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EQUIPMENT LEASING AND FINANCE ASSOCIATIONEQUIPMENT LEASING AND FINANCE ASSOCIATION

MANAGED SOLUTIONS: NOT YOUR GRANDFATHER’S LEASING INDUSTRY ANYMORE

ELFA 2017 Equipment Management ConferenceFEBRUARY 28, 2017

Andy Mesches, Director Mike TobakThe Alta Group Kutak Rock LLP

EQUIPMENT LEASING AND FINANCE ASSOCIATION

Terminology Must Be Clarified

• Need one term to describe the concept: Managed Solutions• Deliberate terminology selection to avoid the legal / regulatory / accounting minefield• Must also sharpen the definition or meaning around specific parties, roles and other

elements in a Managed Solutions transaction


Managed Solutions – Alta’s DefinitionThe service provider enters into an agreement with an end user for a service or ‘solution’. The end user solution can include hardware, software, professional services and operational support. The hardware is not necessarily ‘incidental’ as it can be a heavy component of the service.

Written Agreement Differs From

Traditional Leasing and

Finance Deals

The service provider might have one or more subcontractors providing some of the required services, hardware, software or support. Hardware and/or software is owned by the managed service/solutions provider or one of the sub-contractor providers

The end user payment is structured as a subscription service or might be based on usage

Although some service agreements might incorporate non-cancellable terms, others can be very fluid and cancellable. The trend is towards a ‘pay as you use’ with more cancellation flexibility

Service level agreements are incorporated into the managed services/solutions agreement and govern the performance obligation


Why is Managed Solutions on the Radar Screen Now?

• The concept of - or market interest in - Managed Solutions is not new

• The industry has reached a “tipping point” due to market factors and client demand

• Managed Solutions is positioned to make up as much as 20% of industry activity


Test & Measurement Equipment – Keysight

Water Purification

Office Equipment – Xerox, the first

Telecommunications – AT&T Solutions

Aerial Work Platforms - JLG

Technology – Cisco, HP, IBM

Managed Solutions – A 30 Year old+ ConceptSelected Timeline by Equipment Type

2010s2000s1990s

Networking Solutions – Brocade, Juniper

Source: Alta IP Archives5


The Equipment Financing World Is Changing

Customers demand more

flexibility in structure

1Not just IT / Cloud but across all industry

segments

2Managed Solutions

• Bundled services, maintenance, products

• Payment variability: may include cancellation, usage, up/down –grade, unit based

3


How the Model is Evolving• Technology sits on customer

premises

• Technology deployed/controlled by customer

• Customer owes payment for entire solution up front

• Customer uses financing to extend payment terms

• Vendor title transfers to customer or lessor, depending on financing structure

• Payment obligation potentially off balance sheet

• Vendor accelerates revenue on products sold

• Technology sits on or off customer premises

• Technology deployed / managed by vendor(s)

• Solution is delivered as a service - customer payments due over time

• Payments may vary based on customer’s rate of use

• Customer may have right to terminate service agreement early, with or without penalty

• Customer does not take title to products

• Vendor’s initial infrastructure investment may be sizeable

• Vendor recognizes revenue for services ratably over contract term

Old Model New Model

Customer Wants• Agility (standardized

apps managed by Service Providers)

• Technology maintenance expertise

• No commitment, pure consumption- Pay-as-you-go

models to match profit models / cash flows

• Value v. commoditization

• Does not want to own any assets- Looking for a way

to keep equipment off balance sheet

• Solution delivered by Vendor or Provider


How Big a Deal is This?

• OEM profit margins shifting to lower price equipment – especially PCs -> need Managed Solutions will grow the top line

• Double Digit growth in excess of 20%- Mobile Devices:

27%- Private Cloud:

22%- Infrastructure:

40%

• Fleet management leaders expect flexible end-to-end service solutions will become central to competing

• Example: Navistar On Command - bundled approach to service and after sales support- Better

lifecycle value - Lower TCO

38% of companies use some sort of Managed Solutions structure today

80% of companies say they will adopt Managed Solutions offering in the next 12 months

Managed Solutions is positioned to make up as much as 20% of industry activity

• 75% increase in construction rentals from 2013

• New technology integrates equipment with diagnostic, reporting and security features

• Rising full-service, rental based acquisition model

• Global smart grid managed services market growth forecasted at 54% CAGR 2014-2019

• Deployment of smart meters and integration of renewable energy with smart grids

• End-users of smart grid services are power utilities and IPPs

• Key Vendors are Accenture, Capgemini, GE Energy, IBM and Siemens

• Top 20 outsourcing firms realizing double-digit growth annually

• Healthcare companies shifting toward pay-per-use over traditional purchasing of equipment

• Popular among hospitals is integrated radiological floors


MANAGED SOLUTIONS: METHODOLOGY

Alta used a number of resources, including the

ELFA SEFA report to dimension the MST activity

within the equipment leasing and financing

industry.

QUANTITATIVE QUALITATIVEQUANTITATIVE/ QUALITATIVE

SYNTHESIS

Alta interviewed an extensive and varied group of industry participants to address

the critical aspects of MST. Interviews covered a range of equipment lessors in the information technology, healthcare,

document technology, agriculture, energy, material handling, transportation, lift truck

and general commercial equipment sectors. Interview participants included

captive, independent and bank lessors as well as funders, rating agencies and

service providers.

Alta analyzed the data sources and interview

findings, overlaid with its own knowledge of MSTs, to reach the Study’s findings

and conclusions.


NOT A ONE-SIZE FITS-ALL ALTERNATIVE The Managed Services Continuum

Source: “Managed Solutions: Evolutionary or Revolutionary?,” Equipment Leasing & Finance Foundation, 2016.


Managed Services Continuum Matrix

Not Bundled Partially Bundled Bundled Appearance

True Service Offering

Asset ManagementFrequent changes to asset composition No No Yes Yes

Significant upgrade/return flexibility No No Yes Yes

Ability to redeploy assets displaced by upgrades – Mid-term No No Yes Yes


MSTs drive efficiencies for End Users because

they eliminate the need to manage multiple Service

Providers and all the associated capital

expenses.

“One of rthe most significant impacts of MSTs is the ‘quantum changes’ in

equipment churn which requires more rigor around the equipment’s mid-term

lease experience.”

~ CEO, captive lessor

“Lessors need to evaluate not only the credit of the End User but also their integrity, based on the

exposure in MSTs and the possibility of feigning performance issues.”

~ Chief credit officer for captive lessor

“Think very carefully about what is actually

going on with the transaction

structure to be sure it makes

business sense.”

~ CEO, independent

lessor

“MST is a natural fit for captives and independents but less so for banks with a direct sales model and diverse asset

and customer base.”

~ Head of vendor finance bank lessor

Even industries with less

obvious services components

have demonstrated the need for

MSTs.


Industry leaders believe MSTs are viable product for

all leasing company types.

In most MSTs there is no

particularly thorny issue involved in accounting and

booking the contracts.

It is expected that many variations in

documentation will be introduced as

volumes grow and End Users

requirements become more refined.

Depending on the nature of the MST,

revenue recognition may be negatively affected

if an MST arrangement

contains a lease.

In the structuring and documenting of MSTs there has

been notable pushback from

End Users to the inclusion of

HOHW provisions.

The Finance Entity must have a lease

management system that is robust enough to link and process

the multiple elements in an MST.


In coming years, as MSTs are expected to

represent a growing proportion of volume, alternatives such as

DRB-like dispute resolution must necessarily be developed and

accepted.

“MSTs really reflect a broader shift to access versus

ownership. It is akin to the Netflix model; we want to watch content but no-one wants to own a bunch of

DVD’s.”

~ CEO, independent lessor

“In order for bankers to begin to lend against contracts with upgrade and cancelation provisions, very specific parameters around levels allowed and robust reporting around performance against such parameters will need

to be developed.”

~ Senior lending executive to the industry

“Lessors are asking how do

you transform the market without cannibalizing

sales and have the Street

understand what you are doing

without penalizing you for it?”

~ CEO, captive lessor

As a rule, the more a transaction appears to

resemble a lease or loan, the more likely it is to fall

within the scope of some form of regulation.


MST STUDY TAKEAWAYS1

2

3

4

MSTs will continue growing as a proportion of all offerings of equipment leasing and finance industry participants.

They will grow organically along a continuum of increasingly “bundled” equipment, financing, and services.

They will present growth opportunities for captive, bank and independent lessors across a wide variety of industries.

They will require a fair amount of rethinking and retooling of many individual industry practices, disciplines, and functions embedded in equipment leasing and financing services today.


INDUSTRY IMPLICATIONSMSTs will continue growing as a proportion of all offerings of equipment leasing and finance industry participants.

They will grow organically along a continuum of increasingly “bundled” equipment, financing, and services.

They will present growth opportunities for captive, bank and independent lessors across a wide variety of industries.

They will require a fair amount of rethinking and retooling of many individual industry practices, disciplines, and functions embedded in equipment leasing and financing services today.

Alta predicts MSTs will make up more than 20% of industry volumes over the next 3 to 5 years.Asset management becomes more important due to significantly greater equipment churn with End User upgrades and equipment swaps.Additional headcount needed to structure and manage an MST portfolio: credit, asset management, treasury, legal, accounting and systems.Lease management system upgrades are needed to handle MST complexities, especially for reporting and compliance.

Substantial outbound education efforts required with regulators, lenders and rating agencies concerning MSTs.


The reasons why customers want a Managed Solutions structure are the same reasons why the structure presents heightened risks/challenges

• Customer desire to shift more risk to vendor and/or financing source (e.g., obsolescence and utilization risks)

• Desire for a “turnkey” solution under one agreement with one monthly payment

• Desire for more flexibility (e.g., pay-per-use, mid-term upgrades/substitutions, walkaway options)

Variations in Structures

• Financing source (Finco) buys / takes an assignment of some/all of Vendor bundled paper

• Bundled items (equipment, service, software, consumables, etc.) provided under one 3-party doc

• Hybrid: Agreement between Vendor and Customer, referencing Finco and with separate leases

MST Challenges & Risks


Risks/Mitigants

Risks Mitigants

Loss of “hell or high water” (HOHW) protection for Finco with a bundled offering with “blurry” lines

HOHW language (caution if using Vendor paper) Disclosure of assignment to Finco and portion of

payment assigned Waiver of defenses provision

Taking an assignment of Vendor paper lacking typical lease provisions (e.g., defaults; remedies; tax and insurance provisions; maintenance and return provisions; security interest grant; etc.)

If possible, work with vendor early to ensure inclusion

of such provisions Reps, warranties and indemnities from vendor (but be

prepared for pushback due to effect on true sale / rev rec)

If assigned payment not broken out, agree on breakout

with Vendor


Risks/Mitigants

Risks Mitigant(s)

Services being provided are integral to the use of the equipment and/or are available from only a limited number of suppliers/vendors

Agreement from customer that service provider may

be substituted upon default/insolvency of Vendor Identify suitable/available options for substitute

providers upfront If Vendor is only source of service, and service is a

key component of transaction, Vendor credit-quality becomes much more critical (e.g., consider collateralizing indemnities)

Pay-per use, early cancellations/returns and other variable payment structures

Provide for customer SLV, TV or other make-whole

payment to Finco Obtain Vender residual value gap and/or

remarketing support, but be prepared for pushback due to effect on true sale / rev rec


Risks/Mitigants

Risks Mitigant(s)

Large amount of services/software being financed by Finco (e.g., prepaid services and/or software licenses). Both a credit challenge and a challenge taking competitive residuals

Include “shut-off” rights Obtain remarketing and/or residual support from

Vendor

Finding of agency relationship between Vendor and Finco (e.g., if found, can void enforceability of waiver of defenses provision)

Adequate disclosures / disclaimers regarding agency in

MSA Adequate disclosures regarding roles, responsibilities

and obligations of the parties

How to ensure priority of Finco’s interests over other creditors of Vendor/bankruptcy trustee?

Because MSA may or may not be chattel paper, (i) take possession of the MSA in case it is and (ii) do lien searches and file UCC-1s against the Vendor in case it is not



Special Considerations for Captive Fincos

• (-) HOHW may be a longer putt; Greater risk that Vendor and Finco may be lumped together

• (+) Likely easier to get done when Vendor and Finco are affiliates

• (+) Finco more likely to get financial support from Vendor (margin sharing)

Key Challenges/Risks Takeaways• Partner only with established and financially sound vendors with a strong reputation in their market;

the value of vendor due diligence cannot be over-emphasized

• Important to understand the equipment, software and services being offered in order to take smart and competitive residuals (e.g., secondary market, “stickiness” of equipment, services needed and available providers, etc.)

• Very little case law to guide us

• Bad facts make bad law; courts will go out of their way to ensure customer is not left “holding the bag”

• IF YOU DON’T UNDERSTAND THE OFFERING, CUSTOMERS WON’T; CONSIDER TAKING A PASS


FLEXIBILITYFlexible terms inherent in MST structures demand greater

operational acuity to proactively handle back-end processes such as asset management and billing.


PRICINGEnd-user flexibility demands premium pricing to compensate for the greater risk in the MST structures – but is the market

willing to support it?


RISKBecause MSTs give rise to new types of credit risk,

understanding all the players in a MST, their motivations and ability to perform is paramount should a deal go into default.


GROWTH OPPORTUNITIES

Global demand for Managed Solutions is growing which creates unique logistical and operational challenges in many

regional markets.


Additional Observations

Pricing to reflect risk – no min. commitment means high price, increasing commitment reduces price.

– Are enterprise clients prepared yet to pay the premium for total flexibility?

Can banks make decisions based on behavior and probabilities – insurance companies can BUT at a price.

– These are risk decisions in the broadest sense – are traditional bank risk departments (balance sheet analysis) skilled to make such decisions?

On whose balance sheet will this financing be recorded?


Questions?

28

Economy & Finance

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