MANAGING RESIDUAL VALUE AND
REMARKETING
An exploratory qualitative analysis of the possibilities for
asset based leasing for ING Lease.
July 2007
Rijks Universiteit Groningen, Faculty of Management and Organization
Research conducted by: Sjoukje Minnema
Student number: 1273159
Research supervisor: R. Rozier
Organization supervisor: M. Rost van Tonningen
Dear reader,
In front of you lie the results of a research conducted in the field of leasing, with its specific aims at residual values and remarketing. The results are brought to you in the form of a thesis.
For me this thesis contains my graduation research, which I carried out in order to bring my study Management and Organization, specialization business development, at the University of Groningen to an end.
The research was conducted in order of ING Lease, in specific in order of the International Channel Management department.
Aim of the research was to investigate - for ING Lease - the possibilities of remarketing. Hereby keeping in mind the possibilities and restraints of working with residual values. This report presents the design and the execution of the research as well as a number of recommendations to the organization. Based on the recommendations, the organization should be able to make a well- grounded decision as to what to do with residual values and remarketing.
My gratitude goes out to everybody who has helped me in the course of the research project. I would like to thank my supervisors from the organization and from the university, as well as all the experts who have willingly shared their knowledge with me. Last but not least I would like to thank my brother for practically reading every part of the thesis!
Sjoukje Minnema Amsterdam, July 2007
Thesis index
Management Summary... 5
Chapter 1 Introduction and problem definition... 6
1.1 Motive of research... 6
1.2 Research objectives and central question... 9
1.2.1 Research methods... 9 1.2.2 Type of research ... 10 1.2.3. Research variables ... 10 1.3 Research line-out... 12 1.3.1 Thesis structure ... 13 1.4 Delineation ... 14
1.5 Research methods: theories and methods... 15
1.5.1 Critical success factors ... 15
1.5.2 Delphi - Method ... 15
Part I: Take off and preliminary research ... 18
Chapter 2 Introduction to leasing... 20
2.1 What is leasing? ... 20
2.2 Different types of leasing ... 21
2.2.1 Financial lease (FL)... 21
2.2.2 Operational lease (OL) ... 23
2.3 Leasing and risk ... 25
2.3.1 RAROC (Risk Adjusted Rate Of Return) ... 28
2.3 Leasing as a process ... 32
2.3.1 Life cycle management ... 32
2.3.1.1 Finance ... 33
2.3.1.2. Asset management... 34
2.3.1.3 Remarketing ... 35
2.3.2 Primary process ... 36
Chapter 3 Residual Values ... 40
3.1 Dynamics of residual value ... 40
3.2 Estimating residual values... 42
3.3 residual value and risk... 44
3.4 residual value and car lease ... 45
3.5 What is the importance of residual value? ... 46
Part I: Summarized... 48
Part II: Remarketing ... 51
Chapter 4 Remarketing ... 55
4.1 Introduction to three options for remarketing ... 55
4.1.1. The organization does remarketing itself... 55
4.1.2 Third Party Agreement... 56
4.1.3. Residual Value Insurance... 58
4.2 Critical Success Factors (CSF) applied to remarketing ... 58
4.3. Opportunities for remarketing measured with CSF ... 61
4.3.2. Third party agreement... 63
4.4. Which option to choose? ... 64
4.5 International perspective ... 65
Part III Internal structure of remarketing ... 67
Chapter 5. Remarketing and the processes ... 69
5.1 The remarketing process ... 69
5.2 Critical success factors and the remarketing desk... 75
5.3 Third party? ... 77
Chapter 6. Conclusions and recommendations ... 81
6.1 Conclusions ... 81
6.2 Research discussion... 84
6.3 Recommendations for further research ... 85
Management Summary
Taking more (open) residual values (RV) is expected to be inevitable in the future of leasing. To be able to distinguish oneself, as a lease organization, from other lease organizations is an important aspect of competition.
Important aspects of RV are how they are determined, what factors influence RV, the risks involved – in particular residual risk- and how risk averse an organisation is.
A factor that is important in RV policy is remarketing. To organise remarketing with a third party is the most viable option at this moment.
There are international perspectives for remarketing. However to get this well organised will take time and effort.
What to do with residual values is a strategic question. It is a matter that goes through several levels of the organisation, horizontal (business units) and vertical. This implies that if the organisation wants to implement the use of residual values more often, this is a decision that should be well thought over. Either do it right or stay away and focus on efficiency to make financial lease more attractive.
To implement it well can be on organisational level, considering all business units, or on business unit level. Since the different BU’s are still autonomous to a large extent, and, since there are still major differences between countries, it can be argued that BU’s should be allowed to implement a policy for residual values on their own. This could for instance be based on a general policy given by the holding.
With the Netherlands as example, a solution for the remarketing issue is the establishment of a remarketing desk. A unit solely dedicated to remarketing and residual values. Such a unit would be placed at the end of the process but ideally have good communication lines with the front end of the process. Benefits of a central unit are diminishing risks and less uncertainty in the market. Risks are that when a remarketing unit does not work well, it might weaken the leasing process.
When the option to set up remarketing agreements with third parties is chosen, it is of great importance to decide how the relations will be organized and how they will be controlled. How do you avoid opportunism? How do you encounter unexpected problems in the relationship?
A final note is that ING Lease certainly has potential to do more with residual values and remarketing. When the organisation can find a good balance between money based financing and asset based financing, in such a way that core processes are not harmed and in such a way that it leads to greater benefits for the organisation and the customer, then, doing more with residual values will also lead to greater benefit.
Chapter 1 Introduction and problem definition
This chapter will introduce the problem and discuss the research objects and methods.
1.1 Motive of research
Leasing is a way of financing; it is one of the many ways of financing. A specific characteristic of leasing is that it is (to a larger or lesser degree) asset –based. This means that the way of financing is directly related to an asset. One of the benefits of this way of financing is that the lease organization runs a lower risk, since it has the asset as back-up security.
In the leasing market there is a difference between financial lease (FL) and operational lease (OL), with FL being a more money based form of leasing – that is it is more based on the financial position of the customer than on the value of the asset. For the organization FL covers the greater part of the lease deals at the moment.
Within the FL market competition not only comes from other lease providers but also from other financial services such as loans. The competition is strong and there are few ways of distinguishing ones product from another. It is as Mr. Evans, director of Acuitis Business consultant, puts it in an article in Leasing Life (2004, journal for asset finance):
‘A commodity market arises when the products offered by most companies are similar. Everyone copies everyone else making it harder for customers to distinguish between products or suppliers. The only basis on which to compete is price, because that is how customers make purchase decisions for identical products. No supplier can afford to be more expensive than the market. Buyers have all the power and competition is intense in the market place’.
Coincidently, these were also the words of the director of International Channel Management, the international department for all the ING general lease business units in Europe. The idea is simple. If all the organizations offer the same (financial) product then price is one of the main things you can compete on.
Instead of fighting for a small margin though, an organization could try a different path. As Evans (2004) argues, the key ingredient that causes whole markets to head toward commoditisation is a lack of innovation. Without innovation all you can do is cut costs and copy other products in the market. Innovation seems more difficult, but will eventually pay back in the long run.
For this, developing a culture is essential to achieve a constant flow of product enhancements. Developing this culture, however, involves taking more risks, a concept which goes against most the risk averseness of most financial institutes (Evans, B. 2004)
The problem that can be extracted from the above is not so much an urgent problem at the moment; as it is an expected problem for the near future. With all the organizations offering the same products and services, what is left to compete on but price?
Worded differently:
‘In what way can the organization achieve a more unique position in the market? What path should it follow to keep its current customers satisfied, to attain new customers and to establish a more secure position in the market?’
Residual values
Within the organization the idea lives that the organization can reach this unique position by changing its current residual value and remarketing policy. Residual value is the value of a second hand asset at the end of a leasing process, also known as the resell value. A residual value is a policy aimed at the back end of the leasing process, that deals with reselling ex-lease assets and the risks involved. A policy that at the same time influences the front side of the process – for instance with lower monthly rentals for customers (source: the author).
Since managing residual values is an issue that is concerned in operational lease, the focus within the organization will have to shift from more finance based leasing to more asset based leasing. Within the market spectrum this looks as follows:
Figure 2. Spectrum finance based leasing – asset based leasing (ING Lease)
At the left end of the spectrum are the captives1 and other organizations that operate asset based. Their competitive advantage is based on the fact that they know a lot about the asset, and even more of their own brand (in case the organization is brand based). They know the market, they know exactly what the asset is worth and they have established selling channels.
1
A lease organization that is connected to a manufacturer, e.g Volvo Lease Asset based leasing
Captives
General Electric
Finance Based leasing
Financial institutes such as:
- ING Lease - Amstel Lease - Societé General
At the right end of the spectrum are the financial institutes such as ING Lease. They work mostly money-based. They are usually better credit rated than captives and have in this way ‘cheaper’ money than captives.
The idea here is that the organization could move from the one end of the spectrum more towards the middle. Not to go into full asset based leasing, but to become a financer with knowledge of the market. In this way the organization can combine the benefits of ‘being good with money’ with – albeit to a lesser extent – be good with the asset and the market.
Internal organization & remarketing
For the organization this means a different approach towards customers and towards their own leasing products. With this, what are the issues within the organization that are key factors in this process of change, if the organization would decide to change its course? And, how can the organization at the back end of the process get things right to be able to achieve a good internal process suited for offering OL and managing residual values?
This research will focus on the way how ING Lease can fill in its processes at the back end of the leasing process to achieve its goal of becoming more asset- based, to be able to move in the ‘money based – asset based’ spectrum, to eventually increase its profits.
1.2 Research objectives and central question
In a nutshell the above discussed can be described as follows:
Because the lease market for financial lease heads more and more towards a commodity market (with as a result stronger competition and less profit), the organization assumes that a shift towards more asset based leasing can be a suitable new direction for the organization.
Asset based leasing requires a good policy for managing residual values and a good remarketing policy and network. The organization wants to find out in what way this can be best organized.
Thus leading to the following research objective:
The goal of the research is to design a model for organizing the management of residual values and remarketing. The model has to give a detailed overview of the consequences of changing the management of residual values as a means to change lease proposals towards the customer.
The central question for the research then is:
How should the organization organize the process of managing residual values in order to be able to provide its customer with a better lease proposal (in order to be more profitable with operational lease)?
1.2.1 Research methods
During the research several data gathering methods have been made use of.
First of all, literature research: The documents that are used for the research include scientific books and articles from the (online) library of the Rijksuniversiteit Groningen. The aim of this method is to find out the current knowledge level on residual values and remarketing and to find independent information on the topic that can be used as a yardstick.
Second, face to face interviews: based on the Delphi method for doing research, several rounds of interviews have been held to obtain information from several experts within the organization. This method is used to find out which variables are thought of to be important in structuring the back end of the lease process - by experts from several backgrounds from within the organization. The exact variables and the way they will be measure is discussed in more detail in the introduction into part II. Theories and the ways of conducting research used are further discussed in 1.4.
1.2.2 Type of research
The type of research conducted can be defined as analysis – design – change research (De Leeuw, 2000). It is not so much a problem-related research, as it is a research aimed at restructuring and designing a specific part of the organization.
As mentioned in 1.1, there is an underlying problem. However this is a general problem the organization faces and for which they are trying to find a solution. This research only considers a part of the solution. It investigates one of the ways in which the organization can face the problem.
A first characteristic of a design problem is that an organisational problem in this light usually concerns a problem in the organizational structure. Usually this type of research also includes a strategic component – as a long term vision on a higher level (meta level) (de Leeuw, 2000).
This specific research does not entail the entire analysis- design – change process. It only covers the first two steps, the third step falls outside the scope of this research.
1.2.3. Research variables
Looking at the research objectives several variables can be extracted from it, with managing residual values and managing remarketing as most important. An important characteristic of research variables is that it is known what is understood by them and how they can be measured (Baarda, 2001).
First of managing residual value is defined as:
Managing residual values is seen as managing a second-hand asset with residual value. One important aspect of managing RV is the risk component (source: the author).
Second, remarketing is defined as:
Remarketing is the umbrella term for all the activities at the back end of the process aimed at reselling the asset (or otherwise getting rid of the asset for a reasonable price) (source: the author).
(Managing) remarketing is seen to be a(n) –important – part of managing residual values.
These variables are operationalized in part II of the research. In the questionnaire used in stage II (appendix II) questions have been formulated to determine important aspects of the variables. Parts of the ‘answers’ were to be found in the tacit knowledge held by the experts.
The relation between these two variables is first of all that they are closely interrelated and second, as mentioned, that remarketing is part of managing residual values. It covers a specific area of managing residual value, namely reselling the asset.
When one variable changes it is expected to influence the other. For example, suppose that the organization has a well structured remarketing process, it is expected that this will positively influence the management of residual values.
There is however a small difference between the ways the two variables influence each other. Since remarketing is considered to be part of managing residual values, the existence of a policy for managing residual values is as it were a prerequisite for the existence of a remarketing policy.
Remarketing though is not a prerequisite for managing residual values. As said, it is an important part of managing RV, however it is not indispensable for the existence of a policy for managing residual values.
Furthermore it is expected that managing residual values (including remarketing) can influence the leasing and lease offers. A shown in figure 8, there is an assumed relation between the back end of the lease process and the front end of the lease process. A good organization of the back end of the process is considered to have a positive influence on the front end of the process.
1.3 Research line-out
Scientific research... many books have been written about it. And just as the number of roads that can take one to the beautiful city of Rome there are many ways how a research can be done; there is no one easy way how research can be conducted.
It took a while to shape this research, especially to get grip on the central question and research objectives was a long process. Eventually it was chosen to use one central question, however this question was to be supported by other research questions to get a complete view of the problem. At that point the idea started to grow that instead of working with one research objective it might be more fruitful to work with more research objectives at different stages of the research. Thus instead of considering the research as one large research, the research can be subdivided into three smaller researches with each their own research question and their own theme.
As de Leeuw (2001) describes it, it is a matter of procedural rationality – the placing of several research parts in time, with a well-thought sequence. Important is that each part has to lead to a specific conclusion and has to be separable of the other parts.
Research in incremental steps
Another way of describing the research it is to call it incremental. Incremental research is a form of research that goes step by step to a next level. The goal of the research here is to show how the research process ‘worked’ from A to Z. Important is to see how the different steps interrelate and how they gradually work towards the end, together.
The central question answered in the third stage of the research is the question mentioned above; it is therefore that the third part is considered most important in the research. The first two steps are necessary however to gain a good understanding of the problem, they work together towards the third step.
1.3.1 Thesis structure
Conform the research; the thesis is also divided into three parts. 1. Stage one
In the first part the research starts off preliminary, hereby considering all the important aspects that concern the problem. The thesis is literally unwritten. All the relevant available information is gathered and during this gathering process also shifted out, and pinned down to the most relevant aspects of the subject. The goal is to give a general and objective view on leasing and residual values and the way these interrelate.
The research question in part I is based on a brainstorm by the researcher on the important aspects related to the subject.
The research conducted in the first stage is exploratory. In terms of de Leeuw (2001) this is a form of research that explores the field of research to generate ideas and ideally make hypotheses. The goal of the first stage of the research is to gain more knowledge on the subject (as stated by the organization) and to find the most important issues involved with residual values and remarketing.
Though this part is preliminary research, it is added to the thesis to give the reader a complete view on the problem and the issues involved. If one already has sufficient knowledge on the topic (by its own judgement) the first part can be skipped.
More details on the research method and sub questions are discussed at the beginning of part I.
2. Stage two
The second part is aimed at the organization and different sides of the problem. This part goes more into the deep based on the obtained information and ideas in the first part of the research. The most important aspects for remarketing and residual value are taken into further consideration in this part. Eventually the first stage and the second stage should deliver enough information on which a design can be made in the third stage.
The research question for part II is based on the findings in part I.
Points of interest in this second stage are how people within the organization consider the issue, what they see as most important factors and in which direction they look for possible solutions for the problem. The first goal is to recover (tacit) knowledge that employees hold on the subject; the second goal is to obtain critical success factors (CSF) for residual values and remarketing and to measure two remarketing options against these CSF. The subject of research is from a general perspective brought into the organization. Interviews will be held with experts in the field of leasing, remarketing and residual values.
The main research method in this stage is interviewing, done in the framework of the Delphi method. This method is further discussed in paragraph 1.4.
The end goal of stage two is to gain insight in two ways of remarketing: do remarketing yourself or outsource remarketing. These two options are at the moment the two most viable options, as will become clear in stage two.
3. Stage three
At the start of the third part of the research it is clear now:
- How the leasing mechanism and in particular residual values and remarketing work - What the issues and ‘hot topics’ considering residual value are
- How RV is considered within the organization
The third part of the research is, as said, the most important part of the research. This part will eventually have to lead to an answer on the central question. The main objective here is to analyze the effects of remarketing within the organization.
The third step is a design process aimed at the back-end of the process. The main subject here how remarketing can find its place is the leasing process.
In this way the multi-levelled problem will be covered by a multi-levelled research. As said, the problem itself is not on one level, nor does it concern one part of the leasing process. The first two stages of the research look at different aspect within the lease process and discuss how remarketing might fit into this. The third part brings this together and actually shows the fit between the lease process and remarketing.
From the first step till the third step the research objectives will be narrowed down more and more until eventually it will be able to answer the central covering question. The basic idea behind this form of research is to let the three independent parts at the end interact. This will eventually lead to a holistic solution of the problem: ‘the whole is more than the sum of the parts’.
1.4 Delineation
• From a broad perspective in the beginning, the research is narrowed down during the stages. Eventually the research will consider the internal organization of ING.
• Possible outcomes of the research have to be applicable within the organization.
• Only assets used in operational lease are considered in the research. The focus will be on buses and trucks since these are – within ING lease - the most used assets in operational lease. • Even though customers are of influence, their influence will furthermore not be considered in
the research. It is thus taken for granted, but not further more examined.
• It is a qualitative research. Costs incurred in the leasing process and for instance in remarketing are not taken into consideration. The goal of this research is to get a qualitative overview of residual values and remarketing options.
1.5 Research methods: theories and methods
The research consists of several methods of research. In accordance with Braster (2000), there has been made use of a combination of methods. This can be placed under the covering term ‘triangulation’. In the research, the following two forms of triangulation have been made use of (Braster 2000):
• Data triangulation – several sources of data have been made use of
First of all documents on leasing offered by the organization and from books and academic texts. Furthermore texts on research methods, in particular the Delphi method and critical success factors method. And third, management and organization literature on systems thinking, modelling and other important theories and lines of thinking.
• Method triangulation – several research methods (qualitative and quantitative) have been made use of
First of all, the studying of books and academic texts (one could call this a more passive form of collecting information).
Second and foremost: interviews and conversations. With the Delphi method as ‘guide’, several rounds of interviews were held with experts. The Delphi method was chosen since it is a method that puts emphasis on several rounds of interviews, including feedback and building further on earlier results. In this research -since it comprises several ‘rounds’- having several (advancing) rounds of interviews, has been a very fruitful way of working.
1.5.1 Critical success factors
The criteria used to weigh the options are the so-called critical success factors (CSF). The critical success factors method is a way to delineate information and was first designed in 1979 by John F. Rockart. He originally designed the method as a way to obtain the required information managers need for making (strategic) decisions (Rockart 1979). In the research, first of all the CSF method was used to get a clear view of what the most important aspects of remarketing are. Experts were interviewed on this and based on their opinion several critical factors were identified.
This method was chosen since it is a clear and simple method and because its suits the research. That is, the method of first identifying criteria and second measure options against it was a suitable way of comparing the different methods for remarketing.
Second, the criteria were used as a framework for testing the two remarketing options.
1.5.2 Delphi - Method
As said, the most used way of gathering data was interviewing. Not just unstructured, random interviews but planned interviews with a select group of experts throughout the organization.
This group has been questioned several times during the research. In the first two rounds there have been rounds of interviews. Based on these interviews, the conclusion in the third round is reached.
The method by which these interviews were structured would be best described as the Delphi method. The core of this method is interviewing experts in several rounds. In this way the researcher can process information gathered and again ask the expert’s opinion on it. The expert not only evaluates its own input in this way, but also input from other experts (www.viwta.be/files/methdelphi.pdf2). One of the great benefits of the Delphi method is that it does not require that all the interviewed are together at the same time in the same place. This was in this research a blessing, due to time and space constraints (busy schedules and people from different countries).
Second, since much of the knowledge on the topic was ‘tacit knowledge’ held by people from several backgrounds, the collective base of the Delphi method was very useful for preventing to prevent only biased interview results. The method ideally lends itself for collecting subjective results on a collective base (www.viwta.be/files/methdelphi.pdf ).
The Delphi method is reflected schematically in figure 1. One can see clearly in this figure how the process of feedback and re-using information works, and how this gradually works towards a final answer.
Some remarks have to be made concerning figure 1.
Step 3. The selection of the experts in the first round was mainly done in dialogue with the principal. The experts who were again approached in the second and third round were chosen based on their shown expertise in the previous rounds. This means that the core of the group of experts has remained the same throughout the research, but that some other experts were only questioned once or twice. The composition of the group of experts will be discussed later on.
Step 4. The traditional Delphi method uses questionnaires which are spread by post or mail. In this research -due to the multi-levelled character of the problem and all the aspects considering first the leasing process and later the remarketing- this was not a suitable way of gathering information. As said, interviews – based on questionnaires – were the more suitable candidate.
2
Figure 1. Overview Delphi method3
3
Source: free version by the researcher based on figure 1 (page 115) from www.viwta.be/files/methdelphi.pdf
1. Start
2. Problem description
3. Selection of experts based on their fields of expertise
4. Preparation and spread of questionnaire (interviews)
5. Analysing answers of the interviews
8. Draw an overview of the answers
6. Are the answers sufficient?
yes 7. New questionnaire based on anwers previous questionnaire
9. Draw final report
Part I:
Take off and preliminary research
The goal of the preliminary research is first of all to gain more insight in the dynamics of leasing and what role residual values play in this process. The research question in part I is based on a brainstorm by the researcher on the important aspects related to the subject.
The main research question at this point is as follows:
‘How can ING improve its leasing product by managing residual values?’
Improvement is defined here as:
‘To enhance in value or quality: make better, to make useful additions or amendments’ (Merriam Webster online dictionary: 2007)
Important sub questions at this point are: • What is leasing?
• What does the leasing process look like? • What is residual value?
• How is residual value estimated?
• What is the role of residual value in leasing?
• In which countries do they already have a way of managing RV and can this method be copied to other countries?
As said in chapter one, the research in this part can be characterized as exploratory. The goal of this first part is to obtain all the relevant knowledge on leasing, residual value and remarketing on which the further research can be build. It is to see the things as they are, and to get ideas on how they can be developed into the desired situation.
Research method
The information used for the first part of the organization is mainly obtained through literature studies, interviews and profession literature. Since theories and (economical) literature on leasing are scarce, information obtained through interviews also play an important part.
The interviews held in this stage can be seen as the first round in the Delphi method. An example of an interview is to be found in appendix I. Mind that this interview was held in light of the research question of stage I.
Composition group of experts
As said in chapter 1, in this stage of the research the group of experts was partly composed on advice of the principal. The group existed of a wide variety of people, each expert in their own field of work,; for instance: asset specialists, risk managers and even people from the administration who work with lease contracts on a day to day base. The experts were selected on their knowledge of leasing, operational lease and other aspects of leasing or on their specific task in the leasing process.
Delineation
There are not many restrictions with regard to the topics, as long as they are related to leasing, residual values or remarketing. The goal is to obtain as much relevant information as possible in order to create a complete picture of the subject of research.
This part of the thesis contains the following chapters: • Chapter 2 An introduction to leasing
This chapter will cover all issues concerned with leasing. It will focus on operational lease and its characteristics. An important part of the chapter is dedicated to the primary process of leasing and the ways the different parts of the process are interrelated.
• Chapter 3 On residual values
This chapter is focused on residual values and the issues concerned with it. An important issue with residual values are the risks involved, these will discussed in great detail.
As mentioned, if one has – in its own opinion- already enough knowledge on the topic and the issues involved, one could skip this part or only read the summary at the end of part I.
Chapter 2 Introduction to leasing
Leasing is the generic term for all kinds of object financing and (possible) additional services (e.g. maintenance), by which a lessor enables a lessee to purchase an asset for a longer period of time. Two main types of leasing can be distinguished, namely financial lease and operational lease. Whatever the type of leasing, in general the lessor has made investments in or invests in an asset, on which the lessee takes on payment obligations towards the lessor (van Hees, 1997)
2.1 What is leasing?
The earliest records of lease go back to ancient Sumeria prior to 2000 BC and include transactions ranging from land and water rights to oxen and agricultural equipment. Leasing is a way of financing assets and considered a financial service: it has characteristics of a service and is subject to financial regulations.
Leasing is best described by general characteristics of a lease transaction; it is difficult in the literature to find a clear-cut definition of leasing. Within the organization the following characteristics are said to be the basis of leasing (ING module leasing 2006):
1. Leasing is object oriented. This means that leasing is always based on or used for an asset; every asset can be leased, as long as it has economic value. In practice this comes down to durable capital goods.
2. The use of the object is central. A leasing contract provides the lessee with a right to use the asset during the term of the contract. The legal ownership plays a marginal role; it only serves as a security for the lessor in case of default.
3. The contract term of the lease doesn’t exceed the economical life of the asset. In case of operational lease it is even shorter.
One important aspect of leasing is who has the economical ownership of the asset and with it the risk on the asset. This will be discussed in more detail later on.
In literature on marketing the difference is made between products and services. Services are said to possess certain characteristics that products don’t have and vice versa. Leasing is considered a service since it has no tangible output, the consumption of it is inseparable of its means of production, it is perishable e.g. cannot be stored and to own it is also difficult (Kotler, 2003)
2.2 Different types of leasing
There are two main types of leasing: financial lease and operational lease. In the following paragraphs both types will be discussed and compared to each other. Even though operational lease is the focus of the research, it is important to define financial lease first since it the basic form of leasing from which operational lease is derived.
The classification of the two types of leasing is originally based upon ‘the general principles of lease classification and accounting (IAS-17, International Accounting Standards)4’.
2.2.1 Financial lease (FL)
Financial lease is a type of leasing which shows much resemblance with other financing products. The lessor gives possession of the asset to a lessee for an agreed upon period, normally for the commercially useful life of the goods. In consideration for this the lessee pays an agreed periodic rental to the lessor.
The first characteristic of financial lease is that it is a full payout method. This means that the financial repayments for the asset (by the lessee) are done during the term of the contract. By the end of the contract the asset (legal) ownership is transferred from the lessor to the lessee. The asset is then fully repaid by the lessee (Van Hees, 1997).
The lessor has the legal ownership and the lessee has the economic ownership. The lessee bares any risks involved on the asset and has to activate the asset on its balance (ING Lease module, 2005). The characteristics and benefits (for the lessee) of financial lease are summed up in the following table:
4
Financial lease Features:
Benefits of Leasing (lessee):
Economic ownership with lessee Pay as you earn
Legal ownership with lessor Fixed costs, fixed tenor facilitates budget process
Fully amortising during tenor Object related financing - 100% of capital expenditure - non house bank related
First preferred title to assets involved Full ownership at maturity
Price quoted as a spread over the benchmark Deal driven rather than relationship driven Annuity payment schedule
Table 1: features and benefits of financial lease (ING General Lease presentation 2006)
The last feature mentioned in the table - financial lease is characterized by an annuity payment schedule - means that the payment schedule is predetermined at the beginning of the contract for a fixed payment each (agreed upon) period. There are two major benefits related to this feature (ING lease module 2005):
1. You pay as you earn; in contradiction with a ‘normal’ depreciation schedule in which the payments in the beginning of the term are higher than at the end of the term, in an annuity the payments are fixed. In the beginning of the term, yields of an investment might not be optimal yet for instance due to start up problems. With a ‘regular’ payment schedule the payments in the initial period don’t match the yields, whereas with an annuity payment this difference is much smaller.
2. Since the payments are fixed you know what costs to expect. This makes the budgeting process for a customer \easier.
2.2.2 Operational lease (OL)
Operational lease is usually defined based on the characteristics on which it deviates from financial lease.
First of all, operational lease differs significantly from financial lease in that it is the lessor who is and stays the owner of the asset.
Second OL is different in that the rentals paid by the lessee will not be sufficient to repay the lessor’s investment in the asset (non full payout). This has to do with the residual value of the asset which is also part of the repayment of the initial investment.
However the main difference between FL and OL is who has economical ownership and therefore, amongst others, bares the risk of the residual value5. In financial lease this is the lessee, in operational lease this is the lessor.
The characteristics and benefits (for the lessee) of operational lease are summed up in the following table:
xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Table 2: features and benefits of operational lease (ING General Lease presentation 2006)
The first benefit mentioned is the availability of assets without the burden of ownership. With OL the lessor has the legal and the economical ownership of the asset. The lessee has the right to use the asset. The second benefit is that OL requires lower monthly payments than FL for the same asset with the same initial value and the same duration of the contract. Where FL discounts the asset to zero, OL discounts to a certain value: the residual value.
5
Residual value risk may be defined as ‘the risk that the value of an underlying asset in a leasing contract, when sold on the market at the end of the contract tenor, is lower than the contract residual value (ING Lease Wikipedia 2007)’.
Figure 3. Depreciation graphs (simplified) for financial lease and operational lease
As can be seen in the above graphs the total amount that needs to be paid by the lessee is smaller with operational lease than with financial lease. It follows that the monthly payments are also lower for an operational lease for identical assets with the same duration of the contract and the same margin. One of the most important benefits of OL and at the same time an important difference between OL and FL is the possibility to account the leasing off balance. Operational lease avoids the down payment usually required for the purchase of equipment. Because leased equipment is not owned by the company, it does not appear on the balance sheet (Euromoney Lease training 2000).
Furthermore OL can enhance the return on capital employed (ROCE). Capital employed refers to the investments required for a business to function. By ´employing capital` a company makes an investment. If it manages to generate the same revenues with a lower investment or generate higher revenues with the same investment, it has a better performance.
The return on capital employed is also closely related to the capital expenditures of a company. Capital expenditures are used to describe the process of making and managing expenditures on long-lived assets. Capital expenditures are also closely related to capital budgeting and involves the firm’s capital structure (Ross et al, 2005).
In terms of accounting, an expense is considered to be a capital expenditure when the asset is a newly purchased capital asset or an investment that improves the useful life of an existing capital asset. If an expense is a capital expenditure, it needs to be capitalized. With operational lease the company doesn’t make an investment, purchasing an asset through an OL construction thus doesn’t require a company to capitalize and activate it on the balance (Ross et al, 2005).
Time t=5 Value of asset FL Time t=5 Value of asset Residual value OL
2.3 Leasing and risk
It is common knowledge that the expected return on an investment should be positively related to its risk (Ross, 2005). An organization will, for instance, only make an investment if the expected return compensates for its risk.
Risk is defined here as (Merriam Webster’s online Dictionary 2007): ‘The chance that an investment (as a stock or a commodity) will lose value’
One of the major issues in leasing is the risk and uncertainty involved in a leasing transaction (Rode, D.2002).
Why is risk such an important component of leasing and of residual value?
As a financial institute ING Lease is subject to financial regulations and financial laws. The idea behind this is that banks have to be trustworthy and safe since people store their money with banks. There are several ways to define whether banks are trustworthy, e.g. the financial ranking system of Standard and Poors6. The external rating – an estimate of the institution’s ability to repay its creditors – is an indication for debt holders of the level of ongoing solvency (ING introduction to RAROC economic profit and economic capital, 2005).
Next to this, for the company itself it is also important to know ‘risk’. Sound economic risk assessment can help strategic decision making, especially if returns are then compared on a risk adjusted basis. Both the institution and its stakeholders require a proper understanding of their risk appetite (ING Introduction to RAROC, 2005)
From a shareholders perspective there is a need for transparency in the trade-off between the risk taken and the expected return, since they are the providers of the capital and the ones that actually run the risk on the capital invested (ING introduction to RAROC, 2005).
The most recent development in financial regulatory was the introduction of Basel II. Basel II is ‘a revised framework on international convergence of capital measurement and capital standards’ and is build upon Basel I (Basel committee on banking supervision 2005).
It serves as the basis for national rulemaking and implementation processes. The new framework is meant for those financial institutes that move onto the internal ratings based approach (IRB). In this approach institutions will be allowed to use their own internal measures for key drivers of credit risk as primary inputs to the capital calculation, subject to meeting certain conditions and to explicit supervisory approval (Basel committee on banking supervision 2005).
6http://www2.standardandpoors.com
One of the major changes with the previous system (Basel I) is that all institutions using the IRB approach are allowed to determine their client’s probabilities of default (PD) and advanced users are also allowed to rely on their own estimates of LGD and EAD on an exposure-by-exposure basis.
The implications for financial institutes are that they can estimate the consequences of to whom they lend money, or in this case who they accept as lessee. They can – worded differently - define the credit risk7.
For the amount of outstanding ING Lease has on its clients, roughly said, the organization needs to have risk weighted assets (RWA). Risk weighted assets are defined by the exposure at default (EAD) the financial institute faces multiplied by the regulatory risk weighting (RRW)8.
The amount of RWA times 8 % (that is the legal amount of money required as a buffer for the outstanding) defines the amount of regulatory capital a financial institute has to have in order to meet the Basel II demands.
The 8% weighting is only fully used on ‘risky clients’. Trustworthy clients such as governments or large multinationals who have a negligible chance of defaulting have a weighting of 0%. They are assumed to be risk free. There is of course a wide range in between the 0-8 %.
In formula regulatory capital is defined as: Regulatory capital = RWA * 8%
Credit risk can be measured by the Expected Loss (EL), the anticipated expected annual level of credit losses. It can be calculated for individual transactions or for an entire portfolio.
Expected Loss is calculated as followed (ING introduction to RAROC, 2005):
Expected loss = probability of default * exposure at default * loss given default
The connection between Exposure at default and expected loss is that expected loss defines a portion of the amount of regulatory capital required.
7
‘Credit risk is the potential for the issuer of the marketable security to default and be unable to pay back some or all of the investor’s principal or interest’
(Chambers et al 2004).
8
The exposure at default is the amount of money that a company can lose on its creditors in case they default. The regulatory risk weighting is a function of the (PD, LGD maturity and the asset class) (ING introduction to RAROC 2005).
Probability of default (PD)
Is the probability that a customer will default on its obligations within a specific time period. This is based upon the credit rating of a borrower (e.g. Standard and Poor’s). It is typically defined as a failure to make a payment of either principal or interest, or a restructuring of obligations to avoid a payment failure (ING introduction to RAROC, economic profit and economic capital 2005).
Exposure at default (EAD)
EAD is the expected size of exposure to a customer or counterparty at the time of default. Usually, this is higher than the amount of the current outstanding. The EAD of many products is often not contractually specified (ING introduction to RAROC, economic profit and economic capital 2005).
Loss given default (LGD)
LGD is the measure of anticipated losses in a given event of default. It is the total loss on a defaulted facility expressed as a percentage of the exposure at default. LGD is facility specific and is largely a function of the quality of collateral, customer type and the country of the borrower. Unsecured facilities typically have much higher LGD’s than facilities secured by high quality covers. (ING introduction to RAROC, Economic profit and economic capital 2005)
Table 3. Definitions related to credit risk (source: ING introduction to RAROC, EP & ECAP 2005)
2.3.1 RAROC (Risk Adjusted Rate Of Return)
For integrated risk measurement and the possibility to manage all risks properly, it is important to design one consistent risk measure. An example of such a risk measure is RAROC, a measurement system based on economic capital.
RAROC- Risk-Adjusted Return on Capital is a business performance measurement system that enables management to view its revenues in the perspective of the risks taken to obtain that revenue. RAROC is calculated as the risk adjusted return divided by economic capital:
RAROC = risk adjusted return Economical capital
When correctly applied, RAROC can form a substitute for the Return on Economic Capital (ROE)9. The RAROC of an activity can be compared to the minimum required return by the institution’s shareholders, i.e. the cost of capital, to identify activities that are creating or destroying shareholder value. The economic profit is calculated by deducting the weighted average cost of capital (WACC) from the RAROC and multiply this with the economic capital. Economic profit that is also known as economic value added or EVA, is thus expressed as an absolute amount.
Economic capital (EC) The amount of capital that a transaction or business unit requires in order to support the economic risk it faces. It should be available to absorb future unexpected losses.
Expected loss (EL) A forward looking measure that takes into account the up-to date risk profile of the portfolio. It reflects the long-term average risk of the portfolio.
Economic Profit (EP) (Economic value added)
Economic profit is created when the absolute return of an activity is higher than the cost of capital required undertaking that activity during the period of measurement.
Weighted average cost of capital (WACC)
The average cost of capital on the firm’s existing projects and activities. The WACC for the firm is calculated by weighting the cost of each source of funds by its proportion of the total market value of the firm. It is calculated on a before- and after-tax basis (Ross et al. 2005).
Table 4. Definitions related to RAROC (source except for WACC): ING introduction to RAROC, EP & ECAP 2005)
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Risk adjusted return
The risk adjusted return is mainly based on the valuation principles as applied under ‘Generally Accepted Accounting Principles’ (GAAP)10, only with two main differences.
RAROC makes use of expected losses instead of actual credit risk. Expected losses reflect the average credit losses over the entire economical cycle.
Secondly, book capital is replaced by economic capital in adjusting for the profit and loss account. The economic capital is the assumed economic capital that is required due to the inherent risk of the specific business (ING introduction to RAROC, 2005).
Economic profit
A business activity creates economic value when the absolute return is higher than the cost of capital required undertaking that activity during the period of measurement. This is called economic profit (or economic value added)11. In formula:
Economic profit = risk adjusted return – cost of economical capital
Or
Economic profit = (RAROC % - cost of capital %) * economic capital
In these formulas, value (EP) is created when the actual RAROC is higher than the cost of capital. To be able to determine this, the cost of capital needs to be measured. This can for instance be determined by means of the Capital Asset Pricing Model (CAPM)12.
By using economic profit it is important to decide on one measurement approach and stay with it over time.
Economic profit is a measure that tells what happens to the wealth of shareholders. When right, this does not conflict with the long-run interest of other stakeholders. If the market value of an institution is greater than the amount of capital invested, then the organization has managed to create shareholder value (ING introduction tot RAROC, EP & ECAP 2005).
It is suggested that EP is amongst others responsible for the market values of an institution’s shares.
10 GAAP are a common set of accounting concepts, standards and procedures by which financial statements are prepared (Ross et al. 2005)
11 The term economic profit (EP) will be used from now on
12 For more information on the CAPM or other general financial terms used, please see: Ross et al. corporate finance, McGraw Hill New York: 2005. Only the research related terms will be discussed in detail here.
Economic capital
The denominator in the RAROC equation is the amount of money that a transaction or Business unit requires in order to support the economical risk it faces.
Economic capital measures in terms of economic reality rather than regulatory or accounting rules. It is also called economic ‘capital’ because part of the measurement process involves converting a (statistical) risk distribution to the amount of capital that is required to support the risk, in line with the institutions target for financial strength.
Economic capital can also be used in order to be sure that capital is being used efficiently to produce the best returns, and to assess strategy and support decision making.
As such, economic capital offers an enterprise-wide language for discussing and pricing risk that is directly related to the principal concerns of management and other key stakeholders: institutional solvency and profitability.
One of the most important prerequisites to properly assess risks is the availability of adequate and sufficient representative data. For aggregation of risk positions and/or economic capital amounts of consistency of data used is critical (ING introduction to RAROC, 2005).
Summarizing, a proper RAROC framework binds together the incentives of all major stakeholders (ING introduction to RAROC, EP and ECAP 2005):
• Shareholders, that have a primary focus on value creation prospects and the risk- return relationship.
• Management, appointed by the shareholders to optimise the value of the firm under the constraint that they maintain a required capital level.
• Debt holders that have a primary focus on solvency and thus the match between the available and the required capital.
• Regulators that have the legislative powers to protect the debt holders and depositors against defaults.
The RAROC framework is applied in order to measure and compare the economic performance of several activities on a consistent and risk adjusted base and to facilitate the efficient use of capital throughout the organization.
The RAROC tool is an invaluable tool both for senior management to assess different business decisions and for line managers to compare different products, customers and/or transactions on a like-to-like basis.
ING Lease is also rated based on RAROC. Departments with a good RAROC use less economic capital and therefore get more capital to invest since the invested capital yields a better return.
For ING lease therefore the question rises in which way she can achieve the best result with a good RAROC. The question is how managing residual value fits into this picture.
2.3 Leasing as a process
In this part the leasing process and its characteristics will be considered
2.3.1 Life cycle management
The first level to view leasing on is on a general level. The first assumption here is that leasing can be defined in terms of life cycle management. Because of the usefulness of describing lease in terms of life cycle management the underneath figure is assumed to be a realistic -be it simple- model of the reality.
Life cycle management can be seen as:
Managing the stages of the useful life of a product
or service. This should not be seen as the life cycle the financial product goes through – with stages of introduction, growth, maturity and decline (Tidd. 2001) – but as the stages in a lease transaction; one could say it is the stages the asset goes through.
When life cycle management is applied to the lease process of ING some conclusions can be made:
1. ING is good at the financing component of the life cycle. With a Standard and Poors rating of AA-/Stable/A-1+.
It is in a relatively good position to lend money (http://www2.standardandpoors.com) 13. 2. The second stage in the cycle – asset management - is difficult to analyze, since the
organization does not offer full service operational lease in most countries. One could say that in this case it is taken care of (through a third party). However it is hard to define the quality of this part of the process. It is an indispensable part of the life cycle of the lease. The better the asset is looked after, the longer it works logically and the more it is worth at the end of the lease term (ING Lease module 2004).
3. The third stage is an interesting stage; it is what this research is about. As can be seen in the figure above: remarketing is an essential part of the life cycle of lease. This figure actually implies that lease can be subdivided in these three stages. For the rest of the research this assumption will be followed.
The usefulness of viewing leasing in this way is to see how different stages in the lease process are interrelated on a general level
13 An obligor rated 'AA' has very strong capacity to meet its financial commitments. It differs from the highest-rated obligors only to a small degree.
Following, the three parts of the cycle will be discussed. Based on figure 3, the analysis will be made at a more detailed level. Each step in the process will be looked at differently. After this they will be rejoined again in a final outlook of the primary process of the organization.
2.3.1.1 Finance
The first part of the leasing process is the financing part. A customer with a financing need approaches the organization. The customer’s choice for this organization is assumed to be influenced by information from the market.
Furthermore the supplier provides the asset for which the financing is needed and finally ING provides the leasing solution14 to the customer’s need. These three components go into the contracting process and result in a lease deal and satisfied customer need during the lease term.
14
Here assumed to be operational lease
Figure 5. Financing process (source: the author)
Finance
Customer
Supplier
Financing need
Asset with certain value
Market input (push): Information on: - Existing competitors - Pricing -E.g. ING Lease Financing solution
Contracting
Satisfied customer need During contract
2.3.1.2. Asset management
The second step in the cycle is asset management. Asset management is a vital part of the leasing process. The managing of the asset is for the organization not of great importance, though the output of the process is.
The output – the asset with certain value – is the input for the remarketing process. This will however be discussed later on.
The satisfied customer need from the financing process and the lease deal are considered to be the inputs of the asset management process.
With managing assets the entire scope of making repairs, painting, fixing or any other service concerning the asset is covered. These activities fall outside the range of the organization since they do not offer full service.
The process of asset management results in the output of a used asset with certain value, that is, the asset that needs to be resold.
The leasing deal is only considered sideways; it does for instance state the qualities that the used asset has to live up to, but it furthermore plays no active role in this process.
Asset management
Satisfied customer need
During contract
Used asset after termination (With Certain value) Lease deal Management of asset (outside organization): -Repairs -Refurbishments -Etc. Service requests Contract Prequisites Terminated Lease deal
2.3.1.3 Remarketing
Remarketing is the third and final part of the lease cycle.
The used asset – with certain value - after termination of the lease deal is the input for the process. This asset goes into the remarketing process and, when right, is sold. The process of remarketing is influenced by the market need in terms of supply and demand and furthermore by the experience in remarketing the organization has.
The revenue of the sold asset is the money the organization receives for the asset. The revenue is weighed against the costs of remarketing. This can lead to final remarketing results in terms of profit or loss.
The value of the used asset should (at least) equal the residual value as estimated in the beginning of the process. The mechanics of residual value will be discussed later on.
Figure 7. Remarketing process (source: the author)
Remarketing
Used asset after termination (with certain value)
Transformation Process (remarketing)
Revenue of sold asset
Final remarketing result in terms of profit/ loss
Market need in terms of supply and
demand Experience in
remarketing
Second hand asset
Sold asset
2.3.2 Primary process
These three steps in the leasing life cycle together lead to the primary process of the organization. The primary process of an organization is the main reason for its existence, it is the process for which and because of which the organization exists and derives its meaning from (de Leeuw 2000). Within this process, the integrated development of production and marketing plays a central role.
• The blue, pink and red line show the different stages in the leasing process, conform the leasing life cycle.
• The dotted line around the process indicates the boundaries of the organization, or as can be said, the boundaries of the process.
Figure 8. Primary process for operational lease (including the remarketing component) (source: the author) Customer Financing need Asset with certain value Transformation process (contracting) Satisfied customer need During contract
Used asset after termination With value Transformation process (remarketing) Sold asset: revenue
Market need (In terms of supply and demand) Market info
push
Costs of remarketing Hypothesis: Feedback /influence
Primary Process: Operational lease and Remarketing
Final remarketing result in terms
of profit / loss
Finance Asset management
Remarketing
Financing solution
• For ING Lease, the primary process is described as providing a financial solution to a customer shaped as an operational lease. The primary process is designed as follows15:
1. The input of the process consists of a customer with financing need, and an asset with certain value. These two are interrelated since the customers financing need concerns the asset, and the asset wouldn’t be an input if it wasn’t for the customer. Furthermore ING offers a financing solution to the financing need that can also be seen as input.
2. In the second step, the input goes into the transformation process, the process of contracting. In this process ING Lease puts the problem right; that is, here the financing solution for the customer need, in the form of an operational lease is matched to the financing need. This process will be discussed in more detail later on.
The input is influenced by step (7).
3. Marketing and information that ING ‘pushes’ into her environment is assumed to influence the choice that a client makes for a specific lease provider.
4. If done right, the first output of the contracting phase is a satisfied customer need. An important remark is that this will already need to take place during the term of the contract. 5. A second output of the first transformation process is the used asset with certain value after
termination of the contract. With certain value is added in this case, because otherwise the asset couldn’t serve as an input for the final part of the primary process, the remarketing. 6. The next step, is that the asset is indeed put into the final transformation process, the process
of remarketing.
7. The remarketing processes, as well as the asset (with value), is influenced by the market need in terms of demand and supply. The value of the asset is set by the demand and supply of the market, for instance depending on the amount and the price of new assets. These factors also influence the remarketing process. These factors are already known in step (2), since at the beginning of the lease process it needs to be clear to what residual value the asset will be depreciated.
8. The output of the second remarketing process, if done right, is a sold asset that will command certain revenue.
9. The revenue combined with the costs of remarketing and the value of the used asset against which it was sold, result together in the final remarketing result in terms of profit and loss. 10. With the hypothesis of feedback and influence shown in the primary process, it is assumed
that the activities at the back end of the process influence the beginning of the process. The choice of a customer for a certain lease provider can for instance be influenced by the height of the residual value (which influences the monthly payments).
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