Gary Lomonaco,
Senior Managing Director & Head, Business Assessment Practice,
The Alta Group

In recent years, a number of community and mid-sized banks have entered the equipment finance industry. The benefits of equipment finance are numerous, ranging from an opportunity to better serve the client base, to diversify the portfolio or to create more attractive returns than in core businesses. Investments were made in building equipment finance assets, sometimes without a full understanding of the market’s nuances.

Whatever the reason for entry, it is clear that financial conditions have changed, putting stress on returns, loss reserves and asset liquidity. Banks’ equipment finance leaders are having to defend their businesses as consistent with overall bank strategy. But, the equipment finance product should not be cast aside without fully understanding the risks and opportunities the business holds.

DRAMATIC SHIFTS IN THE EQUIPMENT FINANCE MARKET
A key reason banks enter the equipment finance market is the liquidity of the paper and the relative ease of growing or contracting through syndications as needs change. In the recent low-rate environment, banks could opportunistically acquire or sell assets via the syndication market depending on priorities. As the Fed ratcheted up interest rates, however, asset liquidity tightened sharply, as discounting the paper at current rates would yield book losses for the seller.

The COVID-19 pandemic also had a dramatic impact on the equipment finance market. Initially, there were supply-chain issues due to worker, raw material and component shortages, as well as consumer demand shifts. Goods backed up at ports without a viable means of transportation as the trucking industry lost numerous companies and workers. The void was filled by new entrants, and shipping revenues spiked upward for a while. They dropped sharply, however, as the supply chains normalized, exacerbated by rising fuel costs.

Government subsidies masked the problem temporarily, but without them, the trucking industry saw depressed asset values and rising delinquencies and defaults. The construction industry faced challenges as well, with rising mortgage rates choking off demand for new homes and rising fuel costs squeezing margins. Fuel costs have impacted many other industries, some of which have successfully passed through the costs, while others could not.

REFLECTING ON PORTFOLIOS AND FINANCIAL CHALLENGES
Some banks also elected to participate in equipment finance by providing funding to leasing companies seeking capital and an intermediate funding step before securitization. If a bank entered into such a relationship primarily by analyzing past performance, recent macro-economic trends could drive unexpectedly poor portfolio performance.

As market challenges have unfolded, many banks look back at portfolios built over time with a new perspective — one that currently demands a book-to-hold orientation. Asset classes that have chugged along in good times are reflecting the current financial challenges of their industries. Without a syndication “safety valve” to manage concentrations, banks must understand fully what they have, especially with higher losses, deteriorating LGDs and delinquencies.

Regulators are keenly aware of these challenges and are focused on potential portfolio issues. The question is, do you want to wait for an audit to discover what these portfolios hold, or would a more proactive approach keep the bank in good stead with its various key constituencies? An informed third-party opinion can often help reinforce management’s perspective on the business to bank management, the board of directors and especially compliance and regulatory officials.

EVER-EVOLVING EQUIPMENT FINANCE
Not all is doom and gloom in the equipment finance market, however. Investment in enterprise computing and networking is continuing due to a rapidly-evolving IT environment. Also, several industries have made sustainability commitments to their stakeholders, and equipment finance represents a viable means to build assets in key markets such as climate equipment.

Equipment leasing (as opposed to loans), a product long suppressed by a low-interest-rate environment, is seeing increasing demand as a means to acquire assets. Meanwhile, it’s also managing the risks of ownership and technology cycles and matching payments with the benefits derived from the new equipment. Additionally, as the Fed signals potential rate reductions over the coming months, statutory liquidity concerns may become less of a driving force.

Maintaining an EF presence during these challenging times will position a bank for future growth as management priorities shift to asset expansion.

THE FUNDING GAP
Other opportunities exist because some banks have de-emphasized or sold equipment finance businesses, leaving a significant opportunity for independent leasing companies and banks that provide their funding. Independents are not immune to the market conditions described above. Any prudent lender needs a strong understanding of not only the company’s financials, but also the places in the financials where problems can hide.

This unique mix of market conditions makes understanding your portfolio critical to defending your equipment finance presence to stakeholders. It is vital that banks not lose sight of the opportunities EF provides for the sake of navigating the current storms.

WHAT BANKS SHOULD BE ASKING

Some of the questions a bank’s equipment finance unit should be exploring are:

• With all the market fluctuations in play, is the portfolio what you think it is? Are there concentrations that need to be managed or explained? Do industry-specific risks need to be addressed and understood? Are there transactions showing early signs of financial stress?

• Are you prepared for regulator reviews and internal strategy discussions?

• Are there opportunities in the equipment finance market that fit your strategy and could drive future growth?

• Is there bench strength in your organization to understand market opportunities and risks?

• Is your residual portfolio a risk or opportunity given recent asset value fluctuations? Similarly, those who participate in the equipment finance market through lender finance facilities need to understand their client base.

Leaders should ask:

• Will clients’ portfolios hold up to the scrutiny of an independent review?

• Do you understand your clients’ markets as well as you need to?

• Would you benefit from a dispassionate review of your clients’ strategies and markets?

• Is there a viable exit strategy for your client’s lending facility?

The time to understand these issues is before a problem arises or an opportunity is missed. A thorough understanding of the equipment finance portfolio can help defend its existence and position the product for future success. •

Gary LoMonaco is a senior managing director and head of the business assessment practice at The Alta Group, a global advisory firm exclusively dedicated to equipment finance since 1992.