The traditional equipment finance and leasing business model is changing. It has experienced increased pressure from customers to move to more of a utility/consumption, pay-for-use or anything-as-a-service model. These customer demands have had an impact on many market segments but none more prominently than the effect on the information technology space.

I can understand how a manufacturing vendor with a captive finance company can offer a ‘pay-as-you-go’ model because they have a healthy gross profit margin in their products, particularly technology products, which seem to be where these products are most frequently used. Original equipment manufacturers (OEMs) can take the risk because they sometimes have product margins as high as 70% to 80%. Dell Financial Services, Cisco Capital, HPE Finance, IBM Global Finance and others all promote consumption models. They can play with the gross margin to justify the risk coverage, but a third-party independent or bank takes on significant risk when offering a consumption model.

Since financial transactions have spreads that are significantly smaller than the margins for vendors, I wondered how banks and independent finance companies could compete with captive offerings, with or without some form of backstop from their vendor partners. I sought input from a handful of experienced vendor lessors working for banks or independent leasing companies, as well as folks from The Alta Group, to gain insight on how companies can compete with the consumption model offered by captives. I received several interesting responses.

One Model Does Not Fit All

The Alta Group has been at the forefront of addressing emerging market requirements for consumption and usage models. After supporting a wide variety of clients, its observation is one model does not fit all. Common structures can include embedded leases with consumption minimums, pay-per-use options with no minimums and various subscription offerings. The process of defining an offering depends on a variety of factors.

The Alta Group thinks parties to these contracts can be dramatically different while also having equally different requirements. End users can range from small startup enterprises to global Fortune 500 companies. Equipment manufacturers or service providers can have strong balance sheets to absorb asset risk or highly encumbered balance sheets that require funding support from third parties. Funders can have varying levels of risk tolerances for credit as well as residual and service performance.

“Clients who are successful are those who conduct a careful examination of accounting, cash flow, documentation and pricing requirements for each of the parties involved in the service contracts,” Diane Croessmann of The Alta Group says. “Understanding these requirements triggers variations in contract terms and conditions. Some of the key contract variables impacted include content of the transaction, contract term, shared risk, minimum payment commitments and the end user’s required flexibilities. Only when these requirements and variables are effectively resolved does the ultimate business model emerge.”

“Bank and independent lessors have provided usage-based financing for many years, with financing for copiers being a good example,” Jonathan Fales, divisional president at VAR Technology Finance, a division of LEAF Commercial Capital, which is a subsidiary of People’s United Bank, said. “The key to underwriting any financing structure is first to understand the risks involved and then to be able to mitigate the risks and price for an acceptable return.

“The challenge all lessors face with technology consumption models, including captives, is understanding the variability of payment streams and getting comfortable with performance. Many lessors initially shied away from public sector financing because of funding-out provisions but now have data to show these financings perform as well as or better than commercial transactions. Similarly, 100% software financing was intimidating at first because of the lack of underlying collateral. But lessors now have years of experience providing software financing and understand there are certain provisions, such as critical use, that are important in successful underwriting.”

“I believe that technology consumption model financing will follow a similar path. As more data becomes available, lessors will get a better understanding of the risks involved and decide whether and how to participate.”

Understanding the Risks

It really does come down to understanding the risks and gaining comfort by understanding the data from past performances.

Earlier this year, Rita Garwood, editor in chief of the Monitor, interviewed Mike Infante, chief credit and risk officer at Cisco Capital, for a podcast about changing customer consumption models and the impact on risk. During the podcast, Infante detailed how Cisco looks at the consumption model. He talked about the way he assesses risk by analyzing the essential needs of the equipment, software and services customers are acquiring from Cisco. He said, “We do have a slightly different lens than an independent lessor because we are here to enable Cisco and we want people to be able to consume our solutions, and therefore we are willing to take some risk and put financial packages in place for some non-traditional, non-hard asset type of models.”

When asked how Cisco is assessing the risk during the pandemic, Infante explained that for the non-hardware centric solutions being provided, “We look at what is provided over time, how our cost-of-goods-sold are being allocated. Is it all up front or is it all over time, the ratability of the revenue?” He went on to say Cisco was exploring different types of accounting treatment, with some hardware sales receiving revenue recognition up front while other services are spread over three to five years to align with customers’ commitments.

Infante’s comments align well with what Croessmann of The Alta Group and Fales from VAR are saying.

One bank-owned finance and leasing company that has jumped in the deep end of the pool is DLL, which created an entire division to serve the consumption model. Matthew Frankel is the vice president of pay-per-use solutions for DLL. He is responsible for development, implementation and strategic positioning of consumption products within DLL.

“When we look at the market, we see a continued rise in ‘conscious consumption’ behaviors focused on limiting waste and matching costs with revenue,” Frankel says. “We believe that further demand will emerge as customers adapt to post-COVID realities. This is a vibrant and growing segment with enough room for multiple players, including captives, but we also believe there is a compelling reason for captives to partner with DLL.

“True consumption pricing models offered by manufacturers or their captives require substantial balance sheet resources, as they are effectively rentals from an accounting perspective. Through our focus on long term partnership and our proprietary risk sharing models leveraging years of asset and usage data, DLL has successfully assisted OEMs in reaching their revenue recognition goals while delivering differentiated usage-based offerings to customers.”

Once again, as alluded to by Infante and Croessmann, oftentimes the accounting treatment, revenue recognition and understanding of historical data are significant decision drivers.

“Nimble and customer-focused independent finance companies have a long track record of adapting and evolving to meet the needs of the marketplace,” Robert Moskovitz, CFO of Verdant Commercial Capital, says. “I believe the expansion of the consumption model within the equipment financing [industry] offers a great opportunity for independents for all the same reasons it is beneficial for equipment vendors to partner with independents.

“When independents act in a properly structured private label program with an equipment vendor, they essentially have the same benefits as a captive but with several important advantages. An independent, in such a program, will be more responsive because they will be held to a higher standard by the vendor than an owned captive and therefore should provide better service. In addition, an independent with a controlled billing process and access to multiple funding sources should provide better support for all of the vendor’s customers that come in a wide range of credit and deal size parameters. If an independent can structure a private label program with the same benefits that vendors give their captives, the independent can be a better solution and comes without the significant capital allocation that a vendor must make with a captive.”

“Underlying economic objectives of an equipment sale don’t change with a consumption model. The seller still needs to recover their cost plus a profit and preferably at the time of sale, and the financial party, either a captive or an independent, must also make an acceptable return. Consumption models really are an innovative new wrapper for an old finance model that customers are used to and that is paying for the use of a product over a specified period of time.”

One competitor in this field is heavily focused on the multiple risk elements that need to be properly assessed.

“Now that ‘X as a service’ transcends all industry verticals, banks and independents need tools to successfully monetize comprehensive, consumption-based service and support transactions,” Vince Mollica, managing director of equipment finance at CIT Business Capital, said. “These tools include strategies for fairly apportioning risk between the service provider, end-user and funding partner, and for ensuring an adequate level of servicing sophistication to support contract administration and invoicing.”

Mollica addresses an important issue by drawing attention to contract administration. If a vendor partner is allowing customers the flexibility of variable billing, a funding source must have robust, adaptive back-office systems to efficiently service such portfolios.

“Obligor credit risk is a given in these deals, but varying degrees of embedded flexibility options — committed versus variable-usage payments and cancellation for convenience — create new risks,” Mollica says. “These require that third-party funders rely on service provider financial indemnities, backstops and/or operational support, including, but not limited to, asset management/remarketing, as well as ‘artful’ end-user termination provisions, to ensure recovery of their investment and return.”

Mollica goes on to address performance risk of a service provider, a large sector of the IT market, “Third-party funders must also be capable of both assessing and accepting the reliance/correlation risk associated with a service provider’s ability to perform. In addition, a third-party funder must be able to consume and assimilate a service provider’s variable charge data, invoice it on a bundled basis and distribute or pass through collections to all relevant constituencies. Not every consumption-based deal will be third-party financeable, but success is possible when the right balance is struck between the above-noted risks and capabilities.”

The Bottom line

Is it impossible for an independent or bank lender to deliver a consumption model? No, not impossible, but it will likely include multiple elements of risk that need to be carefully assessed. The combination of accounting risk, credit risk, equipment risk, performance risk, operational risk, cancellation risk and the flexibility to honor variable end-user payment commitment risks put standard lessors in harm’s way and make them very culpable for potential losses. However, as Moskovitz points out, “Consumption models really are an innovative new wrapper for an old finance model that customers are used to.”

Few financial institutions have found the recipe for successful delivery of a consumption model. But as an industry, we find ways to adjust, flex and adapt to the changing needs of our customers. We always do.

Dexter Van Dango is a pen name for a real person who is a senior executive with more than 25 years of experience in the equipment leasing industry. A self-described portly, middle-aged, graying, balding leasing guy in the twilight of a mediocre career, Van Dango will provide occasional insight from the front lines via Monitor.