2.4 Financing and Accounting Issues
2.4.1 Financing
recession of 1990–1991) through a decade of the longest US economic expansion, it is probably atypical.74The terrorist attacks of September 2001 and the fuel price spike in 2008 temporarily moved the ratios into abnormal positions.
2.4 Financing and Accounting Issues
high-cost source of funds as compared to debt, which enjoys tax advantages. Export credit agencies, established by governments, provide support for exports but lack the financing flexibility and relative ease of bank financing. However, bank financ- ing is rarely longer than 12 years, which is much shorter than an aircraft’s useful life. Tax leases, which are used to lower the cost of financing by transferring the tax benefits of owning an airplane to companies that find such benefits even more valuable, require complex arrangements. And operating leases, which are regularly used as a source of funds, have their own distinct intricacies.
US carriers in particular have come to rely on the debt capital markets as a major source of funding. They finance aggressively through debt issuance when interest rates are low and they sell equity or convertible debt when the equity markets favor the company’s shares with a high price-to-earnings or price-to-cash flow valuation.
The goal is to find a mix wherein the weighted average cost of capital (WACC), including debt and equity components (or variants), is as low as possible. Without going into greater detail, the province of pure texts on finance,WACCcan be stated as
WACC¼rddebt=ðdebtþequityÞ þreequity=ðdebtþequityÞ;
whererdis the cost of debt expressed as an interest rate, andreis the cost of equity, as estimated using risk premiums and risk adjustment factors (known asbetas).
Capital-intensive transport industries also use other means of equipment finance to shift debt off their balance sheets and to gain further potential tax advantages.
Fig. 2.15 Airline industry ROIC versus world GDP growth, 1990–2014.Source: IATA,www.
liata.org/economics
Airlines or railroads, for example, often sell their equipment or have other parties buy their equipment for them in a sale-leaseback type of arrangement (the account- ing implications of which are discussed in a later section). By shifting some of the equipment-related debts and assets off the balance sheet, not only do the companies appear less financially risky to potential investors, but also they provide financial companies specializing in these areas with annuity income and tax advantages that might otherwise go unused.
Issuance of plain-vanilla common and preferred shares would be as typical a way for this industry to finance itself as it would be for any other. The same holds for convertible bonds of various flavors. But companies that have a need to finance large and expensive pieces of movable equipment (for instance, airplanes, ocean tankers, rail cars and locomotives, and trucks) have found that equipment trust certificates (ETC) are especially adaptable. Such certificates first evolved in the rail industry and are a form of secured debt, which means that the trustee, as the formal owner of the equipment, can upon default immediately repossess the equipment that has been pledged as collateral. In this structure, legal ownership is vested in the trustee (who leases the equipment to the company) and in an investor who has a claim rather than a mortgage lien.
The advantage to the company using the equipment is that it can conserve cash over the near term, making only a down payment in the range of 10–25 % of the cost of the equipment and paying the balance on a scale of maturities that could be between 1 and 15 years. Moreover, debt-ratings agencies such as Moody’s will often rate the trust certificate debt one grade higher than the company’s other debts, thereby making comparative financing through issuance of such debt certificates a little less costly.77 ETCs are often also created as much for tax reasons as for spreading risk and lowering of borrowing costs.
A modified version of the ETC, introduced by Northwest Airlines in 1994, is the enhanced equipment trust certificate (E-ETC). Such certificates are a type of debt securitization in which the plain ETC is divided up into several readily tradable pieces, each with a different risk/reward profile in terms of security and access to
77Insurers, banks, and other financial institutions may invest in equipment trust obligations or certificates adequately secured and evidencing an interest in transportation equipment, wholly or in part within the United States, if the obligations or certificates carry the right to receive determined portions of rental, purchase, or other fixed obligatory payments to be made for the use or purchase of the transportation equipment.
2.4 Financing and Accounting Issues 103
lease rental cash flows. As Morrell (1997, p. 186) notes, “a structure of this type will give the senior (lower risk) certificates a much higher credit rating than under the ETC.”78
78An E-ETC prospectus will provide a description of the numbers and types of planes to be financed, projections of annual depreciation rates, and loan-to-value ratios obtained from inde- pendent appraisals. Such ratios are used to subdivide the bonds into credit tranches, with Class A certificates having the most conservative ratios of generally 40–45 % of debt relative to appraised value as compared, say, to Class C certificates with ratios of 60–70 %. Additional variations would include callability and sinking fund features.
Lunsford and Carey (2003) explain that leveraged leases using E-ETC financing structures became popular in the 1990s. “. . .an equity provider puts up 20 % of the cost of the airplane, enabling it to have ownership of the airplane. As owner, the equity provider can get the tax benefits of depreciating the aircraft over a 7-year period. . .The remaining 80 % of the loan—the debt portion—is borne by the airline, which finances all or part of it by borrowing from investors.”
Also, E-ETCs are usually issued on a pool of around 20 or so airplanes and the A tranche of the notes carry lower interest rates than the B or subsequent tranches because the A tranche is the least risky debt as it is the most likely to be repaid. Of course, when the market sours, as it did after September 11, 2001, the 20 % equity holders would be the last to be repaid and the first to be wiped out. Many of the certificates issued in the 1990s were priced at interest rates of 1.25–5 % above comparable-length Treasury bonds for periods ranging from 5 to 20 years.
Lunsford, Michaels, and Carey (2004) write that bankruptcy filings have been used by airlines to negotiate more favorable lease terms or to convert long-term leveraged leases into shorter-term operating leases. Lunsford (2004) further describes the so-called Cape Town convention that makes “it easier for creditors to call in the repo man, even when the plane is located in some countries where that is an impossibility.” Prior to this treaty, large financial institutions had avoided airplane loans because of the risk that the collateral asset could be flown to countries with laws that shielded the asset from creditors. The reasons bankruptcies and losses have not reduced the number of major carriers is discussed in Wessel and Carey (2005). The 2011 bankruptcy filing for American Airlines is discussed in Cameron (2011) in which it is shown that American’s labor expense in cents per available seat mile was 4.1, as compared to 3.6 for Southwest, 3.4 for United/Continental, 3.3 for Delta, 3.0 for US Airways, and 2.5 for JetBlue.
According to Morrell (1997, p. 187), the first international securitization of aircraft was offered by Guinness Peat Aviation (GPA) in 1992. Fourteen aircraft valued at $380 million were leased.
Equity investors in this would get a 10–12 % return in annual dividends plus a share in any residual value from the aircraft at maturity. Until GPA ran into financial difficulties (from inadequate capitalization and overleveraging), along with International Lease Finance Corporation (ILFC) it was one of the two dominant firms in the aircraft leasing business. GPA’s assets were acquired by General Electric Capital Asset Services (GECAS) and, with a fleet of 1000 aircraft as of 2002, GECAS became one of the two major leasing firms. ILFC was acquired by American insurance giant AIG in 1990 and was sold to AerCap Holdings of the Netherlands in late 2013. ILFC added nearly 1000 aircraft to AerCap’s 373. The story of ILFC’s founder, Steven Udvar-Hazy, is described in Wayne (2007) and in Lubove and Rothman (2012). Zimmerman (2009) discusses the firm’s financing problems, and Cameron (2011), the company’s revival. Steven Udvar-Hazy subsequently went on to found Air Lease Corp. As of 2011, IFLC had 933 aircraft and 23 % share of market. See Ng and Michaels (2011).
According to Lunsford (2002), ILFC “makes the bulk of its money by renting out airplanes for the first 5–7 years of their life at rates of between 9 and 12 % of their value annually. At around 5–7 years, the companies either re-lease the airplanes or sell them on the secondary market. Mean- while, the value of the airplanes can be written down quickly, reaping big tax benefits for the leasing company.” Such lessors receive discounts on large orders for planes and make money by renting them to carriers for various lengths of time (a few months to several years) at rates that