By Michael Keeler
The biggest threat to the economics of a lease, in which the lessor has taken a meaningful residual, is mismanagement at the end of the lease term. In the worst case, poor End of Term (EOT) management can lead to evergreen payments, in which the lessee misses the lessor’s notification deadline or fails to return the equipment on time and continues to pay for the equipment on a month-to-month basis. It can also lead to forced buyouts, double payments in the refresh cycle, and sub-optimal financial decisions. In this article, we explore why companies mismanage the EOT process and then examine the many tactics, techniques, and tools that companies can use to improve their EOT performance.
“I Don’t Have the Time or Resources to Return Equipment On-time”
No one likes another deadline added to their plate. Many equipment managers and users inside Fortune 1000 companies view returning equipment at the end of the lease term as a burden – an artificial deadline imposed by management with no direct benefit to them. Equipment managers often argue that they do not have the resources to decommission equipment at the end of term or manage the logistics of the return and refresh on schedule. They would prefer to continue using the equipment until the end of its life without considering the expiration of the warranty, the costs of maintenance, and other factors that increase total cost of ownership, until the equipment either is no longer useful or breaks and must be replaced.
Users miss return deadlines for a variety of reasons. Some users become attached to their machine, such as a car or a PC, and are reluctant to give it up and learn to use a new one; some consider their other responsibilities to be more important than dealing with return tasks; and some just ignore the issue or procrastinate.
Human behavior is difficult to predict, control and incent. Resistance to returning equipment on time is natural given how busy many people are, especially during a recession when headcount cuts have resulted in everyone having to do more with less. However, human nature aside, most people will comply with a request to return equipment, if given the chance – and a little help from their firm. The truth is most firms don’t give their equipment managers and users that chance.
Can’t Find Equipment; Don’t Know EOT Options
Many companies fail to track equipment during the lease term and can’t find it at the end of term. They don’t know where the equipment is or who is using it. If they can’t find it, they can’t return it. Even if they know where the equipment is, some companies do not track the date they are required to notify the lessor of their EOT intentions or they neglect to follow up. Many companies also don’t track their return options, which can vary widely. So, when the EOT arrives, they can’t perform the economic analysis to determine which option is best.
Zombie Portfolio and Evergreen Payments
The decentralized nature of a business can inhibit a company’s EOT performance. In many large companies, leasing is a decentralized, local activity in which buyers engage and select lessors on their own, resulting in a cornucopia of EOT provisions. In highly diversified businesses, with several lines of business, a decentralized approach to leasing addresses the fact that each line of business has different equipment needs and financial dynamics. In other cases, businesses have grown through acquisition and each acquisition brought with them their own approach to leasing. In a decentralized environment, EOT performance depends exclusively on local management and execution, which has many competing priorities. If the local manager responsible for tracking the EOT leaves the company, quite often the relationships and understanding of the EOT process goes with them, resulting in an unmanaged, zombie portfolio that rolls into evergreen payments – a lessor’s dream come true.
In the sales process, every lessor will pitch their strong EOT support for lessees. Many attempt to differentiate themselves here with their superior capabilities, especially their website, and customer support. In practice, for many lessors, nothing could be further from the truth. Many of them want evergreen payments. These payments are critical to the Return on Equity and Return on Asset metrics, which are key to their business model. If you believe the upfront sales pitch, prima facia, that the lessor will make it easy for you at the EOT, you may be sorely mistaken. Even if the stated intention of the Lessor is truthful, administrative difficulties in addition to system and staff turnover issues can create problems for the lessee at EOT. As I explain below, lessees need to take matters into their own hands.
Buy Out Everything
In order to avoid evergreen payments, some executives at large lessees will simply adopt a policy to buy out every lease when it comes to term if the equipment is not returned on time. If the leases were originally negotiated with caps, this approach, although crude, can still yield benefits if the Present Value of total payments, including the buyout, does not exceed the original cost. It is certainly better than a zombie, evergreen portfolio. However, it avoids dealing with the root of the problem – the broken return process. Worst of all, it leaves money on the table.
Ambiguous Objectives and Delayed, Sub-optimal Decisions
It may be helpful to break the EOT return process down into two sequential phases (or subprocesses): decision-making and execution. In the decision-making phase, companies fail when those individuals responsible for analyzing EOT options and making a decision fail to do so on-time. Many firms lease in order to improve working capital. With this objective, the emphasis is on timely returns to ensure that the Present Value savings calculated in the original lease vs. buy analysis is protected and the lessor bears the responsibility of monetizing their equity investment in the equipment. This is true of PC leasing programs, for example. However, returning equipment at the end of the initial term may not always be the best economic decision.
For example, let’s assume a hospital leases a 64-slice CT scanner for a four-year initial term with two one-year renewal terms. Then, let’s say in year four, the physicians evaluate the next generation of equipment (a 256-slice machine), consider their EOT options, perform their cost-benefit analysis, and determine that the economics do not justify a change at the end of the initial term. However, their research indicates that the prices of the 256-slice machines will drop over the next year, shifting the economics of their analysis to favor a replacement. In their analysis, they conclude that when prices drop, migrating to the 256-slice machines will: 1) bring better information to the health care providers, improving patient care; 2) enable them to do more procedures in less time without adding staff; and 3) help the hospital to keep pace with its competitors. So, the medical community decides to schedule a refresh in 12 months – at the end of the first renewal term.
If the hospital had simply returned the equipment on time at the end of the initial term and had not considered their EOT options carefully, it would have resulted in a sub-optimal financial decision: they would have paid too much for the new machine by adopting it too early.
The hospital’s primary objective with leasing is to mitigate the risk of technological obsolescence. Leasing enables the hospital to upgrade or add new equipment that may hit the market with much greater flexibility when compared to a purchase.
If the hospital had purchased the equipment and depreciated it on a straight-line basis over its economic life of 7 years, replacing the old with the new equipment after 5 years would be a much more expensive decision. If the hospital could not sell the old equipment at a price that covers the remaining value, it would be forced to write off up to two years of depreciation (cost), assuming the equipment sits idle. By leasing, the hospital can capture significant savings (two years of depreciation) by returning the equipment to the lessor at the right time. The lessor then has the challenge of finding a buyer for the old equipment.
While this is just one example, many medical devices used by hospitals and many other kinds of high technology used by corporations, such as computer servers and storage and networking equipment, are subject to frequent upgrades or major improvements. Every 3-5 years there is a new generation of product. By leasing this equipment, the risk of obsolescence is transferred to the lessor, as the owner of the equipment, and, in this case, the hospital’s financial community benefits from the flexibility to respond to the future needs of the medical community and save the hospital a considerable amount of money. The challenge here is timing. When the hospital acquires the equipment, the hospital’s finance team and physicians do not know exactly when the new technology will become available and affordable. Structuring a lease with multiple return/renewal options is a useful tactic. However, it must also be recognized that if your objective is obsolescence risk mitigation, it may make sense to renew the equipment or buy out the lease even if the total amount of the payments exceeds the original cost. This contrasts sharply with the objective of maximizing working capital.
The overarching point here is that if you don’t have clarity about your objectives – why you lease – and you don’t make timely, well-informed decisions at the EOT to meet those objectives, your leasing program is likely to perform poorly.
Poor Execution Hurts Cost Savings
In the execution phase, companies fail when those individuals responsible for executing the decision (timely lessor notification of intentions, decommissioning, removal, packaging, shipping, and lessor receipt confirmation, replacement ordering, configuration, and deployment) fails to do so on-time. Even if the equipment manager makes a clear, timely decision to return equipment, if someone downstream fails to execute their role in the refresh process in a timely manner, it can result in overpayment, in which the company is forced to pay beyond the lease term. Or it could result in double payments, in which the company is forced to pay for the lease on the old equipment and the new equipment simultaneously because the cut-over takes too long.
Fixing the EOT Process
There is no silver bullet – no single trick – that will fix a broken end of term process. Rather, with a broader view of the end-to-end lease lifecycle, there are a variety of tactics, techniques, and tools you can employ to improve the EOT process, including new processes and procedures, automation, and policies.
Let’s first turn our attention to some of the “human nature” excuses for poor EOT performance discussed above. When equipment managers argue that they do not have the resources to decommission, return, and refresh equipment to meet the strict requirements of the lease EOT, be skeptical. In order to minimize operational cost, equipment managers should pursue a predictable equipment refresh strategy, whether buying or leasing. If you wait until equipment is inoperable before replacing it, then your resource allocation will be unpredictable. Where there is uncertainty and risk, there is typically cost. If the planned refresh is unpredictable, then you may likely have to increase staffing in order to manage the peaks in returns, whether purchasing or leasing. By minimizing the peaks and troughs in the return cycle, you can staff for a constant stream of equipment refreshes. Even if you purchase equipment, you still need a systematic approach to refreshing the equipment, otherwise you miss out on productivity gains and your maintenance costs will exceed the profit contribution of the equipment, as the value of the equipment diminishes and your break-fix costs increase.
Ask the Equipment Manager(s) for a Return and Refresh Plan
Equipment managers must have a coherent, planned refresh policy that is based on a predictable schedule, whether the assets are purchased or leased. If your operations teams lack competency or resources in this area, the introduction of leasing and the deadlines that go with it might be just the thing to force them to rethink their resource allocation strategy carefully to improve equipment management. This will also reduce risk and create savings in the process. If you are an IT outsourcing company (let’s say for PC desktops), you might consider charging your clients more for untimely returns – because it costs you more to support them.
Now it may be true that the equipment manager lacks resources for the refresh process. However, more than likely the equipment manager is not interested or not measured on the success of the refresh process and reduction in total cost of ownership. For example, if the engineering team in a high-tech company manages their own equipment lifecycle, it is unlikely that the responsible equipment manager is measured on the effectiveness, risks, and costs of the equipment lifecycle. Engineers are paid (and typically prefer) to spend their time designing and building things, not attending to the refresh of old equipment, especially on someone else’s schedule. However, the equipment manager may not know how to run this kind of operational process, and may need advice and training.
Ask the equipment manager making the “lack of resources” argument to give you a plan for managing the refresh process (again whether the equipment is leased or purchased). Ask them to diagnose, measure, and explain with data why returning equipment on a schedule is difficult to do. Ask them to show you a report on return performance with metrics such as the percentage of on-time return performance by each equipment user and the aging of the late returns. Finally, ask the equipment manager to analyze and explain how much the unpredictability in equipment user returns is costing the company and how much savings the company would enjoy if the EOT process, both decisions and execution, was managed like clockwork. Once you have a return and refresh plan and a sense of the savings, the equipment manager will likely be more open to leasing.
Communicate Corporate Objectives and Personal Benefits
Of course, it is imperative to communicate the objectives of the leasing program and how it benefits the company, how it impacts each budget manager, and the responsibility of the equipment managers. For example, “Our company leases medical equipment primarily to hedge technology obsolescence risk. In the event that there is a major improvement in a medical technology that our company wants to adopt in the future, if we have leased the equipment, we can save money. If leased, we can return the equipment to the lessor before the end of the economic life of the equipment and the lessor will have to monetize the remaining value in the equipment. This is important because it brings us budget flexibility, maximizes returns on our capital investments, and brings opportunities to our health care providers to improve patient care. Therefore, it is important that each equipment manager return equipment on-time.”
An effective way to communicate this message is to capture a video of your Treasurer or CFO or CIO explaining the corporate strategy and the responsibility of each user then make the video available on your intranet and send out a link to the video to all stakeholders by email.
Track the Leased Equipment Information During the Term
You can improve the EOT process by deploying software that tracks the key information for leases and leased equipment. Knowing where equipment is at the end of term makes it easier to return it. Leased equipment software will allow you to track the equipment during the term and assure that you remain in compliance with your lease. You can configure the software to send out email notifications once or twice per year requesting that equipment managers (either the financial owners or the physical users) attest to the accuracy of the information about each asset, including the equipment description, serial number, location, and General Ledger account code. This diligence and attention can result in additional benefits. For example, if equipment changes location, you can notify the lessor so that property taxes are properly collected and remitted, and insurance coverage is properly maintained for the leased equipment.
Send Automated Notifications Requesting EOT Decision
If the information about the equipment is correct, as you approach the EOT, you can configure the software to send automated EOT notifications by email. Effective notifications will include the applicable EOT options in the lease schedule and the economic analysis for each option. Ideally, the system should provide a mechanism for the equipment manager to indicate their EOT intentions (return, renew for x period, buyout). If you want to discourage renewals or buyouts, you can require an explanation or an approval step.
Use a Transparent Escalation Plan
If you want to make sure users make a timely decision, you can also include an escalation plan that is visible to them. Example: “Please respond within three days (company policy). If you do not respond within seven days, an automated notification will be sent to
Review Aging Reports with Responsible Executives
With this kind of leased equipment management technology in place, you can generate reports that will further help you to improve EOT performance. On a weekly basis, you can generate an aging report and review it with the appropriate executives to resolve problems and devise new tactics for improving performance.
Automate the Notification of All Stakeholders in the Return Chain
When the appropriate equipment manager makes the EOT decision, you can then notify everyone involved in the execution phase of the process. Again, an effective software solution will automate this for you. You can notify the lessor about the decision and request that they prepare the appropriate documentation. If the decision is to return and refresh, notifications should be sent to the logistics coordinators responsible for physically managing the return process. In the message, you can provide them with guidance as to the appropriate workflow for the EOT process, including getting an RMA number from the lessor and instructions for packaging and shipping. The EOT process should also include a notification to the appropriate buyer to initiate the lease of the replacement equipment with the appropriate deadlines to ensure that there is sufficient overlap of the old and new equipment to bring about a timely swap while avoiding double payments. Once the equipment is shipped, you can send a message to the lessor requesting confirmation of receipt. With the sheer number of stakeholders involved in the EOT process, an effective software solution that combines automated notifications with EOT workflow will be essential to successfully navigating the rapids of EOT.
Improve and Communicate EOT Policies
Beyond the software-driven tactics, you can also use policy in a variety of ways to improve EOT performance. You can design the policy to require timely decision-making and execution, for example: “Equipment managers will receive a notification at least 120 days before the notification deadline to the lessor. Equipment managers have 30 days to make a decision about their EOT intentions for the equipment. If the decision is a return, the equipment must be decommissioned and made available to the logistics coordinator by the deadline indicated in the notification. The equipment must be shipped within three days of the end of term.”
Add Incentives or Penalties
If you want to add teeth to your policy, you can also develop financial incentives or penalties for on-time returns. For example, you could charge their budget based on the math for a purchase based on straight line depreciation over the term and then if the EOT decision and execution are carried out on-time, they can earn the savings from leasing. Or you could just keep it simple: determine who the most important manager is in each department with regard to the EOT process and give them a cash bonus at the end of the year if the return performance meets an important metric (e.g. percentage improvement over previous year or overall return performance exceeds 85%). You could make it competitive and offer the manager with the best return performance a larger bonus. In another example, you could add an internal penalty to the rental expense if the equipment manager chooses a renewal or fails to respond to the notifications and the lease goes month-to-month. If you decide to use an incentive or a penalty, you must be able to carry it out logistically and enforce it, otherwise you are introducing unnecessary complexity which may have unintended consequences.
Select Lessors Carefully and Take Control of Your Leasing Process
Regardless of what lessors tell you in the sales process, there are lessors who really don’t want the equipment back and those that really do want the equipment back. The ones that do want the equipment back, may have poor EOT data and communication processes, causing increased work and complexity for the lessee. If you really want to prevent Evergreen scenarios, a corporate lessee has to create their own processes independent of the lessor to accommodate for inadequate support from the lessor (whether intentional or not).
IBM Global Finance (IGF) and HP Financial Services (HPFS) each have a multi-billion dollar revenue subsidiary that is exclusively focused on computer component reuse, remanufacturing, and remarketing. In order to keep their operations flowing smoothly, they need a predictable stream of incoming equipment. That being said, both of these firms still have “impedance” or “friction” in their return and acceptance processes. Also, it should be clear that if any of their leases extend into evergreen payment scenarios, they do not lose money. Their remanufacturing and remarketing subsidiaries put them in a position to win regardless of how the lessee performs at the end of term.
Lessees need to place more emphasis upfront in the lease negotiation process. In addition to running a competitive process with a detailed RFP, lessees should perform due diligence on each lessor to ensure they are capable of delivering on what they promise in their proposal. Lessees should look for those lessors that do have strong remarketing and take-back reputations. Lessees should also test for reasonable return provisions and look for notification deadlines that are attainable. For example, one of the largest vendor captive lessors only makes FMV’s known 60 days prior to lease end, and then require a 30 day notification. This gives the lessee only a 30 day window to notify (60-30) them. The lessor also requires you to print out a form, tick some boxes, sign the form, and send it back to them. (By contrast, one of the large networking equipment lessors accepts a simple email as notification, a low impedence, low friction approach.) Moreover, some lessors continue with Evergreen invoicing even when the Lessee has advised them of their return or buyout intentions. These are all unnecessary steps creating an unnecessary burden on the lessee.
The point here is that you get what you inspect, not what you expect. The lessee needs to have their own independent process and controls, with step-by-step reconciliation throughout the term, in order to be in a position to scrutinize their evergreen invoicing and ensure the charges from the lessor are legitimate. If you don’t have control of your own EOT process, you won’t be in a position to manage your lessors effectively, and will likely overpay.
Equipment lessors provide a valuable financial service and can be helpful and healthy financial partners. Every lessee should want a vibrant and profitable lessor community competing for their business. However, lessees need to make sure that they take full responsibility for their own actions in a lease contract to ensure that a lessor’s profits are not achieved because of the lessee’s poor EOT performance. If you return and refresh on-time, or establish reasonable renewal terms and buyout caps to protect yourself from the unknown, you and your lessor can have a win-win relationship.
Help Your Team Perform EOT
Most employees want their company to perform well. They want to excel in their work and contribute to the company’s success. You can help them perform their responsibilities in the EOT process by clarifying the objectives and benefits of leasing, reminding everyone in the EOT process through automated notifications, giving them the information required to make timely EOT decisions, simplifying execution, and improving EOT policies. If your firm needs additional expertise or resources to implement these suggestions, you can outsource the administration of your lessee leasing process to a qualified third-party provider.
If your leasing portfolio is large and your EOT process is broken, you can generate substantial savings for your company by fixing it. With the roadmap above, you can quantify the savings, and make the internal business case. There is no longer any reason to tolerate poor EOT performance.
If you have any thoughts or feedback about this article or any ideas to contribute about fixing the EOT leasing process, please respond below. Or you can send an email to firstname.lastname@example.org.