The Charter Capital Conundrum
I work in the business of aviation finance, and I often have charter companies reach out to me for financing. They're usually shocked to find virtually no banks will finance an aircraft for a charter company without some sort of independently wealthy (usually very wealthy) owner to backstop and personally guarantee the loan. Even then, its not a guarantee that the rate and terms will allow for a profitable return and it usually makes the entire exercise not worth it.
They see press releases announcing debt financing by publicly traded companies or bond offerings from large companies like Flexjet or Vistajet and don't understand why they don't qualify for a loan. They have a strong track record chartering aircraft owned by other people, why wouldn't they qualify for debt financing?
Then, there are those that want to do a triple net lease to a charter operator and take advantage of depreciation. They're shocked to find out that the charter revenue projections mean very little to a lender and they want to see tax returns and wealth statements, and usually bring over a large sum of deposits (sometimes a 1:1 ratio of the loan!) in order to secure the financing at an above-market rate.
"It's an asset based loan! The aircraft is collateral and we're buying it well!" is what I often hear, usually with a tinge of frustration.
Its easier to finance heavy equipment or other business use equipment, why are aircraft different?
Let me explain how banks look at risk when it comes to airplanes, and maybe it'll make a bit more sense to you.
How Banks Make Money
Not financial advice. No investment is free of risk. Yada yada.
Banks are in the business of loaning money and making a return on their equity. They take deposits (businesses, little old ladies at church, your kids checking account, CD's) and then lend money at a rate higher than their cost, called a spread. All my finance bros are puffing out their chest in their Patagonia vest ready to explain bank spreads.
Here's the explanation in real simple terms:
Now, the cost of funds a bank has is not perfectly tied to federal funds rates (a common misconception, someone forward this to Trump) but they generally follow each other as a good benchmark.
The Cost of Funds is relatively the same across all lenders. CD rates and high yield savings accounts are competitive, so the cost of funds isn't the big issue when it comes to aircraft lending.
How Banks Price the Spread
Post 2008 banking crisis, the world needed some regulation to make sure we didn't have a global financial crisis again. See movie: The Big Short.
Welcome: Basel III
There is a group of international bank regulators called The Basel Committee on Banking Supervision. They have had 3 sets of regulation creatively called Basel I (1988), Basel II (2004), and Basel III (2010). Basel II created the scenario for the Lehman Brothers collapse after appearing to be well capitalized.
Banks today are governed by Basel III. It introduced a dramatic increase in the amount and quality of capital that the banks must hold, introduced new liquidity requirements, and (very relevant here) created more sophisticated risk-weighting to prevent another meltdown. The unintended consequence here is that banks now avoid any lending that requires significant capital reserves.
Bank's Required Capital Reserves
Under Basel I, II, and III, banks are required to hold a ratio of Capital (shareholder equity) to Assets (loans to customers) at 8%. The Capital is not to be confused with Deposits (this is actually a liability for the bank).
Basel III introduced a 2.5% capital conservation buffer and required the quality of the 8% equity to be higher (complicated and not relevant to this conversation).
What you need to remember is that 8% requirement. The bank must retain an 8% equity ratio to the risk rated loans at the bank, and that cannot be paid out to shareholders.
Risk Rating: What're the Odds We Get Paid Back?
The risk categories are clearly defined in Basel III. This is one of the ways in which bank spread is calculated.
In layman's terms, the risk rating is a weighted average chance that the loan is paid back.
Here's where our private aircraft vs. charter operators come in.
Banks are allowed discretion outside of the base categories listed above. They classify specific loans based on borrower creditworthiness, collateral quality, and industry-specific risks.
For Part 91, personal use aircraft, the bank has a personal guarantee that the loan will get paid back. Plus, they anticipate much less usage, therefore depreciating the asset less over the life of the loan. They think: "Oh, rich guy's plane - he'll probably pay us back. If we reposes, the asset residual value will cover it."
For charter operations, they think "Oh, this business might fail and there's no rich guy backing it. It's very risky." Therefore, banks will rate it between 120% and 150% risk rating based on a few factors.
- Commercial operations (business risk)
- Company's creditworthiness (are they making enough margin)
- Regulatory complexity in a specialized industry (Part 135)
- Revenue dependence
- Higher utilized assets
The Pricing/Spread Calculation
Now we're going to tie all of those together, and here's how you get your interest rate! We're assuming a $10,000,000 loan just for the sake of easy math. This would be a $12,500,000 purchase price at 80% loan to value (like this 2009 Global XRS from Guardian Jet.)
So you see, because of the riskier loan profile of a charter operation, the bank would be required to hold $400,000 more in equity for the same loan amount, meaning they would need to charge a higher spread to make up for the additional equity they have to hold, while not making any more money. At the same time, they're increasing their risk. Banks are conservative.
This is why far more banks will do residential mortgages than do commercial lending or aircraft (Part 91 and regular corporate lending fall in the same risk category).
It's also why some banks want deposits when they loan on your aircraft, so they can go lend to a less risky endeavor and can make more profit!
"But the asset will carry it!"
I can hear the outcry now... and I hear it a lot of times when I break this news. The asset will carry the note. The pro-forma calls for massive charter revenues and limited maintenance expense. Let's look at the numbers.
Below is an example of what we might see in a Part 91 scenario on our hypothetical $12,500,000 aircraft. This assumes a 5% depreciation rate, which is conservative. The payment comes out to $87,110 per month.
But as a charter operator, you're classified as "riskier" and your interest rate is 200bps higher (and because of the capital requirements, the bank isn't making any more money for the risk).
So the table looks a bit more like this. 8.5% interest rate instead of 6.5%.
Uh oh, in order to make your higher payment of $98,474 you had to charter the aircraft 50 hours a month, which depreciated your aircraft at 10% instead of 5% per year, leaving you in a negative equity position after ~ Year 3. The bank is now incredibly exposed as its not backed by the asset anymore, so they shorten your amortization to 10 years.
And now your payment went up again. Significantly.
So Who's To Blame?
The bank regulations is a primary driver of why charter operators can't finance aircraft to own in their fleet. The business is risky, yes, but there are ways to mitigate the risk.
The bank regulations are set by a board of directors (anonymous, of course) that resides in Switzerland.
If you're a charter operator frustrated with the banks, don't blame them. They are handcuffed and can't get creative. Blame the Bank for International Settlements (BIS).
An Interesting, Innovative Solution
Last week, I flew on the inaugural flight of Craft's Challenger 350. Craft is doing something interesting to try and solve their own problem. They met with banks to expand their fleet, but ran into the problem outlined above. Instead of growing their managed fleet, like so many charter operators are forced to do and collect a revenue share, Craft wanted to have their own assets.
This inspired their 721 Exchange Fund with a Challenger 350 at the core.
By selling "shares" in the aircraft through a 721 Exchange Fund, owners are able to gain access to private aviation without having to liquidate their stocks and are able to get some interesting depreciation benefits as well.
To be completely honest, I don't fully understand it as I'm not that sophisticated in equities markets. But, I am a firm believer that necessity is the mother of invention. Without access to traditional debt funding, this is a new way for a charter operator to gain access to aircraft and expand their customer base.
They're backed by some big name angel investors such as Ilya Fushman of Kleiner Perkins, Sheel Tyle of Collective Global, Seth Berman of Sussa Ventures, Jordan Lowe of Deft, and Santo Politi of Spark Capital. So they see something in this model that could be cool.
As always, this isn't investment advice. This is also not a paid placement, nor do I make any money if you call them from this newsletter (as you know, I'm always transparent!)
I hope it works out, and might be a blueprint for the future of funding charter companies.
Until next week,
Preston Holland
P.s. Forward this to a friend who flies private and hates dealing with banks. Then, have them pick you up, pop some champagne on the plane, and laugh all the way to the bank.
Preston's Links:
My main business: Prestige Aircraft Finance
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