Leasing’s Evolution – A Guide To Strategic Decision Making Part II

This is the second part of the article Leasing’s Evolution – A Guide To Strategic Decision Making written by Sudhir P. Amembal is Chairman & CEO of Amembal & Associates, the world's most highly respected lease training and consulting firm.

LEASING’S EVOLUTION – A GUIDE TO STRATEGIC DECISION MAKING
How the industry moves from being newly born to maturity and what causes such movement is best understood by reviewing the six phases of the leasing cycle. Diagram 2 details the six phases.


THE SIX PHASES OF THE LEASING CYCLE

1. Rentals
2. “Simple” Finance Lease
3. “Creative” Finance Lease
4. New Products
5. Operating Lease
6. Maturity


THE SIX PHASES OF THE LEASING CYCLE
Rentals (Phase One) have preceded the leasing product by centuries and, even today, this industry is extremely competitive and vibrant in every country in the world. Rentals are characterized by their short-term (less than 12 months), full-service nature. Full-service means that the typical responsibilities of ownership – such as maintenance, repairs and insurance – are provided by the one who rents out the equipment and not the user. At the end of the rental contract period, the user returns the equipment to the owner.

Modern day leasing began over a century ago — both in the United Kingdom and the United States – in the form of the “Simple” Finance Lease (Phase Two). The words “Simple” and “Creative” are words used by the author to distinguish between the two types of finance leases in the context of the evolution of leasing. In the marketplace, both these types of leases are finance leases. In every single country in the world, the “Simple” finance lease is the first lease product that is introduced at the industry’s birth. The product is invariably characterized by the lessee’s intent to eventually own the equipment. The lease is merely a financing instrument. At the end of the lease term, the lessee, having fully paid the lessor through the lease rentals, purchases the equipment for a nominal amount of consideration. As leasing is a new product, the psychology of ownership is still very much inherent in the user’s thought process. The lessor, too, intends to merely finance the equipment through a lease and is not desirous of having the asset returned at the end of the term.

Credit risk, not asset risk, is acceptable to the lessor, as the latter requires developed secondary markets, which do not necessarily exist during this phase. The lease product is almost invariably offered on a net basis (opposite of full- service) in which the lessor’s services are limited to financing the equipment. During this phase the market is usually rate driven and not value added driven. Needless to say, spreads are generous.

From a strategic point of view, for those seeking to cross borders, this is generally a good time to expand into emerging markets - well before competition becomes too intense! For those who are on the ground in the country in question, this is a good time to consider becoming value added and thereby not necessarily becoming victims to margin compression.

Both with the passage of time and the entry of other players in the market, the leasing industry enters Phase Three - the “Creative” Finance Lease Phase. During this phase, lessors begin to structure many of their finance leases and also provide the lessee with varied end of term options such as the option to renew based on a fixed residual. (The lessee must either purchase or renew.)


It is during this phase, in most countries, that leasing experiences the largest growth, in terms of both absolute volume and market penetration. Also, many dealers/manufacturers, that hereto have relied on independent leasing companies, begin to form their own leasing companies. Tax authorities and regulators, realizing the significance of leasing, take a closer look at the industry and arrive at rules, regulations, and guidelines, meant to stimulate further growth.

This phase, too, is generally rate focused though some lessors, based on severe competition, begin to address the value added aspects of leasing. These aspects may include shortening the response time from the date of lease application to the date of lease funding or bundling of services, such as maintenance, into the finance lease. As the market experiences substantial growth, rate focused leasing at times leads to volume competition. Lessors begin to narrow their spreads in a buyer’s market. Continued narrowing of spreads causes many lessors to exit the industry. The industry learns from experience that it cannot remain rate driven.

From a strategic point of view, this is also a good time to enter emerging markets. Though margins will have shrunk, leasing infrastructure will be more solid – items having to do with clarity on legal and tax issues. For the strictly domestic players this is the time to decide whether to focus on niche markets - be it by region, by asset type, by sector, by credit quality, or by transaction size.

Phase Four, the Operating Lease Phase, comes about with the passage of time, intense competition, transfer of technology from one leasing country to another, demand by multinational lessees, and developing or developed secondary markets. In some countries, the product is fueled by the fact that finance leases are denied “true lease” or “tax lease” status. The introduction of international accounting standards further fuels the demand for operating leases as finance leases no longer qualify for off balance sheet financing.

The key features of this product are the ability of the lessee to return the equipment at the end of the lease term, and the full-service nature of many operating leases. Bundling of services and one-stop-shopping become a convenience to the lessee. With these features, (using computers as an example) hardware, software, installation, maintenance, and training are packaged into one transaction. All mature lease economies offer the operating lease product; emerging markets have begun to introduce it only recently.

From a strategic point of view, this is a good time to expand overseas by offering skill base and experience through joint ventures with those lessors who seek to offer new products. For those on the ground, this is the time to decide whether to stay with finance leases only (nothing wrong with this as the overwhelming majority of lessors globally successfully stay in this phase) on a value added basis or to consider new products.

On-going intense competition, continued lessor creativity, and ever-increasing transfer of technology propels the industry to Phase Five, the New Products Phase. In this phase, the operating lease becomes extremely sophisticated, with complex end-of-term options (such as puts, calls, and first amendment clauses), early termination options, upgrades and rollovers, technology refreshes, and the like.

Phase Five also brings about new products such as securitization, income funds, venture leases, and synthetic leases (off balance sheet loans).

From a strategic point of view, now is the time to consider domestic joint ventures and or mergers and acquisitions as the next phase - maturity, will bring about flatness in market penetration.

Finally, the industry, following the classic industry curve from infancy to maturity, enters the last phase, Phase Six, Maturity. Maturity is characterized by substantial consolidation within the industry. Such consolidation takes the form of mergers, acquisitions, joint ventures and alliances. Maturity also brings forth lower margins, causing lessors to look for profits through operational efficiencies as versus increased sales volume. Penetration flattens during this phase, as leasing volume increases only with the overall growth of the economy

Though the six phases apply universally, it is important to note two points. First, the sequence applies to the industry in general within each country, and not to all of the players. It is very common for lessors not to grow sequentially. As an example, some that offer new products such as venture leases may not be in the operating lease business. Second, each phase is not mutually exclusive. Using the United States as an example, though the industry has reached maturity, many lessors continue to offer only finance leases, some only specialize in operating leases, whereas others diversify into products such as synthetic leases.

As emerging markets evolve toward maturity, it is critical to note that the leasing cycle (from the “simple” finance lease to maturity) has become shorter and shorter. This is obviously due to information sharing and technology transfer among markets.


CONCLUSION
Many factors impact the timing of strategic decisions - one of them has to do with the evolution of leasing. It is hoped that this article will provide sufficient insight into the relationship between certain strategic decisions and leasing’s evolution.