IAA-Advisory director Nick Gallop looks at research produced in conjunction with the Leasing Foundation
The first phase of this research was completed in 2014. It examined the wider context of all kinds of hire, rental, managed service and subscription agreements. It developed a current definition of the term leasing and looked at the ways the leasing industry is maintained with a wide and evolving range of products. The research showed there was a wide variety of leasing arrangements and an even wider range of leasing-like activity. While some questions were answered, the research raised more that needed answers.
Value in this kind of research comes from both the breadth and depth of opinions embraced. IAA-Advisory exploits its extensive network of senior contacts, to continue this research. There were over 40 individual interviews for this second stage research project, as well as group discussions with the Captives’ Forum and the High Value group.
The questions to explore included: Do we know the size of the market? Can we define the products being offered? Is the industry merging with other forms of financing? Or is it maintaining a distinctive and identifiable position? Is the growth in financing services and subscriptions recognised? Do industry statistics reflect the changes that have taken place?
Many institutions call their lease-like products by names other than leasing. Whatever the name, there’s widespread use of rental or hire as a way to circumvent investment hurdles and encourage consumption of services or equipment. Cloud service providers, for example, don’t use the word leasing, and whatever they call it, the user doesn’t own the IT equipment and the key contract terms are similar.
Thinking along the lines of the circular economy affects product design, building in re-usability from the start. It also affects approaches to funding equipment for use, refresh and re-use. This way of thinking demonstrates an obvious role for captives, and it’s a role in which specialised lessors can participate.
It will be interesting to see how this trend evolves. Around the same time that the interviews were conducted, DLL began to use it as a theme to promote its financing, and the World Economic Forum stated leasing as one of a few approaches to the circular economy that could endure. Lessors’ advantage lies in their ownership of the product, and end of lease terms which ensures the goods are collected, potentially for re-use, rather than simply being dumped or recycled. For entertainment, rather than information value, the graph shows how the term ‘circular economy’ is now as popular as ‘sliced bread’, at least as a Google search term.
Massive investments in technology to satisfy hugely variable and sometimes unpredictable demands encourage a shared solution. Pay per use of a high-capacity infrastructure shared between multiple users, will offer more attractive economics than cost recovery via single user agreements. This is essentially what cloud computing offers. The supplier also obtains the additional ‘no pay – no use’ credit benefit.
Consumption pricing seems to be growing. Interviews explored examples in equipment as diverse as lighting, hospital equipment, bus manufacture and power generation; car sharing exits somewhere on the consumption pricing spectrum, even if the service consists of serial leases of very short duration. While the providers all agreed their offering had leasing characteristics, none used the term leasing, nor was this financing reported as a lease.
Services have long been included in financing arrangements and it’s a growing trend. Captives in particular, offer their parent a way to assure high service penetration From the users’ perspective it’s a logical extension: if financing eases investment in an asset, then financing services and software with the asset eases investment in a complete solution.
Pure services are also financed, with the usual cash flow benefits for customers. Funding can be done by loans, or perhaps invoice financing with an instalment payment plan, with the advantage for the end-user that the invoiced amount remains on the supplier balance sheet. However it’s done, financed services are regarded as financing business, and neither thought of, nor reported as, leasing business.
After this report was published, the new Lease Accounting Standard was finally released. It’s concerned with defining when a contract is for a lease and when it’s a service, and changed the accounting practice for leases. Lindsay Town of IAA-Advisory carried out many of the interviews, and organised discussion with the High Value Group. Town speculates on the implications of this distinction: "We found there’s a services continuum. It starts with a contract that’s mainly for equipment financed with some services, and goes all the way through to pure services. The new accounting standard may give impetus to service integration in asset financing."
Town goes on in the vein of the old joke: when is a lease not a lease? When it turns into a service. Now there’s a new incentive for asset financing to be repackaged as a service. There are meetings and conferences to discuss accounting implications of the new standard, but I think they’re missing the point. The interesting questions are how the new accounting standard will affect the way asset financing is offered in future? What opportunities does that create for a financing business? What are the implications for the way the industry develops? IAA-Advisory plans to offer a seminar, or single company workshops, to explore these questions.’
When is it a lease?
Much lease-like financing is reported to regulators as part of ‘total lending’, rather than broken down by activity, or characterised as ‘safe’ and ‘less safe’.
Asset-backed security (ABS) financing in transportation offers one example of substantial and systemic exclusion: There appears to be a wide gap in the reporting of statistics between the end-user of equipment, who has a lease, and the lender, who may have an alternative lending product and who is not a lessor. Statistics are usually collected from the providers of the lending product and not from the users of the facilities. Many large transactions are under-reported: in the transport sector, aircraft, rail and shipping the under-reporting is billions of dollars annually.
This under-reporting is corroborated from a capital markets and securitisation perspective. Leasing and rental accounts for a significant proportion of ABS issuance. Broad statistics show European ABS outstanding at $17.6bn (16.2bn) for leases and $73.7bn for auto at the end of 2014, representing 35% of the ABS market. Where leased assets have been securitised, the entities investing tend not to record the activity as ‘leasing’.
Transactions written under sharia law are also systemically excluded. Over $34bn of Islamic bonds, called sukuk, have been issued on the London Stock Exchange. Most commonly the sukuk relates to partial ownership of an asset (sukuk al-ijarah). Elements of the lease transaction mirror those required under sharia law: the lease rental payment being a natural alternative to repayment of capital and interest. With attractive growth rates, developing a sharia-compliant lease business seems like a natural opportunity for an organisation familiar with the leasing market, rather than one representing banking products.
Risks and regulation
Leasing enjoys risk advantages that make it a safer form of lending, and this advantage is dispersed as leasing is under-reported and leasing-like lending grows. Given the safer credit quality of leasing, it would probably be helpful if regulators were to focus on it.
There’s a virtuous cycle more where leasing and leasing-like activity will attract regulator and policy-maker attention. Given the safer credit qualities of leasing it’s reasonable to suppose any differentiation would favour leasing compared to other forms of lending, which would in turn attract more participants in the industry and more reporting of leasing-like activity.
A collective name for these safer-credit activities would help to break into the virtuous cycle. The report suggests the industry adopts the phrase ‘leasing and asset financing’ and uses it consistently.
The report attempts to measure the market that exists today for safer credit, leasing-like financing (and recognises that the unreported numbers need better estimates). Even so, unreported safer credit lending, in all its forms, is significantly higher than reported numbers; and as the chart shows, under-reporting grows, as transactions get larger. The state of reporting in our industry resembles an iceberg.
Inevitably, the answers raised more questions in turn: some were about the way governments, regulators and commentators approach this market, and differentiate it from traditional bank lending. Others were about the value that is, or should be, attributed to the ‘safer lending’ heritage of the leasing and asset finance industry. The report suggest challenges for the industry now and for further research:
First, the industry should agree on an inclusive name for safer lending via leasing-like financing (for example ‘leasing and asset financing’) and start using it consistently.
Second, we should investigate under-reporting more rigorously: the true size of the leasing and asset financing business is large enough to justify specific regulation, to its advantage.
Finally, we should commission work to demonstrate the better outcomes of leasing and asset financing, compared to other forms of lending. This would support discussions with regulators about its safer credit characteristics.
Facinating and frustrating
Derek Soper, IAA-Advisory’s chairman, summarised the research as fascinating and frustrating in equal measure: "We made some interesting discoveries, and we laid down some challenges for the industry. And then it’s like peeling an onion: answers to one set of questions go on to reveal the next set of questions.
"That said, the report has helped take thinking about the industry forward; it stimulated discussion about challenges for the industry at the Leasing Life conference. We must keep the momentum going.