Turbulence Ahead: Private Equity’s Airline Venture

While the global coronavirus pandemic has brought the travel industry to its knees, the outlook hasn’t always been so bleak. Leading up to the crisis, the economy was enjoying its longest bull run in history and the travel sector was doing very well for itself. The increasing trend of globalization and rise in population with the discretionary income to spend meant that the pool of travellers was diversifying. The global aviation industry was booming in the past decade as the number of travellers from developing nations took-off, in-line with global economic prosperity. One major profiteer from the growth in travel has been commercial airlines. Since the Great Recession in 2008, commercial airline revenues have increased steadily and there was no apparent reason to think that would change. Steady growth and solid future outlook attracted many investors to the sector, including private equity firms, who sought out ways to maximize operational efficiency and capitalize on the industry.

Private equity firms have been able to enter the airline industry through direct acquisitions or investment in commercial airline companies themselves. In fact, some firms such as Indigo Partners are solely focused on the air transportation sector. Indigo invests directly into commercial airlines, including the ownership of budget airline Frontier in the US and major stakes in JetSmart in Chile as well as Wizz Air based in Hungary. 

Budget airlines have been a primary target of private equity firms seeking to enter the industry. While often smaller, low-cost airlines can boast impressive margins relative to standard airlines and are often more profitable. There are many reasons for this phenomenon; standardized seats, streamlined booking process, and lower operating costs are just a few of the ways budget airlines are able to offer tickets at lucrative prices while maintaining a solid bottom line. All of these contribute to far lower operating costs and higher efficiency, some of the qualities private equity firms seek out in investment opportunities. Finally, the nature of low-cost offerings is that they are inherently less vulnerable to cyclicity. While airlines certainly cannot be classified as a defensive industry, budget airlines often operate at near max capacity for extended periods of time. If discretionary spending goes down during economic turmoil, consumers may seek out a discounted option. 

Towards the end of 2019, Canadian private equity giant Onex took Calgary-based budget airline WestJet private for almost C$5 billion. This major deal highlighted pre-pandemic bets that travel would continue to rise, and low-cost methods of transportation would be favourable to many future customers. Onex planned to diversify and expand WestJet’s route offering, demonstrating their confidence that budget options would resonate with travellers nationwide. Wanting to capitalize on this trend, legacy airlines were also actively acquiring budget airlines. About a year ago, Air Canada came into an agreement to purchase Montreal-based low-cost airline Air Transat’s parent company for C$720 million. The trend sets up a competitive landscape where legacy airlines hope not to be caught flat-footed as investment firms identify and take advantage of trends before they can.

Sky-high valuations stemming from the boom of air transportation before COVID-19 made entry through direct investment difficult for some private equity firms. However, some rationalized investing because of the bright long-term prospects of the industry. Onex paid a steep 67% premium on WestJet’s share price to complete their acquisition. The high valuations and premiums paid only amplify the pain these firms may now be feeling. The factors that once rationalize their investment theses are likely in a vastly different situation than before. 

Clearly, the bets some private equity firms made on air travel may have been premature and did not fully take into account the inherent risks of the industry. A historically cyclical industry on a seemingly nonstop boom was ripe for misplaced confidence. However, the downturn in air travel may not necessarily be game over for airlines with private equity ownership. WestJet announced they would re-hire thousands of employees who had been laid off due to the pandemic with the help of the Canadian government. In the United States, private equity firms are doing their best to lobby for exemptions that would allow their portfolio companies access to federal COVID relief funds. Currently, businesses owned by private equity firms are ineligible to access these funds, but that doesn’t mean that they aren’t going to fight. Many large investors in private equity are pension funds, and that gives private equity firms a strong weapon to wield in the debate. Leaving businesses backed by private equity out to dry also means putting pension returns at risk, giving rise to a difficult situation for policymakers. Although as strong as they are, private equity has not busted down the door to relief funds yet, and it looks like it will be a difficult path.

Aside from the difficulty some private equity backed businesses may be facing in the air travel industry, the crisis leaves room for opportunities for firms to do what they do best; make investments and acquisitions. The ultimate factor in the decision to proceed with a leveraged buyout is an attractive price, and the crisis may have put some opportunities in air travel on sale. Airlines were one of the hardest-hit sectors through the crisis, but more importantly, they were one of the least prepared. Airlines have had to rely on state aids in the form of state-backed loans, bailout packages, and wage subsidies worth more than $123 billion, as well as issuing junk bonds in public markets to preserve their liquidity and avoid defaults. As COVID-19 and related travel restrictions dried up international air travel for a few months, the airline industry estimates that lost revenue will be worth more than one hundred billion dollars by the end of the year. Even in the most optimistic scenario, airlines have acknowledged it will take at least 2 years for air travel to reach its pre-COVID level. With the average international airline having less than two months of cash on hand to cover expenses, air travel companies are fighting to stay alive, and those that are on life support have become targets for private equity. This week, two major private equity firms, Bain Capital and Cyrus Capital Partners, submitted their final and binding offers to purchase distressed Virgin Australia, Australia’s second-largest airline. 

Short-sighted private equity firms who hoped to jump on the bandwagon and reap the gains of a travel boom may find themselves in a precarious position with their air travel investments.  On the other hand, veteran firms who specialize in the industry may be able to not only outlast the turbulence but seize on discounted opportunities in the meantime. However, uncertainty lies in the future; if air-travel numbers never resurge to their pre-pandemic glory, private equity firms and other investors may be in over their heads.