An Equity Participation Lease can help railroad chief financial officers in various transactions, particularly when it comes to big-ticket machinery used for maintenance-of-way such as this one putting down concrete ties on CN North America.

A New Twist on Equipment Leasing

By building service into the original lease or purchase, railroads can keep equipment working and make use of the manufacturer's expertise in maintaining MOW machinery.

by Dennis J. Gilstad
Financial Corporation of Michigan

Dennis J Gilstad started his railroad career with Union Pacific Railroad in 1965 and later joined Grand Trunk Western Railroad' In 1980 he left the rail industry, moving into the leasing business with a major equipment lessor as executive vice president. After a three-year tenure, he started building Financial Corporation of Michigan (incorporated 1979) as a full-service leasing entity. FCM over the last ten years has acquired, negotiated and l or sold more than $150 million of capital assets to more than 50 major U.S. corporations. Assets include computers, CNC machine tools and transportation equipment. Since the beginning of 1993 a number of railroads have been added as customers including Southern Pacific, Santa Fe and Grand Trunk Western. Currently a subsidiary division, FCM Rail, is being formed to specialize in maintenance-of-way, locomotive and other longer-life rail assets.

Chief Financial Officers of capital-intensive industries frequently must make the unappetizing choice between balance sheet presentation niceties and economic sense. In the case in which a company is going to acquire heavy equipment with a useful life of almost forever, it can do so on-balance sheet (capital accounts) or off-balance sheet (operating accounts). Eager to avoid showing excess debt on the balance sheet, the CFO will frequently turn to the most common method of securing needed capital items by securing operating leases.

Leasing capital equipment, rather than outright purchase, can serve a number of corporate ends. It affords operations the opportunity to use a new piece of state-of-the-art equipment for a term of years and then to replace the equipment at the end of the lease term with what would then be the state of the art. It shifts the technical obsolescence to the lessor. But most importantly, it allows purchasers and financial managers to accommodate operations' appetite for capital equipment without doing violence to their capital acquisition budgets or to aggregate debt and debt-to-worth limitations, provided the lease is properly structured.

FASB 13 is Catch 22

Here one runs into the Catch-22 scenario-FASB 13!

Essentially, FASB 13 requires a lessee to forfeit any long-term benefits that it could otherwise obtain in a leasing transaction. In order to be a true off-balance sheet acquisition, the lease must be an operating lease. In an operating lease, the lease:
  • term cannot be in excess of 75 percent of the estimated economic life of the equipment,
  • and the lessee cannot have the option to purchase or otherwise acquire the equipment during or at the end of the lease term for less than the estimated fair market value of the equipment at the time of acquisition.
Fortunately for lessors, FASB 13 allows the lessor under an operating lease to charge rentals having a pre-sent value at the inception of the lease of up to 90 percent of the cost of equipment.

Economic realities being what they are, lessors typically do just that. Thus, the lessee under an operating lease will usually pay up to 90 percent of the cost of the leased equipment for not more than 75 percent of its useful life. This apparent inequity is exacerbated by the fact that, in the usual equipment lease, the greater portion of the purchase price of the equipment is provided by the proceeds of a loan from a bank or other institutional lender whose loan pricing and ultimate lending decision is driven by the creditworthiness and debt-serviceability of the lessee. Although the experience and track record of the lessor is important to the lender's credit decision, the financial standing of the lessor is not usually a factor, for the loan is usually without recourse to the lessor. Lessees (especially with A or A+ credit ratings) should get a better break. Less lender risk equates usually to a lower debt rate for the transaction.

Evening things out

There is a way to even things out: the Equity Participation Lease.

This lease is a straight, ordinary operating lease with an FMV option to purchase at the end of the lease term. In the case of equipment with a long useful life (such as railway maintenance equipment) the lessor will usually perceive his best interests served if the equipment is re-leased (not sold) at the end of the lease term. The sale of the equipment will (of course) recover for the lessor his equity interest (usually 10 percent) in the equipment and a profit thereon for his risk and efforts. This will also trigger depreciation recapture and will end the lessor's earnings potential from the equipment.

Benefits for lessors

If the lessor is able to re-lease the equipment, the lessor:
  • retains the equipment's earning potential,
  • does not require depreciation deductions and
  • generates an entirely new rental stream of payments.
It is clearly worth some considerations for the lessee not to exercise his FMV purchase option.

FCM Rail (under the Equity Participation Lease) will give an additional option to the lessee of rolling stock, railway maintenance equipment and similar equipment with extended economic lives. The company will agree to give the lessee a share of the proceeds of FCM Rail's sale or re-lease of the equipment.

The idea is to negotiate the residual participation option so that the lessor will retain the first sale or re-lease proceeds until it has recovered its equity investment and agreed profit on the transaction and then the lessor and lessee will split all remaining proceeds. Thus, the lessee (whose credit standing allowed the lessor to acquire the equipment and whose rental payments accounted for typically 90 percent of the cost of the equipment) could get back something more than 75 percent of the economic life (at most) of the equipment.

It would appear that this equity participation would not breach FASB 13's rules for operating leases. Paragraph 7 of FASB 13 defines an operating lease as one which:
  1. does not transfer ownership to the lessee at the end of the lease term;
  2. does not give a purchase or renewal option for less than fair market or rental value; and
  3. does not require rentals over the lease term, the fair market value of which equals or exceeds 90 percent of the value of the equipment at the inception of the lease.
It would appear that the Equity Participation Lease meets none of these definitional criteria. The lease should therefore be classified as an operating lease. An argument could be made that any interest of the lessee in the residual value of the leased equipment would necessitate that the lease is not a true lease and, hence, is a capital lease. This argument would receive some support from the IRS National Office's Technical Advice Memorandum 9144001. However, Paragraph 73 of FASB 13 states that the Board rejected equity build-up as a criterion in favor of the criteria set forth above.

Typical contractual equity participation lease verbiage

The following is an example of typical wording of an equity participation lease.

The Lessee at its option by written notice to Lessor given not less than six months prior to the expiration of the Lease Term may irrevocably waive and reject the Purchase Option. Provided that, as of the date giving such notice and as of the date of the expiration of the Lease Term, no default on the part of the Lessee shall have occurred and be continuing. Lessor shall pay to Lessee in consideration for such waiver and rejection a portion of the proceeds of sale or re-lease of the Equipment calculated as follows:
  1. Lessor shall receive and retain out of Residual Proceeds [i.e., (x) proceeds of sale, (y) rentals received, and (z) proceeds of discounts of or loans secured by rentals, all with respect to the Equipment] the first $_____ there-of..

  2. Lessor shall pay _____% of all additional Residual Proceeds to Lessee.
As used herein, the term Residual Proceeds shall mean the aggregate of all (x) proceeds of sale of the Equipment in any portion thereof by Lessor, (y) rentals received by Lessor from the rental of the Equipment in any portion thereof after the expiration of the Lease Term.

Lessor will account to Lessee for and will pay to Lessee its share of the Residual Proceeds quarterly.

Nothing herein shall be construed to create a partnership or joint venture between Lessor and Lessee or to convey to Lessee any titles to or interest in the Equipment or in future rentals thereof. Lessor, in its sole discretion, may sell or re-lease the Equipment or any part thereof upon expiration of the Lease Term and may discount or borrow against re-lease rentals without prior notification to or consent of Lessee.

Ability to negotiate

As stated, there is ample room for negotiation here. Equipment with an extensive useful life affords lessor and lessee great flexibility in planning the financial structure of the loan transaction. The extruded useful life justifies the lessor's taking more of a risk on the residual value.

For example, a lessor with good contacts in domestic and foreign markets for equipment of the type at issue may well feel justified in making 15 percent or 20 percent investment in the equipment not covered by the rental stream of the initial lease. This will result in either lower rental payments or a shorter lease term to the initial lease and will necessarily result in a higher priority distribution of residual proceeds to the lessor.

Refer to subparagraph one ( 1) of the sample price claim to Residual Proceeds if it is looking to Residual Proceeds for more than the usual 10 percent investment and a fair return thereon.

Subparagraph two (2) is also negotiable and is a function of subparagraph one (1).

In summation, leasing is an accepted method of financing the acquisition of capital equipment. Balance sheet and accounting considerations somewhat circumscribe the economic benefits otherwise available to a lessee in leasing transactions. However, leasing remains a flexible financial tool, at least between lessor and lessee, if not as to the institutional lender.

We at FCM Rail believe that the Equity Participation Lease assures the lessee the usual benefits for equipment leasing, but also gives the lessee a measurable economic benefit in a sharing of residual proceeds.

Therefore, it is important for a lessee to select carefully a lessor with knowledge and experience in the relevant industry and in the domestic and foreign markets in which the equipment may most readily and profitably be sold or re-leased.

Reprinted from Progressive Railroading Magazine

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