If you double your chip, “It’s like putting your whole mouth in the dip!“
A scene from one of Seinfeld TV’s most iconic comedy series is proving to be good advice in this time of Covid. You really don’t want to poison the entire dip portion and should take extra care when investing and financing planes. Which brings us to another type of “DIP” or “liquidity facility” as it is called in the financial world.
A “DIP / Liquidity” facility is a credit enhancement for structured finance vehicles such as Asset Backed Securities (ABS) and Enhanced Equipment Trust Certificates (EETCs). It is essentially an overdraft facility, there as a safety net to allow the structure’s financiers to relieve themselves of the risks of tenants (airlines) who do not pay rents on time. This helps prevent a sudden void in cash flow; interest payments, allow time to allow restructuring. This feature is useful whether you are the investor in an EETC, ABS, or any other loan structure, but it can also represent false hopes by simply postponing the inevitable.
In the world of aviation finance, EETCs (tenant sponsored) and ABS (donor sponsored) have been a cheap, efficient, and popular way to finance aircraft, especially older aircraft, with dozens of billion invested in the sector. With the abundance of cheap finance, much has been supplemented by capital markets and especially new institutional investors. These structures may have been too successful as rates have fallen and terms / conditions have become more generous for sponsors to the detriment of investors. You can’t just blame the sponsors, but rather the eternal search for more returns by investors in a low / negative interest rate environment. EETCs have rarely been in default and the airlines that use them have always chosen to retain assets, even in the event of a Chapter 11 restructuring. This trend continued until the recent wave of airline failures and restructurings. , in particular the LATAM Airlines restructuring. LATAM illustrated non-US airlines taking advantage of what was one of the most favorable financings in the industry. LATAM has rejected modern and highly prized assets.
What if the delay in execution was just a pause before the abyss? This amounts to getting into more debt by drawing on overdraft facilities when there is really no more hope. One statistic that should worry everyone in the industry is that aviation is reportedly a $ 750 billion industry that now borrows $ 300 billion a year. There is no doubt that there has been a drop in the market value of airplanes, with more movement towards older technology, but that does not mean that new technology is unaffected. What if values continued to fall and the overdraft facilities only created the illusion of normalcy with the potential for larger losses a few years later?
When overdraft facilities are used, it is a warning sign for debt holders. While useful for junior B and C ticket holders, it is an annoying delay tool for A ticket holders, who are more protected and want to get out. In the event of additional problems, preventive measures are not taken until the structural procedures are exhausted, which means that the aircraft will incur costs for parking, maintenance and storage, while the values of the aircraft depreciate, missing potential opportunities to capture the remaining value.
The nature of the debt structure, with many classes of creditors, makes renegotiation difficult if not impossible, rooted in legal and contractual procedures. Investors are not all equal and their concerns are different and with more deposits I can feel the desperation building. Continuing on this current path, some noteholders will be wiped out or lose a substantial portion of their investment, which until recently was unfathomable. This is not an unexplored path like structured products (mortgage backed securities) during the financial crisis and structured aviation products before 2000.
Lower note holders can redeem the higher ranked parties in most structures, but if they invested to receive a 6% coupon on their B tranche, will they really invest millions more for a return of? 3% to 4%. In addition, a majority is needed to reach agreement and it may not be as easy an exercise as it seems. It is not known within what timeframe investors are able to realize, to normalize the investment thanks to the environmental improvements. To add to the dilemma, if this is a case like the LATAM EETC, where the airline rejected the plane, there are other costs to recoup the investment, including reconfiguration and ongoing maintenance.
Noteholder A is high in the cash flow pecking order, the inevitable delay is just another inconvenience and expense. They earn interest through borrowed facilities, but for how long and what about all the extra costs that pile up? This interest-paying bank, which usually has the right to be super senior, will soon take the lead, while all other note holders become more junior and further removed from the earned value of any asset sale. I hear investors talk about no problem, but these structures weren’t designed to make up for an extra 18 months of interest payments. It’s not free money!
People can shrug their shoulders and claim that the values of the underlying assets of an EETC or ABS are conservative and that ultimately only stocks and lower ratings will be affected. History shows that in aviation, as with other asset classes, even liquid investments are difficult to exit in a declining market. In a prolonged market rout, DIP facilities represent the proverbial possibility of being kicked out and people continue to live a fantasy due to the continued support of more borrowing.
If I were a lender I would read my legal documents because I would like to know what additional risks I am now obligated to take. Are there valuation clauses triggering an event of default? The values are not close to the levels when these transactions were consumed. Will the aircraft market recover, and when? I would definitely say they will, because I believe in the resilience of aviation, but the question is when and what will be left for investors when all the debts are paid.