The Key to Risk Management: Asset Managers Play an Increasingly Vital Role

by Lisa A. Miller January/February 2016
Monitor contributor Lisa A. Miller sits down with four asset management executives to discuss the essential role they play in the sales and decisioning process and their never-ending quest to balance risk and reward, manage regulatory compliance and achieve growth despite “fierce” competition.

In today’s competitive lending environment, equipment finance companies rely on their asset managers for much more than the numerical value they jot down on a piece of paper. The expanded asset management role has become an integral part of the sales and decision-making process. The asset management team’s expertise on equipment types, commodity markets, federal regulations and economic trends is critical to an organization’s long term success.

“As asset managers we look to do deals by coming up with alternative structures and defining our terms and conditions in contracts,” says Robert Mercogliano, managing director and head of Asset Management, Equipment Finance Group at SunTrust Equipment Finance & Leasing. “We work with our credit and sales teammates, go out on sales calls and make presentations in the boardroom. We hire highly educated, trained experts.”

“The equipment manager during these highly competitive times ensures that the market value analysis of equipment is thoroughly researched and accurate,” says Terese Kramer, vice president, Equipment Management Group at BMO Harris Equipment Finance. “Equipment managers can also assist in drafting strong market-acceptable maintenance and return conditions.”

“Asset managers are increasingly looked to for our role in fine-tuning collateral valuations,” adds Greg Larson, vice president and asset manager, Equipment Finance Division at Bank of the West. “We spend more time looking deeply at the specific parameters of transactions to help win the deal by digging into every pertinent variable when assigning values on equipment and transactions.”

“The asset manager is key to helping manage risk through structure,” says Dennis A. Bolton II, senior vice president, Equipment Management Group at Wells Fargo Equipment Finance. “As every dollar is the same, successful equipment finance companies leverage their teams to find creative ways to add value and differentiate their products from their competitors.”

The competition for desirable transactions increases year after year, putting more and more pressure on asset managers to assess present and future values. Just when you think it can’t get tougher, it does. “One word comes to mind regarding competition for desirable deals — fierce!” says Kramer. “A short term approach in this environment doesn’t work.”

This reality forces lenders to be creative while managing risk and staying within regulatory guidelines. “With the rates as low as they are in the marketplace and too much money chasing too few deals, we need a strong syndications team to maximize opportunities,” says Mercogliani.

Balancing Risk and Reward

When asked if their valuation practices will change to better compete in the current environment, our participants agreed that sticking to fundamentals is important.

“When we invest in an asset, the core essential asset management decisions we make here lie deep within our policy and strategy,” says Mercogliano. “These fundamentals are important when you’re trying to determine your investment strategy. We have stuck to that, and we hire asset managers who think the same way.”

“Our market sector outlook may vary through cycles, but our decisions remain based on fundamentals,” says Bolton. “We leverage our well-seasoned team’s experience and expert judgment in making any required adjustments needed to meet market competition.”

“Historically, when ascribing residual values, we’ve tried to maintain a balanced approach,” says Larson. “Recently we’re experiencing increasing pressure to better understand residual risk and reward. The level of competition means we must do more and more due diligence on every deal.”
“We apply fundamental equipment management principals in our underwriting but also increasingly require each equipment manager to become a specialist in asset categories that our company has targeted,” says Kramer. “This includes developing and maintaining strong relationships with third-party subject matter experts.”

“On the asset management side, our evaluation process continues to evolve based on the environment,” says Larson. “We’ve always been very careful in how we conduct and document appraisals, but the current regulatory environment adds additional pressures by increasing documentation and information requirements. We’ve seen a shift in this area in 2015, and we anticipate it will continue in 2016.”

“The collapse in oil prices was one of the biggest headlines in 2015,” says Kramer. “This impacted economic growth and had a ripple effect in a wide variety of equipment types. If we assume slow but steady overall economic growth in 2016, certain asset types should see both replacement and expansion. Other asset categories will continue to be stressed. Part of an equipment manager’s job is to not only understand the ups and downs of equipment cycles but also analyze whether market conditions are normal/temporary or permanent. This makes the role of the equipment manager increasingly complex as we try to set equipment values five to 10 years into the future.”

Managing Regulatory Compliance

Everyone accepts that the credit and asset-risk assessment process has changed, given the compliance and regulatory constraints, but the rules for non-regulated independents and captives are less stringent — and that can affect a bank financing company’s ability to compete.

“Equipment managers are impacted by the regulatory environment in two ways,” says Kramer. “First, many of us are affected by the overall finance industry’s newly enhanced regulations. Second, we are required to understand the regulations and laws impacting various equipment types that can have an impact on future values. An example of the regulatory environment impacting an asset type is the standards that were released this past May stipulating specifications for certain tank cars built after October 2015. There is still some uncertainty about the final outcome of some of these requirements. Uncertainty with regulatory issues makes the job of assessing future equipment values even more challenging.”

“The increased compliance and regulatory constraints have compelled us to enhance our credit approval and risk evaluation, adding numerous steps to these processes,” says Larson. “While the added steps initially threatened to degrade service levels, we addressed the increased workload by automating as much as possible. We know that turnaround time on approvals is critical to being competitive, so handling additional due diligence while keeping our turnaround time short has been a very high priority for us.”

“I came to SunTrust from a captive finance company, so this is my first position with a bank since the regulatory restructure,” says Mercogliano. “In the non-regulated environment, you are free to be creative with structures. The assets played a heavier role in determining the credit approvals. In a bank, the structures are much more controlled and affect what you can and can’t do. There are more requirements from the cash flow perspective, and the financial statements play a larger role. A significant amount of time and resources is spent understanding, complying and auditing these new regulations.”

“Compliance and regulatory constraints demand more oversight, requiring more detailed analysis and stricter controls and adding further layers of complexity,” says Larson. “We have to look more closely at equipment based on maintaining compliance and staying within regulatory constraints. This comes not only from outside regulators but also from our bank’s own internal audit, control and compliance requirements.”

“Due diligence, reporting levels, deal cycle time and cost have all increased,” says Bolton. “In cases where other market players do not subscribe to the same compliance/due diligence levels, we have been challenged. In most cases, our clients understand our needs and comply. There are cases, however, where business is lost to non-complying entities. Ultimately, we believe the playing field will level as regulators continue to enforce the new regulations.”

“Part of the solution is to hire the right people,” says Mercogliano. “The first thing I requested when I took this role was to hire an operations manager. This is a full-time dedicated employee who handles all of the Sarbanes-Oxley requirements in addition to the risk-controlling policies and procedures reporting and audits. This person concentrates on those things so that the asset managers can focus on their jobs. My operations manager is very busy, and we’ve done very well on our audits since adding that role to our department.”

“We feel increasingly compelled to get more asset evaluations done through certified appraisers,” adds Larson. “Recently we’ve seen regulators pay more attention to these third-party service providers, particularly in terms of their background qualifications and certifications. Regulators are keenly interested in understanding the expertise of the appraiser as well as how they are compensated.”

“I believe captives and independents will remain strong competitors based upon their different risk appetites and other characteristics such as less restrictive loan/value levels,” says Kramer. “However, I predict that bank lessors will continue to dominate new business volume for the foreseeable future.”

Finding Room to Grow

Despite the challenges, Bolton claims strong residual realizations despite anemic economic growth. “We have seen our profitability mix benefit from both equipment sales and renewals. The strong transportation and construction markets have also helped when equipment has been redelivered.”

“Like most in the industry, we hear anecdotal evidence about lessees getting more savvy about leasing in general and more decisive about how they go about these processes,” says Larson. “Our approach has remained relatively conservative, and we continue to see decent returns on residuals and are able to win business at that level. Of course, we’d all like to see even more of that, but we’re happy we’ve kept it where it is and have been able to continue to realize gains versus seeing them decline.”

“In the old days the asset managers thought about the equipment, its value and whether it could be sold on a readily available secondary market,” says Mercogliano. “For those assets that were easier to sell, you’d take more risk. But we deal with commodity-driven events now where the price of oil is driving the price of railcars and tank cars, and the legislation of coal is governing the number of coal cars we need. We have to balance and review those commodity decisions relative to the equipment value. We used to put heavy reliance on GDP and how the economy was performing overall, but we really didn’t look at it from a micro-economic perspective.”

“At BMO Harris, two things work in our favor when it comes to residual realization,” says Kramer. “First, our portfolio is young so we don’t have a pool of leases coming to full maturity. In addition, we focus on financing critical-use equipment. Even in a downturn, our customers tend to hold onto equipment that is critical to their operations. These factors continue to bring us good residual realization when the opportunities arise.”

“Trucking, inland marine and construction continued to lead market performance,” says Bolton. “Oil and gas-related assets were well behind. While overall economic growth is slower than historical recoveries, equipment acquisitions continue to benefit from both the economic expansion and replacement buying. For 2016, we expect to see the same asset trends continue although potentially at a more moderate pace.”

“There is a huge demand for financing operating leases on aircraft, but many financial institutions have shied away,” says Mercogliano. “They will give you loans with decent terms, but it’s a volatile market and banks are not willing to invest in residuals on aircraft. The least demand is in the printing, textile, mining, oil and gas sectors where there’s not a lot of activity. Some of the stronger sectors include medical, construction, aircraft and rail cars that are not related to oil, gas or coal. Chassis and container railcars are in high demand as are most marine vessels.”

“There is strength in the transportation sector with companies that haul products other than crude oil,” says Kramer. “They are doing well, replacing fleets and adding equipment. Class 8 truck-trailer equipment markets are positive. Electronic medical records equipment is another area of growth. Intermodal freight transportation using trucks, railcars and ships is also a strong sector.”

“While we anticipate that some demand will fall off in 2016, we expect to see increases in construction and certain sectors of technology,” says Larson. “With construction, we’re optimistic that private sector spending on residential and commercial real estate will continue to be strong. In technology, we anticipate growth not only because of obsolescence but also because these assets typically have short life cycles. We also expect to see growth in the healthcare equipment segment, driven by the overall aging of the population and more stability following the implementation of the Affordable Care Act.”

The general consensus among our panelists is that 2015 consisted of both replacement and expansion. “In 2016 we expect to see continued replacement but more along traditional trends and continued expansion,” says Bolton.

Larson feels that 2015 financing activity was primarily based on replacement demand. “But looking ahead, we see evidence of expansion in 2016. Some construction companies are beginning to add equipment, and we continue to see smaller companies coming back into the market after leaving in 2008 and 2009.”

“In 2008, no one was buying new equipment in the construction industry; they were holding onto their assets, because they couldn’t afford to buy new ones,” says Mercogliano. “Seven years later, people are starting to replace, and the secondary market is pretty strong in construction equipment. The values are good, and there are not a lot of used assets out there. That forces people to consider acquiring new assets. Another example would be medical equipment where lower government reimbursements for imaging procedures have slowed the demand for new equipment for many years now, but reinvestment in new equipment has driven opportunities.”

“In some sectors, expansion is stronger,” says Kramer. “The truck-trailer fleet business is doing both replacement and expansion, but oil rigs are experiencing neither. Certain coal and oil equipment businesses are suffering. We expect both replacement and expansion activity in 2016.”

“The factors driving decision-making vary depending on the industry and the company,” says Larson. “From a macro standpoint, the driving force for larger companies is the overall increase in demand in the economy. If those larger companies have international components — as many of our clients do — they’re looking at the economic situation offshore, which has been less robust in Asia and Europe.”

“Continued economic growth and replacement buying drove investment decisions,” says Bolton. “While the mix and pace have the potential to change, overall these factors are expected to remain consistent.”

“As long as low oil prices, strong dollar and global uncertainties continue, we expect investment decisions will look similar to 2015,” says Kramer. “Companies are buying back their stock and hiring employees, but they are not investing their cash in capital expenditure. That will add to this slow, bumpy growth that looks to continue for the next 12 to 18 months.”

“Money is extremely cheap right now, and we still see a fairly large component of cash investment in equipment — as opposed to financing — than we have in the past,” says Larson. “In the agriculture equipment market, falling commodity prices have had a serious impact in the last year or so. As a result, many farmers have pulled back on some of their bigger investments, and equipment is one of those.”

“I see a lot of replacing but not a lot of growth at this point,” says Mercogliano. “If you look at GDP growth, it tells you how much is new versus replacement: When you start to see high growth rates, you know the markets are expanding. As opportunities expand, people buy more capital equipment.”

It Takes a Team to Win

In such a tough, competitive environment, Kramer says it takes a team to balance new business growth targets with a balanced credit and equipment analysis. “Communicating early and often, plus honest respectful dialogue between key stakeholders, has and will continue to help us reach our strategic goals.”

“The heightened levels of due diligence require that more people work together to analyze the information available, gain a broader sense of a potential client’s priorities and find the best way to meet client needs,” says Larson. “Our sales, credit and asset management groups often come together to discuss prospects and try to identify their hot buttons and highest priorities. We don’t do this in a vacuum; each team draws on its expertise and knowledge to help design the right solution for every customer. Collaborating across groups and with our vendor partners helps us come up with better deals for our customers, and we have been able to approach them more successfully by working together.”

“In my group, we each have our own specialty,” says Mercogliano. “The deals come into a pool, and my two senior managers review them. They assign each deal to the asset manager with the most applicable experience as well as the availability to turn the deal promptly. We work within that network of knowledge to maximize our turnaround time and get the deal done quickly and accurately. We have back-ups and redundancies so that more than one person can handle a specialty. We have working managers who also step in and support deals.”

“At Wells Fargo, we believe our people provide the distinctive competence required to differentiate ourselves in the market,” says Bolton. “We coordinate early and often including all functions — sales, credit, equipment management, portfolio management and syndications — to identify and strategically address opportunities whereby we can execute and deliver when other companies can’t.”

Despite a can-do attitude, skilled team members and strong partnerships, there is always something to keep an asset manager awake at night. We asked each member of our panel to tell us about his or her greatest worry.

“If the price of oil stays at its current level — or drops even further — for a sustained period, the ripple effect through the economy and in some asset types will continue to be volatile,” says Kramer. “It is the need to predict the future that keeps me awake at night!”

“Nothing keeps me up at night,” says Larson, “but while awake and working, I’m focused on staying current on market conditions, balancing risk and reward through enhanced due diligence and ensuring compliance requirements are met.”

“Market competition is irrational as a result of the hyper-liquidity available,” says Bolton. “Signs of an economic softening are appearing in multiple industry segments yet discipline continues to erode. Transactions in the current environment are likely to be the biggest challenges should a softening take place.”

“The trucking industry is an area where people may have over-invested,” says Mercogliano. “Many institutions are highly concentrated in that asset class. If you haven’t taken the right measures to protect yourself and you did not have discipline on valuations, structure and credit, it could spell trouble. You have to be careful. It’s like eating all the lollipops: The lollipops are delicious, but in the end if you eat all that you can find, you might gain 20 pounds!”

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