Equipment-Backed ABS – Footprint Expanding to Encompass New Players

by Sergey Moiseenko and Chuck Weilamann Monitor 100 2015
Sergey Moiseenko and Chuck Weilamann of DBRS take a look at trends in the U.S. equipment ABS market, including private equity investment and the rise of smaller specialty originators. They caution that oil price uncertainty could play a role in the months to come.

Following the Great Recession, interest has grown in the U.S. asset-backed securitization (ABS) market for securities backed by equipment collateral. The equipment leasing sector is going through a favorable phase of the economic cycle, benefitting from an increase in replacement CapEx, continuing strength of residual values for many types of equipment and a relatively steady credit position of lessees coming out of recession.

Key Industry Trends

Several private equity investments in equipment leasing companies have occured in recent years, including Fortress Investment Group’s acquisition of MicroFinancial, the acquisition of ENGS Commercial Finance by Aquiline Capital Partners, investments in Axis Capital by Amur Capital and investments in Nations Equipment Finance by Abrams Capital. This infusion of private equity demonstrates that many participants see the competitive landscape as opportune for increased capital investment. A corollary of this activity has been the expanded footprint and scope of equipment-backed ABS, which continues to evolve in order to reflect the developments in the equipment finance industry, as demonstrated by several recently executed transactions.

Another notable trend is the growing acceptance of transactions supported by collateral portfolios focused on larger small- and mid-ticket equipment. This is not too surprising, since the trend has been set against a backdrop of increased manufacturing activity, rapidly developing — at least, until recently — domestic oil production, and healthier conditions in the transportation and construction sectors. All of these factors have contributed to a greater demand for machinery and tools, large trucks and trailers, mining equipment, and yellow metal assets. In addition to the size of equipment, the introduction of more concentrated portfolios to the ABS market has also been occurring. In some cases portfolios may comprise mixed collateral which includes larger-ticket equipment together with more traditional assets like computers and software financed to larger middle-market obligors.

While both of these trends are not entirely new, what is particularly interesting is that originations are increasingly driven by smaller specialty finance lessors that target the middle market and/or small business customer base. Traditionally, equipment-backed ABS involving more concentrated portfolios has been sponsored by larger, investment grade originators such as ABS issued by MassMutual, GE Capital or Macquarie Equipment Finance. However, over the last two to three years, a number of relatively smaller specialty finance originators like Nations Equipment Finance, for example, have explored or accessed the ABS market for financing of their portfolios which include more concentrated obligor exposures and/or larger-ticket equipment.

Additionally, while many of the larger-ticket portfolios originated by traditional lessors typically contain a sizable share of investment grade obligors, trends support a growing acceptance by ABS investors of transactions supported by leases and loans to middle market and small business obligors further down the credit spectrum.

Changing Ticket Sizes

Generally, more widespread inclusion of the larger-ticket collateral in equipment-backed ABS has taken two forms. First, some specialty finance originators who have traditionally focused on small-ticket equipment are increasing the volume of larger small-ticket and low mid-ticket equipment leases in their portfolios — Axis Capital is a good example. As the share of larger-ticket collateral in an originator’s portfolio grows, those elements may need to be evaluated independently from or viewed differently than their small-ticket counterparts. Second, new participants originating more concentrated portfolios, like Nations Equipment Finance, have been entering or exploring the market aiming to exploit specific market niches.

Considerations differ somewhat when evaluating larger-ticket and/or more concentrated portfolios. Thus, for larger-ticket equipment, estimating the recovery — and in some cases, the residual — value against the collateral assets as well as the recovery timeline and associated realization expenses can become an essential element of assessing the risk of a transaction. Traditionally high recoveries, ranging from 65% up to 90% for the larger-ticket collateral, may be explained by many factors including better insight into the financed asset’s value which is sometimes supported by a third-party appraisal, the essential nature of equipment for a business, use of collateral asset cross-collateralization when financing multiple pieces of equipment for the same obligor and setting the financing term within the useful life of the financed assets.

Larger-ticket portfolios may present other elements that need to be understood, like higher obligor concentrations. Higher obligor concentrations often necessitate developing an opinion on underlying credit quality of the largest obligors. In addition, the back-end obligor default risk in the concentrated pools may be more accentuated, which necessitates the assessment of the changes in potential top obligor mix over the life of a transaction.

Delayed Delivery Contracts

A corollary trend particularly relevant for the larger-ticket equipment is the introduction of the delayed delivery contracts in the collateral pools for equipment-backed ABS. The practice of delayed delivery has become more widespread following the recession, when many vendors were left holding unsold equipment due to the drop in demand. This experience resulted in some of the distributors switching to the equipment delivery system analogous to “just-in-time.”

While this practice is understandable from a practical point of view, delayed delivery contracts are somewhat atypical as collateral for ABS because they can introduce rejection risk into a transaction. As such, they create uncertainty regarding willingness on the part of a lessee to pay and potentially increase reliance on the originator for repurchases in the event of rejection of delivery.

The risk can be somewhat mitigated by having a strong originator, allowing inclusion of such contracts subject to eligibility criteria with respect to the maximum delivery window and ensuring that such contracts are only permitted for more commoditized equipment types. Nevertheless, because of the inherent risk, it is not expected that delayed delivery contracts will constitute a sizable share of collateral pools supporting ABS in the future.

Keeping an Eye on Oil Prices

Finally, one of the more prominent and widely discussed factors potentially impacting the collateral in equipment-backed ABS — with ability to potentially reverse some of the trends discussed in this article — is the price of oil. On one hand, low oil prices can decrease fuel costs for transportation companies, which is certainly a positive. However, the benefit may be limited when compared to past business cycles due to more widespread use of fuel surcharge provisions built into the underlying contracts and other hedging activity by transportation companies. On the other hand, a long-term depression in the price of oil will be a negative for equipment lessors with clients in the domestic oil production business and auxiliary industries.

The curtailment of activity in domestic oil exploration may affect a wide range of equipment. In addition to the direct effects on demand for and performance of leases related to the industry — drilling equipment and FRAC tanks, trucks and trailers transporting water and sand to and from the sites, site lighting and power generation equipment, barges on which drilling equipment is mounted — may also be negatively impacted. However, many lessors have been proactively reducing exposure to the domestic oil sector since the first signs of decline in oil prices. To further mitigate the impact of lower oil prices, lessors have also been seeking OEM support and have been restructuring existing leases and loans to stem obligor defaults, as well as migrating to stronger credits.

The situation is still developing, and it is hard to fully quantify the size and scale of the ultimate impact that depressed oil prices will have on the equipment leasing industry in general and on larger-ticket lessors in particular. ABS market participants will be closely watching for months to come for any signs of increases in lessee defaults, decreases in recovery values, lease extensions and residual realization rates for the affected equipment types.

Thus far, the ABS market has demonstrated acceptance of portfolios with varying mix of equipment types. It will be interesting to watch the reaction of the ABS investors as this trend continues to develop, particularly in light of other changes taking place in the industry. While many market participants believe that the robust structures of recent equipment-backed ABS transactions will result in limited performance volatility, some may expect to see higher enhancement levels in the future if larger-ticket and more concentrated portfolios experience signs of deterioration.

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