state of the industry 2005 · report is an invaluable strategic planning tool. the report is the...

2005State of the Industry

The premier provider of industry research.

The Equipment Leasing and Finance Foundation is the only

non-profit organization dedicated to providing future oriented research

about the equipment lease and financing industry.

The Foundation accomplishes its mission through development

of studies and reports identifying critical issues impacting

the industry.

All products developed by the Foundation are donor supported.

Contributions to the Foundation are tax deductible.

Corporate and individual contributions are encouraged.

Equipment Leasing and Finance Foundation4301 N. FAIRFAX DRIVE, SUITE 550

ARLINGTON, VA 22203

WWW.LEASEFOUNDATION.ORG

703-527-8655

LISA A. LEVINE, EXECUTIVE DIRECTOR, CAE

The Equipment Leasing and Finance Foundation

wishes to express appreciation to the following companies

for providing the sponsorship to support development of the

2005 State of the Industry Report:

Prepared by:

FINANCIAL INSTITUTIONS CONSULTING, INC.

October 2005


TABLE OF CONTENTSPage

Preface ....................................................................................................................11

Executive Summary ..................................................................................................13

Leasing Industry Overview

Market Size ........................................................................................................15

Market Drivers ....................................................................................................16

Economic Conditions ..................................................................................16

Legislative, Accounting, and Regulatory Issues ............................................18

Funding ......................................................................................................20

Competition ................................................................................................20

Analysis of the Survey of Industry Activity

Overall Industry..................................................................................................23

New Business Origination............................................................................25

Profitability and Funding ............................................................................27

Portfolio/Credit Quality ..............................................................................30

Operations ..................................................................................................32

Application Processing/Approval ............................................................32

Operational Efficiency ............................................................................35

Lessor Profitability ..............................................................................................38

Banks ..........................................................................................................38

Captives ......................................................................................................41

Independent, Financial Services ..................................................................42

Market Segment Profitability ..............................................................................43

Micro-Ticket ................................................................................................44

Small-Ticket ................................................................................................47

Middle-Ticket ..............................................................................................48

Large-Ticket ................................................................................................51

Sidebar Stories

Going Global 101 ........................................................................................52

The Middle-Ticket Squeeze..........................................................................54

How Can Large-Ticket Lessors Adapt to the New Environment? ................56

Concluding Thoughts ................................................................................................59

About Financial Institutions Consulting ....................................................................60


4301 N. Fairfax Drive, Suite 550 • Arlington, VA 22203 • Phone: 703-516-8363 • Fax: 703-465-7488 • www.leasefoundation.org

October 2005

Dear Equipment Lease Finance Experts,

I am pleased to provide you with this copy of the Equipment Leasing & Finance Foundation’s2005 State of the Industry Report. With its focus on the future, I’m certain you’ll agree that thisReport is an invaluable strategic planning tool.

The Report is the product of an exhaustive review and analysis of leasing industry informationsources, including ELA’s 2005 Survey of Industry Activity, government data, independentresearch and interviews with key executives in all the major leasing industry segments. Itprovides a comprehensive portrait of the leasing and finance industry in the near term.

The annual State of the Industry Report is a centerpiece among the many forward-lookingresearch products the Foundation provides. Just recently the Foundation debuted:Long-Term Trends in Healthcare and Their Impact on the Leasing IndustryKnocking Down (Great) Walls: Identifying Factors for Success in the

Chinese Equipment Leasing MarketCredit Risk: Contract Characteristics for SuccessIn early 2006, we’ll be releasing Why Diversity Ensures Success and The Response to CustomerDefault: Captive vs. Finance Leases.

None of these ambitious projects would be possible without your generous support. TheFoundation is funded entirely by individuals and companies within the equipment leasingindustry, those who—like you—understand that their donations to the Foundation are aninvestment in the industry and in their own businesses.

As you read and use this Report, I hope you’ll keep in mind that your contribution helped tocreate it, and that your continued generosity will help the Equipment Leasing & FinanceFoundation provide you with a glimpse of the future, long into the future. Please visit theFoundation’s website at www.leasefoundation.org for more information on the Foundation’s products and mission.

Sincerely,

Joseph C. LaneChairman, Equipment Leasing & Finance FoundationVice ChairmanGE Technology

S T A T E O F T H E I N D U S T R Y R E P O R T 2 0 0 5

The Equipment Leasing and Finance Founda-tion (the Foundation) selected Financial Institu-tions Consulting, Inc. (FIC) to prepare its Stateof the Industry Report. The mission of theFoundation is to focus on and evaluate futuretrends and their impact on the leasing industry.The Foundation and FIC have designed thisreport to analyze and interpret the performanceof the industry based on responses to theEquipment Leasing Association’s (ELA) 2005Survey of Industry Activity (the Survey) and,using this and other information, project anddiscuss future implications for the industry.

FIC is a management consulting firm focusingon bank and non-bank financial services. Wework with clients on strategic issues related toincreasing growth and productivity. Beyondcommercial finance and leasing, our areas ofexpertise include the middle market and smallbusiness segments and wealth management.While most of our work is U.S. based, we havecompleted project in close to 20 other countries.

The FIC methodology for this analysis incor-porates statistical data, our past client exper-ience, and in-depth personal interviews. BothFIC and the Foundation wanted to take advan-tage of the leasing industry’s valuable humancapital. Therefore, in addition to presenting datafrom the Survey, the report includes FIC pro-prietary research and analysis as well as theinsights and perspectives of leasing industryexecutives and industry experts. FIC conductedin-depth interviews with 14 industry expertsrepresenting a cross-section of lessor types,ticket sizes, and industry vendors.

The Survey reflects fiscal year-end 2004performance. Therefore, it cannot present a fullyaccurate picture of the leasing industry today.Overall, business investment in equipmentcontinued to increase through the first half of2005. However, some industry sectors, equip-ment types, and leasing products remain weak.

Therefore, our interviews focused less oncurrent performance and more on qualitative

assessments of key issues and the critical chal-lenges facing the industry. The industry expertswho shared their insights include:

James Ambrose - GE Healthcare FinancialServicesMichael Brown - CITGary Corr - Orix Financial Services Inc.David Davis - 1st Source Aircraft FinanceMajor Horton - Dell Financial ServicesMichael Humphreys - Microsoft CapitalJoseph Lane - GE Technology FinanceJames McGrane - US Express Leasing, Inc.Deborah Monosson - Boston Financial & EquityDennis Neumann - Bank of New YorkRichard Remiker - Merrill Lynch CapitalJames Renner - Wells Fargo Equipment FinanceDavid Smith - CitiCapitalScott Thacker - Accenture

We thank these individuals for their generouscommitment of time and candid insights intothe intricacies, opportunities, and challenges ofthe leasing industry. Throughout this mono-graph, we include direct quotations from theseinterviews; however, to preserve confidentiality,we present quotes on an anonymous basis.

The lessor types analyzed in this report fallinto three categories: Banks (either separately-operating subsidiary or integrated), Captives,and Independent, Financial Services lessors.

We think it is important to clarify the defini-tions of these various lessor types:

Bank lessors often combine leasing activitieswith other bank functions. They use internalfunding sources and operate under the juris-diction of the Comptroller of the Currencyand/or the FDIC. They may be integrated withthe bank or organized as a separate entity withinthe bank holding company.

Captive lessors are the subsidiaries of dealersor manufacturing companies. At least 50 per-cent of the lease portfolio consists of productsproduced by its parent and/or affiliates. They

11E Q U I P M E N T L E A S I N G & F I N A N C E F O U N D A T I O N

PREFACE

12


may also finance other companies’ products.Independent, Financial Services lessors are

usually finance companies offering leasesdirectly to businesses and are not affiliated withany particular manufacturer or dealer; alterna-tively, an Independent may also operate as thefinancial services subsidiary of a corporationthat does not restrict its financing activities tothe parent company’s product and activelygenerates new business outside of thoseproducts.

The Survey captures four leasing marketsegments: micro-ticket ($0-$25,000), small-ticket ($25,000-$250,000), middle-ticket($250,000-$5 million), and large-ticket (over $5 million).

We begin this report with an overview of theleasing industry, including an estimate of thesize of the equipment leasing market, andanalysis of the dynamics impacting industrydrivers and related implications.

Following the industry overview, we presentan analysis of the Survey of Industry Activity.This discussion highlights a number of impor-tant areas, including: new business origination,profitability and funding, credit quality, andoperations. In addition, our analysis discussescurrent performance, ongoing challenges, andpotential opportunities by lessor type andmarket segment.

In this year’s Report, we present sidebaranalyses of some of the critical issues impactingthe industry and offer our perspective on poten-tial opportunities arising from these issues. Wetitle these sidebars:

Succeeding in the Global Economy -While government statistics indicate thatU.S. manufacturing remains healthy,some developing countries, such asChina, are increasing their manufactur-ing base at a phenomenal rate. Theserapidly growing economies requireequipment and the capital to finance it. We look at some of the basics thatlessors must consider before expandingoverseas.

The Middle-Ticket Squeeze - Asopportunities for large-ticket playersdecrease, many of those players aremoving down into the middle-ticketarena. At the same time, small-ticketplayers are leveraging their technologicalefficiency to move up market, encroach-ing into the lower-end of the middle-ticket space. We look at what playersmust do to survive in this segment.

What Happened to Large-Ticket - Asa result of Basel II, as well as accountingand regulatory changes, large-ticketvolume has declined sharply. We look atwhy this happened, the likelihood of itsmaking a comeback, and the oppor-tunities that remain in this segment.

As strategy consultants to the leaders in thefinancial services industry, throughout thisReport, we offer our perspective on how thecritical issues identified may impact the leasingindustry. Where possible, we provide insightsinto how best practice players are reacting andwhat lessors can do to create opportunities inthe market today.

Financial Institutions ConsultingCharles B. Wendel, PRESIDENT

Matthew L. Harvey, SENIOR ENGAGEMENT MANAGER

E Q U I P M E N T L E A S I N G & F I N A N C E F O U N D A T I O N


While economists expect the economy toexpand through at least 2006, the leasingindustry continues to confront a number ofchallenging issues while it seeks new oppor-tunities for growth. From our analysis of ELA’sSurvey of Industry Activity (the Survey) and our discussions with industry leaders, a number of key messages emerge:

New business volume improved in 2004 andcontinued to improve through 2005. Despiteanother sharp drop in large-ticket volume,Survey respondents reported an 11.7 percentincrease in new business volume in 2004. Ourinterviews with leasing executives as well as ourreview of available quarterly data indicates thatvolume continued to improve through thesecond quarter of 2005. Further, mosteconomists anticipate continued growth incapital expenditures through 2006.

Capital appears plentiful. Financing by ventureand private equity firms, combined with a re-newed expansion of the capital markets and anapparent increase in banks’ willingness to lendto the industry has contributed to the abundanceof low-cost capital. However, in many lessors’view, there is still too much capital chasing toofew deals. In turn, this excess of capital iscontributing to the industry’s pricing pressures.

Margin compression worsened. Due to intensecompetition and an overabundance of capital inthe market, lessors have been unable to increasepricing enough to compensate for their increasedcost of funds. As a result, pre-tax spreads de-clined and, although net income increased,Return on Equity (ROE) declined from 2003 andReturn on Assets (ROA) remained unchanged.

Some lessors, however, have identified nichemarkets that allow them to increase pricing andimprove profitability. While the types of nichesvary (equipment type, end-user industry seg-

ment, customer credit grade, etc.), the messagefrom these players was similar: employ atargeted approach, develop an expertise, and be ready to move if the market changes.

In all likelihood, the large-ticket market segmentis permanently changed. The impact of recentlegislative, regulatory, and accounting changes,coupled with the impact of Basel II, havepermanently reduced or eliminated many cross-border and leveraged lease transactions. In aview echoed by most interviewees, one execu-tive said, “It’s gone and it’s not coming back.”However, opportunities continue in the large-ticket segment. There remains a need for large-ticket equipment and the capital to finance it. In the near-term, however, many large-ticketcategories, such as aircraft and marine, remainslow. The industry should expect that, becauseof these changes, average transaction sizes will decrease and large-ticket leasing will onceagain depend on “traditional” equipment finance deals.

The competitive environment continues to change.Although Banks reported only a small increasein new business volume and lost market shareto Independents, this was likely due to thedecline in large ticket volume experienced by a small number of the largest Banks. In ourview, banks will continue their emphasis onleasing, aligning their leasing units more closelywith the commercial bank. Bank lessors willcontinue to increase their focus on existingcustomers and will increasingly work to developbanking relationships with non-bank customers.Banks have already started to use the leasingunit as a way to extend their footprint out oftheir local geography.

Independent, Financial Services firms (Inde-pendents) reported significant improvementover previous years. New business volumeincreased sharply and lessors enjoyed adequate


EXECUTIVE SUMMARY

14


and more cost-effective funding. The mostsuccessful Independents, aside from the twolargest (GE Capital and CIT), appear to havefound success by developing a niche or nichesand focusing their efforts on developing exper-tise and creating a compelling value propositionfor the customer. Most industry experts expectthat the “barbell” trend will continue, with twovery large lessors on one end, many smalllessors on the other end and few, if any, in-between. As one executive noted, “Independentsthat get too big are either bought out, orcollapse under their own weight.”

Captives appear to be continuing to increasetheir focus on financing their parents’ products.We expect Captives will focus on becomingcompletely integrated with the parent’s saleschannel with the goal of capturing 100 percent

of the potential financing opportunities. As oneCaptive executive put it, “Success for us is if wefinance every piece of equipment that rolls offthe assembly line.”

As the economy continues to expand, andwith it the demand for equipment, oppor-tunities for lessors will also increase. However,the changing market and an increasingly savvycustomer mean that even in a growing market,lessors that fail to provide value beyond money-over-money will be prone to failure. As marketschange with increasing rapidity, lessors mustcontinually evaluate changing demand andanticipate customers’ needs. Those that are ableto do so will prosper while others becomemarginalized or disappear.


15


Overall, the leasing industry appears to haverecovered from several years of slow or negativegrowth. The U.S. economy continued to expandthrough the second quarter of 2005. Economistsproject real GDP growth of 3.4 percent in 2005and similar growth in 2006.

The National Association for Business Eco-nomics (NABE) projects growth in businessinvestment in fixed assets (BFI), one of theindustry’s primary drivers, to outpace overalleconomic growth, the result of pent-up demandand solid corporate profits. They do not expectincreasing interest rates to significantly impactthis growth. Changes in some other industrydrivers, however, may have permanentlychanged the leasing landscape.

Market SizeIn last year’s State of the Industry Report,

we estimated that the percentage of equipmentfinanced by leasing had declined to below 30

percent in 2003 for a number of reasons,including:

• Record-low interest rates• Bonus depreciation• Decline in large-ticket transactionsA number of industry experts believe that

penetration declined further in 2004 and con-tinues to decline in 2005. In their view, therepeal of bonus depreciation did not signifi-cantly increase leasing volume (as many hadanticipated) and the negative impact of regu-latory and accounting changes on the large-ticket segment has outweighed any benefit fromrising interest rates. As a result, we estimate that,in 2005, leasing penetration remains below 30percent in the range of 27-28 percent. Due tothe decline in penetration, the projected com-pound annual growth rate for leasing from 2001through 2006 is 1.3 percent, versus 3.6 percentfor BFI.

As shown in Figure 1, based on annualized


LEASING INDUSTRY OVERVIEW

16


second quarter GDP estimates, BFI in 2005 willincrease to approximately $791 billion. Giventhe reduced penetration, we estimate total leas-ing volume at approximately $213 billion forthe year.

In 2006, economists project a nearly sevenpercent increase in BFI, to approximately $850billion. We estimate that total leasing volume forthe period will increase to $229 billion, with nofurther decline in penetration

As shown in Figure 2, GDP data for thesecond quarter of 2005 indicates that computersand transportation equipment will experiencesignificant growth over 2004 (13.3 percent and12.1 percent, respectively). GDP data furtherindicates that “other equipment, ” whichincludes agricultural and construction equip-ment, will grow by just over 10 percent in 2005.Non-computer IT equipment (including medi-cal, communications and office equipment)shows the least growth, less than four percent.

Estimates of future growth are, by definition,uncertain. Any number of events, economic orpolitical, can impact future growth.

Market DriversAt the Equipment Leasing & Finance Foun-

dation’s Industry Future Council meeting thisyear, industry leaders identified four primarydrivers of the leasing industry:

• Economic Conditions• Legislative, Regulatory, and Accounting

Issues• The Marketplace/Competitive Environment• Human Capital

Economic ConditionsAs has always been the case, the demand for

equipment and the availability of capital driveleasing industry volume. In its most recentOutlook report, NABE projects continued stronggrowth in BFI through 20061. In addition, 75percent of the economists surveyed believe thatinterest rates, while increasing, will remain lowthrough the end of 20062, indicating that therewill be adequate capital available to fund newequipment purchases.

As noted above, any number of events canpotentially impact the economy and the demand



for equipment. A number of executives weinterviewed expressed concern about the near-term impact of Hurricane Katrina on thenational economy. Most believe that the directeconomic impact of the disaster will beregionally contained and may, in fact, fueldemand for equipment related to the cleanupand reconstruction of the region as well as tothe repair of its infrastructure. The issue may bewhether this demand is captured by aggressiveand opportunistic entrepreneurs versus moreestablished players.

A recent report by Deloitte Research statesthat, historically, natural disasters have had a positive long-term economic impact3. As an example, Deloitte notes that the 1989 North-ridge earthquake in Los Angeles led to therebuilding of bridges statewide. However, withKatrina, they also noted that the increase inenergy costs may reduce national GDP growthby .5 to 1 percent through the end of 2005 with much of the impact felt in the retail andconsumer goods sectors.

Conversely, the Business Roundtable, an asso-

ciation of 160 CEOs of leading corporationsemploying 10 million people and generating $4trillion in annual revenue, recently released asurvey of its members indicating that few expectany significant long-term impact from Katrina.The survey reports that only 14 percent ofBusiness Roundtable members have reconsideredplans to expand capital spending over the nexttwelve months. Most of those reconsideringexpressed their intent to leave capital spendingat current levels; only one percent indicatedintent to reduce capital spending4.

As the recent bankruptcies of Delta andNorthwest Airlines indicate, higher energyprices have hurt the already troubled airlineindustry, likely prolonging weakness in thecommercial aircraft market. However, theincreased price of fuel is unlikely to have adirect negative impact on other fuel intensiveequipment such as trucks and constructionequipment. Although the trucking industry will be impacted by any slowdown in theshipment of manufactured goods, virtually alltransport companies include a fuel escalation


18


clause in their shipping contracts, passing fuelprice increases directly to the shipper. Inaddition, the demand for construction equip-ment related to the cleanup and rebuildingeffort from hurricanes Katrina and Rita shouldmore than offset any weakness resulting fromhigher fuel costs.

Over the past several years, concerns aboutthe availability and cost of funding have plaguedthe leasing industry. Today, industry expertsagree that there may be an excess of capital inthe market. Many executives commented thatthe industry is “awash in capital,” contributingto the existing pressure on pricing and spreads.

As Figure 3 indicates, the securitizationmarket appears to be returning to near its pre-2000 levels. Based on the first six-monthsactivity, total volume for the year could exceed$10 billion. As shown in Figure 4, however,players appear to be increasingly opting forprivate placement of their offering, avoidingmuch of the regulatory oversight associated with public offerings.

Bank credit also remains an important sourceof funding for the industry. Leasing executivesreport that banks appear to be more willing tolend to lessors than they have been in recentyears. In their view, this renewed willingness toextend credit to the industry represents banks’desire to grow assets as well as their increasedcomfort with the health of the industry.

Private equity and hedge funds also becamean important source of capital in 2004. Execu-tives noted that these funds either financed orpurchased a number of leasing companiesduring the year. However, in the words of oneexecutive, “This is not a repeat of the dot-comdays when venture firms handed out money toanyone who asked. Today, these firms are look-ing for strong management, a solid businessplan, and positive results. The second round offunding is not guaranteed this time around.”

Legislative, Regulatory, and Accounting IssuesIn 2004, changes in the legal, regulatory, and

accounting environments may have permanently



altered the industry. Tax law changes impactedcross-border and other types of structured deals,and the continued emphasis on simplicity andtransparency has made lessees wary of any off-balance sheet structuring. In addition, as Banksbegan implementing Basel II, they found that,under its risk/capital requirements, many oftheir leveraged transactions no longer madeeconomic sense. These changes led to a sharpdecline in large-ticket volume, volume that somelessors believe may not recover in the near- ormedium-term.

The recent changes in U.S. federal tax lawretroactively impacted the taxation of cross-border and LILO/SILO transactions. Under thenew law, certain tax benefits are restricted,effectively eliminating the economic attractive-ness of these vehicles. In addition, the law wasimplemented retroactively, opening past trans-actions to potential additional taxation.

Fallout from Enron and other corporate scan-dals continues to impact large-ticket leasing, asit has in the past few years. Executives statedthat lessees, particularly publicly traded com-panies, continue to avoid any type of off-balancesheet transactions. In the words of one leasingexecutive, “Most lessees are opting for the mostsimple, transparent structure. And that istypically a loan.”

In 2004, the industry began experiencing theimplications of Basel II. As discussed in oursidebar related to the large-ticket segment, BaselII had a profound impact on the viability oflarge-ticket leveraged leases.

Again this year, leasing executives have dis-cussed the adoption of International AccountingStandards (IAS), as a pending issue for theindustry, particularly related to defining operat-ing versus capital leases. Unlike previous years,however, lessors are discussing the issue as anear-term concern.

At issue is International Accounting Standard(IAS) 17, which narrows the definition of anoperating lease. Under IAS 17, a lease is classi-fied as a capital lease if it transfers substantiallyall the risks and rewards of ownership. Whilethis definition is very similar to the U.S. Gen-

erally Accepted Accounting Practices (GAAP),International Financial Reporting Standards(IFRS) is a principle-based rather than rule-based system. Therefore, it is the intent of thetransaction, not its form, which dictates itstreatment. As such, many transactions currentlyconsidered operating leases would, under IASrules, be treated as capital leases, recorded onthe lessee’s balance sheet as an equipment assetand financing liability. The lessee would receivetax benefits for depreciation and interestexpense, not for rental payments.

In the view of a number of industry experts,micro- and small-ticket lessors will experiencethe greatest impact from these accountingchanges. Under the IFRS rules, popular struc-tures, such as “dollar-out” deals, would become,in effect, loans, extending the lessee’s tax bene-fits over the useful life of the equipment ratherthan over the life of the lease.

The Marketplace/Competitive EnvironmentAmong the forces influencing the leasing

marketplace, The 2005 Industry Future CouncilReport emphasizes that changes in the waylessors segment themselves may have a pro-found impact on the industry. In addition,globalization is also affecting the leasingmarketplace, as is always the case, presentingboth challenges and opportunities.

The “Whale and Minnow” syndrome con-tinued to prevail as a number of last year’smega-bank mergers were completed. Theoutlook for Independent, Financial Servicesfirms appears brighter while most Captivesappear to continue focusing on their parents’products.

The MarketplaceThis year’s Industry Future Council Report

states that, “...lessors who once identifiedthemselves by the size of their primary leasetransactions will describe themselves accordingto their ownership or industry served.” In theview of many leasing executives, this transitionhas already occurred, driven primarily by theunique competitive advantages lessors enjoy by


20


virtue of their ownership structure. In the wordsof one lessor, “When we compete for a deal, wedon’t compete with a middle-ticket lessor, wecompete with a Bank that has some specificadvantages in winning that deal because it is aBank. We rarely compete with captives; becausetheir point of sale advantage means we nevereven see a deal that they want.” We agree thatsegmentation by ownership may becoming morepronounced as banks move to absorb theirleasing units into the general commercial bank,turning “leasing guys” into “bankers.”

While there has been much talk of how U.S.manufacturing is disappearing to low-wagecountries such as China and Vietnam, Depart-ment of Labor statistics show that between 1987and 2003, U.S. manufacturing output increasedby over 30 percent in real terms. However, overthat same period, U.S. manufacturing shed mil-lions of jobs. The inevitable conclusion is thatmanufacturers have increased their productivitythrough their use of technology. For the leasingindustry, this translates into continuing oppor-tunities within this sector.

In addition, continuing economic globaliza-tion offers opportunities for the leasing industryto significantly increase its total market. TheGlobalist reports manufactured exports fromdeveloping countries grew by over 11 percentannually between 1990 and 2003, comparedwith five percent annual growth over the sameperiod from developed countries5. This rapidincrease in manufactured exports from develop-ing countries indicates a growing need forcapital and equipment. As we highlight in oursidebar, our view is that with planning and duediligence, focused lessors will be successful inthese markets.

The Competitive EnvironmentThe past year may have seen Banks lose some

of their competitive advantage in light of strongernon-bank competition. At the same time, itappears that a number of Independents mayhave finally “got it right” and a number of Cap-tives have indicated an increased willingness to“push product” for their parent.

BanksFor the first time in a number of years, Banks’

share of new business volume declined. Mostleasing executives attribute this decline to theoverall decline in large-ticket volume, a segmentin which Banks traditionally were very involved.As Figure 5 shows, in 2002, large-ticket trans-actions comprised 38 percent of Bank leasingvolume, by 2004, large-ticket represented lessthan 28 percent of Bank leasing volume.

Figure 5 also shows that, over the same period,Banks began moving down into the middle-ticket space. From 2002 to 2004, middle-ticketvolume increased from 32.4 percent of Bankleasing volume to over 41 percent.

To be successful in the already crowdedmiddle-ticket space, Bank lessors must leveragethe presumed relationship advantage that theyhave with their parent’s commercial customers.Attempting to operate independently of thebank franchise will likely result in the Banklessor becoming a “me too” player, competingprimarily on price.

Overall, we have seen Bank-owned lessorscontinue to increase their focus on existingcustomers. While, initially, senior managementmay have mandated this focus, many Banklessors admit that it is easier to compete whenyou have an existing relationship with thelessee. One Bank executive we spoke with indi-cated that the percentage of his new businessvolume generated from existing customers isrunning about 10 percent ahead of where it was a year ago.

In addition to its relationship advantage withexisting customers, the Bank’s cost of funds is a key competitive advantage. Banks typicallyemploy low-cost deposits to fund their lending/leasing operations.

However, Banks also have some significantdisadvantages. In addition to increasing regula-tory scrutiny and the implications of Basel II,most Banks will usually only consider thehighest rated credits, and they are typicallyunwilling to take more than a token residualposition, often less than 10 percent. These areareas where a focused Independent can carveout a profitable niche.



Independent, Financial ServicesIn the past year, Independents appear to have

won the market share lost by Banks, as theyimproved their strategic focus. In ourconversations with small and mid-sizedIndependents, management echoed that theme.We repeatedly heard phrases such as “focused,”“targeted,” and “niche” to describe theirapproach.

The Independents’ competitive advantagetypically lies in their underwriting skills andtheir asset management capabilities. SomeIndependents cite their service and flexibility asadditional advantages.

Successful Independents that we spoke withunderstood their competitive advantages andcreated targeted approaches to exploit them.One independent business head discussed how,at the beginning of 2005, he implemented astrategy that targets several equipment types thatBanks typically avoid, aiming at credits that arejust below Banks’ comfort zone. As a result, new

business volume has improved dramatically, andpricing and spreads increased as well.

Independents of all size have been successfulin the vendor space. Operating vendor programsallows the Independent to reduce one of itsmost expensive cost components, origination.While large lessors focus on achievingeconomies of scale through nationwidevendor/dealer programs, one small Independentwe spoke with described his niche approach.His company develops relationships with smallgroups of vendor/dealers located within thesame geographic region. The lessor will create aprogram for that group of vendors with specificservice levels included in the contract. Thegeographic proximity of the dealers bothreduces costs and saves the account managertime. This lessor stated that he has experiencedstrong continual growth since founding thecompany only a few years ago.

The two disadvantages facing Independentscenter on their cost of origination and the


22


availability and cost of funding. While Bankscan generate deals from their existing customersand Captives enjoy their point-of-saleadvantage, in contrast, Independents must relyeither on internal sales officers or outsidebrokers for customers. While lessors can reduceexpenses to some degree by focusing on vendorbusiness, the high cost of origination willcontinue to put Independents at a disadvantage.

As discussed earlier, an abundance of low-costcapital exists in the market, and Independentsappear to have sufficient funding at acompetitive cost. However, many lessors easilyrecollect an entirely different situation just a fewyears ago when funding was scarce andexpensive for all but the largest Independents.Independents should begin positioningthemselves now to ensure their continued accessto funding if, and when, the excess capitalleaves the market.

One Independent that has had consistentaccess to the capital markets when others havenot stated that planning is the key to getting andkeeping access to funding. In his words, “Startfrom the first day you open your doors to buildthe track record, transparent operation, andstrong financial reporting that Wall Streetdemands, even if you never plan to go public. Itwill give you a significant advantage over otherlessors in obtaining scarce funding.”

CaptivesCaptives enjoy three nearly insurmountable

advantages over other players: their ability tobundle the equipment and financing at point-of-sale, their knowledge of the equipment forcalculating residuals, and their assetmanagement capabilities. While most Captivesconcentrate on financing only their parent’sproducts, a number of Captives have broadenedthe scope of their operations to include a varietyof manufacturers. With a few exceptions,however, those Captives financing a broader

range of manufacturers rarely venture outsidetheir industry. Many of the Captives thatattempted to become generalist equipmentlessors, such as Boeing Capital and UPS Capital,have since abandoned or limited that approach.

This year’s Survey indicates that over 43percent of new business volume was originatedthrough either a captive or a vendor program,meaning that the end user arranged financing atthe point-of-sale. In the small- and micro-ticketsegments, the percentage of equipment soldwith point-of-sale financing exceeds 70 percent.The challenge for the Captive is to fully integratethe financing with the equipment sale, creatingan environment in which it becomes secondnature for the equipment sales person toincorporate the financing into his/her quote.Captives that stand out in that regard includeDell and Caterpillar.

In this year’s Survey, as in the past, Captivesreport a much higher credit approval rate versusother lessor types, approving 89 percent ofsubmitted applications (compared with 68percent for both Banks and Independents). Inthe view of many leasing executives, Captives’equipment knowledge and asset managementcapabilities allow them to approve more margi-nal credits without significantly increasing theirrisk. As one executive noted, “If a lesseedefaults, the Captive is in the best position tograb the equipment, refurbish it, and then sell itthrough their own network. In all likelihood,they will lose little if anything from that default.”

One challenge for Captives is to balance theircredit/risk responsibilities against their missionto support and facilitate the sale of their parents’product. As a result, few, if any, Captives haveany reporting responsibility to the sales organi-zation. According to most executives, conflictsare few and those that do arise are often resolvedthrough recourse or other arrangements thatprotect the Captive’s portfolio quality.


1National Association for Business Economics: NABE Outlook, May 20052National Association for Business Economics: NABE Industry Survey, July 20053Deloitte Research: Why Katrina Won't Sink the U.S. Economy, September 20054Business Roundtable: CEO Economic Outlook Survey, September 21, 20055The Globalist, The Truth about Global Manufacturing Exports, September 6, 2005


This year’s ELA Survey includes 142 surveyresponses from 130 companies. Five companiesprovided separate surveys for their various linesof business.

Each year’s Survey asks respondents for cur-rent and prior year data; unless otherwise indi-cated data charts comparing two years’ data onlyinclude respondents providing information forboth years. Since the respondent set varies eachyear, it is not possible to compare absolute num-bers between different years’ Survey Reports.However, the Survey Administrator, Pricewater-houseCoopers, analyzed data representing anumber of years and determined that therelative data (for example, percentage of newbusiness volume generated by a specific lessortype, or percentage of new business originatedthrough a certain channel) is statistically accu-rate. Therefore, some of our analysis of theSurvey relies on relative, not absolute, data.

We have organized our analysis of this year’sSurvey into the following major components:

• The Overall Industry• Lessor Profitability• Market Segment Profitability

In addition to providing data by lessor typeand transaction size, this year’s survey providesdata by lessor size (by annual volume). In somecases, analysis by lessor size provides additionalinsight into the data’s meaning. In those cases,we incorporate lessor size into our analysis.

The Overall IndustryOverall, Survey respondents reported growth

in 2004, as new business volume increased.While pre-tax yields improved slightly, spreadscontinued to shrink due to an increase in thecost of funds. Net income increased significantlyover the previous year; however, (ROE) declinedand (ROA) remained unchanged. Credit qualityalso improved, with both delinquencies andmedian charge-offs declining over 2003.Operational efficiency improved as lessorsincreased volume without increasing staffing.

Our analysis of the overall industry focuses onthe following areas:

• New Business Origination• Profitability and Funding• Portfolio/Credit Quality• Operations


ANALYSIS OF THE SURVEY OF INDUSTRY ACTIVITY

24




New Business OriginationThis year’s respondents reported an 11.7

percent increase in new business volume over2003. As shown in Figure 6, the largest lessors,those with over $1 billion in annual volume,contributed 83 percent of total new businessvolume. These lessors reported a 13 percentincrease in volume over 2003. With the excep-tion of lessors with volume between $250 mil-lion and $1 billion, lessors of all sizes reportedsignificant growth over the previous year.

As Figure 7 shows, origination by channelchanged little from 2003. Nearly half of all new business volume is originated directly.Volume originated through captive and vendorchannels increased slightly, from 42.6 to 43.8percent. Business originated through third partiesdeclined by two percent from 9.2 to 7.2 percentof total volume.

Five end-user industries generated nearly 60percent of all new business volume. As shown in Figure 8, new business volume from the con-

struction industry increased significantly. Onlythe health-related services industry showed adecrease in leasing activity, potentially due toanticipated restrictions on the allowance of taxbenefits to lessors resulting from finance trans-actions with “tax disinterested” entities, such asnot-for-profit hospitals.

As Figure 9 shows, the five largest equipmentcategories generated over 40 percent of totalnew business volume. Of the five categories,only trucks and construction equipment showedincreases over the prior year. The remainingcategories, computers, medical equipment, andaircraft all declined. Industry leaders speculatethat, as the price of computers declines,business may prefer cash purchases rather thanfinancing.

Given recent regulatory and accounting changes,it is not surprising that the use of leveraged leaseproducts declined. As Figure 10 shows, newbusiness volume booked as leveraged leasesdeclined by nearly 55 percent from 2003. Over


26





the same period, new business volume bookedas operating leases and conditional sales/loansboth increased, likely reflecting lessors desire for transparency.

Industry Perspective and PotentialImplicationsAs the economy expands, the demand forequipment and leasing will continue toincrease. However, changes in the legal oraccounting environment as well as in othereconomic variables can dramatically changethe attractiveness of a particular industry,equipment type, or even product.

Potential Implications➮ While growth in overall volume is likelyto continue, lessors will need to react quick-ly to changes that may impact only specificmarkets, for example, a specific equipmenttype or industry. This is particularly true forsmaller lessors that, in order to effectivelycompete, have focused their efforts and built

expertise in one or two equipment categoriesor industry segments. Lacking diversity toinsulate them from market shifts, theselessors must be able to anticipate changes in their markets and react before they arenegatively impacted.

Profitability and FundingWhile net income improved in 2004, profit-

ability measured by ROE declined and ROAremained unchanged from the year before. Aver-age pre-tax yield improved slightly, but pre-taxspread declined, driven by an increase in thecost of funds. As in past years, lessors appear tohave improved net income through expensereduction and increased efficiency.

As shown in Figure 11, net income increasedby 13 percent (to 26.3 percent of total revenue)versus a 39 percent increase the previous year.However, ROE declined by eight percent from2003 to 13.3 percent and ROA remainedunchanged at 1.7 percent. The decline in

18.5% 16.1%

23.1%22.0%

26.7% 29.1%

28


returns is largely due to shrinking spreads as theindustry requires more capital versus last year togenerate the same revenue. As Figure 12 indi-cates, this year’s increase in net income resultedlargely from decreases in provisions for bad debtand reduced interest expense. That net incomeincreased at a slower rate than the previous yearmay indicate that lessors have less “fat” to cut.Lessors may become unable to increase netincome without a significant improvement inspreads.

As Figure 13 shows, average pre-tax yieldincreased by over three percent from 2003.However, the 8.1 percent increase in the cost of funds drove pre-tax spread down by less than one percent. Figure 14 shows that the twosmallest lessor groups, those with less than $50million in annual volume and those with annualvolume of $50-250 million, generated thehighest yields, but also the highest cost of funds.Although these lessors earned pre-tax spreads inexcess of five percent, their high cost structureresulted in below average net income.

Industry Perspective and PotentialImplicationsAccording to industry experts, strongcompetition, fueled by an abundance of

capital, has continued to keep pricing low,even with increasing cost of funds. As oneexecutive stated, “There is too much moneyand too few deals, the best credits canvirtually name their price.” In addition,large-ticket players, typically Banks, havemoved down market to make up for volumelost in their traditional segment. With theirlow cost of funds and the potential to earnadditional revenue through a bankingrelationship with the customer, Banks areoften willing to price deals lower thancompetitors.

Potential Implications➮ While the best credit customers can“name their own price,” companies withlower credit ratings appear willing to pay foraccess to capital. Success in serving lower-grade customers requires strong underwrit-ing skills and excellent asset managementcapabilities. While strong underwriting willreduce the likelihood of default, the lessor’sability to reclaim and quickly remarket theasset will reduce its loss if a default doesoccur. One Bank lessor known to FIC hascreated a separately managed portfolio forlower grade deals. These deals require more


intense underwriting and are monitoredmore carefully than higher-grade deals. Thisapproach has allowed the Bank to generatemore volume and increase its yields withouta significant increase in losses.

Portfolio/Credit QualityOverall, credit quality and portfolio perfor-

mance improved over the previous year. AsFigure 15 shows, delinquencies, measured asreceivables over 31-days, declined by nearly 37percent over 2003 to 1.9 percent. Receivablesover 90-days decreased by almost 38 percent, to less than one percent. However, as Figure 16shows, smaller lessors have the highest delin-quency rates. This may indicate that smallerlessors have fewer resources dedicated to collec-tions versus larger lessors. Another possibleexplanation is that smaller lessors have not beenable to invest as heavily in underwriting tech-nology (credit scoring, financial analysis pack-ages, etc.) as have larger lessors.

Average charge-offs increased over the previousyear, from 1.3 to 1.5 percent of net receivables(Figure 17). However, the median declined to .5

percent, indicating that a small number of lessorsreported significant charge-offs.

Industry Perspective and PotentialImplicationsCredit quality typically improves as theeconomy improves. However, as shown inFigure 16, smaller lessors typically exper-ience higher delinquencies and charge-offsversus larger lessors. As noted above, under-writing and collections capabilities may be atleast partial explanations. Another factorimpacting portfolio performance reflects thedegree to which smaller lessors are morelikely to be involved in the micro- andsmall-ticket segments than other players. By their nature, these segments typicallyexperience the highest delinquency anddefault rates,’ however, pricing for micro-and small-ticket transactions reflect theincreased risk.

Potential Implications➮ In the current low-margin, highly compe-titive environment, lessors can often generate

30



higher yields and greater volume by huntingfurther down the food chain in terms ofcredit quality. While a number of lessorshave developed the expertise to profitablyoperate in the sub-prime market, mostlessors should be extremely cautious indoing so, remembering that even industryleaders have fallen because of credit issues.As noted above, the requirements to succeedin the sub-prime market include very strongunderwriting experience and the capabilityto quickly reclaim assets and remarket them efficiently (meaning quickly and formarket prices).

➮ Credit quality may be “as good as it gets”both for the leasing industry and financialservices players overall. In many cases,lessors can expect higher delinquencies andcharge-offs over the next 18-24 months.This means that net income and returns willneed to rely further on interest spreads andcost efficiencies, difficult accomplishmentsfor many.

OperationsThis year’s Survey focuses on several aspects

of lessor operations, including:• Application processing• Equipment remarketing• Employee distribution• Operational efficiency

Application ProcessingThis year, 93 of the 142 respondents provided

data related to applications submitted, approved,and booked then funded or sold. Therefore, thedata in Figures 18 and 19 represents approxi-mately 60 percent of total new business volume,providing directionally correct ratio and trendinsights.

This year’s respondents approved almost 72percent of the applications submitted and over75 percent of the dollars submitted (Figures 18and 19). In general, larger lessors approved ahigher percentage of both applications anddollars submitted. While the largest lessors,those with over $1 billion in annual volume,approved nearly 73 percent of applications

32




submitted and 79 percent of dollars submitted,the smallest lessors (less than $50 million involume) approved 61 percent of applicationssubmitted and less than 50 percent of dollarssubmitted. These lower percentages reflect thatsmaller lessors are primarily involved in themicro- and small-ticket segments, where rejec-tion rates are typically much higher versus theother market segments.

Overall, the industry lost6 16 percent ofapproved applications and over 27 percent ofapproved dollars (Figures 18 and 19). Lessorswith over $1 billion in volume lost the fewestapplications, but they lost the largest dollars,indicating that large lessors lost, or were unableto complete, a significant number of large-ticket transactions.

Equipment RemarketingOverall, respondents reported that the original

lessee purchased nearly 53 percent of leasedequipment (by fair market value [FMV] leasevolume). An additional 24.7 percent was re-leased by the original lessee. As shown in Figure

20, this year’s remarketing activity closelymatched activity in 2003.7

Not surprisingly, large-ticket lessees purchasedover 90 percent of their leased equipment versus57 percent for middle-ticket lessees and 43percent for small-ticket lessees. Since large-ticketequipment typically has a long expected usefullife, lessees can continue using the equipmentfar past the lease term.

Employee DistributionDespite an 11 percent increase in volume,

this year’s respondents reported operating withvirtually the same number of employees as inthe previous year. However, as Figure 21 shows,lessors reallocated employees, partly in responseto improved economic conditions.

In 2004, respondents reported reducingcollections and workout and asset managementstaff by 1.1 percent of total full-time equivalentemployees (FTE), likely in response to improvedportfolio quality and lower delinquencies.Lessors also reduced customer service and salesstaff by 0.9 percent and 0.7 percent, respectively,


34




and increased administrative staff by 1.1 percent.Although no comparative 2003 data is availablefor respondents’ outsourcing activity, the reduc-tion in customer service staff may be the resultof increased reliance on outsourced resources.

Operational EfficiencyOverall, lessors reported improved operational

efficiency in 2004 versus 2003. As shown inFigure 22, respondents gained efficiency in mostareas except for loan and lease revenue per FTE.The apparent decrease in efficiency in this areais likely due to the margin compression exper-ienced by most players.

Two groups of lessors, those with volume lessthan $50 million and those with volume be-tween $250 million and $1 billion, reportedbeing less efficient in 2004 versus 2003. Asshown in Figure 23, both new business volumeper sales FTE and new business volume percredit approval FTE decreased for both groups.However, the reasons differ. The smallest lessors

(less than $50 million in volume) reportedincreasing headcount by nearly 28 percent in2004, far ahead of their increased volume. Thelarger lessors ($250 million to $1 billion involume) reduced headcount by seven percentversus 2003, but also experienced a 1.1 percentdecline in volume (Figure 6).

Industry Perspective and PotentialImplicationsOverall, lessors’ operational data points tosound credit decisions and improvedefficiency. However, lessors may have moredifficulty squeezing profits out of enhancedefficiency in the coming years. While mostexecutives we interviewed and our clientsbelieve they can obtain some additional costsavings from their organizations, few believethat they can continue to do so indefinitely.As we noted in last year’s Report, one way toadd new volume efficiently may be to stemthe flow of “lost” deals. As discussed earlier,


36


these lost deals represent significant dollars,and, while many of those dollars likelyremain within the leasing industry (i.e., thedeal was lost to another lessor), it is clearthat many more dollars leave the industryentirely. In our view, each lessor, as well asthe overall industry, should know wherethese lost deals went and the reason why.Another area where the industry may beable to generate operational efficiencyrequires increasing the use of technology.One service provider stated that, as anindustry, lessors spend less on technologythan nearly any other industry group. Whilemany lessors may argue that, “the capital isbetter spent funding deals rather than pur-chasing technology,” it maybe a shortsightedapproach.

Potential Implications➮ Lessors that perform honest post mortemson lost deals and then take action to improvetheir products, service, and operations should

see a rapid return on their investment.Because of the cost of origination, saving adeal often becomes more valuable thanfinding a new one. While certainly not alldeals can be saved, even saving a smallpercentage of them will have a meaningfulimpact on the bottom line

➮ The best players will continue to improveoperational efficiency and will seek outinnovative means to do so. Intelligent invest-ments in technology, with well-conceivedbusiness plans and defined ROIs, willimprove efficiency and service. While somelessors can use technology to facilitate theflow of new business, most will find thattheir most likely use of technology willinvolve streamlining operations and offeringenhanced customer service at a reducedcost. Increasingly, customers require 24/7access to their data and the ability to self-service at their convenience. Lessors that are not able to offer these basics can expect


38


their business to declineLessor Profitability

In 2004, respondents reported a significantvolume increase for Independent, FinancialServices lessors. Market share, as a percentage of new business volume also increased for Inde-pendents. Banks experienced only a moderateincrease in volume and lost market share toIndependents. Market share for Captivesremained unchanged from 2003 and newbusiness volume grew with the market. Averagepre-tax spread declined for each lessor type, acombination of declining yields and increasingcost of funds. Among the three lessor types,Banks reported the highest net income andReturn on Equity.

BanksBanks suffered from the decline in large-ticket

volume. Figure 24 shows that new businessvolume increased by just 2.8 percent, andmarket share declined from 42 percent in 2003to 38 percent in 2004.

However, Bank lessors remained very profit-able, as Figure 25 shows. Banks generatedsignificantly higher than average net income andROE. Overall, they remain the most profitablelessor type.

Banks generate over 50 percent of their volumedirectly (Figure 26). A number of large Banksare heavily involved in the vendor business,accounting for over 30 percent of total Bankvolume. In 2004, Banks reduced their relianceon third parties for volume.

This year the Banks’ cost of funds is not thelowest among competitive groups (Figure 27).Banks’ cost of funds increased from 2.7 percentin 2003 to 3.0 percent in 2004. Captives, how-ever, reported their cost of funds at just 2.8percent in 2004.

Why this change? As the bank parents beginimplementing Basel II, they have increased theinternal cost of capital charged to the variousbusiness units. Although average pricingincreased by one-tenth of one percent, pre-taxspread declined from 2003. Banks report the




18.5%

23.1%

26.7%

21.6%

6.1%

35.8%

13.3%

21.2%

15.1%

20.9%

30.5%

30.2%

40


lowest spread of the three lessor types.As in previous years, Banks rely primarily on

loan and lease revenue (Figure 28). The per-centage of total revenue generated from “otherrevenue” lags the other lessor types. Otherrevenue results from fees, typically late paymentand other “nuisance” fees. Given that Bankstypically target the highest credit grade cus-tomers, the lack of fee income should not besurprising.

As Figure 29 shows, Banks have the lowestdepreciation expense (as a percentage of totalrevenue), indicating that they are more likely tostructure deals as loans or finance leases ratherthan maintain ownership of the equipment.Sales, general, and administrative (SG&A)expense is also lower compared with the othertwo lessor types, likely the result of Banks’ability to leverage the parent franchise togenerate volume.

Again, given that Banks typically target the

highest credit grade customers, it is not surprisingthat they have the lowest delinquency andcharge-off rate (Figure 30). However, theamount of non-accruing assets Banks reportedversus the other lessor types indicates that acombination of regulatory oversight and theirinherent caution may cause Banks to be moreconservative than other lessors.

Banks’ operational efficiency, as shown inFigure 31, falls between that of Captives andIndependents. Although they outperform in NetEarning Assets per FTE and Net Income perFTE, they lag Captives in key sales areas, suchas New Business Volume per FTE.

As discussed elsewhere, Banks will continueto be active in the leasing market. Those thatrelied heavily on the large-ticket segment willrefocus their efforts, likely on the middle-ticketsegment. The most successful will continue tomine existing bank relationships and exploittheir relationship advantage. Those Banks that


*Full year loss as a percentage of full year average net lease receivables balance.Source: 2005 ELA Survey of Industry Activity


have not yet determined how to work with theircommercial bankers must make that a priority.

CaptivesCaptive lessors reported that their volume

increased by over 11 percent in 2004 (Figure24). Their share of the market remainedunchanged at 25 percent. As Figure 25 shows,Captives generated net income of 25.5 percentof total revenue, ROE of 15.6 percent, and ROAof 1.9%. Overall, Captives continued to growprofitably.

In 2004, Captives generated nearly 98 percentof their new business volume either directly toend-customers or through dealers and manu-facturer representatives (Figure 26). Volumedescribed as sourced through third parties mayrepresent deals originated by independentdealers or it may represent deals purchased forgrowth or diversity by Captives engaged in

financing equipment other than their parents.Traditionally, Captives have the highest cost

of funds of the three lessor types. However, asFigure 27 shows, this year’s respondentsreported the lowest cost of funds, 2.8 percent,unchanged from the previous year. The relativelylow cost of funds may result from the parents ofseveral large Captives funding the leasing unitfrom excess cash instead of from capital raisedin the market, essentially equivalent to a bankfunding its leasing unit from deposits. Despitetheir low cost of funds, Captives’ average pre-taxspread shrank from 4.3 percent in 2003 to 3.9percent in 2004, due to a corresponding declinein pricing.

As in past years, Captives derive most of theirrevenue from loan and lease revenue and fromother revenue, typically fees. As Figure 28shows, nearly 25 percent of Captives’ revenueresults from fees. The Survey reports that in


42


2003, fee income for Captives also representednearly 25 percent of total revenue. While sometypes of fee revenue are tied to volume (e.g.,application fees), other fees are less predictable(e.g., late fees). Lessors generating a significantamount of revenue from fees should understandthe origin of the fee revenue and whether it islikely to continue.

Captives typically generate less of theirrevenue (as a percentage of total revenue) fromexcess residuals versus other lessor types. Thispoints to the Captives’ expertise in theirequipment area and to the continued stability oftheir earnings and profits. By being sufficientlyfamiliar with the equipment, Captives are ableto accurately estimate residual values at end-of-lease. As a result, Captives revenue stream isbased largely on stable lease payments and isnot dependent on excess residuals, which can be negatively impacted by multiple factors.

As shown in Figure 29, Captives reported thehighest depreciation expense (as a percentage oftotal revenue) of the three lessor types, indica-ting that they are much more likely to retainownership of the equipment. One area of poten-tial concern may be the Captives’ provision forbad debt. Despite full-year charge offs of 3.2percent (Figure 30) and delinquencies topping 3 percent (both the highest of the three lessortypes), Captives’ provision for bad debt totaled2.4 percent of revenue, the lowest provision ofthe three lessor types. This may result in someCaptives reporting unexpected charges for creditlosses in upcoming financial statements.

On a per FTE basis, Captives generated morenew business volume and more loan and leaserevenue versus the other two lessor types(Figure 31). However, on average, Captivesappear to operate with more FTEs than bothBanks and Independents. This year’s Surveyreports that Captives operate with an average of 188 FTEs, versus 163 for Banks and 178 forIndependents. The Survey also reports thatCaptives deploy the fewest sales/originationFTEs, just 17.4 percent of all FTEs. At Banklessors, 22.6 percent of FTEs are engaged insales/origination and at Independents, 32 per-

cent of FTEs are sales related. Those Captivesthat have integrated the finance process with the equipment sales process have been able tosignificantly reduce their origination cost. Whileit is not obvious from Captives’ sales, general,and administrative expenses, some Captiveparents may allocate some of the costs of theequipment sale back to the leasing unit, reflect-ing the lessor’s integration with the equipmentsales channel.

Captives’ point-of-sale advantage and equip-ment knowledge make them strong competitors.They will continue to work to integrate them-selves into the sales process and the best will bein a position to capture virtually all the financ-ing needs of their parents’ customers.

Independent, Financial ServicesNew business volume grew sharply for Inde-

pendents, creating an increase in market share.However, both net income and ROE lagged theother lessor types. Executives of Independentlessors indicated that 2004 remained a year oftransition for their businesses. Several discussedsome fundamental strategic changes that theyimplemented in either late 2004 or early 2005.In our view, if they are able to execute on theirplans, these Independents will show very strongresults in next year’s Survey.

In 2004, Independents’ new business volumeincreased 23.5 percent (Figure 24). However,even with this volume increase, Independentsreported ROE of just 9.3 percent, far below theaverage (Figure 25). Net income was also belowaverage, 24.2 percent of total revenue versus30.0 percent for Banks and 25.5 percent forCaptives.

In general, Independents directly originateover 70 percent of new business volume. Asshown in Figure 26, they generate an additional26 percent of their new business through vendorand captive programs. The captive programvolume shown, approximately 10 percent ofIndependent’s total volume, likely represents theactivities of two firms: one that finances equip-ment produced by its parent and one thatoperates a captive business through a joint-



venture with a manufacturer.As shown in Figure 27, Independents operate

with the highest pricing, the highest cost offunds, and the highest pre-tax spread. Margincompression between 2003 and 2004 resultedthrough a combination of increased cost offunds (300bp increase), and a decline in pricing(200 bps decline). The Independents’ highpricing results from their willingness to dobusiness with lower credit grade customers.Moreover, as shown in Figure 30, they appear to be doing an adequate job managing the risk.

There are two items to note related to Inde-pendents’ expense components (Figure 29).First, sales, general, and administrative expenseis typically significantly higher versus otherlessor types. While the other lessor types have aready supply of “captive” customers (Banks havethe existing banking customers and Captiveshave the equipment purchaser), Independentsmust originate each customer through its exter-nal sales force. Independents have struggled tofind an alternative origination model, such asoperating vendor programs.

The second item to note involves the interestexpense reported by Independents. As Figure 29shows, Independents report interest expense ofover 30 percent of revenue. Analysis of Indepen-dents’ balance sheets, however, shows that two-thirds of reported debt is classified as inter-company loans. That would indicate that approx-imately two-thirds of the reported interest expensemay be transfer payments to a parent or affiliate.

Because of their need for a strong salesorganization, Independents will remain lessefficient, on an FTE level, than both Banks andCaptives. However, from our discussion withindustry executives, two trends have emerged.Independents are increasingly operating vendorprograms, an occurrence we discussed as aprobability last year. We have seen severalinstances in which Independent lessors havegained traction operating vendor programs.While there is certainly a need for a sales organ-ization to successfully find and maintain vendordeals, the sales role becomes more relationship-focused and less transaction-focused. And, one

vendor relationship, managed by one accountexecutive, can yield hundreds or thousands oftransactions annually.

The second trend that emerged is an increasingfocus on identifying a niche and developingexpertise in that niche market. A number ofIndependent lessors discussed their ability to set rather than accept pricing and noted thatboth their volume and margins have increasednotably.

These trends will continue and others willemerge as smaller Independents innovate newways to compete in the industry. We believe thatthese innovations are less likely to be product-related. This is a mature and increasinglyregulated industry; success is more likely toresult from execution or specialization ratherthan significant innovations.

Market Segment Profitability This year’s analysis of the leasing industry by

market segment assesses each segment to iden-tify some of its key characteristics and uncoverdrivers of profitability. Lessor type remains thedominant driver of profitability in the industry.As discussed in previous sections, factors suchas cost of funds, access to customers, and opera-tional efficiencies are inherently related to lessortype and little influenced by transaction size. Inthis section, we focus on the components ofprofitability and assess the skills required forsuccess within each segment.

The defining characteristics of each trans-action size can be indicative of the necessarycompetencies required to play in that segment.They include:

➮ Micro-Ticket - Among the characteristicsdefining this segment are: vendor/captiveorigination, high pricing/spread, and highdelinquencies and charge-offs. Requirementsfor success include low-cost origination,highly automated processes, sophisticatedportfolio management, and superior assetmanagement skills.➮ Small-Ticket - As with the micro-ticketsegment, key definers include:vendor/captive origination, high spreads,


44


and high delinquencies and charge-offs.Keys to success in this segment are verysimilar to those of the micro-ticket segment:low-cost origination, highly automatedprocesses, sophisticated portfoliomanagement, and superior assetmanagement skills.➮ Middle-Ticket - Narrow spreads andheavy competition define this transactionsegment. As large-ticket players move downinto this space, competition and pricingpressure will increase. While operationalefficiencies such as low-cost origination, low cost of funds, and tight cost controls are critical in this segment, the key tosuccess or even survival involves strategicdifferentiation. Players must find ways todifferentiate themselves from the compe-tition and deliver some unique value thatthe customer is willing to pay for.➮ Large-Ticket - As we have discussed

elsewhere, the rules for this segment havefundamentally changed for, in some lessors’view, at least the next ten years. Keys tosuccess will likely no longer be sophisticatedstructuring capabilities and cross-borderexpertise. Keys to success will be access tocustomers, access to funding, and equip-ment expertise.

Micro-TicketThe micro-ticket segment experienced a sharp

increase in volume from 2003, albeit from a lowbase. As expected, this segment generates higheryields and spreads than the other market seg-ments; it also has the highest cost of funds.However, micro-ticket yields declined from theprevious year, compressing spreads. Yet, despiteits high charge-off rate, this segment producedthe most attractive returns for its investors.However, the characteristics of the type of lessorthat is active in this market drives profitability,


20032004

46


rather than the attributes of the market segment.As Figure 32 shows, micro-ticket volume

grew over 23 percent to $6.3 billion. However,despite its strong growth, micro-ticket volumerepresents only six percent of total new businessvolume. According to the Survey, the micro-ticket segment generates over 91 percent of itsvolume from personal computer, servers, andrelated hardware. The segment derives anadditional five percent of its volume from officeequipment. This concentration in the computersector mirrors last year’s data. However, theprimary type of lessor involved is this segmentmitigates this concentration risk to some degree.

As shown in Figure 33, captive programsgenerate nearly 92 percent of micro-ticketvolume, a strong indication that Captives are the primary lessor type involved in the market.As we discussed earlier, Captives’ equipmentknowledge and asset management capabilitiescan help mitigate default risk. Concentrationrisk becomes largely a moot issue, particularly if the Captive’s parent manufactures primarilyone product, in this case, computers.

Figure 34 shows that the micro-segment

commanded higher than average pricing, butthat competitive pressures reduced its averageyield by 80 bps versus 2003. Surprisingly,respondents in this segment reported a slightdecrease (10 bps) in average cost of fund,although at 5.8 percent, it remained the highestof all market segments. As a result of the declinein average yield, the segment’s average spreadalso declined, offset only marginally by thereduction in cost of funds.

Typically, Captives operate with the lowestsales and origination expense of any lessor type.As discussed earlier, they employ, on average,the smallest sales force of the three lessor types.However, as Figure 36 indicates, SG&A expensefor the micro-ticket segment, one that stronglyappears to be dominated by captives, is higherthan for any other segment. Possible explana-tions include respondents allocating costs forequipment sales (assuming that equipment salesand financing are bundled) or respondentsallocating the cost of establishing and runningthe captive program through a third party.

Further analysis of the segment’s expensesreveal that depreciation expense is very low, just



over one percent, indicating that most of thissegment’s volume involves loans and/or financeleases. Provision for bad debt is significantlyhigher than for other market segments, reflec-ting the risk associated with this segment.Figure 36 shows that both the charge-off andthe delinquency rate are significantly higherthan for other segments.

Given the nature of micro-ticket transactions(high volume and low value), it is too expensivefor lessors to underwrite each transactionmanually. Most micro- and small-ticket trans-actions are credit scored and some are auto-decisioned. Therefore, the underwriting is onlyas good as the scoring tool; however, during the recent economic downturn, most banksscored portfolios outperformed theirunderwritten ones.

In order to mitigate risk, micro-ticket lessorsmust possess sophisticated asset managementskills and superior asset management capabilities.They must be able to detect a problem early,

reclaim the equipment, and then dispose of itquickly and efficiently.

Small-TicketAs in previous years, this year’s Survey includes

a separate analysis of the small-ticket segment.As shown in Figure 37, over 70 percent ofSurvey respondents are active in the small-ticketsegment. Banks show the least involvement inthe segment, with just 65 percent of Bank res-pondents reporting activity. Ninety percent ofCaptives report being active in small-ticket as donearly 72 percent of Independents. A number ofBank respondents outsource small-ticket dealsto third parties. They are primarily middle-ticketplayers, understand the fundamental differencein approach required for small-ticket, and havechosen to concentrate in their area of expertise.

As we noted earlier, the small- and micro-ticket segments share many of the samecharacteristics. As Figure 33 shows, a higherpercentage of small-ticket transactions are


*Full year loss as a percentage of full year average net lease receivables balance.Source: 2005 ELA Survey of Industry Activity

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originated directly; however, captive and vendorprograms remain the primary channels. Pricingdeclined slightly for the small-ticket segment(Figure 34) and, as a result of decreased yieldsand increased cost of funds, average spreads also declined.

Small-ticket lessors retain ownership of moreequipment than do micro-ticket lessors, as indi-cated by the depreciation expense shown inFigure 35. In addition, both credit quality andportfolio performance are significantly better for small-ticket versus micro-ticket. Provisionfor bad debt (Figure 35) is significantly lower asare charge-offs and delinquencies (Figure 36).

As shown in Figure 38, the percentage ofsmall-ticket lessors that used some type of creditscoring in their underwriting process remainedrelatively unchanged between 2003 and 2004.From our perspective and client experience, it is difficult to understand how the nearly 45percent of small-ticket lessors not using creditscoring remain profitable. In a segment that isdefined by its high volume of low value trans-actions, reducing the cost to process each trans-

action is one of the keys to survival.Figure 38 also shows that almost 42 percent

of small-ticket lessors use auto-decisioning tools,a significant increase over the previous year.However, when we analyze the underwritingmethods for small-ticket transactions, onlyabout 25 percent of small business volume isauto-decisioned, a slight increase over the pre-vious year. What is most surprising is that thepercentage of small-ticket volume that ismanually underwritten increased by nearly sixpercent over 2003. Survey respondents reportthat they manually underwrite almost 40percent of small-ticket volume. Figure 39 showsthat Independents, almost certainly very smallIndependents, are the most likely to manuallyunderwrite small-ticket transactions. While thecost of purchasing and implementing credit-scoring tools may seem prohibitive for smallplayers, it is, in our view, a required cost toparticipate in this segment.

Middle-TicketMiddle-ticket transactions represent 62 per-


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cent of total new business volume. As Figure 32shows, this segment grew by nearly 13 percentover the previous year to $65.1 billion. Asdiscussed elsewhere in this Report, lessors inthis segment, though it is by far the largest, facea number of challenges resulting from changesin the market and in the competitive landscape.The sidebar, The Middle-Ticket Squeeze, looksat some of the challenges facing lessors in thisspace and some potential opportunities.

Over 63 percent of middle-ticket transactionsare originated directly (Figure 33) and an addi-tional 29 percent are generated through captiveor vendor channels. Middle-ticket respondentsreport generating nearly eight percent of theirnew business volume through third parties,through either brokers or syndication deals.

While many executives discussed the pricingand margin pressures on the middle-ticket seg-ment, Survey respondents reported the segment’spricing increased, average yields improved 20bps over 2003, the only segment reporting an

increase in yield (Figure 34). However, a 40 bpsincrease in the cost of funds caused spreads toshrink by 20 bps. Overall, in terms of yields andspreads, the middle-ticket outperformed theother market segments.

As shown in Figure 35, the middle-ticket seg-ment has a relatively high cost structure. How-ever, analysis of middle-ticket lessors’ balancesheet shows that 75 percent of lessors’ interest-bearing debt involves inter-company borrow-ings. It is likely, therefore, that transfer paymentsto a parent or affiliate comprise most of themiddle-ticket’s reported interest expense.

The delinquency rate for the middle-ticketwas 1.4 percent (Figure 36), with less than onepercent over 91 days. Charge-offs for the seg-ment were also less than one percent.

As we discuss in detail in the middle-ticketrelated sidebar, there are significant opportunitiesin the middle-ticket for lessors that are able toestablish niches, develop targeted expertise, andhunt off the beaten track.



Large-TicketThe large-ticket segment has undergone some

fundamental changes over the past two years.The sidebar titled, “How Can Large-TicketLessors Adapt to the New Environment” exploresthe factors responsible for those changes, howplayers should react, and what, if any, oppor-tunities remain in the large-ticket segment.

As Figure 32 shows, large-ticket volumedeclined sharply from $4.6 billion in 2003 to$3.8 billion in 2004. Over 75 percent of newbusiness volume was originated directly (Figure33). Third parties generated the remaining 25percent, from either brokers or syndication.Neither captives nor vendor programs generatedlarge-ticket volume.

The large-ticket segment suffered the mostfrom spread compression. As Figure 34 shows,

average yields for the segment declined by 140bps while funding costs increased by 20bps.The net impact on average spreads was a 160bps decline.

Due to the large-ticket segment’s relatively low cost structure (Figure 35) and the sterlingquality of its portfolio (Figure 36), the large-ticket segment generated admirable returns,despite its problems. As shown in Figure 40,both net income and ROE outperformed theaverage, coming in second only to micro-ticket.

As we discussed, there will remain a demandfor large-ticket equipment and a need forfinancing. Players that will remain successful in this market segment will be banks that caneffectively mine their parents’ customer base touncover opportunities and large independentsthat will continue to leverage their relationshipswith the airline industry and other large-ticket


6We define lost deals as the difference between applications approved and applications booked and funded or sold72003 data comes from the 2004 SIA and represents a different respondent set

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Going Global 101This year, a number of interviewees discussed the need to expand outside the U.S. and

follow the global economy. One expert stated, “Within the next five years, lessors will have tobegin developing international capabilities.”

Developing international capabilities does not necessarily mean establishing a brick andmortar presence in a foreign country. The following case examples demonstrate that lessorscan expand globally while limiting both their risk and investment.

Case Example: Generating International Business Without an Overseas PresenceOne small, bank-owned player has built international volume with no offshore presence.

In order to generate higher yields in its aircraft finance unit, this lessor began to financebusiness and personal use aircraft for non-U.S. individuals and companies. Throughrelationships with manufacturers, they have successfully completed deals in Mexico, Centraland South America, Canada, the E.U., and other countries.

According to this lessor, beyond country risk (including the legal and regulatoryenvironment), attributes that contribute to an attractive offshore deal include the individualor company's ties to the U.S. and the amount of down payment. They look for deals inwhich the borrower either has assets or business operations in the U.S. and in which theborrower has substantial equity in the aircraft. In the words of one executive, “Most wealthyindividuals, particularly in Latin America and the Middle East, have sizable assets in the U.S.We make sure that we have a claim on those assets, as well as the aircraft.”

When doing offshore deals, this player makes it a practice to use in-country attorneys toprepare and review financing documents, security agreements, etc. Their in-house counselworks with the foreign attorney to ensure the lessor is protected. They also require clients touse a specific international aviation services company to maintain the financed aircraft.Therefore, they know that the aircraft is being properly maintained (the bank receives reportsfrom the aviation company) and the aviation services company will, with virtually amoment's notice, fly the plane out of country, either to the U.S. or a safe harbor country.Although the bank has never had a delinquency with its overseas accounts, it regards thisservice as necessary method to protect its assets.

By leveraging manufacturer relationships and selectively choosing deals, this player hasdeveloped a substantial, higher yielding, international business, without any investment in anoffshore presence.

Case Example: Minimizing the Investment in Overseas InfrastructureOne Captive lessor needed to expand overseas to support its parent's operations. While its

parent does business in virtually every country in the world, this lessor wanted to expandslowly and limit its infrastructure investment. Following a model it employs domestically, itco-located sales officers with its parent's sales representatives. The company contracts withlocal financial services companies to provide back-office support on a fee-per-transactionbasis.

As one senior manager stated, “We are here to support our parent's business and help tosell product. Transaction processing, billing, and collections are not our expertise, and we donot want to invest in building those capabilities.”



However, since this lessor keeps the asset, it has had some difficulty finding banks willingto participate as a servicing agent only. “Most banks are trying to grow their assets and wantus to source deals that they can fund and put on their books. But, that means that ourcustomers are subject to the bank's underwriting standards. There are many times when wewant to do a deal for strategic reasons that would never pass a bank's credit requirements.So, we feel we are better off funding and holding our own deals.”

To support its business, they often use both banks and commercial finance companies toprovide back-office support. As the company expands overseas, it contracts back-officesupport on a regional basis rather than for each individual country in which it does business.In this lessor's view, this model allows it to expand overseas to meet its parent's requirementswithout making a significant investment in “non-core” operations.

Industry ImplicationsImplications for the industry include:

• Given the highly competitive nature of the equipment finance market today, lessors trying to grow volume and increase margins, should consider selected offshore opportunities

• Best practices players are finding ways to do business overseas while limiting both their risk and their need for significant investment, including:

• Sourcing business through relationships with domestic manufacturers that sell their equipment to overseas customers

• “Following their customers overseas” by developing relationships with foreign subsidiaries of existing customers

• Establishing an overseas sales presence and contracting local infrastructure

• Leveraging the Import Export Bank to mitigate credit risk

Concluding ThoughtsIn the U.S., business investment in equipment, the key determinant to the size of the

leasing market, is expected to grow by less than seven percent annually through 2006. Manylessors have growth goals that are significantly higher than the growth rate of the totalindustry. As one lessor stated, “No lessor ever said they planned negative or even zerogrowth. In fact, planning growth at anything less than double-digits will likely get him fired.”In order to meet growth and profitability goals, lessors may have to look overseas. The bestplayers are already beginning to do so.


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The Middle-Ticket Squeeze

The decline in the large-ticket segment has forced many large-ticket players (typicallybanks) looking for volume growth into the middle-ticket arena. At the other end of the sizespectrum, small-ticket players are gradually redefining small-ticket upwards to include largercompanies. While the ELA defines the upper range of small-ticket at $250,000, many small-ticket lessors consider $500,000 to be a small-ticket transaction.

Typically, middle-ticket executives are unconcerned about small-ticket players enteringtheir market. However, they express concerned about the impact of large-ticket playersmoving into the middle-ticket space. As one lessor stated, “It has already happened, they arealready here and have been for over a year. The trouble is that some of them are so hungryfor deals, and have so much capital to deploy, they are offering prices below anything I caneven consider looking at.”

As we discussed in our analysis of the middle-ticket segment, yields increased in 2004 (SeeFigure 36), although an increase in the cost of funds caused a 20bps decline in spreads.However, competition has intensified further throughout 2005. Many middle-ticketexecutives agree that competing on price is likely to be self-destructive, but they feel limitedin their competitive options. Unless they compete on price, some believe that they will besqueezed out of the market completely.

Lessors must develop a value proposition that differentiates them in the market. Some ofthe more innovative lessors have developed expertise in one or more of several areas,including:

• Equipment category: Some lessors have differentiated themselves through equipmentexpertise, particularly in the technology field. Since many of the price competitors enteringthe middle-ticket segment are banks, successful players need to focus on equipmentcategories that banks typically avoid, such as trucks and trailers or gaming equipment.

In addition to hiring experienced sales people, other tactics to build equipment expertiseinclude developing underwriting skills and asset management capabilities that support theequipment focus.

• Industry segment: Building an industry expertise allows a company to provide insights toits customers and build a marketing advantage by becoming known to the key buyers withina segment.

One of our clients has created a niche in the “environmental industry” (trash haulers).They regularly attend industry events, advertise in industry publications, and participate inevents important to the industry. As a result, this client is a first choice when a trash haulerneeds a new truck, and they are able to command pricing 25-50bps over the competition.This client entered this market by hiring a salesperson known to the industry. He broughtclients with him and convinced other salespeople to join the team.

• Credit grade: A number of lessors have created a niche focusing on customers of a riskgrade with which some banks are uncomfortable. For example, one company focuses onstart-ups funded with venture capital. They view these customers as ideal because the



companies are less price sensitive and are leasing mission-critical equipment. As oneexecutive noted, “They would sooner go hungry than miss a payment and risk having us takethe equipment back.” (This lessor retains ownership of nearly all of its equipment.) In fact, in the past five years the executive could only remember one time a customer was late, bytwo days.

This lessor views asset management capability as the primary skill required for focusing onlower grade credits. As the executive noted, “Our underwriting typically consists of creditchecks on the principals, otherwise, what else is there to underwrite? Besides, those venturefirms are going to do a far more thorough job vetting this company than we ever could. Allwe need to be able to do is go in, get our equipment, and turn around and sell it withoutlosing money.”

Another lessor targets mid-size, non-investment grade customers. These companies aretypically not of interest to banks, and they expect to pay higher rates for capital. In addition,this lessor limits its focus to two or three types of equipment. This allows them to leveragetheir underwriting expertise as well as their asset management capabilities.

Strong underwriting skills are most critical to this lessor. “We check everything,' the lessorstated, 'we look at their suppliers, their customers, their competitors. We are very thorough,and it has paid off.”

The second way this company mitigates its risk is through its asset management expertise.By focusing on a limited set of assets, the company believes that it is able to determine theequipment's value curve when it structures a deal, ensuring it is never “under water” duringthe life of the transaction. It also relies on its ability to remarket the equipment and recoup itsinvestment in the event of default.

Concluding ThoughtsIn the competitive environment of the middle-ticket segment, lessors must differentiate

themselves either by exploiting existing internal capabilities or by buying/building expertiseto satisfy a need in the market. Lessors that do not differentiate themselves and try tocompete on the cost of money will find it increasingly difficult to generate profitable growthin this segment.


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How Can Large Ticket Lessors Adapt to the New Environment?

In recent years, large-ticket transactions have suffered a dramatic decline. In 2002, thelarge-ticket segment generated 37 percent of new business volume. This year's Survey ofIndustry Activity reports that the large-ticket segment generated just four percent of newbusiness volume. In just two years, large-ticket's contribution to new business volumedeclined from 37 to four percent, a drop of more than 89 percent.

What happened to large-ticket leasing? How can lessors adapt to the new environment?

Background Aside from the continued weakness in a number of key large-ticket equipment segments,

such as commercial aircraft and marine equipment, we trace the disappearance of large-ticketvolume to two events: Enron and Basel II.

Some industry observers have commented that until the collapse of Enron no one inCongress had even heard of a “Special Purpose Entity.” However, in its aftermath, asrevelations about how these structures had been used to “cook the books,” a series ofaccounting and regulatory reforms were enacted to ensure that these entities could neveragain be used fraudulently.

In fact, it was not so much the regulatory or accounting restrictions that slowed the use ofthese vehicles in legitimate lease structures. Rather, it was management concern aboutperception and the reticence of lessees to use them. As one leasing executive said,“Customers turn white as a ghost if you even say the words 'Special Purpose Entity,' theystart edging toward the door in fear.”

Another event impacting the large-ticket segment occurred when Senator Chuck Grassley(IA), Chair of the Senate Finance Committee, decided that it was time to reign in “all theabuses in the leasing industry.” He was referring to transactions in which U.S. lessors receivetax benefits from assets bought from and re-leased to a foreign tax-exempt entity andtransactions in which a U.S. lessor receive tax benefits from assets bought from and re-leasedto a U.S. tax-exempt entity. He stated that lessors should not receive tax deductions forshipping American money overseas nor receive tax benefits from transactions with tax-disinterested parties.

Grassley included provisions into the American Jobs Creation Act of 2004 that would closethose “loopholes” retroactively. A significant piece of large-ticket volume ceased.

While the 2004 tax legislation was mainly aimed at so-called “SILO” transactions, recentFASB rulings regarding how lessors report the tax benefits resulting from any leveragedtransaction will likely further limit volume for these type of leases.

The impact of Basel II may be even more long lasting. As one bank-owned large-ticketlessor stated, “Basel II really killed my business.” He went on to explain that Basel II requiresthe inclusion of three elements when calculating the amount of risk-adjusted capital the bankmust hold: the lessee's credit rating, the probability the lessee will default, and the loss givendefault.

Loss given default, the element that Basel II adds to the equation, requires the lessor todetermine the value of the underlying asset and, therefore, the actual loss the lessor would



suffer in the event the lessee defaults. “However', as the executive noted, 'large-ticket lesseestend to be Fortune 500 companies that strongly influence the value of the revenue-producing asset. Therefore, if that lessee fails, chances are very good that the underlying assetwill be worth little. For example, if a major railroad were to fail and liquidate, the value oflocomotives and railcars would plunge. That means that, because these are leveraged dealsand the debt-holder is paid first, our loss given default would likely be total. The inclusion ofloss given default reduces a deal's Risk Adjusted Return on Capital from 18 percent (pre-Basel II) to 6-7 percent, well below our required internal rate of return.”

The combined impact of Enron and Basel II has resulted in new business volume droppingto zero for some large ticket lessors. These players have to pursue new business models inorder to survive.

Success in the Large-Ticket Space: A Case ExampleOne Bank lessor continues to do well in the large-ticket space by emphasizing “out of

favor” industries and individual companies Although never involved in the leveraged lease or cross-border markets, it has still felt

some impact from their demise as lessors focus on recovering volume. One executivecommented, “We are seeing those Banks that lost their cross-border volume scrambling forvolume. There is a lot of capital chasing too few deals and, particularly in investment gradedeals, it is pushing pricing through the floor…”

“There are a number of ways to react to the kind of margin compression we are seeingtoday. Lessors can try to generate enough additional volume to stay ahead or they can holdthe line on pricing and give up some volume. They can also be creative about generating feesto boost the return on deals, for example, through syndication.”

This player's strategy in this segment centers on holding the line on pricing, adding newvolume when appropriate, and adding fee income when it can.

It maintains its pricing largely because of its strategy of focusing on B or BB non-investment grade credits: “We focus on large companies with good long-term prospects thatmay have stubbed their toe along the way. These companies may have three or four years oflosses and may be in an industry that is in the downside of its cycle. They are companiesthat banks are typically not going to look at.”

One executive explained further, “There are two ways to make money in this industry,either from credit risk or equipment risk. We make money from well-mitigated credit risk.”The company mitigates its risk through strong and thorough underwriting as well as throughstructuring.

“Every deal we do has a 20-30 page credit write-up. We look at the company's current andpast performance, its dependence on raw materials, the price fluctuation of its products, etc.Our analysis includes, for example, how much the price of plastic resin must increase beforethe company's products are no longer generating the cash flow required to service its debt.”

Executives explained that part of their underwriting process includes an analysis of howthe equipment will be used and how critical it will be in the lessee's business. “For example,we look at whether the equipment will be used to produce gas-guzzling SUVs, which maynot sell well with gasoline priced at $3 per gallon, or to produce hybrid vehicles for whichthere is a nine-month waiting list of buys.” He went on to say, “We want to financeequipment that the borrower will affirm in a bankruptcy procedure.”

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Deal structuring is also important: “We use the standard structuring tool, down payments,letters of credit, guaranties, etc. But, we make sure that structure fits both the type andintended use of the equipment as well as the risk profile of the company.”

While it does generate some business from internal referrals from its private banking unitand its corporate and investment banking group, this lessor largely relies on its outside salesforce to originate new business volume. Management cited a number of reasons why it doesnot rely more heavily on referrals from its parent's other business units. “Although we maybe doing $50 or $100 million deals, that is largely below the radar of the investment bank.Another issue is that the corporate and investment bank's clients are typically investmentgrade companies with plenty of access to capital. They are not our target market; we couldnever get the pricing from them that we need.”

Implications for the IndustryImplications for the leasing industry from the regulatory, legislative, and accounting

changes impacting the large-ticket segment include:• Given the current environment, large-ticket leasing may never return to “the way it was”• Many large-ticket players have already moved down market and will increase the

intensity of their focus in the middle-ticket arena• With limited exceptions, large-ticket volume will be comprised primarily of single-

investor, structured transactions• Going forward, competitive advantages in this segment include:

• Origination ability/access to customers• Strong underwriting and structuring capabilities• Equipment expertise

• Other potential competitive advantages may include a captive relationship (Boeing Capital) or a close relationship with a manufacturer (GE Capital/GECAS)

ConclusionWhile certain large-ticket activity has been limited by legislative or accounting changes,

there remains a need for capital to finance large ticket deals. Success in this segment requiresplayers to:

• Determine their market focus - The Bank lessor profiled above focuses its efforts in aspecific market niche. While most Banks may not have the appetite to work with non-investment grade credits, they may decide to focus on a specific industry sector orequipment type.

• Create a value proposition - Given the liquidity in the market and the number ofcompetitors, players that are chasing investment-grade deals must be able to offer thecustomer value beyond just capital. For example, First Union Rail (a subsidiary of Wachovia)built an expertise in railcars and locomotives, creating a value proposition that includes notonly equipment financing, but also a wide range of fleet management services

• Execute, execute, execute - One of the reasons that the lessor in the above case examplehas been successful in its market segment is its ability to execute well against the mostcritical pillar of its strategy - underwriting. As one executive stated, “If a company cannotexecute on the credit side in this market, they will quickly disappear.”



CONCLUDING THOUGHTS

The leasing industry has undergonesignificant changes over the past two years,including shifts in the competitive environment,fundamental changes to a major marketsegment, an increasingly vigilant regulatoryenvironment, and wholesale changes to the leaseaccounting structure, among other changes.

However, the leasing executives we spokewith were, with few exceptions, uniformlypositive about the future of both the industryand their companies. They talked about theirplans to meet the industry's challenges throughan understanding of their own company'scompetitive advantages and a strategic plan toexploit those advantages.

There is a best selling book by Spencer

Johnson titled, “Who Moved My Cheese?” In thestory, four mice live in a maze and feast daily on a large mound of cheese that appeared seem-ingly from nowhere. One day, the mound ofcheese disappears. Two of the mice return everyday to the place where the cheese used to be,expecting, that, somehow, it would reappear.The other two mice spent their days searchingthe maze for another source of cheese. In theend, the two mice that went in search ofdifferent cheese found it and prospered. Themice that stood waiting for “their” cheese tocome back met an early demise.

When the market changes, those that changewith it will survive and prosper, those that waitfor it to come back the way it was, will not.

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About Financial Institutions Consulting, Inc.Financial Institutions Consulting, Inc. (FIC) focuses on providing advice and counsel on issues

related to growth and profitability for financial services clients. We emphasize practical, bottom-lineresults based on quantitative and qualitative research and an in-depth understanding of industrydynamics.

In addition to completing earlier projects for the ELA and The Foundation, our work in leasinghas included process streamlining, segmentation strategy, and new business acquisition. Ouractivities include conducting formal engagements, leading brainstorming sessions, and providingongoing retainer counseling to clients.

Please visit our website at: www.ficinc.com for more information about our consulting andadvisory services.

For additional information about research presented in this report, or to discuss how FICconsulting capabilities, please contact:

Charles B. [email protected]

Or

Matthew L. HarveySenior Engagement [email protected]

324 Silver Spring Road • Ridgefield, CT 06877



EQUIPMENT LEASING AND FINANCE FOUNDATION2005 BOARD OF TRUSTEES

ChairmanJoseph C. Lane, GE Commercial Equipment Financing

Vice ChairmanMichael A. Leichtling, Esq., Troutman Sanders Llp

TreasurerEllen Alemany, CitiCapital

SecretaryEdward A. Groobert, Dykema & Gossett PLLC

PresidentMichael Fleming, ELA

Executive DirectorLisa A. Levine, CAE, Equipment Leasing and Finance Foundation

John H. Beville, SunTrust Leasing Corporation

Rodney W. Darensbourg, UPS Capital Corporation

Daniel Dyer, Marlin Leasing Corp.

Paul W. Frechette, Key Equipment Finance

Henry Frommer, Wells Fargo Equipment Finance, Inc.

Larry Hartmann, Z Resource Group

James M. Johnson, Ph.D., Northern Illinois University

Deborah J. Monosson, Boston Financial & Equity Corporation

Robert P. Rinek, Piper, Jaffray z& Co.

James. S. Schallheim, Ph.D., University of Utah

Michael Sheehan, Main Street National Bank

David S. Wiener, Ge Commercial Finance - Capital Markets Group

Edward S. Yocum, CIT

Robert Young, Moody’s Investor Services

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4301 N. Fairfax Drive, Suite 550Arlington, VA 22203-1627

Phone: 703-527-8655Fax:703-465-7488

www.leasefoundation.org

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