Aircraft Leasing - LCs Alternatives to Cash Maintenance Reserves

Commercial Aircraft Operating Leases

Letters of Credit Alternatives to Cash Maintenance Reserves (MRs)

1. Introduction

Commercial aircraft operating leases have grown in popularity since the inception of the aircraft leasing industry in the early 1970s1. As of 2023, the total percentage of leased aircraft (industry average) is close to 50% with the same percentage well above 50% for narrowbody aircraft2

A natural question is ‘Who pays for the maintenance of leased aircraft?’ Under aircraft operating leases, the lessee (airline) is responsible for the aircraft’s maintenance costs during the lease term. In that regard, in addition to basic rent, depending upon the lessor’s view of the airline’s financial standing, monthly payments toward future maintenance costs are made. These are referred to as ‘Cash Maintenance Reserves’ (MRs) and are divided among major high-cost components such as engine performance restoration and LLPs replacement, airframe heavy checks, landing gear and APUs, among others, (Major Events). For an airline with a strong balance sheet and robust financial history, maintenance usage payments (usually referred to as utility consumed) may be deferred to the end of the lease term (EOL Compensations)3

Determining whether to structure a lease through MRs or EOL Compensations is a choice that involves commercial and risk considerations. Additionally, the industry cycle may play an important role in this respect (lessor´s versus lessee´s markets). Thus, this issue is heavily discussed by lessees and lessors during lease agreement negotiations.

1 Robert Agnew, ‘The birth and growth of the aircraft leasing business’, n.d., https://www.world-leasing-yearbook.com/feature/the-birth-and-growth-of-the-aircraft-leasing-business/

2 Flightradar24, ‘What is aircraft leasing?’, June 18, 2024, https://www.flightradar24.com/blog/aircraft-leasing-explained/

3 Ibid.

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Based on these considerations, a lessor may demand MRs as a condition for placing an aircraft with a given lessee. However, the prospective lessee may argue that its financial condition may allow it to instead pay EOL Compensations. This is because lessees (airlines) tend to favour EOL Compensations instead of MRs as they provide financial flexibility and a stronger balance sheet and because MRs become the lessor´s property and are not accounted for in airlines' balance sheets. Moreover, incumbent lessors may face stiff competition from new entrants into the aircraft leasing space (i.e. new lessors) that may be more willing to take on a higher risk to win deals and, therefore, be more willing to drop MRs and agree to corresponding EOL Compensations4. This is because cash MRs provide a lower risk exposure for lessors against unforeseen circumstances, such as airline defaults and bankruptcies.

In many instances, lessors and lessees may reach a compromise in which a lessee does not pay MRs, yet the lessor does not acquire the risk of exposure to an airline default and lose EOL Compensations. This is usually achieved using Letters of Credit (LCs) as an alternative to MRs, commonly called MR LCs. LCs are generally issued by a bank and serve as a guarantee of the lessee’s payment to the lessor under specific terms and conditions. This is typically seen as a middle ground since the lessor’s risk of not getting paid is minimised whilst the lessee can enjoy greater cash liquidity during the lease term. It is noteworthy that banks may have strict credit history, risk and cash collateral requirements, among others, associated with granting LCs to airlines. Thus, not all airlines can afford an LC.

This paper illustrates how MR LCs work throughout the life of a lease agreement. For familiarisation purposes, a publication from 2022, ‘Leases that Apply Maintenance Rent’5 (hereafter,

4 Ishka, ‘Lessors under pressure to drop maintenance reserves’, March 5, 2017 https://www.ishkaglobal.com/News/Article/5587/Lessors-under-pressure-to-drop-maintenance-reserves

5 Omar Zuluaga, ‘Commercial Aircraft Operating Leases, Economic Aspects of Utility Consumption, Leases that Apply MR’ n.d., https://issuu.com/omar_zuluaga/docs/commercial_aircraft_operating_lease_d10fa92589ca39

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‘2022 Paper’) illustrates how MRs work throughout the life of a lease agreement. Another publication from 2023, ‘Leases that Apply End of Lease (EOL) Compensations’6 (2023 Paper) explains the main principles of EOL Compensations. Becoming familiar with the 2022 and 2023 Papers is recommended to fully understand the concepts associated with MR LCs.

2. Assumptions

To illustrate how MR LCs are defined, calculated and managed, one of the highest-cost Major Events will be used, engine performance restoration (Engine PR). Since the methodology discussed works similarly to other Major Events described, only Engine PR will be discussed in this paper. For this scenario, notional assumptions are made as follows.

2.1. A notional aircraft engine lasts on wing 20,000 flight hours (FHs) (Mean Time Between Removal - MTBR) before it must be removed to restore its performance at a specialised shop. This is usually referred to as a performance restoration shop visit (PR SV). The time-on-wing of a new engine, before it requires an SV, is higher than the time-on-wing after each subsequent SV. Yet, here, for simplicity, it is assumed that the MTBR is the same for each SV.

2.2. The notional cost to restore the performance of the engine is $2,000,000 (SV Cost). The cost of the first and subsequent SVs differ. This is due to differences in the work scope of each SV. Yet, for simplicity, it will be assumed that this cost is the same for each SV.

2.3. This results in a cost per FH of $100 ($2,000,000/20,000 FHs) (MR Rate). This rate may change over time, but for simplicity, it will be assumed that this rate remains static over time. This rate will be used in all discussed scenarios.

2.4. Annual utilisation of the aircraft is 2,500 FHs per year. The length of the lease is 12 years.

6 Omar Zuluaga, ‘Commercial Aircraft Operating Leases, Economic Aspects of Utility Consumption, Leases that Apply End of Lease (EOL) Compensations’ n.d., https://issuu.com/omar_zuluaga/docs/aircraft_leasing_-_economic_aspects_of_utility_con

2.5. The return condition (RC) of the engine, per the lease agreement, is that the engine has had no more than 10,000 FHs of operation since new, or the last PR SV, whichever is more recent. This is usually stated as 10,000 FHs since last SV (FHs SLSV).

Notably, strict lease requirements must be followed to qualify an SV for MR LC adjustment purposes. Usually, predefined scopes of work described in the engine manufacturer’s ‘Workscope Planning Guide’ are stated in the lease agreement. Ordinary engine repairs do not usually qualify for MR LCs adjustment purposes. The term shop visit (SV) used in this paper assumes that these qualify for LC adjustment purposes.

3. Maintenance Rent LCs (MR LCs) – Engine New at Delivery (First Lease)

The following is based on the assumptions of section 2.

3.1. Upon delivery of the aircraft

The monetary equivalent of the engine’s utility consumed during the first year of operation will be $250,000. This results from multiplying the 2,500 FHs achieved during the year by the MR rate of 100 $/FH. Usually, the lease agreement stipulates that the lessee must provide an LC for $250,000 in advance at delivery which will cover utilisation for the first year of operation.

3.2. On the first anniversary and subsequent anniversaries following the delivery of the aircraft Usually, the lease agreement stipulates that the lessee must increase the value of the current LC or provide an additional LC for an aggregate amount equivalent to the utility consumed during the first year of operation plus the expected utilisation of the second, and subsequently for each year of operation.

Based on these considerations, the progressive value of the LC during the operation of the aircraft will be as follows:

LC value at delivery: $250,000

LC value, beginning of year two: $500,000

LC value, beginning of year three: $750,000

LC value, beginning of year four: $1,000,000

LC value, beginning of year five: $1,250,000

LC value, beginning of year six: $1,500,000

LC value, beginning of year seven: $1,7500,000

LC value, beginning of year eight: $2,000,000

3.3. At the end of year eight, the engine must be removed to restore its performance

Usually, per the lease agreement, once the SV is conducted, the lessee pays $2,000,000 to the shop and then requests the lessor reduce the level of the security back to ‘one-year utilisation’ as was the case before delivery. At that point, the cycle begins again. It is understood that once an engine undergoes a PR SV, the lessor´s risk (exposure) goes back to zero and the LC amount maintained will then be the monetary equivalent of utility consumed during the first year of operation following the SV.

At the end of year 12 (redelivery), the value of the existing LC will be $1,000,000. This results from multiplying 2,500 FHs per year by the MR Rate of 100 $/FH over four years following the SV.

This assumes the engine is reinstalled following the PR SV at the beginning of year nine of operations. This is illustrated in Graph 1.

Graph 1

3.4. At redelivery, the lessor returns the LC to the lessee and the EOL Compensation is calculated.

3.5. Following the principles described in the 2023 Paper, the EOL Compensation payable by the lessee to the lessor will be $1,000,000. This is because the engine is being returned with 10,000 remaining FHs compared to the 20,000 FHs it had remaining at delivery.

3.6. The total amount spent by the lessee on the engine PR SV Major Event during the life of the lease will be $3,000,000, which is equal to the aggregate amount of (i) $2,000,000 paid to the shop at year 8, and (ii) the EOL Compensation of $1,000,000 paid to the lessor at redelivery.

4. Maintenance Rent LCs (MR LCs) – Engine with usage - not new or ‘fresh’ at delivery

The same assumptions made in section 2 will apply to this case. It will be assumed that the engine had 10,000 FHs SLSV at delivery. Once the aircraft is delivered, the engine will accrue utilisation.

4.1. At the end of year 4 of the lease, the engine must be removed to restore its performance

In year 4 during the lease, once the engine reaches 20,000 FH SLSV, it must be removed and sent to a specialised shop for a PR SV. The value of the existing LC will then be $1,000,000 (resulting from 2,500 FHs per year multiplied by an MR Rate of $100/FH, multiplied by four years). Once the engine PR SV occurs, the following occurs.

4.1.1. The lessee pays the specialised shop $2,000,000.

4.1.2. The value of the new LC once the engine begins being used again will be $250,000 (following the principle described in section 3.1).

4.1.3. The lessor does not contribute toward the SV since this is a non-MR lease.

4.2. At the end of year 12 of the lease, the engine will have accrued 20,000 FH SLSV

The engine will be removed and sent to a specialised shop for a PR SV. The value of the existing LC will then be $2,000,000 (per the principle described in section 3.2).

4.2.1. The lessee pays the specialised shop $2,000,000.

This is illustrated in Graph 2.

4.3. At redelivery, the lessor returns the LC to the lessee and a corresponding EOL Compensation must be calculated

4.4. Following the principles described in the 2023 Paper, the EOL compensation amount payable by the lessor to the lessee is $1,000,000. This is because the engine is being returned with 20,000 FHs remaining compared to the 10,000 FHs it had at delivery.

4.5. The total amount spent by the lessee on the engine PR SV Major Event during the life of the lease will be $3,000,000 (the same as in section 3) and is equal to the aggregate amount of (i)

$2,000,000 paid by the lessee to the shop according to section 4.1.1, plus (ii) $2,000,000 paid by the lessee to the shop according to section 4.2.1, minus (iii) $1,000,000 paid by the lessor to the lessee per section 4.4.

5. Conclusion

MR LCs are an important mechanism that may benefit both lessees and lessors. For the lessor, it provides the required level of security against unforeseen circumstances, such as airline defaults and bankruptcies, during the lease term.

Graph 2

For the lessee, it provides financial flexibility since it does not have to pay MRs during the life of the lease. This is provided that lessees can secure LCs from providers that comply with the required lease agreement provisions.

Understanding corresponding lease agreement provisions associated with the mechanism to periodically adjust LC amounts during the lease is key. This allows for the smooth management of the lease during the contractual term.

Finally, it is important to understand that MR LCs are usually dependent upon the lessor’s view of the lessee’s financial standing and are generally granted to lessees with strong balance sheets and robust financial histories. Yet, this may be influenced by the risk appetite of new lessors entering the commercial aircraft leasing space.

About the Author

Omar Zuluaga is a former Vice President and Head of Technical Support at AerCap. Currently, he is an independent advisor providing services to institutional investors, management consulting firms and corporations. He spent nineteen years working in technical areas of the aircraft operating leasing industry and worked ten years in airline technical operations.

One of Omar´s core principles is sharing his knowledge and experience, which is why he provides instruction on key aspects of commercial aircraft leasing—particularly technical clauses—to various audiences.

Omar holds a Bachelor of Science in Aviation Electronics from the Riga Civil Aviation University in Latvia (formerly RKIIGA) and a Master of Science in Aviation Management from Arizona State University. www.linkedin.com/in/omar-zuluaga

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Aircraft Leasing - LCs Alternatives to Cash Maintenance Reserves

Published on Dec 2, 2024

omar_zuluaga

The publication examines the use of Letters of Credit (LCs) as an alternative to traditional Maintenance Reserves (MRs) in aircraft operating leases. LCs provide bank-issued guarantees for maintenance payments, offering lessors financial security while allowing lessees to retain cash. Unlike MRs, which require monthly payments, LCs are adjusted annually and reset after major maintenance events. At lease end, any remaining obligations are settled through End-of-Lease (EOL) Compensation. This approach reduces financial risk for lessors, improves lessee cash flow, and adds flexibility to lease terms, making it particularly attractive in competitive markets. Feasibility, however, depends on the lessee’s creditworthiness and clear lease agreements. #aircraft, #aircraftleasing #maintenancereserves, #aircraftlessors, #aviation, #aviationfinance, #commercialaircraft, #finance, #leasing, #maintenancerent, #aercap, #avolon, #airleasecorporation, #SMBC, #BOC, #BBAM, #ICBC, #caryleaviationpartners, #DAE