Ancient clay tablets from 2000 B.C. Sumer record the leasing of farm implements. Ancient Phoenicians leased ships using very specific residual assumptions, thus making equipment leasing the world’s oldest form of finance. Banking, in contrast, began during the Roman Empire about 700 B.C., and compound interest did not exist as a concept until well into the second millennium. Today, all types of personal property can be leased, including equipment used in transportation, manufacturing, mining and medical applications, as well as software and even intellectual property and artwork. And where would commercial real estate be without leasing?
- Paul Getty’s famous quote, “If it depreciates, lease it. If it appreciates, buy it,” still holds true as more than 78 percent of U.S. businesses utilize equipment financing. These companies range from the largest investment-grade firms and municipalities all the way to venture capital–backed emerging-growth firms. In 2015, public and private investment in equipment and software totaled $1.5 trillion, of which 68 percent ($1.02 trillion) was financed. Of the amount financed, $585 billion was leased, mostly via capital lease structures; $240 billion was financed via secured loans; and $195 billion was financed through credit lines. Further, the shift has seen growth in leasing and secured loans at the expense of credit lines.
If the current presidential administration is successful in boosting U.S. manufacturing and infrastructure, the need for equipment is projected to grow even more significantly. This is great news for providers of lease and secured loan financing.
A PRIMER ON EQUIPMENT LEASING
From a GAAP perspective, there are two types of leases: operating leases and capital leases. With an operating lease, at the end of the primary term of a lease the lessee has the option of (a) purchasing the equipment for its then-fair market value, (b) extending the lease based on a fair market rental rate, or (c) returning the equipment to the lessor. In all cases, it is critical to the lessor that the fair market value meet the residual position it took at the initiation of the lease. Most equipment-leasing direct-participation programs used operating lease structures, wherein the lessor took significant equity positions in the equipment being leased, with the anticipation that the fair market value of the equipment at the end of the lease would be enough to generate attractive investor returns.
The operating lease market thrived into the late 1990s, at which point something significant changed the face of operating leases. Commercial banks, whose portfolios were increasingly compromised in other areas, saw equipment leasing as a growth market. The challenge for the banks, however, was they were not in the business of taking equity/residual positions on equipment. What transpired was the engineering of so-called “synthetic leases.” These synthetic leases met the technical criteria of a Financial Accounting Standards Board operating lease but sidestepped the need to take residual risk, essentially allowing lessees the ability to simultaneously expense the lease payments like an operating lease for GAAP financial statements, while also providing the benefits of ownership on their tax statements, all with no uncertainty about the future value of the equipment and at very competitive bank rates. As a result, the market for true operating leases shrunk dramatically, and sponsors of direct participation programs (DPPs) found they were now operating in a much more competitive environment, which led to tremendous difficulty in providing compelling returns to retail investors.
THE COMPELLING PRESENT
The attraction of past equipment leasing programs has been based on several factors:
Consistent cash flow: Fixed lease payments provided for consistent and high distribution rates throughout the operating periods of most programs.
Low correlation: Thoughtfully underwritten leasing receivables have a demonstrable ability to withstand the biggest hits to both equity and debt markets.
Strong collateral position: Leases typically provide lessors with a purchase money security interest (PMSI), meaning the lessor legally owns the equipment. Contrast this with a loan where the lender may have a lien on an asset, which is a significantly weaker position than a PMSI.
Tax advantaged: Operating leases generate significant depreciation, leading to passive noncash losses that equipment leasing wrap structures efficiently passed through to investors and could be used to offset passive gains.
Let’s now understand how “equipment leasing” differs from “equipment financing.” Equipment leasing programs typically used operating lease structures with fair market value residual risks, while equipment financing programs are more akin to a debt financing, with the added benefit of having a PMSI in the equipment collateralizing the financing. Most equipment leasing programs were indeed successful in terms of the four advantages listed above. Where the programs largely struggled was in realizing large enough residual payments because hoped-for fair market values were never realized, due to competitive pricing at the outset; the overleveraging of certain assets; and in most cases, charging ongoing management fees that compensated the sponsor regardless of their investors’ experience.
Equipment finance programs, however, which rely on capital lease and loan structures, provide the same potential advantages as earlier equipment leasing programs — sans tax benefits — without the residual risk or the lengthy timeframes inherent in operating lease programs. Indeed, an equipment finance program compares very favorably to many business development companies (BDCs), the key distinguishing characteristics being an equipment finance program will typically have a PMSI, meaning a stronger collateral position, and it will be self-liquidating, which also means an equipment leasing program is potentially less correlated to the traditional markets than a BDC.
OPPORTUNITIES AND RISKS
Several facets of the current economy portend good things to come for equipment lessors/lenders. While consumer spending increased 3.3 percent through second quarter 2017, equipment and software investment expanded by 8.3 percent, indicating a ramp-up in the need for equipment financing. Increases to inflation would be good news for the industry; past inflationary periods have been particularly good for equipment lessors/lenders because, in addition to increasing the cost of new equipment, inflation tends to increase the value of used equipment. Provided leases/loans are properly underwritten, the performance of fixed-rate, fixed-term leases and loans has very little correlation with the dynamics of traditional investment markets. There are two somewhat competing factors to watch for. First, any repeal to the Dodd-Frank Wall Street Reform and Consumer Protection Act could bring new competition as banks reenter the market, which could have a downward impact on interest rates. The second factor, however, revolves around the perception that interest rates have remained artificially low and, with the end of quantitative easing, increasing interest rates are anticipated.
There are numerous opportunities to invest in equipment leasing programs. A key distinction between these programs versus something like a BDC is equipment leasing programs tend to be self-liquidating investments, while BDCs tend to rely on stock appreciation, and a listing or liquidity event down the road. Under a self-liquidating scenario, as capital is raised, it is invested in a portfolio of leases or loans, and as those transactions pay out, distributions are made. When the last lease or loan is fully paid off, the program is closed. These structures need to be viewed from a total-return perspective — how much cash was invested versus how much was returned. Other things to consider when reviewing the risk profiles include:
Collateral type: The two key considerations are: (1) Does the equipment have a useful life in excess of the transaction term, and (2) is the equipment critical to the lessee’s/borrower’s business?
Form of collateral: In order of priority, is there a PMSI, first security lien (and is it direct or a beneficial interest), or subordinated security interest?
Financing type: Does the fund take residual risk via an operating lease, or does it use capital lease debt structures?
Credit quality: Programs focused on investment-grade lessees/borrowers can expect very little credit risk and commensurately lower yield expectations. A middle-market focus should provide greater yield opportunity but also more credit risk. What is done to manage risk, both in the underwriting process as well as ongoing portfolio management? A subprime focus should provide even greater yield opportunity but significantly greater default risk — remember, the greater the default risk, the more important the collateral becomes, both in terms of its value in the secondary market as well as its likelihood of trustee confirmation in the event of a bankruptcy.
Leverage: Leverage can be used to boost yield, especially in this current low-rate environment, but a dip in credit quality can have a profoundly negative effect on investor returns. If leveraged assets are lost due to bankruptcy or an inability to refinance, there is no chance for recovery.
Track record: What is the sponsor’s history of managing a portfolio full cycle, and how do investors in previous programs view the investment? Is sponsor compensation correlated with investor profitability?
Keep in mind an equipment-leasing DPP is a form of wrapper, much as a REIT structure is a common wrapper for real property investment programs. It provides an efficient structure for investor pass-through, which makes sense because the basic idea of a DPP is to allow investors the benefits (and risks) of business ownership without the burden of having to actively manage the operation. While many past equipment-leasing DPPs have underperformed, it was not a result of the equipment leasing structure. Look deeper to find underlying value. With cap rate compression challenging new real estate investments and equity markets potentially peaking, this could be the ideal time to find value in equipment leasing.
James Kamradt is in charge of fund syndication at SQN Investment Advisors.