The global aviation industry had been recovering from the lows of 2020 and 2021 with a surge of pent-up consumer demand for travel with most countries now ‘living’ with the COVID-19 coronavirus, albeit with some (notably China) remaining committed to its eradication. This recovery has started to come up against headwinds with up to US$15 billion of aircraft stuck in Russia, a very strong dollar, high oil prices and increasing inflation.
Despite this, there has remained strong liquidity in the aviation finance sector, and even with some players retreating (notably the capital markets), we have seen some major new aircraft lessor entrants (such as PIMCO-backed High Ridge Aviation and Saudi Arabia’s AviLease), banks remain keen to grow their book and a continued growth in private equity and non-bank alternative funding vehicles investing in the aviation funding and leasing space.
Review of 2022
The number of new deliveries of aircraft in 2022 has improved as compared with 2020/21 but still remains far below pre-pandemic levels. While Boeing is now delivering its 737-Max aircraft to the Middle East, the global deliveries remain significantly below its peak delivery years. This has resulted in a shortage of a number of newer aircraft types.
This production cut, coupled with deferrals, has resulted in a lower number of new deliveries in 2022 in general, but Shariah compliant banks have continued to play their part with the new delivery market with a number of new portfolio facilities.
While every airline restructuring and bankruptcy is different, we have continued to see airlines use the US formal restructuring process such as US Chapter 11 in conjuncture with (or often instead of) their domestic bankruptcy processes. 2022 saw airlines like Philippine Airlines and LATAM exit the US Chapter 11 bankruptcy protection processes, but Garuda and SAS entered into US Chapter 15 and Chapter 11 procedures respectively. That said, the number of airlines seeking bankruptcy protection or going into liquidation remains lower than average.
The long-threatened exodus from LIBOR [London Inter-Bank Offered Rate] to SOFR [Secured Overnight Financing Rate] has started in the aviation finance and leasing market. In the context of Shariah compliance financings, there has been a clear preference for the certainty and simplicity permitted by Term SOFR (as a forward-looking rate) with key commercial discussions being over the calculation of the relevant CAS [credit adjustment spread] adjustment methodology on existing deals and the fallback options.
We also saw operating lease transactions (whether Shariah compliant or not) follow the Term SOFR route, which is helpful for Shariah compliant financings that are ultimately supported by underlying floating operating lease cash flows.
Preview of 2023
The International Air Transport Association (IATA) air passenger market analysis shows the improving recovery in demand despite geopolitical issues in Europe and the ongoing zero-COVID-19 strategy in China restricting travel. International revenue passenger kilometers (RPKs) in July 2022 were down only 32.1% versus 2019 levels whereas it was 58.4% down versus 2019 levels at the end of 2021 — this may be a question of whether you see the glass as half-full or half-empty. The latest forecast from IATA estimates 2022 traffic demand in RPKs to still be around 17.6% below pre-COVID-19 levels but it is possible the industry could finally see positive growth in 2023.
With the June 2023 deadline to switch out of US LIBOR, we would expect a big push in early 2023 in order to finalize the switching process ahead of the inevitable last-minute scramble.
Even though aviation makes up roughly 2.5% of total CO2 emissions (with roughly 4% of global GDP), it has still ended up with a high profile compared with some other much larger emitters. With COP27 [2022 United Nations Climate Change Conference] in Egypt and COP28 [2023 United Nations Climate Change Conference] in the UAE, the Islamic world is at the very heart of the climate change debate, and we would expect that Shariah compliant transactions will start to make a greater use of green and sustainability-linked principles in their structuring.
2023 is expected to see the delayed adoption of the the EU’s Taxonomy which will seek to regulate options that can be marketed as green or energy transition financing transactions for aviation; while this is an EU regulation, given the makeup of the aviation market it is likely to have a large impact in general.
We are also seeing a series of joint ventures and offtake agreements relating to sustainable aviation fuels and other technologically-driven solutions, and would expect to see a greater use of the tax credits available for sustainable aviation fuels in the US.
Conclusion
As we look toward the future, we would expect to see increased opportunities for Shariah compliant banks and funds as the aviation industry looks to grow out of its current position back toward pre-pandemic levels. Despite the considerable headwinds, there is reason to believe that the overall outlook for the global aviation industry is positive, and that the innovations on ESG and energy transition will start making a difference to our transactions.
Antony Single is a partner at Pillsbury Winthrop Shaw Pittman. He can be contacted at [email protected].