CHAPTER ONE: UNDERSTANDING THE LEASING INDUSTRY
The chapter introduces the reader to the equipment finance and leasing industry by examining its size and scope; and, by detailing how it has evolved from finance leases to managed services, with intermediary stages including operating leases, leveraged leases, synthetic leases, venture leases, and TRAC leases. More importantly, historical, and prospective product evolution provides the starting point in guiding lessors with their strategic plans.
The chapter then explores the five drivers and motivators that either propel or retard the industry. These are the economic environment; the availability, variety, and cost of funding — the lifeline for lessors; the turnover, or the replacement rate, of plant and machinery; the varied characteristics of the marketplace; and, public policy. The characteristics of the marketplace delve into the real-world dynamics having to do with the basis of competition; customer awareness of the product; product sophistication; and, the adequacy of skilled talent. Public policy, which varies from country to country, details the four pillars that constitute leasing infrastructure — the legal, tax, regulatory and accounting facets that support leasing. Reviewing the five drivers and motivators facilitate an understanding as to which factors a lessor should focus on — primarily funding, operational efficiency, customer behavior, and pricing policy.
The chapter concludes by driving home the point that leasing is complex, as it is significantly influenced by four disciplines — accounting, finance, law, and taxation; yet, it advises the reader to take the simplistic approach that leasing entails three activities — find, fund, and service! This approach provides the foundation to substantial detail contained in subsequent chapters.
CHAPTER TWO: WINNING THE DEAL — CONVINCING THE CUSTOMER
The chapter provides step-by-step guidance on how to garner incremental business volume by convincing customers to lease. It provides a thorough understanding of the 33(!) benefits that leasing offers. This is done by placing the benefits into six categories — cash flow or cash management, tax, financial, financial reporting, convenience and flexibility; and, a hedge against obsolescence. Each of the 33 benefits, plus certain benefits unique to the U.S.A. — owing to recent tax nuances, is further categorized by product type, such that the reader is able to distinguish the benefits offered by full-payout finance leases as versus those offered by non-full-payout operating leases. Fully understanding all the benefits that leasing offers is indeed the first step in winning new business.
The chapter then provides a list of commonly encountered objections to leasing, and presents counters to these objections. All the objections, except one, are perceived objections. Lessors are advised to have each sales person create an exhaustive list of all the real-world objections encountered in the marketplace. The combined list, based on input from all those who liaise with customers, will indeed be exhaustive. Management, with input from the sales team, should then arrive at counters to each objection. If each sales person is armed with meaningful counters to each and every possible objection to leasing, this by itself is bound to increase volume by converting skeptical customers to actual customers.
The chapter concludes by explaining the process that customers use to acquire and finance equipment. Two comprehensive examples, made easy to understand, convince the reader that leasing not only offers a myriad of benefits, but can often be the lowest cost mode of equipment acquisition! Present value, after-tax is the approach taken to arrive at this conclusion, with a focus on using a unique tool, break-even internal rate of return. This tool will help close many transactions that otherwise could be lost. Those who liaise with customers will find the contents of this chapter to be indispensable; others in the firm will gain tremendous knowledge as to why leasing continues to be a viable financing alternative.
CHAPTER THREE: WINNING THE DEAL — OUTSMARTING COMPETITION
This chapter follows through on the groundwork laid out in the preceding chapter on how to win incremental transactions by convincing customers to lease. It begins by stating that there are two types of customers, those who need to lease, and those who want to lease. Yet, the approach advocated with both types is the same — to take the time and make the effort to communicate all the benefits of leasing, something surprisingly, not done by most lessors in the marketplace! The chapter provides a simple but powerful template on how to accomplish this.
The chapter then proceeds to suggest the obvious. Communicating the benefits of leasing accomplishes two goals. It heightens the customer’s awareness that leasing indeed has far more benefits than the customer ever imagined; as importantly, it allows the lessor to gauge each customer’s unique motivations and needs. Once customer needs are understood, the lessor should offer the product type that suits the need; and, tailor the product, as needed, to maximize the benefit to the customer. Again, surprisingly, not all lessors do this; those that do will definitely stay one step ahead of competition.
The chapter concludes by providing a list of ideal attributes lessors should possess, and emphasizes the point that lessors should strive to never sell rate! Though many customers are rate conscious, there are many others who are cash flow conscious or are motivated, as an example, with a speedy response to their credit applications. As common as it is to witness lessors selling rates, it is not difficult to win transactions by focusing on customer needs and by truly adding value. One way to add value is to use the concept of present value to structure transactions. As theoretical as this may sound, it is commonly used in large-ticket transactions. There is no reason why this practice should not permeate the middle market. In summary, communicating all the benefits of leasing, tailoring the transaction to meet the customer’s needs; and, using present value to structure transactions, when warranted, will enable a lessor to win incremental transactions and outsmart competition.
CHAPTER FOUR: THE SIGNIFICANCE OF BUSINESS DIFFERENTIATION
This chapter takes to a conclusion the varied suggestions made in the previous two chapters. Convincing customers to lease, understanding their needs, tailoring the product, and possessing ideal attributes are precursors to business differentiation. In an increasingly competitive marketplace, it is critical for lessors to differentiate themselves from their competitors. Also, winning transactions to increase volume is insufficient; increasing margins, and thereby profitability, should be the eventual goal.
The chapter makes a strong case that rate-driven markets cause the playground to be a buyers’ market, which undoubtedly favors the customers, and is detrimental to the lessors. Unfortunately, buyers’ markets are more the norm than the exception; and, lessors must strive to entrench themselves out. If they do not, margins — which globally, have been shrinking, will continue to shrink. Overcoming declining margins can be accomplished by embracing numerous strategies, particularly pursuing or sticking with niche markets, and embracing product differentiation. The latter precludes product homogeneity. To use an analogy — if competitors are only offering vanilla ice cream, the lessor who strives to differentiate should offer strawberry and pistachio as well! The chapter provides seven different ways this can be done.
The chapter concludes that shrinking margins can be prevented by exercising pricing discipline. Using an easy-to-understand example, it behooves lessors to create a simple matrix, correlating the interest rate in the lease to overall profitability. The matrix should be used to set a floor on interest rates. As with the preceding chapter, those who liaise with customers will find this chapter to be indispensable; others will find it interesting, to say the least.
CHAPTER FIVE: OPERATING LEASES — MAXIMIZING PROFITS, MINIMIZING RISKS
This chapter is an A to Z on operating leases. The product is commonly referred to as an FMV lease in the U.S.A. Often, those who use the expression “operating lease”, are not entirely aware as to the framework within which they use the expression; hence, the chapter starts by defining an operating lease from three diverse perspectives. The marketplace perspective has to do with product characteristics. In this context, there is only one difference between a finance lease and an operating lease — residual value. Every other difference is not a difference, it is a consequence of residual value. The accounting perspective is reviewed both from a U.S. and an international point of view; as well as from a pre and post new accounting standards point of view — as the standards, generally effective January 1, 2019, are not yet applicable to all entities. The tax perspective concludes that marketplace operating leases are almost always accorded true lease status throughout the world.
The chapter then proceeds to highlight the 15 unique benefits the product offers the customer — unique in the sense that these are benefits no other mode of equipment acquisition offers. Detailed explanations are provided for items such as improved ratios, higher earnings, and early termination options. Emphasis is placed on the fact that off-balance sheet financing has not been repealed in the entirety; that partial off-balance sheet financing, offered by the new accounting standards, can still be a major benefit to customers. The reader is able to conclude that the product is unquestionably superior to the full-payout finance lease, as it not only offers significant benefits to customers; it is also more profitable to lessors.
The chapter concludes by detailing five risks unique to the product; risks that lessors have to either mitigate or eliminate. For good reason, focus is placed on residual risk. The reader is exposed to 18 factors that can impact the future value of an asset. In order to preserve and enhance residual values, lessors are urged to focus on understanding lessee behavior and relying on their own asset management skills. Techniques presented to mitigate residual risk include forming a residual committee, whose function — though asset focused, would not be much different than the credit committee. In conclusion, the chapter emphasizes that the new accounting standards will not have a significant impact on the product; in fact, any potential decrease in operating lease volumes owing to the new standards will be more than offset by continued, and more rapid, changes in technology. Its growth will further be fueled given that it is a precursor toward the movement to a usage and subscription-based economy.
CHAPTER SIX: PROFITING FROM VENDOR LEASING
This chapter highlights the significance and benefits of vendor leasing programs as a source of origination to independent and bank-based lessors. It provides the reader with a detailed list of vendor motivations to utilize lease financing. The complex motivator, revenue recognition, is explained in simple terms; with a conclusion that the best of both worlds for the two parties is for the vendor to sell equipment to the lessor with recourse amounting to less than 10 percent of the fair value of the equipment. The vendor benefits from immediate revenue recognition and avails of the benefits of sales-aid leasing; the lessor benefits from partial recourse, enabling it to be more competitive in the marketplace.
The chapter then details the various types of programs and lists the pros and cons of each program type to both parties, concluding that the two preferred types are third-party and private label programs. Pros and cons of a vendor choosing the captive approach are discussed. This guides independent lessors in convincing vendors not to form captive finance subsidiaries; thereby encouraging them to enter into alliances with third-party lessors.
The chapter concludes by listing and explaining the host of benefits that vendor leasing programs offer the vendor, the lessor and the customer — essentially a win-win-win! Lessors gain a thorough understanding of the key elements of a program, as well as techniques to mitigate risks emanating from the program. Emphasis is placed on vendor equity insertion. Management, business development, and sales personnel will benefit from the extensive explanations provided to either enter into or tweak existing vendor programs; others will gain an understanding about the significance, the benefits, and the mechanisms of the programs.
CHAPTER SEVEN: FUNDING THE COMPANY
This chapter is premised on the fact that adequate, well-sourced financial resources comprise the raw material essential to the successful operations of a leasing company. Through a building-block approach, using simple and easy-to-understand examples, the reader fully understands the impact of leverage on a firm’s return on equity. To debunk any potential conclusions that the weighted average cost of capital is a theoretical concept, it is referred to as the cost of money. This enables the reader to grasp that lessors, as financial intermediaries, besides adding value, cannot sell money without arriving at its cost; and, that leases should indeed be priced using the weighted average cost of capital. Sensitivity analyses, using varied gearing ratios and varied costs of debt, demonstrate how lessors compete with others in the marketplace.
The chapter then proceeds to discuss the two approaches to funding — match funding and pooling, convincing the reader that pooling, though complex, offers benefits that match funding does not.
The chapter concludes by detailing an exhaustive list of funding mechanisms used by lessors in mature markets. Not all lessors utilize all of these mechanisms. The complete list, with detailed explanations of each funding source, enables lessors in mature markets to fully appreciate the diversity of options available. For those who are not directly involved in sourcing funds, it serves as a primer in better understanding the myriad of funding options available. Lessors in emerging markets, who perhaps unduly rely on bank loans, are challenged to embrace additional sources such as income funds, leveraged leases, securitization, and syndication.
CHAPTER EIGHT: MEASURING FINANCIAL PERFORMANCE
This chapter facilitates a thorough understanding of measuring the financial performance of a leasing company. Previous chapters provided a roadmap to winning incremental transactions, outsmarting competition, profiting from business differentiation, availing of the benefits from operating leases and vendor programs; and, utilizing varied funding techniques. All of what was gleaned should result in increased profitability! This chapter provides the reader with tools to measure and analyze profitability. Varied yields are discussed, both from a single transaction and a portfolio point of view.
The chapter then proceeds to introduce numerous financial ratios. Benchmarks, gathered from real-world data, are provided for key ratios such as the gearing ratio, varied debt service ratios, and the cost to income ratio. Emphasis is placed on analyzing, as versus arriving at, portfolio returns; particularly, return on assets and return on equity. This is accomplished by adapting the DuPont Model to a leasing company. The model allows a company to grasp exactly why returns vary from one period to another.
The chapter concludes by providing the reader with an extremely practical tool to monitor and control costs. This is accomplished by allocating all expenses into three areas — find, fund, and service. Through an understanding of yields, returns, and ratios; through grasping how to analyze them; and, through cost control, a leasing company should be able to further enhance profitability.
CHAPTER NINE: NAVIGATING THE NEW ACCOUNTING STANDARD
This chapter examines the changes to lease accounting brought about by the issuance of IFRS 16 and Topic 842. Standard setters have struggled for decades with the idea of certain types of leases being off the lessee’s balance sheet and the run-up to the new standards was no different. Detailed examinations of several studies, such as the McGregor Report, are made along with an exploration of the multiple positions and methodologies that were proposed before the final standards were issued. Now that the new lease accounting rules have been put in place, these issues have been put to rest, as all leases are now on lessees’ balance sheets, which represents a significant change in how lease liabilities are recognized by lessees. There is a discussion of the process lessors and lessees must follow when assessing whether a transaction involving equipment is, or contains, a lease, along with an analysis of why this requirement will cause lessees to more closely examine their contracts in order to minimize the balance sheet impact of these transactions.
The chapter then proceeds to discuss the requirements for booking and amortizing leases from both the lessor and lessee perspective. It is pointed out that most of the changes affect lessees, who now must present value the lease payments and book that amount as a lease liability for each lease that does not meet the two exceptions. How the leased asset is computed as being equal to the lease liability plus any prepaid payments and initial direct costs is shown. The lessee’s amortization of the lease liability, using its incremental borrowing rate, and how it depreciates the leased asset on a straight-line basis is illustrated through several examples. After discussions of the lessees’ accounting requirements, the reader is exposed to reassessment requirements if factors in the lease change, along with the accounting rules for lessors, which do not differ substantially from the previous standards. The differences between IFRS 16 and Topic 842 and relevant disclosure requirements are then identified, after which the chapter illustrates the transition requirements through an example.
The chapter concludes by discussing the challenges lessors face as their customers cope with the new lease accounting rules, along with relevant strategies they may undertake to address these challenges. It details how the new lease accounting standards have changed how lessors’ customers view leasing and explains how lessors must understand and proactively address the impact of their customers being required to show all leases on balance sheet. Lessor strategies for dealing with their customers, such as more in-depth and frequent communication with customers and how they must continue to point out that fair market value leases still provide partial off-balance sheet benefits, are listed. How the communication strategy should include all levels of the organization, especially the sales team, is also discussed.
CHAPTER TEN: MANAGED SERVICES — THE NEW WAVE
This chapter takes a fresh look at a topic that is not new to the equipment finance industry. The concept of adding maintenance and management services to equipment acquisitions has existed in various forms for decades. These managed services programs have successfully promoted a better experience for the customer and improved service revenue streams for the manufacturer or service provider. Therefore, it is no surprise that an increasing number of end users are requesting models that are less focused on ownership and owner maintenance, and more focused on usage that includes service provider support. Fortunately, with the emergence of the digital era, assets are becoming digitally connected and smarter. This has had a significant impact on the desire for change as well as the ability to enable it.
The chapter then proceeds to explore critical intersections between hardware, software and IoT (Internet of Things), as one moves from ownership models to usage models powered by connectivity. The reader will understand how roles will shift between lessors, lessees, financiers, service providers, manufacturers, and end users. Operational challenges throughout the value chain are also to be examined in detail with the intention of highlighting risks, avoiding pitfalls, and identifying new opportunities.
The chapter concludes by challenging the reader and the leasing industry to embrace innovation. Advances in technology are impacting everything that is familiar. One does not have a choice to ignore it. In order to stay relevant, one needs to be creative, invest in technologies that align with the market requirements, and focus on operational change that is more efficient and effective for all parties engaged in managed services transactions.