ROUNDTABLE PARTICIPANTS

But if 2005 was the year of competition, 2006 brought it up a notch. Just how much is apparent in the fact that one asset manager this year backed out of our interview after the first question, citing his fear that competitors might pick up on something of his strategy. “Call me paranoid,” this manager said, “but I’m concerned about my portfolio.”

Still others said they were too busy to participate or simply didn’t respond to phone calls and e-mails seeking their comments.

In February, when some 400 asset managers gather at the Equipment Leasing & Finance Association’s (ELFA) annual Equipment Management Conference & Exhibition in Tucson, AZ, I suspect at least some of those in attendance will be tightlipped when it comes to sharing business strategies.

Fortunately, not everyone we asked to comment this year saw the industry as quite that cutthroat, but all agreed that increased competition continues to be a driving factor for asset managers.

“The leasing environment remains very competitive, maybe more so than in prior periods,” says Bernard Funk, a senior vice president at Key Equipment Finance.

Dennis Bolton, managing director of Wachovia Leasing & Equipment Finance, agrees, and says equipment finance companies are pushing to meet their volume in a margin-challenged environment.

“The most successful companies are leveraging relationships and finding new ways to create customer value and differentiate themselves from the competition,” he says.

Bolton, who serves on the Management Committee of the upcoming conference, says pressure on residuals, structure, fee income and expense controls have all increased as a result.

“The environment this year has been extremely competitive,” adds Brian D. DeRusha, director of asset management at AIG Commercial Equipment Finance. “More companies are looking to increase their volume by expanding their product offerings in different sectors and locations.”

Among these, he points out, are the areas of public financing, franchise financing and cross borders ventures — particularly opportunities in Canada.

In fact, in March 2006, Statistics Canada issued a report on the commercial finance sector that indicates investment in leased equipment in the country is on the rise. Since the beginning of last year, several leasing companies have announced major initiatives and personnel shifts north of the border — among them PacLease, ICON Capital, Hertz Equipment Rental and Key Equipment Finance.

Besides industry and regional diversification, a competitive market has led some leasing companies to branch out into deals and deal structures they once may have avoided.

According to Barry Rollins, vice president of collateral valuation and management at Merrill Lynch Capital, appetite for volume is leading to increased activity in non-traditional sectors.

As a result, Rollins suggests, even traditionally high-risk, high-yield structures are feeling the pressure.

“Competition is becoming heavy for less-than-investment grade credit transactions,” he explains. “Increased attention from large banks and other finance providers that traditionally avoided this space are negatively affecting returns for these transactions.”

Furthermore, as competition increases, customers gain leverage over the structure of a deal. One asset manager from a large national company who asked that he not be identified, said that as companies strive to be more flexible to customers’ options at the end of the term, new challenges emerge for equipment managers to maximize returns. Thus, leasing companies in general — and asset managers specifically — are taking more risks.

Sidney Sexson, an executive vice president of CIT Construction, says asset managers have been forced to be more aggressive in setting residuals. He adds that he expects that the challenge of maintaining residual balance in such an environment will be a topic of discussion in Tucson.

Sexson says that asset managers today are forced to walk a fine line. “It’s necessary to look at each deal on its own and analyze all factors before setting the residual at an amount that is high enough to have a chance to win the deal, yet not so high as to unduly increase the risk of downside at maturity.”

“Aggressive residual setting is the easiest route to compensate for lower margins,” says Rollins. “Unfortunately, it’s easy to book aggressive residuals but harder to actually get them in the end. Short-term focus leads to long-term margin issues.”

Carol Neale, equipment manager of TCF Equipment Finance, says while it’s easy to fall prey to such temptation, she spends more time looking at alternatives to price incentives to win over customers.

“We’re very conservative when it comes to residual setting,” says Neale of her team. “While volume is important to us, we’re not going to jeopardize credit quality or take increased residual positions.”

DeRusha agrees. “A concerted effort has to be made not to adjust residual values based on market pressures,” he says. “Sometimes the best deal you can do is the deal that you don’t do.”

The key, adds Neale, is being creative in both the structuring and delivering of deals to offer customer value beyond simple rate setting.

“We ask ourselves what else do we have to offer that the competition doesn’t and how can we add value to a deal by selling turnaround time or relationships or other sorts of things other than just that we have the biggest residual value so you’re going to get the lowest payment.”

DeRusha says there are better ways to maximize returns than with risky residual positions. “If anything, keeping residuals at appropriate levels and reducing the margin has the same effect as increasing residuals,” he says. “It’s just that you then have profitability issues, not volume issues, to deal with.”

“Residuals always must be directly linked to the value of equipment,” warns Richard Newton, senior vice president of asset management at Chase Equipment Leasing. “Any attempt to violate this separation will only prove to bring less rather than more revenue in the long run.”

Last year, another key topic that once again reared its ugly head was fraud. Several high-profile cases — some of which have impacted the industry’s leading players — brought the subject of risk management back into the spotlight. Not a conference passed in 2006 without a roundtable, panel or seminar on the subject.

AIG’s DeRusha is one of three executives who will discuss the topic in Tucson on a panel entitled, “Identifying and Dealing with Fraud: Flags for Prevention.” He says it’s a mistake to dismiss the role asset managers need to play in fraud prevention.

“It’s the asset managers’ responsibility to change the culture of lending institutions by stressing the critical importance of having assets verified, inspected and tagged,” says DeRusha.

Neale agrees that too often it’s easy to dismiss fraud prevention as someone else’s problem. She says asset managers need to be more proactive in insisting that risk mitigation procedures get followed for every deal.

“I don’t think that asset managers have been given the opportunity to play that role,” she says. “It’s almost like by the time the deal gets at the asset managers’ level, somebody else has already decided that we’re not going to spend the money or take the time to do it right.”

“Dedicated, trained and experienced asset professionals can go a long way to help avoid pitfalls,” says Newton.

He recalls one particular deal he passed on last year that he calls one of the “largest recent reports of lending fraud.” Newton says something about the transaction just didn’t feel right. “Our analysts could not get satisfactory answers to specific questions about the equipment involved and we shut the transaction down.”

But in such a competitive environment, often the overriding pressure to get a deal done leads to the cutting of corners. According to Rollins, there’s simply no good excuse for taking shortcuts.

“When someone states due diligence will lose the deal, that’s when proper due diligence is most critical,” he says.

Rollins suggests asking probing questions from as many people as possible, and analyzing presented information including purchase orders, invoices and marketing materials. After that, he says, “If something seems strange, dig further, and learn from your mistakes.”

This time last year the economy was roaring along at full speed, leading the Federal Reserve to embark on a year of belt tightening that by the end of the summer had pulled the rug out from under the residential construction market and was beginning to be felt across the economy.

Just about everyone we spoke with said the economy remains strong, but all noted volatility in specific sectors and warning signs of a pending economic slowdown.

“I’m somewhat surprised that the period of growth in the economy has been as strong and as lengthy as it has,” says Newton. “We have to keep an eye on the future, looking for signals the economy has peaked.”

Rollins says this environment has produced a certain cautious optimism about current portfolios and future transactions.

“The macro economy is currently stable, but there has been much volatility in a number of industries,” says Rollins. “Certain sectors have seen tremendous growth in a number of deals while other sectors have stalled.”

He says that among other things, asset managers this year will be talking about volatility in Class 8 truck purchases, where the energy sector is heading, if U.S. automotive manufacturers will pull out of their marketshare slide, and when and to what extent cooling in the housing sector will affect customer base.

Aggravating these concerns are indications that industrial spending may be on the slide. Back in November, the Institute for Supply Management reported that the manufacturing sector failed to grow for the first time in 41 straight months. And last October, new orders for durable goods took their biggest hit in six years.

The Virginia-based trade group Manufacturers Alliance/MAPI says U.S. industrial production is on pace to rise just 2.6% this year, a pronounced slowdown from the 4.8% growth in 2006.

At the same time, backlogs in many sectors are at record levels. Key Equipment Finance’s Funk says asset managers are already experiencing the pressure of extended delivery schedules and longer lead times on equipment (he cites 2006 orders with 2008-2010 expected delivery). Funk says this has created an anomaly in the market.

“Premiums were added to the price of used equipment due to the longer than usual delivery schedules of new equipment,” he explains. “The challenge is does the lessor residualize the total price or the pre-anomaly equipment cost? The market reflected both positions, which will potentially impact future gain opportunities at lease expiration.”

Sexson says he has seen a similar trend in the trucking sector, where apprehension over new regulatory standards prompted a pre-emissions buying spree last summer. “We are seeing strong used truck values and expect that trend to continue until new engines are a proven commodity. We certainly won’t be taking an aggressive residual position on trucks powered with new engines early on.”

Bolton agrees. “A residual impact is expected in the used market as companies look to late model vehicles in the short-term as pre-2007 new inventory has been depleted.”

Meanwhile, economic factors such as a stagnant housing market, a slump in domestic auto sales, inflated oil prices and slowing GDP makes the question not if the economy will bottom out, but rather how hard it will hit.

Yet everyone we talked to stressed that the market is mixed and some sectors continue to thrive despite the softening economy, particularly business aircraft, rail and marine.

Rollins says the key is to take the ups and downs in stride. “Our industry will always have ebbs and flows, you have to remember to roll with the changes and try to anticipate rather than react,” he says.

“We, as an industry, will always have to deal with a changing environment with different dynamics,” says DeRusha. “The institution that is open to change and not set in their ways will be the best suited to take advantage of new market trends.”