Joint ventures between aircraft leasing companies and strategic investors are on the rise. The robust expansion of the commercial aviation industry over the last decade and projections for continued future growth have caused new investors from around the globe to turn their focus to the industry. Aircraft leasing companies have been among the chief beneficiaries of the recent industry expansion. As airlines look to operating leases to maximize their operational and financial flexibility, lessors have rapidly expanded in numbers and in profitability. In this environment, new investors are looking to sidecar transactions with successful lessors as an opportunity to earn solid yields and gain a foothold in the industry. Asian institutional investors and private equity investors have shown particular interest in breaking into this sector and have unsurprisingly joined forces with some of the world’s largest and most profitable leasing companies.  

Lessors and investors find these sidecar investment vehicles mutually beneficial for a number of reasons. For leasing companies, the structure provides them with inexpensive capital to expand their business and stay competitive in what has become an extremely crowded operating leasing market. The structure also gives lessors the opportunity to invest in aircraft and airline relationships that might otherwise be off limits due to concentration limits or other restrictions applicable to their existing portfolio. The structure allows lessors to share asset and airline risk with the investor while at the same time earning additional revenue through equity returns and servicing fees.

New investors are attracted to sidecar investments in aircraft leasing because it allows them to break into the industry, providing them with a platform to learn the business with a view to developing their own independent enterprise in time. Savvy investors recognize that aircraft leasing is a relationship business, and by forming a joint venture with an established lessor, investors can hit the ground running by gaining immediate access to the lessor’s airline and supplier network.

This article provides an overview of the structure of a typical sidecar transaction and highlights some important legal and commercial considerations to keep in mind when embarking on an operating leasing joint venture.

TYPICAL SIDECAR STRUCTURE

In a sidecar transaction, the leasing company and the outside investor form a new, special purpose company that is the vehicle for the investment. Both the lessor and the investor commit to contributing equity to the joint venture, with the investor usually contributing the vast majority of the equity. The lessor adds value principally by acting as servicer to the sidecar, leveraging its expertise and relationships in the aircraft leasing industry to generate value for all investors.

 The respective equity contributions of the parties and the other fundamental governing principals of the joint venture are typically set out in a shareholders’ agreement or similar document entered into among the joint venture and the investors. The lessor’s obligations to provide aircraft leasing services to the joint venture are documented in a servicing agreement between the lessor and the joint venture. The lessor, in its capacity as servicer, acts as the sole point of contact for the sidecar’s customers and suppliers. In exchange for providing these services, the leasing company earns servicing fees, including origination fees, rent-based fees and sales-based fees.

The sidecar does not typically own aircraft directly. Instead, it establishes subsidiaries, referred to as “aircraft owning entities” or “AOEs”, which hold title to the aircraft and enter into lease agreements with operators.

 The chart below illustrates a simplified sidecar structure, which would need to be adapted to account for applicable tax and other considerations.

KEY CONSIDERATIONS IN A TYPICAL SIDECAR TRANSACTION

i. Tax Structuring

Efficient taxation is a critical consideration in the structuring of every aircraft leasing joint venture. In a typical structure, the joint venture is organized under the laws of a tax neutral jurisdiction, such as the Cayman Islands or Bermuda, and is resident in Ireland for Irish tax purposes, which has several benefits including low corporate tax rates and access to Ireland’s tax treaty network.. In order to achieve Irish tax residency, the sidecar must, among other factors, be managed and controlled in Ireland. Irish tax professionals should be be engaged to ensure that the structure and governance framework of the sidecar vehicle will allow the venture to be deemed an Irish tax resident. Common steps taken towards this goal include: requiring that a majority of the board of directors be based in Ireland; ensuring that board meetings take place in Ireland and that company decisions are made in Ireland; and ensuring that the servicer is an Irish entity with employees servicing the joint venture’s portfolio from Ireland. As noted above, Ireland has a very favorable network of tax treaties that exempt aircraft rentals paid to Irish residents from withholding taxes that might otherwise be imposed by lessee jurisdictions. The lessees who will be managing such exemptions will therefore also have a keen interest in getting comfort as to the Irish tax residency of the relevant entity.

Where equity for the venture is sourced from outside of the United States, it may be advisable to form one or more “blocker” entities as subsidiaries if there are any aircraft leased to U.S. airlines. The function of such blocker entities is to block potential U.S. source income from being attributed to the offshore investor. This avoids the foreign investor having to file a U.S. tax return and the risk that the foreign investor will be considered to be engaged in a U.S. trade or business and therefore subject to U.S. taxation.

While the above outlines some common taxation considerations, the tax structure of each joint venture is bespoke and will vary depending on the identity of the investors, the servicer and the target portfolio and lessees. Tax advisors should be involved in both the structuring and the documentation process in order to develop a tax efficient structure that minimizes the risk of any unexpected taxation for the venture that would eat into the profits available to investors.

ii. Equity Commitments, Ownership and Distributions

While the leasing company is usually a minority investor in a sidecar transaction, the absolute and relative size of its equity commitment can vary substantially depending on the goals and respective financial positions of the parties.

The equity commitments of the parties need not be set in stone at the outset of the transaction. Where the parties are interested in hedging the risks associated with entering into a venture with a new partner, investors should consider committing a smaller up-front investment at closing with an option to upsize their equity commitment at a later date, prior to the end of the agreed investment period. If things go better than expected, this also provides an easy avenue to increase the investment amount and the anticipated returns.

When it comes to ownership of a sidecar entity, shares or other ownership interests are typically allocated to each investor in proportion to its equity investment. Profit distributions, on the other hand, can be structured in many ways. The simplest approach is to provide for pro rata distributions to the investors in proportion to their capital contributions. Another popular structure is derived from the private equity model. Under this model, distributions are paid as in the following order of priority: (1) to the strategic investor or all investors, until their capital contributions have been repaid; (2) to the strategic investor or all investors, until a specified rate of return has been achieved; and (3) to the investors in accordance with their specified allocation of profits, with a common approach being the private equity model of 15% or more to the lessor servicer, as an incentive fee, and the remainder to the non-servicer investors.

Proponents of the private equity approach consider that it better incentivizes the servicer to maximize profitability by providing it with a residual distribution in excess of its pro rata equity contribution, once the strategic investor’s preferred rate of return has been achieved. This approach is unsurprisingly taken by private equity investors and other sophisticated strategic investors motivated to achieve a specific rate of return. The specific allocation of returns is highly negotiated and will depend on a variety of factors, including the respective equity contributions of the parties, the strength of the lessor servicer, and the relative bargaining power of each party.

iii. Investments

For a joint venture to succeed, there must be an alignment between the parties on the purpose and goals of the venture. The parties should establish clear investment guidelines at the outset, and also come to an agreement on the investment period and term of the venture more generally.

Will the venture invest in narrowbody or widebody aircraft, new or mid-life aircraft, passenger or freighter aircraft? Who are the target lessees and what types of lessees should be avoided? What will be the geographic, lessee and aircraft type concentration limits for the portfolio? What will be the minimum required remaining lease term of the aircraft? Concentration limits are often of particular interest to lessors who view sidecars as an avenue for investing in aircraft which may otherwise be off limits to them as a result of concentration limits imposed on their own portfolio by prudential risk management and/or outside financiers. Lessees based in countries subject to applicable sanctions under the laws of the United States, the United Kingdom or the European Union or the laws of the home country of any investor will also need to be clearly excluded by the investment eligibility criteria.

In addition to identifying target investments, investors should come to an agreement up front on the period during which new investments will be made and the term of the venture itself. If the term of the venture is on the shorter side, it may be advisable to build in an option to extend the investment period and/or the term in the event that more time is needed to build up the desired portfolio or generate the required returns. This structure, while establishing a clear timeline and framework for investments, builds in the flexibility that is often needed to maximize the profitability of the enterprise.

Finally, a critical component of the investment framework for a successful joint venture is the establishment of clear and unequivocal capital contribution procedures. Once the board has approved the acquisition of an asset, the investors should be required to make their capital contributions within a specified period. There should be no room for second guessing the board or delaying the equity funding process. These requirements are essential to ensuring that the joint venture can move quickly to acquire assets and close deals in a competitive marketplace.

iv. Governance

The Board of Directors

The board of directors of the joint venture will typically be comprised of several directors, the majority of which will, as discussed above, need to be based in Ireland in order to benefit from the Irish tax regime. Directors are nominated by the investors. The majority investor will typically seek the right to nominate the majority of the directors on the board, with the minority investor/leasing company seeking to hold nomination rights in relation to at least one director. Where there are multiple strategic investors it can be useful to appoint an asset manager to manage conflicts among the investors and to avoid a standstill in the event of a dispute. Independent directors are also increasingly utilized on the boards of sidecar vehicles. Independent directors are attractive for a number of reasons. First, given the large number of sophisticated aircraft leasing professionals in Ireland, they can provide an easy solution to the need for Irish directors. Second, independent directors can perform a tie-breaking role where minority and majority investors have elected to appoint an equal number of directors. Finally, independent directors are often required in order to obtain favorable financing terms under rated deals and other structured financings, including warehouse facilities and aircraft ABS transactions, as discussed in more detail below.

Decision Making

The parties to every joint venture must decide how company decisions will be made. Most everyday decisions of the board will require a vote of the majority of the directors to proceed. This usually includes decisions on whether to proceed with the acquisition, financing, or lease of an aircraft within the parameters of the company’s investment guidelines. Major corporate changes and amendments to the company’s governance documents, on the other hand, generally require a unanimous decision of the board.

Given that the majority investor commonly controls the board, the minority investor should consider requiring unanimous board consent for the following categories of decisions, and any others of particular importance to the minority investor: budget approval; approval of major transactions, investments or liabilities above a certain dollar threshold (other than aircraft specific transactions within the investment guidelines); amendments to the constitutional documents and the equity structure of the company; changes to the number of directors; material changes to the nature or scope of the joint venture’s business; changes to the investment guidelines or investments outside of the investment guidelines; modifications to the investor distribution waterfall or the term of the sidecar; mergers and other major corporate changes, restructurings or the initiation of an insolvency proceeding; decisions in relation to material litigation; any transaction between the joint venture and an investor; and changes in tax elections.

v. Transfer Restrictions and Exit Options

Parties may enter into a joint venture with high hopes and the best intentions, but investments and partnerships do not always play out as planned. Parties should therefore take care at the outset of a transaction to develop an orderly framework to govern the exit by one or more of the parties from the partnership.

Joint ventures commonly contain restrictions on the ability of the partners to transfer their interests in and obligations to the vehicle. A great deal of effort goes into finding a partner whose interest are aligned with your own, and investors are rightfully wary of transfers to an unknown party who may have very different interests and goals.

Parties should consider including the following types of transfer provisions in any new sidecar venture:

Limitations on Transfers: In light of the substantial time and resources that are required in order to establish a sidecar, and to avoid causing undue disruption before the joint venture gets off the ground, investors should consider barring transfers during the initial investment period (including transfers of initial capital commitments). Parties also typically impose certain limitations on transfers following the investment period, especially where a single strategic investor is brought in on the basis of forming a long-term partnership.
Tax-Driven Restrictions: Tax counsel should be involved in the development of transfer restrictions, as it is often necessary to impose tax eligibility requirements on transferees to ensure that transfers will not have any adverse tax consequences for the vehicle. For example, consideration should be given to barring transfers where the transferee’s tax status would result in the vehicle ceasing to be eligible for material tax treaty exemptions.
Prohibition on Transfers to Competitors: Leasing companies are naturally very concerned about potential transfers to their competitors. They would not want a competitor turned investor to have access to all of their proprietary information, documents and relationships. It is therefore typical to prohibit these transfers at any stage.
Performance-Based Transfer Rights: The parties should consider whether strategic investor or other investor transfer rights should be triggered in the event of underperformance by the vehicle. This can be useful to include where the relationship among the partners is new and/or the servicer is not the most seasoned player in the industry.
Permitted Transfers to Affiliates: Transfers to affiliates are often permitted so long as there are no adverse tax consequences for the vehicle. This allows the parties the flexibility to internally restructure their investment if necessary.
Transfers in Connection with Servicer Termination: Parties should consider whether to allow the transfer of the servicer’s shares in the joint venture in connection with a termination of the servicing agreement. This is generally not controversial, as a lessor typically does want to be invested in a venture serviced by another leasing company, and the non-servicer investor will prefer that the new servicer be incentivized to perform through an equity investment in the vehicle.

A framework of rights and obligations governing the exercise of transfer rights can also be included in the documentation. This framework will help ensure an orderly and fair transfer process that protects the rights and interests of both parties. In addition to establishing an orderly process for the exercise of transfer rights, parties should consider whether to include the following rights:

A Right of first offer requiring the transferring investor who wishes to sell any of its shares to first offer those shares to the non-transferring investor for purchase before offering such shares for sale to a third party. This allows the non-transferring investor to avoid an equity sale to an undesirable partner and to increase its ownership stake in the process.

A Right of first refusal giving the non-transferring investor the right to match an offer received by the transferring investor from a third party or made by the transferring investor to a third party. Like a right of first offer, this allows the non-transferring investor to block the sale of the shares to a third party and to simultaneously increase its own stake in the business.

Tag along rights granted in favor of the non-transferring investor permitting it to sell its shares to the same third party buyer purchasing the transferring investor’s shares, and on the same terms and conditions as the transferring investor. Tag along rights protect minority shareholders, allowing them to both capitalize on a deal that a larger shareholder negotiates with a third party, and to avoid an uncertain future with an unknown partner.

Drag along rights in favor of the majority investor, allowing it to force the other investors to join in the sale of the company. These rights give comfort to a majority investor that a minority investor will not be able to prevent it from liquidating its interest in the company where an acquirer is interested in an acquisition of 100% of the company’s equity. These rights may also benefit minority investors for the same reason as tag along rights – they will benefit from participating in a larger deal negotiated by the majority investor, likely on more favorable terms than the minority investor could obtain on its own.

vi. Dissolution

In their simplest form, dissolution provisions can be minimal and triggered only upon the expiration of the term or upon the unanimous resolution of the board or if otherwise required under applicable law. However, it is often in the interests of the parties to negotiate more comprehensive dissolution rights, which allow dissolution in certain scenarios where unanimity may not be achievable.

Parties should consider including some or all of the following dissolution rights in their joint venture documentation:

Dissolution right following servicer termination: This right may be granted solely in favor of the strategic investor in the case where the servicing agreement is terminated as a result of a servicer default. Alternatively, this right can apply more broadly in the event of any servicer termination where the parties do not with to remain in partnership where the servicing arrangements have been terminated.
Dissolution right in favor of the lessor-investor following failure by the strategic investor to approve any investments proposed by the servicer during a prescribed period: This right affords the servicer the ability to exit the venture where it has become clear that the parties’ interests and goals are not aligned and that there are grounds to terminate the partnership.
Dissolution right following sale of all of the joint venture’s assets: This right is typically exercisable by either party following the expiration of the initial investment period. Where there are no assets owned by the company the venture is likely winding down and it makes sense to include a procedure for liquidation to avoid the indefinite continuation of an asset-less vehicle.
At the election of a non-defaulting investor following the default of the other investor in payment on capital call or other required payment: This dissolution right is commonly exercisable by either party, but is of greatest interest to the servicer, who will look to exit the venture if the strategic investor is not fulfilling its capital commitments.

vii. Servicing Arrangements

Servicing arrangements are critical in an aircraft leasing sidecar, as the venture is entirely dependent upon the servicer to source and service its aircraft investments. The servicing arrangements and other aspects of the transaction structure will therefore be structured to incentivize the servicer to maximize returns for the vehicle, and so that the servicer has sufficient flexibility to do its job. At the same time, the servicing agreement includes provisions to protect the company, in particular, standards governing the servicer’s performance and mechanisms for oversight. While market standards on these provisions have emerged, they continue to be ardently negotiated in every transaction. The below provides an overview of some of the most critical issues to be addressed in a servicing agreement.

Origination Requirements and Incentives

Investors should consider whether to rely on origination fees and rent based fees to incentivize the servicer to perform, or whether more specific origination requirements are merited. More cautious entrants or those investing in start-up servicing platforms may also wish to include contractual origination obligations for the servicer. Ultimately, however, if the investor does not have faith in the servicer’s ability to originate opportunities to deploy capital, it will probably not go through the lengths required to establish the investment vehicle. Conversely, a servicer will want to have comfort that bona fide opportunities that meet the investment guidelines and return hurdles will be approved by investors. Otherwise, they may face reputational consequences from busted deals in addition to the opportunity costs of missed servicing fees and investment returns.

Other Servicing Fees

In addition to origination fees, a servicer will earn rent-based fees, which may be payable as a percentage of rents collected or a combination of rents payable and rents collected. Servicers may seek fees based on rents payable to compensate them for their collection efforts, while investors will seek to limit rent-based fees to rents actually collected by the servicer. Sales fees are payable as a percentage of net disposition proceeds. What constitutes a sale or disposition proceeds for this purpose can be contested, as servicers and investors may disagree on what sale or loss scenarios merit a substantial payment to the servicer.

If the sidecar has been formed with a view to selling the aircraft portfolio into an ABS vehicle, then the parties may also consider whether it would be appropriate for the servicer to earn a separate or additional fee in connection with the ABS where the equity in the portfolio will be sold to one or more third party investors.

Servicing fees are normally paid prior to any debt service and profit distributions to investors.

Standard of Care and Standard of Liability

Servicing agreements commonly include a “standard of care”, requiring the servicer to perform its duties under the servicing agreement with reasonable care and diligence in accordance with the standards of a leading international aircraft operating lessor. A breach of the standard of care is often an important element in servicing agreement termination rights, and the standard of liability for the servicer.

The “standard of liability” limits the liability of the servicer under the servicing agreement to losses resulting from a breach of the standard. The standard limits the company’s recovery from the servicer to losses resulting from certain specified and highly negotiated categories of conduct by the servicer. Examples include losses due to the servicer’s gross negligence, fraud and willful misconduct, the servicer’s breach of representations and warranties, and losses due to the servicer’s breach of the servicing agreement and/or breach of the standard of care. The standard of liability is always a point of negotiation among the parties and commonly includes various materiality qualifiers.

Conflicts of Interest

The servicer for any sidecar will, in addition to its work for the vehicle, be simultaneously managing its own aircraft leasing business and possibly acting as servicer for other sidecar or securitization vehicles. Of critical concern to investors in any sidecar is that the servicer not discriminate between these other activities and its obligations to the joint venture. The conflicts standard and related provisions require the servicer to perform the services in good faith and provide a standard by which the servicer’s management of these conflicts can be judged and procedures to ensure transparency and fairness in the handling of any conflicts. Where a conflict arises, and that conflict that requires an arm’s length negotiation between the servicer and the joint venture, it is often useful to appoint an independent representative to act on behalf of the joint venture in that negotiation, and the servicing agreement may provide for this.

Termination Rights

Every servicing agreement includes termination rights in favor of both the joint venture and the servicer. Standard termination rights include termination following certain payment defaults, covenant breaches, misrepresentations, or insolvency events, subject to applicable grace periods. Termination rights in relation to covenant breaches and misrepresentations are typically only triggered when these breaches have a material adverse effect on the other party. In the case of covenant breaches with respect to the performance of services, the servicer may also seek to limit a breach to a scenario where the breach is in violation of the standard of care or the conflicts standard. These limitations on termination rights are in recognition of the fact that it is generally in the interests of all parties to avoid unnecessary termination of the vehicle’s servicing arrangements.

viii. Leverage and ABS Take-Outs

Financing is critical for every aircraft leasing sidecar. Aircraft are capital intensive assets and financing is essential in order to build up a portfolio. The servicer, having expertise in aircraft financing, typically manages the procurement, negotiation and implementation of any financing. Parties should consider whether a warehouse facility or term facility is best suited to their goals. Where the aim of the enterprise is to acquire a portfolio and then refinance it in the capital markets via an ABS transaction, or to exit the structure entirely via an ABS transaction coupled with a sale of the equity to one or more third party investors, a short-term warehouse facility will likely make the most sense. A warehouse provides an efficient and cost-effective mechanism to finance a large number of aircraft in a short period of time. Where the investors instead plan to own the aircraft over a longer period, term financings may be a preferable option.

Where the parties are considering an ABS take-out, the following factors should be kept in mind:

Rating Agency Criteria: Rating agencies have very specific criteria for aircraft ownership and company governance in an ABS transaction. If the company plans to enter into an ABS transaction, the investors will save time and money by using AOEs and LILO entities that satisfy rating agency requirements from the outset when acquiring a portfolio. This will usually avoid the need for multiple lease novations. Novations are a costly and time-consuming process that can strain relationships with lessees and are best avoided where possible. Key rating agency criteria to keep in mind are:
o AOEs should be newly formed, bankruptcy remote special purpose companies. In order to achieve bankruptcy remoteness, each AOE’s organizational documents should include special purpose covenants, limiting its activities to the acquisition, financing and leasing of the aircraft owned by it and making it difficult for the entity to enter bankruptcy, for instance by requiring unanimous shareholder and board approval to do so;
o Each AOE should have an independent director;
o Each AOE should be organized under the laws of a jurisdiction that has ratified the Cape Town Convention, with Ireland or the U.S. being the typical choices, as discussed above; and
o To the extent possible, each AOE should hold title to no more than four aircraft, as this is a preference, if not an absolute requirement, of some rating agencies.

Concentration Limits: Concentration limits should be incorporated in the sidecar’s investment guidelines to ensure that the portfolio has sufficient diversity with respect to lessees, lessee jurisdictions, and aircraft types to be attractive to warehouse lenders and ABS investors, who seek a diversified collateral pool.

• Servicer Quality: Investors should take care to select a high-quality servicer. Aircraft invariably need to be re-marked during the life of an ABS deal, so investors want to see a strong servicer who has a demonstrated track record of skillfully navigating these situations. Perceived servicer quality impacts the marketability and pricing of the ABS notes and any equity interests issued by the ABS issuer.

Conclusion

The contractual arrangements entered into at the outset of an aircraft leasing joint venture establish a framework of rights and obligations that will govern the relationship between the parties throughout the life of their partnership. As discussed above, there must be an alignment of interests among the parties to any successful venture from the outset, and their mutual understandings must be carefully documented in the joint venture documentation. Particular care should be taken to ensure that the parties are properly incentivized to maximum the performance of the vehicle, and that the rights of all parties are sufficiently protected in the event that things do not turn out as planned. Ultimately, the sidecar documentation should establish a governance framework for the partnership that facilities open communication and the development and maintenance of trust among the parties, critical components to a successful joint venture. Parties should structure these transactions with an eye on the end game, to maximize the synergies available when capital and expertise combine to tackle the promising investment opportunities available in the aviation industry today.