CEO & President, Amembal Capital Corporation; Amembal & Associates; Amembal & Gilyeart--Counselors to Government
e-mail: [email protected]
Editor's Note: This article is a new article which expands and updates Sudhir Amembal's 1991 article previously posted, The Leasing Cycle--Examining Overseas Opportunities..
Introduction
Webster (the dictionary) defines "emerging" as evolving, and "mature" as relating to a condition of full development. The past decade has seen a tremendous boom in emerging lease markets. From 1990 to 1996, the average annual growth in lease volume in the mature North American region was approximately 6%. On the other hand, using the South American region as an emerging region, the growth of the same period was a stupendous 42%. Of course, every reader would acknowledge that the higher percentage of growth is due largely to the fact that it is applied to a lower base; yet, very few would disagree that the future growth of leasing lies not in mature, but emerging markets.
This article traces the growth of leasing throughout the world and is based on my personal observations over the past two decades of extensive travel to over 40 lease markets.
The Evolution of Leasing Markets
Exhibit One details "The Stages in the Evolution of Leasing Markets" from non-existent to mature. As examples, leasing is non-existent in Laos and Macedonia, nascent in Egypt and Nicaragua, emerging in most of the Asia Pacific and Latin American Countries, and mature in places such as Australia, the United Kingdom, and the United States.
Exhibit 1 The Stages in the Evolution of Leasing Markets How the industry moves from being newly-born to mature is detailed in Exhibit Two, "The Six Phases of the Leasing Cycle."
1. Non-existent
2. Nascent
3. Emerging
4. Mature
Exhibit 2 The Six Phases of the Leasing Cycle
1. Rentals
2. Simple Finance Leases
3. Creative Finance Leases
4. Operating Leases
5. New Products
6. Maturity
The Six Phases of the Leasing Cycle
Rentals (Phase One) have preceded the leasing product by centuries and even today, this industry is extremely vibrant and competitive in most every country in the world. Rentals are characterized by their short term (usually less than 12 months), full-service nature. Almost invariably, at the end of the rental contract period, the user returns the equipment to the user.
Modern day leasing, as we know it, began approximately a century ago--both in the United Kingdom and the United States--in the form of the Simple Finance Lease (Phase Two). In every single country in the world (except Argentina, due to a nuance in their existing legislation), this is the first true lease product as distinguished from the rental. The product is invariably characterized by the lessee's intent to purchase equipment in the guise of a lease. The lease is merely a financing instrument, whereby at the end of the lease term, the lessee, having fully paid the lessor through the lease rentals, purchases the equipment for a nominal amount of consideration. As leasing is a new product, the psychology of ownership is still very much inherent in the user's thought process. The lessor too intends to merely finance the equipment purchase through a lease and is not able or willing to have the asset returned at the end of the lease term. Credit risk, not asset risk, is acceptable to the lessor, as the latter requires a developed secondary market, which does not exist during this phase. Phase Two generally lasts five to seven years. Among countries in this phase are Honduras, Poland, Russia, and Thailand.
Both with the passage of time and the entry of other players in the market, the leasing industry enters Phase Three--the Creative Finance Lease Phase. During this phase, lessors begin to structure many of their finance leases and also provide the lessee with varied end of term options, such as the option to renew based on a fixed residual. (The lessee must either purchase or renew.) It is during this phase, in most countries, that leasing experiences the largest growth, both in terms of absolute volume and penetration. Also, many vendor/manufactures, who hereto have relied on independents, begin to form their own leasing companies. Tax authorities, regulators, and accounting bodies, realizing the significance of leasing, take a closer look at the industry and arrive at rules, regulations and guidelines, hopefully meant to stimulate further growth. Often times, however, the actions are directed at curbing tax abuses, such as those caused by the very short tem "Norwegian leases." Examples of countries in Phase Three are Colombia and Pakistan.
Phase Four, the Operating Lease Phase, results from the passage of time, intense competition, transfer of technology from one leasing nation to another, demand by multinational lessees and developing or developed secondary markets. In some countries, such as Mexico, the product is fueled by the fact that finance leases are denied "true lease" or "tax lease" status.
The key features of this product are that the lessee can return the equipment at the end of the lease term, and many operating leases are full-service leases. Bundling and one-stop-shopping become a convenience to the lessee whereby (using computers as an example) hardware, software, installation, maintenance, and training are packaged into one transaction.
During the Operating Lease Phase, unconnected to the lease product, the lessee becomes an astute, sophisticated player, as leasing has become acceptable as an extremely viable financial product. As a result, language in lease contracts is not unilaterally drafted by the lessor, but is carefully negotiated; in fact, quite often, lessees insist on using master leases drafted by their own legal counsel. India, and many countries in Western Europe are in Phase Four.
On-going, intense competition, continued lessor creativity, and ever increasing transfer of technology propels the industry to Phase Five, the New Products Phase. In this phase, the operating lease becomes extremely sophisticated, with complex end-of-term options (such as puts, calls, and "first amendment" clauses), early termination options, upgrades and rollovers, technology refreshes, and the like. Phase Five brings about new products such as securitization, venture leases and synthetic leases (off-balance sheet loans). The Australian leasing industry has recently entered Phase Five.
Finally, the industry, following the classic industry curve from infancy to maturity, enters the last phase, Phase Six--Maturity. Maturity is characterized by substantial consolidation within the industry. Such consolidation takes the form of mergers, acquisitions, joint ventures/alliances, and "equity roll-ups" (the latter recently witnessed in the United States). Maturity also brings forth lower margins causing lessor to look for profits via operational efficiencies as versus increased sales volume. Penetration flattens during this phase, as leasing volume increases only with the overall growth of the economy. The United States leasing economy entered maturity approximately five years ago.
Though the six phases apply universally to every country in the world, it is important to note: First, the sequence applies to the industry in general within each country, and not to all of the players. As a clear example, only a few entities in India offer the true operating lease. Also, it is very common for lessors not to grow sequentially. Some who offer new products such as venture leases may not be in the operating lease business. Second, each phase is not mutually exclusive. Using the United States as an example, though the industry has reached maturity, many lessors continue to offer only finance leases, others specialize in operating leases, while others diversify into products such as synthetic leases.
As emerging markets evolve toward maturity, it is critical to note that the leasing cycle (from the simple finance lease to maturity) has become shorter and shorter. This is undoubtedly the result of information sharing and technology transfers between markets, speeding progress through the evolutionary cycle.
Varied Frameworks
Shifting from the evolution of emerging markets, with respect to the six phases, it is important to gain a better understanding of the varied frameworks that impact the world of leasing in such markets. We can then arrive at a model that will best facilitate the evolution. Leasing infrastructure consists of the following four important frameworks: legal, direct taxation, financial accounting and regulatory. (This article will not cover the miscellaneous frameworks such as indirect taxation, customs, excise duties, and foreign exchange controls.)
Legal Framework
Historically, very few countries have a leasing law, although more and more countries are enacting one and the pace of enactment is quickening. Where such laws have been enacted, they have generally been modeled upon the Unidroit Convention on International Financial Leasing (the "Convention"). Although the Convention is directed toward international, cross-border transactions, it provides a useful model for the domestic law of countries in need of one in the domestic leasing arena. It was drafted with the need of emerging lease economies in mind. It has been used as a drafting model in China, Ghana, Indonesia, Nigeria, Panama, Russia, Turkey, and elsewhere.
Whether a finance leasing law is needed is, of course, based on clarity, or lack thereof, in other existing laws or codes. Having stated this, the existence of a finance leasing law can only help if it will define a finance lease with the utmost clarity and set forth with certainty items such as the lessee's absolute duty to pay after acceptance, the lessor's lack of equipment responsibilities, the lessee's recourse against the supplier, and that the equipment is not liable to other creditor claims.
Direct Taxation Framework
From a direct taxation point of view, most emerging lease economies are currently "form" countries where the lessor claims the tax depreciation and the lessee claims the rental deduction. This allows leasing to grow during the evolving period, enabling the user/lessee to generally claim tax benefits faster on a lease than a purchase. Many lease economies such as Costa Rica, Indonesia, and Mexico have moved from "form" to "substance" whereby the finance lease for tax purposes, is treated as a loan. This generally retards the evolutionary process.
Financial Accounting Framework
From a financial accounting point of view, there are two distinct approaches: "form" and "substance." Under the former, finance leases are treated as leases for balance sheet and income statement purposes of the lessor and lessee, as as such give rise to off-balance-sheet financing. Under the latter, finance leases are capitalized by the lessee. Setting aside off or on-balance-sheet issues, the world, by and large, is mostly "substance." The purpose of financial accounting is to provide meaningful information to shareholders, potential investors, and lenders. In "substance", a finance lease is indeed a loan and should be treated accordingly. Accounting harmonization, following the guidelines of the IASC and the FASB, makes the most sense for all lease economies.
Regulatory Framework
Finally, in the world of regulation, not all countries supervise or regulate the leasing industry. This is especially true in the developed and mature leasing marketplaces, such as Australia, Germany, the United Kingdom, and the United States. In emerging markets, practices vary, but one generally encounters a licensing and supervision process. Licensing can be healthy if the process imposes few requirements, such as minimum capital. such a requirement eventually enables the industry to remain strong and viable. Regulation should be, at most, a mild form of off-site supervision requiring leasing companies to adhere to prudential norms, such as debt-to-equity limitations, provisioning rules and single customer exposure. Such norm will, once again, help keep the industry as financially sound as possible. Where leasing is evolving, it is critical to maintain a healthy, credible industry which in turn creates customer confidence.
A Model
The model to facilitate growth and evolution in emerging lease economies is summarized below:
1. Legal: A finance leasing law modeled after the Convention
2. Direct Taxation: Form
3. Financial Accounting: Substance
4. Regulation: Licensing and mild off-site supervision
Conclusion
In conclusion, leasing will remain a significant financing tool throughout the world: yet, it will continue to grow more rapidly in emerging markets.
Updated 9 October 1998
