Buy Desk Dilemma: No Change on the Horizon

by Lisa A. Miller March/April 2016
Though they don’t agree on the method, our buy desk roundtable participants do agree on one thing: the lending environment needs to change. Lisa Miller catches up with three capital markets executives who discuss the delicate balance between pricing, terms and valuation.

The Greek philosopher Heraclitus said, “Change is the only constant in life.” Though most of us resist change, we also yearn for it. Which brings us to the topic of today’s lending environment and its frustrating lack of change.

When we asked capital markets executives to join this year’s roundtable, each remarked that he had nothing new to say: This year looks like last year, and last year looked like the year before. So we asked, “If you could have just one wish, what single change would be most beneficial to the current lending environment?” Surprisingly, there were three different answers:

“Pricing, far and away!” says Bob Wright, SVP Capital Markets Buy Desk at Wells Fargo Equipment Finance. “Pricing is key to bring the risk/reward more into balance. If we could change pricing, it would make the industry healthier. It’s important to bring in new people and new blood. With the current rate environment, people have no choice but to focus on making very thoughtful decisions and watching all their nickels and dimes. I think this makes our industry less exciting for people who might come into it, and that’s not good for the long-term health of the industry.”

“An increase in interest rates would benefit the industry the most right now,” says Steve Gray, SVP of Capital Markets at BB&T Equipment Finance Corporation. “When rates rise, an increase can accelerate the decision process for someone sitting on the fence thinking about acquiring equipment. The depreciation becomes more valuable to the lessor, and the leasing alternative becomes more attractive to a lessee. If rates rise, corporations may want to hold onto their cash and use financing and leasing to get their CAPEX financed.”

“I would choose economic growth,” says Eric Stazcek, SVP of Capital Markets at MB Equipment Finance. “When the economy is growing, companies buy equipment, and that creates opportunities. I’m not sure how confident financial decision makers are about the economy growing, and that is the biggest driver of capital equipment acquisition.”

Unfortunately, wishing doesn’t make it true, so we turned our conversation back to reality. How did 2015 volume performance measure up to expectations? Were there any surprises? “We exceeded plan by a nice margin, but from a volume standpoint, it was an odd year for us,” says Wright. “The year was very good through the first nine months, but in the fourth quarter it was a little softer than we anticipated. It felt as if equipment acquisitions tailed off a bit; it seemed more like an economic issue than any specific industry issue.”

“We had an aggressive plan for both the direct and indirect sides,” says Gray. “Deal flow was less than expected throughout the year, and we knew it would be a challenge to make our number. A few unexpected deals dropped our way in December, and we pulled it out at the end. That was very rewarding.”

“We hit all of our production and other measurement goals,” says Stazcek. “It was a really good year, but the challenges in 2015 were the same as in 2014. There is too much money chasing too few deals. With the margin and pricing compression, everybody tries to buy the same deals, and that drives rates down.”

“More and more companies are looking to build their balance sheet and assets, and they paid attention to that across the year,” says Wright. “It could be that those companies wanted to retain a high level of assets on their books at year-end. We still did a lot of business in the fourth quarter — more than any other — but it was not as robust as we would have thought. In the first quarter of 2016, we have quite a bit of activity. It’s starting off well — not great, but good.”

BB&T’s plan will again be aggressive in 2016, but the burden will be shared. “On the indirect side we have shifted the buying of tax exempt paper to BB&T’s government finance group,” says Gray. “Previously we had been buying government paper on the equipment finance side. In essence we have the same plan number for indirect, but it is now split between two divisions of the company.”

“Last year we strategically refined our business model to focus our efforts, first and foremost, on our direct origination channel, which grew considerably,” says Stazcek. “Our indirect channel goals were intentionally reduced from the previous year to facilitate our organizational focus on the direct channel. In 2014, our indirect channel represented approximately 75% of our business, and we completely flipped that in 2015. We intend to continue growing our direct channel and leverage capital markets — both inbound and outbound — to strategically support both our customers and investment partners.”

Finding the Balance

The balance between pricing, terms and valuation is a delicate one. “At this time of year I like to look at trend analyses for the business,” says Wright. “From a pure pricing perspective, spreads continue to decline. I don’t think they can go much lower from where they are today, but I said that last year. Our valuations are pretty consistent. We don’t make drastic changes in one direction or the other, but we do see that people got more aggressive in 2015.”

“There has been a flight to quality on the buy desk, and the better credits command such low rates that it gets kind of silly,” adds Stazcek. “Some companies are becoming more aggressive on structure, too. As an example, we have seen offering memorandums where terms have been stretched, especially on transportation assets. It feels similar to pre-2008 recession conditions. I expect pricing pressures to continue. There is just so much money in the marketplace, and the volume of deals available for sale is smaller than it has been for some time.”

Gray agrees. “Spread compression was the biggest factor, and that grew out of the fact that there just aren’t enough deals for sale. Everyone was holding more of the business rather than syndicating. When you get rate compression like that, it doesn’t leave enough room to make much of a fee when you sell. A lot of the deals that otherwise would have come to market did not do so.”

The decline in the oil and gas business has a pervasive effect across the economy. As consumers, it is hard not to be happy about the price at the pump, but when you work in finance, you are painfully aware of the other side of that equation. “I’d like to see equilibrium,” says Gray. “It is possible for a price to be too low. It helps people, but it might mean they can go out to dinner once a week again. Meanwhile, a lot of other people are losing their jobs. The price of oil affects a lot of industries — especially transportation, rail and marine. It touches a lot more [industries] than most people understand.”

“Most prognosticators weren’t anticipating a $30 barrel of oil, so that industry became more and more challenged as the year went on,” says Wright. “We are not doing as much business in that space, and neither is anyone else. If you are, you are probably taking on a higher level of risk than you were before.”

“The last two years, the oil and gas sector drove a lot of the economic growth in the capital equipment market,” says Stazcek. “Clearly the decline in that market sector created investment headwinds from a risk standpoint, and I don’t know what is going to replace it. There is economic uncertainty about whether we are in — or are about to enter — a recessionary environment, and companies seem very conservative with their investment and expansion plans.”

“I don’t see how it is going to get any better in 2016,” says Gray. “All the players have aggressive hold budgets, and so many deals touch oil, gas or coal industries, which are a problem for a lot of banks right now. Many deals that we would have done in that space a year or two ago aren’t possible now.”

Stazcek says, “The best way to meet your numbers is to become very selective and adjust your outlook accordingly. We met our overall company targets by doing mostly direct business this past year. The direct channel gives us a better depth of underwriting, because we have direct access to financial decision-makers, which mitigates the need to rely on the secondhand information typically characteristic in buy-desk transactions. We have seen the larger SIFI banks move mostly into the investment-grade and near-investment-grade space, and that has provided more opportunity for the smaller, less-than-$50-billion banks to capitalize on opportunities with middle market credits.”

Wright feels that the risk-versus-reward was, and remains, out of balance — especially at the non-investment grade end of the scale. “Many of the companies in that category are getting structures and pricing below where they should be. Across the board, we saw deterioration in structures. Terms are stretched out in certain circumstances, and the competitive landscape as it relates to residuals became more competitive.”

BB&T prices off a return on equity model that is driven by the risk grade of the credit. “That determines the spread that is required over our cost of funds,” says Gray. “It boils down to two different paradigms. One is your threshold of creditworthiness that indicates whether you can do the deal at any price. The other is the threshold of pricing tolerance that indicates whether you will do the deal at any price. You have to balance both. Because of the spread compression, the pricing tolerance paradigm has become paramount for us. As a bank, the deal has to pass or fail an internal credit test, and we price it from there. That makes it a matter of will we versus can we.”

“The competition for buy-desk deals is so intense that the returns are being driven lower across the risk spectrum,” says Stazcek. “We stuck to our risk/return guidelines and actually had higher year-over-year margins in our indirect channel. In fact, we are going to stick to our risk/return and credit profile, even if it means slower growth in the portfolio. That will ensure portfolio stability and enable us to realize acceptable current and prospective returns.”

Resisting Temptation

To compensate for the new normal of risk-adjusted rates and compliance issues, there is a temptation to change the credit review process. Our panelists resist that temptation with great resolve. “BB&T has strong risk policies and a reasonable risk tolerance, and we have always been consistent in applying that,” says Gray. “We really scrub a deal, so not much has changed there. Some underwriters wonder if there’s a recession looming and if we should look at some deals a little closer, but other than that, our credit review process is the same. Credit does join us on a few more calls these days, but we’ve always brought them in at the early stages.”

“Our credit review process is always under review, because we always try to enhance it and make it better,” says Wright. “By better, I mean faster but with quality decisions. We put more resources and discipline around that process, especially with our large deal team, to make both quality and timely decisions.”

“We have always engaged our credit team early in transactions, often before we bid them,” says Stazcek. “Our credit review process hasn’t really changed. Clearly, there have been some changes for companies exposed to the oil and gas industry or for those that have commodity risk. In those sectors, we probably dig a little deeper in the underwriting process when evaluating new opportunities.”

“Compliance certainly has impacted the process and continues to do so,” says Wright. “We want to play by the rules, and we want to do it well — that is very much a part of our culture at Wells Fargo. We want to be one of the top compliant companies in the space. It creates challenges for us, but in the long run, we feel it will play to our favor.”

Gray adds, “Compliance is the word of the day, and we all have the same issues there. It creates additional steps internally to stay compliant, but it’s necessary, and there is nothing wrong with really knowing your client.”

Price compression, low interest rates, tight margins and increased competition continue to rule the day. “There has been no change, and it’s going to be more of the same,” says Gray. “There have been many new entrants during the last couple of years — and an exit or two — but it surprises me to see new entrants in a business that is so compressed.”

“New entrants into the marketplace will likely continue in 2016, but maybe not to the same extent,” says Wright. “What’s going on with GE Capital has an impact on the overall industry. It is difficult to say what that impact will be, but it will be positive for us.”

“The effects of GE’s exit remain to be seen, but I think it is going to affect the whole industry,” says Gray. “I cut my teeth at GE about 35 years ago. I watched it grow, and it’s sad for me to see it end. It will create opportunities for people who want to do a finance company type of credit as opposed to a bank-type of credit. It’s going to be interesting. This environment makes each deal that much more precious. You can’t stumble. You have to make sure you can deliver the deal that you are expected to deliver, quickly and efficiently.”

“At the pricing levels where we are doing business today, you can’t afford to make mistakes,” says Wright. “With these spreads, you have to make the best possible investment decision you can.”

“It seemed that sellers held more of their originations for their own accounts, and that limited the supply in the market,” says Stazcek. “Then there was such a thirst for buy deals, from new and existing players, that the demand was huge. So again, we had that imbalance of limited supply, and huge demand driving rates down. If you have something to sell, there is an active market for it. Since we moved from a net buyer of business to a net seller in 2015, we hope to bring some new product to market and fill some of the supply.”

Finding Opportunity

While technology increasingly helps with compliance and transaction processing, there were no big changes affecting the buy desks in 2015. “We look at technology as a way to enhance our processes and constantly improve the amount of information we get, so we can improve our decision-making,” says Wright. “That is very much front-of-mind for us. We also use it to make sure our offerings give our clients better access to the information they need to do business with us.”

“Things have certainly changed over time,” says Gray. “Back in the day, we would print pages and put books together to send out by Federal Express. I’d have a wall full of books with deals I couldn’t even do, and now it is all done electronically through various sharing sites. Now the buyers do the printing instead of the sellers! We installed a new IT system here about two years ago, and it makes us more efficient internally in the way we process things.”

“We are using best-in-class technology to create a CRM and workflow system that lets everyone within our organization know where any transaction stands at any point in the process,” says Stazcek. “We leverage the technology to enhance our communications and make sure our buy desk is not in conflict with our direct originations team.”

In a mature business, where do you go to uncover new opportunities? “You can go into different specialties, change your ticket size or adjust your credit parameters to expand your box,” says Gray. “We just merged with Susquehanna Bank, and their leasing platform will help us expand our small ticket business opportunities. The government finance business was a separate and distinct business, and that has come under BB&T Equipment Finance as well. We now have three major segments: government finance, small ticket and middle-to-large ticket. We’ve ventured into aircraft, too. A lot of people got out of that space, but we are very committed to it and plan to expand our aviation team this year.”

“We will continue our expansion into the small ticket area, a direction we took in 2014 and 2015,” says Wright. “The capabilities we have in the small-ticket space have allowed us to offer portfolio purchase to some of the small-ticket companies out there. In 2016, we plan to take a closer look at the government space. We play in that space now, specifically state and municipal, but we will look to expand our role within the buy desk.”
“I expect there will continue to be opportunities in the middle market area due to our organic growth and, to some extent, the divestiture of GE Capital,” says Stazcek. “GECC was a significant player in the middle market, and I believe both the industry and MB Equipment Finance can step up and fill some of the void.”

“The biggest challenge is to stay disciplined,” says Wright. “In today’s environment, it is easy for the sales people to pursue volume at a cost that won’t lead to a good decision. Your structures need to make sense, and it’s important to play in the marketplace in a way that lets you feel comfortable.”

“The challenges are pricing, credit quality, hold limits, compliance, you name it,” says Gray. “There’s nothing new.”

“Pricing will likely be a challenge in 2016 for indirect transactions, as the demand/supply imbalance has created continued margin pressure in the market,” says Stazcek. “We are selective where and with whom we invest in this channel and have been unwilling to trade price for volume.”
“I am always excited at this time of year,” says Wright. “Everyone wakes up early in the year realizing you are starting all over again. You’re at zero and you have a big number to hit, but it’s almost a rebirth. There are always new and different things on the horizon.”

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