Alive and kicking - Jol/Jolco update
The Japanese operating lease with call option and Japanese operating lease aircraft financing products have weathered past crises, and they are still seeing deals despite Covid-19, Sumitomo Mitsui Finance and Leasing managing executive officer and head of transportation, Shinichiro Watanabe, tells Dominic Lalk.
Since the beginning of the year many naysayers have said that demand for Japanese operating lease with call option (Jolco) and Japanese operating lease (Jol) financings was “gone”; others said the market was all but “dead”.
Shinichiro Watanabe, Sumitomo Mitsui Finance and Leasing (SMFL) managing executive officer and head of transportation, begs to differ in an exclusive interview with Airfinance Journal.
“It’s very important to distinguish between the Jol and Jolco markets. For the Jolco, the main investor focus is on tax solutions and deferral. For the Jol, it’s investment-focused, so the investors expect a larger return for taking more risk,” Watanabe explains.
The finance product market is heavily dependent on the state and the health of the greater Japanese economy. With Covid-19 still wreaking havoc everywhere, a slump in transactions is a temporary situation rather than a new normal, notes the seasoned SMFL financier.
“The Japanese economy is, of course, heavily impacted by the continuous spread of Covid-19, so overall demand and volumes are down and this translates into less demand for tax solutions like the Jolco,” says Watanabe.
Under the parachute of the SMBC conglomerate, which also includes lessor SMBC Aviation Capital, SMFL has consistently ranked among the top dealmakers in Airfinance Journal’s annual Jol/Jolco survey. This year will be no different, says Watanabe.
“The Jolco market is not dead like many seem to think. We still see some demand right now. For the first half of the year, volumes were 20% to 30% of 2019 levels. I believe that this is probably the bottom of the market. We expect demand to rise in the second half. You must remember that the fiscal year in Japan starts in April, so right now we are actually only in the second fiscal quarter, and typically the second halves have seen much stronger demand for tax solutions like the Jolco,” he says.
The Japanese can be cautious investors. Convincing them to be less conservative, and enter the often-tumultuous aviation industry in the first place, is often no easy feat, especially when less-experienced small regional players get involved. The Covid-19 crisis hit just as Japanese investors were becoming more comfortable with aircraft assets, and Jolco underwriters were becoming more open minded in terms of structure, jurisdiction, lessees and aircraft types.
“The point is whether investors have confidence to invest in aircraft Jolco at the moment. There are alternatives as you know, like ships and container boxes, so some investors may find those safer alternatives for Jolco transactions as demand for freight and cargo is up and demand for passenger aircraft is down,” says Watanabe.
“For us, we have more than 2,000 Jolco investors that we look after. Of course, we are in ongoing discussions with them about what their options and alternatives are. As you know, there’s a lot of negative outlooks for the global aviation industry reported in the media, so Japanese investors may not be confident in aircraft Jolco except for some very experienced ones at the moment so they seek less risky alternatives,” he adds.
In the second half of 2019, many financiers involved in Jolco transactions began bemoaning excess supply in the market, which forced arrangers to sell down their inventories at a discount. Are we still seeing those discounts in a market believed to be dead now?
“First of all, it’s about pricing and quantity of the equity available to the investors. The market picked up in end 2018, beginning of 2019, in tandem with the Japanese economy. Then, demand declined in the second half of 2019 as the economy was slowing down. But still, Jolco demand was not too bad. It slowed down for sure, but what you need to consider is that we usually start structuring the deals about one year prior to the start of servicing the equity, so that means the equity we started to sell in the second half of 2019 was actually arranged in 2018, which was the peak period. So, if you talk about the pricing, the tax benefit, it was probably the least attractive to the investors at that time. That’s the real reason why arrangers had difficulty in the second half of 2019 to sell their inventories without discounts. We started at a very high level and we discounted from those peak rates,” says Watanabe.
In recent years, the market has observed the emergence of more Jolco transactions done directly with the operating lessors. This is a trend that will continue.
“This is an area we are very interested in because lessors are often considered less risky than airlines, owing to their robust financings in place, so this gives Japanese investors more confidence to invest in Jolco transactions done with lessors. As you know, until now we have done much less Jolco financings with lessors because we own a very large lessor in our own group – SMBC Aviation Capital,” says Watanabe.
Other financing tools with growth potential, even in the current Covid-19 environment, are innovative Jolco products, such as debt structures combined with Aircraft Finance Insurance Consortium (AFIC) and export credit agency (ECA) debt.
“AFIC is a product we have jointly launched with Boeing. As an SMBC Group company, we are, of course, very supportive of this product. Under the very difficult credit environment for aviation industry, AFIC and ECA financing demand is, of course, very strong now. AFIC Jolco with good airline credits is a good business, because even very cautious banks can provide debt finance, and some experienced investors are very familiar with those good airline credits even if they are not covered by the insurance,” says Watanabe.
Impact of airline bankruptcies on Jol/Jolco investors
“We have seen some airline bankruptcies and Chapter 11-like proceedings in the past six months,” says Watanabe. “Of course, some Jol and Jolco aircraft are attached to those airlines. We have been taking care of some very disappointed investors recently.
“As we all know, even though it’s called ‘with call option’, in reality every Jolco investor expects that the call option will be exercised. In the case of some of the Covid airline fatalities, the aircraft won’t be exercised, and some will be returned, so the Jolco structure will be terminated completely,” says Watanabe.
Since the beginning of the year many airlines with Jol/ Jolco aircraft have gone belly up, including large exposure with carriers such as Avianca, LATAM, Virgin Australia and Airasia.
“Maybe we can say that we have become a little bit too lenient and optimistic in the past few years with airline credit risk assessments. We have to go back to the basics now. We need to start to exercise more discipline again when selecting our lessee credits, and that will certainly include more lessor Jolcos in the future. Some regional Japanese banks that provide the debt for Jolco transactions would be more comfortable doing lessor Jolcos in the future after learning from the current events,” says Watanabe.
Many in the industry have been discussing what it means for the Japanese investors to have aircraft assets tangled up in Jolco structures with under-administration carriers, especially if they are still getting their monies and what recourse they have in case of default.
“Jolco aircraft are usually new or at least still relatively young aircraft so generally the expectation is that the under-administration carriers will still continue to use those aircraft. However, depending on the details of the proceedings and protections offered under different jurisdictions, investors may have to agree to restructured transactions. In many cases, the rentals will be paid based on what we call PBH, or power-by-the-hour, agreements,” says Watanabe.
PBH
Over the summer the industry has observed a proliferation of PBH requests from lessees to lessors as airlines continue to be largely grounded and those flights that do take off often show money-losing load factors. Some movers and shakers with lined pockets have said only “desperate” players would agree to PBH contracts but Japanese investors may take a different view.
“It’s a global pandemic, so even if they repossess their aircraft, it will be really difficult to place them again given the economic environment. So, in those cases, PBH payments may be better than no payments at all,” says Watanabe.
“The Jolco equity providers are admittedly in quite a weak position right now. In the case of Jol, they are the owners – it’s basically 100% equity financing by themselves – so it’s purely their choice whether they accept PBH. But in a Jolco structure, there are more parties to consider and consult, and some may feel that accepting PBH is still better than potentially nothing,” he adds.
There is usually less flexibility in Jolco transactions vis-à-vis Jol transactions. In a typical Jolco structure, about 70% to 80% of the financing is provided by debt but the balance comes from Japanese investors.
“In the worst case, those investors may be squeezed by debt providers to recover the debt portion,” says Watanabe.
“Individual Jolco investors may not have the financial power and resilience that some of the big lessors have, so that’s why for some of them PBH may still be acceptable given the Covid environment. Our job is to advise and guide them through that process,” he adds.
Typically, PBH requests in the market as Airfinance Journal went to press were for 12- to 24-month periods.
737 Max Jol/Jolco
SMFL says it still expects to close Jol and Jolco financings when the Boeing 737 Max programme returns. He notes that “it is all the lessee credit”, so investors may still be persuaded to invest in Max variants so long as a strong airline or lessor credit backs the deal.
“If it’s a really strong lessor or airline credit then I can still see that some Japanese tax investors will be interested because it’s basically a credit deal. But in the case of Jol, it will be more complicated, given the nature of the asset deal, and Jol investors are more cautious about the future value of the 737 Max,” says Watanabe.
He adds: “Of course, it’s much easier for us right now to structure an