Virgin Australia in talks to buy back rest of frequent flyer programme - source

* Potential deal could value 35% stake at A$700 mln

* Virgin sold stake to Affinity for A$335 mln in 2014

* No details of how loss-making airline would finance purchase

HONG KONG, Sept 15 (Reuters) - Virgin Australia Holdings Ltd is in exclusive talks to buy back the 35% of its Velocity frequent flyer programme that it does not already own from private-equity group Affinity Equity Partners, a person familiar with the matter said.

While nothing has been finalised, a deal is likely to value the business at around A$2 billion ($1.38 billion), or around A$700 million for the stake Virgin is looking to buy, the person said on condition of anonymity as the talks are confidential.

Virgin had sold the stake to Affinity in 2014 for A$335 million and the private equity group has this year been canvassing exit options, including a potential IPO.

An agreement would be part of a turnaround plan for the loss-making airline under its new CEO Paul Scurrah, as it competes against deep-pocketed rival Qantas Airways Ltd in the Australian market.

The source declined to disclose how Virgin would finance the purchase. The airline, Australia’s second largest, lacks an investment grade credit rating and has delayed the purchase of Boeing Co 737 MAX jets as well as announced plans to cut 750 jobs to help fix its balance sheet.

The Australian Financial Review first reported the exclusive talks between Virgin and Affinity on Sunday. Virgin declined to comment and Affinity did not respond immediately to a request for comment outside usual business hours.

Velocity was a bright spot in Virgin’s annual results last month, with earnings before interest and tax up 12% to A$122.2 million. For airlines, earnings from frequent flyer programmes are typically far less volatile than those from flying planes.

The value of loyalty schemes lies in the steady income from banks, retailers and other partners who pay up front for points and then pass them on to customers who typically do not redeem them with airlines for many months.

Scurrah last month told Reuters the airline did not intend to sell any more of its stake as part of an Affinity exit plan, having earlier left open the option of reducing it to as low as 51% via an IPO or trade sale.

Major strategic investors in Virgin - Singapore Airlines , Etihad Airways, HNA Group, Nanshan Group and Richard Branson’s Virgin Group - have baulked at providing more capital since an equity raising in 2016, seven current and former Virgin managers have said. ($1 = 1.4541 Australian dollars) (Reporting by Jamie Freed; Editing by Himani Sarkar)