In 1993, Cisco Systems Inc. reported net income of $172 million on revenues of $649 million. At the time, it employed about 1,000 workers, but foresaw its headcount ballooning as the company embarked on a string of acquisitions that would create the telecom behemoth it is today. To accommodate that growth, Cisco began an office-space expansion that year and financed it with synthetic leases in order to preserve cash and leverage for its upcoming M&A. Destined to become all the rage in the 1990s, synthetic leases are off-balance sheet financial tools that unload debt to special-purpose entities, or SPEs. Their purpose: to allow high-growth, but cash poor or below investment grade concerns to get the use of sizable amounts of relatively inexpensive capital without hurting their debt to equity ratios.
The 1990s are over, and to a large extent, so too are synthetic leases. Thanks to Enron Corp., which buried a multitude of debt in its various SPEs, synthetic leases are now red flags to investors and regulators that corporate hanky-panky could be afoot. In 2002 Cisco paid $1.9 billion to extract itself from these clever arrangements, opting instead to put the real estate on its books. This was no big deal for Cisco, which in its fiscal 2002 fourth quarter boasted revenues of more than $4.8 billion and a net profit of $772 million in what was undeniably a bad year for the San Jose, Calif.-based company. Cisco no longer needed the synthetic leases from a liquidity perspective and felt their very existence–despite the fact that it dutifully disclosed them–was a negative for shareholders. "Cisco has grown so huge that the impact of the real estate has been minimized," observes Craig Lund, president of San Jose-based Lund Financial Corp., which put together more than 70 synthetic lease deals over the past decade.
Such may be the fate for most synthetic leases held by larger publicly traded companies, despite the fact that the Financial Accounting Standards Board (FASB) recently released regulations that provided a structure for maintaining synthetic leases in some form. "Balance-sheet transparency will be very important going forward, and I expect a significant number of companies–I can't give you an exact percentage–to opt to bring assets back on balance sheet, despite the fact that from an accounting point of view they don't have to," says Michael Rotchford, senior managing director of structured finance at Cushman & Wakefield Inc., a New York real-estate services firm.
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Still, not all large companies are ready to jump ship. The best example of a company apparently prepared to ride it out with synthetic leases is AOL Time Warner Inc., which has been constructing its twin-towered corporate headquarters in Manhattan's Columbus Circle with the aid of an SPE. Despite controversy swirling around the use of synthetic leases, AOL has remained committed to the strategy, saying that synthetic leasing has tax advantages and cost savings the financially troubled media conglomerate continues to appreciate.
Trouble in Silicon Valley
But while the larger companies may do it by choice to please investors, smaller, below-investment-grade companies–the group for which synthetic leases had been developed–may be forced to explore alternatives, although the cost to restructure is apt to be prohibitive because of unresolved issues over taxes and bankruptcy.
Many of Cisco's neighbors may face this dilemma or the effect of declining real estate values in Silicon Valley. Take, for instance, Inktomi Corp., an Internet search company based in Foster City, Calif. In September, Inktomi exercised the purchase option on the synthetic lease for its corporate headquarters and paid approximately $114 million of long-term restricted cash to the bank holders of the synthetic lease to extricate itself. The company was forced to do so after the tech-sector meltdown led to the company hemorrhaging cash, which violated lease terms requiring Inktomi to generate a profit during the life of the five-year lease it signed in August 2000. Inktomi now plans to sell the building, the value of which fell to between $37 million and $55 million, according to a company filing submitted in August 2002.
In the meantime, while it is not technically difficult to unwind a synthetic lease–it is just a matter of paying off the lender–experts like Rotchford and Lund are already busy advising firms trying to get out of synthetic leases on ways to do it cost-effectively. Companies unwinding synthetic leases have a number of options. The most popular these days are:
o Sale/Leaseback. The property or properties are sold to an investor, which leases them back to the corporate tenant on a long-term basis.
o Outright Ownership. The value of the corporation being an owner depends on whether it intends to use the building for a lengthy period of time.
o Conventional Lease. The term of the lease should be coincidental to the amount of time the property will be useful to the corporation.
o Credit Tenant Lease. A lender provides financing based on the credit strength of the corporate lessee, which usually results in a below-market rent.
As Rotchford sees it, a two-tiered market will develop for investment-grade and below-investment-grade synthetic lessees. For below investment grade, the footing will be precarious. "The aggressive pricing that first accompanied these instruments just isn't being offered anymore," he says. And with the economy in its current limp state, "that will be a problem for many of these companies."
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