News — 2018

Investors and airlines are seeing continued opportunity in the JOLCO market. Brian McArdle of SMBC Aviation Capital examines what's driving the growth


Japanese companies are recording strong profits and this is driving demand for investments that deliver tax-depreciation benefits. One of the investment products that has been around for a long time, and for which demand continues to grow, is the Japanese Operating Lease with Call Option - known as JOLCO. The JOLCO is an attractive product for many reasons:It provides Japanese investors with depreciation allowances that can be used to offset otherwise taxable profits and airlines with 100% financing at an attractive equity IRR, since the equity investors are focused more on tax benefits than yield.The call option, which is usually ten years into the lease term provides the airline with an ability to re-acquire the aircraft and the investor with an exit that avoids a remarketing event at lease expiry.

Recent research indicates that the amount of equity investment into JOLCO structures, and particularly aircraft related JOLCOs, has doubled in the past five years and that the total amount of equity invested in aircraft JOLCOs could reach ¥380 billion (US$3.4bn) in 2018. Other asset classes, such as shipping, account for a relatively small portion of the market and the aviation sector has been the major driver of growth.

At SMBC Aviation Capital, we have been working on JOLCO deals since 2005, when we provided JOLCO debt financing for Xiamen Airlines.Today alongside our Japanese shareholders we provide full-package JOLCO solutions to the market: Sumitomo Mitsui Finance & Leasing Co. Ltd., our groups' domestic Japanese leasing business provides JOLCO equity underwriting to airlines and places the equity with tax investors, Sumitomo Mitsui Banking Corporation provides debt to JOLCO structures and SMBC Aviation Capital liaises with the airlines and provides aircraft management services to the investment vehicle. Combined we are one of the largest players in the JOLCO market.

Traditionally the JOLCO market was open to only a small group of airlines such as ANA, British Airways, Japan Airlines, Lufthansa and select flag carriers.But with growing demand, and aircraft backed investments becoming ever more mainstream in Japan, things have been changing. For the traditional JOLCO airline, investors are willing to accept ever lower tax benefits given their track record and a familiarity factor and this is driving down the equity IRR for those airlines to historic lows. The falling tax benefits available from the old-stalwart airline deals, plus the growing market capacity, has also opened the market to airlines who have traditionally not used JOLCO before -airlines such as Air Canada, Avianca, AeroMexico and Copa - who are very strong credits but were relatively unknown to the Japanese investor community until recently.

There has also been a natural shift in the types of aircraft being financed.JOLCO financings are typically closed on new aircraft, at or just following delivery from the manufacturer.As such we have seen a large growth in Boeing 787 deals, as well as Boeing 737 MAX and Airbus A320 NEOs.Airlines are keen to lock in relatively low-cost and long term financing, and the lack of refinancing rights in a JOLCO are acceptable on aircraft types the airlines are planning to operate as a core part of their fleet for many years.We still see a healthy trade in the remaining A320 CEO & 737 NG deliveries, which will naturally drop over time as deliveries trail off.We also expect the Airbus A350 will further grow in popularity as the number of its deliveries increase.

Whereas in the past underwriting widebody aircraft was considered more risky for the equity underwriters than narrowbody - the equity underwrite ticket is larger and also the month of delivery of an aircraft relative to their year-end impacts on investor appetite, so the placement risk is more concentrated for a single widebody in one day versus a number of narrowbodies delivering over a few months - today we see even new entrant airlines close well priced transactions for new widebody aircraft.

As the JOLCO is a tax based investment product, there remains a risk that future changes to Japanese tax law could have a significant impact on the effectiveness of the product.On the other hand, there is robust long term demand for these kinds of products in Japan, and the market has proved resilient and flexible in the past, similar to when the previous Japanese Leverage Lease tax structure was no longer possible and the current JOLCO scheme was invented.As with any tax based product, tax law change is a risk that needs to be carefully monitored.

Flowing on from strong demand in the JOLCO market, we also seen a very robust Japanese Operating Lease (or JOL) market - where the deals are standard operating leases, with no call options, and owned by Japanese investors. Market demand has been driven by Japanese investors seeking tax efficient investments, but without the inflexibility of a 12+ year JOLCO lease and with the possibility of equity upside from their eventual exit.With the average age of Japanese company owners in their seventies and rising, there is also a growing demand from company owners seeking inheritance tax planning investments - one of which is the acquisition of hard assets such as aircraft.Like the JOLCO market, the demand increase for JOL investments has driven a real increase in the volume of aircraft and in the number of airlines and lessors participating each year.Although the barriers to entry as a JOL arranger are high (typically you should be at least a Japanese affiliated lessor) we have seen JP Lease invest in Arena Capital and before that FPG into the Amentum platform and both have rapidly grown their market share of the JOL business.Notwithstanding increased market competition, good opportunities for airlines, investors and JOL arrangers remain and SMBC Aviation Capital has recently surpassed $1bn in JOL sales from a standing start in 2015.

With both JOL and JOLCO markets performing well, we see no signs of reduced demand for services from Japanese lessors like ourselves. Where we do see big growth is in the number of airlines who can access the Japanese market as part of their financing solutions. That's been one of the major changes in the past two or three years and this looks set to continue in the months ahead.

Brian McArdle is Senior Vice President and Senior Director of SMBC Aviation Capital. Based in Hong Kong, he is responsible for aircraft trading in the Asia-Pacific market. Brian has more than 13 years in aircraft leasing, four of which were spent in Japan focusing on the sale of aircraft to Japanese investors and arranging JOLCO financing.

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