Industry Executive Roundtable: Despite a Challenging Economy, Industry is in a Good Place

by By Lisa A. Miller Sep/Oct 2014
Monitor contributor Lisa Miller catches up with four industry leaders to get their take on the current economic environment, industry sentiment and pending regulations. Overall, despite excess liquidity, spread compression, increased regulation and other issues, our roundtable participants remain upbeat about future opportunities.

The changes in our economic environment are subtle. Little if anything happens in Washington these days, and a pending election will only exacerbate the gridlock. With no help from the outside, the equipment finance industry must rely on its own devices to develop new business and grow volume. Yet, despite excess liquidity, continuing spread compression, increased regulation and a possible decline in industry confidence, leaders remain upbeat about the opportunities ahead.

As part of the Monitor’s annual check-up with industry executives, we talked with Rich Doherty, president of PNC Equipment Finance; Bill Fite, president of Regions Equipment Finance; John McQueen, executive vice president and head of Wells Fargo Equipment Finance; and Adam Warner, president of Key Equipment Finance.

Spread Compression

In the Monitor 100 survey, respondents talked about spread compression as a challenge to doing business in 2013. As we close out 2014, margins are tighter than ever, with no relief in sight. “I’ve been at Wells Fargo Equipment Finance for 21 years, and we have been through a few cycles, and spread compression is a normal part of that cycle,” says John McQueen, who has served 31 years in the industry and plans to retire at the end of 2014. “We are managing 10 to 12 businesses, so we see things across a broad spectrum. When we look at any indices or financial metrics in our business, we compare these to our past performance. We expect to see more compression before we bottom out, but how far is anyone’s guess.”

“In the current economy there is a lot of liquidity, and banks are being rewarded for growing their balance sheets,” reports Adam Warner, who finishes his term as ELFA chairman of the board this October. “That, along with the fact that there are a lot of new entrants in the market, means there is a lot of money chasing the same transactions. When you have a lot of finance sources competing for the same relationships and deals, it drives down margins.”

“Traditionally when markets begin to heat up, pricing comes under pressure and gives way, then structure and then credit,” notes Bill Fite. “For the first time since the crisis, I’m beginning to see an easing by banks in the equipment finance space on the credit side of the equation. We are seeing deals getting done in the market today that would not have happened a year-plus ago. So, clearly the bank market has transitioned — not just from its pricing strategy but also from its structuring and now risk strategies.”

“Three years ago we started to experience increased competition, which resulted in spread compression in the larger middle market and large transaction market segments,” adds McQueen. “We didn’t experience that compression in the smaller middle market segment — deals under $1 million — until the beginning of 2013. I think we may be at or near the floor on the larger deals, and I expect it to stabilize. In the smaller-flow transactions, we expect to see further erosion of spread.”

“Spread compression can tempt capital providers to deviate from their initial risk/reward strategies,” stresses Rich Doherty. “With new entrants increasingly joining our business, the pressure on new business development mounts as the desire to build assets escalates. Our industry routinely sees smaller regional companies attract lower lease rates than larger publically traded companies. Since these companies depend on our product offerings more than publically traded companies, it creates more competition, thus driving compression even more. At some point you ask yourself why you would propose on a particular financing when an equivalent credit-rated company’s bonds offer a better yield and are more liquid.”

“In a very low interest rate environment, it’s difficult to get an extra few basis points,” states Warner. “When you have a moderate interest rate market — where instead of rates being at 2% to 3%, they are at 5% to 6% — adding another 10 basis points isn’t so hard because, as a percentage of the overall yield, it isn’t much. But 10 basis points on today’s yield are significant as a percentage. A rising interest rate environment is good for our industry, but I am not so sure it is good for the economy as a whole.”

“As the compression results in lower portfolio margins, companies will be hard pressed to grow revenue, thus creating the need for higher levels of assets to keep revenues flat,” says Doherty. “If one’s strategy is to maintain margins, they could be driven to expand their risk appetite, which creates another set of challenges. In the end it will be those companies, whose value proposition and delivery model helps them maintain stronger spreads for equivalent credit profiles that will be the winners.”

Industry Confidence

The monthly ELFA industry Confidence Index sat unchanged at 61.4% in June and July and then dipped to 58.9% in August. Based on survey answers from a cross-section of 50 industry executives, the index is considered a consistent barometer of industry confidence. August was the first time the index slipped into the 50s since December 2013. Despite the recent downward movement, the overall curve has held its own in the 60s for the past seven months. We asked our participants, some of whom participate in the survey, to give us their take on the recent stats.

“By definition, the Index is a forward-looking barometer of the equipment finance space with a 50% measure being net neutral,” emphasizes Fite. “A confidence index of 61.4 implies to me a positive inclination by our industry’s constituencies, which matches my own opinion. At Regions Equipment Finance, we’re seeing broad-based energy with our commercial banking teams across our footprint. Though we’ve enjoyed robust energy with our larger commercial client relationships throughout the year, we’re pleased to see growing equipment finance activity by our smaller commercial clients as we head into the end of the year.”

“My colleagues and I often refer to today’s economy as a ‘Goldilocks economy,’ quips McQueen. “We think it’s a great market — not too strong, as we experienced in the early 2000s when the market got overheated, and yet not too weak. The outlook is positive when you talk to people in the industry. Business volume continues to grow, and portfolio quality and losses are at very low levels.”

“Confidence has been fairly strong over the past several months, because even though there has not been a lot of action on the part of the federal government, there also hasn’t been as much strife,” observes Warner. “We are not under sequestration, and we aren’t bumping up against a debt ceiling. When those things happen and the federal government appears dysfunctional, it causes a drop in confidence. Then, businesses and consumers worry about whether the government is going to shut down or raise taxes to balance the budget or change spending patterns. But things have been quiet since the beginning of the year. My gut is that confidence is a little inflated from where it should be, but I think we have a new benchmark as to what bad times really are.”

“As a senior level person looking at profitability and financial metrics, we are performing at a very high level, partially because we are growing volume at the same time as we are experiencing historically low portfolio costs,” relates McQueen. “Strong financial performance seems consistent across the industry. Another market positive is that most industries and sectors continue to grow, so overall that has been good for many equipment finance businesses. When you step back and look at the national view, I think 58% or 60% is a very confident index.”

“There are a lot of innovative leaders who I have met over the last 35 years who have creative strategic plans to grow their business,” encourages Doherty. “When the economy is growing, they take advantage of the opportunity, but you cannot build your business and strategies around the assumption that the economy is going to bring incremental opportunities. In the meantime, there will be opportunities that companies will have to work a little harder to find, but for now the economy does not seem to be helping.”

Moving into 2015

With so little momentum in the economy, it appears that 2015 will bring more of the same. New players will continue to enter the market, and rate compression and competition will continue. To be successful, companies must have strategies and tactics in place to expand their business — without giving up much more on margin.

“Competition is going to continue to increase, and you’re going to see more rate compression,” warns Doherty. “That will be the key theme for the next six to 12 months, until people say they will no longer play at these margins. If there was one thing I could change, it would be to remind people who they are, what they want to be and their value proposition. Competition can get crazy, people can do irrational things in an effort to be all things to all people; but if lenders stick to their original values that made them who they are today, in the long run they will most likely have continued success.”

“I am hopeful that things will start to pick up in 2015 after we get past the election cycle,” expresses Warner. “Regardless of what happens there, we hope there will be more cohesiveness in our government, one way or the other. I think a lot of the growth will be specific to certain segments. The construction marketplace will likely continue to grow, along with the industrial segment and manufacturing. If there was one thing I could change, I’d like to believe that we could get paid for our services in a more balanced way. Our margins are way too compressed right now, and we are dealing with increased expense loads due to the regulatory environment. I’d like to believe we can get to a place where margins are more in line with the real cost of doing business.”

“We expect the U.S. GDP to continue to grow in the 2% to 3% percent range,” remarks McQueen. “We expect consistent to slightly higher interest rates, but we don’t expect any real change in the market demand in the next 12 months. As we manage our business, we forecast that new business volume will remain positive, but we will produce that volume at lower spreads, which will affect our margin and put some pressure on our profitability year over year. However, we are forecasting volume and revenue growth for this year and next.”

“Barring geo political shock, I think the bank-owned equipment finance segment in 2015 will continue to see solid, broad-based activity,” says Fite. “On the downside, however, I think bank loan growth demand will continue to outstrip the supply of bankable opportunities and continue putting pressure on margins. I expect the favorable economic conditions we currently enjoy will continue to promote solid credit quality characteristics in bank portfolios. For Regions Equipment Finance, next year will be one of continued refinement and growth. We’ll remain focused on furthering our relevance to our commercial banking teams in acquiring new and deepening existing client relationships by delivering differentiated equipment finance solutions to our markets. Additionally, we see potential in new markets such as solar renewable energy along with specialized industry opportunities where our bank has a significant commitment, which can be leveraged to create value for our clients.”

Industry Impacts

One of the biggest challenges facing our industry today is meeting the federal regulatory requirements. “We’ve seen an increase in our operating costs as we hire team members and increase technology spending to help meet the guidelines and maintain strong data integrity,” declares McQueen. “As we manage this change, a big challenge is keeping our team members engaged. The added regulation can put a burden on people to perform their tasks. Three or four years ago, a credit person might have checked off 10 tasks to approve a credit, but on certain transactions today, there might be 30 to 40 tasks. In addition, we ask our team members for data accuracy in meeting the requirements, which brings up another challenge. We need improved technology to offset some of the manual tasks we do now.”

“Increased regulation through Dodd-Frank has impacted companies that are financing small businesses,” adds Warner. “There is a blurry line in Dodd-Frank between what are consumers and what are businesses, and small businesses are sometimes swept into consumer regulation. For example, if a doctor or beautician is running a business but is not incorporated, is he or she a consumer or a small business?”

“The regulatory pressures add a burden that we need to work through, but it doesn’t stop the value we bring our customers,” insists Doherty. “We need to have the right leadership in place to guide our people through these difficult times, so that as an organization we can be successful. Our people are our greatest asset. Communicating goals clearly and providing tools to help them navigate through these competitive times are essential — as is fostering an environment that welcomes change, since what worked yesterday may not be the course that works today. We don’t have to be a speedboat that turns on a dime, but we do have to be ready to navigate these waters to get where we want to be in the future.”

“Minimal economic growth and increased regulatory pressures are major themes that serve as friction points to all equipment finance organizations owned by banks and their leadership teams,” agrees Fite. “It’s a growing point of consciousness in my every day. Our challenge as equipment finance leaders in the bank space is to maintain our focus on driving relevance to our bank’s local client strategies by acquiring, growing and deepening client relationships while at the same time meeting our compliance and regulatory commitments.”

“Despite slower GDP growth, the equipment finance industry has grown dramatically,” proclaims McQueen. “In 2011-2012 the ELFA reported funded business volume growth of over 17% per year. After two years of slow growth due to the recession, we experienced higher growth due to pent-up demand. Last year the industry grew in the 5% 7% range, and this year it is forecasted to grow 3.5% to 4.5%. The industry has now recovered to a point where growth has stabilized, and our industry is still growing at a faster pace than the economy. So, this industry is in a good place.”

Opportunities for New Business

“From energy, oil and gas to rail to manufacturing and production, to corporate aircraft to the tax-exempt municipal space, our portfolio is quite diversified by collateral, industry, product and geography,” informs Fite. “REFCO is expected to finish this year with well over $2 billion in originations and a portfolio over $6.5 billion in a diverse mix of leases and loans. Our portfolio growth will primarily occur through serving the equipment finance needs of our clients within our footprint. That said, we will opportunistically grow our business for the benefit of our bank, in and out of footprint, where superior risk and return on capital opportunities are afforded us.”

PNC Equipment Finance sees growth over the next three to five years in the advisory, rail and technology software business. “We continue to grow our rail car business,” shares Doherty. “We don’t see any other asset that would displace how goods and services are moved back and forth on railcars. We are a substantial player in this market and plan to expand it as we move into 2015 and beyond. PNC Equipment Finance has also put some effort into the large-ticket advisory business. In August we hired a new team, Structured Finance Solutions, which is a nice complement to our regular business. We believe there is room for growth in the software technology space, too. There is a lot of new technology emerging. The manufacturers are trying to figure out how to get their product to market and how to finance the product by the end user. We have a couple of programs with some major vendors that have been very successful, and we are leveraging those.”

“Construction and industrial are good growth areas,” predicts Warner. “A year ago I saw a lot of growth for technology companies, but some of those companies are reporting slower earnings growth, and that has Wall Street a little uncomfortable. There is a real opportunity around energy, both in traditional fossil fuel-based and alternative energies. Clearly, U.S. gas and oil production creates real opportunity for companies that want to finance part of that supply chain. If you think of energy as a supply chain rather than just a vertical, think of all the industries that touch energy. It includes construction equipment to build pipelines plus rail, trucking, manufacturing, real estate and so on.” Key also sees opportunity in the financing of water utilities and has financed several water infrastructure projects for municipalities. “There is a lot of aging infrastructure in the U.S., whether it is water or highways or anything else, and there is opportunity for financing companies to get actively involved.”

In the 2005-2006 timeframe, Wells Fargo Equipment Finance built its business models while focusing on what the company considered to be the core U.S. growth industries. These included transportation of goods, construction and healthcare. “We try to build expertise around those industries to allow us to keep broadening the products we can sell into those markets,” says McQueen. “For us, it is not so much that we will look at new industries for opportunity but rather focus on products and opportunities within these core industries. If you want to enter certain markets, you need to build the internal teams and processes to do it. This may involve hiring people or reorganizing parts of the business, so that you are more effective in managing a segment of an industry you weren’t previously in.”

Looking Ahead

To bring in new business in this environment, Warner admits that you have to be persistent and have a good strategy. “If the economy isn’t growing, the only way you can grow is to take market share. You need to differentiate yourself from your competition and know the markets where you play and where someone will be willing to pay to work with you. The good news for Key Equipment Finance is that, for the last several years, we have been significantly outpacing overall industry growth. I am pleased that we have done a nice job of growing our market share, but we do need some help from the economy.”

“There is a lot of opportunity in front of us,” suggests Doherty. “We have built a good foundation with our company, and we have become more efficient in what we do. We have built our brand inside and outside the bank at the levels and quality we hoped. We have upgraded our talent and continue to attract new people. It’s a competitive environment, the table is set, and now all we need to do is execute. I am excited about that!”

“The equipment finance industry has always been a resilient and material provider of capital to businesses across our planet,” sums up Fite. “Regardless of the segment of the industry, our constituents have always filled the void between the dynamic equipment financing needs of corporate America and the services willing to be provided by traditional lenders. Though our creativity may be boxed in, in the future, by changes in accounting standards, tax law or regulatory frameworks, I’m confident that the ingenuity and creativity that have defined our industry will prevail in providing unique solutions that meet the dynamic needs and expectations of our clients and owners, just as we have done since our industry’s inception. So, it’s onward and upward for our industry and I say, ‘Bring it on. We’re up for the challenge!’”

Lisa A. Miller is a regular Monitor contributor who has worked in the equipment financing industry for more than 15 years.

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