KBRA Managing Director Marjan Riggi said the agency has rated Avolon for a whlle in respect of private transactions. The latest published ratings had been assigned after an exceptional amount of in-depth research into the various risk factors of the leasing company's business, she said, including on the issues of ownership, the levels of leverage within its immediate listed parent company, HNA Group subsidiary Bohai Capital, and the implications of treating maintenance rights assets and lease premium assets as intangibles, along with goodwill, when calculating tangible common equity.

Marjan Riggi, KBRA.

'I think one of the parts I'm most proud of is the detailed analysis of the ownership structure,' she told Aviation Finance. 'We did a lot of analysis of Bohai, using publicly available information, as well as conversations with the company to separate fact from fiction, and to identify the real risks and benefits associated with the ownership of a global lessor by Bohai and ultimately by HNA.

'At the end of the day it comes down to qualitative factors and understanding the business logic behind the ownership of a global lessor by Bohai and ultimately by HNA and what value it creates for them in the medium to long term' Riggi said. It was also important to distinguish between the levels of debt within Avolon, as a stand alone company with adequate governance around its separation from Bohai, and that of Bohai’s own leverage.

'Are there risks related to all of this? Definitely. But we see them as manageable,' she said. 'The strong Asian connection gives Avolon a big advantage in that expanding market, but against this leverage is the opaqueness of a very large and complex conglomerate as its ultimate parent, and so too, potentially, the integration of CIT. That said, it is a transformative acquisition for Avolon and so far the evidence points to them having moved fast and seamlessly on the integration.'

In its rating report KBRA says the BBB+ issuer rating assigned to Avolon 'reflects the strength of the company’s leading market position, seasoned management team, young and in-demand fleet, focus on lowering and maintaining relatively low leverage, as well as a staggered and diversified funding profile.'

It adds that the ratings are also driven by the growing strength of Avolon’s global franchise 'fostered by the demonstrated support and enhanced relationships provided through its parent companies, Bohai Capital and HNA Group, while the company also benefits from 'the quality of its order book, upward trending profitability metrics and a stable industry outlook'.

On the negative side the ratings are constrained by 'the inherent risks associated with the recent acquisition of the aircraft leasing business of CIT, such as integrating a sizable platform and slightly less attractive fleet, high level of encumbered assets, high leverage levels at Bohai, its immediate parent, as well as limited transparency at HNA, its ultimate parent.'

The decision to assign Avolon a senior unsecured debt rating of BBB, one notch below the issuer rating, reflects 'the company’s relatively high level of asset encumbrance,' KBRA says.

In the agency's view, the CIT acquisition solidifies Avolon’s market leading position, enhances its global franchise and further diversifies its customer base. 'The scalable business will provide synergies and financial benefits going forward. Despite prior success in integrating, integration risks will remain a concern - especially considering CIT is a sizable platform with a relatively long history. In addition to integrating the businesses, it is expected that Avolon will focus on reducing leverage and improving fleet metrics over time.'

Reviewing the contentious issue of Bohai's debt level as a result of the funding of the CIT acquisition, KBRA notes that as of March 31 this year Bohai reported debt of RMB232.8 billion and equity of RMB38.2 billion on a consolidated basis, resulting in a debt-to-equity ratio of 6.1x.

'The vast majority of the debt was issued at the operating companies’ level with approximately RMB14.0 billion issued by Bohai Capital. Bohai’s leverage is expected to improve significantly through retention of profits and other capital initiatives in 2017 and 2018,' KBRA asserts.

In KBRA's view, Avolon's corporate governance structure, while complex, is designed to insulate it from the liabilities and indebtedness of the parent companies as well as its affiliates. 'Undoubtedly, as a wholly owned subsidiary, Avolon can always upstream dividends to its immediate parent Bohai to improve Bohai’s cash position especially in times of stress. However, given Bohai’s significant investment in Avolon, $6.2 billion to date, as well as the importance and potential value creation of Avolon to its parents, it is logical that both HNA and Bohai are highly motivated to preserve the value in Avolon. Together with the debt protection and separation framework listed above, Avolon's debt holders are protected to the extent possible.'

That said, KBRA also notes the credit risks stemming from Avolon's ownership by a highly levered immediate parent, as well as the limited transparency at the ultimate parent HNA, a highly complex conglomerate.

In relation to the acquisition of CIT, which was completed on April 4, 2017, KBRA says that while Avolon was able to integrate HKAC into its platform smoothly in 2016, CIT is a considerably larger one with a significant number of employees and a longer history. Integrating CIT is expected to be more challenging, therefore.

Reportedly, to date employee integration across the two platforms into the new combined organizational structure has substantially been completed and transition service agreements have been in place for 6 - 18 months for certain roles. Previously, Avolon and CIT separately employed approximately 130 and 150 people respectively. After full integration the number will be 260. The migration of lease and technical information from CIT to Avolon systems are also on track to be completed by the end of third quarter and complete integrated centralized operations are expected to be completed in the first quarter of 2018.

KBRA also anticipates that total revenue will grow significantly in the future as a combined entity with stable and healthy margins. 'It is expected that margins will improve further as synergies are realized and operations are fully integrated,' the agency says.

With $2.62 billion of undrawn facilities and $1.48 billion of unrestricted cash at the end of June, KBRA considers Avolon’s liquidity to be 'abundant'. It observes that to finance the acquisition of CIT's aircraft business, Avolon (through its subsidiary, Park Aerospace Holdings Ltd) issued senior unsecured notes of $3.0 billion and term loans of $5.5 billion in addition to the $2.4 billion equity injection from Bohai.

'As a combined entity, the weighted average cost of debt is approximately 4.2 per cent with a weighted average term of 4.4 years as of June 30, 2017. Given the high level of encumbered assets, access to additional funding could be constrained and impede financial flexibility. However, Avolon is focused on broadening its capital structure as evidenced by recent established lines of credit and the unsecured notes associated with the CIT acquisition,' KBRA says.

It also observes that Avolon has 'various financial covenants in place and maintains metrics at comfortable margins within limits, allowing a higher degree of operational flexibility, while reducing the potential impact associated with a downturn scenario. Importantly, Avolon has a diverse group of global banking relationships. In sum, liquidity risk is viewed as well managed with sufficient oversight and monitoring in place.'

In its report KBRA pays particular attention to the issue of leverage in respect of treating maintenance rights assets and lease premium assets as intangibles. While this question concerns some complex accounting concepts related specifically to acquired operating leases, Riggi said, one important thing to bear in mind is that on forward looking basis the intangibles will go down over time.

In its report KBRA notes that as of June 30, 2017, Avolon reported total debt of $16.8 billion and total equity of $7.6 billion, resulting in a debt to equity ratio of 2.2x, increased from roughly 1.7x prior to CIT acquisition.

However, if maintenance rights assets and lease premium assets were to be treated as intangibles along with goodwill when calculating tangible common equity, total intangibles would amount to $2.8 billion ($1.4 billion maintenance rights, $0.9 billion lease premium assets and $0.5 billion goodwill) as of June 30, 2017, resulting in a debt-to-tangible common equity ratio of 3.5x. Nevertheless, the agency says, 'All things considered, KBRA views Avolon’s capital adequacy metrics as adequate and consistent with its balance sheet risk profile; moreover leverage is considered relatively low compared to its peers.'