Additional Residual Pool

by Bill Bosco and James Hershberger January/February 2013
Leasing experts Bill Bosco and James Hershberger present a case for the use of a well-designed and actively managed additional residual pool plan to win additional business at higher spreads/yields and, as a result, cause higher earnings/profits to occur for the business.

A common complaint among leasing sales staff and executives alike is, “Our residuals are too low and we can’t win business.” When this happens, new business volume and net revenue/profit results are negatively impacted. Compensation of salespeople is negatively impacted, as few FMV residual-based deals get done. It also is all too common that the residual risk management group in the leasing company (a necessarily separate and independent reporting entity under the risk management unit) tracks residual gains (on albeit few FMV deals won) and uses the results to tout its prowess and justify its bonuses.

Our opinion has always been that it is better to take higher residual risk (in a controlled way) to win more business and enjoy the revenue/profit associated with it, while accepting that residual gains may not be as robust. One also has to expect that there will be an occasional residual write down. However, one could view this potential reality in the context of: “If you have no losses, you’re probably not taking enough risk.”

The goals of all business units in the leasing company, including the independent risk management units, must be aligned to generate maximum revenue while reaching growth targets in assets and achieving targeted returns on equity capital. Lack of alignment means few residual losses and few residual gains, but, unfortunately, less total revenue and profit for the business as a whole.

We have developed a plan to generate higher and more consistent earnings via the prudent management of an additional residual pool.

Plan for an Additional Residual Pool

Essentials of the plan include:

  • A willingness to trade residual gains to win additional business at higher spreads/yields and, as a result, higher earnings/profits for the business.
  • The pursuit of modest residual gains with the understanding that there will be occasional residual write-downs, but with the expectation that residual gains and increased revenue/profits will more than offset any residual write-downs.
  • A desire to smooth out residual earnings as additional residual amounts are accreted into income over lease terms.
  • Targeting transactions and creating structures where lessees are motivated to purchase equipment at the early buyout option (EBO) point or lease expiry.
  • Pricing to achieve targets for minimum return on risk-adjusted capital, assuming worst case (distress value) residual results. Also pricing to a premium return over “normal” pricing when assuming the “additional” residual.

Concept and Implementation

Broadly, the purpose of the additional residual pool is to increase and smooth out earnings by allowing the assumption of additional residuals on specific transactions. The pool would represent the total amount of assumed residual risk that can be assumed by businesses in excess of expected distress value (the value assumed from a sale within 90 days (wholesale) regardless of market conditions, as opposed to fair market value where there is a willing buyer and seller with less compulsion to sell (retail), subject to specific controls and guidelines.

The plan would be implemented through the controlled management of financial risk, systematic risk and unsystematic risk, as summarized in the accompanying table.

Financial RiskThe risk that earnings or the portfolio could be impaired beyond the tolerance for residual risk. This risk is managed by the size of the pool, annual adjustments to the pool, earnings at risk limits and by the targeted minimum return for each transaction/customer rating, forcing consideration of risk versus return.
Systematic RiskThe risk that all equipment values will be less than expected due to a general economic downturn, resulting in a greater likelihood that equipment will be returned at lease expiry. While this risk cannot be mitigated by diversification, it can be controlled by other means such as limiting additional residuals per year of expiry of the associated leases. Although difficult and not covered by this article, selling participations is also a means of managing systematic risk.
Unsystematic RiskThe risk that individual industries will suffer downturns or that specific categories of equipment may be in over-supply or become obsolete, resulting in lower-than-expected-values and a large volume of equipment returns. This diversifiable risk is managed by avoiding concentrations by year of lease expiry in equipment class and industry. Although difficult and not covered by this article, selling participations is also a means of managing unsystematic risk.

Now that we have outlined the broad aspects of the plan, here are some specifics:

Managing Financial Risk

Pool Size: To control total exposure, limit the additional residual pool to say 2% to 5% of the total managed lease portfolio.

Annual Pool Adjustment: To adjust for performance and to limit losses if experience is unsatisfactory, distress values of the leased assets in the pool will be periodically updated and compared to assumed residuals. The unutilized portion of the pool will be adjusted through a mark-to-market process, e.g., a decrease in distress value for a leased asset represents a utilization of the pool).

Earnings at Risk Limit: To ensure that earnings in any one year are not materially impacted by the accretion of additional residuals into income, there will be no more than $X million in additional residual accretions per year (this is a limit, say 10% as an example, that is compared to total net earnings in the leasing business). This is intended to maintain a high level of quality, stable earnings. Residual write-downs represent the elimination of future residual accretion and possibly the reversal of prior earnings depending on the amount of the write-down compared to unamortized residual earnings.

Normal Pricing: This plan assumes that the leasing company determines its “normal” pricing yield by summing its cost of funds, its cost of doing business and a profit target derived to meet the leasing company’s risk adjusted return on assets/equity target. A normal profit target might be 1.5% as an example.

Minimum Pricing Limit: To enforce risk versus return, individual transactions will be priced so that realization of distress value only will cause the yield on the transaction to meet minimum return targets. A minimum profit target might be 0.75% as an example. This minimum pricing target is designed to ensure no loss of “principal” or capital if the worst case of realization of only the distress value from the sale of the asset occurs at lease expiry.

Premium Pricing Requirement: The return from realizing an additional residual assumed in the pricing must be at a premium of at least 25 bps higher than normal pricing.

Transaction Structuring: EBOs will be included in the terms of additional residual transactions to encourage customers to buy the equipment. The EBO price will be derived from the termination value schedule assuming the additional residual and premium pricing. If the customer exercises the EBO, it means you have recovered your investment and all earnings recognized thus realizing the premium pricing while avoiding all residual risk at expiry. Capped purchase options set at or above the priced residual may also be included in the terms to encourage lessee purchase. When structuring purchase options care must be taken to comply with IRS true lease guidelines.         

Managing Systematic Risk

Year of Expiry Limit: To avoid severe impacts from general economic downturns, additional residuals assumed will be tracked by year of expiry so that no single year will have more than $X million in maturing additional residuals.

Managing Unsystematic Risk

Equipment Limits: To diversify equipment risk, no more than $X million in additional residuals will be assumed for each equipment category targeted by the leasing company, including, as examples, 1.) autos, 2.) trucks, 3.) computer equipment, 4.) medical equipment, 5.) construction equipment, etc., as well as other equipment added to the list that may not be targeted by the leasing company but where an opportunity arises. (Commercial aircraft and railcars/locomotives are excluded, as those equipment types are typically managed by a separate group within a leasing company with specialized asset managers.)

Industry Limits: To avoid industry concentrations, no more than $X million in additional residuals will be assumed for each of the specialized industries targeted by the leasing company or identified through review of the industry segments of customers in the existing portfolio.

The Review Process

The pool will be periodically re-evaluated to insure that it is working properly. Annual targets for new business volumes and pricing premiums will be reset. Residual write-downs, if any, will be forecast and included in the budget plan.

  • The annual review process for individual lessees will compare assumed residuals to distress values and will allow usage of the pool to expand or contract, based on actual performance.
  • Additional residual pool utilization and availability will be monitored versus the limits. Quarterly reports will be provided to all concerned parties.
  • Normal pricing, minimum pricing and premium pricing will be monitored to validate transaction profit target limits under the plan.
  • Management information reports will be compiled to track deals by asset type, industry of lessee and year of expiry.

Conclusion

A well-designed and actively managed additional residual pool plan can generate significant new business volume and smooth earnings at higher spreads in a controlled manner. The net result will be more new business which designed to create higher profits. Additional information on the plan for additional residual pool may be found at www.leasing-101.com.

Bill Bosco is the president of Leasing 101, a lease consulting company. He can be reached at [email protected] or www.leasing-101.com. James Hershberger is the owner of Hook Mountain Graphics, a company that designs websites and provides graphics services. He can be reached at [email protected] or www.hookmtn.com. They have a combined 70-plus years of experience working at Citigroup and elsewhere in leasing, credit, finance and banking. Their expertise includes customer sales, pricing, structuring and negotiating complex lease transactions. Special thanks to Bob Lynch, also a 30-year veteran of the equipment finance and banking industries, for his assistance with this article.

 

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