I’ve long been interested in equipment backed closed-end funds as an alternative source of income. Probably the biggest part of this equipment backed space comprises the aircraft leasing funds which have collectively raised a few billion via the London funds market, although we’ve recently seen some diversification via outfits such as the Tufton Oceanic fund which invests in ships. On a side, this new fund announced this week that it’s looking to raise additional capital via a C share issue – I imagine that demand will be strong given that the original shares trade at a 5% premium.
Anyway, back with the aircraft leasing funds. The income yield is fairly attractive but the $64 billion question has to be residual values. In sum, these are classic depreciating assets backed by loans. You’ll receive your regular income coupon but this won’t really matter very much if the residual value collapses to zero.
In an ideal world, we’d have an accurate, real-time update on residual values, especially for the big A380 planes which dominate most portfolios. But planes can’t be sold via Autotrader and real-time values are non-existent. These are classic illiquid assets where the value varies enormously. All sorts of factors can get in the way of either a ‘market value’ or an independent assessment. The quality of the plane matters of course as does the company the plane is leased to. There’s also a fairly small list of potential buyers for the really big planes and many of the A380s, for instance, are owned by a small pool of funds.
So getting to the bottom of the residual value question is a big and important question. The problem is who to trust. The fund’s, of course, have their own take on establishing a sensible price but they have an obvious bias. The good news is that this week we finally got a proper take on the economics of aircraft courtesy of the excellent Matt Hose of Jefferies. He’s just penned a very detailed analysis of the main funds and their assets and tried to get to the bottom of the residual value question.
Matt rightly points out that the general “assumption for aircraft depreciation schedules was based on a ’25:15’ rule of thumb, namely that aircraft would depreciate over a 25-year period to a 15% residual value. However, this model is now outmoded, as the economic life of passenger aircraft is shortening. This is due to the current rate of technological innovation, increasing refit costs…”. The first graphic below demonstrates a not untypical depreciation profile.
The problem for many of the funds is that the main planes they invest in don’t tend to have such a ‘common depreciation pattern’. In fact, we’ve seen very few secondary market transactions for A380s for instance, which makes working out residual values very tricky.
According to Hose “only now are the leases entered into at the start of the aircraft’s operations (in 2005) beginning to expire, with two Singapore Airlines operated aircraft being parted-out, and a third recently re-let to a wet-lease operator. As a result, its residual values have been the source of much debate and is something we need to take into careful consideration when analysing the returns of the funds.”
The Jefferies analyst admits that there aren’t really any reliable market values for the planes so instead builds a model which looks at how a big hit to rates of return would come from a 50% loss – whilst also looking at residual cash flows. Crucially the Doric Nimrod vehicle has 82.8% of its residual value tied up in the value of the plane versus regular cashflows, whereas Amadeo Air Four Plus has only 62%. Assuming a 50% bear haircut in values, AA4 would still generate an 8.6% IRR and return your existing NAV. With DPA that would fall to 3.7% by contrast.
According to hose “even after applying a 25% residual value assumption haircut, all of the funds still produce attractive (nominal) IRRs, ranging from 6.7% to 13.5%, noting that for the A380s this broadly takes the residual values to those implied by the parting-out (i.e., c. $80m). The degree of sensitivity is understandably a function of how much of the remaining cash flows are comprised of the residual value, as opposed to future dividend payments. As a result, the IRR of the short-life DNA markedly declines under this scenario, to 13.5%, while the longer-life AA4’s IRR holds up relatively well, becoming 11.1%. “
The next chart below also tells a story. It shows the full range of A380s held by funds and operated by big airlines. You’ll notice that a small group of funds own the vast majority of these huge planes. This speaks to concentration risk in my mind.
So which fund would Hose at Jefferies go for? His preference is for the Amedeo fund, AA4, “reflecting its attractive return profile, with its IRR currently driven less by the aircraft residual values than the other funds. Taken together with the benefits of its diversification, we initiate coverage with a Buy recommendation. Elsewhere, we initiate coverage on the remaining funds with Hold recommendations. The Doric funds also offer attractive returns, particularly given the quality of the lessee, but have more of their assumed cash flows represented by the residual value of the aircraft and lack any diversification by aircraft type. DPA on the other hand usefully avoids the heavy focus on A380s present throughout the other funds, instead of owning the potentially more liquid Boeing 787s, but the quid pro quo is lower returns with higher credit risk.”. I’m also a fan of the DPO fund which currently yields 8.3% but I note the caution in this analysis. The Amedeo fund currently yields 7.6% with a bid-offer spread of around 2%.