A MAGAZINE FOR AIRLINE EXECUTIVES 2008 Issue No. 1

T a k i n g y o u r a i r l i n e t o n e w h e i g h t s

A Conversation with Tim Hoeksema, chairman, president and chief the executive officer, pilot . pg. 36

Special Section I N SID E Airline Mergers Airlines are scrutinized for affects and Consolidation 26 on the environment

Etihad doubles its revenue from 44 2006 to 2007

Carriers can become true customer- 62 centric businesses

© 2009 Sabre Inc. All rights reserved. [email protected] industryprofile THE BARBARIANS ARE STILL AT THE GATES

Some carriers may continue to be targets of firms as pressure for privatization and consolidation of airlines unfolds this year.

By Peter Berdy | Ascend Contributor

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rivate equity has a colorful history, first out prominent U.S. and European carriers that ing last year — around the time gaining prominence during the junk-bond were in financial trouble during the year. was rumored to be raising cash Pand leveraged buy-out heydays in the “We believe UAL is a potential private for a stake in Iberia. 1980s. Most notable was the case of RJR equity play, given the US$4 billion we esti- TPG’s investment in represents . In 1988, RJR Nabisco was purchased mate it can earn in free cash flow over the another start-up example. Ryanair President by private equity firm next four years,” Daniel McKenzie of Credit Michael O’Leary said, “He [Bonderman] got & Co. (now called KKR), in what is the second- Suisse told BusinessWeek. McKenzie said 20 percent for pretty much nothing. Sold us in largest buy-out in history (the 2007 buy-out such groups “could take UAL private today, ’97 and made a fortune.” The US$42 million of the -based utilities giant, TXU, by collect dividends and go public when the that Bonderman and his partners invested KKR, TPG Capital and is the industry consolidates, thereby capturing the in Ryanair’s of largest). valuation .” increased sevenfold. At that time, the use of a leveraged Private equity firms also rediscovered Private equity firms invest in buy-out buy-out to acquire RJR Nabisco along with proven ways to unleash hidden shareholder situations where they acquire a significant por- the aggressive pursuit by the private equity value by attempting to spin off undervalued tion or a majority control in a mature company. principals was seen as an ominous threat to businesses within the airline’s portfolio, such Buy-outs usually involve a change of owner- the free capitalist structure. The men behind as frequent flyer programs and regional feeder ship. Some examples in 2007 included TPG’s these plays were termed “corporate raiders” divisions. unsuccessful attempts at Qantas and Iberia; and “.” (The story was and both TPG’s and Matlin-Patterson’s unsuc- written in the book called, Barbarians at the Opportunistic Focus Of Private cessful bids for Alitalia. Look for private equity Gate, by Bryan Burrough and John Helyar). The Equity firms to play a role in the coming years as RJR transaction also benefited the investment Typical private equity opportunities, speculation and action swirls around mergers bankers and lawyers who advised KKR. These including those in aviation, fall into one of and consolidation in the airline business. advisors walked away with more than US$1 several categories: billion in fees. Leveraged and go-private Unlocking Value During the 1980s, high-profile airline pur- transactions, Blackstone Group got a return on suits included TWA (featuring Frank Lorenzo Spin-offs and carve-outs from larger invested capital after it bought — a and Carl Icahn) and Continental (with Frank companies, reservations conglomerate that owns a major- Lorenzo once again, and of Restructuring and recapitalization, ity stake in Orbitz Worldwide Inc. and Galileo Texas Pacific Group). Structured minority and and has agreed to buy Worldspan. Blackstone strategic stakes, bought Travelport from Cendant in 2006, using The Business Model Financing acquisitions, US$1.1 billion in debt to fund the purchase. Once a targeted company was acquired for new enterprises. Seven months after the deal with Cendant by the private equity firm, the firm would As “venture capitalists,” private equity closed, Blackstone received a dividend equal to restructure it, implement a series of cost- firms may invest to create a new company or its debt. The company went on to file an initial cutting measures and usually sell off underper- expand a smaller company that has undevel- public offering for Travelport last December. forming assets. The new “leaner and more- oped or a strong potential to grow revenues. The IPO could raise US$2 billion. efficient” company could then be resold, often For example, Apax Partners provided financial A go-private example is Sabre Holdings®, at significant return on investment. backing for the creation of Airlines, a the publicly traded firm known for providing Now, 20 years later, the image of private Spanish low-cost carrier that was created in software solutions and consulting services to equity has changed dramatically. The private 2004. Apax Partners initially had a 40 percent the travel industry that was purchased last equity “barbarians” are now shrewd global interest in Vueling Airlines and sold its remain- year by TPG and Silverlake. investment managers and specialists whose financial backers are looking for high ROI Frequent Flyer Program Value from acquisitions, spin-offs, re-financings and restructuring businesses. They also help Market Estimated capitalization bail out ailing companies by pro- Airline Value of FFP of parent viding management services, guid- Air Canada C$4.3 billion C$2.9 billion ance and United Airlines US$7.5 billion US$3.4 billion advice as well US$6.4 billion US$2.9 billion as look- ing for American Airlines US$5.7 billion US$3.3 billion ways to increase British Airways £1.0 billion £3.4 billion share- Air /KLM €2.4 billion €6.6 billion holder value. Lufthansa German Airlines €2.8 billion €8.0 billion P r i v a t e equity has become a fully Source: Bear, Sterns and Morgan Stanley, January 2008 fledged industry. Private equity firms Private equity firms have identified frequent flyer programs as hidden assets that can made headlines in the airline industry potentially be far more valuable to the firm if they were separated from the airline business. last year. They were identified as firms to bail

ascend 29 industry Photo by shutterstock.com by Photo Private Equity Money During the last two decades, the global private equity market has experienced explo- sive growth. New sources of liquidity created from rocketing oil prices and the developing Asian economies, among others, has been put into the hands of private equity firms. Private equity has become an invest- ment option for many of the world’s largest investors, including pension funds, companies, banks and university endowments. These institutions are committing an increas- ing proportion of their capital to private equity, which often out performs more-established investment choices available. Photo by shutterstock.com by Photo Private Equity Investments Private equity firms generally receive a return on their investments through an IPO, a sale or merger of the company they control, or a recapitalization. Their offering of unlisted securities may be sold directly to investors through a private offering or to a private equity fund that collects contributions from smaller investors to create a capital pool. Most private equity funds require signifi- cant initial investment, usually US$1 million or more, plus further investment for the first few years of the fund. Investments in limited partnerships, the of courtesy Photo dominant form of private equity investments, are typically illiquid — it is very difficult to gain access to money that is tied up in these long-term investments. Distributions are made only when investments are converted to cash. Limited partners typically have no right to demand that sales be made. Private equity firms can provide high returns, with the best private managers sig- nificantly outperforming the public markets. Private equity fund investments are for those who can afford to have their capital locked in for long periods of time and who are able to risk losing significant amounts of money. This is balanced by the potential benefits of annual

returns that range up to 30 percent for suc- shutterstock.com by Photo cessful funds. Given the risks associated with private equity investments, investors can lose all their investments if the fund invests in fail- ing companies. The risk of loss of capital is typically higher in venture capital funds, which invest in companies during the earliest phases of their development, and lower in funds, which provide interim invest- ments to companies that have already proven their viability but have yet to raise money from public markets.

Major Private Equity Players The majority of investment in private TPG, one of the most prominent private equity firms in the world, has invested in several air- equity funds comes from institutional investors lines, including , , Tiger Airways and Ryanair, giving it including public pension funds and banks and the most experience in the airline industry. financial institutions, which, together, provided 40 percent of all commitments made glob-

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ally according to data from -based Prudent capital investment, research and of €305 million (US$452 million) on its stake Private Equity Intelligence Ltd. Other promi- development, new product marketing, tal- in in 2006. nent groups investing in private equity include ent development, improved operations, and corporate pension plans, insurance companies, appropriate strategic acquisitions. endowments, family offices and foundations. The degree of involvement is also likely In 2007, European Union transport min- Last year, Private Equity International to be related to the size of the investment isters approved an open-skies agreement that magazine published a ranking of the larg- made by the private equity firm. went into effect in March. The agreement est private equity firms in the world. The allows European carriers to operate flights to Carlyle Group was ranked the largest private Private Equity Moves To Aviation the that originate in cities out- equity firm, followed by KKR, Goldman Sachs Industry side their home countries. The agreement also Principal Investment Area, The Blackstone With the airline industry posting profits makes it easier for European carriers to acquire Group, TPG, , Apax Partners, Bain in 2006 and 2007 amid strong demand and airlines in other E.U. countries. Capital, Partners and CVC leaner costs as well as a stable outlook, It was long thought that changes brought Capital Partners. The sector also includes airlines were potential targets for private about by open skies would trigger consolidation multi-billion-dollar portfolios managed by equity firms. among airlines in Europe. Some of the larger or Cerberus Capital Management, Summit “They’ve significantly picked up their financially weak airlines have been considered Partners, Golden Gate Capital, Hellman & interest from, say, five years ago,” said John to be prime candidates for privatization and Friedman, and Equity Capital Markets Group, Luth, chief executive of transport-focused , including Iberia and Alitalia, as well among others. Several of these firms and investment bank Seabury Group. “They’re as state airlines Olympic and TAP. smaller private equity players, such as Yucaipa really open for business both here in the Iberia has undergone a major restructur- and Ranch Capital, have invested in the avia- United States and elsewhere.” ing in recent years. Its extensive Latin American tion sector. route system, “would make a good network fit” for any of Europe’s three bigger carriers, Investment Targets Last year, American Airlines’ parent according to Andrew David Lobbenberg, a Private equity firms share common AMR Corp. came under pressure by its third- London analyst with ABN AMRO. themes to their strategies, objectives and largest shareholder, the Icelandic investment A consortium lead by British Airways approaches to investment: firm FL Group. The investor wrote to AMR’s and TPG (BA owned 10 percent of the Spanish Identify out-of-favor, under-appreciated board urging it to spin off American Airlines’ carrier) made an initial bid for Iberia, and then industries and businesses, and undervalued frequent flyer program and make other dis- withdrew, citing that “a bid under friendly companies, posals. Hannes Smarason, FL Group chief terms was no longer possible,” according to Pursue opportunities to change the structure executive, said the carrier was burdened by the Nov. 28 issue of ATW Daily News. and profit potential of specific industry sec- a cluttered corporate structure that needed In , private equity firms TPG and tors through consolidation, slimming down. Matlin Patterson expressed interest to bid Avoid -term investments and trades; “There is no question that they have during the first round to purchase the Italian private equity firms are in it for the long not been performing as well as they could government’s shares in Alitalia. However, the haul. have,” Smarason told The Guardian last government’s rules of procedure were consid- While these may be stated objectives, September. “If you have too complicated ered onerous enough that they, as well as all private equity firms also are interested in mak- a structure and no one is responsible, then the other bidders, withdrew their offers. ing a quick return on investment. Many private you have a problem and you need to clean equity firms play an active role in managing it up.” /Pacific their investments, and there are certainly some FL Group said AMR’s structure mud- In November 2006, ’s national common threads among the key players: died the profitability of the company’s con- flag carrier, Qantas, announced that it was Take a long-term view; be prepared to work stituent parts, a situation compounded by the target of a takeover bid by a private equity with management through the inevitable ups the fact that it does not publish details on consortium lead by TPG and the Australian and downs of business life to achieve objec- individual units. Fort Worth, Texas-based bank, Macquarie. The deal was structured to tives, American Airlines warned that third-quarter give TPG about 15 percent voting interest and Ensure there is active board participation, revenue growth would lag behind some 25 percent of its earnings. The bid failed in Provide expert resources and a network of rivals and rising fuel costs would affect earn- April 2007 when the consortium could not gain advisors consisting of skilled former senior ings for the rest of the year. the percent of shares needed to complete the corporate executives, FL Group had a history of investing takeover. Work with management of the company and in airlines, and at one point last year, it had outside advisors on a plan to enhance the an investment portfolio of approximately 25 Texas Pacific Group company’s operations. percent of its assets in the industry. The TPG has the most experience in the Obtaining financing is an important FL Group has made a series of success- airline industry among private equity firms. offering to a company about to be acquired or ful investments including the acquisition of Its past and present investments in aviation in need of financial assistance. Private equity Sterling Airlines, Scandinavia’s largest low- include Continental Airlines, America West, firms offer: cost airline, with its head office in , Southwest Airlines, Ryanair, Tiger Airways, Financing expertise to lower the cost of cap- building a 23 percent stake in Finnair, the Midwest Air Group, Sabre Holdings, Hotwire ital, reduce risk and uncover hidden assets, Finnish flag carrier. FL Group was the former and Gate Gourmet. Last year, TPG made bids Use of efficiencies of scale from invest- sole owner of Icelandair, the Icelandic flag to acquire Iberia, Alitalia and Qantas. One of ments across companies in an industry, carrier and former owner of a 16.9 percent TPG’s founders, David Bonderman, is currently such as combining purchasing power of stake in easyJet. chairman of Ryanair. goods and services at lower prices to On its easyJet stake, FL Group made a TPG’s buy-out of Continental Airlines in achieve savings, profit of €140 million (US$207 million) when 1993 and then America West Airlines in 1994 it was sold in April 2006. It also made a profit became models for private equity investment.

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Private Equity Investments

Private Equity Firm Aviation Acquisition or Investment Notes

ARINC provides communications Carlyle Group Acquired ARINC; July 2007 services to airlines Sale of MRO company, ACTS (Aero Technical Support ACTS is part of ACE Holdings, Kohlberg Kravis Roberts (KKR) and Services Holdings) owner of Air Canada

Goldman Sachs Considered PE investment in business-class airline

The Blackstone Group Purchased Cendant’s Travelport company for US$4.3 billion

Apax Partners PE funds to start Spain’s LCC, Vueling in 2004 Considered bid for Iberia

FL Group AMR, IcelandAir, Finnair, Sterling Airlines, easyJet

Attempted hostile takeover of Air Canada/Canadian merger; Onex teamed with Airline Partners Australia in takeover bid for Qantas

Cerberus Capital Management ACE Holdings, privatization of Debis AirFinance

Indigo Partners LLC Tiger Airways, Spirit Airlines

Wexford Capital LLC Republic Airways

Yucaipa 2005 Aloha Airlines

Ranch Capital LLC Hawaiian Holdings

Global Aero Logistics (ATA Airlines, North American Airlines MatlinPatterson Global Advisers LLC and World Airways); Owned and sold VarigLog logistics Bid for Alitalia business of Varig Continental, AmericaWest, Southwest, Ryanair, Gate Bids in 2007 for Qantas, Iberia, TPG Gourmet, Sabre Holdings, Hotwire, Midwest Air Group, Alitalia Tiger Airways

Silverlake Partners Sabre Holdings partnered with TPG

Several of the world’s top private equity firms have invested in travel-related companies, and many of them have current bids on the table to acquire additional businesses.

TPG’s strategy was to invest in an airline built up the carrier’s Houston, Texas; Newark, employee morale and even the photos on emerging from bankruptcy during a cyclical New Jersey; and Cleveland, Ohio, hubs and executives’ walls. downturn, oversee the carrier’s turnaround upgraded the fleet. Bonderman and his partners believe this and then cash out after the economy and TPG’s founders spent years on its is prime time for long-term-value investors. company had recovered. turnaround. Eventually, it was rewarded with “There’s a lot of trouble in the world, but At the time TPG, which was named, extraordinary returns on investment. Thanks it is also a potential time of value,” said TPG “Best Global Firm of the Year” in 2006 by to a clever purchasing arrangement, TPG’s co-founder James Coulter. “As investors, we Euromoney Magazine, stepped in, Continental partnership controlled Continental Airlines, like this environment better than the bubble. It Airlines was ailing in a weak U.S. economy. The although it owned only 14 percent of its stock. may stay rough for a while, but we’re focused airline had been plagued with labor and cus- Continental’s share price, once as low as five years out.” tomer service challenges. TPG’s plan included US$2, soared to US$65 by 1998. Some of TPG’s recent targets have bringing in a new management team that “It was a huge gamble with an even been challenging. On the success side, TPG focused on improving customer yield, aircraft larger payoff in an industry where net profits and Northwest Airlines acquired Midwest utilization and financial performance. It took are close to zero,” said Continental Airlines Airlines earlier this year (see cover story rapid action to close unprofitable routes, shut board member George Parker. on page 36), in the airline’s effort to stave down the airline’s low-cost division (CALite) After eight years, TPG’s total return off an unfriendly takeover bid by AirTran and reduce maintenance costs. The private on its US$66 million investment was nearly Airways. However, there were unsuccessful equity firm addressed one of the primary cus- US$700 million. bids that were publicized last year, such as tomer complaints, moving Continental Airlines TPG’s partners get high grades from TPG’s deal in conjunction with Australia’s from consistently near the bottom of the airline insiders for its knowledge of the indus- Macquarie Bank for Qantas Airways, which on-time departures table to consistently in try and eye for executive talent. Before any was rejected by the Australian carrier’s own- the top three by creating financial incentives major investment, the company’s executives ers in March 2007, as well as the attempted for front-line staff. At the same time, TPG walk the halls of the business, checking out bids on Iberia and Alitalia.

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FFP Spin-Offs Private equity firms and investors have Size Of Investment found that airlines may have hidden assets that could be worth as much as or more than the carriers themselves. The crown jewels Co-investment Lead Investor High — airlines’ frequent flyer programs. Team with leading strategic Involvement through board seats. The underlying concept to this hidden partners. Long-term involvement Develop strategy and structure. wealth is that a stand-alone frequent-flyer and relationship building. Commitment and expertise. business, with its high margins, good growth prospects and steady cash flows, would trade at a much greater multiple to earnings when separated from the airline business. The theory is relatively simple: Unlike Size of stake Trading Active Ownership airlines, loyalty programs tend to be stable, Opportunistic investment, Constructive dialog with manage- cash-producing businesses with low fixed leveraging company’s expertise. ment. Communication with share- costs and substantial growth opportunities. holders. PR where appropriate. Separating them from their riskier airline Low gives investors direct access to the busi- Degree of involvement ness, resulting in a higher valuation. Low High The airline would benefit by getting cash from the FFP sale, and it could still Source: FL Group collect profits by keeping a share in the program while the FFP grows. Once out of the airline’s control, mileage programs could The degree of involvement a private equity firm has when acquiring a company move outside the air travel industry and add depends on the size of its investment. partners and attract more members. The success story and model for deter- mining FFP value is Air Canada’s Aeroplan. done in the right way,” said Smarason, the spinning off FFPs may make the core Prior to 2002, Aeroplan was integrated FL Group’s chief executive. In the letter airline parent less attractive (valuable) to with Air Canada. Aeroplan became a wholly to AMR’s board, Smarason said, “… our investors. owned, of Air Canada conservative analysis indicates the unbun- in 2002. It was spun off in an initial public dling of AAdvantage could lead to value Mining Gold offering in 2005 and had an initial valuation creation of US$4 billion.” Private equity firms represent a global, of C$2 billion (US$ 1.9 billion). It has since This was based on FL Group’s esti- sophisticated industry. They follow tradi- doubled in value to about C$4.3 billion (US$ mate of US$6 billion business valuation tional “buy low, sell high” investment advice 4.2 billion) compared with the market cap of offset against a cost of US$2 billion to de- and have a history of out performing other C$ 2.9 billion (US$ 2.8 billion) for ACE, Air couple from American Airlines. FL Group investment categories for the private inves- Canada’s holding company. also encouraged AMR to sell its feeder tors who fund these firms. “Creating a separate structure made business, American Eagle. The aviation industry has provided Aeroplan a better business with more freedom Citi analyst Andrew Light said it opportunities for this group to mine gold. to add partners and grow,” said Karl Moore, a would be “much easier” to divest American Just like mining, there can often be long, professor at McGill University in Montreal who Eagle than AAdvantage because the car- hard work to achieve good payouts, as well worked with the mileage plan’s executives rier is run as a separate entity. Similarly, as the occasional nugget that was there for on business school projects. “It unleashed an airlines such as Continental Airlines, Delta the taking. Challenges include finding under- enormous amount of capital that they [ACE] Air Lines and Northwest Airlines have valued companies or hidden businesses that wouldn’t have otherwise had.” spun off or sold regional carriers. could be spun off for large gains, such as Qantas Airways has met with Aeroplan to “As with Air Canada’s Aeroplan, frequent flyer programs, and then getting discuss how to release value from its rewards stripping out the frequent flyer program the green light to go forward to restructure, plans. The carrier may find a buyer in Aeroplan, would leave a barely profitable, volatile refinance and spin off value to shareholders and the frequent flyer program’s chief executive and poorly valued core airline,” Light and investors. officer, Rupert Duchesne, said in an interview said. Private equity may well continue to in last August that Aeroplan was in talks to buy “Spinning out the mileage programs play an active role as airline consolidation stakes in other loyalty programs. would be very beneficial to sharehold- rumors began to swirl earlier this year. a American Airlines’ FFP, AAdvantage, ers,” said Craig Hall, a Dallas investor which could be worth as much as US$5.7 bil- who owns the fifth-biggest stake in AMR lion, according to a Morgan Stanley estimate, and wants American Airlines to divest was under pressure to be sold last year. That AAdvantage. Hall calls the frequent flyer amount is about the same as the market value plans a “hidden asset” not reflected in of parent company, AMR. airline valuations. FL Group, which at one point owned 9.1 Several major airlines have since percent of AMR, urged American Airlines to sell examined setting up their FFPs as sep- its frequent-flyer program in an open letter to arate companies. However, there are Peter Berdy is a partner for Consulting the AMR board last September. some concerns. The cost of spin-off is and Solutions Delivery at Sabre Airline “This has the potential to become a steep. In the AAdvantage case, the cost Solutions®. He can be contacted sustainable source of value creation if it’s was estimated at US$2 billion. In addition, at [email protected].

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