LEVERAGED LEASING
By Richard Contino
[Richard M. Contino, author of several books on equipment leasing, is an internationally reputed expert on leasing. Richard Contino is the managing partner of Contino & Partners, a practising attorney firm based in New York. Click here to read a detailed profile of Contino. Click here to visit the web site of Contino & Partners.]
What Is the Concept of Leveraged Leasing?
The leveraged lease can be one of the most complex and sophisticated vehicles for financing capital equipment in today’s financial marketplace. The individuals and firms in the leveraged leasing industry are aggressive and creative. As a result, the environment is one of innovation and intense competition.
Is the concept of a leveraged lease complex? Not really. It is simply a lease transaction in which the lessor puts in only a portion, usually 20% to 40%, of the funds necessary to buy the equipment and a third-party lender supplies the remainder. Because the benefits available to the lessor are generally based on the entire equipment cost, the lessor’s investment is said to be “leveraged” with third-party debt. Generally, the third-party loan is on a nonrecourse-to-the-lessor basis and ranges from 60% to 80% of the equipment’s cost. The nonrecourse nature means the lender can only look to the lessee, the stream of rental payments that have been assigned to it, and the equipment for repayment. The lessor has no repayment responsibility even if the lessee defaults and the loan becomes uncollectible.
The fact that a nonrecourse lender cannot look to the lessor for the loan repayment if there is a problem is not as bad as it seems for two reasons:
1. The lender will not make a nonrecourse loan unless the lessee is considered creditworthy, and,
2. The lender’s rights to any proceeds coming from a sale or re-release of the equipment comes ahead of any of the lessor’s rights in the equipment and lease. The lessor’s equity investment is subordinated to the loan repayment obligation. If a lender only contributed, for example, 70% of the funds necessary, the subordination arrangement would put it in an over-collateralized loan position that, in turn, would decrease its lending risk.
Although the third-party loan is usually made on a nonrecourse basis, this is not always so. If the lessee’s financial condition is weak, a lender may only be willing to make a recourse loan. Under this type of loan the lender can look to, or has recourse against, the lessor for repayment if it cannot be satisfied through the lessee or the equipment. The lessor still, however, has the economic advantage of a leveraged investment.
Although the concept of leveraging a lease investment is simple, the mechanics of putting one together is often complex. Leveraged lease transactions, particularly ones involving major dollar commitments, frequently involve many parties brought together through intricate arrangements. The “lessor” is typically a group of investors joined together by a partnership or trust structure. The partnership or trust is the legal owner, or “titleholder,” of the equipment. The “lender” is often a group of lenders usually acting through a trust arrangement. This is further complicated by the fact that each participant will be represented by counsel with varying views. As a result, the job of organizing, drafting, and negotiating the necessary documents is generally very difficult.
Observation: Because the expenses involved in documenting a leveraged lease can be substantial, transactions involving less than $2 million worth of equipment can be economically difficult to structure as a leveraged lease. If, however, documentation fees (such as counsel fees) can be kept within reason, smaller equipment amounts can be financed in this manner. In many cases a prospective lessor or underwriter has an in-house legal staff with the ability to originate and negotiate the required documents. If so, this will help keep costs down. Generally, leveraged lease financings are arranged for prospective lessees by companies or individuals who specialize in structuring and negotiating these types of leases. These individuals and firms are referred to as lease underwriters. Essentially, their function is to structure the lease economics, find the lessor-investors, and provide the necessary expertise to ensure that the transaction will get done. In a limited number of situations, they also find the debt participants. They do not generally participate as an investor in the equipment.
Underwriting
Because the vast majority of leveraged leases are brought about with the assistance of lease underwriters, lease underwriting has become synonymous with leveraged leasing. The premise on which lease underwriting services are provided by an underwriter (that is, on a “best efforts” or “firm” basis) varies significantly. It is, therefore, worthwhile at this stage to explore the two types of underwriter offers: “best efforts” and “firm commitment” underwriting arrangements.
A ‘Best Efforts’ Underwriting Arrangement Can Be Risky
Lease underwriting transactions are frequently bid on a “best efforts” basis. This type of bid is an offer by the underwriter to do the best it can to put a transaction together under the terms set out in its proposal letter. There are no guarantees of performance. As a result, a prospective lessee accepting the offer may not know for some time whether it has the financing. In practice, a best efforts underwriting is not as risky as it appears. Most reputable underwriters have a good feel for the market when bidding on this basis and usually can deliver what they propose. Thus, there is a good chance they will be able to get “firm commitments” from one or more prospective lessor-investors to participate on the basis offered.
Recommendations:
A prospective lessee must always keep in mind that a best efforts underwriting proposal gives no guarantee the transaction can be completed under the terms proposed. Thus, it must give careful consideration to the experience and reputation of an underwriter proposing on this basis before awarding a transaction to it. An inability to perform as presented can result in the loss of valuable time. When there is adequate equipment delivery lead time, a prospective lessee may be inclined to award a transaction to an unknown underwriter who has submitted an unusually low bid. There is, however, a risk that must be considered. If the transaction is so underpriced that it cannot be sold in the “equity” market, it may meet resistance when it is reoffered on more attractive investor terms. This can happen merely because it has been seen, or “shopped,” too much. It is an unfortunate fact that when an investor is presented with a transaction that it knows has been shopped, even if the terms are favorable, it may refuse to consider it. A prospective lessee, thus, should not be too eager to accept a “low ball” best efforts bid unless it has taken a hard look at the underwriter’s ability to perform. Best efforts underwriters sometimes submit proposals that are substantially below the market. At times this happens by mistake. For example, transactions may have been priced in good faith based on acceptable investor market yields, but by the time the award is made the market has moved upward. At other times, an underwriter may intentionally underprice a transaction to make sure it wins it. If it cannot be placed as proposed, the underwriter will go back and attempt to get the prospective lessee to agree to a higher rental rate. With its competitors no longer involved, it may be in a good position to do this. A prospective lessee with near-term deliveries must be particularly careful in recognizing this possibility. Otherwise, it may have little choice but to be pushed into a less favorable deal.
A prospective lessee can control the risk of nonperformance under a best efforts proposal by putting a time limit on the award, for example, by requiring the underwriter to come up with, or “circle,” interested parties within one week following the award and securing formal commitments by the second week. It is not unheard of for a prospective lessee to make a time limit award to an unusually low bidding, or unknown, underwriter without telling the remaining bidders. The purpose is to try to keep them around just in case the underwriter cannot perform. This can be unfair to an underwriter who, in good faith, is continuing to spend time and money on the transaction in the hope of winning it. Doing this can also hurt a prospective lessee in the long run. Reason: It is likely that the other underwriters will find out that this happened. Once the word gets around that a company does business in this manner, reputable underwriters may refuse to participate in future biddings. Even if they do participate, they may quote rates that have not been as finely tuned as possible. Reason: They will not spend the time or money necessary in situations in which they may not be treated fairly. Thus, this tactic is not recommended because a prospective lessee may, as a result, not see the best possible market rates.
A ‘Firm Commitment’ Underwriting Arrangement Is Often the Best
From a prospective lessee’s viewpoint, a “firm commitment” underwriting proposal is generally the preferred type of offer. When an underwriter has “come in firm” it is guaranteeing to put the proposed lease financing together. Typically, before an underwriter submits this type of proposal, it has solid commitments from lessor-investors to enter into the transaction on the terms presented. This, however, is not always the case. The underwriter’s firm bid may only represent its willingness to be the lessor if it cannot find a third-party lessor.
Recommendations:
If an underwriter proposing on a firm basis does not have “committed equity” at the time its proposal is submitted, a prospective lessee may be subject to certain risks. Unless the underwriter is in a strong financial position, its commitment may be worthless if a third-party lessor cannot be found. Thus, a prospective lessee must always investigate whether an underwriter has lined up one or more lessor-investors. If not, the underwriter’s financial condition must be reviewed to determine, before making the award, whether it has the financial ability to stand behind it. Underwriters sometimes state they have firm “equity” even through they have nothing more than a verbal indication from a prospective lessor-investor’s contact that it will recommend the transaction to its approving committee. Thus, a prospective lessee must ask to be put in touch with each lessor-investor to confirm its position. Doing this will also ensure that there are no misunderstandings as to the transaction terms