Derek Delaney was delighted to speak at the Ishka+ Aviation Investival: North America

Hello, everyone. Welcome to today’s session. My name is Matthew Dolan. I’m a tax partner in Deloitte’s aircraft leasing and finance team based out of Dublin. Deloitte have been a proud sponsor of the Ishka festivals in New York and Dublin for many years. Happy to be involved again this year with their virtual conference, really looking forward to getting back to the face-to-face meetings as soon as we can. I’m very happy to be joined today by Derek Delaney. He’s the Global Chief Executive Officer at Waystone, as we’re gonna have a brief discussion today on the role of regulated funding in an aviation context. Derek, would you maybe like to give us a brief introduction of yourself, and what Waystone are about?

Thank you for having us on. I actually remember you speaking with one of my colleagues three years ago at one of the Irish events. Waystone would be quite familiar to a lot of your clients for its equity real estate for hedge funds. The focus very much for us today is around getting aviation exposure into those regulated funds for the benefit of the European investors. That’s…you know, we’re very excited about some recent developments, and look forward to chatting through it with you today.

Private Equity & Institutional Investors Continue to See Opportunities in Aviation

Super. Thanks, Derek. So, the last couple of years have, of course, been particularly challenging for the industry. However, one thing we certainly recognized, and that became evident very early on was that while traditional commercial lenders had taken a step back, private equity and institutional investors continue to see real opportunities in the sector. The result, as far as we saw it anyway, was kind of a host of new investments and platforms, new joint ventures, including the likes of…Arena, Kennedy Lewis, Ares and Vmo, and a host of new entrants who had kind of dipped their toe into the water for the first time. I do think that the increased M&A activity, capital market transactions, all of the enhanced fundraising that we’ve seen throughout 2021 really demonstrates that investor demand is as strong, if not stronger than ever. Is that kind of echoed in terms of the stuff that Waystone have been involved in in 2021?

Absolutely. And look, whilst you’re often looking at it from the perspective of the person offering the product, we tend to be brought in to solve for the investor, so from an inside out perspective. What we’ve found is that the European institutional investors, particularly insurance funds, pension funds, they’re under pressure to make sure that they have a certain return. And they generally achieve that through having a certain amount in equities, a certain amount in debt, PE, and…AIFMD allowed them to invest more into regulated alternative assets, and aircraft are very much falling into that space for them. So initially, we would have thought that it would be viewed as an alternative to real estate and real assets, and it is, but what we’re finding is that because of the low interest rates, the lower yield on bonds, a number of the institutional investors, particularly out of Germany, have started replacing bond exposure with annuity-like products that you get from the return profile of leasing aircraft.

Excellent. Yeah, yeah, really interesting stuff. So, you’re actually seeing that investor demand, which kind of echoes what we’ve been doing for the last years now, which is great. But I guess, Derek, historically certainly, from our perspective, the more favored investment structure from a private equity asset manager type…would be the limited partnership type structure, with Irish SPVs as your asset owning entities underneath. So I guess, the Irish offering this space in a regulated fund context kind of falls really into two camps, right?

Corporate-Type Vehicle

It’s your corporate-type vehicle, so the likes of the PLC type of company, and the more kind of en vogue ICAB structure, which we’ve seen a lot of and a huge amount of interested in, not just in aviation, obviously.

Common Contractual Funds

But also on the other side of the same offering, we have the likes of common contractual fund, unit trusts and, the Investment Limited Partnership, which very recently got an overhaul to make it more fit for purpose, I think, as everybody has agreed, and we certainly expect this to be quite an interesting product from a private equity perspective, going forward.

Are you guys seeing much interest in the ILP as a regulated product?

We very much are. It seems a given when we talk to any manager structuring a product, or investor, that the asset, the aircraft will be held in Section 110. But it’s still how would you get exposure to that? The issue for a lot of pension funds, in going into that directly, is that it can go to their balance sheet, and they want it to be an at arm’s length investment. The way they achieve that is by putting the funds between themselves and that entity, so it is an essential part for them. Even from the U.S. perspective, if it’s a U.S.-equivalent regulated product, there is different tax treatments, so it’s absolutely critical. The reason that there hasn’t been a significant number of regulated aviation funds to date has been the inability to put that tax transparent limited partnership structure over the Irish Section 110. And we currently have two in the process of launching with yourself, as it happens, and they are a direct consequence of being able to offer the limited partnership. The limited structure doesn’t cause issues for European investors, but when you’re looking at investments that are 5, 10, 15, 25-year investments, they’re really only invested in via limited partnerships. So, it’s just providing the underlying exposure in the manner that we’re used to seeing it in the market. And that’s our simple interpretation of what the ILP delivers.

Irish Funds & Taxes

Yeah, I think it’s just something that’s just gonna continue to grow and grow. It really, really is an excellent offering to the overall Irish offering as well. You did mention tax…at that point, one thing we certainly think is, from a tax perspective, having that Irish regulated fund sitting above the SPV, the asset owning SPVs can make a lot of sense from a tax perspective. So, I mean, optically, it just looks better. And at a time when our experience is airlines are increasingly concerned with the allocation of tax risk in a lease agreement, particularly in light of the multilateral instrument principal purpose test, issues we have in tax treaties now, it can just be an easier discussion with an airline, rather than having to explain the role of say…So, just optically, it can just look a little better.

You know, the Irish fund offering itself is really efficient from a tax perspective. The funds are exempt from Irish income tax, as you know, and you can make those distributions to non-Irish investors free from any withholding tax, kind of irrespective of their tax residence, which is a really great selling point as well. You mentioned the ILP, which is itself tax transparent, and depending on your investor profile, that can really be a unique selling point, or something that’s a real must-have in many structures. And then on the flip side, you have the offering of the ICAP, the corporate vehicle, which itself can check the box from a U.S. federal tax perspective.

International Tax Law Changes

The other point I think that’s worth mentioning, Derek, is as you and I have discussed, there’s been a plethora of international tax law changes over the last number of years, such as you know, the introduction of anti-hybrid rules here in Ireland, and I’m sure your own clients are…of some of these changes. And I guess one of the more critical ones from an Irish perspective is the soon-to-be-introduced interest limitation rules, which can have or may have a significant impact on the aircraft leasing sector, given its…nature.

So at the time of recording today, as we sit here, we don’t necessarily have the draft law in front of us on the interest limitation rules, but one thing we’re hopeful for when we do see the budget, and the Finance Bill, Finance Act is that it’s hoped that that Irish regulated fund above an Irish platform…aircraft owning SPVs can mitigate, or will hopefully mitigate some tax leakage which could arise as a result of these rules. So, it’s just another benefit of the use of a regulated fund in this type of an investment. So Derek, I know we’ve been working on a couple of projects together.

Any kind of practical things that have been jumping out at you as you’ve kind of worked through one or two of these projects?

No, the point you make, Matt, has come up a lot with investors and the investment managers. The hope, as you say, is that if the Section 110 is set up, and is an at arm’s length investment …type of degree, it gives the option to pay the leverage at the fund level, and have the Section 110 be fully funded. It will be interesting to see the advice come out from yourselves once the final guidance comes. There are certainly a few waiting to understand that before determining how to finish the structure.

The really interesting thing we’re seeing, Matt, is it’s the first time that we’ve seen the industry come into funds. And what I mean by that is, say even taking the two that we’re working on with yourselves, one is a direct lending manager that is now doing aircraft leasing, and it’s not a huge stretch. But the other is quite interesting, it’s a commercial leasing company that are looking to package within a fund, and to use that fund as an alternative source of funds. And that’s new and that’s very interesting. And when you couple that with the fact that manufacturers may be producing some aircraft right now, and they may not find the creditworthiness at the airline side, and that alternative source of funding is stepping in with a different risk appetite to the traditional lenders. And that means that besides getting the 8% to 12% returns on the leasing, they’re actually starting to pick up some new aircraft at a discount to the roll-off price.

Flipping Warehouse or Platform to an ABS-Type Structure

Yeah, yeah, really interesting. I think…So, I think one of the other questions we get asked a lot, Derek, and it is interesting that we had those discussions with the assets managers as well, the more familiar route has been, in more recent times, has been to kind of flip your warehouse or your platform into an ABS type structure. And the thought of a regulated fund, I know certainly from my own client base, if I mention, you know, have you considered this regulated product, you know, it’s an issue, well, that’s just gonna be too expensive, or we’re not at that scale yet to make that kind of investment. Based on your experience, you know, what is the right number…

Yeah. If you’re structuring these products, you’re structuring them for institutional, probably, pension money. And everyone will know that engaging with those investors, you are talking in a best-case, a three-month process, and probably longer. They are worth that, though, because the tickets tend to be at least $250. And often, they will speak to colleagues running pension funds within the same state, or in different states across Europe to try and bring their exposure down to 50% or less. So, we do see the starting figure being $250, $500. Because you want to achieve diversification in the assets, and because of the price of planes, you do need to be talking a $250 million type starting ticket. So, we’ve done the analysis for several clients in looking at the tax-efficient benefits on a basis point versus the cost of the fund, that comes out at around $90 million, but the reality is you’re not going to have enough diversification in the aircraft. So commercially, $90 million, but reality to achieve the diversification, $250.

The Importance of Diversification

Yeah. Yes, you know, given some of the portfolios that may come to market, or indeed, you know, some of the acquisitions we’ve seen over the course of the last two years alone, we can get to that number very quickly, I guess… Yeah, I like the idea of the whole diversification point because one thing we shouldn’t lose sight of is, I guess, no matter what platform or what kind of legal structure you use in an Irish regulated fund context, there is the ability to have that kind of umbrella fund structure, with multiple sub-funds, depending on you know, whatever…you might want to be invested in.

And I guess the point you make is interesting around some of the asset managers who may be coming from a different starting point, that direct lending piece, you can still have your… It’s almost like a one-stop-shop, you have your umbrella fund, with a direct lending feeder, your aircraft leasing investment platform as well, and then, you know, potentially something outside of the industry as well, I guess. And that could help get to that scale that you mentioned, and that diversification point. And most certainly, I’ve seen the ICAB used in a couple of structures where they make an existing platform that’s already there. There can be a management required certainly on the tax structuring piece where you’re using an existing platform, where there may or may not be some regulatory kind of issues that you may wanna work through. But on the basis that it does offer that diversification, segregated subfunds, I think it’s just a super offering that asset managers should certainly take a look at.

Yeah. And because hedge funds, they don’t jump up and down to advertise themselves, they have a particular number of investors. But the first fund we’ve done in this space was…it was 37 engine refits for an Asian airline, and that was financed by a U.S. direct lending manager, and they weren’t able to secure the funding through traditional lending sources. And so, that’s been done now the last four years, we’ve gone through audits with your colleague, Brian Jackson, on the fund audit side. So, it’s not massively well known as a product, but it is very much embedded down. So anyone looking at this, the perception shouldn’t be that they would be a test case. And that’s very important for our clients, in particular, to give comfort to the investors.

Derek, I know Waystone have put in kind of significant work into this as a product itself, including kind of, I’m sure, a long, drawn-out conversation with depositories. How did all that go?

We were fortunate enough to have Frank Dowling, CFO of Airbus Ireland…for a number of years, and Niall McNamara, ex-GPA, so we have the pedigree in house to understand it, and be entitled to talk about it. So, that has very much allowed us to bring the depositories and custodians to the table. That though, we have gotten there with the likes of NT, the likes of SEI, where we have active funds that do hold aviation assets. And so, it has been more true that did involve a lot of consultation at an Irish fund level. It did involve discussions with the CBI, explaining this new asset cash flow went up in a regulated fund. But as I said, these are all years past now, and gone through audit cycles. So it was worth it, but it’s rare we get to do things this interesting in governance and running regulated product. So the work has been done, but it was enjoyable work to do.

One of the other things, especially the likes of an asset manager who hasn’t, you know, stepped into the…might be a little nervous around just the whole area of AIFMD, and the requirements I guess, for a fund, a regulated fund in an Irish context to have that AIFM, that alternative fund manager.

Practically, how does that work if you’re coming to this cold in terms of your own structure or your own manager structure?

Yeah. So, well, we actually have three different entities that are involved in servicing this, which might sound like it complicates it more, but it’s just a specialty in everything. So, the agents I mentioned earlier, some others like Andy and Patricia, they will sit and provide the demonstrable aviation expertise at the holding company level, the Section 110, that’s essential. Then as we move up, you want a regulated and an experienced investment manager. We actually use a MiFID firm that’s been regulated by the CBI for 25 years, so it’s the oldest lineal group in all of Waystone. And then, their actions are overseen at an arm’s length by the AIFM. So, because we always think of these things from an investor perspective, the investor is then looking at it and seeing a regulated investment manager, a regulated AIFM, and we’re then working with the asset managers, the people sourcing the proper credits, or the proper assets. They’re recommending those into a very well-structured IC, and they’re the experts. So, we’re going to check that the asset’s qualified, we’ll never talk about a good or a bad asset. So that’s what they’re bringing, the money is coming in because of their expertise in picking those assets. So, we’re able to structure around the level of experience that they have.

Excellent. Yeah. I guess, you know, that has been…or certainly has come up in conversations that I’ve had, is oh, well, we’re not an AIFM, so…this is manageable, that whole process, and this isn’t something that hasn’t been done before so you know, there is a tried and tested path for this. You know, Derek, overall, you know, certainly from my perspective, the main benefit here is that alternative source of equity and capital that a regulated fund can bring.

While the industry has been lucky enough over the last couple of years that it hasn’t been an issue, it’s always good to have that alternative there, right?

And, Matt, it’s matching that off against the demand for it as well. So, the reality is you have people who have the ability to deliver 10% returns from leasing in a market where annuity products are at zero, and there’s huge demand. So, Deloitte Ireland is going to be the meeting point for those international asset managers, and the European institutional investors. It’s because of that, the supply and the demand, and there not being a matching house to date, I think the ILP has come just in time for it to be Ireland.

Excellent. Well, I think hopefully, yourself and myself will be quite busy over the next couple of years, as people look more and more at this as a…But listen, thanks a million for your time today. Really good to talk to you.

Absolutely. Thanks for having me on, Matt. I appreciate it.