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Law360 (August 7, 2020, 6:39 PM EDT) --
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| Matthew Herman |
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| Amna Arshad |
The pandemic is clearly separating winners and losers across all of the aviation ecosystem. These include carriers, original equipment manufacturers, financing sources and lessors, governments, as well as secondary ring participants, such as maintenance, repair and operations providers, airports, and the duty-free industry.
We start with the premise that — like many other industries — the aviation sector was not built to deal with the current crisis. Many of its participants are dealing with business models that are inflexible, operating on thin margins.
Dips, let alone massive drops, in travel stemming from COVID-19-related movement restrictions and plummeting demand, have made survival the foremost concern for many airlines.
This is reflected in the mood from the top of the house across the industry: IATA's CEO has called airlines' cash flow an "apocalyptic situation," and according to a recent Forbes poll, nearly 70% of top aviation leaders believe the airline industry will be fundamentally changed.
But as of early August, we are still amid the pandemic. While some regions around the world are moving toward reopening, the U.S. is largely not, and consumer air travel remains the exception not the rule. So, our predictive abilities are going to be biased.
Predicting the future of the industry right now can feel a lot like trying to rebuild New Orleans amid Hurricane Katrina. We need to deal with the storm, then assess the new reality, and then dust off the crystal ball.
But we think change will likely happen swiftly, with the best capitalized and best managed likely to survive. And size will matter, too.
Through 2019, the world's largest airline groups had until recently seen record profits. Indeed, the five years ending in December 2019 had been the most profitable five-year period in 80 years of industry history.
Mid-sized carriers had seemed probable targets for consolidation, especially in Europe. The largest global carriers could hedge fuel costs, leverage better deals from suppliers and, crucially, borrow more cheaply. This finance eased access to greater numbers of newer planes, through both purchases and leasing. And the importance to airlines of so-called pricing innovation — often, the fees paid by consumers — cannot be underestimated.
Post-COVID-19, we see a few themes likely to define the future of the sector.
Receipt of State Aid
The aggregate amounts, timings and companies that receive state aid will be the first rung of defining winners and losers. Logic suggests that large national champions will be the beneficiaries. However, we do not believe that size alone shows the complete picture.
There will also be airline and freight carriers of different sizes that are seen as national champions, and large employers that can also be disproportionate beneficiaries of state aid. And as in real estate, location matters. Airlines where aid is less available, notably in Latin America, are already suffering.
Avianca SA and LATAM Airlines Group SA, the region's largest airlines, have both filed for bankruptcy. Ecuador's government has liquidated TAME EP, the state-owned carrier.
So, a combination of those too big to fail (financially), too important to fail (national pride, employment) and wrong place/wrong time, will create a muddy middle ground of carriers that will have to find their way through without as much state aid.
Finally, state aid can come with strings attached, particular given its volume and pace amid COVID-19. Repayment terms and deferred taxes will limit flexibility going forward.
In addition, state aid may come with greater government control and conditions, which could correlate to protectionist measures. These may lead to complaints from countries seeking to ensure fair and equal opportunity for their airlines to compete. Such measures would also be contrary to the liberalized open-skies regime that has been a hallmark of the aviation sector over the past decades.
Enhanced antitrust scrutiny and foreign investment limitations on mergers and acquisitions in the sector can likewise not be ruled out.
Aircraft Footprint
Most industry experts expect that domestic markets will recover more quickly than international markets due to government-imposed limitations, including quarantine requirements. In addition, they expect that short haul will recover more quickly than long haul. This is to some extent an extension of the "domestic over international," but also reflects consumer preference in a prevaccine world.
This will favor carriers with a larger proportion of narrow body portfolios and will last through a health care driven end to the current crisis, until the consumer mindset transitions back to something resembling pre-COVID-19 normal.[2]
Capital Structure and Diversity of Counterparties
Clearly, having enough liquidity to make it through the crisis will be a critical first-level differentiator, but that will be impacted in turn by both the length of the COVID-19 crisis, as well as the factors noted above.
More interesting, perhaps, is what happens next. Have these entities borrowed so much, and on such terms, as to preclude success in a post-COVID-19 environment? Similarly, are their customers, suppliers and other counterparties diversified enough so as to avoid rippling through and mitigating any post-COVID-19 recovery?
We think that these factors are less obvious without specific deep dives into individual names, differentiating this test from the broad strokes discussed above. It is also worth noting that in the crisis, there have been innovative financing responses.
Some airlines are raising credit in novel ways by securitizing routes, gates and landing slots. For example, Delta sold $3 billion in high-yield debt secured by routes and airport slots and gates.
With the proliferation of alternative capital providers, one would think this trend will continue. However, there is some risk associated with the transferability of these rights, and possibly their value, given that these rights are subject to regulatory oversight and may not technically be in the full control of the airlines.
Given the suspension of regulatory use-or-lose slot rules due to plummeting service, there could also be impact to slot valuations impacting their trade. Ultimately, while significant fleet reductions are not yet evident, significant restructuring in the industry is likely.
Continued Growth of Leasing and a Focus on Portfolio Management by Lessors
As carriers recover, OEM production and the customer uptake of new aircraft will need to be looked at closely. And leasing of new aircraft will play an important role in bringing the industry back, as the capital costs of acquiring aircraft may be prohibitive. Leasing allows carriers more agility in response to demand.
But successful lessors will not only be those that are the best capitalized and the ones that manage counterparty risks efficiently, including around rent deferrals, and any strings attached to financing activities of customers, diversity of customer base. Also successful will be the ones that have the strongest management teams and established platforms to help place the aircraft on redelivery or offer other innovative solutions.
Lessors broadly take the risk of residual value, though during COVID-19, redelivery could come prior to end of lease term due to financial instability of the customer. Only the best placed lessors — size, capital, management team, track record and reputation — will be the survivors.
Finally, a vigorous aircraft leasing sector may also offer reason for optimism about air travel: In the past 30 years, airlines have adapted to changing market conditions, including people costs and fuel risks. While industry has made progress in technology, there is more to do, and the leasing industry could help drive that change.
Adjacent Verticals
Beyond the four corners of OEMs, airlines, lessors and financing sources, other aviation-related industries will feel the pain of COVID-19 for a period of time, with their survival a function of the overall sector's survival. These include maintenance, repair and operations, airports, catering, airport retail and the like.
And the final chapter on the airfreight industry has yet to be written, including with respect to Amazon Air's ambition. The airfreight industry has felt the whipsaw of locked down consumers' increased reliance on shipped products and fewer passenger planes, on which more than half of air cargo historically traveled.
As each of the above themes moves quickly from theory to reality, market participants will need to pay close attention to contractual and regulatory arrangements impacting each of the players. Covenant and payment defaults under financing arrangements, OEM terms, rent deferrals, force majeure and impossibility of performance claims, and insolvency proceedings are all playing out in real time.
Portfolio optimization, including significant acquisitions and dispositions, and transactions as part of restructurings and insolvencies, are likely to feature large across all of the industry players.
But an awareness of the commercial realities of the sector — especially for long-term players — is as important as the words on the page, especially if the industry comes back to anything close to pre-COVID-19 levels.
In short, reputation matters too. So being patient and nimble, but also creative and opportunistic, including in mergers and acquisitions, will define the industry's survivors.
The post-COVID-19 aviation sector — which definitionally will follow a health care solution that leads to behavioral change — will also need to address legacy concerns over sustainability and carbon emissions. This will, in turn, likely require even greater access to capital. Here, alternative capital providers — including environmental, social and governance funds — and lessors may play a role more prominent than traditional lenders.
Flying is also becoming democratized. Chartering smaller aircraft for private journeys is understandably attractive amid a pandemic and may become commonplace if cheap enough. Novel ownership options may proliferate with well-planned engagement from lessors, and there may be potential in the next generation of so-called air taxis.
Regardless of the flexibility offered by technology, which has become the new normal of 2020, our global economy will continue to need air travel.
Airlines and the wider aviation ecosystem face an unprecedented crisis, with questions around liquidity, financing, insolvency/restructuring and consolidations, in differing and sometimes conflicting international regulatory environments.
In dealing with these short-to-medium-term issues, we should not lose sight of the potential to evolve air travel, taking a global, cross-sector and cross-jurisdictional approach to building airlines fit for the 21st century.
While there is significant speculation over travel patterns and product development in a post-pandemic world, we would expect that, over time, the travel industry will recover and not look much different than the period before the pandemic.
Traffic ultimately recovered from previous existential threats. Air traffic has a long history of regaining lost ground after crises, including after 9/11.
Air travel transports more people at a lower cost than ever before. The economics of air transport will ultimately lead to an industry that looks different in many respects, but likewise substantially familiar.
Matthew F. Herman is the U.S. managing partner and co-head of the global M&A practice at Freshfields Bruckhaus Deringer LLP.
Amna Arshad is special counsel at the firm.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
[1] The authors would however like readers to recall that in 1999, at the Allen & Co Conference, Warren Buffet — when reflecting on the then-true fact that there had been "zero money" made from the aggregate of all stock investments in the airline industry in history — said "So I submit to you: I really like to think that if I had been down there at Kitty Hawk, I would have been farsighted enough and public spirited enough to have shot Orville down. I owed it to future capitalists."
[2] When the pre-COVID-19 history of narrow-body aircraft is written, the impact of the Boeing 737 Max cannot be underestimated. As late as February 13, Airbus confirmed that it was further ramping up production for the A320 program. That competitive advantage will be materially disrupted by COVID-19.
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