Self-Funded Leases: An Option in Tight Credit Markets

It is an environment unprecedented in the post-World War II era. Although interest rates skyrocketed in the early '80s, money was available, expensive as it may have been. But today, the real estate and banking meltdown has dried up credit as never before.

Fleets are most often funded via floating rate master lease agreements, the rate factors based on instruments such as commercial paper, LIBOR, or Treasury issues. But with banks teetering on the edge of insolvency, both commercial paper and LIBOR have nearly disappeared; neither companies nor banks are selling or buying these short-term money instruments. This pullback in turn has led some fleet lessors to experience a lack of funding for new orders under existing lease agreements and to either limit or cut off altogether customers' new-vehicle orders.

What are fleets to do? They can simply extend replacement until the funding crisis eases, keeping a critical eye on maintenance and buying out-of-stock vehicles, the inevitable result of extended replacement cycles. They can also seek other leasing alternatives. Funding remains available, but the cost versus the major lessors can be a burden. One option is self-funding the lease; that is, the lessee becomes the funding source for the lessor, either internally or externally.

Self-funding uses either cash on hand or bank lines within the company to provide the lessor funding. When traditional lessor funding is scarce, self-funding is one option that can maintain a fleet's lease status.

Self-Funding Differs from Ownership
Self-funding a fleet lease program isn't necessarily the same as company ownership from a tax and accounting standpoint. However, the administrative requirements are the same; vehicles must be ordered, tracked through the process, drop-shipped and delivered, registered, and titled.

A fleet lessor provides both vehicle acquisition funding and required administrative tasks. The lease payment covers the lessor's cost of funds, a monthly depreciation reserve, and an administrative fee to cover such costs, plus a level of profit. Self-funding a lease generally does not contain the same administrative fee as a lessor-funded lease, since the funding source is the lessee, and the lessor is entitled to a reasonable level of profit.

Banks May Provide a Funding Option
Companies who remain creditworthy during tight markets usually have bank lines already in place. These money sources can be used to fund fleet vehicle leases. In addition, a company's lead bank often has leasing products it might be willing to make available for this purpose as well. One way or another, the lessee may be in a position to provide funding to a lessor suffering in one of the tightest credit markets in memory.

The first step is to negotiate a fee structure that covers the lessor's costs with a reasonable profit for handling the administrative and clerical processes it continues to perform. This arrangement will most likely take the familiar form of an administrative fee charged in the lease billing. The fee will be higher than that detailed in the existing master contract. Lessors' profit margins are contained in several steps of a vehicle lease transaction: purchase, funding, and billing. Since the funding portion of potential revenue will be lost, the administrative fee must make up the difference.

The next step is developing a communications process determining order placement and vehicle delivery dates. The lessor (or lessee, depending upon the parties' preferences) notifies the funding source that a funds "takedown" must occur to pay for a vehicle. Further, depending on the fleet's capabilities and resources, the lessor handles the initial title and registration (as it has previously), carries the receivable, creates a billing, sells the out-of-service vehicle, and retires the balance of the debt takedown.

Fortunately, electronic communications channels, unavailable as little as 20 years ago, can now help set up a smooth and nearly automatic process. The lessor's existing order system can remain in place as vehicles are ordered, status tracked, and shipments confirmed. The only difference is the debt takedown necessary to buy the vehicle when it is delivered.

Companies Establish Funding in 'Quasi-Ownership' Model
A company can also self-fund a fleet via direct lease lines set up with a company or bank. Several options are available, including lease-funding companies and the aforementioned leasing subsidiaries of the company's banks. In this scenario, the company carries the debt and either arranges national purchasing contracts for ordering or uses its fleet lessor for a purchase/disposal - P&D program - for vehicle acquisition and remarketing.
This "quasi-ownership" program allows the company to establish its own funding, while taking advantage of the purchasing and used-vehicle sales resources of its fleet management company.

Funding can be structured as straight debt or capital lease, in which the accounting treatment places the asset on the company balance sheet with corresponding debt, or an operating lease, which treats the asset as a monthly expense, kept off the balance sheet. Either way, the company must address how administrative issues are handled on a go-forward basis. More specifically, these issues include:

Initial Title/Registration. When the new vehicle is delivered, the dealer must have funds, or access to funds, to obtain title and registration. Normally, this task is handled by the lessor. However, if the fleet is self-funded, the process must be negotiated. Further, there must be a process by which the lessor can bill the fleet for title and registration costs, in addition to the fees associated with the service.

Registration Renewals. Registrations also must be renewed. This task is less challenging, as most lessors offer fee-based renewal programs.

Resale. Vehicles coming off lease must be sold. If the lessor is funded directly, resale is part of the master lease agreement, and from an administrative basis is not an issue. The same holds true for a self-funded lease in which vehicle acquisition and disposal is provided via a P&D agreement. However, in a self-funded "quasi-ownership" arrangement, in which the fleet has established purchasing agreements directly with fleet dealers, the fleet must either sell the vehicles or develop an arrangement with an outside supplier. Such options are available.

Self-Funding Always a Viable Option
It isn't just in tight credit markets that self-funding fleet vehicle leases is a viable option. Depending on how it is structured, self-funding can provide a more flexible program, with greater control and the potential for measurable cost savings.

Lessors usually are cooperative in setting up the program, as are the company's banks in agreeing to establish the debt instruments. Keep in mind, however, the Terminal Rental Adjustment Clause (TRAC) lease is almost exclusive to the vehicle leasing industry, and the open-end TRAC lease is exclusive to the fleet leasing industry. If funding is arranged through a bank, it is a good idea to explain the structure of the lease agreement in detail: how and why the depreciation reserve is established, the TRAC itself, who is responsible for what payment, etc.

Some lease funding sources are familiar with TRAC leases. (They often are used in the lease of over-the-road trucks and trailers.) However, the open-end concept, which states after a relatively short minimum term, the lessee will determine the lease term, may be unknown even to bank officials.

Proven Concept Now May be a Necessity
Self-funding is not a new concept. Fleets have used it, selectively, for many years. Recently, it has become almost a necessity to consider in some cases, as credit markets have dried up and many lessors are forced to limit new-vehicle orders under existing master agreements. If the process is carefully researched and implemented, the fleet manager may find a long-term answer to a short-term problem:

■ Determine a funding source. Solicit first those banks currently servicing the company, either through a "revolver" or via other bank products (treasury management, deposit accounts, etc.). Do not ignore outside sources such as leasing subsidiaries of other banks and lease funding companies, which may be in a better position to understand a fleet lease and structure debt to fit the need.

■ If the funding is provided to an existing fleet lessor, make certain the resulting program is as transparent (vis a vis the existing program) as possible. This process will no doubt require negotiating fees to cover a lessor's administrative and carrying costs, along with a reasonable profit.

■ If the funding is provided directly to the company ("quasi-ownership"), match the company's existing resources versus outsourced licensed, title, and resale program costs.

■ Educate the funding source on the open-end TRAC lease, an arrangement unique to the fleet industry.  

■ Ensure the communication process is outlined before implementation. The funding source must know when takedowns are required. Use the existing lessor's ordering and status-tracking capabilities when possible.