Lease Contract Valuations for Asset-Based Lenders
Date June 2017
Asset-based loans can be a much-needed source of capital for companies that are highly leveraged, undercapitalized, growing rapidly, or are in the midst of a turnaround. However, these companies may not have the traditional hard assets available to secure additional financing. In recent years, lenders have expanded their collateral sources to account for the growing significance of intangible assets to a company’s value. One of these assets growing in acceptance among lenders is lease contracts or rental stream. Utilizing the value of lease contracts allows lenders to maximize the collateral for a loan or make a loan that would otherwise be insufficiently collateralized.
Considerations for Utilizing Contracts as Collateral
As with all income-generating assets, the basic principles of discounted cash flow valuation apply. The value of contracts is derived from the expected future benefits, or ability to generate cash flows, to the company. These cash flows are discounted to a present value utilizing a rate suitable for the risk associated with realizing those cash flows. Depending on the history, length and quality of the contracts, the likelihood that the actual returns will deviate from the expected cash flows (i.e. risk) can vary dramatically. Estimating the cash flows derived from the contracts over the forecast period can prove to be the most challenging task in lease contract valuation.
The most important factors to consider when analyzing a cash flow stream include the history of the contracts/cash flows, the overall economic outlook and industry performance, the financial performance of the contracts, the financial health of the company’s lessees, and the risks associated with the performance of the contracts. To assess these factors, an appraiser should conduct a thorough investigation as to the key drivers that underlie any contract. This investigation will generally begin with a detailed interview with key company personnel. Through these interviews, the appraiser is gaining an understanding of the characteristics of the contracts. Furthermore, these interviews will allow the appraiser to identify any opportunities or risks associated with the performance of the subject contracts.
By examining historical risk factors, financial performance, and profitability, the appraiser is able to make judgments concerning the expected future performance of the contracts. While the appraiser may receive the borrower’s input regarding future performance estimates, the appraiser should consider historical performance and then employ independent judgment to arrive at future performance estimates. Specifically, the appraiser should consider factors beyond the borrower’s control in developing any expectations for future performance.
In some instances, the appraiser could limit the expected cash flows to a term that either matches the contract period or is supported by historical performance. In addition, focusing on the lender’s underwriting requirements may cause the appraiser to shift focus and concentrate only on contracts whose revenues are greater than a specific dollar amount, contracted for a minimum amount of time, or contracts in which certain profit margins are met, among others.
Further complicating the valuation of contracts is that most often the contracts are to be valued under a premise of value of Orderly Liquidation. The orderly liquidation value concept considered the contracts as if the seller had a compulsion to sell in short order. Essentially the orderly liquidation value assumes a degree of distress or duress. In an orderly liquidation scenario, an exit strategy for realizing the value of the long–term contracts needs to be explicitly considered. The exit strategy should include identifying the most likely market for the asset and the time and manner in which a sale could be consummated. The appraiser should consider who at the borrower’s company will need to be retained to collect the lease payments and the associated costs of retaining these employees during the orderly liquidation process, as well as any overhead expenses that may be incurred. However, the number of assets underlying the contracts within an analysis could range from hundreds to millions. Therefore, it may not be realistic for a lender to manage the collection of the lease payments at a reasonable cost. In these instances, the lender may choose to only focus on collections from high revenue/high margin contracts and sell the remainder of the contracts to a collection agency, or the lender may engage a collection agency on a fee basis to collect all of the rental or lease payments on behalf of the lender. In total, the exit strategy should be considered carefully and discussed with the lender regarding these assumptions.
It is common for the appraiser to adjust the discount rate for the underlying risks within the cash flow stream, as well as adjusting for factors that exist under an ‘orderly liquidation value’ premise. However, this risk may also be reflected in the projection of the cash flow stream. Regardless, the appropriate discount rate should “match” the risk of the underlying cash flows. Additionally, the appraiser could modify the contractual cash flows or the selected discount rate to approximate different levels of potential borrower distress. Regardless of the lender’s needs, these assumptions and value conclusions should be thoroughly documented in the appraiser’s report in order to maintain its independence. Furthermore, if the definition of value is Net orderly liquidation value then the costs associated with having to liquidate the contracts would be considered and deducted from the orderly liquidation value.
Types of Contracts/Lease Streams
There are several situations where contracts, both short and long-term, represent significant value and are conducive to asset–based lending.
First, there are often circumstances in which the cash flows associated with lease contracts exceed the value of the underlying assets. Since this situation includes the fixed assets (i.e., equipment) and periodic contractual cash flows (i.e., the lease payments), the lender may choose to use both the fixed assets and lease payments as collateral. By utilizing the fixed assets and contractual cash flows, the lender is able to maximize the collateral for the loan and make a loan that might otherwise be insufficiently collateralized.
Second, there are situations where a borrower would sell both the capital good (i.e., the razor) and a consumable good (i.e., the razor blade). In these ‘razor–razor blade’ situations, there is often a long–term contract in place for the consumable good. These long–term contracts are particularly attractive to lenders for several reasons. In these situations, the sale of the consumable good is often very predictable. Furthermore, the borrower typically earns a very attractive margin on the sale of these consumable goods. And, in the event of liquidation, another party could easily assume the long–term supply contracts for the consumable good based on the population of deployed capital goods.
Third, there are situations in which a borrower would have long–term contracts to provide a routine product or service on a regular interval (monthly, quarterly or annually). Because these contracts involve somewhat predictable cash flows, they are amenable to being used as collateral. However, an appraiser should give explicit consideration to the associated renewal or cancellation rates, as abnormally high or unpredictable rates would diminish the value.
To help further assist lenders in their decision-making, appraisers should contemplate how best to monitor lenders’ collateral over time. In some cases, appraisers are specifically engaged to analyze certain leases over their projected time horizon. Contrarily, lenders that issue revolving collateral to a borrower hope that the value provided in the appraisal roughly reflects the value of the lease portfolio at any given point in time over a prolonged period. Since every appraisal has an “as-of” or “valuation” date, lenders’ collateral pools and values change over time. During the appraisal process appraisers should consider how to best monitor the lender’s collateral base. This may include instructing the lender to monitor new contracts coming “on lease (or rent)” versus older contracts “falling off lease (or rent); the average size (in terms of revenue and/or profitability) of the contracts being added versus falling off; observing key industry dynamics or economic factors; and the financial health of key customers.
Lenders will obtain the greatest comfort from working with appraisers that understand the intricacies and complexities of valuing lease contracts and the rationale behind asset-based lending decisions. Communication with the lender should be a regularity throughout the appraisal, not a rare occurrence. The appraiser should partner with the lender to make sure the lender fully understands the methodology utilized to derive the value, what the biggest risk factors are, what dynamics will influence value most, and how best to protect the lender’s collateral. By working hand-in-hand with the lender throughout the appraisal process, the lender will be better suited to make informed decisions and ensure a healthy loan portfolio.