COVID-19: What next for aviation finance and leasing?

COVID-19 has had a tremendous effect on the aviation industry. In the months since the W.H.O declared COVID-19  a pandemic, there has been a negative impact on airline share prices, air travel, airline workforce, and liquidity of operators and lessors generally. In addition to the more apparent issues facing the aviation industry, there has also been a flurry of activity behind the scenes. Operators, lessors, and financiers are realigning to salvage ongoing lease and financing arrangements in light of reduced operator liquidity.

Despite the disruption brought on by the pandemic, aircraft lease rentals have remained payable because aircraft leases are hell or high-water agreements; i.e., rentals are to be paid by airline lessees/operators irrespective of circumstances. Carve-outs in a hell or high-water clause would typically include scenarios where there is a total loss of the aircraft but rarely risks related to pandemics.

Additionally, force majeure clauses (which are quite rare in aircraft lease agreements, but which could be available as a relief by operation of law) would not give airline operators an automatic exit from obligations under lease or finance obligations. It could be quite challenging, as a matter of fact, for an obligor to equate a difficulty in the performance of its duties due to the pandemic to an impossibility to perform due to an intervening (force majeure) event.

Below are a few emerging trends in aviation finance and lease, in the face of decreased liquidity brought on by an unavoidable dip in demand for air travel:

  • Rent holidays: A number of airline operators have approached or are currently negotiating standstill agreements with their lessors. An upshot of these standstill agreements is inevitably the effect a standstill would have on financing arrangements, particularly if same would result in a cross-default. This notwithstanding, it would appear that the trend is to embrace rescheduling negotiations by lessors and financiers who are unwilling to terminate leases or take enforcement action where there have been defaults and cross-defaults under current arrangements. 
  • Sale and leasebacks: Some lessors are undertaking sale-leaseback transactions with airline operators, where the aircraft is being repurchased by the lessor; and leased back to the airline operator. This appears to be the trend with unencumbered aircraft and with lessors who are not facing liquidity issues and can acquire aircraft unconstrained in these unprecedented times. This approach is beneficial to both parties, as the airline operators would gain liquidity and the lessors could regain ownership of aircraft assets at lower than usual prices. 
  • Predelivery payments (PDPs): PDPs are usually paid to manufacturers several years before the delivery of new aircraft, and manufacturers typically deliver on an agreed schedule. With delivery schedules hanging in the balance, PDP financing has been affected, with several financiers facing possible payment defaults from airline operators. Typically in a default-by-an-operator situation, a financier would probably step-in, pay the remainder of the PDPs and then take delivery of the aircraft. With reduced liquidity, this may not be an attractive option for lenders. As such, it is expected that these step-in terms are likely to be re-negotiated by parties.
  • MAE/MAC clauses: Material adverse change/material adverse effect clauses are inevitably becoming heavily negotiated. Parties are increasingly negotiating to include risks related to general economic conditions, natural disasters, and now specifically, pandemics. This is particularly the case where drawdown or deliveries are heavily reliant on the non-occurrence of MAE / MAC events.
  • Information undertakings: Loss of income by the operators has resulted in financial covenants and ratios being tested. As such, operators are paying keen attention to the information undertakings in their transaction documents and informing counterparties where there is likely to be a breach of a financial covenant; and in some cases, requesting for financial ratios to be adjusted accordingly to take into account current market conditions. 
  • Private equity: There appears to be an increased interest in the aviation sector from investors who are able to purchase interests in aircraft assets at a lower than usual cost. Additionally, the pandemic has presented an opportunity for private equity firms who focus on distressed investments to acquire interests in airline operators and leasing companies that are facing liquidity issues. 
  • Government bailouts: Another trend during this pandemic has been for some governments to provide low-interest loans and grants to the aviation industry to cover payroll and, in some cases, working capital needs. The United States of America granted a USD 50 billion bailout package to several airlines through its CARES Act, Payroll Support Program. The United Kingdom, through its Coronavirus Corporate Financing Facility, provided GBP 3.075 Billion to the transportation sector (including aviation). The Dutch and French government provided EUR 3.4 billion in state-backed loans to Air France-KLM, and the German government provided a EUR 9 billion bailout to Lufthansa.

In the current environment, it is difficult to anticipate or predict what the attitude of the market will be towards acquiring and leasing new aircraft (or financing these acquisitions) in the next few months. Arguably, the closure of airspace and low traveler confidence has had a domino effect in the aviation industry. For lessors, the ability to acquire new aircraft hangs in the balance. At the same time, for lessees, the loss of income from decreased air travel has had an undeniable effect on leasing and financing arrangements.

Arguably, government support coupled with re-opening air spaces and increased traveler confidence could return air travel to pre-pandemic volumes. This, in turn, could aid the airline operators to regain income, which would consequently assist those operators and lessors with liquidity issues to meet their various obligations under their current leasing and financing arrangements.

IN THE NEWS: ADNOC, GEMS Education and more

** Viewpoints will be publishing a routine round-up of the most notable, newsworthy dealmaking events in the GCC and beyond.

This week’s edition features notable dealmaking news in the the Gulf Cooperation Council (GCC) over the last seven days. This week’s highlights are ADNOC’s joint venture with Wanhua Chemical Group, Kuwait’s pension fund announcing changes to its investment strategy and GEMS Education’s most recent debt finance fundraising round.

ADNOC / Wanhua joint venture

Abu Dhabi National Oil Company’s (ADNOC) shipping division (ADNOC Logistics & Services) has launched its joint venture with China’s Wanhua Chemical Group. The 10-year joint venture, which was entered into in July 2019, aims to create downstream opportunities for both China and the United Arab Emirates. The joint venture is in line with ADNOC’s strategy to pivot some of its business to partners in East Asia.

Kuwait’s pension fund to boost investment in infrastructure and private equity

Kuwait’s USD 112 Billion pension fund, the Public Institution for Social Security is planning investments in infrastructure and private equity, following a revamp in its management and investment strategy. According to Raed Al-Nisf, PIFFS’ deputy general manager for investments and operations, PIFSS aims to invest 12% to 17% of its portfolio in real estate, between 8% and 13% in private equity, and between 3% and 10% in infrastructure. PIFSS is the second largest sovereign investor in Kuwait (after the Kuwait Investment Authority).

GEMS USD 150 Million Fundraising:

GEMS Education, a private schools operator based in the United Arab Emirates, has raised USD 150 Million in debt, from newly issued senior-secured bonds due in July 2026. The funds are intended to reinforce working capital needs. GEMS Education operates more than 250 schools in 13 countries, and is considered a well-regarded choice for quality private education in the Middle East and North Africa.

COVID-19: Emerging trends in M&A deal-structuring

COVID-19 has had a significant effect on mergers and acquisitions globally, with a lot of on-going transactions pulled or delayed due to the uncertainty caused by the pandemic, and at least until parties have assessed the impact on their financial positions. It is estimated that worldwide merger activity so far this year has the lowest year-to-date figures for dealmaking since 2013. 

The substantial change in operating conditions for most companies as a result of the pandemic has forced a lot of parties to ongoing transactions to consider termination of terms, particularly for transactions that were still in early negotiations. Where binding offers were signed, and parties decided to terminate, it’s been necessary to examine the termination clauses in such binding offers and the implications of termination, e.g., if any break fees would be payable. Additionally, parties are examining force majeure clauses to determine if the pandemic would constitute a force majeure event warranting a termination of the binding offer with minimum liability to either party. 

For parties who have decided to proceed with their transactions, the trend appears to be re-negotiation of terms, taking into account disruptions caused by COVID-19 on the operations of target companies. The following trends have been of interest: 

  • Material Adverse Change: A natural consequence of the pandemic has been the treatment of material adverse change (MAC) clauses. MAC clauses are traditional buyer deal protection clauses and the definition of a MAC event is usually heavily negotiated. As a result of the pandemic, there is a lot more negotiation around the broadening or narrowing of MAC events, depending on buy or sell side.  Additionally, buyers are increasingly requesting stand-alone conditions to closing in relation to the non-occurrence of MAC events, especially where there is a significant amount of time between the execution of transaction documents and closing. 
  • Purchase price considerations: Due to the effect that the pandemic has had on target companies’ financial positions, parties are leaning towards abandoning the locked box mechanism in favour of the more traditional purchase price adjustment mechanism. It is also anticipated that while buyers may prefer the purchase price adjustment mechanism, sellers are likely to negotiate earn-outs in the event that the target company’s performance exceeds revenue expectations within a certain time frame. Given the unprecedented effect that the pandemic has had on revenues of companies globally, sellers should anticipate heavy resistance to earn-out provisions since same would typically be based on projections that are now uncertain due to recent global events.  
  • Representations and Warranties: In addition to the customary representations and MAC qualifiers, it is anticipated that buyers are likely to require that certain specific representations are made with respect to COVID-19 and its impact on a target company’s material customers, material contracts, material suppliers, employees, and the target’s material assets.
  • Due Diligence: It is likely that buyers will require additional confirmatory due diligence particularly on forward-looking positions that have been impacted by COVID-19, the effectiveness of crisis management procedures, insolvency risk, liabilities arising out of actions taken with respect to employees in response to the pandemic, to mention a few. 
  • Transaction Timetables: Parties are generally negotiating timelines that take into account the reduced operating capacity of regulatory authorities around the world as the world slowly eases lockdown measures. 
  • Representation and warranty insurance: While W&I insurance has become quite prevalent in acquisitions in recent times, an emerging trend is that underwriters are generally excluding COVID-19 and its impact from coverage. Therefore, parties will need to structure feasible risk allocation structures in anticipation of this trend. 
  • Financing arrangements: In leveraged buyouts, buyers are taking care to ensure that certain terms such as MAC events are defined consistently in both the acquisition and the financing documents. Financial covenants in financing documents will also have to be consistently drafted in line with due diligence findings on targets arising from disruptions from the pandemic. 

Although globally deals are at a 7 year low, there is a lot of optimism that deal flow will resume especially as buyers and sellers continue to assess opportunities. There have been a number of recent notable high-value transactions, particularly in the Gulf Cooperation Council (read about Abu Dhabi National Oil Company’s recent USD 10 billion transaction here ), which are bound to return investor confidence in due course.