The nature of risk in leasing
Financing the long-term use rather than the ownership of an asset defines the risks of lessors, lenders and equipment users.
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Introduction from Executive Producer CHRISTIAN ROELOFS
Throughout the commercial world, businesspeople and governments are continuously concerned with the rights and obligations of property ownership. Economic, legal and fiscal measures are necessarily complex and anomalies frequently arise in the treatment of specific items of equipment. The difference between the risks of lessors, lenders and equipment users between leasing equipment and buying equipment arise principally as a result of financing the long-term use (leasing) rather than the ownership (some form of purchase) of an asset. As Derek Soper, Chairman of IAA-Advisory and of the Leasing Foundation, observes in this piece as part of our series Leasing Fundamentals, this is this essential difference which needs to be addressed within the commercial rules of each country.”
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
The nature of risk in leasing
A leasing company entering into a finance lease looks to the lessee for the recovery of the full, or at least a major part of, the outlay on a leased asset. The lessor needs to be assured that the user of the equipment is in a position to meet the rentals payable during the primary lease periods as they fall due.
In the event of premature termination of the lease before the end of the primary period – through default by the lessee or in other circumstances such as a total loss of the equipment – the lessor will require the outstanding capital cost of the equipment to be paid as a lump sum. In the absence of insurance proceeds, the lump sum terminal payment has to be found by the lessee. The terminal payment is usually calculated by discounting future rentals from their due dates to the date of measurement at a rate specified in the lease and, except in the case of total loss of the leased equipment, by deducting therefrom an amount related to its then market value. For most types of equipment, it is unlikely that the second-hand value at the date of termination will be high enough to eliminate the outstanding capital cost, in which case any unrecovered balance will remain to be paid by the lessee; from time to time there are assets which are exceptions (such as aircraft and ships in a period of rapid inflation and other items of equipment in limited supply) and which retain a sufficiently high market value.
From a credit-worthiness viewpoint, a finance lease is akin to a medium-term loan secured on the equipment; however lessors will make the point that they are the owners of the equipment and not just holding another form of security over the equipment – this may have an advantage in certain countries where the repossession of equipment is difficult. Leasing companies need to make the same enquiries and obtain the same information regarding the credit standing of prospective lessees as banks and other financial institutions do for loan applications.
A credit appraisal is necessarily a subjective assessment of the solvency of a potential lessee. Although the past cannot be ignored, leasing companies also place particular emphasis on a lessee’s future viability. The following list presents some of the criteria taken into account by lessors.
- The nature of the lessee’s business.
- The quality of management.
- Future prospects, particularly the adequacy of the forecast of future cash flow to meet rentals and other outgoings.
- The financial position shown by the latest accounts.
- The likely value over the primary lease period of the equipment to be leased.
Although, in certain circumstances, financial institutions may regard one form of medium-term finance as more risky than another, a finance lease, a secured loan for the full cost of equipment, and a hire-purchase facility (without an initial deposit) have much the same degree of credit risk. Groups providing a range of financial services usually access the credit-worthiness of a prospective customer on the same basis, whatever type of equipment finance is required. If a bank or finance house decided that it could not lend or provide hire purchase to a company for the purchase of equipment, then an associated leasing company would be likely to be equally unwilling to provide a leasing facility for the same equipment.
For marginal propositions, leasing companies can improve the credit position in the same way as other financial institutions. They can take additional security, such as guarantees, floating charges and cash deposits or they can require a higher initial rent to be paid.
There are several specific factors that may make the overall risk in leasing different for the lessor from that in other forms of finance. For example:
1. The inherent risks of ownership. As owner of the equipment, a lessor may be liable for claims from third parties for losses arising out of the use of the leased asset. In some situations, both the owner and the user are legally responsible. In other cases and in certain countries the law is uncertain, and a lessor could possibly be involved in expense in defending an action for damages; injured parties may prefer to institute proceedings directly against a leasing company, as part of a large financial group, rather than a lessee. Although a lessor is normally indemnified by the lessee against any such claims, and may be entitled to the proceeds of insurance covering the equipment against third-party liabilities, there will be occasions when the lessee has insufficient resources to meet the indemnity and there is inadequate insurance cover.
2. Default claims. In many countries the law applying to a claim for repayment of a loan following a default by a borrower is more certain and tested than the corresponding claim by a financial lessor for recovery of the unamortised cost of equipment.
3. Collateral. A lessor is financing the acquisition of an individual item of equipment and may be unable to enjoy the benefit of additional security in the same way as a lender who also provides a comprehensive banking service to a customer and who may have previously arranged collateral security.
4. Interest and tax assumptions. For leases without variation clauses, there is a risk that an adverse change in interest rate or taxation is more detrimental to the lessor’s return than the element, if any, included in the rental to compensate the lessor for assuming these risks, In particular, a lessor’s cash flow is more sensitive to a change in the rate of corporation tax or in the general basis of taxation than that of a equivalent medium-term loan. For leases with interest or tax variation clauses, a change may result in higher rentals, which increase the lessor’s overall exposure.
On the other hand, leasing may reduce the level of risk.
1. Asset recovery. It may be easier and cheaper for a lessor as owner to repossess leased equipment following a default by the lessee than it would be for a mortgagee or chargee.
2. Productive investment. A lessor may often be leasing income-producing or expense-saving equipment and not just augmenting a firm’s general body of assets.
3. Value of investment incentive. A lessee unable to take immediate advantage of any taxation allowance that would be available if the equipment was purchased may receive a benefit to the extent that the capital allowance claimed by the lessor is reflected in the rentals. The lessor’s risk is thus less than that of a lender providing an equivalent medium-term loan because of the actual reduction in rentals and the improvement in the lessee’s overall financial position as a consequence of paying less for the use of the equipment concerned.
The nature of risk in leasing by Derek Soper is licensed under a Creative Commons Attribution 4.0 International License.