It s old news that a lot of lessors are doing as many. Profit Leader. The Lease as

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2 The Lease as Profit Leader Leases often produce higher returns than loans. To expand their use in banks and multi-line finance companies, be willing to share the wealth. By Susan L. Hodges It s old news that a lot of lessors are doing as many loans as leases today, and in some cases, more. In part, this is because many customers believe they want a loan rather than a lease. But all too often, at firms that offer both types of product, the loan wins out for the wrong reasons. Everyone understands how a loan works, after all many times to the detriment of a lease. Laird Boulden, president of RBS Asset Finance, in Chicago, will gladly finance an asset with a loan but only when a loan is the best choice for the customer and for his parent company, The Royal Bank of Scotland and its U.S. entity, Citizens Bank. I m there to create value for the customer and return it to the bank, says Boulden. If I can provide value through a loan instead of a lease, I ll do that. August

3 Willingness to execute a loan is neither a sell-out to traditional lending nor a wish to take the path of least resistance. It is the result of an evolution that s reshaping some of the largest and most successful leasing entities in America. financed for just five years, to preserve a residual. The upshot: generalized lenders incur unnecessary risk and cost by not understanding the asset. But, unless every department within the finance company can execute and receive credit for a lease, the turf battle between leases and loans is bound to continue. Such willingness to execute a loan is neither a sell-out to traditional lending nor a wish to take the path of least resistance. It is the result of an evolution that s reshaping some of the largest and most successful leasing entities in America. Consider the blizzard of legislation that emanated from federal and state governments in the last three years, and you understand the rationale behind the loan s current popularity. To save the lease from oblivion at banks and multi-line finance companies, education, demonstration and reorganization are required and unfortunately, nothing less. RAROE and Respect If this sounds impossible to you, the embattled lessor, read on. Leasing executives like you have shifted the paradigm at their companies so that the lease is viewed with as much respect 26 August 2005 and enthusiasm as the installment loan. To understand how, let s look at Risk- Adjusted Returns on Equity (RAROEs). RAROEs are the criteria by which all financial products are measured, at least at a bank. Any company that calculates RAROEs has its own model to measure these returns. Thus, a RAROE of 25 at one institution may be equivalent to a RAROE of 19 or 31 at another institution. Both loans and leases funded by equity produce RAROEs and often, this return on an equipment lease will be higher than one for an equipment loan. No one knows this better than lessors, who achieve these superior earnings by applying their special knowledge of equipment, deal structuring, and competitive rates. Example: A lender who is not a lessor might structure a loan or lease for a fleet of trucks over the span of 10 years. A lessor who specializes in trucks would know that these vehicles should be Profit Center or Product? To end the struggle, RBS Asset Finance and a number of other leasing entities are trading their roles as profit centers for new roles as products. When I m a profit center, my own bank competes with me, explains Boulden. That s because every profit center competes to place the same asset on its balance sheet. But when our balance sheet is the same one, we re no longer conflicted, he says. We all want to do the deal that makes the bank the most amount of money with the least amount of risk. Of course, arriving at such a sharing culture is easier said than done. The first step is to put your ego and your need for independence on the back burner. In the words of Rick Newfield, senior vice president, sales performance executive at Bank of America, If you want to be independent, don t work for a bank. Subduing your ego will make it easier to allow each profit center in the company to receive credit and income

4 for every lease it generates. Once this approach is implemented, much of the internal competition between leases and loans is eliminated. Instead, savvy profit-center managers will evaluate each financing opportunity for its potential as a lease, because the more leases generated, the higher the probable profits. We try to eliminate the thinking that says a lease is a loan that To save the lease from oblivion at banks and multi-line finance companies, education, demonstration and reorganization are required and unfortunately, nothing less. got away, says Newfield. Banc of America Leasing does this by aggressively marketing to all bank profit centers. At the same time, however, qualifies Newfield, We re still careful of the bank. At JPMorgan Chase, leasing is viewed August

5 Subduing your ego will make it easier to allow each profit center in the company to receive credit and income for every lease it generates. as a product that supports the bank and its customers and prospects. Lessors do not execute leases independently; all work with Chase s relationship managers. Yet, each profit center within Chase has an annual leasing goal. As Ed Perkowski attests, This could never happen without the support of the bank s senior management. Education is Key Perkowski is senior vice president, regional leasing manager, of Chase Equipment Leasing, in Rochester. A member since 1983 of what is now the Chase group, he has worked over time to demonstrate to senior management the high returns that a lease can produce. Then, with the bank s blessing, he and his team have educated all bank markets on the uses and advantages of the lease. They now conduct presentations on leasing to relationship managers every first quarter. When each market team understands that it will receive income and asset credit for each lease it generates, enthusiasm for the lease product heightens. When they further realize that they, the bankers, will continue to control the transaction while a leasing professional 28 August 2005 approves the lease structure, completes the equipment evaluation, sets the residual risk position and documents the transaction, any remaining resistance disappears. Explains Perkowski about the task distribution, The bankers know the customer better than we do. Imposition of leasing goals assures that each market consider a lease at every lending opportunity. And when lease RAROEs are tracked and compared with loan RAROEs, the case for selling leases becomes strong indeed. Yet, high returns are just one benefit of leasing, albeit the most impressive. Soft benefits include repeat business, cross-marketing opportunities, broadening of the product range, and the addition of a distribution channel. Success stories stemming from the use of a lease instead of a loan abound. At one finance company, a $25-million lease for trucks and over-the-road transportation produced a RAROE of 43.4 percent. A $75-million lease line of credit for cement production equipment yielded a RAROE of 36.9 percent. At another firm, successful bids to finance school equipment resulted in 14 new clients and cross-sales in depository, trust, and credit-card services. Proving that leases often generate higher risk-adjusted returns on equity than loans may be as simple as breaking out lease performance data from the rest of the company s product performance information. But beware: lease RAROES may not be higher than loan RAROES every time. No one wants to talk about the deals that we make less on, says one lessor, but it happens. A loan RAROE can be calculated immediately, but since a true-lease RAROE cannot be accurately calculated until you know the residual rate at the end, you can only estimate the return up front. And of course, unforeseen circumstances can alter that figure. Beyond Banks Having concerned ourselves mostly with banks so far, it is important to explore whether or not the same principles governing lease RAROES apply at non-bank leasing and finance firms. And the answer is: sort of. Non-bank leasing and finance companies may not label their RAROEs as such, but they do calculate them. And whether or not they re in the business of providing loans, they frequently provide capital leases with dollar-purchase options, which in many ways are similar to loans. In other words, you can figure the RAROE of a capital lease up front, because you lock in the rate of return and determine the residual. With a true lease, however, you cannot know the exact return until

6 Proving that leases often generate higher risk-adjusted returns on equity than loans may be as simple as breaking out lease performance data from the rest of the company s product performance information. the end of the term. While this uncertainty can result in lower returns, it can also create higher ones and to Brad Pike of Creekridge Capital LLC in Edina, Minnesota, that is the beauty of the true lease. Whenever there s a fair-marketvalue (FMV) residual and purchase option, the rate of return is usually significantly higher, says Pike. This is so, partly because the FMV option at lease end allows a greater return, based on the asset. But Pike sees another reason as well: the competition for capital leases now is huge, and the result is aggressive pricing that all but eliminates good returns. Pricing, says Pike, is being sacrificed for volume at some companies, and a number of firms position volume as their top priority. This may be due to two events: the abundance of portfolios wiped clean after last year s write-downs, and the low level of equipment acquisition since September, Even so, Pike believes companies should implement strong risk rewards. Translation: If you re pricing at an investment-grade level, you d better have an investment-grade lessee. Creekridge Capital writes both true and capital leases. And Pike says company experience has shown that true leases produce better returns on equity than capital leases. Why? Because we find that the upside [increase] on a true lease is more prevalent than the downside, says Pike. No wonder Creekridge aspires to write true leases whenever possible. But then, Creekridge specializes in technology equipment, which by virtue of its short life cycle, lends itself to true leasing. Were the company to focus on yellow iron or another longlived equipment market, it would be forced to write more capital leases. If capital leases produce lower RAROEs than true leases, should those whose markets lend themselves to capital leases diversify into markets that foster true leases? Not necessarily. Each firm s answer depends on the way it manages risk and its knowledge of other asset markets. I think the risk [on true leases] is slightly broader, because you re taking the additional risk of the asset into your equation, says Pike. Another disadvantage can be the lower monthly payments for true leases as opposed to capital leases, due to the residual on the back end. Another consideration: You need an asset that will have value at the end of the lease. And finally, leasing and finance firms, be they banks or not, must have the talent to correctly analyze an asset risk. When they do, Pike believes they will fare considerably better in the true-lease environment. At the same time, conventional wisdom says that lessors who provide mostly capital leases are of a different ilk than those who thrive on true leases. This may be because capital leases so strongly resemble loans, and there is an inherent difference in the mentality and philosophy of lending and those of leasing. If you as lessor are comfortable executing both true and capital leases, you re probably comfortable providing both leases and loans. Just remember, whatever you write: the RAROEs favor the lease and the true lease, most of all. Susan Hodges, of Silver Spring Maryland, writes about leasing and other topics. Contact her directly at hodgeswrites@aol.com. August