The New World Order: Lessors Must Refocus

Over the last year, it has become obvious that there must be a fundamental shift in the way large-ticket leasing companies look at their tax shelter businesses. This article will examine what has brought about this shift and how lessors will find ways to cope with it.

In the 70s, 80s and early 90s, the large-ticket equipment leasing business consisted mainly of investments in equipment transactions wherein lessors bought and then leased equipment to corporate lessees. This business was fairly basic wherein corporations, which for one reason or another could not use tax benefits, would sell a piece of equipment to a lessor and lease it back, in essence trading tax benefits for a lower after-tax cost of financing. As companies became profitable in the mid- to late-90s, corporate users of equipment required less of the aforementioned financings. Companies discovered that they could make more efficient use of the tax benefits themselves than by trading them through leases. This led to lessors looking for new types of transactions where they could still generate tax benefits from equipment financings, and lessors found a new market in tax-exempt entities. While the corporate transactions of the earlier era relied on the credit of the lessee directly, transactions to the tax-exempt entities generally involved some form of credit enhancement in addition to the credit of the lessee. Although the lessee was always primarily liable, credit committees of investors required support for the credit of the lessee.

Some leasing companies at this time also took an interest in other forms of tax credits such as Section 29 and Section 42 Affordable Housing Credits. Certain of the Section 42 credits were also sold in a credit enhanced basis so that the lessor was looking not at the project itself, but to a guarantor to provide the investors' return should anything go wrong. Each of the Section 29 and Section 42 transactions involved the lessor owning a piece of property.

As the century turned and we moved into the 2000s, the leasing business has seen a combination of events come together, all of which have the effect of significantly limiting the number of transactions. As a general rule, some things happen that favor a particular form of financing and others happen that do not in the same timeframe, so there are mitigating circumstances at any particular time.

This time, however, is different. Virtually all of the things that set the tone for an environment of leasing have turned negative:

1) Interest rates are at all time lows. In general, a high interest rate environment is good for leasing and a lower rate environment not. The current historically low rates serve to put a damper on leasing.

2) Capital expenditures have been down in general. The events of the past few years have slowed the economy, thus forcing companies to cut back on capital spending. While the lawmakers have tried to jump-start this through bonus depreciation and other techniques, the fact remains that if a corporation does not need new equipment, no amount of tax incentives will compel the corporation to increase its capital expenditures.

3) Tax bills currently before Congress have provisions that will, if enacted, severely curtail leasing to tax-exempt entities. As of press time, it is not clear which version of the bill ultimately will be passed, but it is clear that lessors cannot at the present invest in any transactions of this type due to confusion over effective dates of the legislation and, what if anything, the effect of the bill will have on these transactions.

As can be seen from above, this does not particularly create a pretty picture for big-ticket lessors.

What will leasing companies do going forward to generate the volume they require? How can they stay active in the marketplace?

First, the mindset of an equipment leasing company will have to change. The mission of the company must change from “investing in equipment in a prudent way to make a profit utilizing both after and pre-tax cash flows” to investing in a transaction rather than equipment that accomplishes the same thing.

These transactions may include things like Section 42 Affordable Housing Credits, or (if passed by Congress), Section 45 Wind Power Credits or other to-be-determined tax credit programs.

Secondly, lessors may also have to re-educate their credit committees that the days of credit enhanced equipment transactions are over. Lessors must once again be willing to take lessee credits only (noncredit enhanced risk). Lessors will also be forced to look harder at residual values than they have in recent years.

The companies whose mission is to shelter taxes through only equipment leasing must now change to a broader mission of tax shelter by whatever means possible.

Lessors must find new ways to use their tax attributes. Compensation programs for employees will be changed so that they are paid not by investment, but by earnings generated through transactions.

We have already seen a trend where “leasing companies” have changed their names to “credit company” or “financial company.” This is the first sign indicating that such a re-think is occurring.

Will the leasing market rebound? Yes, probably, but it will be a long trek. It will probably not be as robust as it was in the 90s, which means to generate the same amount of earnings lessors must adapt a new outlook in the new world.

Over the last year, it has become obvious that there must be a fundamental shift in the way large-ticket leasing companies look at their tax shelter businesses. This article will examine what has brought about this shift and how lessors will find ways to cope with it.

In the 70s, 80s and early 90s, the large-ticket equipment leasing business consisted mainly of investments in equipment transactions wherein lessors bought and then leased equipment to corporate lessees. This business was fairly basic wherein corporations, which for one reason or another could not use tax benefits, would sell a piece of equipment to a lessor and lease it back, in essence trading tax benefits for a lower after-tax cost of financing. As companies became profitable in the mid- to late-90s, corporate users of equipment required less of the aforementioned financings. Companies discovered that they could make more efficient use of the tax benefits themselves than by trading them through leases. This led to lessors looking for new types of transactions where they could still generate tax benefits from equipment financings, and lessors found a new market in tax-exempt entities. While the corporate transactions of the earlier era relied on the credit of the lessee directly, transactions to the tax-exempt entities generally involved some form of credit enhancement in addition to the credit of the lessee. Although the lessee was always primarily liable, credit committees of investors required support for the credit of the lessee.

Some leasing companies at this time also took an interest in other forms of tax credits such as Section 29 and Section 42 Affordable Housing Credits. Certain of the Section 42 credits were also sold in a credit enhanced basis so that the lessor was looking not at the project itself, but to a guarantor to provide the investors' return should anything go wrong. Each of the Section 29 and Section 42 transactions involved the lessor owning a piece of property.

As the century turned and we moved into the 2000s, the leasing business has seen a combination of events come together, all of which have the effect of significantly limiting the number of transactions. As a general rule, some things happen that favor a particular form of financing and others happen that do not in the same timeframe, so there are mitigating circumstances at any particular time.

This time, however, is different. Virtually all of the things that set the tone for an environment of leasing have turned negative:

1) Interest rates are at all time lows. In general, a high interest rate environment is good for leasing and a lower rate environment not. The current historically low rates serve to put a damper on leasing.

2) Capital expenditures have been down in general. The events of the past few years have slowed the economy, thus forcing companies to cut back on capital spending. While the lawmakers have tried to jump-start this through bonus depreciation and other techniques, the fact remains that if a corporation does not need new equipment, no amount of tax incentives will compel the corporation to increase its capital expenditures.

3) Tax bills currently before Congress have provisions that will, if enacted, severely curtail leasing to tax-exempt entities. As of press time, it is not clear which version of the bill ultimately will be passed, but it is clear that lessors cannot at the present invest in any transactions of this type due to confusion over effective dates of the legislation and, what if anything, the effect of the bill will have on these transactions.

As can be seen from above, this does not particularly create a pretty picture for big-ticket lessors.

What will leasing companies do going forward to generate the volume they require? How can they stay active in the marketplace?

First, the mindset of an equipment leasing company will have to change. The mission of the company must change from “investing in equipment in a prudent way to make a profit utilizing both after and pre-tax cash flows” to investing in a transaction rather than equipment that accomplishes the same thing.

These transactions may include things like Section 42 Affordable Housing Credits, or (if passed by Congress), Section 45 Wind Power Credits or other to-be-determined tax credit programs.

Secondly, lessors may also have to re-educate their credit committees that the days of credit enhanced equipment transactions are over. Lessors must once again be willing to take lessee credits only (noncredit enhanced risk). Lessors will also be forced to look harder at residual values than they have in recent years.

The companies whose mission is to shelter taxes through only equipment leasing must now change to a broader mission of tax shelter by whatever means possible.

Lessors must find new ways to use their tax attributes. Compensation programs for employees will be changed so that they are paid not by investment, but by earnings generated through transactions.

We have already seen a trend where “leasing companies” have changed their names to “credit company” or “financial company.” This is the first sign indicating that such a re-think is occurring.

Will the leasing market rebound? Yes, probably, but it will be a long trek. It will probably not be as robust as it was in the 90s, which means to generate the same amount of earnings lessors must adapt a new outlook in the new world.