Executive Summary
By Laurence W. Carter, Teresa Barger, and Irving Kuczynski (1996)
Financing Opportunities for Small Firms
Consider three entrepreneurs seeking financing:
1) The owner of a small, three-year-old road maintenance company in Ghana has secured his first big break: a contract from the Ministry of Public Works to maintain roads in a region of the country for three years. He needs to double his truck fleet from two to four. His bank manager, although sympathetic, points out that the owner has only two years of accounts and has already mortgaged his house to secure a loan to buy one of the earlier trucks. The owner approaches a leasing company, which concludes that the firm will be able to make the lease payments without difficulty. After a 20% down payment from the contractor, the trucks are supplied within two weeks, on a three-year lease.
2) A Romanian chemist wants to set up a private medical testing laboratory to conduct tests for several local hospitals. She has identified the equipment required, which needs to be imported from Germany. She has 25 years of experience, lots of contacts within the local medical community and an option to rent lab space. But she has limited personal savings, no fixed assets to collateralize, and no corporate sponsor. She approaches several banks, which suggest that they might consider a loan after two to three years of successful operation, but that they could not help now. After looking at her business plan, the manager of a leasing company concludes that she will be able to service the lease payments. The leasing company imports the equipment (handling all of the paperwork) and supplies it to the chemist under a two-year lease.
3) Following a year of growing orders, a small textile manufacturer in Bangladesh wants to borrow US$500,000 to double the capacity of his factory. He needs US$300,000 worth of new machinery and US$200,000 in extra working capital. His bank manager tells him that the bank is suffering from constrained liquidity and can only make loans for under six months. The manufacturer borrows US$200,000 of short-term working capital from the bank and arranges a four-year lease for the machinery with the local leasing firm.
Without leasing companies, investments like these would not happen. Twenty years ago (more recently in most developing countries), these entrepreneurs would not have found a leasing company. Demand from new, small- and medium-sized enterprises such as these has turned leasing in developing countries into a US$40 billion-plus industry-from nothing-within just 20 years.
IFC has played a central role in this change, through a combination of advising governments about leasing regulations, undertaking feasibility studies, identifying sponsors and technical partners, drafting business plans and operating policies, and investing in new leasing companies. IFC has invested in leasing companies in over half of the developing countries which have a leasing industry today (and often, IFC investment has been the country's first leasing company).
What Exactly Is Leasing?
Financial leasing is a contractual arrangement that allows one party (the lessee) to use an asset owned by the leasing company (the lessor) in exchange for specified periodic payments. Critical to this arrangement, legal ownership (retained by the leasing company) is separated from economic use of the asset (held by the lessee). The leasing company focuses on the lessee's ability to generate cash flow to service the lease payments, rather than relying on its credit history, assets or capital base. This arrangement particularly suits new, small- or medium-sized enterprises (SMEs) without a long history of financial statements. Security for the transaction is provided by the asset itself.
A Large, Growing Industry
Leasing can be traced back thousands of years, although it has evolved considerably during the last 40 years. The industry evolved from being a manufacturer's selling technique into a specialized financial service with the formation of the first independent leasing company in 1952 in the United States. The industry extended to Europe and Japan in the 1960s and has been spreading through developing countries since the mid-1970s. By 1994 leasing had been established in over 80 countries, including over 50 developing economies.
In 1994 over US$350 billion of new vehicles, machinery and equipment was financed through leasing, accounting for about an eighth of the world's private investment. In OECD countries up to a third of private investment is financed through leasing.
Developing countries are driving most of the leasing industry's growth today: between 1988 and 1994, new leases written increased from US$15 billion to US$44 billion. The most spectacular increase has been in South Korea. Started in 1975 and supported by IFC investments in the first leasing company, the South Korean leasing market was the fifth largest in the world by 1994.
Furthermore, market penetration (leasing as a share of private investment) more than doubled in both middle and low-income countries between 1988 and 1994. By 1994 leasing accounted for an average of 11% of the financing of capital equipment in middle-income countries, up from just 4% in 1988.
Why Has Leasing Grown So Fast?
Leasing has addressed an unmet demand from new, small- and medium-sized firms and attracted borrowers away from traditional bank loans. It offers advantages to all parties:
The Lessee
Although leasing is a high-spread business it offers potential advantages to the lessee:
- Simpler security arrangements and the less strict requirements for historical balance sheets mean that SMEs can access lease finance more easily than bank loans.
- Availability. In developing countries leasing may be the only form of medium- to long-term finance available for purchasing equipment.
- Convenience. Leasing can be arranged more quickly and simply than conventional loan financing because outside security often does not need to be established.
- Lower transaction costs. Despite the relatively high spreads of leasing, the costs of assigning collateral, documentation, and slower processing times for bank borrowing can be significant, particularly for smaller borrowers.
- Little cash required. Leasing can finance a higher percentage of the capital cost of equipment than bank borrowing, often with little down payment.
- Flexibility. Leasing contracts can be structured to meet the cash flow needs of the lessee. Tax incentives. In many countries lessees can offset their full lease payments against income before tax, compared to just the interest on bank loans. Furthermore, lessors may pass on tax benefits associated with their depreciation to lessees via reduced financing costs. Governments grant tax incentives to leasing because they recognize that it enables new and small firms to access financing for investment.
Leasing Companies
Leasing companies also benefit SMEs:
- Ownership of the asset gives the lessor strong security. In countries where weak collateral laws hinder bank lending, leasing offers the advantage of (often) not requiring collateral beyond the security of leased asset itself, and of simpler repossession procedures, because ownership of the asset already lies with the lessor.
- Dedicated use of funds. Because the lessor purchases the equipment directly from the supplier there is no opportunity for the lessee to use the funds for other purposes.
- Relatively simple documentation keeps transaction costs down, allowing leasing companies to achieve high leasing volumes efficiently.
- Lighter regulation. Because leasing companies are not usually deposit takers they tend to be less tightly regulated than banks.
Governments
Many governments have promoted leasing as a way of encouraging investment. But leasing offers other benefits: it broadens competition in financial services and introduces businesses and financiers to innovations such as cash-flow-based credit analysis.
IFC's Experience
In addition to over 50 technical assistance projects to advise governments on how to promote leasing, between 1977 and June 1995, IFC's Board approved US$523 million via 120 transactions to 63 leasing companies in 36 countries. IFC invested equity in most of these companies at an average of just under US$500,000 per approval. Over 75% of IFC's leasing financing was approved during the last five years, reflecting:
- Industry growth. The industry is quickly spreading to more countries.
- Needs of transition economies and low-income economies. Leasing has proven an appropriate financing source for the emerging private sector in transition economies and in low-income regions, such as Sub-Saharan Africa.
- Financial sector stabilization and liberalization. Following severe macroeconomic and financial sector instability during the 1980s debt crisis, many countries have implemented stabilization and liberalization programs that have allowed leasing industries to flourish.
- IFC focus. As the importance of leasing to SMEs has become more evident with experience, IFC has stepped up its promotion efforts.
The leasing companies in which IFC has invested have, on average, proven relatively profitable and efficient. Returns on equity have averaged over 20 percent. Combined with relatively low provisioning rates (compared to bank lending), this suggests that leasing is less vulnerable to default than lending. Since IFC made its first loan to a leasing company in 1977 there have not been any defaults to IFC-and none of the loans have shown arrears to date.
Lessons from IFC's Experience
Within this positive picture, several lessons have emerged from IFC's experience:
- Technical partners should have a substantial equity stake (20%-40%). Although foreign technical partners have played an important role in the majority of the leasing companies that IFC has sponsored, they have not always proven effective, for various reasons, including unfamiliarity with the market, cultural differences, and lack of interest. Technical partners with a substantial investment are more likely to contribute effectively.
- Careful portfolio management pays. Many of the problems that arose in IFC-sponsored leasing companies resulted from overly concentrated portfolios by client or sector.
- Leasing companies are vulnerable to adverse macroeconomic changes. A worsening of the macroeconomic climate usually affects small- and medium-sized firms quickly. Such firms often form a high percentage of leasing customers. Furthermore, if credit is tightened, leasing companies may suffer from financing constraints or term mismatches.
- Leasing companies benefit from foreign exchange convertibility and reduced tariffs on imported machinery and equipment. Leasing companies in developing countries often require foreign exchange to purchase imported equipment, but prefer to denominate their leases in local currency (because of their SME client base). Without foreign exchange convertibility leasing companies write mostly foreign currency leases to match their loans to finance imported equipment, which restricts their market to exporters.
- Stand-alone leasing firms compete more vigorously for markets and focus on their portfolios. For this reason IFC usually prefers to finance stand-alone companies, although such firms can be at a disadvantage when competing with leasing subsidiaries of commercial banks, which can tap low-cost depositors' funding from their parents.
- Difficulties in mobilizing domestic financing are often one of the most serious constraints to expansion. This is one of the key roles that local partners can bring to a new leasing company, as well as knowledge of local markets.
What Is IFC's Role?
In the long run, IFC's most important and effective approach to financing SMEs is indirect, through promoting domestic financial institutions that target small and new firms. IFC uses three main mechanisms:
- Sponsoring leasing companies;
- Making loans to banks for on-lending to SMEs; and
- Promoting venture capital funds which provide SMEs with equity and managerial advice.
Building these institutions enables a sustainable flow of local financing to reach SMEs, as they all primarily mobilize domestic financing (appropriate for SMEs, which are not usually prepared to take foreign exchange risk). Working through such institutions IFC can ultimately reach more SMEs at lower costs than via its complementary direct financing programs.
Because of its developmental importance, IFC often takes the initiative to promote leasing. Broadly, IFC seeks to extend the leasing industry to more countries and to promote vigorous, competitive leasing industries in countries where it already exists. More specifically, IFC advises governments, initiates concepts, undertakes feasibility studies, sounds out potential technical partners, helps draft business plans and operating policies, mobilizes funding, invests directly, and sits on the boards of leasing companies.
Mobilizing domestic financing is a particularly important part of IFC's role. Some mobilization follows almost automatically after a new leasing company is established because leasing companies typically leverage themselves. Thus, while a dollar of IFC equity is matched on average by three other dollars of sponsor equity, the company will leverage its equity by raising 5-6 times as much debt, enabling it to write over US$20 of leases.
Over the medium-term, mobilization is higher still because most leasing companies grow rapidly. For example, a sample of 11 leasing companies which IFC helped start between 1977 and 1988 had an initial capitalization of US$61 million (that is, about US$5 million a piece). By 1994 the capitalization of those 11 companies totaled US$3.3 billion.
What Is the Development Impact?
A ripple-effect of related development impacts from leasing can be identified, with each subsequent impact being more widespread and powerful than the previous:
- More SMEs access financing. In 1994, 16 of IFC's leasing companies wrote over 10,000 new leases worth over US$2 billion. Lease sizes varied enormously between countries and companies, ranging from one company that wrote over 2,700 leases worth an average of US$18,000 each to another that wrote a similar number of leases averaging US$580,000 each.
- The industry grows rapidly as lessors gain experience, and potential borrowers come to understand leasing. For example, when IFC helped establish Malawi's first leasing company in 1986, it expected the volume of new leasing business to rise to US$3.6 million after five years. In fact, its new business in 1991 was over double this level and two new competitors entered the market.
- Increased competition stimulates new product development (leasing to new sectors, cross-border leases, and so on) and sometimes reduced spreads. In Botswana, for example, the new leasing company captured 25% of the market within its first year. Leasing spreads fell from over 10% in the late 1980s to under 5% in 1994.
- Private investment in capital equipment has increased in many countries which have developed leasing industries. Although sample sizes are small (18 countries) and direction of causality cannot be proven, there does seem to be a correlation between the market share of leasing and private investment as a share of GDP.
- Leasing companies help develop capital markets. On the asset side, they introduce small and medium businesses that previously relied on informal financing, supplier credit, and internal cash generation to formal financial markets. They also increase financing options for larger companies. On the liability side, leasing companies' efforts to mobilize debt and equity help deepen and broaden domestic capital markets. Leasing companies mobilize debt by:
1) borrowing from banks and finance houses or, where available, pension funds and insurance companies. Demand from leasing companies broadens the term lending options for all of these institutions.
2) issuing bonds or other marketable instruments. This broadens the choice and liquidity of instruments on domestic capital markets. In their search for financing, several of the leasing companies which IFC has supported have innovated in their domestic bond markets. In Korea, KDLC's W20 billion non-guaranteed corporate bond, issued in May 1986, was the first domestic securities issue by a Korean leasing company.
3) finally, securitizing their lease receivables. IFC is working on securitizing lease receivables for some of its leasing companies.
On the equity side, several IFC-sponsored leasing companies have floated their shares. IFC has invested both in leasing companies that had already listed (for instance, in Sri Lanka and several in India) and has supported others in which it had stakes to issue shares publicly (Korea, Portugal, Pakistan, and Zimbabwe).
What Makes Successful Leasing Companies?
IFC's experience suggests that six factors enable leasing companies to flourish:
- Management. A high standard of cash-flow-based credit analysis and supervision of clients, complemented by follow-up and equipment insurance procedures are critical.
- Competent partners. In many markets where leasing is being introduced, it is important to have an active, committed and competent foreign technical partner. The technical partner, which should have enough equity to ensure active participation, should: establish and monitor standards and procedures; train local staff; advise on lease pricing, marketing and administration; and perhaps second the first general manager.
- Funding. The single biggest obstacle to the growth of IFC's investee leasing companies is access to term local currency funds. Access to term deposits from insurance companies or pension funds or to a local bond market helps overcome this problem.
- Asset-liability matching (ALM). Leasing companies must match fixed-rate leases with fixed-rate term funding, or if only floating rates are available (locally or internationally), it needs a regulatory framework that allows periodic adjustments of lease rates.
- Attractiveness to lenders. Given their high debt-equity ratios, leasing companies must remain attractive to lenders. Security sharing agreements that establish equal rights to a pool of collateral for senior lenders are often used in IFC agreements. Also, IFC gives guarantees or direct loans, particularly to new companies that have not yet established credit histories that allow them to borrow locally.
- Regulatory framework. Leasing companies need a regulatory, legal and fiscal environment that at least provides equal treatment compared with other sources of capital investment financing. Clear, simple and effective legal procedures are important to reclaim assets if the terms of the lease agreement are breached.
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