Fractional advantage

Buying a part share of an aircraft makes financial sense unless you’re planning to fly hundreds of hours a year

The correlation between demand for business jets and the health or otherwise of the global economy is well documented. Once the recovery from the 2008 crash began to splutter in mid-2011, demand once again fell back and operators specialising in fractional jet ownership propositions have had to take their share of the pain. But there is finally some optimism in the sector that 2013 could see a turnaround both in the global economy and in enthusiasm for private jet ownership.

Chris Moody, chief executive of consultancy Fractional Jet Europe, points out that market downturns also inevitably hit the residual values of pre-owned aircraft, making the cost of ownership that much greater. In particular, the residual values of light jets and very light jets (VLJs) has plummeted over the last five years, so the amount having to be written off becomes markedly higher.

This has hampered fractional sales since light jets constitute a significant part of the fractional market. Purchasers know there will be some value left in the aircraft – or their share of it – but have no real way of knowing exactly what that value is going to be five years hence. With the global market going through a protracted recession, part-owners are likely to get anything from 20% to 40% less than they may have expected. Because anxieties over the stability of resale values play a role in the initial decision process, fractional providers have to work hard to address the residual value problem if they want to get potential buyers over the line.

Providers such as NetJets Europe, or Bombardier subsidiary Flexjet in the US, solve the residual problem by building into the contract a promise to buy the fractional owner’s share of the jet back at the end of a standard five-year contract “at fair market value”. This promise addresses part of the problem, since it guarantees the owner an immediate end-of-contract exit with some cash for their share, but leaves open the question of what constitutes fair market value.

The same point can be made for the standard break clause in a five-year fractional contract. This gives the owner the option of exiting the contract after three years at a penalty, but in accordance with the same fair market value buy-back clause. Again, you don’t know what the market is going to be doing at that time so you are still shouldering the residual risk. Fair market value can mean different things to buyers and sellers.

“In essence, the fair market price is set by whatever the market value is for that class and age of jet at the time, but the fractional provider is going to sell that jet at a mark-up,” Moody says. “The mark-up has to be at a level that the market will bear, so the seller, by definition, is going to get less than the value of that particular jet on the open market.”

Part of Fractional Jet Europe’s raison d’etre is that Moody provides a broking service to fractional owners who want to exit their contract irrespective of where they are in the life of the contract. He claims to be able to do deals at significantly better prices than the seller would get from, say, NetJets at the approved three-year break point.

However, it should be noted that any transfer of contract needs to be conducted with the consent of the aircraft operator, as would be expected in such a highly regulated industry.

“If you have a contract on a mid-range jet, that contract could be costing you a million euros a year in maintenance costs and you are tied in for a minimum of three years. If economic conditions change, for example, and you want to exit the contract early, that’s where a broking service like ours comes in. You can’t terminate your contract, but you can sell your contract on and we operate as a broker to find you a buyer,” he says.

Many buyers, whether outright purchasers or fractional purchasers, are not in the kind of financial position where they would be particularly hurt by a standard break clause or greatly benefited by shaving a few hundred thousand euros off a contract. However, as Moody points out, people tend to work hard for their money and while they don’t mind paying for what they want, there is an inherent reluctance to squander cash needlessly.

300-hour tipping point
The fractional jet market only exists because it makes financial sense for someone who is not going to be flying their aircraft for hundreds of hours a year to think in terms of a part share, rather than a whole aircraft.

Bruce Peddle, VP of sales and marketing at Flexjet, which specialises in fractional sales of Bombardier aircraft, puts the cut-off point at which fractional ownership becomes a more cost-effective option than outright ownership at around 300 hours a year. If you fly less than that, then fractional is sensible, unless you really want to own your own jet for purely personal reasons. Clearly, if you have your own dedicated plane, no one else has any say over it. The 300-hour cut-off point generally holds good for corporate buyers and private individuals alike.

About 95% of Flexjet’s customer base is US-based and a good deal of their flying is point-to-point within the US. “Basically, the fractional jet market is Europe and the US, with NetJets Europe being the dominant player in Europe and ourselves and NetJets Inc dominating the US market. As the fractional model evolves, however, and we see more geographical acceptance of this mode of ownership, we will see the fractional fleet expanding to emerging markets in something other than its current form,” Peddle says.

With the Cessa subsidiary CitationAir announcing back in February that it would not be offering new fractional ownership contracts and would instead concentrate on its jet card services, Flexjet is now the only major manufacturer-owned provider. NetJets Europe is backed by Warren Buffett’s Berkshire Hathaway and its sister company, NetJets Inc, is a Berkshire Hathaway subsidiary. Both companies source their aircraft from Bombardier, Cessna, Hawker Beechcraft, Gulfstream and Dassault.
NetJets Inc recently placed the largest order in the history of private jet ownership. The firm order is for 100 Bombardier and 25 Cessna aircraft, but the total rises to 425 aircraft, worth some $9.6 billion, if NetJets decides to take up all its options. Either way, the order represents a huge vote of confidence by Berkshire Hathaway in the future of fractional jet ownership.

The benefits of fractional ownership over both outright ownership and the charter option are well understood and the market leaders lose no opportunity to hammer them home. Setting aside the cost savings, which will be more important to some clients than others, the clincher is that the aircraft (or one that is similar or better) is readily available.

Even with a third-party management contract which takes the hassle out of maintaining a wholly owned aircraft, there is always going to be a time when it is “in the garage” and unavailable. With fractional ownership you are guaranteed availability of your chosen class of jet with as little as 10 hours’ notice.

An entry figure for an acquisition through NetJets would be $125,000 for a 1/32nd share of a jet. This represents 25 hours of flight time per year, but the actual cost will vary depending on the size of the share purchased, the age of the aircraft and the aircraft type. For example, a 1/4 share of a mid-sized jet such as an Excel will cost $850,000, representing 100 hours of flying time per year.

To this you have to add a monthly management fee to cover fixed operating costs such as pilot salaries, training and insurance. A third charge is the “occupied hourly rate”, which covers the variable operating costs of flying the plane, such as fuel, landing fees, handling, catering and cleaning. For NetJets Europe, this ranges from €4,500 to €12,000 per hour depending on the aircraft type.

This fixed fee takes out of the equation “surprise” maintenance bills, which, of course, any corporation or individual who owns their own plane will face from time to time. Predictable pricing is one of the big attractions of fractional ownership for corporates.

NetJets Dessault Falcoln FX7 private jet. Interiors by Norman Foster.

Chartered represents a key alternative to fractional ownership but is only a worthwhile option if you fly less than 10 hours a year, argues Eric Connor, chairman and CEO of NetJets Europe. More than this and the 1/32nd fractional ownership option comes into play. It is hard to conceive of anyone contemplating a jet purchase, fractional or otherwise, who flies less than 10 hours a year. Why would you bother? So Connor is setting the entry level very low indeed.

With NetJets Europe, the contract provides an actual physical asset, a share of a particular, named plane, but in reality it gives the buyer access to the provider’s entire fleet of aircraft of a particular chosen type, with the option of upgrading as needed to a larger or smaller plane. The buyer’s chances of actually flying every journey on their “own” plane are actually quite slight, since it is part of such a large fleet and may be positioned elsewhere.

Connor adds that another upside for the fractional model in general, and for NetJets Europe in particular, is that if you have a schedule that is likely to change, a company with a large fleet is much better placed than a regular management company. “If you are flying Paris to Munich, for example, and the night before you find out that you need to go to Amsterdam first, that is something we can accommodate very easily, but it is not something many of our competitors have much practice at doing,” he says.

NetJets Europe considers an aircraft to have a potential 800 hours’ flying time a year, and likes to sell 1/8th shares, so a corporate who buys 300 hours can have three planes in a day on their standard contract. That is generally enough to get a sizeable project team to a client site somewhere in Europe. Or the requirement might be to fly various groups of people, from different departure points, to a central location.

Again, all this is very achievable with a fractional contract. However, corporates who have their own jet will need to look to the charter market to supplement their jet’s seating capacity – which means they are paying, say, 5/8ths more than the corporate that is using fractional ownership, plus having to bear additional charter costs.

Fractional providers can also make an excellent case against competition from scheduled airlines, mostly along the lines of convenience, confidentiality through the flight, and the ability to connect city pairs serviced by no convenient scheduled carrier.

“We had a Scandinavian client who had a large project in Russia and needed to fly various groups in to a meeting with the Russian client. If they had tried to do that with a scheduled airline, it would have taken them a week to get there and back. Using their fractional contract they were able to do the meeting in a day,” Connor says.

The Russian promise
NetJets Europe’s operational focus during its growth period from the 1990s through to 2007 was on the UK, France, Switzerland, Germany and Italy. Then Russia, or more specifically, Moscow, appeared on the agenda, and continues to be a growth opportunity, according to Connor.

“The market in Russia is predominantly for large cabins, flying to Europe but also in other directions,” he says. North Africa, particularly Morocco, was a growth opportunity until the Arab Spring, which muted demand for a while. However, as things quieten down again, Connor sees signs of growth in demand from North Africa for the fractional market – though largely as a destination from Europe.

Demand in the Middle East again focuses on large-cabin aircraft. NetJets Europe has just extended its “principal operating area” to incorporate the region, meaning there are no ferry charges for client pick-ups and drop-offs.

“If someone wants to go to Cairo, say, from Geneva, then we would have them pay part of the ferry charge to return the aircraft to the nearest principal operating area,” Connor explains. So the inclusion of the Middle East benefits all customers flying to adjacent markets.

NetJets Europe is keeping an eye on India as a possible fractional market, but at present, Connor feels that infrastructure, both in terms of airports and air traffic control, remains an issue and that the licensing situation is not developed to the point where the country can support a fractional model. Much the same can be said of Africa.

“We will look for solutions to operate in these areas but we will not compromise on safety or service, so we are in a watch-and-wait position with respect to these potential markets,” Connor says.
Peddle says that intercontinental travel probably makes up no more than 20% of total hours flown among Flexjet’s collection of aircraft, excluding trips to Hawaii and the Caribbean.

“We have looked at international expansion and so far our conclusion is very firmly that we should stay focused on the US and consider partnerships as a way of developing into new markets. There are some players who are looking to develop fractional models in China and India, but this is still very much in its infancy and we are not attracted to it as yet,” he says.

Flexjet’s Bombardier aircraft profile highlights this North American focus. Ultra-long range aircraft make up only 1% and long-range a further 12% of the fleet. Demand for the super-midsize fleet, which operates coast to coast across the US and into Canada, constitutes about 45% of business.

“We are pretty bullish about the prospects over the next 10 years,” Peddle says. “Virtually all the wholly owned private jet market flies under 300 hours a year, so they are all potential customers for the fractional ownership model. We see a very encouraging flow through of new customers from the ranks of those who have owned their own plane.”

Of course, moving to the fractional model rules out piloting your own plane. The fractional operator has its own codes and rules to follow on pilot hours and training, so fractional owners can’t expect to go and sit at the controls.

“The key point is that the model has changed over the last 10 years to become very client-centric. For every contract we write, we need to understand the client’s requirements in depth, along with their interests and expectations. We then design a bespoke contract that reflects that understanding,” Peddle says.

A different model
Ian Moore, chief commercial officer at VistaJet, points out that his company’s ownership model is significantly different from that of the big two fractional operators. “Where we differ is on the financial side. There is no asset exposure for ‘owners’ in our business,” he says.

VistaJet sidesteps the residuals problem by offering an operating lease rather than a fractional share. The lease offers the same “number of hours flying” model as a fractional jet lease, and is priced according to the capacity of the jet type on which the lease is written, but there is no “buy back” element, so the client gets what they pay for.

Where we differ is on the financial side. There is no asset exposure for ‘owners’ in our business
Ian Moore, chief commercial officer, VistaJet

Of course, the residuals problem does not vanish, but the risk simply lies with VistaJet rather than with the client. It prices the contract based on its view of the jet’s likely value at the end, while seeking to offer the client the most attractive price possible.
There are some similarities here to the vehicle fleet leasing market, where price is critical and operators are tempted to gamble on residual values. Some companies have had to endure steep losses three or four years after a boom period in sales, when residual values have failed to match the optimistic level assumed when the contracts were written.

The private jet market is less cost-sensitive, but the risk remains. Despite VistaJet’s success so far, only time will tell if it is pricing wisely. What it is doing, which benefits customers directly, is ensuring that it has one of the youngest fleets in the market.
“One of the biggest challenges any fractional operator has is in refreshing its fleet. Because we own our fleet 100%, we can continually upgrade it,” Moore says. A fractional operator, by definition, must wait until all the five-year contracts on a plane have run their course before it can sell on and replace it with a new model.

“Our big selling point for corporates is that with us they know exactly what a contract is going to cost them and how many hours they can fly with that contract. There is no mysterious asset exposure for them to worry about,” he says. This contrasts with the fate of customers who bought a share of a Hawker Beechcraft 800 SP, many of whom saw residual values fall by 40% when Hawker ran into difficulties. A leasing contract holds no such anxieties.
VistaJet currently operates in Asia, the Middle East, Russia and Europe, and has a partnering agreement with Flexjet that gives it access to the US market as well. “We’ve been going great guns in India and China. Because we fully control the fleet, we can deploy aircraft rapidly and efficiently to locations like that as demand arises,” Moore says.

The statistics on average hours flown annually in private jets suggests to Chris Moody at Fractional Jet Europe that almost everyone would fit inside a fractional contract. Only dedicated owner pilots who love flying would have a reason to prefer outright ownership.

On the other hand, Moody believes charter would represent a more logical option for many fractional jet owners. “If you can fly for roughly the same cost on charter as on fractional, but without the need to put up, say, £3.8 million for a fractional share, why would you not do it? You might get half that sum back at the end of the contract, or you might get less, but that is still £1.9 million or so that you are spending unnecessarily,” he says.

Fractional operators would naturally disagree. The fractional market seems set for slow but improved growth over the next two to three years if the global economy picks up, and we could see a more dramatic ramp-up as emerging markets put private aviation infrastructure in place. There will be challenges ahead, but operators feel the worst of the downturn is behind them.