner of theaircraft – the borrower becomes the lessee. Allowing the borrower to operate theaircraft itself instead of insisting on using a professional management company canput the bank itself at risk – no matter how well drafted the loan agreements, somecivil and criminal liability remains strictly with the legal owner of the aircraft.For example, it is the aircraft operators responsibility in Europe to ensure thatinsurance cover, in accordance with EU regulations, exists for each flight. Theregulation defines aircraft operator as the person or entity, not being an air carrier,who has continual effective disposal of the use or operation of the aircraft; the naturalor legal person in whose name the aircraft is registered shall be presumed to be theoperator, unless that person can prove that another person is the operator.Protection Operators can give Financiers: 1. The Tripartite Agreement An increasing trend in aircraft finance has been for financiers to insist that both the borrower and the operator sign what is generally known as a “tripartite” or “multi-party agreement”. Often predicated by certain banks as “standard in the industry”, “every other operator signs it”, the tripartite agreement is a powerful document in a Banks hands and it should be taken very seriously by Operators. The Tripartite agreement is, as the name suggests, a three way agreement between the Bank, the borrower and the operator. In all cases it will seek to impose certain covenants on the operator which will usually mirror those covenants the Bank seeks of the borrower in the loan documents (e.g. to ensure their asset is properly protected and operated to a high standard). So why do operators sign these agreements? The good news is that professional operators should not have an issue with most if not all of these covenants except to note that in signing the tripartite agreement they are now contracting themselves to the Bank and not just the borrower. Breach by an operator of a covenant will not only entitle the borrower to take action against the operator, it will also entitle the Bank to take direct action against the operator. On a day to day level the form and content of these agreements should not trouble operators provided the agreement has been negotiated sensibly with the Bank and does not contain unusually onerous clauses. The challenge can be in getting both parties to accept that they need each other and should negotiate on a level playing field – without the finance, there may not be an aircraft for the operator to manage. Without the operator, the bank does not have the added protection for its asset. Importantly for the financier, the operator will be the person in possession of the aircraft at all times – the AOC does not allow them to part with control
  5. 5. save for the purposes of maintenance. In the event of a default under the loan agreements, the operator can become the most useful person in the room to a financier wanting to move the aircraft quickly to a safe and secure location away from an errant borrower.2. Pre purchase process A pre purchase inspection (PPI) should be part of any sensible acquisition process. Incredibly, financiers do not always insist on this, nor do they even seek sight of the report. The PPI report will highlight any issues with the aircraft and will indicate any previous maintenance or damage history. Most good operators will have the facility on hand to carry out the inspection – it is in their vested interested to get the PPI right as they will otherwise have to deal with the issues on that aircraft doing the course of management. Operators will have teams familiar with different types and models of aircraft and in many cases will bring a lot of previous experience and insight to the PPI process.3. Insurance cover On 30th April 2005, EC Regulation EC 785/2004 on insurance requirements for air carriers and aircraft operators came into force. The Regulation was subsequently amended on 6th April 2010. The Regulation, as amended, specifies the minimum levels of insurance required by aircraft operators and air carriers in respect of third party cover, passenger cover and cover for risks of war and terrorism. It is a legal requirement that aircraft carry this cover. Keeping the premiums up to date is essential to ensure compliance with regulation but also to ensure the liability of the owner and the financier is protected. Many operators offer what is known as “fleet policy” insurance. The operator takes out a policy and aircraft under its management can be added to the policy. Due to economies of scale, the operator may be able to obtain better premiums and more extensive coverage that that available to an owner under a single policy. Operators have a vested interested in keeping the insurance cover current as they themselves are covered in the event of a loss and in many cases the fact that they were the operator at the time of a loss will mean they will be implicated in any claim. There is no benefit to an operator withholding premiums or putting insurance at risk. For Banks this is an important issue – many borrowers who are heading into default will often stop paying everyone else before the bank becomes aware there is an issue. Financiers tends to rely on brokers letters of undertaking which promise to inform the bank if the owner stops paying premiums or if the insurance is about to lapse – the security risk however is that the broker is not legally bound by such letters and in any case the letter may arrive too late. Better to rely on the operator’s policy in such case.4. Taxation and charges, liens and detentions The world of aviation is fraught with taxes and charges. Non payment of such taxes and charges can result in an aircraft being grounded by the relevant authority until the charges are paid. Examples of bodies having the power to exert such statutory liens include Eurocontrol, Revenue and Customs and
  6. 6. local Aviation Authorities. Regardless of the small print in the loan documents and the fact that the bank has a first charge on the aircraft – the aircraft will quite simply not be released until the charges are paid. Operators who run a professional operation will have systems and procedures in place to ensure such charges are paid in a timely manner. Following the change in VAT rules this year as they apply to aircraft imported into Europe, many member states of the EU will recognise AOC holders as having the right to import an aircraft into the EU at the same 0% rate currently afforded to airlines. The 0% rate is permitted where an aircraft is imported and used by an airline operating for reward chiefly on international routes. This rate is not afforded to private individuals importing the aircraft for their own use.5. Professional management and safety Operators are now required to run a safety management system (SMS) which should benefit safety performance in the long run. The relevant standard is laid out by the International Civil Aviation Organisation in Annex 6 Part 2. This states a requirement for operators of business aircraft with a take-off mass of more than 5,700kg (12,500lb) to run an approved SMS. The system is one of reporting issues and taking steps to resolve them – operators are trained and kept regularly updated. Any good operator should have a strong SMS system in place and the financiers should satisfy themselves that the systems work and are respected. Many operators will have taken the issue one step further and will have put in place emergency response plans (ERP) which are effectively procedures the operator will follow should an emergency happen. Evidence of an ERP in place should let the financier know that the operator takes safety seriously and has trained its management and staff in responding to any issues. For example, even basic media training can prevent mistakes being made – the press today picks up almost in real time where there has been an incident. The threat to the financier is that if any misinformation is given to the press, the resulting investigation may be affected or delayed which will have a knock on effect on any insurance pay out. Operators who have systems in place protect not only their own business and reputation but also that of the financiers.6. Warranty claims and Support contracts Part of the value attributable to an aircraft will be the residual life left in any manufacturer or supplier warranties and whether or not it is supported by any programs such as CAMP/Smart Parts etc. In the event of a warranty claim, the insight and expertise of an operator can be invaluable to a financier in assessing the merit of a claim, what should be covered and how to progress the claim with manufacturers and suppliers. Such claims are complicated and are best left to those experienced in handling them. In terms of support contracts, operators tend to name themselves on the programs where the aircraft is under their management – as part of their service, they will ensure the service programs are kept current and fully paid up. If for example an expensive engine overhaul is required, the contributions made over time to the support program will be used instead of requiring the
  7. 7. borrower to pay large sums of money he may not have anticipated. Support programs act as a type of savings policy against such large maintenance items and should be kept current – hiring a professional operator to do so will alleviate any concerns of the financiers in this regard. 7. Maintenance oversight The operator will provide maintenance oversight to the aircraft which is extremely important in terms of protecting its residual value. All aircraft have scheduled and base maintenance requirements and operators will usually be happy to assume responsibility to ensure these requirements are met. A well- maintained aircraft will always have a higher residual value than one that is not. Well-maintained however does not necessarily mean just compliance with regulatory standards – the regulatory standards establish the baseline for airworthiness. Airworthiness is related to safety, not value. Being well- maintained means more than keeping up with the required inspections and component overhauls. It means the aircraft has its equipment in functioning order, non-critical wear and tear items are taken care of, and cosmetics are protected. Who maintains the aircraft is vital to the aircraft value. The MRO (Maintenance, Repair and Overhaul) facility must have the knowledge and skills to perform the required maintenance, and when necessary, troubleshoot and repair the aircraft. 8. Aircraft and record protection According to Conklin & DeDecker, the aircraft maintenance records not only need to be a true and exact representation of an aircraft, they are also the written proof as to the quality of the maintenance. This is the tool to use to communicate the health of your aircraft to your maintenance staff, MRO, and any future buyer. If things are well-documented and thorough, it gives the inspector confidence in the aircraft. If the records are sloppy, but technically correct, the inspector will assume the aircraft is technically airworthy, but not be in as good a condition as it could be. Missing and incomplete maintenance records call into question even the basic airworthiness of an aircraft. If the aircraft has damage history, a well-documented explanation of the damage and repairs can minimize the negative effect of the damage on the aircrafts value. This information will also be invaluable in the event of any loss or damage to the aircraft and in bringing a claim against the insurers. Hiring an operator who has the correct facilities to safely and secure the aircraft records and to ensure they are kept up to date and complete will protect the value in the asset.ConclusionConcentration by financiers on the operation of aircraft is a welcome change. It is inevery party’s interest to have an on-going working relationship so that any issuessurrounding the operation of an aircraft is quickly addressed. Hiring an operator tomanage the aircraft should not be about the ability to put the aircraft to charter and
  8. 8. earn revenue income against finance: it is also about ensuring the asset is protectedto the best extent possible.Contact details:Aoife O’SullivanPartnerT: 0844 692 4966M: 07709 432 350F: 0844 692 4901E: aosullivan@gatesandpartners.comGATES AND PARTNERSSolicitors5th Floor, Capital House85 King William StreetLondon EC4N 7BLTel: 0844 692 4900Further information is available from our website at