Interview Valentine Flynn - Aldus Aviation Fund

8/10/2019 Interview Valentine Flynn - Aldus Aviation Fund

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is a long term business (most leases are 8 years or longer) and this does not sit

very easily with short term trading in public stocks.

Is it a good business to be involved in?

We think so - provided you have a strategy. Over the years it has been one of

the most consistent of investments. This may come as something of a surprise to

people however there is plenty of available data to prove that aircraft leasing

has outperformed many other investment classes. Air travel is a massive and

growing global industry (with airlines being the most visible part) which will

continue to expand for many yearsthe planet has a population of 6bn yet only

1bn fly. Increasing numbers of aircraft are needed and with the banks

effectively dormant leasing has become a very important part of the finance

supply chain.

It sounds very technical and complex. How does an investor get to

understand it all?

There is a short answer and a long answer to that question. The short one is the

investor doesnt need to.Im sure some of your readers own shares in drug

companies. Im equally sure these investors know nothing about drug design -

they rely on the performance of the products and make a judgement. Likewise,

an investor should look at our management team and its track record just like he

would any investment manager.

The longer answer is this: one of the interesting things about the business is

explaining to investors that it is actually very straightforward to understand.

There is no great mystery - nor any need to be an aeronautical engineer.

Think about it for a moment. There are 3 or 4 manufactures producing a small

number of aircraft types (models that are typically leased that is) for some 400

customers across the world. These are mobile, liquid assets with a working life

of 25 years or more that hold value and can be employed anywhere in the world.

There is good visibility around the business and in some senses it is easier to

predict what an aircraft will be worth in 5years time than any given bond or

share or indeed property for that matter. Of course the industry is cyclical but

managed properly a leasing business should generate returns through the

business cycle. Most of it is common business sense and we apply four basic

rulesmake sure we buy the right planes at the right price, look after the


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aircraft properly to maintain values, lease the aircraft to better quality airlines

and make sure that financial risk is managed.

If its so simple and profitable why isnt everyone doing it?

The reason is that leasing companies need access to capital and to get that

access they need to be of sufficient scale which is why the larger leasing

companies tend to be part of, or associated with, financial institutions and thus

out of the public eye. These companies place large orders with Boeing and

Airbus and own a variety of different aircraft models bought from these two

manufacturers. In the main these companies are driven by scale and that is their

principal strategy - size. In our view there is no reason to invest capital in

aircraft leasing unless you have a strategy that differentiates your business from

the bigger players. We would not contemplate attempting to compete with these

businesses in the Boeing and Airbus markets. We have a differentiating strategy

and that is why we have succeeded in establishing Aldus as a relatively small

specialist leasing business. I hesitate to use the word unique but we do

genuinely have a very different approach.

So tell us about Aldus.

Thank you. Id be delighted toI thought you were never going to ask!

Rather than going into the usual this is who we areand this is what we doIll

start with a quick story which really explains more about the business than any

spread sheet or power point presentation might do.

That makes an interesting change.

Back in 1999 Steve Gorman our now CEO bought some aircraft from a

relatively unknown manufacturer to lease to an airline. The manufacturer

explained that they had a plan to design and build a completely new aircrafttype being a series of jet aircraft that could carry between 70 and 120

passengers. Steve, Phil and Ciarn , now our Chairman and COO respectively,

followed the process from design, to prototype to the plant being built and the

first plane being delivered in 2004 and realised that this was something special

an industry game changer that not even aviation insiders such as airlines and

bankers had fully appreciated.

As importantly they also realised that this was an excellent asset to own and

lease - for reasons Ill come onto in a moment. They wereconvinced that this


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plane was going to be a great success and that the aircraft leasing community

were not alert to the opportunity. They were right on both counts and so Aldus

was created to be a dedicated owner of these aircraft.

The manufacturer was Embraer of Brazil and the plane the highly regarded EJet. Since 2004 the E Jet has gone on to become one of the most successful

product launches in aviation history exceeding even the Airbus A320 in sales

growth and with over 1000 ordered the E Jet is now employed by 60 airlines in

40 countries and flown by the majors such as BA,KLM, Air France and

Lufthansa amongst others.

What is so special about the E Jet?

Embraer analysed the aviation market and realized that 70% of take - offsglobally carry 100 people or less. There were no modern aircraft designed for

that particular market place. Existing types were either heavier (larger) aircraft

which were shortened to fit that market place, or lighter types stretched to take

more passengers. The result was heavy and fuel inefficient planes, or

uncomfortable aircraft with operational limitations.

Embraer decided to design a brand new plane, the E-Jet, which first took to the

skies in 2004. The E-Jet is an aircraft optimally designed to fly 70- 110

passengers. It has become a once in a generation event namely a successful

brand new commercial aircraft design.

The E- Jet represents state-of -the-art aviation design and technology. It offers

great passenger comfort with two and two seating, (doing away with the

unpopular middle seat) and spacious luggage compartments. Most importantly,

it is by far the most economically efficient alternative in its market segment

When this aircraft arrived was it was a completely new concept and many were

surprised at how quickly it became a success. However in the financial turmoil

following the Lehmanscrash and as fuel prices went up and passenger numbers

declined the airlines began losing money. They clearly had a problem.

Embraer said you have to buy the right airplane for the right route. To be a

profitable airline you have to be clever in what equipment you deploy. And for

so called long thin routes (intra continental for example) there is really nothing

to beat it and nor will there be for some time to come.

The E-Jet is now seen as a standard component of an airline fleet. At one levelits an aviation industry story and that its a great success story is not in


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question. However the key issue here is what does it mean for the investors?

The first point is that the E-Jet is an aircraft in high demand with limited

competition. That means that if one airline lessee is having problems we wont

be stuck with an airplane that we cant reemploy. Its a good product to finance.

The other point is that the banking crisis is resulting in a lack of finance in

aviation, perhaps even more so for a new product like the E-Jet. If we are in the

market with capital available, we can secure good lease rates from operators and

thus good returns for our investors.

To summarise, its a very good aircraft and more importantly a particularly

good product to be financing. We have strong credit support, good earnings and

the ability to reemploy the planes in case of a problem with a lessee.

You actually say in your business plan that you welcome competition?

Maybe we should rephrase that. The point is that we arent worriedabout

competition. When we started the business it was pretty much just us, nobody

was specializing in the same way. This was our strength and continues to be so.

Competition does not really impact us because we have most of our leases in

place or they will be in the very near term, and equally the more players who

are involved in the market, the more activity and liquidity there is. We have a

quite limited target of 30 aircraft in the portfolio which we will achieve thisyear, and we can't see anything stopping us from getting to that target. We have

good debt facilities and a pipeline of aircraft coming through and there is room

for more leasing companies who wish to buy E jets which they are now doing.

What are the principal risks in this investment?

As management we are obsessed with taking as much risk off the table as

possible. I think we have largely achieved that, however we are not complacent.

We as management are in this business alongside investors and are equally askeen to minimise risk. I mentioned four basic rules. They are obvious rules that

could apply to any investment in physical assets. Dont overpay, make sure you

have the right planes, look after them and get your financing structure right.

I hope Ive managed to explain why we believe that in backing the E jet series

we have chosen an asset that takes a lot of risk out of the equation. We have

been and will continue to be careful in selecting our airline customers and with

a spread of 30 E Jets across 12 airlines in 10 countries will have significantly

diversified our credit risk. If we do happen to get a default (and we


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traded right through 2009/10 when issues did arise and were managed) we

should have little difficulty releasing or selling because the planes are and will

continue to be in demand. We have a policy of not leasing more than three

aircraft to any individual airline, and we spread ourselves across different

countries to minimize country risk. We do not lease into the US because of

Chapter 11 issues.

Our maintenance procedures are very precise, and all our aircraft have to be

kept in full life condition which means that when returned to us they are

essentially as good as new. Airlines are obliged to pay us cash maintenance

reserves to collateralise this obligation.

Our capital structure is also well managed. We have match funded leases to debt

so that we have no refinancing exposure and no currency or interest rate risk

either. We have only very limited banking covenants.

Im not saying we are risk free. No investment is but we have taken as much

risk out of this as we possibly can and on a risk adjusted basis we think the

returns we offer are really double digit income for single digit risk. Thats not

very scientific but we have delivered 11-12% cash dividends since Q12008 with

no volatility in the price of our planes and I think that is pretty good testimony.

There arent too many fund managers that can say that whatever the asset class.

Lastly, we have a pool of existing investors that includes some very successful

private and institutional equity. These people are smart investors and we have

been subject to considerable scrutiny and due diligence as regards both our E jet

strategy and our management and reporting infrastructure.

Talk about the specifics of the investment.

Aldus is headquartered in Ireland (where some 50% of the global aircraft leased

fleet is owned and 9 of the top 10 leasing firms located) with a representative

office in London and has a total staff of 14.

Aldus was established in 2007. It presently has a fleet of 19 E Jets with three

deliveries pending. It has good quality long term debt facilities to facilitate

growth to 30 aircraft and has a pipeline of leases in negotiation.


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New shareholders joining now get into an existing business with start-up risks

and costs absorbed and a strongly performing portfolio in place. Existing equity

gains from expanding the portfolio because of greater scale and diversification

of risk and both gain from the enhanced possibility that as other leasing

companies move into E Jets a buyer will bid for the book at a premium. They

might do so because frankly assembling a portfolio like ours is quite hard work

and the bigger leasing companies prefer to place large orders.

Aldus is very precisely governed. We are an illiquid investment and in

recognition of that we have introduced an unusually high degree of governance

and transparency to protect our shareholders.

What this means is that the business model cannot be varied in any material way

without 75% shareholder approval. We exist to receive rental payments from

airlines, pay down debt and distribute surplus proceeds to shareholders. As

aircraft come off lease they will be sold and capital returned unless shareholders

vote otherwise. Management gets paid after the fund is wound up and

shareholders return targets met.

This is very important for shareholders to understand. We have created a fund

not a leasing company and this is a very precise and transparent vehicle. We as

managers have no ability to suddenly decide to pursue some other strategy orretain dividends to expand the business. We exist as a stream of fixed

predetermined cash flows.

What returns can investors expect?

We have paid cash dividends of 11-12% for the last four years and we see no

reason why this will not apply for the duration of the fund. As debt is paid down

and the value of our fleet increases relative to debt we will see returns of 15%

which is in line with what has happened to date. If a buyer bids at a smallpremium that might well go to 20%. For the time being we are focussed on

paying dividends of 10-12%.

Investors should really think of us not as a business as such but more as a fixed

income bond with predetermined cash flows with upside equity potential. Some

might say like a real estate investment but I think we are actually better than

that because we have a pretty unique position in a special asset class. We are not

correlated to the equity or bond markets, we are globally diversified with a


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liquid and mobile asset and have performed exactly in line with expectations

despite the onset of the financial crisis in 2008 when we had just started.

Management has demonstrated judgement and execution capability in

establishing and expanding Aldus in challenging financial markets and with agood investor basebeing a mixture of high net worth investors, family offices

and more recently institutional investors and first class term debt facilities I

think we have done reasonably well.

If you were to leave investors with one thought what would that be?

Business people look for market gaps to exploitor they create demand for

something that didnt exist before, like Apple with the I Pod.

Embraer did a bit of both in developing the E Jet to fill a very clear gap being

the need for up to 300 mid-sized aircraft a year for the next decade. There is

insufficient manufacturing capacity, existing or planned, to meet this need.

Aldus identified a different gap being the need for finance. We dont see that

gap being filled in a hurry either. The combined effect will see Aldus continue

to make returns for its shareholders with a business model underpinned by good

quality, in demand assets. Weve not changed our views since we conceived

Aldus in 2006 and see no reason to do so now.

Thank you to Valentine Flynn of Aldus for coming to see us.

Thank you.


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Interview Valentine Flynn - Aldus Aviation Fund