On more than a few occasions over the past several years, I have heard multiple versions of the same rhetorical question: “Where do we go from here?" Well, I have finally grown tired of letting the question just hang there.

While enjoying an exceptional one-ounce bag of salted peanuts in my posh and semi-reclining seat aboard a Delta regional commuter plane, I started to do some thinking. I began by reminiscing about some very fond memories with my past partners: Denny Hirt, Mike Rooney, and Vince, my brother and mentor, during our days leading up to and during the building of our leasing company, ILC. My thoughts meandered through the remarkable people, companies, business models, acquisitions, and events I’ve encountered along the way. This was to be the precursor to providing one of many possible leasing avenues of the future outlined below.

Where Do We Go From Here … and Where Is “Here” Anyway?

Let’s begin with: “Where is here?” Well, “here” is a place where:

• Aggressive financial regulatory oversight and continuous threats of punitive federal legal challenges have forced banks to spend heavily on compliance and risk avoidance. It is disturbing when you think about the fact that Dodd-Frank is nowhere close to being finished with its rules making process and Basel III isn't completely implemented. It would appear that this constant pressure is forcing banks to build "fortress-like" risk and compliance departments. Recently, Jamie Dimon announced that JP Morgan would be hiring over 3,000 in that department alone. The saying, “if you can't beat 'em, join'em” applies here since you can't beat them. These bureaucracies are simply too many and too powerful. The end result, when and if this movement finishes, shall certainly change the nature of lending in the U.S. and impact future economic growth.
• Lending spreads continue to be extremely thin for quality assets due to lack of supply. Many independent and captive lessors are functioning as loan aggregators for banks while essentially reducing the risk profile for the banks. These lessor facilities, while also at all-time low rates, are usually at much better spreads than direct commercial lending.
• Immediate gratification supplants patience. From a GAAP standpoint, a capital lease structure provides a better immediate result from an earnings standpoint when compared to an operating lease. If you are a generalist and/or a financial institution, a capital lease would portend less risk from residual exposure and more stable earnings metrics; of course, at the expense of potentially greater rewards.
• A greater percentage of lease originations are of the capital lease variety as opposed to residual-based, FMV structures. That stands to reason, since if you are a generalist doing mostly buck-out structures, there’s really no need to be a specialist or make a market in a particular equipment category.
• There are fewer operating-lessors and more generalists from an equipment standpoint. My definition of an operating-lessor is one that makes a market in specific asset classes. An operating-lessor, has the capability to refurbish, reconfigure, re-certify, warrant performance, rent, sell, buy, and lease new/used equipment. More importantly, they analyze the technology and trends of the equipment, its manufacturers and users. These equipment experts provide value-added benefits to their customers beyond the financing component of a lease.
• Today, leasing company valuations are measured more in terms of multiples of earnings rather than book value as in the past. This too is a logical progression since a larger part of the book value is from the retained earnings of interest income spreads as opposed to future residual value. The upside between the book residuals and the lessor's historical actual residual performance over "book residual" was the subjective part in the valuation equation. Today, acquirers are less accustomed to this notion of residual upside since it is encountered less frequently.
• Lastly, potential changes to operating lease accounting create uncertainty today and clearly won’t drive greater operating lease activity in the future if implemented.

Is There a Place To Go?

As I said earlier, I have been reminiscing. While pondering the past to the days when I entered the industry (circa 1984), I was and still remain impressed by the level of expertise that the computer lessors possessed in mainframes and peripherals. At that time, the Computer Dealers and Lessors Association was a significant organization in terms of its members. There was a real blurring of the lines between who was a computer dealer and who was a lessor. In fact, most members were both. Lessors had varying degrees of competencies in refurbishing, reconfiguring, and remarketing equipment (resale, rent, release, etc.). Justified by their knowledge of the secondary and tertiary lives of these specific assets, lessors made significant residual investments in computers and peripherals. Further, customers realized tangible value-added benefits in doing business with these lessors. Yes, I do recognize that was a different time with a different set of circumstances, and yes, that specific market is long gone.

But still, there were many lessors who had that same competence in other asset classes of equipment. These operating-lessors were comfortable doing very short-term leases (rentals even) as well as longer-term leases. In fact, most preferred shorter maturities, as they knew they could optimize their residual achievement by remarketing the equipment to other customers as opposed to the current in-place user. This expertise differentiated them from other independent lessors and bank lessors. Today, some lessors commonly are willing to put 2-3% residual in some asset or another. While that is an understandable practice, it is more closely related to gambling than it is to a strategy.

So, what’s the point, you might ask? The point I make here is that, in my opinion, a higher percentage of those lessors were truly equipment experts as much as they were experts in finance, legal, transaction structuring, tax, syndications, and general solutions selling.

One might also ask: should lessors, specifically non-bank lessors, seek the future by looking back to the past? I am sure some of you will say, well a lot of those lessors are not around any longer or went out of business. In some cases they are not around because they were acquired and others certainly did collapse for many and varied reasons. However, that does not invalidate all of their ideas, talents and asset specific expertise. For example, today the high-yield corporate bond market plays a major role in US economic growth even though Drexel Burnham Lambert collapsed in 1990.

The past 30 years have clearly seen a trend towards more “equipment finance” and less “equipment leasing”. After all didn’t we see the Equipment Leasing Association (“ELA”) change its name to the Equipment Lease and Finance Association (“ELFA”)? Is it a coincidence that this trend followed a trend in the ascendency of the bank-owned lessors harvesting a larger portion of the annual new business volume? I think not. ILC after all was an equipment leasing company prior to our sale to a very good commercial bank, but a bank all the same. Guess what happened to the percentage of residual-based leasing to capital lease content in our portfolio?

Can the future for equipment leasing be as simple as equipment lessors getting back to focus on the equipment? If you think about it, in this model, banks would provide the non-recourse debt portions on the lease receivables while the non-bank lessors would provide the equity investment in the equipment thereby absorbing the first loss risk. That could be a model that would reduce banks' risk profile while still driving asset generation and interest income. Sure, banks would only finance 80-90% of the original equipment cost, in exchange for less risk, better loan to value metrics, and potentially an increase in new footings as independent lessors migrate to this model.

Can lessors make a market in specific asset classes and become true operating-lessors? There are a few lessors today that have ensured a solid and defensible future doing just that. But, just a few.

Could equipment lessors team up with equipment rental companies for real asset expertise while contributing their leasing expertise (longer maturities than rentals, operations, tax, etc.) and funding models to the rental companies? This could be a place to go.

Surely there are other ideas of where we go from here or what the equipment leasing business will look like in the future. But one thing will likely need to be the same in all approaches: For a lessor to demonstrate value to their customers and by extension their shareholders, they must provide some added-value services and or benefits to the ultimate customer other than being the cheapest source of capital. I encourage your comments on these ideas and would like to hear your ideas about where we might go from here.