Merx Aviation: IQ 2021 Update

Apollo Investment (AINV) has reported its full year and fiscal IVQ 2021 results through March 31, 2021. To management’s credit, much was said about the BDC’s largest investment – aircraft lessor and maintenance company Merx Aviation Finance LLC. We’ve written about Merx before on three occasions. The BDC Credit Reporter has been skeptical of the – let’s say – “generous” valuations AINV has placed on its debt and equity investments in Merx, despite the severe impact of the pandemic on flying and the value of aircraft and their leases. Both in the IVQ 2020 and in the IQ 2021 results, AINV has increased the value of its investment in Merx after a modest unrealized write-down earlier in 2020. As of now, the $190.5mn of first lien debt is carried at par, as was the case before the pandemic. The value of the now $120.3mn in equity is given as $125.1mn, up $0.5mn in the period.

On the latest conference call AINV sought to explain how Merx could be re-leasing planes at lower rates than before the pandemic or having to sell them off and still see an increase in the value of the equity stake. (Previously the BDC pointed to increases in their aircraft maintenance activities for its higher valuation, but this was not mentioned in the most recent conference call). Much as we’d like to, we don’t follow how AINV maintains such a high equity valuation despite the undeniably tough conditions. We rate the company CCR 4 despite the fact that AINV values its overall investment modestly over cost. However, we encourage readers to review the conference call transcript and decide for themselves.

With all that said, industry trends seem to be on the mend for Merx and total capital at risk – thanks to a large principal repayment – has dropped from $321mn as of March 2020 to $311mn a year later. The debt is performing at a 10% yield (down from 12% previously). The equity is non-income producing. The overall annual return on assets invested – both debt and equity – is 6.4% versus something closer to 15% pre-Covid when the loan yield was higher and dividends were being paid. AINV’s management does not envisage a return to those halcyon days but hopes for a ROA somewhere in-between.

This is very much a work in progress, but if industry conditions improve as expected, AINV should be able to avoid any further reduction in its debt yield from Merx. Once securitizations of aircraft are sufficiently paid down – which are senior to where AINV sits – we may even see a resumption of some dividend payouts. However, we cannot estimate when that might occur. We are maintaining our CCR 4 rating till we get more substantive good news and the credit remains Trending because we would not be surprised to see values and income change materially again – probably for the better – in IIQ 2021.

Even if AINV extricates itself from Merx without a realized loss (even though the loss of investment income has been substantial in recent quarters), the question remains why a BDC supposedly committed to portfolio diversification would invest 30% of its capital (using the IQ 2021 numbers) in a single company ?

Merx Aviation: IIIQ 2020 Update

On November 5, 2020 Apollo investment (AINV) provided a substantive qualitative update on aircraft leasing and servicing investment Merx Financial during its IIIQ 2020 conference call. We’ll quote in full from the lengthy – but still lacking in detail – prepared remarks:

” …the pandemic has had a significant adverse effect — impact on the global economy with direct implications for the aviation sector, although we are starting to see some recovery in global air traffic. Merx continues to closely monitor the current market environment and proactively maintain dialogue with its airline clients globally.

During the quarter, the fair value of AINV’s investment in Merx declined by $5.7 million or 1.8%. The quarter-over-quarter change reflects the decline in the fair value of Merx’s fleet given the challenging environment, partially offset by an increase in the value of Merx’s servicing business.

As discussed in the past, in addition to aircraft leasing, Merx has built a best-in-class servicing platform and acts as a servicer or technical adviser for aviation assets across the broader Apollo platform. Merx is now benefiting from a growing servicing business, which has helped partially offset the decline in fair value of its fleet during the quarter. We believe Merx’ portfolio compares favorably with other major lessors in terms of asset, geography, age, maturity and lessee diversification. Merx’s portfolio is skewed towards the most widely used types of aircraft, which means demand for Merx’s fleet should be somewhat more resilient. Merx’s fleet primarily consists of narrow-body aircraft serving both the U.S. and foreign markets. At the end of September, Merx’s own portfolio consisted of 81 aircraft, 10 aircraft types, 40 lessees in 26 countries with an average aircraft age of 9.6 years. Merx’s fleet includes 78 narrow-body aircraft, 2 wide-body aircraft and 1 freighter.

Similar to other industry participants, many of Merx’s lessees requested rent deferrals and/or rent reductions. Merx has been working with its lessees to provide the necessary flexibility during these unprecedented times. Each request was reviewed on a case-by-case basis. Some of the deferral periods have expired, and we’re now seeing a recovery in lease payments. Despite the current industry challenges, we do not expect Merx to require funding from AINV in the near term.

The aviation team has the experience to skillfully navigate this period of market stress and the requisite capabilities to mitigate potential adverse outcomes. Additionally, the Apollo aviation platform will continue to seek to opportunistically deploy capital in the face of widespread uncertainty and market disruption. To be clear, Merx is focused on the existing portfolio and not seeking new investments. However, growth in the overall Apollo aviation platform will inure to the benefit of Merx as the exclusive servicer of aircraft owned by other Apollo firms“.

In the Q&A, AINV also revealed that many lessees received 6-9 month payment deferrals earlier in the year which have not expired. Should those payments not resume – which must be a strong possibility in many cases – that would materially impact results.

The net write-down of Merx was only ($5.9mn) because AINV also wrote up the company’s servicing business in the quarter by $4.4mn due to a deal done with Delta and because “the pipeline remains very, very robust in terms of other opportunities“.  

The BDC Credit Reporter is unconvinced – given the drastic market conditions – that the overall value of Merx at $324mn – a slight premium to $320mn in cost – is appropriate. In the IIQ 2020, the BDC was forced by the impact of the pandemic to restructure its investment, resulting in a substantial loss of interest income due to a lower loan balance and yield. Yet in all of 2020, AINV has written down its value in Merx by only ($39mn), or only (10%).

Of course we don’t have access to the financial records of this huge operation, except for some summary and not very useful numbers AINV is required to reveal. Common sense – and the knowledge that AINV’s capital sits underneath a mountain of secured debt – suggests, though, that the BDC should be sharpening their pencil more. This leaves open the possibility of a further write-down or restructuring of this very large AINV investment in the future as reality catches up with valuation. In fact what happens in the next few quarters to the valuation of Merx will speak very loudly to the BDC’s credibility when marking “control investments”, of which AINV has many.

Merx Aviation: Restructured

Apollo Investment (AINV) reported that its largest investment – Merx Aviation – was restructured in a couple of ways in the second quarter 2020. The aircraft leasing and servicing company, which AINV owns 100% of the stock of, saw $105mn of its $305mn in Revolver debt outstanding from AINV converted to debt. Second, the remaining debt saw its interest rate drop to 10.0% from 12.0%. Management of the BDC were circumspect in discussing the company’s performance, even though Merx’s FMV represents one-third of net book value at June 30, 2020. On the conference call AINV executive spoke in general terms, like this: “The pandemic has caused an unprecedented decline in global air traffic, which has led to a widespread lease deferrals throughout the industry. Although aircraft — air traffic trends have improved slightly more recently, it remains significantly below pre-pandemic levels“.

Despite the huge strains on aircraft lessors and the loss of substantial income because of the above, AINV wrote down its equity stake in Merx – which just increased by 800% at cost – by only ($4.2mn).

BDC portfolio company valuations are always a riddle wrapped in an enigma, initially prepared by internal staff, often reviewed by an outside appraisal firm and the final responsibility of the directors. To our minds – given what we do know about market conditions; the high leverage involved and the restructuring, this write-down is wholly inadequate and inexplicable. At this stage, AINV’s Merx investment taken overall is still valued above cost and would not show up on the BDC’s own underperforming company list.

For our part, we reaffirm the BDC Credit Reporters Corporate Credit Rating of 4, which we instituted last quarter. We do not have Merx on our Weakest Links list only because AINV has such latitude to continue paying interest even if the business is insolvent, which may be the case from what little we know. The fact that one third of debt is no longer accruing income is a negative sign, as is the need to lower the rate. These are the actions of an owner rather than a lender and make the entire valuation questionable.

This is a very serious challenge for AINV. In a short time, the BDC has lost ($16.6mn) in annual investment income. That’s just over 10% of IQ 2020 Net Investment Income. If the entire debt goes on non accrual another ($20.0mn) in annual Investment Income would be lost and AINV would have lost (25%) of its earlier Net Investment Income. We’ve already mentioned the size of the Merx investment on the balance sheet and in relation to net book value.

We will continue to update readers about Merx, but may not have anything to report till AINV does so given the closely held nature of the investment and management’s closed lips. There is a danger of an “October surprise” when AINV reports IIIQ 2020 results, especially as the global aviation business continues to face dire circumstances. Unfortunately, AINV shareholders may not find out till it’s too late that the current valuation was unrealistic. For everybody concerned, we hope otherwise.

Merx Aviation: Added To Underperformers

Merx Aviation is an aircraft leasing company owned by Apollo Global. According to a recent press releaseas of December 31, 2019, [Merx’s fleet] consisted of 83 aircraft, 10 aircraft types, across 40 lessees in 26 countries.  80 of the aircraft are narrow-body which are the most in demand types of aircraft.  Apollo’s aviation platform has 45 investment professionals dedicated exclusively to aviation“. Total assets exceed $2 billion and equity is only $45mn. Despite reassurance from Apollo Investment (AINV), which is a lender to and investor in Merx, that all will be well the BDC Credit Reporter has its doubts. So does Fitch, which recently gave the entire sector a “negative outlook“, down from “stable” at year-end. More worrying to non-leasing specialists like the BDC Credit Reporter are quotes like the following, picked from a recent Reuters article:

“This is the biggest shock I’ve seen. This is much more severe than 9/11, this is much more severe than the financial crisis.”

That’s more than enough for us to add Merx to the Underperformers list. It’s not just the obvious downside from the standstill in aviation; the growing signs that we are entering a global recession, etc. It’s also the very large size of the exposure and where that stands in the company’s capital structure. At year-end 2019 AINV had $320mn invested at cost in Merx, $305mn in what is effectively debt structurally subordinated to lenders with first liens against the assets. Then were was $15mn of equity valued at the time at $57mn. The debt – priced at 12.00% (which by itself speaks volumes) – generates $37mn of investment income for the BDC. That’s equal to 14% of total investment income. Or, put another way, equal to one quarter’s Net Investment Income. The value of the investment at year end 2019 equalled 30% of the BDC’s book value.

We have no special insights to offer on the credit future of Merx or aircraft leasing. We’ll wait till AINV reports IQ 2020 results in May to look closer. However, we’re sure our readers can appreciate that a credit slip-up here would be monumental, both in BDC terms given that this is one of the largest exposures to a single name in the industry and for AINV. All the more reason for the BDC Credit Reporter to fix our sights on the company and the multiple other similar companies funded by other BDCs. We initiate at a Corporate Credit Rating of 3.