IJG 75~ Viewpoint The World Bank e i - s' Note No.86 Leasing in Emerging Markets A potent instrument for financing small business? Teresa Barger, The owner of a small, three-year-old road main- history, assets, or capital base. This particularly Laurence Carter; tenance company in Ghana has secured his first suits new or small enterprises without historical and Irving big break: a contract to maintain local roads financial statements. The asset itself provides Kuczynski for three years. But he needs to double his security for the transaction, and so separating truck fleet from two to four. His bank man- legal ownership (retained by the leasing com- ager, though sympathetic, points out that he pany) and use of the asset (held by the lessee) has only two years of accounts and has already is critical for the lease instrument to work. Over mortgaged his house to buy one of his trucks. the lease term, the lease payments typically am- So the owner approaches a leasing company ortize the lessor's purchasing costs as well as for a financial lease-a contractual arrangement cover interest costs and some profit. that allows the road contractor (lessee) to use trucks owned by the leasing company (lessor) The investment experience of the International in exchange for "rental" payments. Conclud- Finance Corporation (IFC) suggests that leas- ing that the firm's projected cash flow will eas- ing can be a significant source of finance for ily cover the lease payments, and after receiving small firms wanting to invest in equipment. In a 20 percent down payment, the leasing com- 1994 alone, sixteen leasing companies in which pany supplies the trucks within two weeks the IFC had invested (and that had been in under a three-year lease. operation for at least two years) financed over 10,000 leases, worth more than US$2 billion. In another part of the world, a Romanian Relatively little "seed" capital was involved: the chemist wants to set up a private laboratory to IFC had invested just US$13 million of equity conduct tests for several local hospitals. The in these firms and extended US$150 million in equipment she needs must be imported from loans to them. The small size of the leases- Germany. She has twenty-five years of experi- ranging from US$18,000 to US$580,000-sug- ence and contacts in the local medical com- gests that many went to relatively small firms. munity. But she has limited personal savings, Many of these firms were in low-income coun- no fixed assets to collateralize, and no corpo- tries considered high risk by foreign investors. rate sponsor. Several banks suggest that they might consider a loan after two to three years Edge over loans of successful operation. But on the basis of her business plan, the manager of a leasing The success of leasing is due mostly to the company concludes that she will be able to relative simplicity of the transaction. Because service lease payments. So the leasing com- the leasing company retains ownership of the pany imports the equipment and gives it to asset, leasing transactions generally require a the chemist under a two-year lease. less rigorous legal and regulatory environment than do bank loans. Often, leasing requires no These are typical leasing transactions. The leas- collateral beyond the secutity of the leased as- ing company, unlike a bank, focuses on the set, and it allows simpler repossession proce- lessee's ability to generate cash flow to service dures because ownership of the asset already lease payments, rather than relying on its credit lies with the lessor. International Finance Corporation * Vice Presidencv for Finance and Private Sector Development Leasing in Emerging Markets seg e e i s apayment, and contracts can be structured to meet i;dependen leasing cinpanywas etup in f~ZisitheUiitedSfa~es.the cash flow needs of the lessee. While some In te 160s th inusty etenetto Er~p an jaan.ait~asgovernments have offered tax benefits for leas- since beespreadinthroughdeieoing;ounfriIea _ ing to encourage investment by small and medium-size enterprises, leasing has flourished e tein many environments without tax benefits. fifty deelopingeoois n thatugh a leasing is ahigher-spreadbsns o thanthsofmliupeiniuin. Ut$ha0 billion ofnew vebces~ andequipmnt wordwideFrom the leasing company's perspective, own- accontig fr abut n eghthof rbae inestentThe ndutryership of the asset provides strong security. So now mature in most O~CQ ~owitries . whe~eupto cf privatdoes the dedicated use of funds: the lessor pur- invesmentis fnancd thoughlasin.An4it j ynan~e ~chases the equipment directly from thie supplier, once ousneredblgliisRb - - so the lessee has no opportunity to use the funds deveiPping coantriesieve-tthor 0 for other purposes. Relatively simple documen- costsstos ee i88n assigning ollases inad focumentati tation allows leasing companies to achieve high US$1andilliontUS4 iininp sing time.Oe andvasnags fhleasing volumes efficiently. And because leas- shelsseeare ofvethatobleashingoh cn fiddnancen a highr ing companies usually are not retail deposit rak- andlowincme outris. hil th UiteStaes,wut~ U prcenot-. ers, they tend to be less tightly regulated than the arkt. tilldomnats~ Aia' slareothearkt(moetWe2&banks, which enhances their flexibility. prenioertkenthat of thrpe. - - capital costfequpmen n the IFC Os portfolio bankN borwig oftenO G wRith. only a smalldown- Because leasing is proving to be so effective ~~~ - - - ~~~~~~~~~~in catalyzing small business finance, the IFC often takes initiatives to promote the leasing industry in countries where it does not yet ex- 40 ~~~~~~~~~~~~~~ist, providing advice to government on proper regulation for all leasing companies. When the IFC helps set up a leasing company, it fre- quently brings in other investors, mobilizes funding, and sits on the board. The idea is to promote well-managed, successful "demonstra- tor" companies. The IFC also) tends to promote l~~88 - IS~0 - 1992 - -- - specialized, independent leasing companies rather than encourage existing financial insti- Sourc:Eu;ooney,Worlf Looing Yarboo 199tutions to expand into leasing. Managers of -- specialized financial institutions are likely to be more focused in their business strategies, resulting in operations that are easier to moni- Even though leasing is a higher-spread business tor than those of multipurpose institutions. than bank lending, in many developing coun- tries bank loans can turn out to be more expen- Exposure sive-or even simply unavailable-for small firms. Typically, developing countries have weak Between 1977 and June 1995, the IFC's board collateral laws, and so loans can involve high approved US$523 million in 120 transactions costs in assigning collateral, in documentation, with 63 leasing companies in 36 countries. The and in processing time. Other advantages for IFC has invested equity in most of these comn- the lessee are that leasing can finance a higher panies, although only about US$500,000 per percentage of the capital cost of equipment than transaction. On average, the IFC takes a 15 per- bank borrowing, often with only a small down cent equity share in the leasing companies it TABLE 1 IFC COMMITMENTS BY REGION, 1977-JUNE 1995 (US$ millions) helps to establish. Initial equity investments may Number of be followed by a loan. For example, the IFC Region companies Equity Loans Total invested US$0.6 million in Ghana's first inde- pendent leasing company in 1991, invested Asia 18 22 156 177 US$0.15 million more in 1993, and provided a LatinAmerca US$5 million loan in mid-1993 to help the com- pany expand its foreign currency lease portfo- th asian Middle lio. The IFC's strategy is to give guarantees or CentralAsiaMiddle direct loans in particular to new leasing compa- East, and North Akfica 11 2 92 94 nies that have not yet established credit histo- Sub-Saharan Africa 8 3 18 21 ries that would allow them to borrow locally. Europe 7 3 t9 22 Total 49 32 342 314 The IFC has invested in leasing companies in more than half the developing countries that now NotTediftencebetween approvalsUS$523million)ndcnitmentsislagely have a leasing industry-often these investments explained by the prolects approved in 1994/BSAor which lormal comnntment are in the first leasing company to be set up in a agreements are still in progress. Data maynotaddtototals duetoronding. country. By volume, it has directed nearly half Source: International Finance erpeoration data. its commitments to leasing companies in Asia (table 1). The average size of its investments in Africa has been quite small, reflecting the fact that they are mostly in stan-up ventures. And in Lessons the past few years, it has accelerated its leasing activities in Eastern Europe and the former So- Access to term finance and expertise have viet republics. Leasing has proved a particularly proved to be the two biggest challenges facing appropriate financing source for the emerging the leasing industry. private sector in transition economies, where firms have a limited track record, legal difficulties of- Term finance and convertibility ten restrict the use of collateral, and many banks are undergoing restructuring. Leasing companies have to broadly match their lease terms to the financing they can secure. Financial returns But mobilizing domestic term financing is of- ten difficult, and many lessees are unwilling to The financial results have been impressive. Re- take the foreign exchange risk associated with turns on equity have averaged more than 20 foreign currency leases. Moreover, stand-alone percent. Since the IFC made its first loan to a leasing firms can be at a disadvantage when leasing company in 1977, there have been no competing with leasing subsidiaries of com- defaults-and no loans have shown arrears. The mercial banks, which can tap low-cost deposi- companies have lower provisioning rates than tors funding. bank lending, suggesting that leasing is less vulnerable to default. And average debt-equity One way to reduce the risks associated with ratios of about 5 to 1 suggest that many of the access to term debt is to involve local banks or firms are conservatively leveraged. This aver- institutional investors, such as pension funds age may be slightly lower than what might be and insurance companies, as shareholders in efficient for a mature leasing company, because the leasing company. Such local partners have many of the companies are still young and have been involved in IFC ventures in the Czech not yet mobilized much debt, and others have Republic, Indonesia, Jordan, Slovenia, and evolved from pure spread leasing firms into Turkey, for example. Institutional investors of- companies offering a wider range of financial ten go unrecognized as a potentially good products, which typically reduces leverage. source of term finance. In West Africa, how- Leasing in Emerging Markets ever, recent liberalization of insurance com- insurance. The foreign partner can establish and pany regulations allowed the IFC to offer local monitor these standards and procedures; train currency guarantees to two leasing companies local staff; advise on lease pricing, marketing, in C6te d'Ivoire so that they could borrow from and administration; and perhaps second the first local insurance companies. general manager. To do this job well, foreign -partners should have a substantial equity stake This dependence on term funding means that (20 to 40 percent). Partners with smaller shares leasing exposure tends to "unwind" if term fi- have not always proved effective, whether be- nancing dries up. So leasing companies are vul- cause of unfamiliarity with the market, cultural nerable to changes in the macroeconomic differences, or lack of interest. climate. Given their relatively high debt-equity ratios, it makes good sense for leasing com- Dynamic effects panies to make an effort to remain attractive to lenders to help safeguard their access to term The leasing industry tends to grow rapidly as funding. One way to do so, often used in IFC lessors gain experience and potential borrow- agreements, is through security sharing agree- ers come to understand leasing. More compe- ments, which establish equal rights to a pool tition in leasing markets stimulates new product of collateral for senior lenders. Securitization development and sometimes reduced spreads. is another way. In Botswana, for example, where a new leas- The Note series is an ing company captured 25 percent of the mar- open forum intended to encourage dissemina- Another important issue for leasing companies ket within its first year, leasing spreads fell from tion of and debate on is foreign exchange convertibility. Leasing com- more than 10 percent in the late 1980s to less ideas, innovations, and panies in developing countries often require than 5 percent in 1994. best practices for e expanding the private foreign exchange to buy imported equipment, sector. The views but prefer to denominate their leases in local Leasing companies can also boost capital mar- published are those of currency because of their client base. Without ket development. Once they have established the authors and should not be attributed to the foreign exchange convertibility, leasing com- an operating history, they can tap and foster World Bank or any of its panies tend to write mostly foreign currency equity markets. Their demand for term debt affiliated organizations. leases to match their loans for financing im- broadens the term lending options for banks, Nor do any of the con- clusions represent ported equipment, restricting the leasing mar- finance houses, pension funds, and insurance official policy of the ket to exporters. companies. They can also issue bonds or other World Bank or of its marketable instruments. For example a 1989 Executive Directors exmpe or the countries they Marrying foreign and local partners bond issue by a Tunisian leasing company was represent. the first such issue by a local firm, and it helped To order additional Many of the IFC's leasing investments have been reduce the company's cost of funds by 2 per- copies please call the in joint ventures between a foreign leasing com- cent. Finally, leasing companies can securitize FPO Note line to leave a pany and a local financial institution. This struc- their lease receivables, taking some assets off message (202-458-1111) ture has been useful in addressing the mix of balance sheet to achieve higher leverage and SrmciontacitruRanne term finance and know-how risks involved in better returns-and adding another tradable in- G8105, The World Bank, introducing leasing into a market. The local part- strument to local capital markets. 1818 H Street, NW, ners bring knowledge of local markets to the Washington, D.C. 20433, or Internet address leasing venture, but the FC's experence sug- This Note is based on a longer paper, Leasing in Emerging Markets ssmith7@worldbank.org. gests that it is also important to have an active, (International Finance Corporation, Washington, DC, 1996). Previous issues are also committed, and competent foreign partner to available online (blip:!! wwwv.worldbank.org/ provide and nurture the requisite skills. Teresa Barger, Division Manager, Capital htmlffpd/notes! Markets, Laurence Canter, Corporate Planning notelist.html). To succeed, leasing companies must keep high Department (email; lcarter@ifc.org), Irving @Printed on recycled standards in cash-flow-based credit analysis, su- Kuczynski, Director, Financial Sector Issues, paper. pervision of clients, follow-up, and equipment International Finance Corporation