Are time bombs ticking in drawers like yours?.

The rate looks great – the documents seem straight forward – so we sign up, await delivery of the equipment, sign the bank authority and with great relief stick all the documents in the bottom drawer. Sounds familiar?

So what are the traps to this seemingly flexible form of finance, and how can a Lessee obtain equipment finance at what appears to be very attractive rates but not have to suffer “lessor revenue enhancement traps” – also referred to as “fish hooks” or “gotchas” in the trade – ensuring, instead, that the original financial parameters of the lease do not turn into a burdensome financial contract to the Lessee.

Lessor revenue enhancement traps occur at every stage of an operating lease – the beginning, the duration and the end. However, before looking for specific traps it is necessary to gain an appreciation of what it is we are dealing with – what is the nature of the leasing transaction.

Because the payment stream is usually unconditional – a little like a loan – it is very important the deal you get is the deal you anticipated when the smiling lease salesman was providing assurances as to the attractive features and flexibility of the deal. (But have you looked closely at the document? Invariably all representations and warranties up until the date of signing are specifically excluded from the deal). The structure of an operating lease is therefore critical to assessing where the lessor’s risks lie and what he may (attempt) to do to mitigate these risks.

In a true operating lease the lessor has “some skin in the game”. After allowing for amortisation of say 90% of the cost of the equipment through the rental stream it is taking a medium term investment in an asset that is essentially illiquid, rapidly depreciating and whose future value is uncertain – hence the temptation to use as many “gotchas” as possible to reduce the equipment risk to a level where – if the equipment is returned at the end of the lease – his profit is guaranteed.

The attached diagram sets out the typical structure of most leasing companies. There are variations on the theme and some lessors fund both the firm term cost (ie. the 90% cost portion) as well as the residual investment. Mostly, however, these risks are separated.

In the corporate arena most operating leasing has been by way of either vendor related lessors or third party leasing companies – which in fact are behind many of the vendor finance programs. Major trading banks and finance companies are increasing their presence as are a number of specialist principals from offshore. So where are the ‘time bombs’ that can affect the financial parameters of a lease: Some frequently attempted ploys are listed below.

In the beginning:

• Blind discounts – the price the lessor is paying for the equipment is lower than the price quoted for a cash purchase. Rents presented are based on the lower “blind” price and act as an inducement to enter a lease that may otherwise have punitative terms.
• Interim rent – the lessee pays additional pro rata rent before the lease commences, which incorporates a high principal component and allows the lessor to reduce risk at the lessee’s expense before the agreed “firm term” has started.
• Fees – establishment, commitment and drawdown fees are sometimes sought.
• Per diem rent – similar to interim rent in operation and effect.
• Stepped rents – difficult to calculate rental rates.
• Interest rate base adjustments – the lessor’s “cost of funds” is moved between lease bid and drawdown dates.
• Days free credit (up to 60 days) on the equipment purchase accrue to the lessor – not the lessee.

• Equipment upgrades. Lessor’s love it – risk can be totally eliminated through revised rents consequent on a one sided – “captured client” negotiation.
• Early terminations or payouts – again the lessor makes the rules in the absence of clear calculation methodologies and provisions.
• Lease extensions – perfect for profit enhancement.
• Periodicity plays – monthly vs. quarterly rental rates.

• Automatic renewals – super profit territory here.
• Holding over rental provisions for a minimum period – take a substantial portion of the pain away for the lessor.
• Purchase options over which there is no benchmarking or arbitration – the lessor determines the fair market value.
• De-installation and shipping/insurance costs. Lessee pays for goods to both be delivered and then shipped out.
• Make good costs. Often not necessary and invariably with a profit content.

A simple example will show how much devastation is possible through the combination of an interim rent obligation and quarterly renewals at the end of the lease.

The lease that is sold to the lessee is based on the following parameters:

Equipment cost:	$500,000
Term:	36 months
Payments:	12 quarterly in advance

Interim rent:

If the lease does not start on a designated quarterly date a pro rata rental is paid on a daily basis up until the next quarterly date following which the quoted rentals for the agreed term will be paid. (Note – No lease with interim rent provisions ever starts on a quarterly date as the equipment is either not delivered or the leasing company structures the start date to ensure the lease has a healthy interim rental period.)

Renewal Provision:

Automatic for (up to) 12 months if notice not given exactly on time.

Case 1

The underlying cost of funds, including credit risk margin is assumed to be 8.0% pa, quarterly.

This is the case presented for acceptance.
Rentals:	12 quarterly in advance of $42,698.
Rental Rate:	1.79% pa. This based upon the lessor having a 10% residual value investment in the equipment – or $50,000.

Case 2

Due to circumstances managed by the lessor the lease cannot commence on a quarterly date and an interim rent is paid for say 45 days.
Interim Rent:	$21,349
Rentals:	12 quarterly in advance of $42,698 ie. unchanged.
Rental Rate:	4.72% pa.

Case 3

Automatic renewal provisions cut in. For this example we shall look at the scenario on quarterly steps to see the financial impact.
Interim Rent:	$ unchanged
Rentals:	$ unchanged
Rental Rates:	One quarter’s rent extension 9.62% Two quarter’s rent extension 13.60% Three quarter’s rent extension 16.85% Four quarter’s rent extension 19.56%

Note also that under the above strategies the Lessee still does not own equipment – and further payment could be required at a price the lessor determines if the lessee wants title.

Now let’s assume then that the goods are purchased at the end of year four for 5% of cost, ie. $25,000.

Rental Rate:

20.98%

In other words, funding for the asset purchase has been undertaken at 20.98% pa – compared to the underlying funding cost of 8.0% pa.

The above scenarios are only part of the story – so what should lessees do? Options are available. A careful review of leasing contracts and an audit of existing and proposed equipment usage patterns will allow a strategy to be developed where the Lessee is in control of the contract – not the other way around.

Spectra specialises in ensuring safe, transparent leasing solutions are documented for its clients so the risk transfer sought is achieved on its terms – not the lessor’s.

Typical Vendor/Leasing Company Operating Lease Structure
(Note, Alternate Structures Exist)


Diagram 1: Typical Vendor/Leasing Company Operating Lease Structure

Purchase of goods

1. Bank funds, say 90% of goods cost
2. Leasing company funds say, 10% of goods cost
3. Leasing company acts as agent for the bank - it usually does not borrow in its own right
4. The true owner of the equipment is (usually) the bank until its debt is amortised

1. Rents are paid to leasing company which acts as (undisclosed) agent for bank - the principal - it passes rents to the bank
2. Rents amortise the bank’s exposure over the term of the lease

1. From sale of goods on completion of the lease for greater than its investment amount - ie. 10%
2. From early termination profits
3. From lease renewals, extensions or upgrades
4. From other revenue enhancement