Scott Kiley VP, Indirect Origination, Fifth Third Leasing Company

David Coutu President, MassMutual Asset Finance

Joseph Thompson SVP, Capital Markets, AIG Commercial Equipment Finance

Quantity and Quality Point Toward Improvement
For Scott Kiley, vice president of indirect origination for Fifth Third Leasing Company, in Cincinnati, both the quantity and quality of leasing transactions must be evaluated together to get an accurate sense of how 2010 compared to 2009.

“In broad terms, our total volume for the bank corporation was up about 5%, to about $1.2 billion in 2010,” Kiley says. “Our particular group, for the buy side, was up almost 30%.” But Kiley is quick to point out that much of Fifth Third Leasing’s success last year was attributable to at least two factors.

“First, we did several large transactions over $20 million, which helped us achieve our budget,” Kiley says. His company’s buy-side transactions are normally in the $7 million to $8 million range and, in the direct business, national out-of-footprint arena, most deals are closer to $5 million, with affiliate leasing deals within the bank footprint bringing up the rear at between $1 million and $2 million. So closing several large transactions went a long way toward bolstering Fifth Third Leasing’s 2010 performance. “Secondly, we finished the year with two very strong quarters after a slow first half, which seemed to be a carryover from the weaker activity in 2009,” says Kiley.

New business activity in 2010 was likewise strong for Foxboro, MA’s MassMutual Asset Finance, according to David Coutu, president.
“[It] was actually a very strong year for us,” Coutu says. “We were up about 15% over 2009.” Coutu has been with MassMutual since 2004, participating in the company’s evolution and growth from what was a startup, Winmark Equipment Finance, to a wholly owned subsidiary of MassMutual, MassMutual Asset Finance. The company remains focused on its syndication buy-desk model.

“Our strategy focuses on booking larger-ticket leases in the investment-grade space,” Coutu says. The spreads are not as wide in this market, as opposed to middle-market business, but you can be very efficient with larger deal sizes for high-quality credits. The staff has doubled in size to 13 since forming the company and MassMutual prefers to keep the overhead low, adding staff as necessary to support the buy-desk model.

Like Kiley, Coutu saw “a couple of oddball large transactions” contributing significantly to the overall strong showing for MassMutual in 2010. But he is still very pleased with the year: “While we were concerned with the events of the recent past, it turned out to be a really good year for us.”

But if a strong quantity of transactions is only one-half of the formula for success, how did the other half of the equation — deal quality — play out for leasing companies in 2010? For Kiley at Fifth Third, almost anything would have been an improvement over what he had seen the previous year. “[Deal quality in 2010] was definitely better than what we saw in 2009,” Kiley says. “2009 was challenging not only because we looked at fewer deals than in years past, but because the quality of the deals was weaker as well.”

“What was especially good was that you didn’t see the crazy, ‘loosey-goosey’ terms and really crazy pricing that we had seen so often in 2006 and 2007,” Kiley notes. But he’s quick to add that while 2010 marked a return toward stability and normalcy in pricing and structure, with more transactions and better overall quality, pricing had to soften.

“The flight to quality — and Fifth Third Leasing focuses on quality credits — did cause some spreads to compress during the year,” he says. Kiley saw that with many leasing companies chasing the strong credits, the disparity in the availability of liquidity was still pretty great.

“You still had a lot of money chasing the good deals, but I think the average, in the ‘single-B’ credit space, is still lacking sufficient funding liquidity — and that’s a space that a lot of the banks have walked away from or avoided,” Kiley says. Because of that, he says, the pricing in his company’s space definitely came down in 2010.

Coutu saw a similar downward trend in pricing with MassMutual’s portfolio. “There still appears to be a lack of discipline in the pricing arena, in terms of what people expect for an investment-grade spread versus what they expect for a middle-market-type spread,” Coutu says. “To us, that gap does not appear to be wide enough when you compare it to the bond markets and other relative value measures.”

He adds, “I guess that would be the only negative we saw in 2010 in terms of the quality of the transactions before us: the credit was there, but the pricing wasn’t quite as good as it has been.”

The Critical Role of Credit Standards
What role, if any, did changing credit standards have on how transactions were booked? Was it a case of credit standards for buying being raised or that the typical credit had eroded as a result of the recession?

For Joe Thompson, senior vice president for capital markets at AIG Commercial Equipment Finance, in Plano, TX, tighter credit — whatever its source might have been — was probably a key factor in the leasing industry throughout 2010. But because of the unique constraints his company was operating under as a result of issues at the AIG parent company level in 2009 and 2010, Thompson had only limited opportunities to weigh the impact of credit standards on his business. “In 2009 and 2010, we had limited funding in our traditional middle-market space due to these issues. In September 2010, we were asked to begin originating large investment-grade deals directly for the insurance companies,” Thompson explains.

For Coutu, neither rising credit standards nor eroding credit scores had an appreciable effect on how MassMutual fared in 2010. “I didn’t see either of those factors impacting us,” Coutu says. “If anything, I thought the banks that had not been buying deals heavily in the 2008 and 2009 period were perhaps more aggressive [in 2010]. Coutu did not see any substantial change in credit standards, but notes that MassMutual had always had high-quality credit requirements, and had increased its pricing starting in late 2008.

“We don’t change a whole lot at Fifth Third,” Kiley explains. “We’re kind of an anomaly in that we’ve always focused on the better credits. I can tell you that over the 11 years I’ve been here, our credit standards have not materially changed in terms of what we go after.”

In fact, Kiley says, if Fifth Third’s credit standards are changing at all, it’s perhaps reflected in a movement down the credit curve. “We had more success in 2010 than in years past going down the credit curve to some extent,” Kiley says. “If you only play in the better credits, it limits your box. Our ability to go down the credit curve allows us to look at more structured-up kinds of deals, where we can have more influence on the kind of structure,” he explains.

He notes that Fifth Third did have some success with widening the credit box, getting more of that done in 2010 than it had in prior years. “In 2008 and 2009, people were just scared; they were kind of frozen,” Kiley says. “There’s definitely been a thawing of the credits since. In 2010, the standards might have been lowered a somewhat compared to 2009, which is kind of consistent with our movement down the credit curve a little bit.”

Looking But Not Buying?
So if credit standards were rising, was the number of transactions being considered going down? Did higher credit standards make it easier to eliminate certain deals from consideration earlier rather than later?

Coutu saw a reduction of about 5% in the number of deals MassMutual considered, but he is less certain that this reduction is attributable to a more stringent credit filter being applied to potential deals. Instead, it was believed to be increased appetite of banks to hold transactions, as well as good old-fashioned skepticism, he says.

“While we didn’t really raise our credit acceptance criteria, I do think we had more of a wary eye on some of the credits that had been having difficulty during the recession. While they may have been showing some signs of improvement, we weren’t ready to take a gamble on that; we wanted to wait a bit longer,” Coutu says.

For Kiley, more and closer scrutiny was definitely warranted. “I think in general we definitely had to look at more deals to get to the numbers in 2010 than in years past,” he says. “First of all, there were more deals to look at, and, secondly, 2010 was a year of some normalcy, with the pendulum finally swinging back from where it had been after the crazy years of 2006 and 2007.”

Thompson found AIG doing its share of looking but not always turning up much for the effort. “A lot of deals we looked at were not collateralized to the extent that we wanted them to be in that environment,” Thompson says. And he sees a logical explanation for both the greater scrutiny and why it was inevitably yielding fewer viable transactions. “When you think about it, when was the better time to invest: in 2007, or in 2009?” he asks. “You were getting favorable pricing and favorable structures that you’re not getting today.

Thompson feels the leasing industry’s credit mentality places a premium on historical results, particularly on performance over the last three years, which it then attempts to extrapolate into the future. “I’m not sure that’s the best way to look at things; you’ll get caught by cycles doing that,” he explains. “You’ve got to have a strong stomach to step in, like Warren Buffett does, and acquire assets, which is the business we’re in — building assets — in such a difficult economic environment,” says Thompson.

Kiley agrees, and Fifth Third has seen evidence to support the overall tentative nature of the markets during 2010. “Companies were still reluctant to borrow and to make capital equipment investments,” according to Kiley. “So, there were more deals in 2010 than in 2009, but, compared to the heights of 2006-2007, not nearly as many deals to look at. He adds, “I think we did have to plow through more deals to get to the ones that met both our credit and pricing criteria.”

Positive Momentum But Steering Clear of Risks
While the overall movement has been positive during 2010 and momentum seems to be growing for the remainder of 2011, leasing industry leaders remain alert and cautious about the very real challenges that remain.

For Kiley, an ongoing challenge is finding new credit names to invest in that Fifth Third’s direct sales force has not already engaged. “Due to a combination of the same large companies accessing the equipment lease and loan capital markets every year, and our own success in buying and originating billions of dollars with many of these same names, it’s refreshing — but unusual — to be presented a large opportunity with a company that I’ve never heard of before.”

At AIG, the challenges were predominantly internal, but Thompson is optimistic that a corner has now been turned. “Our story for the past two years has been funding availability due to issues at the parent-company level,” Thompson says. He notes that while his group did get some limited funding in 2010, it was very price sensitive.

“We really eliminated soft-collateral deals. Pricing could be a non-starter for us, and a lack of a reasonable collateral position could be a non-starter,” says Thompson. “Because we had limited funding, we were really going to be careful with where we put that money to work.”

And certain sectors raised red flags throughout 2010 — and will continue to do so in 2011. For example, Kiley reports that Fifth Third is being more cautious on new transactions in the energy sector. “Energy credits had a lot of capital equipment financing needs from 2007 through 2009, and we did a lot of business, just like many of our peers,” he notes. “Trucking was also very difficult, as was construction, in 2010,” he says.

Coutu says MassMutual was similarly cautious during 2010 with financials and any transactions with an exposure to the oil spill in the Gulf of Mexico. For Coutu, the reasons for caution in these areas were fairly obvious. “Financial institutions were not quite where they had been in the past decade; they were starting to come back, but we somewhat avoided them,” he explains. And then as the significance of the gulf oil spill became more obvious, its potential impact on MassMutual’s portfolio became a priority. “We knew we had to take a pause on some of the credits related to the spill,” Coutu says. “We probably would have done more business in both these sectors in 2010 if we didn’t have the yellow light on them.”

For Fifth Third, a shift toward asset retention closed many doors that had been open for business in previous years. “One of the other huge factors that limited our ability in 2010 to do even more business is that people wanted to retain assets — they wanted to hold them,” Kiley explains. “They didn’t want to sell them; they didn’t want to syndicate.” In addition, Kiley notes, hardly anyone was selling aged business out of their portfolios. “It used to be that 40% to 50% of the volume we saw in our shop was aged. Last year, I’m guessing it was more like 10% or 20% — much less,” Kiley says.

Coutu has seen the same trend at MassMutual. “The banks were definitely looking to hold a lot more assets than they had in previous years, when they were a little more wounded,” he says. “In some sense, the competition faced by the buy-desk market was attributable to the appetite of the banks to hold assets.”

A Look at 2011 & Beyond
It’s clear that 2010 was a year of mixed blessings for leasing companies, with positive momentum growing on many fronts but an equal number of challenges emerging. But where is the industry headed for the foreseeable future?

Kiley is overwhelmingly positive about Fifth Third’s immediate prospects. “This is the busiest first quarter I’ve ever seen,” Kiley admits. “I’m knee-deep in deals, and I’m feeling optimistic that businesses are starting to step back up and buy equipment.” But he admits there are going to be bumps along the road: price erosion will continue because there’s more and more liquidity coming back into the market, and when that happens, prices inevitably come down.

“I think that bonus depreciation is going to have an interesting and, at this point, undetermined impact,” Kiley says. “I’ve got my own feelings, but a 100% bonus, where you can write everything off the first year, is going to have positive impact on our industry because it will spur some of the people that were on the fence looking to buy equipment into actually doing so.”

But Kiley does have some concerns, as well. “Sometimes I get worried about the follow-the-herd mentality, especially as it follows the flight to quality,” says Kiley. “My gut tells me we as an industry have got to have liquidity in the BB-, the single-B and the privately held areas,” he says. How to foster that liquidity remains to be seen.

After a very difficult past two years, Thompson is optimistic for AIG’s prospects, especially with the parent company’s funding issues largely resolved. He is welcoming a return to the leasing playing field — and with a strong parent company to provide the support necessary for success.

“We have moved from being a middle-market finance company to being an investment-grade finance company,” Thompson explains. With the prospect of leveraging the AIG insurance companies’ monies, Thompson is excited about the prospect for the greatest availability of funds his company has ever had. He can’t help but be optimistic at the thought of being able to address only the external challenges of his business, not the internal ones he has dealt with over the past two years.

“Our portfolio has performed very well through this recession. With our funding issues resolved, we’ve got a strong appetite for new business, and we’re really looking forward to the next few years,” Thompson says.” He predicts AIG is going to be aggressive this year; from a funding standpoint, the company is aiming to do at least $500 million of new business. “We’re excited to effectively be out of the penalty box, if you will, and back to doing business.”

And MassMutual is poised for growth, too, according to Coutu. “I’m highly positive the industry is on its way back up,” he says. “It’s just a question of how quickly we’ll get there.” While he doesn’t see wholesale changes in focus, Coutu does see MassMutual pursuing some more non-investment-grade-type business, provided that the yield is satisfactory.

In addition to being a very highly rated company with a strong balance sheet, MassMutual is very liquid, according to Coutu. “The company is looking to deploy that liquidity into attractively yielding assets, and they’ve given us the green light to selectively pursue some of that business.”

But challenges remain, Coutu admits. “My concern is that there’s a lot of cash on corporate balance sheets, and I wonder if these companies will turn to leasing,” Coutu says. “I think that’s one of leasing’s biggest obstacles right now: the level of cash on corporate balance sheets.”

He adds, “Even though we’re seeing signs that we’re climbing out of the recession and coming back, I wonder whether that will translate into immediate increases in leasing business because all these companies have so much cash and interest rates are so low.” While he admits to being cautiously optimistic about 2011, Coutu remains curious to see whether companies actually begin to spend their abundant cash or not.