In my first blog post on E.a.a.S and Pay-per-Use schemes, I described Equipment-as-a-Service and Pay-per-Use, two new business concepts increasingly explored by equipment manufacturers (OEMs) as a way to boost their sales and capture new revenue streams. I then reviewed the risks involved and in particular zoomed-in on the financial risks, namely the equipment ownership risk, the equipment utilisation risk and the customer counter-party risk.
In this second post, I propose ways to tackle those financial risks by mitigating and even outsourcing them.
Conflicting priorities
Usually the OEM will request a true sale at retail price for the equipment they produce so that they can recognize it fully in their P&L and there is no balance sheet impact. In addition, they prefer not to take the usage risk of the equipment since it is difficult to assess, and although it is an opportunity to increase revenues, the downside weighs more in their mind. Furthermore, only some accept to buy the equipment back at the end of the agreement at its residual value. In a nutshell, most aim at focusing on what they are best at, producing the equipment and delivering the related services, but they resist changing their business model if that means taking-on new risks.
On the other hand, end-customers interested by a E.a.a.S or Pay-per-Use solution insist on a pure opex alternative without any balance sheet implication on their side either. They prefer a pricing system whereby they pay purely according to the utilisation level of the equipment, i.e. without any recurring fixed charge. In addition, they would often rather keep the equipment at the end of the contract, especially if it is somehow integrated into their production process, but for a symbolic residual value only.
Resolving those conflicting priorities requires the involvement of third parties, but also to make compromises on the part of the OEMs as well as their customers.
Financing and ownership alternatives
The first reflex of OEMs is often to turn to their corporate bank to solve the financing and ownership of equipment sold under an E.a.a.S or Pay-per-Use scheme. This is natural since the bank’s relationship manager is generally the entry point for the corporate treasurer, especially when it comes to larger financing arrangements. Banks can indeed provide financing to an OEM or to a Special Purpose Vehicle (SPV) created by an OEM to run their E.a.a.S business, using the same criteria as for traditional corporate lending.
But if the intention is to ask banks to take on the financing and ownership of the machinery equipment, they risk being disappointed. Banks can finance large projects, like power plants or real estate developments, as long as the borrower is a legal entity that has the capability to repay the debt. But they will not use their balance sheet to finance specific assets like machinery equipment. This is why they have set-up finance companies as subsidiaries to handle the asset leasing business.
Finance companies are the obvious candidates but will not be first movers
Finance (or leasing) companies are much closer to the E.a.a.S business concept since vendor financing, for instance the financing of the buyers of equipment from an OEM vendor, is at the core of their offering. They understand the competitive advantage that financing a Pay-per-Use model would bring them as a way to differentiate from other finance companies, and they are interested in the concept.
However, adjusting their products to acquire the flexibility demanded by Pay-per-Use schemes, in particular to absorb the utilisation risk, would require that they develop a new front-to-back-office system, something which is not a priority, for essentially three reasons: First, most are still struggling with their core platform, and the upgrading of their existing IT infrastructure will have a clear priority in the years to come. Second, the little development budget that is left is being channelled towards improving the existing offering. Third, they will not invest money into new administration and risk management systems to cater for E.a.a.S schemes, unless and until an attractive business model is foreseeable, i.e. not before the E.a.a.S and Pay-per-Use business models have been proven and are becoming mainstream. Banks-owned finance companies will not be first movers, they will at best be fast followers.
This being said, they are instrumental already now, since they are specialists of asset ownership, financing, depreciation and residual valuation, for the very reason that it is at the core of their business. They are also accustomed to deal with accounting and tax issues related to balance sheet and P&L treatment of their customers in various jurisdictions. So their expertise should be tapped into with the understanding that E.a.a.S / Pay-per-Use financing structures will have to be built around their traditional vendor financing and leasing products. Any flexibility introduced will need to come from elsewhere. They will not bend on anything which cannot fit their systems and risk policy. For instance, they will not take any usage risk which is inherent in true Pay-per-use models and are unlikely to accept a “dynamic” type of repayment profile.
This means that OEMs looking for financial partners should not expect too much from banks and their finance companies. Relying on them will mean that the solution that they offer to their customers will be incomplete. It will not yet be about Pay-per-Use in its true sense and more the packaging of the production and delivery of an equipment, its installation, maintenance and servicing, and its financing. Still, it could be a good way to start.
In this context, it should be noted that the captive finance companies of some OEMs could be considered as an alternative to a bank’s owned finance company. However, it is unlikely that they will show more flexibility, for the very same reasons.
Niche Pay-per-Use providers offer a ready-made solution
Some market players propose the full package: They buy the equipment from the OEM at retail price and offer a Pay-per-use scheme to the equipment user, taking the usage risk up to a certain level.
This solution is simple for the OEM and it works in the same way as with an equipment leasing arrangement: the Pay-per-Use platform provider enters into a PoS (Point of Sale) financing contract with the OEM or their dealer and gives them access to a PoS calculator to determine the Pay-per-Use all-inclusive recurring payments for each specific case. When a machinery end-user is interested in this sales financing tool, the Pay-per-Use provider automatically evaluates its credit risk and performs the KYC/AML checks based on the input from the OEM and the end-user, meaning that the leasing contract can be closed within minutes. The Pay-per-Use provider then purchases the equipment from the OEM who in parallel signs a service contract with the end-user to ensure high availability and residual value on the machine. As a result, the OEM can use this proposition as a new sales argument towards their customers whilst still keeping the same business model, i.e. the production of the equipment plus the servicing and maintenance over its lifetime.
A few caveats need to be mentioned, though:
At the end of the Pay-per-Use contract, the residual value of the equipment is calculated according to its usage. The lessee has the option to purchase the equipment and, if not exercised, the OEM or their dealer have the obligation to buy it back, something that some are not ready to accept.
Another downside is that OEMs (or their dealers) forgo a business opportunity since by avoiding the risks, like the equipment utilisation risk, they also give-up the upsides of an E.a.a.S or Pay-per-Use scheme. In addition to a new revenue stream, those upsides include a tighter relationship with their customer as well as the flexibility to up-sell and right-size the equipment provided.
Those who wish to go further need to get their hands dirty
In order to keep the business upside, OEMs need to run the E.a.a.S or Pay-per-Use business themselves. It is however complex to do it from the same unit that is selling the equipment, since it brings immediately conflicting interests: The manufacturing business unit will insist on a true sale at retail price, will be unwilling to take unknown risks like counterparty or usage risk and will often resist a buy-back obligation of the machinery at the end of the contract. In addition, when the business scales up, they will face limitations regarding their balance sheet capacity to hold the assets.
This is why setting up a Special Purpose Vehicle (SPV), i.e. a new company dedicated to this new business model, will often make sense. That SPV would buy the machinery from the manufacturer as well as the related installation, operation and maintenance services, and would then run the E.a.a.S or Pay-per-Use model, taking on all the related financial risks.
By keeping its ownership into the SPV at or below 50%, the OEM would normally be able to keep the structure off its balance sheet. Suitable partners include private equity companies and institutional investors wishing to diversify into this new financial asset class, attracted by the hefty remuneration and ready to share the related risks with the OEM.
It may also make sense to contract with an external company that can provide the systems necessary to operate a subscription-like business model, as well as the processes and corporate governance needed. The ability to access and process all the data generated is also key, not only to run the business but also to manage the risks, especially the usage risk.
Each case is unique
At the end of the day, my experience is that each case is unique and a specific solution needs to be drafted for it according to the motivations of the OEM to enter into such a business model.
Jean-Francois Tapprest
Lightbound Consulting
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