Private Equity and Hedge Fund Investments in Aircraft and Aircraft Leasing Airline Economics Growth Frontiers Dublin January 21, 2014 Michael C. Mulitz Willys H. Schneider Daniel J. Hartnett Kaye Scholer LLP

Christopher Chaput Michael Gangemi WNG Capital

Overview • Introduction • Brave New World – New Sources of Capital for Aviation: Aircraft/Aircraft Finance/Aircraft Leasing • What Do Traditional Private Equity and Hedge Fund Investors Expect from their Aviation Investments? • Private Equity and Hedge Fund Investment Structural Issues • How Do Private Equity and Hedge Funds Benefit the Aircraft Finance Market? • Tax Issues 2

Overview (cont’d) • Exit Strategies • Recent Transactions and New Participants in the Market • Important Issues for Aviation Finance in 2014 • Conclusions and Questions

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Brave New World – New Sources of Capital for Aviation: Aircraft/Aircraft Finance/Aircraft Leasing • Private Equity and Hedge Funds maintain an important position in the aviation leasing market and provide a significant source of equity, lending and leasing capital • Transactions involve significant capital commitments – Doric Nimrod Air 1, 2 and 3 (LSE-listed) Emirates financing vehicles for A380 aircraft – German bond backed by an aircraft mortgage (NordLB) – Financial investors backing leasing businesses: • Cinven, CVC, GIC ,Oak Hill and Wells Fargo investment in Avolon • Carlyle investment in RPK Capital Management • Cerberus Capital investment in AerCap and buyback of 10 million shares from Cerberus • Oak Tree Capital Group sale of Jackson Square Aviation to Mitsubishi UFJ Financial Group • Terra Firma investment in AWAS • Onex acquisition of 50% stake in BBAM and funding of Inception Aviation • Apollo Global Management investment in Merx Aviation Finance LLC (aviation leasing) • Acquisition of RBS Aviation Capital by Sumitomo Mitsui Financial Group – Emirates, Aviation Capital, LATAM and Ryanair issuance of bonds backed by Ex-Im Bank guaranty – Guggenheim Partners investment in AerCap aircraft portfolio – Wells Fargo investment in Avolon to start new Irish leasing company – Avolon $636 million ABS for Emerald Aviation Finance Limited to acquire 20 aircraft – Novus Aviation Capital, the Development Bank of Japan and Airbus partnership to create Tamweel Aviation Finance – Launch of Aeronautics Fund (hedge fund focused solely on acquiring jets for the part out market) – Helicopter investments – Milestone Aviation Group, Waypoint Leasing Ltd., Macquarie Group, GE 4

Brave New World – New Sources of Capital for Aviation: Aircraft/Aircraft Finance/Aircraft Leasing (cont’d) • Types of aviation assets for private equity and hedge funds: – Aircraft and lease asset-backed securities (Guggenheim/AerCap securitization Class E Bonds for control of portfolio) – Direct investment in aircraft and aircraft owning entities – Equity investment in aircraft leasing firms or joint ventures – Secured and unsecured privately placed notes – Loans secured by aircraft or aircraft owning entities – Co-investments with other investors/other funds in all of the above

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Brave New World – New Sources of Capital for Aviation: Aircraft/Aircraft Finance/Aircraft Leasing (cont’d) • Why are Private Equity and Hedge Funds attracted to this market? – Significant amounts of capital can be put to work in aircraft related transactions – Aircraft assets, while subject to business cycle and risks, have generally not been subject to as wide valuation fluctuations as other asset types, particularly newer aircraft – Debt can be structured in the form of an asset-backed security, which qualifies as debt for tax, with no U.S. withholding tax on interest, allowing wide range of entities to invest and participate, even if underlying assets generate U.S. source income – Aviation leasing assets provide current lease income and special tax benefits, unlike typical “J Curve” investment fund or venture capital return profiles – Aviation assets are “hard assets” and in turbulent times, investors flock to hard assets – Learning curve for establishment of relationships, technical expertise, documentation of operating leases and purchase transactions help protect the aviation investment and finance industry from complete market overrun and structurally provides a limit or governor on new competitors 6

What Do Traditional Private Equity and Hedge Fund Investors Expect from their Aviation Investments? • Synergies across aircraft related investment platforms • Opportunities based on market dislocations and lack of available financing • Excess risk adjusted returns • Inflation protection in an asset that resets financial terms on a regular basis • Participation in global aviation market following and sometimes leading economic development • Yield returns and effect of interest rates, lease rates and residual values and effect on transaction structure 7

Private Equity and Hedge Fund Investment Structural Issues • Investor Issues – – – – – – –

Participation in Advisory Boards Conflict Resolution Mechanics Investment Advisory Participation Corporate Governance/Acquisitions Manager/Authority, Compensation and Termination Relationship with GP/Ownership or Investor Roles Use of Separate, Special Purpose Entities for Purchase of Aircraft to Achieve Limited Liability – Key Person Restrictions/Investment Criteria Restrictions – ILPA Private Equity Principles Versions 1.0 and 2.0 • Alignment of General Partner and Limited Partner Interests • Governance • Transparency 8

Private Equity and Hedge Fund Investment Structural Issues (cont’d) • Sample Structures (See Diagrams) • Structure Driven By: – Tax Characteristics of Investors – Tax Treaty Availability – U.S./Non-U.S. Investors – Lessee/Aircraft Operator’s Jurisdiction – Aircraft Operation Locations

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Sample Fund Structure 1 U.S. Taxable General Partner Investors (Delaware LLC)

= Tax Corporation = Tax Partnership (or LLC treated as a partnership)

General Partner (Cayman company)

U.S. Tax-Exempt Investors LPs

LPs GP

= Disregarded Entity

Non-U.S. Investors

Management Company Management Agreement

U.S. Aviation Fund L.P.

Management Agreement

(Delaware limited partnership)

LPs

GP

Management Offshore Agreement Aviation Fund L.P. Management (Cayman exempted limited partnership) Agreement

100%

100%

U.S. Source Blocker (Delaware corporation) LP General Partner (Delaware LLC) GP

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LP

LP

Non-U.S. Source Blocker (Cayman corporation)

LP

ECI Master Fund

Non-ECI Master Fund

(Delaware limited partnership)

(Delaware limited partnership)

SPVs

SPVs

General Partner (Delaware LLC) GP

Sample Fund Structure 2 = Tax Corporation = Tax Partnership (or LLC treated as a partnership)

U.S. Tax-Exempt Investors

Management Company

= Disregarded Entity

Management Agreement

U.S. Taxable Investors

Non-U.S. Investors

Management Agreement

U.S. Source Blocker (Delaware corporation) LP General Partner (Delaware LLC) GP

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LP

LP

Non-U.S. Source Blocker (Cayman corporation)

LP

ECI Master Fund

Non-ECI Master Fund

(Delaware limited partnership)

(Delaware limited partnership)

SPVs

SPVs

General Partner (Delaware LLC) GP

Tax Issues/General • Fund Structures to account for different classes of investors (U.S., nonU.S., U.S. tax-exempt) • Parallel non-U.S./offshore funds (Sample Structure 1) or ECI/non-ECI funds (Sample Structure 2) can shelter non-U.S. investors from necessity to file in the U.S. and can avoid U.S. income tax on most fund income if fund is not doing business in the U.S. • Use of blocker enables U.S. tax-exempt investors, otherwise taxable on rental income (and sales income if have “dealer” sales or sales of debtfinanced aircraft), to avoid direct filing and tax payment

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Tax Issues/General (cont’d) • Use of cross-border lease-in/lease-out structure under SVP’s owning aircraft to reduce/eliminate withholding tax on rental payments • Lessee use of aircraft and impact thereof on fund (potential tax liability and tax compliance issues) • Traded corporate fund in treaty jurisdiction can minimize income tax burden if real operations there • Sales tax/use tax/VAT tax on sales and operations of aircraft; varies among jurisdictions; some have exemptions; others do not

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Tax Issues/General (cont’d) • Other U.S.-specific tax issues (if fund managed, and/or aircraft used, in United States) – Income tax to non-U.S. investors dependent upon use of aircraft (rental income) or extent of participation of U.S. office (sales income) – Tax benefits-depreciation (varies dependent upon where aircraft is used; if leased to nonU.S. or tax-exempt entity); 50% bonus depreciation ended as of 12/31/13, subject to possible reinstatement (bills pending).

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U.S. Federal Income Taxation of Aircraft Income • Non-U.S. Persons: – Interest income on aircraft secured debt may qualify for exemption from U.S. withholding tax as “portfolio interest,” unless fund is originating loan in the United States. If so, taxable on net basis as ECI – Rental income may be treated as ECI, taxable on net basis and requiring tax return filing • If not, rental income may be subject to U.S. withholding tax, depending upon use of the aircraft

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Tax Issues/U.S. Federal Income Taxation of Aircraft Income (cont’d) • Non-U.S. Persons - Aircraft Fund Rental Income: – Flights that begin AND end in the U.S. • If U.S. rental office, income is ECI • If U.S. office is not involved, income is not ECI but subject to 30% withholding tax (subject to reduction pursuant to treaty)

– Flights that begin OR end in the U.S. • If U.S. rental office, 50% is ECI and 50% is not subject to U.S. tax • If U.S. office is not involved, 50% is subject to 4% gross tax and 50% is not subject to U.S. tax

– Flights that begin AND end outside the U.S. • Not subject to U.S. tax

– Non-U.S. corporation may be eligible for exemption from tax under Section 883 on rental income derived from flights that begin or end in the U.S. Need to fulfill certain tax residency and ownership tests 16

U.S. Federal Income Taxation of Aircraft Income (cont’d) • Non-U.S. Persons – Aircraft Fund Sales Income – Gain on sales is not taxable to non-U.S. persons, unless: • U.S. depreciation deductions were taken on the aircraft. In general, recapture of such deductions will be subject to U.S. tax (unless aircraft predominantly used outside of United States) • A U.S. office is a material factor in the sales and regularly carries on sales activity, in which case gain is taxable as ECI • If sold for use outside the U.S. and a non-U.S. office materially participates, then gain is not ECI

• If U.S. office is not a material factor or does not regularly carry on sales activity, whether gain is ECI depends on where title to the aircraft is transferred. Not ECI if sold outside the U.S.

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U.S. State and Local Taxes • Even if not otherwise doing business, could be subject to U.S. state and U.S. local income taxes based on aircraft usage in a jurisdiction, in a particular state or subdivision thereof – Typically lessee will indemnify

• Sales Tax – Application varies by state. Generally depends upon where the aircraft is sold and/or used and not solely upon the residence of the buyer or seller – Certain states have specific, aircraft-related exemptions

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How Do Private Equity and Hedge Funds Benefit the Aircraft Finance Market? • Aviation finance is very capital intensive • Maturing of the aircraft leasing market, standardization of documentation for leasing and financing of aircraft and Cape Town Convention • Structural alternatives and methods of investment – dedicated funds versus investments in operating/leasing companies • Balance sheet commitments from large financial sponsors (Morgan Stanley, WestLB, etc.) need to be replaced, Private Equity and Hedge Funds are filling hole • Several significant IPOs have occurred in recent years: AirCastle, AerCap, Air Lease Corporation, which Private Equity and Hedge Funds view as an important potential exit strategy 19

Exit Strategies • Portfolio Sales • Portfolio Liquidations/Part-out Liquidations • Securitization of Portfolios • Asset-Backed/Secured Notes • M&A Transactions • IPOs

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Recent Transactions and New Participants in the Market • • • • • • • • • • • • • 21

Prefunded bonds backed by Ex-Im Bank NordLB’s aircraft covered bond (application of pfandbrief to aircraft) Doric Nimrod’s expansion of program for A380 financed in the Capital Markets through EETC Aircastle joint venture with Ontario Teachers Pension Board AerCap purchase of ILFC Hedge fund investments in GECAS engine ABS transactions Aircastle Limited $400 million senior notes 2018 Fly Leasing Limited $250 million senior notes 2020 Investec third aircraft fund for $400 million with institutional and high net worth investors from Middle East, Asia and UK Indigo Partners LLC purchase of Frontier Airlines Launch of several new aviation funds in different market segments KKR Financial Holdings invest $100 million in Lease Corporation International helicopter leasing unit LCI Helicopter Ltd. GA Telesis and Wafra Capital Partners form GA Telesis Aviation Investments LLC (GAIN) with $500 million to invest in commercial aircraft, engines and components for lease and part-out

Recent Transactions and New Participants in the Market (cont’d) • New players in the market for both equity and debt: – – – – – – – – – –

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Amur Capital Management joint venture with Jet Midwest for mid-life and part-out aircraft Magnetar Capital Wings Capital Partners and Two Sigma Private Investments Intrepid Aviation growth by investment support by Centerbridge Partners LP and Reservoir Capital Group LLC Fifth Street Finance Corp. Brigade Capital Anchorage Capital Investec Aeronautics Fund (part-out) Chinese and Japanese investors

Important Issues for 2014 Aviation Finance Industry • Market challenge of finding sufficiently yieldy investments in an unusually low interest rate environment • PE/Hedge Fund yield requirements effecting mid-life aircraft values: – – – –

PE and Hedge Fund desired yield requirements reduced from the high teens to mid-20’s to 7-14% yields Minimal debt is available to support acquisition of mid-life aircraft Mid-life aircraft lease rates are experiencing 30% to 40% declines, making debt service challenging Declining lease rates compared with engine and part values favor part-outs over forward leases to achieve yield requirements – Mid-life aircraft values will continue to decline, mid-life part-outs will continue to increase – Still attractive returns for PE funds which are opportunistic and understand the market to adapt fund strategy

• There is a potential book value problem lurking below the surface of existing aircraft platform portfolios; and the potential write-offs or write-downs could be material • Increasing investment in securitizations and mezzanine debt • New PE participants in the market has heightened competition for deals, putting downward pressure on pricings 23

Important Issues for 2014 Aviation Finance Industry (cont’d) • Economic useful lives for many new aircraft may be shorter than the historical norms due to dumping of new deliveries and new technologies • Maintenance of newer aircraft in emerging markets may present issues in the trading market • Publicly traded leasing companies may have difficult disclosure obligations relating to the implications of all of the above, which may push an advantage in favor of the private firms • Growing ability of airlines and lessors to access unsecured debt affects demand for private equity funding • Will there be more private sales of leasing companies to PE funds or other PE funded leasing companies rather than IPOs? • Basel III implementation will increase the capital cost of risk-weighted assets and increase costs for loans • Dodd-Frank implications on loans, assets and capital • Volcker Rule and issues relating to funds • New ASU making export credit financing more expensive • Irish Section 110 structure 24

Important Issues for 2014 Aviation Finance Industry (cont’d) • FATCA – “FFI agreements” between ”foreign financial institutions” (“FFIs”), including investment funds, and the IRS will begin to be entered into this year – Withholding on U.S. source dividends and interest begins July 1, 2014 (and withholding on proceeds from sales of instruments producing such payments begins January 1, 2017) – This withholding generally applies to income on all investments outstanding as of January 1, 2013, i.e., no more “grandfathering” (with limited exceptions) – FFIs generally must have procedures for identifying U.S. holders in place by January 1, 2014. (Certain, later, deadlines apply for identification of accounts opened prior to 2014.) – Agreements between the U.S. and various non-U.S. governments (some of which have already been signed and others of which are expected to be signed this year) will override statutory requirements for FFIs operating in jurisdictions that enter into such agreements – To date IGA’s have been entered with: Cayman Islands, Costa Rica, Denmark, France, Germany, Ireland, Japan, Mexico, Norway, Spain, Switzerland, United Kingdom

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Conclusions and Questions

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