In the world of institutional investors, lessors and lenders, investment committee decisions on a proposed transaction tend to focus primarily on credit-based risk and, secondarily, equipment or asset-based risk. Beyond those risks are economic, market, tax and even political risks. However, on the opposite side of the risk analysis, and one area that is most often ignored, is potential opportunities. Risks and opportunities of transactions reliant on assets can become much more apparent when the investor has a clear understanding of the underlying equipment’s value. But, what value? Retail, wholesale, fair, fair market, liquidation, auction, orderly liquidation, forced liquidation, salvage, scrap, in-place, continued use, removed? There are definitions for all these scenarios, but what is realistic in the real world and applicable to your situation?

Price and Value

Appraisers are wise to point out to investors, lessors and lenders that, at a negotiated price, equipment may be sold on any given day and the perceived value may not always be the same. Value at the end of the day is an opinion of the equipment’s worth based on known facts and circumstances, which may result in different values depending on the facts and the standard of value. It may be higher, lower or equal to the transaction price depending on the facts and circumstances of the sale. The new car buying experience is an obvious example that anyone can relate to. How many of us walk into the showroom, look at the sticker and say, “Great, where do I sign, I’ll take it.” In the real world, there’s always the bid/ask between the buyer and seller, each with its own opinion of the vehicle’s value. The precise transaction price is established only when the buyer and seller come to an agreement of values. Or consider marketable securities like stocks, where those with the opinion that the stock price is undervalued will buy the stock or call options, while those who view the stock’s price as overvalued will sell the stock short. So, it is the opinion of the asset’s value relative to the price that drives decisions rather than price alone. Value or price should not be considered in isolation, but rather in the context of the risks and opportunities of the circumstances. Warren Buffet sums it up best by often saying, “Price is what you pay, value is what you get.”

The Transaction Commencement — Forecasted Values

Let us assume in the equipment finance world all investors determine an asset will have the same forecasted value (fair market value, orderly liquidation value or whichever definition may be used). “Doesn’t that mean every investor will arrive at the same conclusion of value?” asks the chief credit officer. “After all, everyone subscribes to the same, ‘Universal Book of Values.’” The asset manager responds, “Of course, why didn’t I think of that? I’ll renew my subscription immediately.” Meanwhile, on the other line, the national sales manager says, “I know my competitor’s value is five points greater than yours. If they can get there why can’t we? After all, the credit is fine, don’t worry about the equipment.”

Despite what credit officers may think, the ‘Universal Book of Values’ is an urban legend. Asset management’s impact will result when it logically investigates values and accurately assesses the risks and opportunities. The necessary steps can include internal due diligence, engaging an independent appraisal or both.

At a transaction’s commencement, the forecasted values of a transaction involving a significant level of dependence on equipment plays a key factor in the win or loss of the transaction, especially in competitive bids. An appraisal can be an important and value-added starting point for estimating forecasted value. Select the appraiser not only familiar with the equipment, but one who knows your transaction’s structure and forecasting values. Additionally, by providing the appraiser with the same underlying assumptions that are in the documents, you will ensure consistency in your approaches. You may or may not agree with all the assumptions and appraisal conclusions, but it is an independent opinion that can underscore both risks and opportunities of the equipment’s value.

As the asset manager who received the appraisal and completed due diligence, why would the forecasted value of the equipment vary among investors? What value is realistic in your situation? “This all depends,” is the short answer, but each individual investor has its own opinions of what the equipment’s real value is expected to be based on the potential risks and opportunities. The following variables provide a few examples of what can greatly influence equipment’s forecasted value, highlighting risks and opportunities:

• Documentation
  Definitions of value, maintenance provisions, return conditions and return acceptance tests are quantifiable metrics directly affecting equipment’s value. However, as an asset manager, the real risks and opportunities are whether you will be permitted to enforce all the parameters that you fought so hard for at the outset.
• Commodity or Strategic Equipment
  Whether the financed equipment is an ordinary commodity or an integral part of the customer’s business will influence a number of factors, but the bottom line is leverage – both for you and your customers. Equipment that is a commodity, such as a wheel loader, trailers or forklifts, can diminish the lessors leverage. Why? First, the equipment can be easily replaced if the lessee is organized on lease timing and equipment placement. Second, chances are you may be competing against the original manufacturer or vendor that has a great relationship with your customer, is acutely aware of the expiring lease, and is pushing that brand-new shiny equipment with discounts, warranties and other extras. On the other hand, there is a fairly tangible, if not always consistent, market in which to assess the real replacement value. In contrast, the integrated manufacturing, generating or processing facility, with its inherent installation and engineering costs, will probably be economically viable longer than your lease or loan. On the other hand, unless the lessee bears the costs of return, it may believe it has the leverage in the negotiation – as this type of equipment will also be difficult to sell in the secondary market.
• Portfolio and Customer Experience
  There is often no better barometer than your own portfolio’s experience and customer behavior. Customer experience can be one of the more important intangibles an asset manager has for seizing opportunities and avoiding risks. Use that first-hand knowledge to be more aggressive or conservative where warranted. Does the customer maintain the equipment to higher or lower standards than industry norms or those required by the lease documentation? Or, will the customer “churn and burn” the equipment for its maximum allowable utilization and then hand it back? Can you count on renewal rents? When considering various transactions with very similar equipment (e.g., marine equipment) if you have the ability and authority to take different risk positions, depending on your knowledge of the operator, it might increase your competitiveness in this market and help to build a portfolio that will produce increased profits.
• Remarketing Capability
  Companies with proactive and dedicated remarketing capabilities, not to mention manufacturing captives and operating lessors, have distinct advantages over traditional passive investors. Consider your remarketing strategy and whether you will be selling to end-users or secondary market brokers. Will you incur costs to store an asset during depressed market conditions or liquidate the asset at any cost to avoid having inventory on the books? Can you re-lease the asset to possibly maximize value?

With the appraisal in hand and due diligence completed, it is time to settle on the equipment’s forecasted value and risk position based on your opinions of the risks and opportunities. It’s now a matter of monitoring those forecasted values, inspecting the equipment, talking with the customer and tracking industry trends — all those portfolio management factors that are critical, but often ignored — but that’s another article.

The Termination — Value Realized or Relinquished?

The equipment’s value has been set, reviewed annually and termination is now in sight. The lessee neglected their early purchase option and the risks and opportunities of that forecasted value (and all the opinions that went into formulating the values) will soon become evident, whether the lessee purchases or returns the equipment. But, does the equipment’s price match its value? As the Asset Manager, your obvious advantage is knowing the equipment’s net investment, while the buyer does not. Your second advantage, and perhaps even more important, should be knowing the equipment’s current value – from the customer’s perspective and from your perspective, as defined by the documents and maybe even a worst-case scenario value.

While out of everyone’s control, economic and market conditions are the most influential factors of realized value. In an up-market cycle, it’s a great time to hit a grand-slam, right? Hopefully, but do not be surprised when sales personnel intervene with customer relationship concerns that can whittle those dreamed-about grand-slams to a “bunt” or a “single.” This may come down to something as little as how the sales personnel are compensated. Are they paid on gains at lease termination or only on new transaction volume? In a down-market cycle, asset managers must prove that they are valuable. Are you an asset manager who is allowed to maximize value by releasing or storing equipment, or does policy dictate that you will be required to simply liquidate equipment, even in depressed markets?

Conclusion

It seems that an asset manager’s role may be more difficult than it looks, although the great ones somehow always make it look easy. Values that are established through due diligence and appraisals are a good backbone to managing equipment value and management decisions. You must look at these in conjunction with the multitude of risks and opportunities in order to manage the equipment in your portfolio and negotiations at lease expiration.

Lauren Hill is a managing director with Alvarez & Marsal Valuation Services in Washington, DC, specializing in the valuation of equipment and facilities for leasing and financing purposes.

Arthur Doering is a senior director with Alvarez & Marsal Valuation Services in Chicago, specializing in the valuation and risk management of capital assets, projects and portfolios from a leasing perspective.