Aviation Report: Aero Engine Leasing
There is no doubt that spare engines are essential to the smooth running of airlines. However, in an economic world blighted by recession, these expensive commodities are often considered ‘deadweight’ on the balance sheets of carriers, on standby for most of their lifetime and yielding little or no direct return.
But what if there was an alternative, whereby airlines could have spare engines at their immediate disposal without the heavy costs weighing down their budgets? The answer, according to Phil Seymour, president of International Bureau of Aviation (IBA), lies in aero engine leasing.
Since its inception in 1988, the independent aviation consultancy has provided a wide range of support services to major players in commercial aviation. Indeed, the valuation of aircraft, engines and aircraft spare parts have become popular services for IBA, growing into more general advice on due diligence and company valuations during aviation-related mergers and acquisitions.
With all this experience behind him, Seymour is a strong advocate of aero engine leasing as a practical and cost-effective solution to the ‘spare engine’ dilemma. “The engines we are talking about vary in value from around US$6 million up to $20 million for the larger versions,” he states. “Keeping such a high amount of cash locked into spare engines just does not make sense.”
Whereas aero engine leasing used to be a service largely catering to smaller airlines, the giants in the aviation world have quickly cottoned onto its benefits as a way of increasing liquidity.
“An airline with, say, 50 B737NG aircraft of between 5 and 10 years old may require approximately 10 to 15 spare engines to cover the scheduled overhaul programme,” states Seymour. “That could equate to $100 million of spare engines, so why keep such amounts on the balance sheet as assets?”
If a healthy bottom-line is not enough to convince the most traditional of airlines, the numerous other benefits may well swing the balance. Due to the diversity of today’s market for aero engine leasing, lending agreements tend to be flexible and reasonable. Not only do the lessors cater to a wide range of engines and aircraft models, but also provide a flexible range of leasing options – short-term, medium-term, long-term.
Unlike the aircraft market, as Seymour points out, the engine market is still a much closed specialist arena, with independent lessors and OEMs (Original Equipment Manufacturers) controlling around 80% of the leasing market. “Most engine lessors have a relatively high amount of technical expertise, either within their organisations or available to support them as and when their own engines require refurbishment,” he says.
As one of the world’s largest aero engine lessors, Engine Lease Finance Corporation (ELFC) provides financial solutions for the acquisition of spare commercial aircraft engines to international airlines and MRO agencies, with an impressive portfolio of over 240 managed engines.
The company’s core business is the provision of long-term operating leases typically of 5 to 10 years duration and the supply of engines for short-term leases on a monthly basis. At times, the company bundles together a package of engines and leases and, together with co-investment from one or more of its partner companies, places them into a jointly owned special purpose company, managing the resulting investment vehicle for the benefit of the co-investors.
“Engines are a popular asset for such investment vehicles because of their relatively strong value retention (assuming they are tightly managed) and the fact that they are a ‘medium-ticket’ value asset, assisting in the spread of investor risk across a larger community than higher-value aircraft, for example,” explains Jon Sharp, president and CEO at ELFC.
As Sharp points out, the off-loading of any residual value risk to the lessor is extremely important for the airline. “Our business model assumes that we will invest in an engine and hold it for a notional 15-year period, during which time it will be leased to several airlines,” he says. “This means that we can bridge downturns in the economy and choose to liquidate the engines when economic conditions are favourable, a luxury of time that an airline exiting a fleet of a given type does not have.”
Sharp founded the company in 1989, when a new engine cost in the range of $3 million to $5 million and the growing complexity and size of engines was driving the cost even higher.
“That consideration is even more imperative today, with the very largest engines costing over $30 million dollars each and so the cash saving to the airline through leasing is considerable,” he says.
Twenty years ago, he estimates, less than 10% of the worldwide fleet of spare engines were leased, whereas today the number is most likely over 20% and growing.
“Much of that growth comes from the OEMs through the various maintenance packages they offer, many of which include spare engine support.”
The engine leasing division of GE Capital Aviation Services (GECAS) is specifically focused on providing spare engine solutions to airlines and MRO facilities in the region.
“We are very active in supplying short-term engine leases for all the engine types we have, entering into long-term operating leases and financing spare engines for airlines,” says Roger Welaratne, senior vice president of marketing, asset management group at GECAS. “This can be for any new spare engines that airlines are buying to support their fleet of aircraft and for existing spare engines to help airlines manage their cash flow and their strategy for holding spare engines over the long-term.”
For airlines in the region, the decision on whether to buy or lease is an individual one. “The airline will only take the engine for the duration of the need that we have to assume is planned. If the plan changes, there is flexibility to extend or in some cases shorten the term,” says Welaratne. “Since the lessor owns the engine, the airline does not need to put equity down, so it is easier on cash flows and there is no exposure on future residual value.”
Last year, the engine leasing division of GECAS executed a deal with Dubai-based Emirates for the purchase/leaseback of eight GE90-115B engines for the carrier’s Boeing wide-body fleet. This was the first engine leasing deal consummated between the two companies.
“Airlines in the Middle East have traditionally been owners of spare engines, but we now see a gradual shift to leasing,” Welaratne says. “The region has a large new account order portfolio along with a spare engine order backlog, so we believe a significant portion of these new orders will be financed under purchase and leaseback type arrangements.”
Emirates is certainly not the only airline to have jumped at the chance at engine leasing. “The main benefit of leasing is it provides spare engines without tying up the airlines capital,” says Abdulkarim Yousif AlAwadhi, director of aviation asset management for another leading Middle Eastern airline, Gulf Air. “This is especially beneficial during difficult times such as the global financial crisis.”
The airline itself currently has eleven spare engines, nine on long-term leases and only two directly owned. For Gulf Air, the flexibility of having spare engines available at short notice is a huge bonus. “There is always a guarantee that a spare engine will be available at any point in time and this is crucial when faced with unforeseen circumstances,” says AlAwadhi. “Another advantage to leasing is the option to exchange or return an engine it if its performance isn’t up to the mark.”
Indeed, IBA’s Seymour believes that during the recent economic downturn, many airlines have avoided sending engines for overhaul.
“This may be because the airlines want to keep these high-value assets off their balance sheet or to support additional spare engine requirements when they are facing a peak of engine overhauls and need short-term leased engines to keep the aircraft flying,” he explains.
“Of course at some point the overhaul will need to be performed but, at a time when ‘cash is king’, it is important that airlines use a balanced approach to such expenditure,” adds Seymour.
As well as cost-savings, many airlines find that leasing arrangements are generally much more flexible than outright ownership.
“Airlines can plan the phase out of aircraft and spare engines more exactly and can better match their total aircraft seat capacity by engaging in leasing of aircraft and engines,” says Paul Da Vall, senior vice president, Aviation Investment Management at DVB Bank, one of the leading specialists in international transport finance solutions.
Da Vall is anticipating that leasing will become much more popular than ownership, as airlines look to use their own capital in running their businesses during these difficult economic times.
“Firstly, it enables airlines to reduce the amount of their own capital that is tied up in the ownership of assets,” he says, echoing the views of both Seymour and Sharp.
“The airline industry is an unusually capital ntensive business given the very high cost of aircraft and spare engine assets. By reducing their capital employed in the ownership of these assets airlines can significantly increase their overall return on capital.”
DVB Bank is also engaged in financing of spare engines on behalf of a number of clients around the world. "Typically the bank will provide loans to airline companies directly and to engine leasing companies, to enable them to acquire their spare engines in support of aircraft fleets,” explains Da Vall.
In total, the bank has provided financing for 67 spare engines to 27 airlines. Among its clients, DVB finances a spare engine with Jazeera Airways in support of its Airbus A320 aircraft fleet.
With the maturation of the engine leasing sector, the market has become very competitive. “Airlines do have a better understanding of the merits of leasing, cost certainty, residual risk exposure and flexibly, thus optimising the solution they need,” says Welaratne.
Others factors in the current aviation market also come into play – the increased number of aircraft being taken on lease for instance, and the move towards twin-engined aircraft.
But at the forefront of the future success of this aviation niche, lies a common-sense approach by the airlines to protect its bottom-line.
“There has been an impact since the airlines have become more focussed on cash preservation and more efficient ways of financing their aircraft and engines,” says Seymour. “Engine leasing provides a useful weapon in the battle for survival and hopefully growth in the future.”
Three global giants form a joint venture company to invest in commercial aircraft engines subject to leases with airlines worldwide.
Earlier this year, DVB Bank, Mitsubishi Corporation (UK) and Engine Lease Finance Corporation (ELF) formed an engine leasing joint venture, Deucalion MC Engine Leasing Limited.
“The company completed its first portfolio acquisition in December 2009, with the purchase of seven commercial aero engines on lease in Europe, the Middle East, Asia and the Americas,” shares Paul Da Vall, senior vice president, Aviation Investment Management at DVB Bank. ”There are now 24 aircraft engines in the two vehicles, on lease to 18 airlines around the world.”
A typical case of aero engine leasing is when airline orders its engines, both installed and spare, usually done separately from the ordering of the host airframe.
“This may involve a lead time of two years and during that time the airline will need to make pre-delivery payments and a final payment when the engine is delivered,” explains Jon Sharp, president and CEO at ELFC, one of the world’s largest aero engine lessors.
“It will turn to ELFC and enter into a forward sale and lease arrangement, whereby ELFC effectively takes over the engine order and makes those payments.”
Once delivered, the engine becomes the property of ELFC and is delivered to the airline that starts paying lease rental (usually on a monthly basis) as it would for an aircraft.
“The lease will also contain arrangements for paying for hours and cycles used on the engine, either on a pay-as-you-go basis or as compensation at lease end. The fees so collected are contributed to engine overhaul when required,” he continues.
During the term of the lease, the airline has control and custody of the engine, which will be treated the same as others in its fleet.
The new company currently has one engine on lease in the Middle East with Etihad Airways.
“It is used as a spare engine in support of Etihad’s Airbus A320 fleet, whereby it is put on wing when another engine needs to come off for maintenance,” says Da Vall. “This way the aircraft is able to continue in operation during such routine engine maintenance.”