Ambiguity of Residual Pricing

by Lisa Miller Jan/Feb 2014

Although equipment replacement continues to surpass expansion, the asset managers assembled for this year’s Monitor roundtable discussion note that certain industry segments are picking up — and some are red hot. All agree that competition is fierce, especially in the investment grade arena, but now is not a good time to loosen up on asset management discipline.

Dennis A. Bolton II,
SVP, Equipment Management Group,
Wells Fargo Equipment Finance

James Grace,
SVP, Equipment Management Executive,
Bank of America Merrill Lynch

Terese Kramer,
VP, Equipment Management Group,
BMO Harris Equipment Finance Company

Will Tefft,
SVP, Equipment Management,
CapitalSource

The U.S economy is expected to grow 3% in 2014 — the fastest pace since the 2008-2009 recession — and the rising interest rate environment could motivate companies to lock in lower rates while they still can. Businesses are making equipment acquisition decisions in a dynamic environment, and asset managers must take extra care to play their cards right.

According to ELFA’s “Annual 2014 Equipment Leasing & Finance U.S. Economic Outlook” released in mid-December, investment in equipment and software is expected to grow 3.1% in 2014, as economic conditions solidify and business confidence heals. ELFA’s more recent report on the “Top 10 Equipment Acquisition Trends for 2014” predicts that U.S. businesses will spend more than $1.5 trillion on capital goods and fixed business investment while financing more than half of those assets.

Discipline Remains Critical

Equipment replacement continues to beat expansion in most market segments. Certain industry segments are picking up, and some are red hot. Most agree that now is not a good time to loosen up on asset management discipline.

“We do not believe our practices should be adjusted for temporary or cyclical conditions, but rather they should persevere throughout the full business cycle,” says Will Tefft, senior vice president, Equipment Management, CapitalSource. “We acknowledge that certain assets come in and out of vogue from time to time, but we remain agnostic: If the price is right, the fundamentals are present, and the structure makes sense, then a transaction is likely to be acceptable.”

“We have a tried-and-true approach to the services we provide across the leasing company,” relates James Grace, senior vice president, Equipment Management Executive, Bank of America Merrill Lynch. “We do a consistent, thorough collateral analysis for all the transactions we look at. We manage them ‘from cradle to grave,’ which includes setting the residual on new equipment financing opportunities, portfolio reviews, collateral analyses for credit migrations and managing the end-of-term process. We deploy sound, proven policies and procedures while focusing on our clients’ needs.”

“Residual value setting, equipment portfolio management and remarketing are the three key areas that equipment managers tend to focus on,” explains Terese Kramer, vice president, Equipment Management Group, BMO Harris Equipment Finance Company (BHEFC). “We continue to take a holistic common sense approach to RV-setting. We use the fundamentals of appraising to determine values and then consider such factors as lease term and structure, historical customer behavior, return conditions, pending regulatory issues and equipment life cycles.”

“Our scale is a ‘distinctive competence,’ which provides us the opportunity to not only develop an industry-specific focus but also better identify and understand competition, industry trends and market and technology changes,” states Dennis A. Bolton II, senior vice president, Equipment Management Group at Wells Fargo Equipment Finance. By “distinctive competence,” Bolton refers to the company’s scale and ability as characteristics that distinctly differentiate it from much of the up-market competition.

“That scale allows us to proactively manage corresponding opportunities and risks in each of these areas and gives us our competitive advantage in managing our business and serving our clients. If you take a look at our platform, you can see that we are in many equipment markets in a variety of ways. In addition to our large-ticket, middle-market and small-ticket businesses, we have a vendor business and various specialty groups focused on specific asset types. We are deeply entrenched in these businesses at many levels.”

Technological innovation will continue to play an important role in managing assets as well as improving the customer experience. “Equipment portfolio management is mission-critical to our overall business success,” articulates Kramer. “The better we can evaluate and analyze our portfolio, the better we manage our risk. This means having strong, user-friendly reporting and database tools that make it easy to mine data from our systems.”

“Rather than ‘dialing for dollars,’ technology allows us to be more proactive by harnessing historical data along with data acquired from third-party experts,” notes Grace. “We can import data into sophisticated, analytical tools that help us accurately project future values as well as volatility of values within any given industry. Asset diversity is another element of effective portfolio management. Well-distributed asset risk allows consistent residual profitability during turbulent economic times when one or several markets may be in a down-cycle and others are stable and profitable.”

“Our experience tells us that some institutions latch onto trends and/or try to extend or pretend with respect to the useful life,” laments Tefft. “Those philosophies tend not to be rewarded in the long run —though they do have the short-term benefit of increased volume.”

Consistent Underwriting Practices

“We will continue to stick with our core equipment underwriting practices that have worked for us through the ups and downs of the economic cycles,” declares Kramer. “These practices have helped us build a balanced and healthy portfolio.”

“Wells Fargo’s strength is its consistent approach to risk,” claims Bolton. “As such, our approach will not change, but our outlook on different industries, markets and their associated risks will help define our strategies. For example, if an industry is white hot, our strategy toward it may soften, because we are concerned that asset valuations are unrealistic. We look at the underlying economic drivers and industry developments that impact the overall supply chain.”

“We apply the same policies and practices using supportable, defendable methodology year after year,” asserts Grace. “We will continue to enhance our internal analytical tools and work with third-party experts, such as appraisers, inspectors and remarketers, to support our assessments as we manage risk in the portfolio.”
“In this highly competitive environment, the discipline of equipment management becomes ever more critical as a way to differentiate ourselves,” emphasizes Kramer. “Our expertise is a critical component to our growth, and there is increased pressure on the equipment manager to understand the dynamics of specific markets. Given the vast amount of equipment we must analyze, equipment managers have to be generalists, but there is also an increasing need for them to become subject matter experts in the company’s core growth equipment sectors.”

“At some point, our market will see a downturn, and when it comes, the institutions that have stretched and mispriced the asset or credit will suffer and pull back,” warns Tefft. “We have already seen institutions radically alter their approach to the corporate aircraft market and some maritime assets as a result of the last downturn. Those that didn’t experience the pain of the last downturn — either through luck or skill — have rushed in to fill the void. They don’t have the institutional memory or scars.”

What’s Hot and What’s Not

Being in the market on a day-to-day basis, asset managers know where there is demand and where it is absent. “The U.S. is undergoing an energy renaissance that was, essentially, developed from a cottage industry, so there hasn’t been a lot of consolidation yet,” says Bolton. “There are a lot of equipment needs relative to frac spreads and drilling rigs for companies developing and maintaining wells, but it goes beyond that. Existing pipeline capacity cannot handle the new volumes coming from non-conventional plays such as Barnett, Fayetteville, Anadarko, Utica and Marcellus. As companies start producing gas, non-gas liquids and oils, they have to find a way to move them into the market. The traditional infrastructure is insufficient to meet that demand, resulting in investment and expansion in other methods as evidenced in the number of tank vessels and rail cars being built. In that sector, you have to look at what is happening in production and how that spills over into the rest of the market.”

“New equipment requirements related to the movement of crude oil and related petroleum products has had an impact on a diverse set of equipment types — from inland barge tanks to rail tank cars to tank trailers,” affirms Kramer. “The backlog for new build in some of these equipment categories is 18 to 24 months. Like all equipment managers, we watch supply and demand developments closely. At the same time we must understand the impact of regulations and legislation that accompanies this expansion.”

“The marine sector is driven by oil, gas and technology changes,” continues Bolton. “For all the oil and gas work done offshore, there is an increasing need for larger vessels that can go out into deeper water. Moving gas, oil and non-gas liquids across the country is driving the inland market.” Grace added that blue water bulker vessels and Jones Act product tankers are doing better while other tankers and container ships remain depressed.

Tefft cautions, “The caveat would be that some of the newer, operational pipelines appear to be moderating future demand for this transportation. But so far it has been a very hot market, especially for the inland tank barge and tank rail car markets.”

Bolton reports that coal production, especially in the central Appalachians, has been affected by regulatory and environmental concerns over emissions. “Because many of those power plants are shutting down, there has been an impact in the eastern style, smaller capacity railcars, and we’re starting to see softening in the marine sector’s coal barges as well.”

“CAPEX for mining equipment was non-existent in 2013, and we believe that will continue throughout 2014,” remarks Tefft. “Some new projects are underway, but most investment is focused on low cost approaches, and creditworthy opportunities are limited to perhaps 20% to 30% of the levels of 2010-2012. There is weakness and stagnation, even in desirable ‘like new’ idled equipment in the secondary market. Until that equipment begins to sell, we don’t think there will be any acceleration or increase in new equipment orders. This also extends into related equipment such as open hopper barges and coal gondola rail cars that transport coal.”

“We have seen quite a bit of activity in the transportation sector, namely commercial and corporate aircraft, rail, marine and trucking,” affirms Grace. “There is a significant amount of investment taking place, but it has more to do with replacing aging technology in existing fleets than it does with expansion of capacity. There is a lot of technology built into this equipment, and lessees need to keep up with the times; the cost of maintaining assets increases exponentially rather than just linearly.”

Residual Realization Trends

Bolton says that 2013 was a good year for residual realization as companies continued to either purchase their equipment or renew leases. “Used inventories were largely resolved, improving values, and the slow but steady economic recovery certainly appears to have helped improve stick rates and overall equipment demand.”
“Portfolio performance metrics in 2013 continued to show improvement from the previous year, but not much more than we expected,” conveys Grace. “We talk about the ‘stick rate’ as the likelihood that equipment reaching lease maturity will stay in its current location. During periods of recovery, lessee retention of the equipment tends to increase, resulting in the lessor receiving a higher price for the equipment as compared to having to sell returned equipment in the secondary market.”

“Good five-year-old or younger used equipment was in short demand which drove used equipment prices up in 2013,” recalls Kramer. “In addition we tend to lease ‘critical use equipment,’ so our customers generally renew or purchase their leased equipment. When we have had the opportunity to realize a gain on disposition, we have done very well.”

“When we began CapitalSource in 2010, the general economic climate was less favorable and less competitive,” remembers Tefft. “Sentiment was much more pessimistic, and that allowed for more conservative residual values. Subsequently, although we have had limited maturities in our portfolio, our residual realizations to date have been in line with or favorable to expectations. We anticipate this trend will continue into 2014.”

Replacement Versus Expansion

“Our activity in 2013 was based primarily on replacement demand, merger and acquisition activity and refinancing,” expresses Tefft. “We continue to see customers taking conservative approaches to immediate, identified projects. Most of our customers are retaining existing equipment and trying to maximize its useful life and utility until it must be replaced. Some are taking advantage of the flexibility provided by leasing and returning equipment at lease maturity, since it is no longer necessary in their operations.”

“The pursuit of newer technology and increased fuel efficiency motivate companies to retire or trade in older equipment and invest in newer technology,” speculates Grace. “All equipment sectors are impacted, but especially those in the transportation sectors, such as container shipping and aviation, where a key differentiator between competitors is price. With high fuel oil prices forecasted well into the future, finding an attractive asset that will provide some technology to improve efficiency is going to make that asset much more attractive to own. I expect this trend to continue in 2014.”

“In the large corporate market, companies have built up their cash reserves and are beginning to expand,” shares Kramer. “In the middle-ticket market, the activity seems to be more replacement than expansion. Some sectors are mixed. For example, some hospitals have built up cash reserves during the downturn and are now showing a preference to use these reserves to acquire equipment. Recently a Class I North American railroad purchased hundreds of locomotives with cash instead of using financing to cover their expansion program. So, it’s a mixed bag as to whether financing activity is replacement demand or capacity expansion or both.”

“We have seen both replacement and capacity demand through equipment orders and acquisitions,” concludes Bolton. “We are optimistic this will continue in 2014 as the general economy continues to recover.”

The Critical Role of the Asset Manager

“The greatest variable in our industry is residual pricing,” asserts Grace. “Here it is critical for the asset manager to protect the company’s balance sheet while ensuring the competitiveness of the firm. The asset manager does this by refraining from setting unrealistic, aggressive residual positions on new investment transactions. But the market requires that we stay competitive, so you can’t just sit back and assign ultra-conservative, low book residuals on new financing opportunities, because you simply won’t win much of the business. The market forces you to play fair and to be competitive.”

“Increased pressure on asset managers to assume risk for higher values is a concern that currently faces our industry, and our decisions will determine the long-term success and performance of certain leasing companies,” stresses Bolton. “At Wells Fargo we dig down deeper to see what in the transaction will give us the comfort level to be more or less aggressive. For example, one of our clients is working on a very long-term project, and it is going to need the equipment for at least the term of the project. We understand how this client uses and maintains its equipment. Proper use and maintenance allows equipment to keep its value as compared to other shops where they take less care. It is the discrete characteristics of the project, the customer, the operation, and how the equipment is being used that helps us better gauge our risk-taking to support our client and protect our investments.”

“The extreme level of competition in 2013 is something I have never seen in this industry,” exclaims Tefft. “Just as today’s individual investors are challenged to find acceptable risk-adjusted yields, lending institutions are also challenged. This is creating a situation where risk-free assets such as treasuries are priced near zero, and riskier assets are following the curve downward, being priced very low and possibly even mispriced.”

“Competition is fierce in the investment grade and near investment grade credit arena with yields and rates decreasing,” notes Kramer. “Bank lessors have the advantage of low cost of funds. Fortunately we have been able to capitalize on BMO Financial Group’s healthy balance sheet as well. We have seen that equipment management’s input is an essential factor in our origination decision-making process.”

The Team Approach Wins

“Success comes in partnering with your internal team to present the most attractive solution to meet your client’s needs,” suggests Grace. “You work with the originator to customize the structural solution and partner with other team members for flawless execution in closing the deal. It is your people in pricing, tax, documentation, credit underwriting and other disciplines that help ensure that the structure and overall pricing of the transaction make sense to your organization.”

“We bring all of our assets to bear,” asserts Bolton. “When we talk to a customer, we’re talking to him about multiple products and solutions. We work with all of our business lines and banker partners to understand our clients’ needs and engineer products to best meet those needs.”

Kramer says the mantra of ensuring a great customer experience is at the heart of everything they do. “This translates into a commitment to build strong relationships and a high level of communication, not only with our customers but also with other parts of BMO Financial Group as well as other BHEFC teams in credit, documentation, tax and accounting. It also means building long lasting and trust-driven relationships with our subject matter experts. Our external service providers, such as the people we hire to do our marine inspections or third-party desktops, provide guidance on new technology and regulatory issues. We have the same level of commitment, communication and team spirit with those folks, too.”

“Transactions are not falling into our laps,” admits Tefft. “We are challenged to be more resourceful and innovative in seeking clients and transactions that are a fit on a risk-adjusted basis. Yields for the most competitive deals are in the 175 bps range, and one large bank lessor recently released financials showing 130 bps compression in margins. While this is not our market, it is indicative of where the market is. When the risk-free rate of return is zero, what is the appropriate rate of return for riskier assets? At present levels, our industry may not be contemplating the full credit and equipment risks. It is an interesting time to be in the business.”

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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