An Introduction to Aviation CLOs
One of the reasons for a reduction in the number of aircraft asset-backed securitizations (ABS) coming to market in 2022 and 2023, is the time lag between the rapid increase in interest rates by central banks and the corresponding increases in lease rates which we are now seeing. Since aircraft lease rentals are typically fixed amounts, it can be difficult to make the cashflows from leases entered into during the low interest rate environment of 2018-2022 service an ABS entered into in today’s higher interest rate environment. It will likely take some time for lease rates to rise sufficiently before the ABS market returns to the levels of issuance seen in 2019 and 2021.
In contrast, aviation loans typically calculate interest based off LIBOR (historically) and SOFR (going forward) so, as central banks have raised interest rates, the prime rate and SOFR have gone up also, meaning that the contracted cashflows on aviation loans have also increased. This reduces the impact that rapid interest rate increases have had on the ability to issue collateralized loan obligation (CLO) notes secured by aviation loans and is one reason why we expect there could be more activity in the burgeoning aviation CLO market than in the established ABS market over the next 12 months. Another reason is the increased role played by so-called “alternative lenders,” several of whom are prime candidates for issuing aviation CLOs to back-lever loans written during the last few years.
What are CLOs?
CLOs are structured finance securities collateralized by a pool of loans. The cashflows generated by the underlying loans are what service the interest, principal and expense payments of the CLO vehicle. Because the focus is on cashflows, we have seen great diversity in the loans used in aviation CLOs including unsecured loans to airlines and lessors, limited and non-recourse loans secured by pools of aircraft, as well as majority and minority positions in larger syndicated loans. It would even be possible to include loans in the portfolio which have little or nothing to do with aviation provided that they generate cashflow.
The CLO issuer issues securities to investors and the proceeds of that securities issuance are used to purchase the underlying assets, which in the case of an aviation CLO are aviation loans.
Key Features of an Aviation CLO
The CLO issuer of an aviation CLO will typically be a bankruptcy-remote special purpose, orphaned entity formed in a manner intended to minimize the risk of consolidation of its assets with those of the sponsor, the Servicer or any other party. For tax and regulatory reasons, we have seen CLOs use asset-level issuers organized in different jurisdictions issuing notes to a single master CLO issuer who then issues securities on the capital markets or privately placed with qualifying noteholders. This structure mirrors a commonly used ABS structure and has multiple benefits as it keeps equity in the underlying assets segregated while amalgamating the cashflows generated by the underlying loans to service the CLO notes.
The CLO notes can be issued pursuant to Rule 144A of the Securities Act or alternatively as a private placement pursuant to Section 4(a)(2) of the Securities Act. In either case, the CLO notes will not have to be registered with the U.S. Securities and Exchange Commission. CLO notes are typically issued in multiple tranches, each with a different risk profile. More senior tranches are paid at the top of the waterfall, while subordinated tranches are paid lower in the waterfall. Senior tranches are subject to more stringent financial testing metrics (described below) and have a lower coupon than subordinated tranches. Senior tranches rated as investment grade amortize through a combination of (a) base amortization calculated by multiplying the initial advance rate of that tranche by the aggregate amount of principal due or collected on the underlying loans for that collection period and (b) supplemental amortization calculated as a percentage of the base amortization but increasing over the life of the transaction.
A liquidity facility is made available by a bank acting as liquidity facility provider to pay expenses, senior hedge payments and interest on the investment grade CLO notes in the event that collections are insufficient to do so. The liquidity facility is typically sized at 9 months of interest on the senior CLO notes and scales down in size as those senior CLO notes amortize. The equity holders of the Issuer may also cure any payment defaults under the structure, a feature familiar to ABS investors.
As discussed, in a typical aviation CLO, a bankruptcy remote CLO issuer will issue the CLO notes. A trustee will manage the issuance of and payment under the CLO notes, a security trustee will hold title to the collateral (the underlying loans) on behalf of the CLO noteholders and other secured parties and an operating bank will hold all accounts used in the structure. A managing agent will provide certain administrative, accounting, cash management and certain other services, including preparing required filings, preparing budgets and monitoring the servicer.
While the roles and responsibilities of the previously named parties may be familiar to those active in the ABS market, the role of the servicer in an aviation CLO is quite different from the role of the servicer in an ABS. In an aircraft-lease ABS, a servicer is responsible for, among other things, collecting rents from lessees, monitoring insurance and maintenance of the aircraft and engines, and remarketing aircraft at the expiration or termination of the underlying leases. In an aviation CLO, the servicer monitors the collection of principal, interest and other obligations under the underlying loans, and enforces the rights of the underlying lenders in respect of those payments. Provided that the servicer is meeting a prescribed standard of care and conflicts standard, the servicer is typically given broad discretion to restructure the underlying loans without needing consent from the issuer’s board or anybody else.
Unlike in an ABS where the servicer fee is based off contracted lease receivables, servicer fees in aviation CLOs are typically based off the aggregate outstanding principal of the underlying loans.
Cash Sweep and Cash Trap Events
Certain cash sweep and cash trap events are included in aviation CLOs to enhance the senior notes. The following tests will typically trigger a trapping or sweeping of cashflows until they are cured.
- LTV Look-Through Test: This test is calculated by dividing (a) the aggregate principal outstanding on the senior-rated CLO notes by (b) the aggregate appraised value of the aircraft securing the underlying loans. While this test may give some indication to investors in senior CLO notes as to the health of the deal, it is important to remember that some of the underlying loans may be unsecured and, in respect of underlying loans which are limited recourse, the security will only extend to the value of the outstanding amounts on the underlying loan regardless of the appraised value of the secured aircraft.
- Overcollateralization: This test is calculated on a tranche by tranche basis and tests the ratio of (a) the aggregate outstanding principal of the underlying loans (excluding any non-performing underlying loans) to (b) the outstanding principal of CLO notes of a particular tranche and the outstanding principal of any CLO notes senior to that tranche. The threshold triggering a cash sweep for each tranche differs based on the seniority of the particular tranche.
- Debt Service Coverage Ratio (DSCR): As with Overcollateralization, DSCR is tested separately for each tranche with varying minimum thresholds to be met. The DSCR test is typically calculated on a trailing 3-month basis by dividing (a) the aggregate amount received on the underlying loans (minus expenses paid at the top of the waterfall) by (b) the sum of (i) the aggregate amount of interest due and payable on the senior-rated CLO notes and (ii) the principal amount due on the relevant tranche.
Credit Risk Retention Requirements
In contrast to aircraft lease ABS transactions, U.S. credit risk retention rules apply to aviation CLOs. The “credit risk” retention requirements provided for in the implementing regulations of Section 941 of the Dodd-Frank Act require the sponsor of a “securitization transaction” to acquire (either directly or through its majority-owned affiliates), not less than 5% of the credit risk of the “securitized assets,” in order to retain “some skin in the game” and therefore align the incentives of the sponsor with those of the holders of the CLO notes. In the aviation CLOs that we have seen come to the market, the credit risk retention requirements have been met by the sponsor retaining a “horizontal” interest consisting of a class of subordinated securities valued at more than 5% of the overall securities issued in the transaction. The sponsor is prohibited from directly or indirectly eliminating or reducing its retained exposure by hedging or otherwise transferring these subordinated notes for the lifetime of the CLO.
This information is provided by Vinson & Elkins LLP for educational and informational purposes only and is not intended, nor should it be construed, as legal advice.