Leasing companies on some occasions will ask for a security deposit as a condition of approving the credit of a customer for a lease. Alternatively, but serving the same purpose, sometimes leasing companies will ask for a letter of credit, other collateral or a cash collateral account. A security deposit, letter of credit, other collateral or cash collateral account are all forms of credit enhancement.
There are generally two reasons why a leasing company could ask for some form of credit enhancement. The first is the most obvious; in the leasing companyís judgment, the credit of the customer is marginal. In other words, the lesseeís balance sheet, stage of development or operating history is not sufficient to warrant an extension of credit for some period of years. Itís nothing personal. Itís only that institutional lending policies of the leasing company, its bankers or other capital sources will not approve the transaction unless there is some additional collateral, i.e., credit enhancement. In those situations, some form of full or partial credit enhancement can convince the leasing company that the transaction is safe enough for them to fund. The credit enhancement protects the leasing company because in the event of a default some part of their risk will be covered by this credit enhancement.
As an example, if the lessee requested to lease $50,000 of equipment and a 10% security deposit was required, the leasing company would know in the event of a default it is holding as a security $5,000. Therefore instead of potentially losing $50,000 its loss would be mitigated by the amount of the security deposit.
The second reason for asking for a credit enhancement is less straight forward. Some leasing companies may request a security deposit as a disguised way of increasing the effective lease rate. A security deposit reduces the leasing companyís upfront cost and thereby increases the lessorís effective rate. When analyzing a lease transaction, any security should be used in the analysis. [If you are interested in getting a spreadsheet which analyzes simple and complex leases, please send an e-mail to LPI Software Funding Group-webmaster
Credit enhancements are, most times, necessary expediencies which work to the advantage of both the lessor and lessee. However, both parties should understand all the implications of that credit enhancement.
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February 27, 2006