What are the drivers for M&A activity in the airline sector?
The global aviation industry is highly competitive and one in which, historically, it’s been difficult to generate sustainable profits. Notwithstanding the tremendous success of the low cost carriers in Europe and Asia, and the improvement in revenues for some flag carriers last year, airlines still face testing times. Part of the difficulty is that airlines have to make major capital investments, primarily in their fleets, based on a business plan looking far into the future and which is subject to uncertainties such as volatile fuel prices, ever increasing passenger duties, new taxes such as the European Emissions Trading Scheme and an uncertain outlook for the global economy. All of these factors point in the direction of consolidation.
Have these drivers resulted in a trend towards consolidation?
Despite these pressures, there has actually been surprisingly few full mergers in the sector, with airlines instead preferring to join global alliances and, in certain cases, entering into joint venture arrangements. The main reason for this lack of consolidation is the surprising degree of nationality based ownership restrictions which apply in aviation. Whilst governments seem happy to permit foreign takeovers of banks, technology companies, mining companies and even utilities, they remain fiercely protective of their airlines.
Structuring transactions to take account of nationality restrictions
Notwithstanding these nationality restrictions, there are structures which can be adopted to mitigate them. A simple solution, is for example an acquiror simply taking a minority stake in the target airline and then entering into commercial arrangements. A recent example of this is Etihad’s acquisition of a 30 per cent stake in Air Berlin, and associated codeshare arrangements which give the Middle Eastern carrier access to Air Berlin’s European network.
Other transactions which have seen an acquiror taking a minority equity stake but gaining considerable management controls over the target airline. These types of structures tend to give ultimate control to nationals of the relevant country but operate in such a way as to ensure that all but the most fundamental decisions are, in practice, taken jointly. A good example of this is the Singapore Airlines investment in Virgin Atlantic.
Full blown mergers between airlines of different nationalities are usually difficult to achieve unless both airlines are European where the flexibilities afforded by the Open Skies ruling mean that full mergers have become possible, such as in the case of KLM - Air France and British Airways - Iberia.
The degree of control which is possible will be very much dependent on the jurisdiction of the target airline and the destinations to which it operates. Even in developed jurisdictions such as the US and EU who are party to detailed Air Transport Agreements, there can be considerable differences in the operation of the rules. For example, foreign national ownership of US airlines is limited to 25 per cent, whereas in the EU the equivalent limitation is 50 per cent albeit that the EU has reserved the right to lower this limit to 25 per cent in the case of US nationals if it so chooses.
The destinations to which a target airline flies are also important for determining what is possible. This is because in most cases an airline will need to be designated under the relevant bilateral Air Service Agreement between its “home nation” and that of the destination country. It may even require rights to be granted by countries which are flown over on its routes. These agreements typically contain provisions allowing the overseas state to deny or suspend a carrier’s flying rights where it ceases to be satisfied that the carrier is substantially owned or effectively controlled by the relevant state or nationals of that state.
In Europe, good progress has been made towards replacing these member state based nationality restrictions with EU based nationality restrictions following on from the 2002 European Court of Justice “Open Skies” decision. However, there are a number of countries in respect of which the old restrictions continue to apply, notably China and Russia.
Are these structures robust?
European regulators broadly accept the increasingly complex structures which have been devised to facilitate airline mergers. However, it should be remembered that under the bilateral agreements it is the overseas government which has the right to determine whether the nationality requirements are met. The British Airways/Iberia and Air France/KLM mergers are two notable examples that have used complex structures to satisfy nationality restrictions, and to date, the merged airlines do not appear to have been challenged on their flying rights by third countries.
However, there is always an element of international politics in aviation, and it will be interesting to see whether, in the future, any overseas states seek to challenge these structures.
The next step towards truly global airlines would be an inter-continental merger going beyond the current Alliance cooperation. However the reaction of third party countries and regulators to such a merger remains untested.