The Need for Independent Analysis On Portfolio Risks

With the current economic condition being the way it is, and the risk assumed by banks and lessors being scrutinized more and more, the once shunned idea of turning to an outside valuation provider for an assessment of potential exposure is now becoming more prevalent. Equipment and portfolio managers within the leasing community are being looked at by their institutions as being the last line of defense against the potential loss or shortfall from a leasing transaction as a result of the down economy or defaulting lessees.

Historically, the leasing community would primarily keep its portfolio reviews in-house to avoid the expense that turning to an outside opinion provider would incur. But as a result of recent economic events, and a growing pressure from management to assure that any shortfalls or potential losses are recognized and resolved prior to any surprises, the once “taboo” thought of allowing a non-employee access to information is becoming more of a necessity. Having the review for potential exposure or losses being performed by the same individuals who are initially setting the residuals is like having students grading their own exams. This is by no means a shot at the equipment personnel within banks and leasing companies; the ones that I deal with are some of the smartest equipment people whom I know. But the main concern is whether the people setting the original residuals are willing to say, “I think I missed this one, we need to take some action,” or are they going to avoid bringing this to the forefront in hopes that the deal will right itself by the time it reaches the end of the lease term. Oftentimes, a potential loss from a lease transaction is a result of an occurrence that could not have been predicted as of the inception of the lease; but even knowing this, the opinion from a party with no “skin in the game” is something that can provide valuable insight and potentially eliminate a potential loss or risk exposure. Because an independent valuation provider has no involvement in the deal other than providing a value, there's less of a chance of the opinion of the valuation provider being swayed by the internal environment of the lessor. Whether there is a potential loss or not, the independent opinion provider will get paid regardless of the outcome of the particular transactions being reviewed.

The Potential for Complacency

Another concern within the leasing industry is the potential for complacency regarding its equipment knowledge and current research. It's something that we have all done in the past in some form or fashion; if you do something enough times you can easily fall into the trap of following procedure without looking outside of usual sources for a new perspective. The downside is that we sometimes miss out on new sources of knowledge and alternative perspectives to what might impact the value. From a lessor's perspective, a new set of eyes looking at transactions or an alternative viewpoint can sometimes provide critical information that can assist in the avoidance of a potential loss and the realization of a gain from a lease engagement.

From the occasions where an outside valuation provider has been engaged to review leases that are either in trouble or are nearing the end of their lease term, some interesting situations have been uncovered:

1. When performing a review of a lease portfolio that included a mix of leases at risk and leases where payments were current, the biggest surprise was from a lease that had been current throughout its term. The lessee was a textile business in New England that made its lease payments for office furniture as scheduled every month. From basic due-diligence, it was learned that the lessee was being sued for age discrimination and had moved from its original location just months into a five-year lease term. The assets were still located at its corporate headquarters as if it were business as usual, and the lessee had arranged for an individual to show up and clean the furniture once a month. After three years of timely payments, the lessor was notified of the situation and was able to initiate action to avoid any losses under the existing lease agreement. In this case, the lessor had no idea of the current situation since the client was never delinquent and there was no need to consider this transaction to be of any concern. It was by random luck that the situation was uncovered because the lessor included this engagement with those it wanted reviewed. The lessor was able to put an action plan into motion that allowed it to recover the assets in accordance with the documented lease language and be proactive in heading off any potential loss or situation where the outcome could have been less than positive.
2. In some instances, a lessor may contract with a service provider who will provide the management of its portfolio. Under these agreements, the responsibility of managing the portfolio is not within the lessor ' s direct control, and it is relying upon the contracted third party to review and stay on top of its portfolio. We had a chance to review a portfolio under these circumstances, and what we determined was that the portfolio manager was not fulfilling its responsibilities as indicated in the contractual agreement between the lessor and the portfolio manager. Delinquent accounts were not being followed-up in the manner they were supposed to be, and the retaining of specific lease documentation was not as it was supposed to be according to the contractual agreement. By reviewing the management of the portfolio, we were able to help the lessor tighten up the control of the portfolio and provide it with indications in advance as to whether there might be potential exposure for some of the leases within the portfolio.

Recent Upswing

Adding to the increasing reliance on outside opinion providers is the recent upswing in new commercial equipment leasing that showed an increase of 15% in April 2010 as compared with the same period in 2009. This is the first year-to-year increase since July 2008, and is looked at as a positive sign that businesses are starting to invest in capital assets again. With this flurry of new business, the review of existing transactions sometimes gets pushed to the back burner, which allows any potential exposure to continue to grow until it's too late to do anything about it. Now with that being said, we are not suggesting that the increase in new business is a bad thing. We are trying to remind the leasing community that the need to remain diligent for potential losses from existing deals has not gone away. While equipment personnel are busy researching and structuring new business, using an outside opinion provider to review the existing transactions allows for the pursuit of new business to remain a key focus.

The Cost

Another area of concern to lessors is the cost to hire an independent opinion provider as opposed to just keeping the review in-house and performed by personnel already within the group. True, the use of an outside independent opinion provider will create an additional cost. But how would that cost be measured against the avoidance or recovery of a potential loss from lease transactions that lose money? The actual cost for bringing in an outside provider can be negotiated, and from our experience the costs are a fraction of the potential loss from bad transactions as well as repercussions from managers and shareholders who are wondering why the exposure was not determined and resolved before its impact was felt on the bottom line.

Redefining How Lessors Account for Their Leases

In addition, the Financial Accounting Standards Board (“FASB”) and the International Accounting Standards Board (“IASB”) are attempting to redefine how lessors will be accounting for their leases. The new standard will replace FAS 13 in the United States and IAS 17 in those countries using international financial reporting standards. The new ruling is expected to do away with the “90% Rule,” thereby eliminating the distinction between operating leases and capital leases, and returning the lease to the lessor's balance sheet. One of the areas of this new ruling that is expected to be a stumbling block is transactions with renewal options. Oftentimes, a renewal option is included in the structure of a lease transaction because the lessee is not sure what it will do at the point in time when a renewal is a possibility. Under the new ruling, the lessor would have to recognize the potential renewal as part of the overall lease term. In other words, a seven-year deal with a three-year renewal option would need to be reflected as a 10-year transaction.

The new draft of this rule change was scheduled to be released this June, and the final outcome cannot be predicted at this point in time. As of now, the FASB and IASB are indicating that this ruling could very well apply to existing leases, potentially requiring lessors to capitalize more than $1 trillion in operating leases. It's a certainty that the leasing industry will be heard on this issue and that the outcome will have far-reaching effects not only for lessors, but also for independent opinion providers.

Rick Daubenspeck serves as National Director for the Fixed Asset Group of BDO Valuation Advisors, LLC. He has more than 20 years of experience in developing valuation opinions of machinery and equipment for a broad range of financial transactions including leasing structuring and dispositions, mergers and acquisitions, bankruptcies, and FAS impairment reviews. He may be reached at [email protected].

With the current economic condition being the way it is, and the risk assumed by banks and lessors being scrutinized more and more, the once shunned idea of turning to an outside valuation provider for an assessment of potential exposure is now becoming more prevalent. Equipment and portfolio managers within the leasing community are being looked at by their institutions as being the last line of defense against the potential loss or shortfall from a leasing transaction as a result of the down economy or defaulting lessees.

Historically, the leasing community would primarily keep its portfolio reviews in-house to avoid the expense that turning to an outside opinion provider would incur. But as a result of recent economic events, and a growing pressure from management to assure that any shortfalls or potential losses are recognized and resolved prior to any surprises, the once “taboo” thought of allowing a non-employee access to information is becoming more of a necessity. Having the review for potential exposure or losses being performed by the same individuals who are initially setting the residuals is like having students grading their own exams. This is by no means a shot at the equipment personnel within banks and leasing companies; the ones that I deal with are some of the smartest equipment people whom I know. But the main concern is whether the people setting the original residuals are willing to say, “I think I missed this one, we need to take some action,” or are they going to avoid bringing this to the forefront in hopes that the deal will right itself by the time it reaches the end of the lease term. Oftentimes, a potential loss from a lease transaction is a result of an occurrence that could not have been predicted as of the inception of the lease; but even knowing this, the opinion from a party with no “skin in the game” is something that can provide valuable insight and potentially eliminate a potential loss or risk exposure. Because an independent valuation provider has no involvement in the deal other than providing a value, there's less of a chance of the opinion of the valuation provider being swayed by the internal environment of the lessor. Whether there is a potential loss or not, the independent opinion provider will get paid regardless of the outcome of the particular transactions being reviewed.

The Potential for Complacency

Another concern within the leasing industry is the potential for complacency regarding its equipment knowledge and current research. It's something that we have all done in the past in some form or fashion; if you do something enough times you can easily fall into the trap of following procedure without looking outside of usual sources for a new perspective. The downside is that we sometimes miss out on new sources of knowledge and alternative perspectives to what might impact the value. From a lessor's perspective, a new set of eyes looking at transactions or an alternative viewpoint can sometimes provide critical information that can assist in the avoidance of a potential loss and the realization of a gain from a lease engagement.

From the occasions where an outside valuation provider has been engaged to review leases that are either in trouble or are nearing the end of their lease term, some interesting situations have been uncovered:

1. When performing a review of a lease portfolio that included a mix of leases at risk and leases where payments were current, the biggest surprise was from a lease that had been current throughout its term. The lessee was a textile business in New England that made its lease payments for office furniture as scheduled every month. From basic due-diligence, it was learned that the lessee was being sued for age discrimination and had moved from its original location just months into a five-year lease term. The assets were still located at its corporate headquarters as if it were business as usual, and the lessee had arranged for an individual to show up and clean the furniture once a month. After three years of timely payments, the lessor was notified of the situation and was able to initiate action to avoid any losses under the existing lease agreement. In this case, the lessor had no idea of the current situation since the client was never delinquent and there was no need to consider this transaction to be of any concern. It was by random luck that the situation was uncovered because the lessor included this engagement with those it wanted reviewed. The lessor was able to put an action plan into motion that allowed it to recover the assets in accordance with the documented lease language and be proactive in heading off any potential loss or situation where the outcome could have been less than positive.
2. In some instances, a lessor may contract with a service provider who will provide the management of its portfolio. Under these agreements, the responsibility of managing the portfolio is not within the lessor ' s direct control, and it is relying upon the contracted third party to review and stay on top of its portfolio. We had a chance to review a portfolio under these circumstances, and what we determined was that the portfolio manager was not fulfilling its responsibilities as indicated in the contractual agreement between the lessor and the portfolio manager. Delinquent accounts were not being followed-up in the manner they were supposed to be, and the retaining of specific lease documentation was not as it was supposed to be according to the contractual agreement. By reviewing the management of the portfolio, we were able to help the lessor tighten up the control of the portfolio and provide it with indications in advance as to whether there might be potential exposure for some of the leases within the portfolio.

Recent Upswing

Adding to the increasing reliance on outside opinion providers is the recent upswing in new commercial equipment leasing that showed an increase of 15% in April 2010 as compared with the same period in 2009. This is the first year-to-year increase since July 2008, and is looked at as a positive sign that businesses are starting to invest in capital assets again. With this flurry of new business, the review of existing transactions sometimes gets pushed to the back burner, which allows any potential exposure to continue to grow until it's too late to do anything about it. Now with that being said, we are not suggesting that the increase in new business is a bad thing. We are trying to remind the leasing community that the need to remain diligent for potential losses from existing deals has not gone away. While equipment personnel are busy researching and structuring new business, using an outside opinion provider to review the existing transactions allows for the pursuit of new business to remain a key focus.

The Cost

Another area of concern to lessors is the cost to hire an independent opinion provider as opposed to just keeping the review in-house and performed by personnel already within the group. True, the use of an outside independent opinion provider will create an additional cost. But how would that cost be measured against the avoidance or recovery of a potential loss from lease transactions that lose money? The actual cost for bringing in an outside provider can be negotiated, and from our experience the costs are a fraction of the potential loss from bad transactions as well as repercussions from managers and shareholders who are wondering why the exposure was not determined and resolved before its impact was felt on the bottom line.

Redefining How Lessors Account for Their Leases

In addition, the Financial Accounting Standards Board (“FASB”) and the International Accounting Standards Board (“IASB”) are attempting to redefine how lessors will be accounting for their leases. The new standard will replace FAS 13 in the United States and IAS 17 in those countries using international financial reporting standards. The new ruling is expected to do away with the “90% Rule,” thereby eliminating the distinction between operating leases and capital leases, and returning the lease to the lessor's balance sheet. One of the areas of this new ruling that is expected to be a stumbling block is transactions with renewal options. Oftentimes, a renewal option is included in the structure of a lease transaction because the lessee is not sure what it will do at the point in time when a renewal is a possibility. Under the new ruling, the lessor would have to recognize the potential renewal as part of the overall lease term. In other words, a seven-year deal with a three-year renewal option would need to be reflected as a 10-year transaction.

The new draft of this rule change was scheduled to be released this June, and the final outcome cannot be predicted at this point in time. As of now, the FASB and IASB are indicating that this ruling could very well apply to existing leases, potentially requiring lessors to capitalize more than $1 trillion in operating leases. It's a certainty that the leasing industry will be heard on this issue and that the outcome will have far-reaching effects not only for lessors, but also for independent opinion providers.

Rick Daubenspeck serves as National Director for the Fixed Asset Group of BDO Valuation Advisors, LLC. He has more than 20 years of experience in developing valuation opinions of machinery and equipment for a broad range of financial transactions including leasing structuring and dispositions, mergers and acquisitions, bankruptcies, and FAS impairment reviews. He may be reached at [email protected].