The Evolution of Risk Assessment: Asset Managers Master the Art & Science of Equipment Valuation
by Lisa A. Miller January/February 2017
In today’s environment, asset managers must not only understand the equipment itself but also the client’s needs and behaviors, regulatory requirements and changing risk appetites. Monitor contributor Lisa Miller catches up with four asset managers who discuss the ever-evolving process of equipment valuation.
Successfully assessing equipment values in today’s marketplace is a multi-faceted responsibility that falls on the shoulders of the asset management team. Already faced with the diminishing balance between risk and reward, asset managers work in a world where new regulatory requirements or an unforeseen market swing can change values overnight.
We invited four asset management leaders to tell us more about the integral role their teams play in closing transactions. We began with a discussion of whether asset managers should be specialists or generalists.
Will Tefft, senior vice president of Equipment Management at Capital Source, believes institutions with equipment-specific expertise outperform generalists in the competitive arena for new transactions and the end-of-term ability to redeploy equipment. “There is a trend toward incorporating more technology into equipment that makes the equipment more customer-specific, site-optimized or purpose-built. Institutions with specific asset-management focus are better equipped to understand what that means with respect to value and resale markets. A truck is not a truck as much as it used to be, because companies acquire them to be optimized for their own operations. When you bring it off lease and offer it to the broader market, it’s going into a different operation, and the value changes.”
“Our residual analysts, who do the front-end pricing, are specialists,” says Bill Gallagher, director of Portfolio Servicing and Asset Management at CIT. “They have a thorough understanding of the program and lease documentation, industry segments and equipment specifics in addition to the potential outcomes such as an early upgrade or end-of-lease purchase, return or renewal. All these details factor into the pricing and residual setting.” On the flip side, CIT’s internal remarketing team understands the equipment and is operationally focused. “They are in tune with our standards for service level agreements, issuing return authorizations, receiving condition reports, dealing with missing and damaged equipment and the monthly tracking of inventory through the sales process.”
At Key Equipment Finance, everyone, with the exception of one analyst, is a generalist, but each analyst has one or two areas of expertise. “Those analysts stay current by going to conferences and maintaining contacts in those industries,” says Amy Paine, senior vice president of Asset Management. “In some markets, we have specialists on the sales side who provide asset managers with contacts and information. Because we finance a significant amount of IT assets, we have one analyst dedicated solely to IT.”
Stonebriar Commercial Finance relies upon the collective expertise of its asset managers, senior executives and strategic partners. “Our asset managers are ASA-designated, have significant appraisal and remarketing experience and have the technical expertise and pedigree to be both generalists and specialists,” says Kevin J. Sensenbrenner, senior vice president and senior managing director of Asset Management. “Senior executives running these platforms and strategic partners also provide expertise and know the asset types and industries extremely well.”
As asset managers play an increasingly important role in creating better quality deals, opinions vary as to what degree they should be involved in the structuring process. “Asset managers provide an unbiased assessment of the value of the equipment, whether that means the current value or projections of the future value,” Tefft says. “Our input allows the deal team to make the right decisions and develop the right structure for the transaction. For the more complex equipment types, an asset manager can be an important member of the structuring team when value is critical to the transaction. For smaller ticket or more common assets, I don’t think the asset manager needs to be involved beyond providing input regarding equipment value.”
“I’m a firm believer that everybody in asset management — and probably everybody in a leasing company — should understand pricing and the product set,” Paine asserts. “In one case, an asset manager here was very familiar with a product used in one vertical. While working on a transaction for another vertical, she realized that the product might be a better fit for the client and offered it as a solution to the salesperson. It is now a standard product in that vertical.” “Stonebriar’s structuring process is a collaborative effort,” Sensenbrenner says. “Our industry and asset expertise helps our originators determine the best solutions for our customers while matching risk with long-term economic objectives. We work with all departments from direct originations to capital markets to credit/risk.”
Gallagher believes that asset managers should be involved in the structuring as well as the negotiation and development of new vendor relationship program agreements. “When we are in lock-step with the vendor and have an understanding of the end-to-end process, we can create an exemplary customer experience. An asset manager who understands the entire process — from originations, negotiation and documentation through to the end-of-lease disposition and reporting process — is in the best position to serve the client.”
Managing Regulatory Guidelines
Since regulations affect both financial institutions and equipment sectors, regulatory knowledge is a priority. For the regulations pertaining to financial institutions, Key Equipment Finance relies on an internal, business-savvy, dedicated compliance partner. “She works in the larger compliance group but acts as our liaison and stays up to date on the industry,” Paine says. “She’s been proactive about keeping us informed on regulatory guidelines and how they impact our business as well as what’s on the horizon. She also shares feedback from her interactions with the regulators.”
CIT’s asset management team collaborates with their compliance and vendor management groups. “Our vendor management group screens every new partner whether it is for appraisals, freight work, storage or remarketing,” Gallagher says. “This includes vetting the contract and insurance requirements as well as meeting know-your-customer and other regulatory requirements. We do a legal review of the documentation and a risk review of each partner to ensure that all regulatory requirements are met.”
As a private independent with non-regulated capital, Stonebriar’s limitations are less rigid. “You always have to stay informed with regulations that have an impact on our industry, but institutional regulations have little impact on Stonebriar. We are uniquely flexible and resourceful to our customers and have advantages in the markets we cover.”
“Regulatory risk is perhaps one of the most important trends we’ve seen in the equipment management space over the past 15 years,” Tefft says. “A lot of it is driven by environmental regulations and has led to volatility for lessors in the short run. It has left equipment owners, including the lessors, with stranded costs. Some very long-lived assets, such as coal cars, have effectively been regulated out of existence. They were once 30- to 40-year assets, and now some are scrapped at 10 to 15 years.”
Tefft notes that another instance of regulatory impact is the crude-by-rail cars where a sizeable chunk of the fleet was made obsolete or required significant expense to retrofit cars to comply with new regulations. “These unanticipated costs created a dislocation in the market and, for many, a severely underperforming asset. The asset manager’s job has become more challenging in this respect, and it requires staying up to date.”
“For those regulations affecting equipment, we go through the normal channels to stay informed,” Paine says. “In addition to industry publications, conferences and consultation with experts, we have business partners — such as appraisers, brokers, dealers and auction houses — that share information that may affect our assets.”
“We closely monitor regulatory-sensitive equipment used in rail, aviation, marine, trucking and energy sectors,” Sensenbrenner says. “We attend relevant industry conferences, review and retain industry research, routinely gather information from our customer and, most importantly, have conversations with strategic partners within each industry.”
“Our regulatory requirements for the equipment itself is limited as all of our deals are sourced through vendor or dealer partners, and they are required to meet the regulatory requirements of the new equipment placement,” Gallagher says.
If President Trump fulfills his campaign promises, there could be a rollback of Dodd-Frank measures and the existing regulatory framework. For lending institutions that have made a significant investment in regulatory compliance, this could be a game-changer.
“Should they effectively roll back some of the current regulatory framework, we expect an impact to regulated capital,” Sensenbrenner says. “We also expect a more relaxed environment to offer immediate benefits to our customers and the industries they work in, ultimately influencing how they finance their capital expenditures.”
“I have gone into 2017 expecting the status quo for the time being,” Gallagher says. “It’s uncertain if there will be a rollback of regulations. We have solid practices in place at CIT that will likely remain in place regardless.” Tefft agrees it is too soon to know what will come out of Washington with respect to financial institutions.
“It’s important to remember the difference between repeal and non-enforcement,” Paine says. “If the regulations aren’t repealed, you still have to be ready to comply. Regulatory changes around specific equipment types could have a bigger impact. I’ll be interested to see if there are changes at other departments such as the EPA, Department of Transportation or Federal Communications Commission.”
The Changing Marketplace
On the changing elements of risk assessment, Tefft says, “It is the risk appetite of the market that changes from year to year as lessors expand and contract their target credit risk profile and their outlook for equipment. Subsequently, the profile changes for the companies or transactions for which you can compete, and you underwrite appropriately.”
Sensenbrenner sees industry cycles and equipment segments becoming more volatile, particularly for commodity-based industries. “It’s important that we closely monitor our industries and assets, have good access to data and the expertise to appropriately interpret and normalize the information. This enables us to mitigate the impact of swings in values and demand. Asset managers must have a global view, so they can develop dynamic exit strategies that match these fluid markets.”
“We have seen the lessee wanting less risk in the equipment with more risk going to the lessor or the vendor,” Gallagher says. “There are more managed solutions where they bundle the soft and hard costs into the transaction and have a per-usage type of payment arrangement. Assessing and determining the risk on those types of transactions is evolving.”
“We saw increased interest in managed service contracts, particularly in the IT space,” Paine says. “That has a different kind of risk assessment in it, because you’re looking at performance risk and not necessarily equipment risk, and you have to look at essential use. In 2017 we will watch for changes to the regulatory environment and how long it takes to implement them.”
Occasionally one asset class falls out of favor for an industry-specific reason, but in 2016 Tefft saw less asset demand across a wide swath of industries. “This year we observed greatly diminished demand for coal and frac-sand cars, corporate aircraft transactions, drilling rigs and pressure-pumping equipment for land-based oil and gas industry. There was little demand for offshore supply vessels, crew boats, anchor-handling tugs and transportation related to coal and crude oil. On the plus side, medical equipment, general over-the-road assets, plastic packaging and construction equipment did well and maybe even outperformed.”
Key Equipment Finance saw significant demand for alternative energy financing, managed services and software, rail and over-the-road trucks in manufacturing. “Areas with less demand included anything associated with oil and gas as well as IT hardware and medical,” Paine says. “Everything is so much more software-oriented now. The mandates in the Affordable Care Act put pressure on the need for improved medical record systems, and that probably decreased investment in large equipment, such as MRIs and CT scanners.”
“We have seen very good opportunities in rail, business aviation and heavy industrial segments,” Sensenbrenner says. “We tend to focus on income-producing, essential-use assets, regardless of industry, to offer the most leverage in a default scenario. Like many others, we are conscious of fossil-based industries and related assets.”
“For technological assets we see more soft costs, managed solutions and usage-based proposals and less hard assets,” Gallagher says. “The market segment is more mobile and more involved in controlling costs. The usage-based application allows companies to pay as they use rather than buy hardware they may not use to capacity. We expect more of this in 2017.”
“There is potential for stability, or at least a floor, under corporate air and the coal-mining space,” Tefft says. “There may be some decline in automotive-related assets, whether related to production or transportation. It’s too early to tell what the future holds for crude oil and energy-related assets.”
Sensenbrenner expects an increase in infrastructure and manufacturing spending as well as uplift in commodity-based industries. Paine doesn’t expect much to change but points out that an increased focus 2017on rebuilding infrastructure could have a positive impact on construction financing. “However there’s a long time between deciding to do it and getting to the point where you need equipment,” she says.
Replacement demand continues to fuel the equipment finance industry. Whether 2017 will usher in a shift toward capacity expansion will depend on the sector, according to Paine. “We are likely to see an increase in IT hardware and software related to cyber-security. To compensate for that, IT procurement managers will hang onto their servers and extend their refresh cycles. So their IT budget might not grow; it will just switch. They’ll spend less on hardware, move to the cloud and increase spending on cyber-security.”
“There hasn’t been robust growth in the industries we typically finance, so vendors try to upgrade and extend the equipment or leases they have in place,” Gallagher says. “Their goal is to maintain the customer base and get a deeper wallet share with those customers. As a result, we have seen a high percentage of repeat, upgrade and add-on business in 2016 and expect that to continue in 2017.”
Tefft sees a lot of excess capacity in the CAPEX-intensive markets. “There are idled rail cars and low utilization for barges and offshore oil and gas equipment. Because many of these assets are relatively new, it may be difficult to right-size the population. Scrapping is the traditional method for disposing of old equipment, but we’ve seen the scrapping of newer assets, including seven-year-old container vessels. This creates a painful mismatch of projected life and usage for the owners. With the excess supply in the market, there may not be replacement demand.”
“Since the recession, economic growth has been sluggish, retrenching in some sectors with slow growth in others,” Sensenbrenner says. “We expect more capacity expansion in the infrastructure, utility and manufacturing sectors, should our economy grow and expand with the new administration.” “Alternative energy will definitely be a capacity expansion,” Paine says. “It is expanding now, but it’s nowhere near the point at which you would need to start replacing. At the same time, you’re going to see less spend in other energy sectors such as oil, gas and coal.”
“There may be some expansion in medical equipment,” Tefft says. “We believe there’s some pent-up demand created by the reimbursement environment of the past several years.”
Many factors can affect a company’s decision to invest in new equipment. Gallagher suggests many waited over the last six months to see how the election turned out. “Buyers who are in an industry that relies on government reimbursement want to understand what they will be reimbursed for. If there are tax advantages around certain investments, they want to know that, too. As the Trump White House formalizes its policies regarding equipment investment and the infrastructure investments they’ve talked about, it will drive company’s decisions on what equipment they need over the next few years.”
“The potential for changes to the corporate tax code in 2017 could lead people to accelerate or postpone decisions,” Paine says. “If they suddenly say you can expense everything in the first year, there will be incredible ramifications on the decision to lease or not lease.”
“We have already seen a rally in equities and bond rates,” Sensenbrenner says. “If the new administration reduces corporate tax rates and regulations and provides an environment beneficial to the repatriation of U.S. dollars, these factors will bode well for increasing capital expenditures.”
“To raise capital for potentially difficult market conditions ahead, some companies sought to unlock the equity in their existing owned equipment through sale leasebacks or refinancing,” Tefft says. “The key is to ask how the values are holding up on the transactions that were done and how those companies are performing. This gives us an idea of any trend moving forward into 2017.”
The Asset Management Edge
The fierce competition for desirable deals has required the asset manager to understand not only the equipment but also the client’s needs and behavior. “Valuation is both an art and a science,” Paine says. “In the mid-to-large ticket arena, it is no longer sufficient to simply say ‘this piece of equipment will be worth X dollars five years from now.’ It is important in any organization for all the stakeholders to collaborate on and understand a deal.”
“We have a strong, experienced asset management department with both general and specialized industry expertise,” Sensenbrenner says. “Our insight is of tremendous help to our risk analysis and profitability. Our work is used in identifying portfolio concentrations and in planning for industry cycles and exit strategies.“
“Winning deals is dependent on our ability to effectively price the residual and document the transaction in a way that makes it easy for both our vendor and end-user partners to do business with us,” Gallagher says. “The ease of doing business and the speed of answer is critical, because most vendor partners have multiple financing sources and want to take the deal off the street.”
“When viewing the Monitor 100, it seems to me that the list represents the majority of the companies doing most of the financing in the equipment CAPEX space,” Tefft says. “Some companies exited the space, which is significant because it reflects the current challenges of competition and profitability. It is in this fiercely competitive environment that the asset manager is most effective when identifying transactions with substandard risk and reward profiles.”
The transportation industry has been significantly affected by the pandemic economy. Now it is seeing a revival, from an equipment finance perspective, despite perceptions within the lending community that COVID-19 has had a negative impact.