Episode 7: Taking Aviation Leasing to Greater Heights through the JOL/JOLCO (Mark Lessard and Olivia Matsushita)

My name is Olivia Matsushita, partner in the Tokyo office of Pillsbury’s Asset Finance Practice, and I’m delighted to be joined by Mark Lessard, our Global Head of Finance, who is based in Pillsbury’s New York office and a veteran in the aviation finance and leasing industry.

Mark Lessard: Thank you, Olivia! It’s really great to be here today. The Japanese leveraged lease was traditionally used by Japanese airlines. Why was it that the JLL, and later the JOL and the JOLCO, came to be used by other Asian, European and even U.S. airlines doing cross-border transactions?

Olivia Matsushita: I think the product was and is still very attractive not only to Japanese airlines but also international airlines because it offers airlines access to a lower cost of funds for financing what can be extraordinarily expensive equipment.

But let’s briefly take a step back and explain exactly what the JOL and JOLCO are.

Lessard: Put simply, these structures are used to deploy Japanese equity. The JOL is an operating lease, typically without a purchase option. Here the investor takes on the asset risk because the aircraft is returned to the investor at the end of the lease and needs to be sold or remarketed. The “JOLCO,” on other hand, is more of a financial product since a fixed purchase option built in. JOLCOs are structured with a high degree of care to ensure that this purchase option is exercised. In both cases, the investor is the owner or lessor of the equipment and leases the aircraft to an airline on a mid-to-long-term lease, typically eight to 12 years.

Lessard: And are we talking about a single investor or a pool of Japanese investors that are providing the capital to finance the acquisition of these aircraft, and what is it that lures the investors to these products?

Matsushita: Traditionally, the investor profile is small to medium-sized businesses (SMEs) that have tax capacity. By this we mean Japanese corporates that have fairly substantial taxable profits that can be reduced through depreciation of the metal and the interest payments on the loan. Many JOLCOs are actually structured using a TK, which stands for tokumei kumiai, or an NK, standing for nin-i-kumiai, in Japanese. The TK or the NK is like a silent partnership in which the investor obtains a share of the profits and losses, including tax losses. The TK structure is geared to any number of small investors, which allows for very broad syndication. The NK, on the other hand, is more geared to a single large investor. The real beauty for the investors lies in the tax depreciation benefits that the Japanese equity investors are able to obtain through their proportional ownership in the TK or NK. Those are accelerated tax losses that can then be applied to offset the investor’s core taxable income.

Matsushita: So Mark, on the same topic, what is the minimum equity contribution that is required from the investor?

Lessard: Japanese equity investors will usually invest around 20 percent or 30 percent of the cost of the equipment, and the balance of the purchase price is funded through bank loans or other types of debt. While we have worked with plenty of international banks funding these structures over the years, recent changes in Japanese withholding rules have meant that lenders need to have a Japanese lending license in order for the borrower to take full advantage of all available interest deductions. JOL transactions are typically back-leveraged with mezzanine or parent debt, and so in those transactions we don’t usually see a mortgage on the metal.

This means an airline could get 100% financing of the asset cost upfront, right Olivia?

Matsushita: Yes, assuming you can strike a commercial deal with the JOLCO, operators can get 100% financing for the cost of the machine. When these advance rates are combined with secular declines in Japanese interest rates, the JOLCO financing becomes very attractive for airlines.

Matsushita: I think we should also talk about the call option and how this works.

Lessard: Yes, the -CO on the JOL … good idea. So there is one key feature of the structure. The JOLCO, unlike the JOL, has a purchase option, where the aircraft can be sold to the airline prior to the end of the lease for today’s estimated fair market value. You see, JOLCO investors don’t typically have the technical ability to manage lease returns, to evaluate, let alone operate, the aircraft at the end of its lease terms—they are financial investors who don’t want residual asset risk. So redelivery conditions and other terms are carefully crafted to mitigate the risk that the purchase option might not be exercised. At the same time, the Japanese tax rules do state that the investor must still take some residual asset risk in order to qualify for an “operating lease” that provides access to tax benefits. So it’s a bit of a balancing act.

That leads to the next obvious question that our listeners might be wondering: Have we ever seen an airline not exercise the purchase option?

Matsushita: Good question. Historically, JOLCOs were only offered to the best of airline credits, such as flag carriers with implicit state backing, to limit this risk. And prior to the pandemic, the answer would likely have been no, or certainly that would have been an astonishing outcome. But as our listeners may be aware, a number of JOLCO aircraft were rejected in recent bankruptcy proceedings, and so this is certainly a possibility and one that wouldn’t necessarily have come to the limelight prior to the COVID-19 pandemic. Mark, can you talk a bit more about how the JOLCO product fared during the pandemic?

Lessard: Sure thing, Olivia. Aviation was in its infancy the last time a pandemic of this magnitude fell on the world! So this was a first-of-its-kind event for aviation that had two significant negative effects—it temporarily destroyed the ability of airlines to generate revenue, which in turn hammered aircraft asset values. Many airlines that did not receive sufficient levels of government support were not able to weather the storm and had to file for bankruptcy. This resulted in restructured lease cash flows and in some cases, returned aircraft. Unlike institutional equity, the retail investors behind JOLCOs don’t have the ability to inject fresh capital into the structure, so that did leave some deals vulnerable to lender foreclosure actions. In most cases, there was a cooperative approach—the loan cash flows were re-cut to match the new lease cash flows and the equity participants were left in the deal to try and recoup their investment over time. But in a few instances, distressed debt funds acquired the loan positions and took actions that were not necessarily in collaboration with the Japanese equity managers. The JP Lease-VietJet case is a well-publicized example, where the equity manager went head-to-head with distressed investors to force an orderly sale process. So it has been a period which has really stress-tested the product, but that is also the case for other asset classes, too. Importantly, industry participants have been working together to alleviate the circumstances as best they can and to find, wherever possible, amicable solutions. As we have seen at Pillsbury, the number of cargo operators interested in the JOLCO through the pandemic has certainly increased and investor appetite does remain and is on the rise again for the JOLCO as airlines find their footing and become profitable. I think it is a structure that won’t easily fade away.

Matsushita: Thanks, Mark. Another challenge in restructuring the JOLCO is that it involves not only a pool of lenders but also Japanese equity investors. And so, at a practical level, there is less flexibility to amend the documentation once it is put in place because you need to bear in mind that it requires consent from your investor group, not just your lenders. It’s a little bit more time-consuming in that sense.

Lessard: Great point.

Matsushita: Mark, coming back to the types of airlines that have used the JOLCO already, I understand the product is very much open to U.S. carriers too. Can you tell us about the appetite for U.S. airlines accessing the JOLCO market?

Lessard: Yes, definitely. Pillsbury was one of the first law firms to pioneer a structure that enabled U.S. airlines to get lift from the JOLCO product, and Pillsbury attorneys have been at the forefront of the U.S. JOLCO for many years now. Although we don’t have time to cover the structure of the U.S. JOLCO today, I would certainly encourage our listeners to reach out to Pillsbury attorneys in your time zone to learn more about this product. I will say we have pioneered several U.S. JOLCO and would be happy to answer any questions the audience may have.

Matsushita: Well everybody, that’s all we have time for today on the “magic” of the JOLCO. We hope that you have enjoyed this podcast, and if so please give it a big thumbs up on whatever media platform you have listened to it on!