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2006 State of the Industry Report:

Prepared by:

FINANCIAL INSTITUTIONS CONSULTING, INC.

October 2006

2006State of the Industry Report

TABLE OF CONTENTS

Page

Preface ..........................................................................................................................9

Executive Summary ........................................................................................................11

Leasing Industry Overview..............................................................................................13

Economic Conditions..................................................................................................13

Market Size

Sidebar: Beyond Stealing Share

Capital Availability

Accounting, and Regulatory Issues..............................................................................17

The Competitive Environment ....................................................................................18Sidebar: Can Small Lessors Compete in a Global Economy?

The Perception of the Leasing Industry ......................................................................23

Industry Trends ..........................................................................................................25

Analysis of the Survey of Industry Activity ......................................................................27

Overall Industry ..........................................................................................................27

New Business Origination

Profitability and Funding

Portfolio/Credit Quality

OperationsSidebar: Accessing the Customer The Increasing Importance of Vendor Finance

Lessor Profitability ......................................................................................................42

Banks

Captives

Independent, Financial Services

Market Segment Profitability ......................................................................................47

Micro-Ticket

Small-Ticket

Middle-Ticket

Large-Ticket

Concluding Thoughts......................................................................................................54

About Financial Institutions Consulting ..........................................................................55

2006State of the Industry Report

October, 2006

Dear Equipment Lease Finance Experts,

I am pleased to provide you with this copy of the Equipment Leasing & Finance Foundation’s2006 State of the Industry Report. I’m certain you’ll agree that this future-focused Report is aninvaluable strategic planning tool.

The Report is the product of an exhaustive review and analysis of leasing industry informationsources, including ELA’s 2006 Survey of Industry Activity, government data, independent researchand interviews with key executives in all the major industry segments. It provides a comprehen-sive portrait of the leasing and finance industry in the near term.

The Report paints a picture of a changing industry, with many strengths and weaknesses. Lessorshave strengthened their risk management practices and credit is good, but profit margins are flator eroding. The lease continues to be an excellent product, even as companies increasingly viewthemselves as “solution providers” offering a variety of financing alternatives.

In short, our industry is faced with myriad opportunities and challenges. That’s why theEquipment Leasing & Finance Foundation and its future-oriented research are so important. All the Foundation’s reports, along with the semi-annual Journal of Equipment Lease Finance aredesigned to help you navigate through uncertain times, to be able to anticipate the direction of the industry’s markets, products and processes.

And nothing the Foundation does would be possible without your generous support. TheFoundation is funded entirely by individuals and companies within the leasing and financeindustry, those who—like you—understand that their donations are an investment 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 to create it, and that your continued generosity will help the Foundation provide you with a glimpse into the future, long into the future. Please visit the Foundation’s website at www.leasefoundation.org for more information on our products and mission.

Sincerely,

Joseph C. LaneChairman, Equipment Leasing & Finance Foundation

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 6

9E 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

The Equipment Leasing and Finance Foundation(the Foundation) selected Financial InstitutionsConsulting, Inc. (FIC) to prepare its State of theIndustry Report. The mission of the Foundation cen-ters on evaluating future trends and their impact onthe leasing industry. The Foundation and FIC havedesigned this report to analyze and interpret the per-formance of the industry based on responses to theEquipment Leasing Association’s (ELA) 2006 Surveyof Industry Activity (the Survey). Using this and otherinformation, we project and discuss future implica-tions for the industry.

Founded in 1995, FIC is a management consultingfirm that focuses on developing fact-based strategicand tactical solutions for its bank and non-bankfinancial services clients. Much of FIC’s work centerson issues related to increasing growth and productivi-ty. Beyond commercial finance and leasing, FIC’s areasof segment expertise include the middle market, smallbusiness segments, and wealth management. WhileFIC is U.S. based and focused, it has completed proj-ects in close to 20 other countries, indicative of thecompetitiveness of the industry worldwide.

The FIC methodology for this analysis incorporatesstatistical data, past client experience, and in-depthpersonal interviews. The Survey reflects fiscal year-end2005 performance and, therefore, does not present afully accurate picture of the industry today. In addi-tion, as discussed later in this monograph, the distinc-tion between leasing (specifically) and equipmentfinance (generally) continues to diminish. Of the newbusiness that Survey respondents generated in 2005,over half was booked through non-leasing products(conditional sales agreements and term loans). As aresult, throughout this Report, the terms leasing andlessor typically refer more broadly to equipmentfinance and its providers.

IntervieweesIn preparing this report, both FIC and the

Foundation wanted to take advantage of the industry’svaluable human capital. Therefore, in addition to pre-senting data from the Survey, the report includes theinsights and perspectives of industry executives. FICconducted in-depth interviews with 14 senior man-

agers, representing a cross-section of lessor types,ticket sizes, and industry vendors.

These interviews focused less on current perform-ance and more on obtaining the experts qualitativeassessments of key issues facing the industry as wellas on identifying trends and issues that may challengethe industry going forward. The insiders who sharedtheir insights include:

Kent Adams – Caterpillar Financial Services Corporation

John Barry – US Bancorp Equipment Finance, Inc.Doug Bowers – Bank of AmericaCrit DeMent – LEAF Financial CorporationCurt Glenn – GATX CorporationJohn Heist – CCA Financial, Inc.Mike Humphreys – Microsoft CapitalPaul Larkins – Key Equipment FinanceJim McGrane – US Express Leasing, Inc.John McQueen – Wells Fargo Equipment Finance, IncPaul Menzel – Pacific Capital BankDebbie Monosson – Boston Financial and Equity

CorporationKen Pell – CNH Capital, Inc.Paul Usztok – Great American Leasing Corporation

We thank these individuals for their generous com-mitment of time and candid insights into the intrica-cies, opportunities, and challenges of the leasingindustry. Throughout this monograph, we includedirect quotations from these interviews; however, topreserve confidentiality, we present quotes on ananonymous basis.

Lessor and Segment TypesThe lessor types analyzed in this report fall into

three categories: Banks (either separately-operatingsubsidiary or integrated), Captives, and Independent,Financial Services lessors.

We think it is important to clarify the definitions ofthese various lessor types:

Bank lessors often combine leasing activities withother bank functions. They use internal fundingsources and operate under the jurisdiction of theComptroller of the Currency and/or the FDIC. Theymay be integrated with the bank or organized as a

PREFACE



separate entity within the bank holding company.

Captive lessors operate as subsidiaries of dealers or manufacturing companies. At least 60 percent of thelease portfolio consists of products produced by itsparent and/or affiliates. They may also finance othercompanies' products.

Independent, Financial Services lessors are usuallyfinance companies offering leases directly to business-es and are not affiliated with any particular manufac-turer or dealer. Alternatively, an Independent may alsooperate as the financial services subsidiary of a corpo-ration that does not restrict its financing activities tothe parent company’s product and actively generatesnew business outside of those products.

The Survey captures four leasing market segments:micro-ticket ($0-$25,000), small-ticket ($25,000-$250,000), middle-ticket ($250,000-$5 million), andlarge-ticket (over $5 million). New this year, theSurvey also presents data by business model, based oneach respondent’s primary origination channel,defined as the channel through which the respondentgenerated at least 60 percent of its business. The fourbusiness models presented are: Direct, Vendor orCaptive, Third-Party, and Mixed. Lessors operatingwith a Mixed business model generate volumethrough a variety of channels, no one of which repre-sents greater than 60 percent of its total volume.While no identifiable trends emerge from the first yearof this data, next year’s Report will incorporate ananalysis of trends by business model.

State of the Industry Report: Primary Focus and Sidebars

We begin this report with an overview of the leasingindustry, including an estimate of the size of theequipment leasing market and an analysis of thedynamics impacting industry drivers and relatedimplications.

Following the industry overview, we present ananalysis of the Survey of Industry Activity. This dis-cussion highlights a number of important areas,including: new business origination, profitability andfunding, credit quality, and operations. In addition,our analysis discusses current performance, ongoing

challenges, and potential opportunities by lessor typeand market segment.

In this year’s Report, we present sidebar analyses ofsome of the critical issues impacting the industry andoffer our perspective on potential opportunities aris-ing from these issues. We title these sidebars:

Beyond Stealing Share – Many lessors reportgrowth goals that are often double or even triple thegrowth rate of the industry. We asked lessors if thereare opportunities for growth that go beyond the seem-ingly self-destructive battle for market share

Can Small Lessors Compete in a GlobalEconomy? – This year’s Industry Future Council(IFC) Report focused on the rapidly increasing global-ization of the U.S. economy and discussed the impor-tance of lessors being able to satisfy the offshoreequipment finance needs of their existing U.S.-basedcustomers. In this sidebar, we assess the importanceof developing international capabilities as well as thepractical issues involved in doing so. This capabilitymay be important to lessors small and large

Accessing the Customer: The IncreasingImportance of Vendor Finance – In 2005, over aquarter of all new business was generated throughvendor programs. Lessors are increasingly focusing ondeveloping financing programs with vendors andsmaller manufacturers, filling a market need, andgaining an advantage over competitors

As strategy consultants to the leaders in the financialservices industry, throughout this Report we offer ourperspective on how the critical issues identified willimpact the leasing industry. Where possible, we pro-vide insights into how best practice players are react-ing and what lessors can do to create opportunities inthe market today.

Financial Institutions ConsultingCharles B. Wendel, President Matthew L. Harvey, Senior Engagement Manager



The most recent full year numbers for the leasingindustry were highly positive with higher volumesexpected to carry over into 2006 and beyond.However, a number of fundamental challenges exist as the industry continues its transition to providingmore complete equipment finance solutions ratherthan lease product sales and the competitive environ-ment further intensifies.

New business volume improved significantly in 2005. Newbusiness volume improved across all lessor types andtransaction segments. Survey respondents reported a10.3 percent increase in new business volume in2005. Our interviews with leasing executives as wellas our review of available quarterly data indicate thatvolume continued to improve through the secondquarter of 2006. Further, most economists anticipatecontinued growth in capital expenditures through2007.

The industry is continuing its transition from leasing toequipment finance. In this year’s Survey, respondentsreported booking nearly two-thirds of new volumethrough non-lease financial products. This is a contin-uation of a paradigm shift away from leasing as astandalone product and toward the reality that lessorscan reposition themselves as full-service equipmentfinance providers.

Capital appears plentiful. As we saw last year, theindustry benefits from an abundance of low-cost capi-tal resulting from financing by venture and privateequity firms, combined with a renewed expansion ofthe capital markets and an increase in banks’ willing-ness to lend to the industry. However, many lessorsnow believe that too much capital is chasing too fewdeals. In turn, this excess of capital is contributing tothe industry’s pricing pressures.

Margin compression worsened. Due to intense competi-tion and an overabundance of capital in the market,lessors have been unable to increase pricing enough

to compensate for their increased cost of funds. As aresult, pre-tax spreads declined sharply and, althoughboth net income and ROE improved, 2005’s increasein net profit was significantly less than in previousyears.

Niche focus emphasized. Some lessors continue to occu-py niche markets that allow them to increase pricingand improve profitability. While the types of nichesvary (equipment type, end-user industry segment,customer credit grade, etc.), the message from theseplayers was similar: employ a targeted approach,develop an expertise, and be ready to move if themarket changes.

Banks command a competitive advantage. Despite losingtheir cost of funds advantage, largely due to Basel IIrequirements, Banks commanded the largest share ofthe market again this year. As we discuss throughoutthis Report, Banks are in an excellent position to takeadvantage of the industry’s transition from leasing toequipment finance. In addition, Banks are increasinglyleveraging internal referrals from their commercialbanking divisions.

********************************

In the coming year, economic growth and the expan-sion of the industry’s focus to include all types ofequipment finance will present lessors with tremen-dous opportunities for profitable growth. That said,individual companies will continue to face challengesas they strive to improve margins and differentiatethemselves from the competition. Increasingly, acrossfinancial services, competitors must institutionalizetheir ability to identify and adapt to market shifts.Virtually all industry analysts and observers expect thepace of change to intensify in the next few years. Thebest performers will exploit their ability to anticipateand adapt to these changes quickly.

EXECUTIVE SUMMARY



Driven by an increase in Business Fixed Investmentin equipment (BFI), the leasing industry grew for thesecond consecutive year. And, based on second quar-ter 2006 Gross Domestic Product (GDP) results andeconomic forecasts for 2007, growth should continuethrough next year. However, despite promising eco-nomic forecasts, the industry faces a number of chal-lenges in the near-term, including accounting and regulatory changes, an intensely competitive environ-ment, and a bruised public image.

Economic ConditionsEconomic growth in general and growth in BFI

specifically drive the demand for equipment finance.In its May 2006 Outlook, the National Association forBusiness Economics (NABE) projects that BFI willgrow by 8.3 percent through 2006 and 6.5 percent in20071, indicating continuing growth for the industry.In addition, the NABE and other sources project thatboth stable interest rates and core inflation will exist as the likely scenario through the end of 2007.

In its second quarter 2006 CEO Economic OutlookSurvey, the Business Roundtable, an association of160 chief executive officers of many of the country’slargest corporations, reports that 48 percent of thechief executives expect to increase capital spendingover the next six months and an additional 48 percentexpect capital spending to remain at present levels.Only three percent expect to reduce capital spending2.

Additional economic forecasts that may impact theindustry include:

• Declining dollar – Economists expect that the U.S.,as measured by the Federal Reserve’s trade-weightedbroad dollar index, will weaken through the remain-der of this year (from 98.3 to 97.4) as well as through2007 (to 94.9 by year-end 2007)3. This may result inan increased demand from abroad for U.S. producedgoods and an increase in investment in manufacturingequipment

• Falling housing starts – As of July 2006, housingstarts fell by 5.1 percent year-to-date and by 13.3 per-cent over the same period last year4. Most economistsanticipate that residential investment will continue todecline in 2007, though estimates vary widely. Thedecline in residential construction will impact demandfor certain types of construction equipment and, giventhat the construction and real estate industries employnearly 7 percent of the U.S. workforce5, will likelyhave implications for the overall economy

• Stabilizing oil prices – Most economists expect oilprices to stabilize or decline through the end of theyear. Nearly half of the economists the NABE sur-veyed anticipate that oil will trade between $60-80per barrel (for West Texas Intermediate) by year-end,compared to $73 per barrel at the end of August.About twenty percent of the economists forecast oil tofall below $60 per barrel by year-end. Most of theeconomists participating in the NABE survey agreedthat rising oil prices will slow economic growth, butwill not trigger a recession unless prices exceed $100per barrel

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

mated that leasing (true leases and lease-like instru-ments) funded 27-28 percent of the total dollarsinvested in equipment. While interest rates, increasedin 2005 and through the first half of 2006, industryexperts do not believe that rates rose significantlyenough to impact the demand for leasing as a financ-ing product. As a result of this factor as well as cus-tomers’ increased demand for simple, transparentproducts, we estimate that leasing penetration, thepercentage of dollars invested in equipment fundedby leasing products, remained largely unchanged in 2006.

As shown in Figure 1, revised BFI (excluding soft-ware) in 2005 was $733 billion and the estimated

LEASING INDUSTRY OVERVIEW

1National Association for Business Economics: NABE Outlook, May 20062Business Roundtable: Second Quarter 2006 CEO Economic Outlook Survey, June 20063National Association for Business Economics: NABE Outlook, May 20064U.S. Department of Housing and Urban Development5U.S. Department of Labor, Bureau of Labor Statistics



Figure 1

total leasing volume reached $203 billion. In 2006,based on economic forecasts, BFI (excluding software)will increase to $794 billion and total estimated leas-ing volume will reach $220 billion. We project 2007leasing volume to reach approximately $234 billion,based on projections for BFI. Our estimates assumeno change in the percentage of equipment financed byleasing products.

However, as Figure 2 indicates, performance by sec-tor will vary. Based on second quarter 2006 GDP data,investment in non-computer IT equipment (includingmedical, communications, and office equipment) willincrease by nearly 11 percent over 2005 and invest-ment in industrial equipment and computers willincrease by 8.8 percent and 8.0 percent, respectively.Investment in transportation and construction equip-ment as well as in furniture and fixtures will alsogrow, but at a much slower rate. Only agriculturalequipment is expected to show a decline in invest-ment in 2006.

Beyond Stealing Share: Growing the Total Market

As we conducted our interviews with senior execu-tives at some of the industry’s leading companies, weasked them to discuss their views concerning howlessors could grow by increasing the total size of themarket (“a larger pie”) versus battling competitors for a larger share of the existing market (“a larger piece of the same pie)”. In addition to expanding overseas,which we discuss below, executives shared their viewson growing the market, including expanding theproducts and services that lessors offer and the typesof assets they finance.

Expanding the Definition of the MarketA number of leasing executives believe the “leasing”

industry has already grown to include all types ofequipment finance. As several managers point out,most “lessors” currently offer a broad array of financialservices products beyond leases and generate signifi-cant volume through non-leasing product (discussedlater in this Report).



A number of managers proposed opportunities tooffer products and services that go beyond traditionalfinancial services offers. In their view, an opportunityexists to exploit niche expertise to offer a verticallyintegrated suite of products. In one disguised exam-ple, an executive discussed the potential opportunitiesresulting from a focus on dental equipment. In thisinstance, this entails financing both personal as wellas commercial financing needs and expanding intoareas requiring value added advice such as a focus on mergers and acquisitions and related valuationanalysis and financing.

“Because of our current focus on financing dentalequipment, we have developed an expertise in assess-ing the cash flows peculiar to this industry to deter-mine whether the practice generates enough revenueto pay for the equipment. The next logical step is thatwe also provide financing for the dentist personally, acar loan, credit cards, etc. When a dentist wants topurchase a practice, we are able to provide acquisition

finance. Again, we have the expertise to analyze thepractice and evaluate the likelihood that it will gener-ate the required cash to pay the debt.”

“Given that we already evaluate practices to deter-mine if they can support their purchase price, it isreasonable that we should also provide practice valuation services for dentists trying to sell. To furtherexpand on our expertise in dental practices, we arealso in a position to provide M&A services for prac-tice acquisition as well as practice management servic-es and consulting.”

Financing Non-Traditional Assets6

A handful of interviewees expressed the view thatfinancing non-traditional assets, such as software orother intellectual property, offers a viable opportunityto grow the market. Conversely, however, most inter-viewees and other experts expressed skepticism of anytransaction in which they could not see, touch, andhold the underlying asset.

Figure 2

6For more on leasing intellectual property, refer to the 2002 Foundation study “Intellectual Property Leasing and Its Implications for the Leasing Industry 2002” available at www.leasefoundation.org/store



Figure 3

Those who believe in the potential of financingintangibles, including those that are currently engagedin the business, point out that the need to financingthese assets may become inevitable. As one executivenoted, “Increasingly, the most important products produced in the U.S. are intellectual properties. Wecannot just cut ourselves off from a huge chunk of the country’s domestic product.”

Even currently active players in this sphere admit anumber of issues must be resolved related to financ-ing intangibles, including:

• How does the lessor determine the value of the collateral?

• What does it repossess in the event of default and what, if anything is the remarket value?

• What is the legal standing of a lien on some types of intellectual property?

One of the more difficult issues to resolve, however,may have more to do with tradition and mindset thanwith liens and collateral valuation. Banks, investors,and hedge funds, among others, have been profitablyfinancing intellectual property and other non-tradi-

tional assets for decades. It seems unlikely that theequipment finance industry cannot do so as well.

FIC’s PerspectiveThe 2006 Industry Future Council Report discusses

Council members’ concern that leasing may becomeindistinguishable from other types of equipmentfinance. However, results from the Survey as well asinterviewees’ comments suggest that this transitionmay have already occurred. As we discuss in moredetail later in this Report, successful players alreadyunderstand that they must be far more than just“lessors” and have adjusted their business modelsaccordingly.

Capital AvailabilityCapital continued to be readily available in 2005;

overly available in the view of many of the executiveswe interviewed who believe that it continues to exertdownward pressure on pricing, preventing yields fromincreasing as rapidly as the cost of funds. Executivesstate that bank credit remains an easily obtainable



source of funding and that venture and private equityfirms are a growing source of capital for the industry.

As Figure 3 shows, the volume of lease securitiza-tions in 2005 grew by 53 percent over the previousyear to $9.6 billion. Based on the first six months of2006, securitization volume appears to remain at2005 levels. This may indicate that the market forlease-backed assets has completely recovered from the2001-2002 meltdown, when volume dropped by over55 percent.

Figure 4 shows that, in 2005, Survey respondentscontinued to rely on private placement of assets, gen-erating over 50 percent of securitization volumethrough this structure. However, respondents reporteda marked shift away from commercial paper conduitsto public offerings of securitization deals. Commercialpaper conduit volume declined by 43 percent in 2005over 2004, and the volume of deals placed throughpublic offering increased by 64 percent over the sameperiod.

Overall, given the expected economic growth,increased investment in machinery and equipment,and the continued availability of funding, and absent

any significant external shocks, solid growth in theequipment finance industry should continue through2007.

Accounting and Regulatory IssuesAs we discussed in last year’s Report, beginning in

the 2004-2005 time frame, a number of regulatoryand accounting changes impacted the industry.Among the changes:

• Provisions in Sarbanes-Oxley mandated that pub-lic companies increase the transparency with whichthey report lease obligations, essentially requiring thatleases be reported as debt

• Changes in the U.S. tax code sharply reduced oreliminated the economic attractiveness of many typesof cross-border and lease-back transactions

• Implementation of Basel II reduced the economicviability of many large-ticket leveraged deals byrequiring that as banks calculate the amount of risk-adjusted capital they must hold, they include theirpotential loss if the lessee defaults

This year, interviewees discussed the impact of

Figure 4



Sarbanes-Oxley in terms of the economic cost of com-pliance. In the words of one Captive executive, “Thecost to purchase, integrate, and test the reporting sys-tem alone cost us millions. That does not eveninclude the cost of the additional people we hired toensure compliance or the time we spent rewriting allof our processes and procedures so that they meetSOX requirements.”

Although industry executives see no major newaccounting, regulatory, or legislative issues on thehorizon, a number of managers believe that oneperennially discussed issue may become an imminentfactor: changes in the lease accounting standard.

Currently, the Financial Accounting Standards Board(FASB) is engaged in a multi-year project convergingU.S. Generally Accepted Accounting Principles (GAAP)with International Financial Reporting Standards(IFRS). The issue worrying some leasing executivesrelates to the FASB and IASB defining leases as eitheroperating or capital based on the substance, or intent,of the transaction rather than on its form; as is GAAP’sapproach. Under a proposed change in the currentstandard, many of the transactions that lessors current-

ly are able to book as operating leases will be requiredto be recognized as capital leases. Lessees will nolonger be able to deduct lease payments as rent butwill instead be required to record the asset and corre-sponding lease on the balance sheet and the currentyear deduction will be limited to the effective interestexpense and the appropriate depreciation based on theexpected life of the asset.

Some interviewees believe that these changes willhave a significant negative impact on their business.Other executives disagree, pointing out that a signifi-cant amount of their current activity is already bookedas loans and on-balance sheet leases.

The Competitive EnvironmentThe competitive environment continues to exhibit

the traits of a maturing industry. Relatively little prod-uct differentiation exists and, given that the Internetaffords customers near perfect information, playerscompete primarily on price and, to some degree, con-venience. Players grow by stealing market share fromcompetitors versus growing new markets. However,changes in market share appear to occur only between

Figure 5



competitors of the same lessor type. As Figure 5shows, market share by type of lessor remained virtually unchanged from the previous year, indicatingthat players may be optimizing the competitive advan-tages inherent to each type of lessor.

BanksBanks’ competitive advantage in the equipment leas-

ing and finance industry results primarily from theirexpertise in assessing risk and their ability to leveragethe commercial bank for origination. As discussedlater, at least in the past year, funding cost no longerprovided a significant competitive advantage to banks.

Bank lessors typically operate much like a commer-cial bank, assessing deals primarily based on the bor-rower’s (lessee) cash flow, that is, their ability to repaythe loan, with little consideration of the underlyingvalue of the equipment. Many banks take a very lowresidual position, typically less than 10 percent. Asone bank executive stated, “The last thing we want isto take back the equipment. What are we going to dowith it, put it in the parking lot?” Bank-owned lessorsare, in affect, lending money. And, as one executive

noted, “No one has more experience lending moneythan banks. We have been doing it for hundreds ofyears.”

Bank-owned lessors’ second significant competitiveadvantage rests on their access to a pool of customersabout which they have a great deal of information andwho are already inclined to do business with thebank, namely the commercial bank’s customers. Asshown in Figure 6, Banks increased the percentage ofnew business volume they generated from internalbank clients by over 12 percent over the previousyear. Small-ticket transactions comprised five percentand middle-ticket transactions comprised 75 percentof the total new business volume generated frominternal clients. Given that few banks participate inthe micro-ticket segment on a direct basis (less thanone-half of one percent of Bank micro-ticket volumeis originated directly), it is likely that large-tickettransactions comprise much of the remaining volumegenerated from bank clients.

Banks-owned lessors can optimize this advantage bylinking closely with the commercial bank and includ-ing its products in the overall package of finance solu-

Figure 6


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

tions that banks offer their customers. Doing so willincrease margins, decrease origination costs, and linkthe customer more tightly to the bank, improving thelikelihood of increasing shareholder value. However,significant challenges often prevent the leasing organi-zation from effectively working through the commer-cial bank. Commercial bankers often do not under-stand the leasing product, its value to the customer, orits profitability for the bank. Often, individual bankersview leasing as a product that eats up part of the cus-tomer’s overall credit capacity and for which theyreceive little compensation or glory.

Some banks, such as Chase, have been successful inovercoming these challenges. Their profitability modelallows bankers to understand the profitability of alease versus a loan for any given deal. Since Chasecompensates its bankers based on net growth in rela-tionship profitability, bankers are incented to structuredeals based both on what is best for the customer andwhat generates the most profit for the bank.

While outside observers may view the linkagesbetween a bank-owned leasing company and its com-mercial banking group as a no-brainer, until recentlylinkages between the two groups have often beenminimal. Most recently, however, bank management’sincreased focus on cross-sell, wallet share penetration,and relationship profitability has, in many cases,resulted in an institutional push that, in effect,demands internal cooperation. While some leasingexecutives still maintain an independent stance fromtheir banks, more appreciate the origination opportu-nity and take advantage of the deal flow commonownership offers.

CaptivesCaptives continue to enjoy three advantages over

other players: their ability to bundle the equipmentand financing at point-of-sale, their knowledge of theequipment for calculating residuals, and their assetmanagement capabilities. While most Captives con-centrate on financing only their parent’s products, anumber of Captives have broadened the scope of theiroperations to include a variety of manufacturers, typi-cally as part of a package to finance a specific project.Most Captives do not expand their scope to becomegeneral lessors and respondents to this year’s Surveyreported directly originating less than five percent ofnew business volume.

Captives’ dominance of the point-of-sale channel

may be under assault by Independents. This year’sSurvey indicates that Independents generated nearlyseven percent of the total volume originated throughcaptive programs. A number of executives of smallerIndependents have indicated that they are increasingtheir focus on creating captive programs for manufac-turers that lack either the resources or desire to buildin-house capabilities. In addition, manufacturers maybe under increasing pressure from shareholders andWall Street to focus on their core competencies anddivest themselves of ancillary businesses, such as cus-tomer financing. Others, such as Ford Motors, maysell their finance units in order to raise cash.

In this year’s Survey, as in the past, Captives report amuch higher credit approval rate versus other lessortypes, approving 89 percent of submitted applications(compared with 69 percent for both Banks andIndependents). In the view of many leasing execu-tives, Captives’ equipment knowledge and asset man-agement capabilities allow them to approve more mar-ginal credits without significantly increasing their risk.As one executive noted, “If a lessee defaults, theCaptive is in the best position to grab the equipment,refurbish it, and then sell it through their own net-work. In all likelihood, they will lose little if anythingfrom that default.”

One of the central challenges that Captives facerequires them to balance their credit/risk responsibili-ties with their mission to support and facilitate thesale of their parents’ product. To reduce conflicts, few,if any, Captives have any reporting responsibility tothe sales organization. According to most executives,conflicts seldom exist and those that do arise are oftenresolved through internal recourse agreements orother arrangements that protect the Captive’s portfolioquality. Another challenge for Captives is to fully inte-grate the financing with the equipment sale, creatingan environment in which it becomes second naturefor the equipment sales person to incorporate thefinancing into his/her quote. Captives that stand outin that regard include Dell and Caterpillar.

Independent, Financial ServicesIndependents’ competitive advantage includes their

flexibility and service. In addition, a number of execu-tives cite their underwriting capabilities as an advan-tage over Captives and their asset management skillsas an advantage over Banks.

Successful Independents understand their competi-

20



tive advantages and create targeted approaches toexploit them. Some compete effectively against Banksby focusing on equipment types and/or credits thatBanks typically avoid. By avoiding direct competitionwith Banks, these Independents are able to earn aboveaverage returns while their underwriting and assetmanagement capabilities help to reduce losses.

Independents are also increasingly competing in thepoint-of-sale channel, providing vendor and captiveprograms. As Figure 7 indicates, new business volumegenerated by Independents from vendor programsincreased by nearly 20 percent over the previous year.The decline in volume from captive programs largelyrepresents CIT’s loss of the Dell program. A number ofexecutives of small Independents indicated that theyare increasingly targeting small manufacturers toestablish captive or vendor programs. In their view,these manufacturers lack the scale and the capabilitiesto establish their own captive finance units and maybe unattractive to large Independents because of theirlow volume potential. These executives believe thatthey can add value for the manufacturer by increasing

sales while generating an attractive return on theirown investment.

Overall, Independents appear to be either minnowsor whales. As Figure 8 shows, of the 53 distinctIndependents reporting in this year’s Survey, nearlyhalf were small, (less than $50 million in annual vol-ume) and in total, they generated less than two per-cent of the new business volume reported byIndependents. However, the three largestIndependents, those generating over $1 billion in newbusiness volume, generated 79 percent of all newbusiness volume reported by Independents. Mostindustry experts agree that it has become increasinglydifficult for small Independents to become large.Many insiders believe that most of the Independentlessors formed within the past five years have incor-porated into their overall strategy a plan to sell uponreaching a certain size.

Continued success for smaller Independentsdepends on their ability to identify and exploit marketniches quickly, reduce origination costs, preservecredit quality, and retain access to funding.

Figure 7



Can Small Lessors Compete in a Global Economy?

As discussed in this year’s Industry Future Council(IFC) Report, one of the “hopes” for the industryrequires U.S.-based leasing companies to adopt aglobal view and develop the capabilities required tomeet existing customers’ potential offshore equipmentfinance needs.

In our interviews, we focused on the extent towhich lessors perceive the need to develop overseascapabilities and how small lessors, which comprisemuch of the industry, can operate overseas without a significant investment in brick and mortar.

According to the Department of Commerce’s Bureauof Economic Analysis, U.S. companies invested $27billion in existing overseas operations in 2005 and anadditional $40 billion to acquire or create offshoresubsidiaries7. Despite this significant overseas oppor-tunity, most lessors we interviewed did not perceivethe need to develop international capabilities.

However, because the opportunity is substantial and

because small companies in particular are at a disad-vantage in pursuing this market, it is appropriate tofocus on how small lessors can compete in a globaleconomy. In its Report, the IFC suggests two waysthat U.S.-based lessors can enter offshore markets:establish a de novo physical presence or, partner with an existing company and leverage its in-countrycapabilities.

Executives agreed that lessors are unlikely to be successful pursuing local business in countries wherethey do not have a brick and mortar presence. Theyalso agreed that the cost to build a brick and mortarpresence outside of the U.S., and perhaps Canada, isprohibitive for all but the largest lessors. As a result,our discussion centered on how small lessors canmeet the overseas equipment finance needs of theirexisting customers and whether partnering with anexisting company is a viable option.

Between 2000 and 2005, the Bureau of EconomicAnalysis reports that U.S. Direct Investment Abroad(USDIA) grew at a compound annual rate of 9.5 per-

7U.S. Department of Commerce, Bureau of Economic Analysis, U.S. Direct Investment Abroad: Country and Cost Detail, July 2006

Figure 8



cent, nearly double the growth rate of the overalleconomy. Given the rate at which U.S. companiesare expanding abroad, an increasing number oflessors will receive inquiries from existing customersthat are interested in financing equipment for theiroverseas operations.

Can small lessors partner with existing local compa-nies and leverage their infrastructure and local expert-ise to finance offshore equipment for their existingU.S. customers? One Captive, albeit the captive of avery large company, is already doing so. This compa-ny’s mandate is to finance its parent’s product in eachof the 170 countries in which the parent operates. Topractically and cost efficiently do so, the Captive hadto establish partnerships with existing local financialservices firms. For each transaction, the Captive pro-vides the funding and the local partner (for exampleGE Capital, a large multi-national bank, or a localplayer) provides processing capabilities, customerservice, and billing, collections, and other operationalfunctionality.

The executive overseeing global expansion for thisCaptive lessor acknowledges that there are risksinvolved, but accepts those risks because this is theonly model that allows it to operate in so many countries without a massive investment in local infrastructure.

FIC’s PerspectiveGiven the rate at which U.S. companies are invest-

ing overseas, even small lessors are eventually likely to face a customer’s request to finance offshore equip-ment. As an alternative to referring business to com-petitors with international capabilities or investingdirectly in local infrastructure, lessors can considerpartnering with a local player to provide the requiredlocal support. Among the issues to consider:

• Retaining ownership of the customer – The pri-mary concern raised by small lessors we spoke withrelated to the potential loss of the customer to thelarger lessor. As one executive noted, “There would be a tremendous temptation for the large lessor toapproach the customer directly and take the entirerelationship, including the U.S. business.” Whilepotentially limited by non-compete agreements, somelimited risk of losing a part or all of the relationship to the local partner does exist

• Ensuring service levels – Turning any customer-facing activity over to a third-party creates risk anddiscomfort the lessor. Lessors need to rely on detailedService Level Agreements in order to ensure the proper level of customer experience

• Maintaining lessor profitability – It is unlikely thata lessor will be able to pass the additional internalcosts associated with the overseas transaction throughto the customer, particularly given the existence ofplayers that can provide international capabilities atno additional cost to the lessee. Players need to evalu-ate each deal to determine if the overall relationshipgenerates enough profit to warrant providing the over-seas service

The Perception of the Leasing andFinance Industry

In this year’s Industry Future Council Report, mem-bers discuss a number of issues, which, if unresolved,could have significant negative implications for theindustry. In their view, the most pressing issue is thepublic’s negative perception of the leasing industry. As we interviewed senior managers, we asked them to discuss their view on the genesis of the issue, what can be done to resolve it, and who should takethe lead.

The CausesMost interviewees agree that multiple events over a

number of years have contributed to the unfortunatepublic perception that lessors and used-car salesmenare cut from the same clothe. However, several specif-ic “events” standout:

• Industry practices – When falling interest ratesand increased competition cause margins to compressdramatically, many lessors turned to fees, end-of-leaserental, and other means to increase the financialreturn from each transaction. While all of the fees andadditional charges may have been stated in the docu-mentation, they were typically not made clear to thecustomer. As a result, the total cost of the transactionbecame significantly higher than the customer, typi-cally a small business owner without benefit of afinance department and legal team to vet the deal,originally expected

• Enron – The fallout from the collapse of Enronincluded a regulatory focus on a number of the prac-



tices that the company used to inflate profits and hidelosses from shareholders, including the use of off-bal-ance sheet Special Purpose Entity (SPE), the entitiesused by large-ticket lessors in highly structured, andcompletely legitimate, lease transactions. However, asa result of the ensuing publicity and regulatory andlegislative changes, public companies eschewed theuse of SPes and any instrument that could be per-ceived as being other than totally transparent

• NorVergence – While the NorVergence scam wasnot perpetrated by a leasing company and, arguablylessors suffered the greatest economic loss from thescheme, poor public relations and crisis managementcaused the scandal to be inexorably linked to theindustry. As details of the scandal emerged whenSprint began to cancel service to the small businessesthat had leased the NorVergence device (the price ofwhich customers were told included unlimited tele-com service) lessors continued to demand paymentfor the now worthless devices. To customers whocould no longer reach their NorVergence salesman,the lessor became the face of the fraud, a fact thelessors involved were slow to recognize

In addition to a number of well-publicized events, a nearly continuous flow of news related to scandal,fraud, and deception involving the leasing industryappears in the press. As one executive noted, “We canbook 10,000 flawless transactions a day, but if onegoes bad, that is the one that will end up on the frontpage. What we do right does not sell papers, what wedo wrong does.”

Based on managers’ comments, the perception issuemay impact smaller Independents far more than otherlessor types. Bank-owned lessors enjoy the reputationof trust that a bank name typically invokes. As oneexecutive noted, “In the customer’s mind, he/she isnot doing business with XYZ Equipment Finance,they are doing business with Bank XYZ. And, peopletrust banks.” Similarly, for Captives, the reputation oftheir manufacturing parent overrides the reputation of the leasing industry

The SolutionVirtually everyone we interviewed agreed that, while

the problem may be the result of the actions of a fewrogue lessors, the solution is the responsibility of theentire industry. Executives discussed a number of

actions, which must be accomplished in concert inorder to have a meaning impact. Among their recom-mendations:

• Enact a strong Code of Ethics – Intervieweesagreed that the Equipment Leasing Association’s (ELA)Code of Ethics should form the basis of industry con-duct. While some managers were aware of the ELA’sactivities related to updating and revising its Code,many were not, indicating that industry leadersshould place an increased emphasis on communicat-ing the Code

• Enforce the Code of Ethics – Without the meansor will for enforcement, the ELA’s Code of Ethics willcarry little weight. However, most managers agreedthat the Association is unlikely to take an aggressiverole policing its members, and they further under-stand that there is little that it can do to regulate theactivities of non-members

• Create an ELA certification program – One wayfor the ELA to regulate how its members do businessand to mitigate its inability to influence non-membersinvolves the creation of a certification program. Muchas Underwriters Laboratories certifies consumer elec-tronics that have met its specifications, the industrymight certify lessors that conduct business accordingto its Code of Ethics and de-certify those that fail tomeet its standards.

• Build the ELA brand – Lessors agreed that for anELA certification program to successfully contribute toa positive change in the industry’s image, theAssociation must create strong brand awarenessaround itself and the program. A number of managerscited the National Realtor Association’s success at cre-ating an image for its members as businesses of thehighest ethical standard. Building and maintaining thebrand will require a prolonged and consistent efforton the part of the ELA and its members

• Promote the positive – As a number of executivesrightfully pointed out, “Bad news sells.” While theindustry processes millions of transactions and fundsbillions of dollars worth of equipment without inci-dent, much of what the public hears about the indus-try relates only to events that rarely occur. To date, theindustry overall has done an insufficient job of gettingits story heard in a way that impresses the public.Press releases related to the percentage of railcars or



inter-modal containers financed by the industry willlikely be of far less interest to most than stories ofhow leasing makes the latest diagnostic equipmentavailable to even small rural hospitals

Overall, interviewees agreed that while individualcompanies must examine their internal practices, it isa central group like the ELA that must take a leadingrole in the effort to change the industry’s image.

The IssuesIn some industry leader’s views, the fact that the

industry’s negative image does not impact all lessorsequally could be a major impediment to action. Theyquestion whether there will be the long-term commit-ment of time and resources that is required to addressthis issue given that the members that are footing thelargest share of the cost are those that may be the leastaffected.

FIC’s PerspectiveUnless there is a strong, focused, and prominent

effort by the industry to address the public’s concerns,

small business owners, fearful of being “taken”, mayincreasingly turn to bank financing and politicians andregulators, seeing the industry as an easy mark withfew allies, will attack it for political gain.

For an industry that is seeking to “reinvent” itself,grow its markets, and head off additional regulation,failure to commit fully to addressing its image problemis shortsighted and over the long term could have adevastating impact on the commercial finance industry.

Industry TrendsOver recent years, some of the major trends we

have observed include the growth of Bank domi-nance, the bi-polarization of the Independents, and the increased use of automation. None has the potential to redefine the industry to the sameextent as the continuing shift of traditional lessors to provide customers with multi-faceted equipmentfinance solutions rather than a standalone equipmentlease product.

In 2000, Survey respondents reported booking just over 40 percent of total new business volume

Figure 9

25



through conditional sales agreements and traditionalloans (See Figure 9). By 2005, the share of new busi-ness booked through these products reached nearly55 percent, an increase of over 28 percent. By trans-action size, the increased prevalence of “non-leasing”products becomes even more striking: a nearly six-fold increase in micro-ticket and an 87 percentincrease in large-ticket.

Even as the ELA expands its mission to includeboth equipment leasing and finance, many lessors, in practice, have already done so. Implications of thiscontinuing trend for the industry, include:

• A leasing specialization may no longer be viable –As customers increasingly expect a variety of productoptions, players may no longer be able to survive byoffering only leasing. Those players lacking the capa-bilities to expand their product set face possible mar-ginalization and eventual disappearance

• Banks will continue to grow in dominance – Theindustry’s trend toward equipment lending versusleasing plays to the Bank industry’s primary competi-tive advantage. As Banks become better at marshallingthe financial products and services available from allareas of their organizations, they should dominate theindustry. Our view, and the evidence supports this, isthat banks are finally becoming better at this

• The available market is huge – The industry haslimited its potential opportunity by defining its avail-able market as the “leasing customer”. Over the years,our estimates have sized that market at approximately$200 billion. By including all types of equipmentfinance, the available market becomes the equipmentpurchaser and its size jumps to well over $800 billion

• Players must broaden their focus - Those playersthat already operate as equipment finance companiesversus equipment leasing companies understand thattheir focus must center on creating a value proposi-tion that differentiates their companies from the com-petition. They further understand that the competi-tion includes all types of lenders, not just those in the“leasing industry”. In addition, their value propositionmust also be strong enough to compel potential cus-tomers, even those that might otherwise choose to paycash, to use that lessor to finance their equipment

To some extent, recognition of this paradigm shiftchanges little, given that most players have long oper-ated as full-service equipment finance companies.However, accepting that this may indeed be the “newworld order” may focus some players to direct theirenergy toward capturing an increased share of a muchlarger market than they believed existed.



This year’s ELA Survey includes 133 survey respons-es from 125 companies. Three companies providedseparate surveys for their various lines of business.

Each year’s Survey asks respondents for current andprior year data. Unless otherwise indicated, datacharts comparing two years’ data include only thoserespondents providing information for both years.Since the respondent set varies each year, it is notpossible to compare absolute numbers between differ-ent years’ Survey Reports. However, the SurveyAdministrator, PricewaterhouseCoopers, analyzed datarepresenting a number of years and determined thatthe relative data (for example, percentage of new busi-ness volume generated by a specific lessor type or per-centage of new business originated through a certainchannel) is statistically accurate. Therefore, some ofour analysis of the Survey relies on relative, notabsolute, data.

We have organized our analysis of this year’s Surveyinto the following major components:

• The Overall Industry• Lessor Profitability• Market Segment Profitability

The Overall IndustryOverall, Survey respondents reported a strong

increase in new business volume in 2005. While pre-tax yields improved slightly, spreads declined sharplyas the cost of funds increased more rapidly than pric-ing. Net income increased slightly over the previousyear as did Return on Equity (ROE); Return on Assets(ROA) remained unchanged. Credit quality alsoimproved as charge-offs declined sharply over the pre-vious year. However, delinquencies increased slightly.Operational efficiency improved again this year, aslessors increased volume without increasing staffing.

Our analysis of the overall industry focuses on thefollowing areas:

• New Business Origination• Profitability and Funding

ANALYSIS OF THE SURVEY OF INDUSTRY ACTIVITY

Figure 10

27



Figure 11

Figure 12

28



• Portfolio/Credit Quality• Operations

New Business OriginationFor the second year, respondents reported strong

growth in new business volume. As Figure 10 shows,overall volume increased by over 10 percent and thedistribution of volume by size of lessor remainedunchanged. The smallest lessors, those with annualvolume less than $50 million, experienced significantgrowth, increasing new business volume by over 28percent.

As Figure 11 indicates, volume originated indirectlyincreased slightly over 2004 as lessors increased theirreliance on third parties to generate business. Vendorand captive programs continued to be important, gen-erating nearly half lessors’ new business volume inboth 2005 and 2004.

The top five end-user industries generated nearly 60percent of new business volume, virtually unchangedfrom the previous year. However, three of the top fiveexperienced a decline in volume over the previousyear. As Figure 12 shows, the volume of equipmentsold to the wholesale/retail industry experienced thesharpest decline, 7.8 percent, while the volume of

equipment sold to both the construction and manu-facturing industries declined moderately, 4.3 percentand 3.1 percent, respectively. In contrast, the volumeof equipment sold to the services industry grew signif-icantly.

As a percentage of total volume, the top five equip-ment categories grew significantly over 2004 (SeeFigure 13). A 20 percent decline in constructionequipment volume was more than offset by a 291 per-cent increase in corporate aircraft. Analysts speculatethat the decline in construction equipment could bethe result of the industry planning for the expectedslowdown in new home construction. In addition,new business volume in both medical equipment andtrucks and trailers grew versus the previous year.

In March, the General Aviation ManufacturersAssociation reported that, while 2005 was a recordyear for the industry, total sales increased by just over27 percent versus 2004. This indicates that theincrease in corporate aircraft volume reported in thisyear’s Survey may be the result of one or two respon-dents entering that business in 2005 rather than a sig-nificant increase in corporate aircraft sales.

The use of tax-oriented and leveraged lease productsdeclined very slightly from 2004. As Figure 14 shows,

Figure 13



Figure 15

30

Figure 14


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 N31

Figure 16

Figure 17


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 N32

this year’s respondents booked 36.7 percent of totalnew business through those products versus 37.6 per-cent in 2004. Illustrating the industry’s trend towardgeneral equipment finance, the volume booked asterm loans grew almost 85 percent over 2004 to com-prise nearly 20 percent of total volume.

Industry Perspective and Potential ImplicationsAs discussed earlier, continued economic expansion

will fuel growth in the equipment leasing and financeindustry. However, growth by equipment type andend-user industry will be uneven as economic andtechnological changes impact segments differently. Inaddition, it is likely, at least in the near-term, that cus-tomers will continue to prefer loans versus more com-plex products.

Potential Implications➣While all lessors must continually monitor their

markets and anticipate potential changes in the envi-ronment, niche players with a focus limited to a smallnumber of market segments or equipment categoriesmust be particularly cognizant of events that couldimpact their business. Lacking the diversity to insulatethemselves from a shock to one of their niches, theselessors must develop strategies to anticipate and reactto changes in their markets. For example, lessors thatcurrently focus on one or two segments should identi-fy alternative segments in which they can successfullyparticipate and uncover the trigger events that willcause them to shift focus

➣Players can no longer limit their focus to leasing.As discussed elsewhere, the market demands a broadarray of products and solutions. Lessors that cannot or will not respond will under perform versus com-petitors

Profitability and FundingThis year’s respondents reported that both net

income and ROE improved in 2005 while ROAremained unchanged. Pre-tax yields improved moder-ately, but spreads declined, driven by an increase inthe cost of funds. Leasing profitability rose in largepart because of companies’ ability to reduce expensesand improve credit quality

As shown in Figure 15, both net income beforetaxes and ROE grew by five percent over 2004. ROAremained unchanged for the third year at 1.7 percent.As Figure 16 indicates, lessors were able to improve

net income by reducing expenses and cutting provi-sions for bad debt. Increasing rates, however, droveinterest expense sharply higher.

Average pre-tax yields increased significantly in2005 to 7.4 percent (See Figure 17). However, a120bps increase in the cost of funds drove averagepre-tax spreads down almost 16 percent to their low-est level since the Survey began.

Figure 18 shows that while the smallest lessors (byannual volume) operate with the highest cost offunds, they are able to command high enough pricesto earn pre-tax spreads rivaling pre-2001 levels. Thereare a number of possible explanations for the highreturns small lessors are able to earn. A number ofexecutives we spoke with stated that small lessorstend to differentiate themselves by offering high levelsof personal service and that some customers are will-ing to pay a premium to receive superior service.However, as we discuss below, an analysis of smalllessors’ delinquencies indicate that they may also dealwith lower quality credits than larger lessors and thatthe premium they earn is tied to the additional riskthey are taking.

Figure 19 indicates that while Third Party lessorsenjoy pre-tax spreads approaching 6 percent, the costsassociated with this business model are substantial,producing net income of 17.5 percent, well below theoverall average and the other business models.

Industry Perspective and Potential Implications2005 again saw increased margin compression as

the market continued to be flooded with capital. Mostexecutives stated that margins shrank through the sec-ond quarter of 2006 with the rare of compressionslowing. However, short of a significant decline incredit quality or an economic downturn, few withinthe industry believe that capital will flee the market orthat margins will return to where they once were.

Potential Implications➣ The rate of improvement in net income has

slowed significantly over the past two years, indicat-ing that lessors are having an increasingly difficulttime increasing profits through expense reduction andoperational efficiency. Unless lessors are able toincrease margins, profits may begin to erode

➣ Although some executives indicate that the rateof margin compression may have leveled off, marginsremain at record low rates. In order to improve yields,



Figure 18

Figure 19



lessors must develop a value proposition for whichsome customers will pay a premium. Several smalllessors appear to have created such a value proposi-tion and found the customers that value it. Otherlessors must do the same

Portfolio/Credit QualityOverall, credit quality and portfolio performance

continued to improve in 2005. Delinquencies, meas-ured as receivables over 31-days, declined by nearlyfive percent over 2004 (See Figure 20). Receivablesover 90-days declined nearly 23 percent to .7 percent.

While the smallest lessors may produce the highestreturns, they also have the highest delinquencies. AsFigure 21 indicates, lessors with annual volume lessthan $50 million reported nearly six percent of receiv-ables over 31-days, over half of delinquencies exceed91-days. As discussed above, this could result fromaccepting riskier credit or from small lessors beingunable to devote the same resources to the collectionsprocess as larger lessors.

Figure 22 shows that average charge-offs declinedfrom 1.5 percent of net receivables in 2004 to onepercent in 2005. Median charge-offs remainedunchanged at .5 percent.

Industry Perspective and Potential ImplicationsA number of lessors noted that credit quality is

extremely good. One executive stated that, “In 25years in the business this is as good as I have everseen it [credit quality].” Of course, economic condi-tions directly impact credit quality, and the economyhas been expanding for several years. In addition,credit-scoring models have reach maturity and theirpositive impact on portfolio performance is evident.

Potential Implications➣ In order to generate higher margins, some lessors

may be able to create separately managed portfolios oflower quality assets. However, building this type ofportfolio requires strong underwriting skills, collec-tions, and asset management capabilities

➣ While overall credit quality remains strong and isexpected to remain so in the near-term, specific mar-ket segments may experience difficulty meeting theirlease and loan obligations. For example, as the hous-ing market slows, lessors could experience delinquen-cies from the construction industry. Portfolio man-agers should be prepared to act quickly in the event

of segment specific difficulties➣ Portfolio credit quality cannot get any better than

it is today. In fact, several of our client banks areincreasing 2006 reserves in expectation of a less san-guine risk environment. Lessors need to evaluate theirreserves, potentially increasing them from prior years.No one expects a major credit decline but conserva-tive lenders are preparing for a return to what theyconsider more normal times

OperationsThe 2006ß Survey focuses on several aspects of les-

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

Application ProcessingThis year’s respondents approved over 72 percent of

the applications submitted, representing just over 70percent of the total dollars submitted (See Figure 23).Lessors booked and funded or sold nearly 55 percentapplications submitted, or 50 percent of the dollarssubmitted. This year, lessors “lost8” just over 20 per-cent of the dollars submitted and approved.

Equipment RemarketingSurvey respondents reported that the original lessee

purchased over 50 percent of leased equipment (byfair market value lease volume) and renewed the leaseon an additional 24 percent (See Figure 24) of equip-ment. Equipment remarketing activity in 2005 closelymatched 2004 activity.

Large-ticket lessors reported that the original lesseepurchased over 75 percent of leased equipment andrenewed the lease on an additional 10 percent ofequipment leased. Small-ticket lessors reported thatonly 64 percent of leased equipment remained withthe original owner. This is likely because of the highrate of obsolescence for small ticket equipment.

This year’s Survey captures a significant amount ofnew data related to asset management and residuals.While no trends emerge from the first year of data, weexpect to increase our focus on this area in next year’sReport.

Employee DistributionDespite a 10 percent increase in volume, between

34



Figure 21

Figure 20



Figure 23

36

Figure 22

Booked and Funded or Sold



Figure 24

Figure 25

37



2004 and 2005, Survey respondents shed over 1,500jobs, over 7 percent of their headcount. As Figure 25indicates, cutbacks appear to have been concentratedin sales and administration. With a few exceptions,employee distribution remained similar to the previ-ous year. Part of the FTE reduction was the result of anumber of bank mergers that were completed in2005. However, Independents reported the largestreductions.

Other than the two areas previous noted, the onlyarea in which a significant change was reportedinvolved collections and workout. In 2004, 7.6 per-cent of lessors’ FTEs occupied these positions. In2005, the number of collections and workout FTEsincreased by nearly 15 percent. This reallocation ofresources could indicate that lessors are anticipatingdelinquency or credit problems in the near future.

Overall, headcount data indicates that lessors con-tinue to improve productivity and efficiency, enablingthem to generate more business with fewer FTEs.

Operational EfficiencyOverall, lessors’ reduction in FTEs translated into

improved efficiency. As Figure 26 shows, lessorsgained efficiencies in nearly all areas except netincome per FTE, which declined by nearly three per-cent and sales, general, and administrative expenseper FTE, which increased by 30 percent.

New business volume per FTE increased by nearly20 percent and loan and lease revenue per FTE grew12 percent. Both of these ratios indicate that althoughlessors reduced their sales staff, they were able to gen-erate increased productivity from those remaining.Overall, it appears that at least some lessors may haveshed headcount in an attempt to increase profitabilitydespite declining margins.

Industry Perspective and Potential ImplicationsAlthough lessors were able to improve operational

efficiency in 2005, it is clear that they may havereached a point of diminishing returns. Despite themost significant reduction in headcount in the pastseveral years, they were able to produce only a fractionof the growth in net profitability of previous years.

A significant number of approved applications con-tinue to fail to be booked. In 2005, lessors collectively

Figure 26



lost almost 30 percent of their new business volumeeither to a competitor or to an alternative source offunding (for example, cash, existing bank line, orequity funding). Since these are applications that arealready approved, not only did lessors lose the busi-ness, but they lost the time and resources they invest-ed in processing and underwriting the application.

Potential Implications➣ Lessors need to focus not only on cost reduction

but also to identify products, equipment types, andcustomers that can generate higher yields without sig-nificantly compromising portfolio quality. One way toimprove yields is to identify why a substantial numberof applications that lessors have processed andapproved are not booked. Lessors that can reduce theflow of “lost” deals will see a marked impact on theirbottom line

➣ While most lessors may have maximized theoperational efficiencies available through automation,the best players are leveraging technology to improvecustomer service and are striving to create superlativeexperience for which a meaningful number of cus-tomers are willing to pay. Other players, particularlybanks, are leveraging technology to increase theirshare of the customer’s available wallet. However,lessors should approach technology investments withwell-conceived business plans and clearly definedexpectations

Accessing the Customer: The Increasing Importance of the Vendor Channel

Lessors currently generate over 25 percent of theindustry’s new business volume through vendor pro-grams. Independents that have flourished in the faceof their expected demise have done so in part byleveraging the vendor channel to “even the playingfield” with Captives and Banks. Given the importanceof the channel, and the likelihood that it will continueto grow in importance, we asked executives from anumber of the top players in this market to discusssome of the challenges related to vendor programsand key factors required for success.

Competitive EnvironmentWhile small manufacturers have been, for the most

part, overlooked by larger players, several small inde-pendent commercial finance companies have focusedon the market and been extremely successful. As a

result of their success, a number of large players,including GE Capital, CIT, US Bank, and Wells Fargohave also recently taken an interest in this segment.However, in the view of one lessor, “Given their coststructure and internal hurdle goals, there is a limit tohow far down the food chain the big guys can go.They cannot make their numbers from a $10 or 15million manufacturer.”

A number of small independent finance companiesare focusing on small ticket vendor program. Becausethere are so many small vendors and relatively fewplayers in the market, competition for vendor rela-tionships may not be as intense as it is in other areasof commercial finance. However, fierce competitionexists from numerous sources, including bank andcredit card companies, to provide financing to the endcustomer. A manager noted, “Just because we have thevendor program does not mean that we automaticallyget the deal. We are competing on every level for thatdeal, with the banks that offer check accessible linesof credit to the credit card companies with mileageprograms. It is rarely easy.”

Service ModelsLessors serve the market through one of two distinct

value propositions:• Generalist/Wholesale approach – Providers

employing this approach typically operate across awide range of industries with little in-depth knowl-edge of any one segment. They primarily compete onprice and typically have highly automated and effi-cient processes

• Knowledge-based/Customer intimate approach –Providers possess in-depth industry experience andunderstand the needs of the customer, industry termi-nology, etc. Typically, knowledge-based providers con-fine their activities to a limited number of industrysegments. They price higher than generalist providersand rely on industry experience and contacts for com-petitive advantage

The vendors’ choice of provider and service modeldepends on its own needs as well as the needs of itscustomers. For example, medical equipment vendorstypically require a knowledge-based, high-serviceapproach to meet the needs of its customers. In con-trast, the materials handling industry often valuesprice more than service.

With both models, programs with recourse back tothe vendor in the event of loss are rare. However,



there are times when the vendor wants the lender tofinance deals that are below the lender’s minimumcredit criteria. To mitigate these situations, vendersand lenders often establish ultimate net loss pools.For each transaction that falls outside the lender’scredit standards, the vendor contributes an agreed topercentage of the deal to the pool. The worse thecredit, the higher the percentage of the deal the ven-dor contributes. The lender is made whole on anylosses from the pool. However, as vendors increasing-ly leverage funding partners that specialize in sub-prime credit, ultimate net loss pools are becoming less common.

Regardless of the model, lenders and vendors mustclearly state their expectations from each other andthe program. Among the elements typically detailed ina vendor finance agreement:

• Minimum credit standards – The lender specifiesthe credit criteria and the types of deals that areacceptable

• Expected volume – Particularly when there ismore than one funding source, both sides agree onwhat percentage of the applicable deals the lenderreceives

• Turnaround time – The lender sets expectationsaround underwriting and credit decisioning. Typically,in small-ticket, decisions are returned within hours oreven minutes

• Funding time – The lender and vendor agree onhow long it will take the lender to fund each deal.The industry standard is same-day funding

Sales ApproachesThe combination of a provider’s service model and

target market largely determine its sales approach. Forproviders targeting the very low-end of the market,economics requires the use of alternative deliverychannels.

One lessor has developed a telephone-based directmarketing platform that focuses sales executives’efforts on the highest potential prospects. The basis ofthe platform is the company’s database of thousandsof prospects. The lessor developed and updates thisdatabase with information from numerous sources,including third-party marketing services, industryorganizations, trade shows, etc. Its typical target is avendor with $1-5 million in annual sales that has hadlimited access to commercial finance programs.

The sales management application provides poten-tial prospects to the sales executives for solicitation. Inaddition, they use sophisticated contact managementsoftware, including predictive dialing technology, tomanage the solicitation campaign. The software allowsthe sales executive to manipulate the database, faxmaterial and send emails to targets, produce corre-spondence and documents, track activity, and numer-ous other activities.

These tools help to focus sales calling time on thoseprospects most likely to become origination sources.Once the dealer becomes an active deal source, thecontact management tool tracks end-user activity,allowing the sales executives to effectively marketdirectly to the end-user to generate additional salesand renewals.

In contrast, players focusing on larger prospectsbelieve that face-to-face sales remain critical for suc-cess. They typically divide territories by geographyand employ traditional field-based salesmen to gener-ate business. One senior executive of a Bank lessor’svendor finance unit stated that, “Technology has cer-tainly facilitated the customer service aspect of thisbusiness, but no vendor of any substance is going toturn his customers over to someone he has never metand only spoken with on the telephone.” The take-away is that, while the direct sales approach is expen-sive, it may be required to sell to larger companies.

Service-oriented providers employ a hybridapproach, using field-based salespeople to originatebusiness and close deals, but relying on telephone-based RMs for ongoing service and account manage-ment. One senior manager noted, “We cannot sellhigh-touch service as our value proposition and thenhave customers unable to reach their account managerbecause he is on the road. In our telephone-basedaccount management model, customers have a consis-tent point of contact. It is not like many call centerswhere the person who answers the telephone knowsnothing about your business.” That lessor’s modelincludes incentives for the telephone-based accountmanager and the field-based salesperson to cooperateand work together to both generate and retain busi-ness.

Barriers to EntryThe most significant barrier to entry relates to the

availability of experienced people. Within the com-



mercial finance industry, turnover among experiencedprofessionals is extremely low, as companies workaggressively to retain those employees. Typically, sea-soned personnel become available as a result of an“event” in the industry, usually an acquisition. Forexample, when CitiCapital purchased Associates, anumber of experienced truck finance people enteredthe market. When CitiCapital sold its truck portfolioto GE Capital, more experienced truck financiersentered the market, including the current president ofUS Bank Equipment Finance. We know one firm thatcould almost be renamed Heller II, given all theemployees that came to that company after the GECapital acquisition. Lacking such an event, one recentclient anticipates that it could take 12 months ormore to hire an experienced commercial equipmentsalesperson.

Particularly in small-ticket, technology is anotherbarrier to entry, although not nearly as significant as itonce was. The CEO of a recent start-up estimates thathis company invested less than $2 million two yearsago when it custom built its transaction-processingplatform. In his view, creating the technology de novoprovided a competitive advantage over companiesrunning existing systems. “We had the latest technolo-gy and no legacy issues. But, that advantage only lastsuntil someone else comes along with the latest sys-tem.”

Industry TrendsThe most significant trend impacting this industry

has been the vendors’ move away from exclusivearrangements in which a single provider owned theprogram and was the sole funding source for all butthe worst deals. Today, vendors prefer to work withthree or four providers, one of which, typically, has anappetite for sub-prime credits. The vendor retainscontrol of both the program and the customer andparticipates in the front-end process to varyingdegrees. More sophisticated vendors may verify docu-mentation and score the credit internally, sending thedeal to the most appropriate funding source basedupon established criteria. Industry executives believethat vendors’ use of third-party scoring applications to screen deals will continue to increase as its costdeclines and the customer insight it provides increases.

The other major trend in the industry has been thevendors’ decreased interest in private label programs.Related to issues raised due to recent leasing industryscandals, vendors understand that they may havesome liability if their name is on a financing program,even if a third-party is completely responsible for theprogram. As a result, some vendors’ desire to appearto have their own finance company has dwindled.

Key implications to the industry of these trends?Providers are less able to rely on contractual exclusivi-ty and instead must compete on approval and fundingtime with other funding sources.

FIC PerspectiveWhile vendor programs offer Independents the

opportunity to exploit their point-of-sale advantage todevelop low-cost origination, a number of key skillsare required for success. Industry executives agreethat one key competency required for success in smallticket vendor finance is the ability to execute. A CEOstated, “There is no real secret in this business. I ammore than happy to show any competitor our busi-ness plan, give them a tour of our facilities, anddemonstrate our technology. In fact, I have done justthat numerous times with competitors. The model isstraightforward, but, if you cannot execute on it, youwill never succeed.”

Experienced people provide another critical elementfor success. Each successful player in this market wasfounded by industry veterans with over 20 years ofexperience. Many executives noted that the availabili-ty of experienced people, more than any other factor,drives a company’s focus on a specific segment orniche. For example, one Bank lessor operates with aspecialty in a segment that would not appear to pro-vide a significant opportunity for a large bank player.An executive explained, “The reason that we endedup in that niche is that a very experienced guybecame available, and we hired him. He happened tohave a specialty in this segment, so that became afocus area for us.”

Additional success factors include:• Commitment to the market – As a number of

executives commented, “To be successful, you have tofully commit to the market. It may take a year or twoto become profitable, particularly if you are starting denovo. But, if you come in and then pull out, don’t



plan on coming back in again. This segment has avery long memory.”

• Access to the target segment – Most intervieweesagreed that it is important to understand the languageof the industry and to have relationships with a num-ber of industry players

• Clearly articulated value proposition – As onemanager stated, “Ease of doing business is the hall-mark of small-ticket vendor finance. You have to beable to clearly explain to the vendor what is in it forhim, what is in it for the customer, and what is in itfor you. You must also spell out what you expect fromthe vendor (related to volume and quality of deals) aswell as what he should expect from you (turnaroundtime, funding time, etc.). You also need to ensure thatyou do what you say. That is where most lenders fail.”

Lessor ProfitabilityRespondents to the 2006ß Survey reported healthy

volume increases for each lessor type. Market share, asa percentage of new business volume, remained con-stant with the previous year. Declines in pre-taxspreads impacted all lessor types, but Banks, with the

sharpest increase in cost of funds, suffered more thanthe other lessor types. Banks remained the most prof-itable lessor type based on ROE and net income.

BanksAs shown in Figure 27, Banks grew new business

volume by over 11 percent to just under $47 billion.Their market share, however, remained unchanged at45 percent of total new business volume.

Banks continue to be extremely profitable, as Figure28 indicates. At 18 percent, Banks’ ROE is significant-ly higher than the industry average as well as otherlessor types. In 2005, Banks’ net income before taxesreached 28.7 percent, again higher than both theindustry average and for other types of lessors.

Banks generate over 54 percent of new business vol-ume directly (See Figure 29) and over 30 percentthrough vendor programs. Banks typically have littleinvolvement in providing captive programs, explain-ing why they generated no volume through that chan-nel. In addition, Banks generated 13 percent of newbusiness volume through brokers and portfolio pur-chases. Overall, the distribution of the Banks’ new

Figure 27



Figure 29

Figure 28

43



Figure 31

Figure 30



business volume by channel in 2005 is not materiallydifferent from the previous year.

In 2005, Bank respondents reported that their costof funds increased 130bps over the previous year to4.3 percent, significantly higher than Captives’ cost offunds and just 10bps below Independents (See Figure30). In discussing the apparent loss of Banks cost offunds advantage, executives suggested two possibleand inter-related explanations. One manager notedthat, “Part of the banks’ preparation for Basel IIincludes implementing processes and systems thatmore accurately track the cost of capital across theorganization. It is likely that the availability of moreaccurate information, as well as the implementation ofBasel II itself, are responsible for the sudden signifi-cant increase in Banks’ cost of funds.”

Despite increasing average pre-tax yield from 6.3percent to seven percent, Banks’ pre-tax spreaddecreased to just 2.7 percent, far lower than other les-sor types.

As in previous years, the Banks’ depreciationexpense is relatively low, 11 percent of total revenuein 2005 (See Figure 31). This indicates that Banks areless likely to retain ownership of equipment, meaning

that they are more likely to employ loans and loan-like products to book deals. Banks’ sales, general, andadministrative expense remains lower than other les-sor types. This likely reflects the fact that a number ofBanks have little or no outside origination activitiesand rely entirely on referrals from the business andcommercial bank.

Banks’ propensity to work with only the highestcredit grades appears evident in its delinquency dataas shown in Figure 32. Banks reported that receiv-ables over 31-days were just 1.6 percent of net receiv-ables. For 2005, Banks reported charge-offs of lessthan one percent.

As shown in Figure 33, Banks’ operational efficiencyis mixed. While they outperform Independents inevery category, they lag Captives in both new businessvolume per FTE and loan and lease revenue per FTE.Banks outperform the other lessor types in net incomeper FTE, a further demonstration of their profitability.

Banks remain a formidable competitor in the equip-ment leasing and finance market and will continue todo so going forward. Some in the industry may stillcling to the hope that they will leave the market at thefirst hint of trouble. Given their investment in the

Figure 32



industry and bank management’s desire to providebroader financial solutions, in our view, expecting sig-nificant retrenchment of banks is more a dream than ahope. One Bank executive stated, “The communitybanks may exit the market at the first hint of a creditdownturn and some regional banks might leave ifthey started taking significant losses. The big banks,Bank of America, Chase, CitiCapital, Wells Fargo, etc.,they are here to stay.”

CaptivesAs shown in Figure 27, Captives reported that new

business volume grew by over 10 percent in 2005,and their share of market remained unchanged at 27percent of total new business volume. As Figure 28indicates, Captives remained profitable, generating netincome before taxes of 24.7 percent, ROE of 16.3 per-cent and ROA of 2 percent.

Not surprisingly, Captives generated over 89 percentof their new business volume through their own cap-tive programs (See Figure 29). In addition, the lessortype overall originated just over 10 percent of its newbusiness volume directly, likely the efforts of a num-ber of Captive lessors which also operate as generalist

equipment financiers. As Figure 30 shows, Captives’ cost of funds

increased by 110bps to 4 percent. However, they werealso able to increase pricing enough that they sufferedspread compression of just 10bps. As reported in thisyear’s Survey, Captives have the lowest cost of funds ofthe three lessor types. However, it is possible thattheir reported cost of funds is artificially low due tosubsidized funding from the parent.

As shown in Figure 31, depreciation is a significantexpense for Captives, indicating that they typicallyretain ownership of the equipment. While interestexpense and selling, general, and administrativeexpenses are low, the Captives’ provision for bad debtmay be too low, based on the delinquencies shown inFigure 32.

Captives reported four percent of receivables past 31-days, the highest of the three lessor types. In addition,they reported charge-offs of 1.6 percent. However, anumber of lessors stated that although Captives maywrite-off an account, their knowledge of the equipmentand their ability to sell it typically means that they arenot forced to take significant losses.

Not surprisingly, Captives operate as the most effi-

Figure 33



cient group in generating new business volume (SeeFigure 33). In addition, because of their heavydependence on lease and loan revenue (versus feesand gains on residuals), Captives also generate moreloan and lease revenue per FTE than both Banks andIndependents.

Captives will continue to exploit their point-of-saleadvantage as well as their superior equipment knowl-edge. In addition, the best players are becomingincreasingly successful at integrating the sale offinancing with the sale of the product. In financingthe parents’ products, Captives will become very diffi-cult to beat.

Independent, Financial ServicesIndependents also reported growth in new business

volume, although at a slower rate than Banks andCaptives. As shown in Figure 27, the Independents’volume grew 8.4 percent to just over $29 billion.Market share remained virtually unchanged from theprevious year at 28 percent of total new business vol-ume.

In 2005, Independents generated net income of justover 27 percent and ROA of 1.7 percent (as shown inFigure 28). Respondents generated ROE of 7.9 per-cent, far below both Banks (18.0 percent) andCaptives (16.3 percent).

In 2005, Independents generated 56 percent of theirnew business volume directly from end-customers(See Figure 29). The vendor channel was an impor-tant origination source, providing over 23 percent ofIndependents’ new business volume. In addition, theysourced nearly 15 percent of their volume throughthird parties.

As Figure 30 shows, Independents also experiencedsignificant margin compression. While pricingincreased by 50bps, the cost of funds increased by110bps, resulting in reduced margins. Overall,Independents command the highest average yield ofthe three lessor types, but also have the highest cost offunds.

Figure 31 shows that selling, general, and adminis-trative expenses are significant for Independents, com-prising nearly 27 percent of total revenue versusalmost 15 percent for Banks and almost 17 percentfor Captives. Interest is also a significant expense,comprising almost 35 percent of total revenue.

Independents reported low receivables and charge-offs for 2005. As Figure 32 illustrates, the percent of

net receivables over 31-days due was 2.1 percent, andcharge-offs for the year were less than one percent.

Because of their need for a relatively larger externalsales organization, Independents will be unable tocompete on efficiency with Banks and Captives.However, as Figure 33 shows, Independents generatedmore net income per FTE than Captives, indicatingthe despite their need for a larger sales organization,Independents are lean and highly productive.

For Independents, a number of trends emerged inlast year’s Report and have grown increasingly impor-tant today. The most important trend that emerged isthat many smaller Independents have created marketniches for themselves and many are thriving. As dis-cussed above, those niches often related to a marketsegment or equipment category viewed as “under theradar” of the banks and large Independents. The sec-ond trend concerns the growth in importance of thevendor channel. Exploiting this channel providessmaller dealers and manufacturers with opportunitiesthey could not obtain from large lessors and it allowsthe small Independents to develop lower-cost origina-tions. Independents that both continue to exploittheir niches and remain flexible enough to operateoutside the realm of their larger competitors will con-tinue to grown.

Market Segment ProfitabilityThis year’s analysis of the leasing industry by market

segment identifies some of its key characteristics anduncover drivers of profitability. Overall, lessor typeremains the dominant driver of profitability in theindustry. As discussed in previous sections, factorssuch as cost of funds, access to customers, and opera-tional efficiencies are inherently related to lessor typeand little influenced by transaction size. In this sec-tion, we focus on the components of profitability andassess the skills required for success within each seg-ment.

The defining characteristics of each transaction sizecan be indicative of the necessary competenciesrequired to play in that segment:

• Micro-Ticket – Among the characteristics definingthis segment are: vendor/captive origination, highpricing/spread, and high delinquencies and charge-offs. Requirements for success include low-cost origi-nation, highly automated processes, sophisticatedportfolio management, and superior asset manage-ment skills.



Figure 35

Figure 34

48



Figure 36

Figure 37

49



• Small-Ticket – As with the micro-ticket segment,key definers include: vendor/captive origination, highspreads, and high delinquencies and charge-offs. Keysto success in this segment are very similar to those ofthe micro-ticket segment: low-cost origination, highlyautomated processes, sophisticated portfolio manage-ment, and superior asset management skills.

• Middle-Ticket – Narrow spreads and heavy com-petition define this transaction segment. While opera-tional efficiencies are critical, the key to survival, ifnot success, centers on the various players’ ability todifferentiate themselves from the competition anddeliver some unique value for which some segment iswilling to pay a premium.

• Large-Ticket – Large-ticket volume is back but notto the position it held several years ago. Today, large-ticket more closely resembles middle-ticket in thatcompetition and pricing pressure are prevalent. As wenoted last year, the keys to success will no longer besophisticated structuring capabilities and cross-borderexpertise. Instead, keys to success will be access to cus-tomers, access to funding, and equipment expertise.

Micro-TicketOverall, the micro-ticket segment enjoyed strong

growth in 2005 with most business sourced through asingle origination channel. The high pricing and largespreads typically associated with the segment are off-set by delinquencies and charge-offs. While the seg-ment generates impressive ROEs, net income andROA lag the other segments.

As Figure 34 shows, micro-ticket lessors reportedthat new business volume increased by over 13 per-cent in 2005 and that market share remainedunchanged from the previous year at seven percent oftotal new business volume. Total micro-ticket volumefor the year was $7.5 billion, nearly 88 percent ofwhich was generated through captive programs (SeeFigure 35).

As Figure 36 illustrates, micro-ticket commandsvery high pricing and attractive returns. While theaverage cost of funds was higher than for other seg-ments, micro-ticket lessors generated average yields of13.5 percent and spreads over eight percent. Despitethe impressive returns, micro-ticket margins fell by 90basis points on pricing pressure and increased cost offunds.

Figure 37 illustrates that micro-ticket lessors operate

with a relatively low cost structure. As we noted inprevious years, the extraordinarily high sales andadministrative expense is related to a small number ofCaptives included in the segment. Given that much ofmicro-ticket volume is generated at point-of-sale, salesexpense should be among the lowest for all the seg-ments.

Micro-ticket lessors typically do not retain owner-ship of the assets, resulting in extremely low deprecia-tion expense. The segment’s provision for bad debtreflects the risk associated with the segment. Figure38 shows that delinquencies and charge-offs are sig-nificantly higher than for other segments. Due to itshigh margins and relatively low cost structure, themicro-ticket segment generates net income beforetaxes over 30 percent (See Figure 39). In addition, thesegment generates 3.4 percent ROA and 17.7 percentROE.

While the micro-ticket segment can generate higherthan average returns, lessors clearly must possess par-ticularly strong credit and portfolio management skillsin order to be successful.

Small-TicketThis year’s small-ticket respondents reported that

growth for the segment substantially lagged othergroups. As with all segments, margins shrank as priceincreases were unable to keep up with increases in thecost of funds. Delinquencies remained low, but overallprofitability for the segment was weak.

This year’s Survey includes a separate analysis of thesmall-ticket segment. As shown in Figure 40, nearly73 percent of Survey respondents are active in thesmall-ticket segment. Banks show the least involve-ment in the segment, with just 65 percent of Bankrespondents reporting activity. All Captives reportbeing active in small-ticket as do nearly 74 percent ofIndependents. A number of Bank respondents out-source small-ticket deals to third parties. These areprimarily middle-ticket players that understand thefundamental difference in approach required forsmall-ticket and have chosen to concentrate in theirarea of expertise.

As Figure 34 shows, small-ticket volume also grewin 2005, but at a much slower pace versus other seg-ments. For the year, small-ticket grew by 5.4 percent,compared with nearly 11 percent for middle-marketand over 20 percent for large-ticket. Lessors generated


51


Figure 38

Figure 39



over three-quarters of small-ticket volume through thevendor and captive channels (See Figure 35). Directoriginations contributed 15 percent of new businessvolume

Small-ticket also suffered from margin compressionin 2005. As Figure 36 shows, cost of funds for small-ticket lessors increased by 120bps compared with an80bps increase in yield. As a result, spreads for thesegment declined by 40 bps.

Small-ticket lessors retain ownership of some equip-ment, resulting in depreciation expense of 10.8 per-cent (See Figure 37). Interest and selling, general, andadministrative expense are the two most significantexpense items for the segment. Relatively low provi-sion for bad debt indicates that the segment is muchless risky than micro-ticket. In fact, as we see inFigure 38, delinquencies were 2.6 percent of receiv-ables and charge-offs for 2005 were less than one per-cent.

One factor contributing to the small-ticket lessors’portfolio performance is the use of credit scoring. AsFigure 41 shows, nearly 61 percent of respondentsthat are active in small-ticket use credit scoring. Inaddition, nearly 43 percent of small-ticket lessors

report using auto-decisioning technology to adjudi-cate at least some small-ticket transactions. In 2005,small-ticket players leveraged scoring technology todecision over 73 percent of small-ticket volume, a sig-nificant increase over the previous year. However,given the requirement for fast, low-cost, and highlyautomated processing that is the hallmark of this seg-ment, it seems difficult to comprehend any lessormanually underwriting small-ticket transactions. Yet,as shown in Figure 41, in 2005, respondents manual-ly underwrote over 27 percent of small-ticket transac-tions totaling $8.6 billion. We believe those compa-nies may be at a cost and credit quality disadvantage.

As Figure 39 shows, segment profitability is mixed.Small-ticket ROA is 1.7 percent, higher than the othersegments. However, ROE lags the others at 11 percentand net income is unimpressive at 26.3 percent ofrevenues. Certainly one approach for improving seg-ment profitability is to reduce underwriting costs andimprove credit quality through the increased use ofcredit scoring technology.

Middle-TicketRespondents reported that middle-ticket volume

Figure 40


53


grew in 2005 to $47.8 billion. Middle-ticket lessorsalso experienced decreased spreads resulting from costof funds increases that could not be recoveredthrough pricing. Overall credit quality for the segmentwas strong as was overall profitability.

As Figure 34 shows, middle-ticket volume grew atapproximately the same rate as the industry, and mar-ket share remained unchanged over the previous yearat 46 percent of total new business volume. In con-trast to both the micro- and small-ticket segments,middle-ticket lessors originate most volume directly.In 2005, respondents reported originating over 62percent of new business volume directly. Captive andvendor programs contributed an additional 25 percentand lessors sourced the remaining 12 percent throughthird parties.

Middle-ticket lessors experienced an 110bpsincrease in the average cost of funds, as shown inFigure 36. While yields did improve by 50bps, thenet result was a 60bps decline in spreads.

Middle-ticket lessors reported the highest deprecia-tion expense of the four segments, indicating that theyare more likely to structure deals as leases versusloans (See Figure 37). The middle-ticket segment

reported the lowest provision for bad debt of the seg-ments despite reporting more delinquent accountsthan large-ticket (See Figure 38). In 2005, middle-ticket lessors reported 1.5 percent of receivables past31-days due versus less than one percent for large-ticket. Charge-offs for the year totaled less than onepercent.

As Figure 39 suggests, middle-ticket appears to bean attractive segment. Lessors in the segment reportedearning 28.7 percent net income, 15 percent ROE,and 1.6 percent ROA. The middle-ticket rivals large-ticket in terms of profitability.

As we noted at the beginning of this section, a keyattribute of successful middle-ticket players centers ontheir ability to identify market niches where they canleverage their internal expertise to offer an attractivevalue proposition to a customer segment willing topay a premium. Successful players have identifiedtheir niche in terms of equipment type, customer seg-ment, credit grade, or even delivery channel. Playersthat continue to approach the market as all things toall customers will earn smaller margins and smallerprofits.

Figure 41



Large-TicketOver the past two to three years, the large-ticket

segment experienced a fundamental change. Whilerespondents reported robust volume growth in 2005,the composition of that volume differs from threeyears ago. Evidence of that change and its implica-tions can be found in the margin compression thatwas, until recently, unheard of in the segment.

Respondents to the 2006 Survey reported that large-ticket volume grew a robust 21 percent in that year to$13.4 billion. Market share remained virtuallyunchanged from the previous year, increasing from 12percent to 13 percent. While the segment's growthrate would indicate that it has returned to its previoushealth, the transactions that comprise today’s large-ticket volume are likely to be very different than pre-viously. As one large-ticket executive stated, “Today,we are doing real large-ticket equipment deals. Fouryears ago, we could reach $400 million with onecross-border sale and leaseback deal. Today, we reach$400 million by booking 40 $10 million railcar trans-actions. It is not as glamorous, and it does not paynearly as well.”

The executive also noted that without the financialstructuring that was the hallmark of large-ticket,today’s large-ticket equipment finance deals mustoften compete on the basis of price against the cus-tomer’s traditional sources of capital: commercialbanks and the capital markets.

As Figure 36 illustrates, both pricing and marginsfor large-ticket transactions are substantially belowwhere they once were. In 2005, respondents reportedthat large-ticket transactions yielded the lowest spreadof all segments. In addition, as shown in Figure 37,

large-ticket has the highest cost structure of all thetransactions, with interest expense the largest item.Although lessors reported a 7.1 percent provision forbad debt, Figure 38 shows that large-ticket lessorsreported both delinquencies and charge-offs of lessthan one percent.

Given the low yields and spreads this segment gen-erates and its high cost structure, it is not surprisingthat it generates the lowest ROA and net income of allthe segments. As Figure 39 shows, net income for thesegment was just over 22 percent in 2005 and ROAwas one percent.

As large-ticket lessors continue to rebuild segmentvolume, they will need to begin to address issuesrelated to its cost structure. If the current large-ticketenvironment continues to force lessors to compete onprice with banks and the capital markets, the segmentwill not be viable in its current form. Lessors mustfind ways to drive out costs, or they must find a valueproposition that will allow them to generate signifi-cantly higher returns.

Concluding ThoughtsAs they take advantage of the opportunities offered

by their expanded focus, lessors will continue to facethe same challenges as other financial servicesproviders: regulatory changes, shrinking margins, andincreased competition from a variety of entities fromoutside financial services. Going forward, the abilityto adapt to change, which has been the industry’shallmark, will continue to be a critically importantstrength.



ABOUT FINANCIAL INSTITUTIONS CONSULTING, INC.

Financial Institutions Consulting, Inc. (FIC) focuses on providing advice and counsel on issues related togrowth and profitability for financial services clients. We emphasize practical, bottom-line results based onquantitative and qualitative research and an in-depth understanding of industry dynamics.

In addition to completing earlier projects for the ELA and The Foundation, our work in leasing has includedrecommending growth opportunities, process streamlining, segmentation strategy, and new business acquisition.Our activities include conducting formal engagements related to strategy and specific growth opportunities,leading brainstorming sessions, and providing ongoing retainer counseling to clients.

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