Rita Garwood,
Managing Editor,
Monitor
A cloud of anxiety hovered over the world the morning of the 15th Annual Equipment Leasing and Finance Association/Information Management Network (ELFA/IMN) Investors Conference. Hours before the opening session, three coordinated bombings exploded in Brussels, demonstrating what DLL International CEO and Chairman William Stephenson called the “wild cards” that “can have a massive impact, not just in this industry but the overall global economy.”
“We constantly have to be prepared to manage the uncertainty,” said Andrea Petro, executive vice president of Wells Fargo, in her opening remarks. “This is probably a more uncertain year than we had last year and probably the most uncertain year we’ve had since 2009.”
Geopolitical unpredictability — terrorism, the influx of refugees into Europe, the U.S. presidential election and China’s transition from an industrial to a consumer economy — was only one aspect of Petro’s concern for the year ahead. Other anxieties, including new leveraged lending and regulatory guidelines and the financial market turmoil sparked by the Fed’s December interest rate increase, left Petro wondering what will happen next.
“Regulation has an impact on cost of funds. What we’re seeing this year for the first time in 10 years is that cost of funds is increasing and all of us have to determine how we’re going to develop strategies around that,” Petro said. “Every one of us is charged with a responsibility of developing strategies to neutralize uncertainty.”
Resiliency to Rise Above
ELFA President and CEO Ralph Petta shared a ray of hope from an Equipment Leasing and Finance Foundation study, which indicated that both the lender finance market and banks’ appetite to lend to the equipment finance industry continue to thrive despite the uncertainty posed by regulation.
“The strong performance of equipment leasing portfolios and the relatively higher yields they offer are beginning to garner the attention of non-traditional lenders to the space,” Petta said. “This dynamic, on top of regulatory constraints faced by some lenders and increasing desire for funding of nonstandard contracts, as well as continued technology innovation, has created the perfect environment for new entrants.”
Stephenson echoed Petta’s optimism, calling equipment finance “the most robust and resilient industry in the U.S.” during an overview of the top 10 acquisition trends for 2016.
The most noteworthy trend Stephenson discussed was the rise of managed equipment services. “Customers are demanding far more flexibility,” he said, noting the prevalence of services attached to assets and the increasing number of solutions providers entering the industry. “This is probably one of the most transformative changes that we’ve seen in decades.”
Overall, Stephenson was bullish about the industry’s prospects in 2016. “We see tremendous opportunity in all the segments that we represent…the industry is going to continue to grow at a pretty steady pace.”
Du Trieu, senior director of Fitch Ratings, agreed that the industry is resilient. “Fitch’s outlook for the sector is stable from an asset performance and positive from a ratings perspective,” he said. Despite this, Trieu indicated that there are several areas of concern, including the global economic outlook — particularly within China’s emerging markets — and prolonged stress in the oil, gas and energy sectors.
Current and forecasted declines in sales related to agriculture, transportation and trucking were also a concern. “Low commodity prices over the last year and a half have resulted in negative impacts on foreign balance sheets, and the replacement demand that took place for construction and trucking sectors has run its course,” he said. “Any significant weakness within any of these sectors could result in increasing defaults, which would increase inventory levels and dealer loss and ultimately impact recovery rates, similar to what we saw during the Great Recession.”
A final area of concern for Fitch was competition within the small-ticket equipment sector. Trieu indicated that a significant increase in competition could result in a loosening of standards similar to what took place in the 2000 and 2001 recession.
BMO Capital Markets Director Jeff Merchant said the ABS market is off to a slow start this year, with approximately $38 billion of issuance volume priced year to date, compared with $54 billion during the same period in 2015. Consistent with the overall market, equipment-backed ABS has also been sluggish, with only five transactions to date representing $2.9 billion of issuance volume.
Merchant expects 2016 equipment ABS issuance to be around $10 billion, a drop from the $11.5 billion of issuance volume in 2015. One of the major drivers for this expected decrease was the exit of GE as a sponsor in the asset class. Although larger players such as the captives and GE traditionally dominated the equipment ABS market, Merchant said the notable absence of GE and CIT has allowed the smaller independents to gain greater market share.
Funding Source Update
The annual funding roundtable moderated by Petro focused on issues facing independent lessors in 2016, including how to fund growth, strategies to lower the cost of capital and comparing funding sources.
The roundtable featured three interactive polls, enabling conference attendees to vote during the session. The first poll asked if recent financial market turmoil has affected equipment finance companies’ ability to raise debt and/or equity — 55.6% of respondents said yes, 33.3% said no and 11.1% were uncertain.
Miles Herman, president of LEAF Commercial Capital, said that the most noticeable change has been the “volatile and choppy” nature of the securitization market, which has ultimately affected cost, but not availability, of funds.
The panel agreed that having multiple funding sources was one way to mitigate funding risk. “In these turbulent economic times, you’re never sure how your counterparty is going to react, or what type of exposure they have to oil and gas,” said Josh Rothman, EVP and CIO of North Mill Equipment Finance. “Having multiple funding sources is never a bad thing. More liquidity is always positive.”
Barry Shafran, CEO of Chesswood Group, agreed. “The recession showed many of us that you could never be certain where the weakness was coming in terms of your lenders,” he said. “Sometimes it’s not about your relationship with your funder but other stresses they feel in their business that have a direct impact on you.”
The second poll asked how the Federal Reserve’s December interest rate increase — and two anticipated rate increases in 2016 — would affect the cost of funds for equipment finance companies. A large majority (87.5%) believed the cost of funds would increase.
Railcar, Fleet and Container
Chapman and Cutler’s Todd Plotner moderated a panel dedicated to new developments in railcar, fleet and container and the role of securitization in the sector. Issuance was down slightly last year, a trend projected to continue in 2016. The softness, which began in the summer of 2015, was correlated to the oil, gas, and high yield sectors, which caused spread volatility that continued into early 2016. However, in the weeks prior to the conference, the ABS market regained some firmness as investors started reentering the market.
The panel discussed the correction taking place in the container market due to a slowdown in global trade, which has resulted in less CAPEX and less need for ABS capital. The macro GDP environment has been affecting the railcar segment, contributing to lower rates and utilization of the assets. Tank cars, already affected by mandatory modifications required by regulators, have seen a decrease in demand due to oil and gas market volatility.
“I think the asset-backed market, as a whole, is on solid footing,” said Pete Rodgers, securities banker with Wells Fargo. “We are going to experience periods of volatility, but I think the overriding good news is that transactions are getting done. The subscription levels aren’t always through the roof, but recently we’ve seen greater participation.” Rodgers noted the importance of riding through the cycle while keeping a close eye on diversification.
Marketplace Lending
The “Marketplace Lending 101” session was so popular that stragglers had difficulty finding a seat. Albert Periu, global co-head of Capital Markets with Funding Circle USA, provided an overview of the marketplace lending space, where players are operating from different models involving various levels of balance sheet risk. Periu said that transparency is essential to investors. Many marketplace lenders update loan data on a daily basis, enabling investors to see signs of deterioration immediately.
Periu said marketplace lending is still evolving. While established leasing companies and banks initially saw these online lenders as competition, many are now forming partnerships with them, including lead-based partnerships, white label deals and co-branded portals.
Alexander Ploch, vice president of DZ Bank AG, said it is important to evaluate the financing chain, including the originator, the aggregator and the ABS investor. When looking to invest, Ploch said the business “needs to pass the sniff test,” which includes evaluating whether or not the loan product makes sense for the borrower, the ownership and equity of the marketplace lender itself, performance of the asset and the credit underwriting process.
Ploch said asset performance is one of the biggest risks in marketplace lending. Since the bigger players in the space were established after the Great Recession, there is no way of telling where asset performance will go in another downturn. A marketplace lender’s underwriting process often relies on the borrower’s cash flow and can be risky for longer-term loans. Another red flag includes the potential for regulatory scrutiny.
Aircraft Finance
Blank Rome Partner Stephen Whelan moderated a panel on aircraft finance, which included overviews of aircraft ABS, lessor business strategies, helicopter finance and legal steps in aircraft finance. Whelan described aircraft ABS as “rosy,” and DBRS projected good, if not robust, growth in the sector this year.
Mark Hirshorn of DBRS said aircraft lease ABS has experienced significant growth on the power of aviation industry demand. According to data from Boeing, deliveries scheduled over the next 20 years will double the existing fleet in use today. Several factors have contributed to this growth, including global GDP, a focus on building infrastructure in emerging markets and more low-cost carriers that are attracting first-time flyers.
With more than $25 billion in deliveries scheduled for 2016, there are three primary options to finance this growth: cash, bank debt and capital markets. While ABS is more expensive than traditional bank debt, Whelan discussed the advantages of ABS, including the inflexibility of banks regarding amortization schedules, unanimous lender consent and banks’ legal lending limits. Aircraft ABS issuance has grown since 2013 (see chart), and more issuance is expected in years to come.
Realities of Regulation
In a panel on regulation, Chapman and Cutler Partner Marc Franson cautioned any financial product or service is subject to regulatory scrutiny in today’s environment, and equipment finance is no exception. Franson noted that there has recently been increased focus on business lending, particularly to small businesses, due to the prevalence of marketplace lending and merchant cash advances, which many consider the commercial equivalent of a payday loan.
While individual state laws govern commercial lending, there has been a recent movement to require more federal oversight. In July 2015, the U.S. Department of the Treasury requested public input on the marketplace lending industry. After receiving roughly 100 comments, the Treasury indicated a renewed interest in business lending. Franson said that additional federal regulation, primarily in the area of disclosure, is a possibility. Due to the Treasury’s desire for a level playing field, Franson anticipates that the regulation will not be limited to marketplace lenders, but will apply across the board in business lending.
Another critical area of concern this year is the collection and storage of data. Dodd Frank 1071, which amended the equal credit opportunity law to require data collection for commercial loans, requires the collection of data on borrowers. Once collected, the data will become publicly available. This issue is not only critical to equipment finance lessors, but to their sources, such as dealers, which collect data and submit credit applications. The panel indicated that implementing this data collection will not only have legal implications, but will also be costly.
The panel also addressed state regulations, primarily those relating to usury and licensing. The usury issue has been central in Madden v. Midland Funding, in which the 2nd Circuit ruled that when a bank transfers a bank-originated loan to a non-bank, the non-bank is unable to charge the same interest rate as the bank. Although Madden is a debt collection case, it could affect commercial loans. The case, which now stands in limbo before the Supreme Court, is affecting the size and structure of securitization deals. Licensing regulations are a big issue in California.
New Age of Lending
A panel on the new age of lending provided an overview of alternative financing sources and current trends. Addressing the need for long-term, flexible capital in the post-financial crisis environment, Alex Saporito, managing director of Flexpoint Ford, discussed the growing role of private equity while MidCap Financial’s Michael Levin and Biz2Credit CEO Rohit Arora discussed how their companies are serving needs that banks cannot meet.
Chuck Weillaman, senior vice president of DBRS examined the changing nature of the equipment finance industry. Since 2010, 35 new marketplace lenders have entered the space, and these companies are developing niches. Weillaman attributed the rise of these companies to the fact that banks left small businesses under served after the Great Recession. Weillaman also noted that these new entrants initially offered a limited number of short-term products, but have now expanded to offer a more diverse array of products and longer terms.
Ascentium Capital’s Evan Wilkoff led a chief credit officer’s panel. When asked what kept him up at night, First American Equipment Finance’s Michael Ziegelmann likened his concerns to a game of Whack a Mole because the issues are always changing. Ziegelmann said the biggest problem areas for his company are healthcare and education. For EverBank’s Eric McGriff, learning to adapt to bank regulatory requirements while looking out for hidden oil and gas exposure were his biggest concerns. Representing independents, Wilkoff said the state of the capital markets have left him tossing and turning.
Monroe Capital’s Ted Koenig presented a “Spotlight on Middle Market Lending,” which included an overview of the current state of the middle market and predicted trends for 2016.
The final panel of the day focused on investors’ strategy and pockets of opportunity. The panel noted that commercial finance has been historically attractive thanks to its high yields, but the last three months have seen some pull back. There is some pivoting going on as investors are no longer having zero losses.
The panel also discussed the outlook for private equity in equipment finance. The last few years have been difficult for private equity investors, but John Fruehwirth of Rotunda Capital said it will be very interesting to see how things play out over the next 12 to 24 months.
Looking Ahead
Despite a general theme of uncertainty, there was a consensus at the conference that opportunity still exists in equipment finance. Stephenson summed up the overarching sentiment when he said, “Regardless of what I view as external factors that come in, our industry — year-over-year, decade-over-decade — has continually proven to be resilient, flexible and adaptable regardless of regulation and political situations that occur. That’s what makes us very unique.”
