1. Leasing Industry in Uganda The Ugandan leasing industry is still in its infancy. Leasing represents less than one percent of private sector capital formation (approximately 5% of total private sector credit) in Uganda as compared to the average of 14% in emerging markets and 31% in USA. X Company Leasing controls over 85% of the Ugandan leasing market. The Company recognizes the growth potential of leasing and acts as a catalyst to grow the entire industry by: Expanding its own profitable operations; Educating the marketplace; Creating a more effective legal and fiscal environment; And, promoting financial sector development by lobbying for new instruments. There are considerable benefits to making leasing available in a developing economy, as well as challenges. The rationale for leasing is highlighted in the following table: Table 1. The Case for Leasing Benefits to Small and Medium Sized Enterprises (SMEs) Accessibility Leasing can allow new businesses with limited capital and credit history or small businesses without a history of financial statements to quickly boost their operations, as long as the cash flow from operations is sufficient to cover the lease service payments. It is not a direct substitute for lending since it does not directly increase operating capital, but when it enables the borrower to avoid using operating capital to purchase an asset, it can have similar results. Security Since lessors own the assets and use the leased asset as the primary security, SMEs can still be eligible for the lease financing when bank loans would not be available.

Duration SMEs often have no access to long-term financing (over one year). Leases can provide longer duration financing, often with terms from one to five years.

Payment terms

Lease payments can be structured to mirror individual cash flow patterns of the lessee in contrast to bank loans, which have standardized repayment schedules.

Process time Owing to the collateral-backed nature of the financing, less analysis is required of the customers credit worthiness, assets or capital base; less time is needed for assigning other collateral; and, simpler documentation can be used. (This may be countered by the time it takes to acquire the assets, usually from foreign vendors).

Benefits to Lessors Security Since lessors own the assets and can repossess them immediately upon

non-payment, the security is easier to claim than when the financier has to chase after a clients collateral, often through poorly developed court systems.

Funds usage Because the lessor purchases equipment and then leases it there is no opportunity for the lessee to use the funds for other purposes.

Benefits to Financial Sector Development Cash flow based lending

Moves the financial industry to rely more on cash flow based lending than on credit history and formal historical financial records. Diversification Broadens product range and competition in financial services, which

should lead to lower cost financing.

Capital markets As leasing companies seek new funding via loans, bond offerings or securing their lease receivables, they help to deepen and broaden domestic capital markets.

Macroeconomic Benefits Technology transfer

Finances the import of more advanced equipment Productivity Increases use of more efficient equipment.

2. X Company Leasing Activities 2.1 Financial Leases Middle Ticket Transactions X Company Leasings core activity is the provision of finance lease products to SMEs i.e. middle ticket transactions in the range of $25,000 250,000. Transactions outside this range are however, handled via special schemes designed to increase market penetration. Some basic information on X Company Leasings standard financial leases is indicated in Table 2 below.

Table 2. X Company Leasing Finance Leases Overview of Terms Size of Leases Ush 50 500 million (~ $25,000 $250,000); average is about Ush

70 million (~$35,000) Repayment Period 2-5 years; average is 3 years Interest Rate 16-26% on local currency transactions; average is 18% for transactions > $50,000 and higher for lower lease amounts (forecasted to drop as cheaper funding is obtained)

Deal Processing Time Maximum of 2 weeks Lease Currency USD or Ush to match lessee income Nature of Equipment Any durable asset, plant, equipment, machinery, commercial vehicles, business cars, computers (Excludes nuclear or military equipment or equipment that supports illegal or industries such as pornography, prostitution, illicit drugs, businesses based on tax evasion or which employ forced labor of any kind.)

Cash Down Payment 10-15% of equipment cost Asset Ownership X Company as the lessor maintains full ownership of the asset

throughout the lease period

Option to Purchase Exercised by lessees at the end of the lease at up to 5% of cost VAT (Value Added Tax)

Charged on rentals, both capital and interest costs, where applicable

Insurance and Maintenance

X Company insures assets and passes on the cost to the lessee; maintenance is the lessees responsibility

2.2 Insurance Premium Financing Introduced in June 2002, the X Company Leasings Insurance Premium Financing (IPF) facility allows the SMEs to meet their insurance obligations associated with their own assets while making payment installments over ten months. SMEs who chose to use this facility obtain premium quotations from insurance underwriters. X Company Leasing pays the full premium to the underwriter and the insured repays the premium in monthly installments ranging from four to ten months. The facility benefits the lessees by providing them an alternative source of working capital and ensuring they maintain insurance on their own assets. The facility benefits the underwriter by giving them more secure receivables, which increases their liquidity and capacity to settle claims. However, this product constitutes only three percent of its activities.

Table 3. Five-year (1999-2003) statistics as of December 31, 2003 Particulars Nos. USD Total disbursements 1999-2003 1,587 Portfolio Quality: Performing NPA

94.5% 5.5% Direct job creation (est.) 1999-2003 5,000 Average sustainable profits 2002,2003 $1.5 m Average profits after tax 2002,2003 $2.2m Lease awareness/education contacts 3,600 3. Results and Impact Leasing is an effective credit delivery tool and has a strong developmental impact on the economy by providing commercial and industrial equipment to smaller scale business enterprises. It is helping to bridge the current funding gap for business enterprises that fall within the missing middle, i.e. too big for the Micro Finance Institutions (MFI) and unattractive for the traditional Commercial Banks. The MFI normally provide funding in very small amounts and for short periods that may not be sufficient to acquire productive inputs while the latter will only deal with well-established businesses with good collateral. Thus, the special donor programs have enhanced X Company Leasings capacity to increase its market penetration by broadening its services outside its current market niche (loans of $25,000-$250,000) and to the rural areas. Small businesses are becoming accustomed to using banking and insurance services and creating savings due to the need for cash contributions for things such as mandatory insurance on leased equipment and using postdated checks to settle rents. This is especially true among the rural population. Leasing is playing a major role in the modernization of the economy via technology transfer, efficient marketing and production methods especially in the areas of transportation, primary processing and cottage industries. Increased production, improved efficiency and value added processing of agricultural commodities lead to improved incomes. Support to small enterprises will result in increased production, the creation of value added products, especially those related to agriculture, and reduce wastage and loss through increased efficiency. The resulting improvement of primary product producer, most often women in rural areas, incomes will stimulate economic growth and better living standards. Modernization of production methods not only saves time (especially for women in rural areas), but also improves the safety and quality of processed food. For example, the use of milk coolers and stainless steel cans for dairy farmers, sinking of bore holes for easier access to drinkingwater, the use of tractors for farming, mills for grinding grain, LPG Gas for cooking instead of firewood, maize shellers and driers all improve food safety and quality when compared to the

existing rudimentary practices. Possibly the most noticeable impact of Leasing on the economy is on the transformation of the transport sector. Provision of appropriate transport via leasing has enabled producers of primary and often-perishable products to access markets in the urban centers and reap competitive prices for their products. Furthermore, the availability of affordable and reliable passenger transport has improved communication and the movement of goods in all parts of the country. 4. Sustainability of X Company Leasing Operations 4.1 Funding As highlighted above, X Company Leasing has the twin objective of profit and development. This policy is intended to enable the Company to leverage its capital and continue its activities on a sustainable basis. The following is a summary of its major funding sources. 4.1.1 Debt Finance Lines of Credit DCU Leasing sees funding as its main constraint to further growth. At present, the Companys major source of funding (accounting for over 65%) is from International Financial Institutions such as, IFC (International Finance Corporation), KFW Bankengruppe, DEG (Deutsche Investitions und Entwicklungsgesellschaft mbH), FMO (entrepreneurial development bank of the Netherlands), EIB (European Investment Bank) that provide long term funding. This is occasionally supplemented by short - term facilities from Commercial Banks and Insurance companies by way of bridge financing. The average cost of X Company Leasing borrowings is about 12%. 4.1.2 Cash Guarantees In addition to debt financing, X Company Leasings cash deposits collected from lessees is over $2,000,000 and represents interest-free financing. 4.1.3 Proposed Bond Issuance X Company Leasing plans to issue a bond so as to mobilize funding from the local market on a sustainable basis. Arrangements are at an advanced stage and subject to the stability of the Treasury bill rates. 4.1.4 Factoring and Securitization X Company Leasing is exploring other innovative avenues of financing including factoring and securing lease receivables. The current legal and regulatory environment does not support factoring so X Company Leasing is working with the Bank of Uganda to gain support to develop the appropriate legislation and procedures.

4.2 Operational Efficiency X Company Leasing is the market leader in Uganda with over 80% market share. The Company faces competition from the East African Development Bank (EADB) in the form of leases and from the European Investment Banks (EIB) Apex loans in the form of very low interest loans channeled through local banks. As the banks look for low-risk, credit-worthy clients, they target X Company Leasing larger clients and lure them away with lower interest rates. The Company has lost some of their bigger clients to the banks and has been forced to look further down market for new customers. In order to counter this competition and continue operations on a profitable basis, X Company Leasing has introduced several innovations aimed at reducing monitoring and processing costs and standardizing of products. A description of these innovations follows: 4.2.1 Deal Flexibility The Company has the ability to offer customers customized financing packages that suit their business needs and cash flow stream. The staff and sophisticated software used by The Company allows for structuring customized rental schedules for lessees. This flexibility also allows X Company Leasing to finance customers who are credit worthy but would not be able to comply with rigid bank loan terms, thus reaching a broader customer base. 4.2.2 Responsiveness and Branch Net Work X Company leasing generally processes deals within two weeks. This is a much shorter period than its competitors and allows it to process an increasing volume of leases. The existing branch network has enhanced the processing of upcountry transactions both in terms of cost and time. The quick response time and high level of customer intimacy has resulted in strong customer loyalty and is exhibited by the level of repeat business and introductions from existing lessees and suppliers. Consequently, the company has built a substantial base of clients, which allows it to grow primarily through repeat business and businesses linked to current clients. This repeat business eliminates much of the risk that accompanies an expanding client base and minimizes marketing expenses. 4.2.3 Cost Management and Procurement X Company Leasing has developed a range of suppliers for both new and used equipment. Approximately 60% of the equipment leased by the Company is used which leads to considerable cost savings. It is vital that the financed equipment is of good quality and is fairly priced as this forms the basic security of the transaction. Financing of used equipment has been especially popular among SMEs, which tend to suffer high production costs and a low capital base. Used equipment also tends to offer more acceptable technology compared to more recent sophisticated technologies that are both too expensive and difficult to maintain in the local environment.

4.2.4 Equipment Preservation & Lease Monitoring

The Company has invested in staff and technology in order to monitor their leased assets. In- house engineers regularly check on the assets; vehicle-tracking software allows management to

know where all their trucks are at any time; and, lease officers and management use regular reporting and client visits to supervise any clients who are delinquent in their payments. The Company insures all of the leased assets and provides insurance premium financing to clients to help them insure their own assets. 4.2.5 Deposit Requirement As mentioned earlier, the cash deposit provides X Company Leasing with interest-free financing for further asset purchases and also confirms the customers commitment to the lease transaction. 4.2.6 Risk Management & Credit Control X Company Leasing has adopted a careful portfolio of management policy that encompasses among others; limiting exposure to single companies, building up the portfolio cautiously, seeking extra security for riskier or large leases, maintaining good Management Information Systems, regular visits to lessees, fair pricing, selection, regular inspection and close monitoring of the leased assets. These policies have enabled management to assess and mitigate risks at an early stage 5. Challenges of Leasing in Uganda Leasing is a fairly recent concept in Uganda and hence there are a multitude of challenges that have to be overcome to ensure the sustainable development of the Leasing Industry. Below is a summary of six major challenges and how The Company is navigating through them: 5.1 Creating a Conducive Leasing Environment (tax, regulation and legislation) Following several years of misrule and insecurity, leasing was reinvigorated in1994 with the establishment of X Company Leasing as the first independent leasing company. The current legal framework has enabled leasing through guidance of the Income Tax Act (1997), VAT statute and Common Law. Whilst these laws have supported the re-vitalization of the leasing industry in Uganda, there are some specific aspects of the legal, regulatory and fiscal environments that are being assessed for revision in order to promote growth in both leasing and financial services. These are: The current tax legislation allows the lessees to claim capital allowances on the leased assets. Unfortunately, most lessees are tax exhausted and hence the tax benefits are lost. Changes in tax laws allowing this tax benefit to the lessors would provide an incentive for rapid growth of the industry (new entrants). Value Added Tax (VAT) is assessed on the entire leasing transaction and is passed onto the lessee, but the majority of lessees cannot claim credit on their VAT expenses since they either

fall beneath the VAT registration thresholds or are in the exempt category. As a result, leasing transactions cost even more for those businesses least able to afford it. There is need to provide training to SMEs on the benefits and facts of VAT registration and VAT administration and if possible waive VAT on rentals to SMEs below the minimum threshold. There is no Leasing Act in Uganda that stipulates the rights and obligations of lessors and lessees towards each other. Many developed countries have avoided specific leasing legislation and expanded leasing operations through common law, accounting guidelines, precedent and practice. However, given the state of development of these supporting industries in Uganda, leasing legislation may prove more effective in providing conclusive direction on the rights and obligations of lessors and lessees. Leasing legislation is not currently flexible enough to support a range of diversified products such as operating leases, contract hire and plant hire. There may be a need to define an appropriate framework for the introduction of additional financial products such as operating leasing and factoring. X Company Leasing is working closely with USAIDs SPEED project to provide a private sector perspective on these and other issues related to leasing legislation, regulation and tax treatment. 5.2 Dispute Resolution and Court Systems In addition to the above legal framework issues, improvements in the operations of the commercial courts would facilitate the enforcement of legal contracts and reduce time and costs associated with contract disputes. The courts need to be automated to allow for faster and cheaper processing of cases and the arbitration services need to be buttressed with more and better trained arbitrators. USAID/SPEED is sponsoring CADER (Center for Alternative Dispute Resolution), a project under the Ministry of Justice, to speed up dispute resolution of commercial transactions. In order to expedite resolution of disputes especially with respect to small transactions, X Company Leasing is revising its documentation to allow for arbitration. 5.3 Increasing Market Awareness of Leasing X Company Leasing continues to educate the market place on the benefits of leasing via several mediums namely; leasing seminars held throughout the country; provision of educational materials such as the Leasing Handbook for Uganda; sponsorship of events and advertisement in the local dailies. By being an advocator for leasing and a source of information, the Company not only increases its business prospects but also improves SMEs understanding of financing options. In addition to the general campaign described above, X Company Leasing is working closely with USAID/SPEED, to educate and engage business leaders and government officials on issues pertaining to the leasing industry. A follow up of the recommendations of the convention has resulted in the formation of the Uganda Leasing Association, an Apex body for lessors and stakeholders in the leasing industry. This will allow collective action in advocating for a conducive leasing environment.

5.4 Building Capacity and Local Expertise in Leasing One of the major constraints to the growth of leasing in Uganda is the limited or absence of local leasing expertise in the market. Consequently, the Company has adopted a policy of recruiting new employees (trainees) from universities, targeting graduates with degrees in engineering, agriculture, accounting, statistics and economics. To train the new staff members, X Company Leasing provides training workshops (conducted by Euro money twice a year), mentoring and on-the-job training. X Company Leasing staff numbers have painfully but steadily grown from four to thirty people since 1999. As the company has grown, its leaders have expanded the compensation package to be more reflective of employee performance. Senior employees are also eligible for financial support for continuing education, mortgages, and car loans, which helps employee retention, growth and morale. 5.5 Mobilizing Suitable Funding As indicated in above, having access to funding is key to the continued growth of leasing. X Company Leasing has so far been successful in attracting competitive funding to develop the business. 6. Operational Competencies X Company Leasing has devised a number of innovative solutions so as to effectively service the SME market and small lease transactions. Some of these processes are described below: 6.1 Customer Assessment and Approval Customer assessment is broken into two processes, initial Screening and Credit Appraisal. During the initial screening, applicants are logged into a database and the loan officer spends time assessing the applicants character and making judgments without formal financial statements. The officer documents the results of this meeting and circulates them to a senior manager to decide whether to proceed with the credit appraisal. In some cases where clients do not have good financial records or understanding of leases but are near either the Lira or Mbarara business development centers opened under the SPEED project, the Company officer will refer them to the center for training. The business centers help get the clients ready for leasing by assisting them with the development of cash flow statements and with the operational and accounting details of financial leases. The credit appraisal process includes a more rigorous review and completion of a Credit Proposal that reflects an assessment of the client; business type, financial position, legal structure and ownership, management set up, competition, sustainability, customer base, export potential, technical aspects, environmental practices. The appraisal also focuses on the cash flow and adequacy of the leased equipment as security for the transaction. While X Company Leasings main security is the leased asset itself, it may in some cases seek additional security to control for

risks associated with the lessees reputation, financial situation, the nature of the leased asset and the amount of investment at stake. For smaller transactions, techniques such as credit scoring, mutual guarantees, peer pressure, and group lending are often practiced in order to strengthen the transactions. 6.2 Committee Approval X Company Leasing Credit Committee (CREDCO) comprises four Senior Executives and is headed by the GROUP Managing Director. CREDICO meets at least once every week to consider deals above $50,000. The General Manager approves lease transactions of up to $25,000 while those above 50% of his limit require post approval ratification by the Managing Director. X Company Leasings main competitive advantage lies in its flexibility and speed of approving transactions. 6.3 Supply Linkages Understanding the supply chain and unblocking constraints is critical to the success of small businesses. X Company Leasing has therefore worked in several cases to facilitate supply chain linkages in situations where the entrepreneurs are too small to compete or lack technical knowhow. One example was in linking small milk suppliers to a large X Company Leasing funded dairy plant to improve the market for their products. Another example is the bee keeping project where the Company has developed a model to address the bottlenecks in the honey industry, which include poor quality, lack of expertise, low volumes, lack funding for the bee hives, and poor marketing of honey products. 6.4 Equipment Procurement X Company Leasing will only purchase equipment after ensuring sufficient resources are available. While the selection of the equipment is the responsibility of the lessee, X Company Leasing only leases equipment that is clearly identifiable, removable and which can be leased or sold in the event of repossession on default. Special care and conditions are applied when leasing specialized or limited use equipment or equipment which can rapidly become obsolete (e.g. computers). However, one issue that X Company Leasing faces is that there is rarely a sufficient stock of the assets on hand, which requires the leased items to be imported, taking three months on average. Because X Company Leasings demand is spread thinly across a variety of assets; the low stock of assets held by local suppliers will remain until there is increased demand either through increased leasing or outright purchasing. 6.5 Prudential Guidelines X Company Leasing prudential norms dictate that the company diversifies its risks across industry, equipment types, regions and client exposure. In general, Company Groups

commitment to any one client does not exceed 50% of the total assets of the client, and X Company Leasings exposure to any one industry should not exceed 25% of its lease portfolio. X Company Leasing makes a general provision of 2% on the Uganda Shilling denominated finance leases and equipment stock and 3% on dollar denominated leases and stock. Directors also make specific provisions on the outstanding capital costs of leases which they consider doubtful, which are leases more than ninety days in arrears. To minimize arrears and ease collection of rentals, X Company Leasing requires lessees to make out post-dated checks or standing orders for payment of the gross rentals due over the lease period. The Company discourages bounced checks and late payments by charging penalties. 6.6 Lease Pricing X Company Leasing prices its leases based on its cost of funds plus: risk associated with the lessee, their business and the type of equipment; market and competitor lease rates; lease term; size of security deposit and value of additional security; currency risk and loan loss provision. 6.7 Reporting and Monitoring X Company Leasing has implemented comprehensive monitoring and reporting procedures, managing predominantly by exception. Management generates daily arrears reports and monthly reports to monitor their portfolio of leases. The monthly reports include a report on each lessee, an arrears aging analyses, and summaries of the lease principles, income and bad debts provisions. As soon as the Company notices a missed payment, they will investigate the clients situation via a call or visit. At least annually, credit officers complete an investment review for each lessee. These credit reviews are reviewed by their managers and include third party feedback, macroeconomic factors and any additional information that they can obtain on the client. X Company Leasing uses a risk rating system to determine which customers need to be closely monitored. The review indicates whether the credit risk is improving, stable or

deteriorating. X Company Leasing will not offer facilities to borrowers classified as non- performing.

6.8 Equipment Inspection X Company Leasing engineers inspect leased equipment at least annually and leased vehicles every six months to ensure that the equipment is well maintained and in sound condition. Leased vehicles are also installed with a car-truck monitoring system to be able to track their whereabouts at all times and minimize on theft and ease repossession. 6.9 Repossession X Company Leasing repossesses equipment and vehicles as soon as arrears exceed three months, except for accounts for which reasonable circumstances can be verified. X Company Leasing may repossess assets at any time. Company staff carry out most of the repossessions, only calling on auctioneers when their staff fail to trace the assets or when they are in dangerous or

inaccessible locations. All expenses accruing as a result of the repossession such as for towing, parking and repair will be charged to the lessee. X Company Leasing has been successful in working directly with their clients to repossess their assets, only having complications in two cases wherein the clients took the Company to court for asset repossession.

Repossessed assets are either re-leased or disposed of to recover the termination sum. Due to high resale value of most of the equipment, X Company leasing normally recoups 99% of the book value when the asset is sold or re-leased.

EXERCISE Please give several recommendations to X COMPANY management for the way forward in regards to the leasing industry, the financial sector in general, and SMEs. (These recommendations should be based on the legal and tax recommendations cited earlier in this case study.)