Equipment Leasing Funds

Over the past several decades, equipment leasing funds (“ELFs” or “Leasing Funds”) have emerged as an alternative or non-traditional asset class. In a best-case scenario, an investment in an ELF provides the investor with the following primary benefits:

• a direct interest in the regular income stream received from equipment rental payments;
• a safety cushion given the nature of the investment itself (i.e., the company is incentivized not to default, or else risks repossession of the asset); and
• diversification (or negative correlation) away from other asset classes, including the volatility associated with the stock market.

Equipment leasing is not a new concept. Put simply, equipment leasing provides a business with the means to fulfill its equipment and associated operating needs while, at the same time, allows the company to preserve its working capital. For example, instead of paying $25 million to purchase a vessel, a shipping company may elect to finance the purchase over the course of a decade, paying installments each year, plus interest and financing expenses. Engaging in equipment leasing allows the shipping company to expand its business without paying large up-front costs and keeps the company’s cash free for other productive uses.

Unfortunately, in practice, an investment in an ELF can prove to be costly, complex, illiquid, and extremely risky.

Leasing Funds pool investor capital to facilitate a fund manager assembling a range (or portfolio) of capital equipment that can then be leased to businesses, and eventually sold off or depreciated out after a particular number of leases. The equipment may even be sold directly to the lessee as part of a lease-to-own program. Equipment might range from railcars, ships, and heavy construction equipment to specialized medical or office equipment.

Typically, ELFs exist for a set length of time (often between 7-10 years). During the offering period, the sponsor of the Leasing Fund will issue a prospectus to attract investors. This document will describe the ELF’s overall business plan, the general market and type of equipment to be purchased and leased, as well as the experience of the fund sponsor and risk factors, as well as other information.

Most Leasing Funds operate as “blind-pools”, meaning that the sponsor does not have a set plan but will take advantage of whatever equipment or market provides the best investment opportunity in their view. Funds may also seek to diversify purchases to reduce the risks of an oversaturated or poor market segment resulting in idle equipment. After the offering period is complete and purchases of equipment have been made, the operating period of the fund begins. The intent is for investors to receive a steady stream of rental income. This period will last for a number of years until the liquidation phase of the ELF commences and the used equipment is either sold on a secondary market, sold directly to the lessee, or depreciated out as obsolete.

Most ELFs are structured as Direct Participation Programs (“DPPs”). Such DPPs are generally income-related investments, designed to provide a stream of distributions or dividend income, and include oil and gas exploration and drilling projects, mortgage and real estate investments, as well as ELFs. However, unbeknownst to many investors, who assume the distributions represent investment income, the “distributions” oftentimes times include a substantial return of the investor’s own capital, in addition to or instead of income from the underlying assets.

Investing in a Leasing Fund through a DPP can be extremely costly and risky. With regard to cost, the up-front commissions paid to brokers who help sell interests or units in certain ELFs are substantial, and can range as high as 15%. With additional fees added on, a typical Leasing Fund may charge commissions and fees of around 20-25% of the investor’s initial capital. Unfortunately, with such a high commission structure, some brokers may recommend an unsuitable investment to a client who should not participate in a Leasing Fund in the first instance.

Aside from substantial costs, the additional risks associated with Leasing Funds include, but are not limited to:

• Illiquidity: perhaps the greatest risk associated with investing in an ELF concerns the illiquid nature of the investment. Most Leasing Funds are structured to last for a significant length of time (7-10 years) and an uninformed investor who wishes to sell before the liquidation phase will learn too late that it is impossible or extremely difficult to sell out of his or her interest (and even where a limited secondary market allows for an early sale, it will usually occur at a significant discount, thus ensuring the investor loses money);

• Conflict of Interest: typically, investors in a Leasing Fund will receive units or interests in the fund. The fund is often structured as a Limited Partnership, where the investors are Limited Partners and the investment manager serves as the General Partner. Because the General Partner is selected by the sponsor of the fund, and the General Partner usually receives fees for performing its duties in managing the Leasing Fund, there exists a very real conflict of interest between the General Partner and the passive Limited Partners;

• Return of Principal: often, distributions paid to investors do not consist of actual income from the leasing of equipment, but rather consist, at least partially, of return of capital. This means that the investor is essentially being repaid their initial capital contribution over time;

• Uncertain Tax Implications: in theory, an investment in an ELF is tax-advantaged, because the investor should receive pass through income being thrown off depreciating assets, and accordingly, may offset some of the tax liability on any income. In practice, however, any anticipated tax advantage often turns on performing a complex and nuanced tax analysis, something many retail investors do not bargain for when initially considering the investment.

In June 2009, the Financial Industry Regulatory Authority (“FINRA”) issued Regulatory Notice 9-09 concerning nontraded (or unlisted) REITs, as well as DPPs. This Regulatory Notice underscored FINRA’s concerns that some investors in illiquid products including Leasing Funds may be the recipients of misleading information regarding the characteristics of these investments, including their illiquid nature and associated valuation complexity.

At Law Office of Christopher J. Gray, P.C., our attorneys have successfully resolved a number of cases on behalf of investors who have sustained losses on their investments, including non-traditional investments such as Equipment Leasing Funds, DPP oil and gas programs, and non-traded REITs. Investors who wish to discuss a possible claim may contact a securities arbitration attorney at Law Office of Christopher J. Gray, P.C. via the contact form on this website, by telephone at (866) 966-9598, or by e-mail at newcases@investorlawyers.net for a no-cost, confidential consultation.