Finance leasing is the most common form of leasing, an important item in the product range of most banks and used by manufacturers and distributors of equipment.
Latest posts by Derek Soper (see all)
- An evolving trajectory for leasing and asset finance - December 2, 2013
- Leasing in a changing landscape - December 2, 2013
- The evolution of leasing's commercial framework - December 2, 2013
Introduction from Executive Producer CHRISTIAN ROELOFS
Derek Soper, Chairman of IAA-Advisory and of the Leasing Foundation, comprehensively describes the structure of the modern-day leasing industry as part of our Leasing Fundamentals series.
Who should be interested in this?
New entrants to the leasing and asset finance industry, industry commentators, anyone wanting to understand the context of modern-day leasing
Finance leasing is by far the most common form of leasing, having become an important item in the product range of most banks. It is, however, also used by a wide range of manufacturers and distributors of capital equipment.
Activity in this sector of the market is concentrated on IT, catering, shop and office equipment, photocopying machines, telecommunications equipment, etc. Given the small unit size (€500 – €15,000) and the consumer credit implications in many countries the number of active lessors in this market has tended to be small; however, as the banks integrate their leasing activities into the bank product range they have recently re-examined the considerable opportunities in this sector following a number of years in which the demand for leasing enabled them to concentrate their limited resources on the larger scale transactions. Leasing companies operating in this sector generally rely heavily on equipment dealers for new business introductions. Documentation, and acceptance procedures, increasingly processed via the internet, tend to be simplified and a certain level of bad debt is anticipated in the pricing.
This term is often used to denote the small-to medium-sized leasing activities of banks or leasing companies and frequently indicates a standard form of transaction, marketed to a wide range of customers often through a branch network or the broker market. In recent years we have seen less and less activity from direct sales forces due to the expense of maintaining this type of distribution network. The types of asset financed typically include industrial plant and machinery, office equipment, cars and commercial vehicles. Lease periods will generally be shorter than the useful life of the asset and rentals will very often be fixed except for any material changes in the basic assumptions taken by the lessor in terms of interest rates and taxation conditions.Although lessors will place some reliance on the recoverable value of the asset, especially in the case of motor vehicles, credit decisions will generally be based on the financial standing and covenant of the lessee. The type of lessee and size of transaction vary considerably but at the top end may easily extend into the range of values more commonly associated with the SME market and the “medium ticket” sector.
This form of leasing activity covers many of the same markets as the previous two, but is based on schemes specifically designed to assist manufacturers and distributors increase the sales of their products. This area requires special branding of the leasing product, flexibility in dealing with discounts, trade-ins, up-grades, terminations, etc, and a skilful balancing of the conflicting interests of the supplier, whose main aim is to sell equipment, and of the lessor, who seeks to finance only credit-worthy purchasers.
This term embraces a wide range of leasing activities which, due to the type of asset, are not only large in value but, more importantly, require extremely complex lease structuring and specialised documentation. Such assets typically include aircraft, ships, oil and chemical equipment and integral production lines often including immovable plant and buildings. The main lessors operating in these markets are subsidiaries of the commercial banks, various investment banks and some specialist lessors. There are a number of ‘advisors' who will often play a prominent role in “arranging” or advising on the leasing facility. Such facilities have generally been tax based and cover periods of around 15-20 years, some going to 30 years. In view of the exposure, the credit risk is often spread by syndication among a number of lessors in partnership or, when feasible, by each party leasing separately identifiable parts of a plant. Tax benefits, coupled with very long-term financing, have been the main factors behind the success of leasing in this sector of the market; although in recent years the sector has been dominated by the Structured Finance divisions of the banks. Lessees have typically been companies in highly capital-intensive industries, e.g. airlines, shipping, oil and chemicals, and thereby very often unable to take immediate advantage of the fiscal incentives. Leverage leasing is also a feature of the ‘Big Ticket' market, mainly due to a recent flux of willing non-recourse lenders who are prepared to take a variety of ‘stratas' of risk within the overall mix of funding of the lease.
Contract Hire and Car Leasing
Contract hire and car leasing is usually first sector of the market to be developed in emerging markets. The market is centred on the vast number of Manufacturer and motor dealerships that exist and require a high level of financial support coupled with service to their customers. This support is provided from a number of very specialised sources including the captive finance areas of the motor manufacturers such as VW, Mercedes, Toyota and Ford whose operations are globally based and rival any of the more broadly based finance companies who compete for business in this sector. The type of finance provided is typically a mixture of floorplan finance for new and used cars, which is very often granted on favourable terms in return for first refusal of retail business, i.e. the opportunity to finance the sale of cars to the consumer. However, for most motor dealers, it is their increasing involvement as financiers that supplement the profit from their distribution activities. For the most part these financial activities take the form of contract hire of fleets of vehicles for use by companies in the commercial sector. Contract hire is in essence a form of true operating lease where maintenance and residual value assumptions are included in the rental. Such contracts normally cover periods of 2-5 years and there will often be provisions in the agreement for additional rental to be payable if certain mileage levels are exceeded or excessive repair costs result from the misuse of the vehicle. A large number of other specialist vehicle contract hire companies have grown up in recent years and these have tended to be substantially owned by banks or finance companies.
This form of finance has been developed into a highly profitable business for a number of manufacturers such as Xerox, Pitney Bowes, IBM, HP and others; in general, financial institutions have been unable to find a means of directly engaging in these activities in the way they have penetrated contract hire in the motor market. It is clear that the manufacturers have made huge strides in recent years in ensuring that the granting of credit to their customer base also ensures a continuous relationship with the customer, thus ensuring follow on business and upgrade opportunities. Whereas the ‘advantage' which accrues to the manufacturer regarding the construction of an operating lease is evident, nevertheless the banks and independent leasing companies have strived to compete in the operating lease market place. Perception that the lessor is taking a residual risk in the equipment can be attractive to the lessee for a variety of reasons. Overall cost is the main motivator – a lessee who is unsure of the residual value in the equipment at the end of a lease may prefer the lessor to take the risk. In the meantime the lessee is paying reduced rentals, achieved by the lessor's perceived ‘valuation' of the residual risk.
Additional features of equipment purchase for the lessor
For any lease transaction the lessor must have ‘clean title’. In some cases the negotiation between lessee and the supplier may have reached an advance state and therefore an unwinding of the ‘sale' may be needed so title to the equipment may flow to the lessor unencumbered. The following are sometimes used for convenience.
1. Novation. A tripartite agreement between the supplier, the lessee and the lessor, who enter into a novation of the original contract where, the rights and obligations are transferred from the lessee to the lessor. These agreements are quite frequently used, especially where it is the standard practice to place orders well in advance of delivery owing to long manufacturing periods.
2. Sale and leaseback. Where the title has passed to the intended lessee it is normal for this to be transferred to a lessor by means of a sale and leaseback agreement. Such agreements are usually timed to take effect after delivery of the asset but before it is brought into use in order to avoid the possibility of its being considered second hand.
In order to carry out a preliminary assessment of the cost benefits of leasing, the prospective lessee will often seek an indication of rental terms either direct from a lessor, from a broker, or from an advisor or investment bank if there is a need for independent advice on some of the more complex matters. The fees payable to an “arranger” of leasing facilities are generally paid by the lessee or passed on by inclusion of the fee in the amount financed.
Having selected the desired method of approach, the following details are normally sent to a selected number of lessors, inviting them to quote terms on which they would be prepared to write the business:
- Details of the equipment, proposed date of delivery and location.
- The estimated cost and timing of payment.
- The required period of lease, rental pattern and fixed or variable basis.
- Details of the lessee, both financial and commercial and what the equipment expectations are for the business. (has it a direct impact on the business – is it essential to the business – will it be subject to shift work – what skills are in the company to understand the impact of the equipment on the business – what competition does for the same process, etc)
On receipt of this information a lessor will be in a position to assess the credit worthiness of the lessee and to decide whether the proposal will stand on its own merits or whether some additional support is necessary, such as a parent company’s guarantee of its subsidiary, director’s guarantees, or a bank guarantee.
This decision made, it is then possible for the lessor to decide what profit margin is appropriate relative to the risk involved. Rentals are calculated using present value analysis techniques of the projected after-tax cash flow of the proposed transaction and are formally submitted to the lessee for consideration.
In the large-ticket transaction it is not uncommon for lessors to reveal their cash flows and profit margins in order to help lessees compare competitive quotations and to assess more easily the true underlying interest cost in the lease.
A full statement will be provided of the other assumptions made by the lessor such as the funding and taxation parameters as well as the timing of any grant receivable (if any), etc.
The lessee normally evaluates the competitiveness of the various quotations by calculating the respective implicit rate of interest represented by the lease rentals as well as the absolute amount of rental payable. The chosen lessor is then advised but there is generally no firm commitment by either party until such time as the lease or agreement to lease is actually signed.
Leasing today by Derek Soper is licensed under a Creative Commons Attribution 4.0 International License.