The Goldman Sachs report is a compelling argument for the introduction of fresh equity into the airline and makes a strong case for an IPO, writes John McManus.

There is a line on page 22 of the Goldman Sachs report into strategic options for Aer Lingus which has turned out to be prophetic. "The retention of the incumbent management is likely to be put at risk without access to new capital for the company," warned the Government's advisers six weeks ago.

For "access to new capital" one should read a stock market floatation and all that brings with it, including share options and other benefits for senior management. However, according to Goldman Sachs, this is not the reason why chief executive Mr Willie Walsh, his chief financial officer Mr Brian Dunne and the chief operations officer Mr Séamus Kearney could be expected to leave if the Government decided not to go down this particular path.

Although it acknowledges that "alternative ownership structures would also likely provide more attractive incentivisation to the incumbent", they go on to conclude that "the status quo in this regard is not seen as a material impediment".

Instead they predicted Mr Walsh and his colleagues' departure on the basis that the three men had made it clear that they were not interested in borrowing money to expand Aer Lingus and face into what Mr Walsh has termed a "brutally competitive market" on this basis. Doing so, they believed, would condemn the airline to a slow and lingering death and the three men were not interested in helping to kill the creature for which they had been the midwives.

The carefully worded 49-page report from Goldman Sachs does not use such direct language, preferring instead the more anodyne phrase "management do not wish to expand the fleet solely on a leveraged basis".

Equally clear in the report is the bank's view that access to outside capital is the most sensible course of action for the Government. Again the words are chosen carefully: "Aer Lingus has the correct attributes for a successful IPO."

But the Taoiseach and his fellow travellers are more likely to focus in on some of the other observations in the report and hope they are as prescient as the bank's views about the intentions of the senior executives.

A large part of the report is devoted to what might be the consequences of the Government remaining the main shareholder and requiring the airline to fund its growth from internal resources.

Those opposed to the full or partial privatisation of the airline will no doubt seize on the following lines in the report: "[ T]he status quo creates no direct impediment to the future commercial success of the company. The company is well placed to continue its success."

They will also be pleased to hear that, in Goldman's view, "Aer Lingus currently has a relatively strong financial profile" and that it has "no short-term need for equity capital other than as a result of long-haul fleet replacement and expansion".

There is certainly ammunition here for those who contend - as the Taoiseach did in the Dáil this week - that the Government should not let itself be bounced into a rash decision about Aer Lingus based on the views of some nameless "right-wing economist" and other interests.

It also raises the question as to why the airline's top management have decided to quit at this juncture, rather than let the issue play out in the political arena.

The answer, it appears, is that they have seen the writing on the wall and don't like the expected outcome, which will be the retention of the status quo dressed up in some way to pacify the junior partners in the Fianna Fáil/Progressive Democrats coalition.

Mr Walsh's fear of the status quo is founded in the intensely cyclical nature of the aviation industry and the current consensus that the long-term winners in an industry characterised by cut-throat competition will be those with relatively low levels of debt. They are ones who will be able to withstand shocks such as oil at $50 a barrel and capitalise on the opportunities such changes bring.

In its report, Goldman Sachs divides the aviation industry into two sectors. Those with a "traditional airline" capital structure and those with a "low-cost airline" capital structure. The watershed is net debt per seat of €60,000.

The bank is of the view that, if Aer Lingus achieves its operational targets between now and 2007, it should be able to meet its objectives and maintain the "low-cost airline" capital structure.

But in the absence of fresh outside capital, the problems start to arise after 2007. The company wants to start renewing its long-haul fleet in 2008 and, in the absence of fresh capital, this will see net debt per seat rise to €61,000 by 2010, according to Goldman Sachs' analysis.

While stopping short of saying this would be a disaster, the report points out: "The most successful airlines in the current and evolving competitive landscape view financial strength as a competitive issue and seek to maintain low levels of debt. If Aer Lingus sees its primary competition as the financially strong low-cost airlines it may feel disadvantaged with a significantly weaker capital structure than those carriers," according to the report.

The alternative "traditional airline" model is viable and these types of carrier will continue to operate in the future, but with much less flexibility, believes Goldman. But it goes without saying - both in the report and in reality - that Aer Lingus's prime competitor is Ryanair and any strategy that fails to take this into account is doomed to failure.

Goldman also points out that, "given the cyclical nature of the industry and a track record of industry-wide or airline-specific adverse events, the ability to have access to equity capital when appropriate is an important mitigant of financial risk and should be taken into account when considering Aer Lingus funding requirements".

The report adds that, under the current scenario, Aer Lingus would not be able to defend its hard-won low-cost airline capital structure in the face of the sort of upheavals experienced by the industry in the past.

In toto, the report amounts to a compelling argument for the introduction of fresh equity into the airline. It also makes a strong case for a stock market flotation as the preferred method.

An IPO, as against a private placement, would extract the best value for the State, argues Goldman Sachs. Or at least it would have up until last Tuesday.

"The loss of the current management team would...restrict the ability of the Department to pursue any change of ownership alternatives for a certain period. That is because investors would need a reasonable period to evaluate a new management team," cautions the report.

The period is deliberately not spelled out by Goldman Sachs but, given the scale of the management departures, it will be a question of years rather than months before an IPO can be contemplated.

However, it is clear from the actions of Mr Walsh and his colleagues that they had already taken the view that a IPO was a non-runner. It would be hard not to form such a view based on the reservations expressed by the Taoiseach and his failure to engage on the subject. He heads the Cabinet sub-committee set up to look at the issues, but has yet to meet to consider the Goldman Sachs report that was completed six weeks ago.

It was becoming increasingly obvious to Mr Walsh and his team that they were being presented with an unpleasant choice. They could build Aer Lingus on borrowed money and, in the process surrender the cost base that underpins their survival, or they could rely on lower levels of internally generated equity, which in turn would involve reining in their ambitious expansion plan and giving up the flexibility to respond to market conditions.

Neither option was very attractive to the three Aer Lingus managers. They appear to have settled on a third option - go somewhere else and be allowed do their job properly.