Fasten Your Seatbelts

In July 2024, 5.5 million passengers boarded aircraft in Australia, up more than 3% on the previous year. Over the past 50 years, commercial aviation traffic has grown at approximately 1.7x global GDP, and despite the demand shocks of 9/11, the global financial crisis (GFC), SARS and COVID, the aviation industry has proved surprisingly resilient. It is a resilience that has played out in the form of consistent and reliable investment returns for investors.

It is perhaps a common misconception that airlines own their own aircraft. In truth, nearly half of the 37,000 aircraft in service are leased by the airlines from companies like AB CarVal – a dominant and successful global player in aircraft leasing.

Principal for AB CarVal and Head of Transportation Assets Greg Belonogoff discusses this industry and why it has been such a consistent investment opportunity for institutional investors. 

Q. What is aviation leasing and what is the investment thesis for AB CarVal?

A. Put simply, it’s owning and leasing aircraft. Why do we do that? It’s an asset that’s cash flowing and one we know well.  And that’s what we like at AB CarVal. We’re credit people. We like to see assets that produce high levels of cash. It’s also a very big market. There are 37,000 aircraft in service, which represents about $680 billion of asset value. And that gives us a reliable, steady flow of opportunities.

Q. What are the market fundamentals?

A. It’s a market where the fundamentals are quite easy to understand. There are two large global suppliers. That’s not going to change in my lifetime. They’re there to make sure that the market is strong and they’re generating good profits. We have the benefit of long lead times on the production of aircraft, so we can see 10-plus years on the supply side. It’s highly unlikely that there’s any disruption there. In fact, we forecast there is demand for 40,000 new aircraft over the next 20 years (Display). And then we need to look at the demand side. Historically, it follows GDP growth at a multiple of about 1.7 times, and there’s over 50 years of data to support that. And as the middle class grows and different markets around the world mature, we see air travel demand steadily increasing. From our viewpoint, the fundamentals are transparent and strong.

Q. What about demand shocks like COVID?

A. The shock of all shocks in aviation was COVID. At the time, we thought we were going to have real problems with payments. In fact, the economic impact turned out much better than we anticipated. Airlines cut costs everywhere except aircraft. We have a client who has been in bankruptcy for four years, but through this entire time, they have paid us every month. An airline without airplanes is nothing. And we have seen from other shocks, like the GFC and SARS, that the market gets back on track quickly. And during those slower periods, we can take a plane and reposition it anywhere. They’re true global commodities. A traveler doesn’t know if the 737 they flew from Sydney to Melbourne was flying Buenos Aires to Santiago six months ago. They’re fungible assets that can work anywhere.

Q. What’s the barrier to entry for leasing companies?

A. Globally, there’s less than 200 leasing companies active in the market. Initially, the market was dominated by the airlines who largely owned their own aircraft. Over the years, the ownership has split roughly 50-50 between airlines and leasing companies. And in the last 10 years, we’ve seen more new entrants in the industry. But the biggest challenge is establishing a presence that enables us to source deals. At AB CarVal, we stand out because of our ownership of a full-service leasing platform, Aergo Capital, who have been in the industry for 25 years. Aergo enables us to find good deals, put them on the books and then, importantly, monetise them. Through Aergo, we see about $2 billion of opportunities per month. That’s the strength, reputation and presence of Aergo Capital.

Q. Can you tell us more about the Aergo Capital platform.

A. Fred Browne and Denis O’Brien founded Aergo Capital in 1999, and in 2014 AB CarVal purchased the business. Prior to this we had service contracts with other leasing companies which were less effective. Deals are done on a principal-to-principal basis, so lessors are talking to each other all the time. I could be the best aviation guy in the world, but I can’t source the aircraft nearly as well as the team at Aergo Capital can. There are really three key groups involved – the commercial team that sources the opportunities; a financing team that raises the finance we need to acquire the aircraft; and a technical team who do the technical underwriting of the assets that we’re acquiring. They also monitor the aircraft over the life of the ownership and help monetise the asset.

Q. As an investment, how correlated is aviation leasing with airline stock or other equities, credit or alternative strategies?

A. We believe that they are totally different business models.. If an airline goes bankrupt, the aircraft itself is going to find a new home and fly somewhere else. In terms of other asset classes, aviation leasing really doesn’t correlate at all – even with other hard assets (Display). It is a strong diversifier in a broader portfolio.

ALRI (Leased Aircraft) is represented by the Ascend Commercial Aircraft Market Sentiment Index; airlines by MSCI Daily TR Net Airlines Index USD; infrastructure by the Dow Jones Brookfield Global Infrastructure TR Index; real estate investment trusts (REITs) by the FTSE EPRA NAREIT Index; shipping by the DAXglobal® Shipping USD TR Index.

Q. What type of aircraft do you own and lease?

A. We like the workhorses – the narrow body planes that tend to do the capital city domestic routes. Airlines always keep working with them and they are also the biggest portion of the fleet by number. So of that 37,000, about half of that by count is the narrow body fleet (Display).

Smaller aircraft, like turboprops or regional jets, are more volatile. They’re smaller investment sizes. They have different dynamics. It’s harder to get long-term contracts. Typically, they deliver lower than underwriting, which means you’re not getting compensated for that volatility risk. So we’ve tended to stay away from those assets. Then, at the other end of the spectrum, there are the wide bodies – the 787s, A3s, A350s. Those are really high-value capital items. They’re higher lease rates, obviously, but they’re more volatile. So you’ve got real price volatility both on the value and the lease rates, and you can really get caught offside there.

Q. What type of assets do you have in the portfolio now?

A. Since inception, Aergo Capital has traded over 420 aircraft with 76 airlines across 49 countries. Today, the fleet consists of owned and managed assets, including 185 assets with a value of more than $5.1 billion

Q. What are the risks involved in this strategy?

A. The main risk is having aircraft on the ground. In this case, you own a depreciating asset that’s not generating any cash. Every day that goes by, the aircraft is worth less, unless the market gets super tight. But generally, when they’re on the ground, that’s a problem. The other problem associated with dormancy is that when the aircraft is on lease and flying, the airline is covering all the costs associated with it. Not just flying costs like fuel, but they’re paying for the primary insurance, and they’re also paying for the maintenance. If it’s on the ground, those liabilities shift to the owner. We have a goal of zero dormancy for our fleet, and that’s largely what we have been able to do with the strategy.

Q. What happens to old planes? Can you monetize them?

A. We don’t often deal in this market. We are trading in younger, in-demand aircraft that have strong, longer-term contractual cash flows. But, when it comes to planes that are end of life, everything of value is taken off and resold – the engine, avionics and landing gear are the most valuable, so those go first, and there are robust secondary markets for these assets. Then the pilot windows and the front edges of the wings are removed – which also have value. Then the fuselage, the body of the wings – the remainder of aluminum – gets compacted and recycled. 

Q. Finally, are you a better or worse flyer knowing what you know?

A. When you look at the statistics, the safety of flying is off the charts. The incident rate is pretty much at zero. But I always tell my friends – fly commercial. Fly with the pilots and the planes that fly every day. And remember to fasten your seatbelt!

For more information on the AB CarVal aviation leasing strategy, please contact our institutional client group at Aust_ClientService@AllianceBernstein.com