The past two decades have seen the rise of new airlines in the Gulf region as global aviation players. The period has been marked by the emergence of Emirates, Etihad, Qatar Airways and Gulf Air. Emirates, in particular, is the largest single operator of the Airbus A380, while stories of the order values placed at the Paris and Farnborough air shows regularly make the front pages of business papers. Given their geographical origins, GCC airlines have been particular promoters of Islamic finance in aviation transactions. BARRY COSGRAVE writes.
The aviation sector is one that is particularly in need of finance. The placement of bulk purchase orders for aircraft regularly runs into the billions. In turn, delivery (and therefore payment) obligations arise multiple times a year over multiple years.
Most airlines do not actually own their entire fleet. While there is a percentage (usually not more than one-third, and as little as zero) owned by the airline, the majority of these aircraft are actually owned by specialist aircraft leasing companies. The leasing companies take over the purchase option that an airline has negotiated with a manufacturer so that it is the leasing company that acts as the purchaser. The leasing company will fulfill the payment obligations to the manufacturer and then lease its newly owned aircraft to the airline. These leasing companies are dependent on finance to meet the purchase orders as their only source of income is the cash generated by the lease with the airline.
Islamic finance and the aviation market have always been closely entwined. Many aspects of Islamic finance have their roots in structures adopted in structured aviation finance transactions. In a typical sale and lease structure for an airline, a leasing company will purchase a new aircraft from one of the big producers (such as Airbus or Boeing) and then lease that aircraft to an airline (such as Emirates). The airline will then operate that aircraft and pay rent to the leasing company. The rent received from the airline will generally allow the leasing company to repay its financing on an amortizing basis such that at the end of the lease term, the related financing will have been repaid in full.
The foregoing description could easily have been written about a classic Ijarah structure. Indeed, aircraft sale and lease structures are the basis on which modern Ijarah structures were originally documented.
Aviation assets are particularly well suited to Islamic finance. The assets are easily identifiable, capable of valuation and income-producing. Islamic banks have therefore always been keen to finance aircraft assets and do so on a bilateral basis regularly. However, in recent years more complex structures have been developed including combined conventional/Islamic syndicated financing, senior/mezzanine financing structures and Sukuk.
The growth of combined conventional/Islamic financing syndicates has not been without its complications, however. While well suited to aircraft finance, conventional banks tend not to view Ijarah structures as appropriate. Such structures require additional entities to be introduced to give effect to the sale and leaseback necessary for an Ijarah and doubts are created as to the true owner of the aircraft asset. Consequently, Murabahah tends to be the preferred route. This is often also the case where Islamic banks act as the sole financier under a bilateral facility; the lower cost and ease of execution that a Murabahah affords over an Ijarah are often determinative.
The rise of both pari passu and senior/mezzanine financing syndicates with both conventional and Islamic banks has given rise to intercreditor issues. These include a scenario where an Islamic bank may be dragged into an action that is not Shariah compliant either by a vote of a majority of the other financiers (who may all be conventional) or because the Islamic bank is the mezzanine finance provider. Islamic banks will need to preserve a right to recuse themselves from voting on non-compliant matters and will also need an ‘escape valve’ to allow themselves to turn over any impure income to charity or otherwise to forfeit it.
Sukuk have also been popular in the aviation industry and the most famous of these is the Emirates Airline Sukuk from 2015. This has a number of notable features including a guarantee from UK Export Finance (Airbus manufactures the wings for the A380 in the UK) and an innovative asset structure. In relation to the assets, the purpose of the Sukuk was to fund the purchase of three A380 aircraft. However, as of the issue date, those aircraft had not been completed. To address the asset gap, Emirates used the concept of ‘rights to travel’ (essentially tickets to fly on Emirates flights) which were capable of valuation and were income-producing. Once the aircraft were completed, these rights to travel are substituted for the physical aircraft as the Ijarah assets. While the Emirates transaction is noteworthy for its complexity, there are a number of other Sukuk in the industry such as one issued by FlyDubai for general corporate purposes and other more plain vanilla corporate Sukuk issued by the likes of Emirates.
Over-the-counter Shariah compliant risk management and hedging products have been used within aviation finance for many years. These are used not only for profit rate and currency hedging but also for hedging the price of jet fuel and other airline exposures. It is now quite common to see an Islamic bank that is financing an airline with a floating profit rate make use of the IIFM/ISDA (International Islamic Financial Market/International Swaps and Derivatives Association) Tahawwut Master Agreement to enter into profit rate hedging and, where appropriate, currency hedging with that airline.
Islamic finance and aviation finance have strong parallels and links, which should continue to grow. The market also anticipates further developments in the complexity of Islamic finance structures being adopted, whether that be purely in the form of Sukuk and other structured products or within a financing structure that involves Islamic banks combining with conventional lenders or joining a structure as a subordinate or mezzanine financier. The Islamic aviation finance market remains extremely active and is expected to be so for the foreseeable future.
Barry Cosgrave is the partner at the London and Dubai offices of K&L Gates. He can be contacted at [email protected].