312-251-1301 info@cfachicago.org
Log In

On January 16, 2024, the CFA Society Chicago welcomed Joe McConnell, Partner, and Co-Chief Investment Officer of Castlelake to present as part of The Vault Series.  Castlelake specializes in complex, asset-rich and cash-flowing opportunities in what they believe to be undercapitalized or inefficient private markets. They invest across the capital structure within three investment strategies: Real Assets, Specialty Finance and Aviation.  Due to weather conditions, the presentation shifted from being in-person to a virtual presentation.  

McConnell began by describing some major trends that have supported Castlelake’s business in recent years such as the rise of corporate direct lending and the growth of financing hard assets.  Castlelake has built on these trends with a focus in the aviation sector.

McConnell noted that hard assets in the aviation sector is approximately a $1.5 trillion asset class.  There are around 25,000 planes in circulation today, totaling $1 trillion, plus $500 billion other assets such as loyalty programs, spare engines, and maintenance facilities.  A key in managing these hard assets and deriving value is to understand the supply and demand of aircraft and the supply and demand of capital.

McConnell admitted than running an airline is not easy – there are difficulties in managing people and managing costs.  Fuel costs are often uncontrollable in the short term.  Revenue can be volatile and cyclical.  Airline bankruptcies have happened and will likely continue to happen, but underlying hard asset values are more stable and resilient. 

Producing airplanes is a unique business.  The market is controlled by 2 original equipment manufacturers (OEMs) in Boeing and Airbus.  It is a duopoly, and it is heavily regulated, as safety of flying planes is paramount to regulators.  The OEMs have control over supply.  The market is heavily undersupplied today as the OEMs have underdelivered around 4,000 less aircraft than expected in the last 5 years.  Meanwhile, passenger traffic has grown at a rate of 1.5 times the rate of Gross Domestic Product growth over the last 50 years.  

Castlelake has around 200 airline customers around the world. The firm deals in working with planes and transact with customers in many ways involving new planes, used planes, late-in-life planes, aircraft engines, and other assets.  The firm also owns an aircraft servicing operation alongside their aircraft leasing business.  When leasing, demand for planes can be beneficial to their business, as they can repossess aircraft from carriers who don’t pay on time to those who will. 

McConnell gave some examples on transactions that Castleake has pursued in recent years.  One is that they can be seen as a replacement for banks.  Banks are decreasing exposure or looking for higher return on capital.  Castlelake steps in to be a partner to offer more financial flexibility.  Castlelake will purchase planes and then lease the aircraft back to carrier if needed.  

OEMs create around $100 billion of new aircraft every year, and approximately 55% of the global fleet is owned by leasing companies and 45% directly by carriers.  This trend is down from about 10 years ago where carriers owned around 60% of the planes they fly.

McConnell noted that Castlelake focuses on key components of return on investment for leasing aircraft.  One is the current yield, and another is stemming depreciation in the asset’s value.  Their leases benefit from the contractual cash flow, which might typically be a 10-year lease.  The contractual cash flows are also designed to include maintenance, and the cash flows typically cover the cost basis during the life of the contract.  The deals are typically into profit by the time the contract ends and then still have the asset returning back to Castlelake.  One difference from other parallel businesses like real estate is that in other business you rely on the assumption that others will pay a higher price for the asset in the future and that can be challenging and risky.  High demand for airplanes is of benefit in their business.  Asset values stay stable and resilient over time.  Commercial real estate is not as flexible since you can’t move the hard asset somewhere else.  In Castlelake’s business it’s quite feasible to pick up the plane and fly it to somewhere else to where there is a buyer.  

The pandemic was a very active time for their business as recoveries and cycles were different around the world.  McConnell noted one example of Indonesia, where the pandemic recovery was lagging in that market.  A carrier didn’t have rapidly recovering passenger demand, so Castlelake stepped in to acquire 29 planes, flew them to California and sold them to Delta.  U.S. passenger demand had grown back much more quickly in the U.S.

McConnell also noted some non-aircraft asset financing deals.  Scandinavian Airlines (SAS), the flag carrier of Denmark, Norway, and Sweden, has been a good airline with decent margins, but needed to file for bankruptcy during the pandemic.  Castlelake was able to provide them with financing to exit bankruptcy.  The deal was for $500 million in financing and 70% of the financing was in issuing senior secured debt, secured by SAS loyalty programs and London Heathrow (LHR) gate slots.  LHR slots have been liquid for a long time.  They are very valuable as it is likely they are not building any more slots at LHR.  McConnell also noted additional structuring involving AirFrance KLM, Delta, and LATAM Airlines.  

Castlelake also has some activity in buying aircraft in the secondary market from other leasing companies.  In more golden years of the economy, there were over 50 leasing start-ups at one point, but now this industry is more in consolidation.  There has been a lot of forced or highly motivated selling, so Castlelake has been buying from these startups.  A key in these transactions is being able to price the leasing contract’s residual value.  

In closing, McConnell noted that individuals from Castlelake are talking to carriers around the world all the time.  They are hearing what is going on, and when aircraft are coming or going from carriers.  When it comes time to deal, they prefer to build in margin of safety.  He noted that appraisers often overvalue asset prices.  He noted that it benefits to heavily involved in the knowledge of the market, and if you are not a leader in an asset class with a lot of info and data then you are likely just a tourist, and that can be risky.  Castlelake aspires to be a market leader in managing aviation hard assets, and it allows the firm to underwrite conservatively.  As deals are bid on, their current hit rate on making bids is about 7%, and he noted that if you get more than 10% of the bids you make then you are likely overpaying.  Castlelake aspires to bid on deals often, and they are content with losing 93% of the time.  Their philosophy is that the more you lose, the more information and data you obtain, so that can be considered a win and helps pinpoint where the opportunities are.

McConnell took some questions from the audience, including his thoughts on where the outlook for undersupply of aircraft compared to demand for passenger travel may be headed in the future.  McConnell noted that this has stemmed first from the Boeing 737 Max crashes in 2018 and 2019 as the requirements for new builds have increased and are hard for manufacturers to overcome.  OEMs working to sell to carriers have been part of the process as well.  Airbus began offering ideas on planes with lower fuel consumption in the last 10 years, especially as many carriers wanted that feature with very high prices of oil occurring in the past.  Boeing also began offering a new design, even as the engines didn’t fit well in the design.  As a result, the OEMs sold around 8,000 of these new planes.  OEMs have pushed the limit pretty far to save on fuel, and the product looks great on paper, but their supply chains are complex to manage.

On the demand side, airfares have been deflationary for the 20 years heading into the pandemic.  Carriers and OEMs found ways to drive down costs, drive down the cost of maintenance, and in addition there was a rise of low-cost carriers.

Regulators have stepped in more aggressively. Crashes haven’t occurred but some planes are experiencing significant technical issues.  So the demand for planes is back, but the supply is not.  If a firm like Tesla or Rivian showed up with airplanes, that could be a potential game-changer.  If production in Russia or China showed up that could also present a different story.

McConnell was also asked how airlines are protecting against risk of the grounding of their aircraft. He noted that diversification in carrier operations is important.  They need good maintenance programs to avoid groundings.  Governments have consistently said air travel is an important part of the local economies.

McConnell was asked if Castlelake had a different strategy for regional aviation hard assets.  He noted that this is a tougher business.  It is higher risk, and higher in maintenance costs and the potential for bankruptcy with makers of smaller aircraft.  Castlelake’s focus has been on Airbus and Boeing.

Finally, McConnell was asked what the potential was for China to grab a share of the airplane market. McConnell noted that there is some growth there.  Over time China will force their carriers to fly Chinese manufactured aircraft, but it will be 20 -30 years in the future before those planes move into other global markets.  Carriers outside of China would have to overcome technical issues.  There is currently no maintenance support for the aircraft and there are not available spare parts.  If your fleet gets grounded, you may have to wait many days before a solution arrives.  You potentially may have to fly the aircraft back to China for maintenance.  So, it makes it currently hard for them to penetrate the global market.  It’s not within Castlelake’s investment horizon for now.

The group thanked McConnell for sharing his insights on the market and more information on sector of aviation industry investing.