Risk Management

In any venture, the question of risk cannot be overlooked in the sense that the investor is taking the chance that the investment might not eventually yield the desired return or the actual cash flow might fall below expectation.  Hence, in every investment particularly leasing, risk must be analysed.  Risk may be defined here as the possibility that an expected stream of earnings or cash flows may have associated with it, the undesired chance of non-attainment.  This non-attainment often referred to as the possible variability in outcome due to uncertainties about the future.  As far as risk analysis in leasing is concerned, Amembal and Isom (1988) have proposed what has come to be known as the 27 C’s of lease credit for assessing lessee risk as follows:

  1. Confirmation which is the ability of the lessor to obtain and confirm information supplied by the lessee upon which to base all quantitative and judgemental risk appraisals. Information is obtainable from the audited accounts of the lessee, tax returns, periodic reports made to the Nigerian Securities and Exchange Commission and the Nigerian Stock Exchange, press reports in the financial and economic journals and newspapers, analyst reports and bankers’ confidential reports.
  2. Corroboration which involves the lessor validating the information obtained from the lessee through bank references showing the lessee’s bankers, loans obtained, amount outstanding, payment records, length of banking relationship, highest credit limit and any outstanding leases with other lessors. Of course, the lessee should give the lessor a written authority to obtain information from its bankers.
  3. Catastrophe is the need for the lessor to assess the lessee from a worst-case position and build up the lessee’s potential performance from that standpoint.
  4. Concatenation involves the lessor deciding on what key variables are important in the credit assessment and appraisals process.
  5. Classification involves ranking the key credit variables identified earlier in descending order of importance in an attempt to prioritise them.
  6. Consideration is defined as the extent to which credit standards are achieved based on pre-selected subjective scores attached to each credit variables.
  7. Computation is calculating the scores on each variable and aggregating them for a final decision
  8. Compilation involves aggregating the weighted average of the computed figures from the computation and then deriving the decision rule for arriving at the credit decision
  9. Character of the Lessee is the willingness to honour obligations as they fall due based on past experience, references, integrity, honesty and commitment to discharge financial responsibilities even in difficult times. Sources of information for ascertaining the character of a lessee include bankers, creditors, and other lessors with whom the lessee has had dealings and the degree of completeness of the lessee’s financial statements, including disclosure of off-balance sheet financial arrangements
  10. Capital refers to the soundness of the lessee’s financial position as evidenced by his prevailing debt or capital-gearing ratio. Essentially, capital is a function of the resources at the lessee’s disposal, particularly the physical productive assets in full use.  However, to minimise risk, the lessor should be attracted to companies with low debt/equity ratios – that is high net worth and low gearing.
  11. Capacity is the ability of the lessee to honour his financial obligations to the lessor and other creditors as determined by the assessed viability of the business or intended use of the lease facility. This can be done by appraising the profits which are the main source of funds for servicing the lease rentals payments.  Profits should be growing at an increasing rate or at least remain stable over time.and serves as a good indicator of the lessee’s capacity to pay its fixed charges from operating income. To ensure that risk is not unduly high, this ratio should be around four times and increasing over time.
  1. Credit refers to the credit policies of the lessee in terms of credit offered its customers and those received from suppliers and the lessee’s payment record in this regard. The lessor needs to evaluate the average collection period of the lessee, to ascertain how fast it collects its receivables as well as the average payment period to determine how frequently it honours its own obligations.  The lower the average payment period and the bigger the lessee, the lower will be the risk of default on lease rental payment.
  1. Cash flow analysis will show the extent to which lease rental payments can be made by the lessee without necessarily jeopardising its liquidity position.
  2. Chronological Age of the lessee company to a large degree determines the level of risk inherent in the company. Older and well established companies with long track record of doing successful business, tend to present lower risk than newer companies and start-ups.  In the latter case, the lessor should investigate the credit record and background of the promoters and major shareholders.
  3. Capability refers to the degree of management skills, ability and experience possessed by the lessee’s management, which can make the difference between success and failure.
  4. Competence and productivity in the use of the resources at the disposal of the lessee is yet another key risk factor related to capability.
  1. Control is the existence of an information feedback system in the lessee’s company for facilitating the decision-making process. Control mechanism includes budgets, variance analysis systems, standard costing systems and forecasts, with which actual performance is compared to determine if the company sticks to its plans and programmes of performance.
  2. Course refers to the financial direction from which the lessee is coming and where it is heading. Trend analysis of financial ratios, cash flows and sources and application of funds, give clear indication of this direction.  When compared to the lessee’s future plans and strategic programmes of action, the lessor begins to appreciate the viability of the lessee’s future course of action.
  3. Constraints and conditions in the prevailing economic and political environment in which the lessee operates which are likely to impact on the company’s ability to honour its lease rental obligations, constitute a major risk factor that must be considered by the lessor. Hence, the lessor should check the characteristics of the lessee that may increase or decrease its ability to perform on a lease contract.
  4. Collateral refers to the ability to pledge assets as security for the lease. Since the lessor relies on the leased equipment as security in the case of default on rentals by the lessee, it is important to understand the erosion effect of time on the value of the asset.  While some assets do effectively maintain their value after a primary lease term, e.g. aircraft, others are rapidly depreciated like computers.  The lease must thus be structured in such as way as to reduce this type of risk through requiring a guarantee residual value.  In addition, the lessor may need to include in the agreement a preventive maintenance clause, which requires the lessee to ensure that the asset is always in good working order and its end-of-lease salvage value kept intact.
  5. Complexity is the degree of sophistication of the asset in terms of engineering design specification, which the lessee must aver to in writing to the lessor that it is operationally appropriate for its business. This reduces the risk of downtimes and the ability to yield revenue targets needed for servicing the lease rentals.  In addition, the more technologically complex the asset is, the greater is the need for the lessor to insist on protective mechanism of its interest.
  6. Currency or foreign exchange risk refers to the risk that currency rate fluctuations may adversely affect rental payments and jeopardise expected returns, especially in lease arrangements that cut across borders. To avert this possibility, lessors try to denominate their lease contracts in stable international currencies like the U. S. Dollar, Euro or the British Pound Sterling.
  7. Cross-Border risk not only refers to fluctuations in the exchange rate of the local currencies in each country but also the socio-political and economic instability either in the country of the lessor or the country of the lessee. It may also result from changes in tax rates in the different countries involved in the leases.  These series of risks must be factored into the structuring process with the objective of an early payback period, particularly in an unstable lessee country from where it may become impossible to recover the asset if anything goes awry.
  8. Competition refers to the extent to which the lessee has a fair share of its markets, leads it or is trying to get a piece of the action. To reduce the risk of asset under-utilisation as a result of keen competition and market erosion, the lessor should ascertain the degree to which the lessee is maintaining its market share, growing or declining before structuring the lease to reflect any inherent risk arising from this source.
  9. Category refers to the unique characteristics of the asset on lease in terms of its essential immobility or vulnerability to excessive wear and tear. Additional Category risk is thus associated with difficult-to-move assets like lifts and central air-conditioning equipment, which are vulnerable to serious abuse and must be quantified and structured into the lease.
  10. Cyclical and Counter-Cyclical business risks arising from the vulnerability of the lesssor’s business to recurring business cycles and their impact on cash flow during the lease term, should also be of interest to the lessor in the structuring exercise.
  11. Co-Partner refers to the reduction of risk through the involvement of another investor in the lease. While this arrangement reduces risk since it is then shared, it also reduces the profitability of the lease.