As the Delta variant threatens to prolong the COVID-19 pandemic era, Monitor asked leaders from four Monitor 100 companies to provide advice for smaller equipment finance players that will help them create resilient portfolios.
John Beard, Senior Vice President, Risk, LEAF Commercial Capital
As we continue to navigate the COVID-19 pandemic, many smaller equipment finance companies may not have access to the same level of information upon which larger industry players rely. Our guest editors suggested we ask several Monitor 100 companies to share insights that could help the Monitor 101+ companies pandemic proof their portfolios.
Many companies are experiencing increased activity due to pent-up demand, but how can they ensure their portfolio remains resilient when this demand subsides?
“The level of pent-up demand varies industry by industry. Our partners are also facing supply chain delays, which is affecting equipment availability and hence opportunities to finance,” Teuni Breg and Andrea VanderLinden, heads of Risk for DLL in Wayne, PA, and Des Moines, IA, say. “Regardless of where we are in the cycle, it is important to stick to the basics. Prudent underwriting is key. Underwriting based on current conditions has long-term risks.”
“To a large degree, you ensure your portfolio remains resilient by sticking with the basics of credit, essentially adhering to credit 101 (booking credit-worthy customers, using good risk tools, ensuring score cuts are set correctly, pricing for the risk, etc.). But beyond that, the item that has given me a lot of pause recently is that we’re seeing inflated asset prices in certain segments, particularly on the transportation side in heavy over-the-road equipment such as tractor-trailers,” John Carroll, chief risk officer at ENGS Commercial Finance, says. “The price of that equipment has dramatically increased over the last six months and that has affected both new and used equipment. That really presents a danger to our portfolio. When the equipment prices fall back to traditional levels, will we have financed the equipment based on a higher amount than it was truly worth? Will that lead to loan-to-value issues when those equipment values come back to traditional levels?”
“The key to a resilient portfolio in all economic cycles is to maintain discipline in executing
your key risk management principles. To remain disciplined and consistent, it’s important to have a detailed plan and closely monitor performance from the 35,000-foot view right down to the ground level,” John Beard, senior vice president, Risk, LEAF Commercial Capital, says. “Especially in a unique environment like this one, vendors appreciate that kind of steadfast approach backed by rigorous planning and continuous monitoring of internal and external factors. It’s also critical to communicate details of what you’re seeing to vendors, not only to benefit their own strategic planning but also to give them confidence and insight into the rationale behind your strategy.”
“We must also keep long-term relationships and goals in mind and not make drastic adjustments because of current conditions or commercial pressure,” Breg and VanderLinden say. “There will always be opportunities to do more, and we should lean in compared to last year, but we still need to be prudent and adhere to risk appetite standards. By understanding your industries and customers there is opportunity to have very healthy portfolio growth.”
“It’s really important to provide your vendor partners with the right financing solutions to ensure they can continue to drive sales and meet the financing of their customer’s needs after that pent-up demand coming out of the pandemic does subside,” Justin Tabone, SVP, Originations, Vendor Equipment Finance, TIAA Bank, says. “It is additionally important that you partner with the right vendors, that you’re well-aligned with, that you have strong understanding of their markets and users and equipment to ensure that you can continue to bring competitive finance offerings to their customers.”
During the height of the COVID-19 pandemic in 2020, there were clear winners and losers when it came to equipment types. Beyond diversification, what lessons can be taken away from this phenomenon?
“It’s about continuing to research and identify new markets for expansion where there’s strong growth opportunities post-pandemic and be willing to exit markets that are mature or declining with unacceptable levels of inherent risk,” Tabone says. “There is a higher likelihood of execution if these expansion markets have adjacencies to industries you currently serve, but at minimum, you should ensure that you have the necessary resources to execute and compete in these new markets.”
“A key risk management principle is to maintain the quality of your origination sources and make appropriate risk management adjustments based on external economic factors and the respective portfolio performance based on your desired economic return,” Beard says. “While various industries have suffered disparate impacts over the past 18 months or so, almost every industry has had to deal with issues like fluctuations in equipment availability and shipping problems. In response, a lot of companies are retaining equipment longer than originally planned, so it’s also critically important to pay close attention to asset management. Work in close partnership with your vendors and related industry associations to determine which equipment types are experiencing expansion or retraction in the present economic environment. Also, pay attention to the critical nature of the equipment to the obligor. A key risk management principle is to diversify with respect to industries, asset verticals, transaction sizes, geographic locations, etc.”
“The pandemic accelerated trends that were already started, such as digitization and online retail offerings moving business away from brick and mortar,” Breg and VanderLinden say. “Tech equipment did well during the pandemic, as companies had to drastically ramp up how and where they worked, as well as digitize their business offerings.”
“I would really recommend that companies be focused on and be experts in the industries and markets that they serve,” Carroll says. “Understand the companies in your market, understand the collateral in your market, understand the performance of that market so that you can make appropriate decisions.”
“It’s really important that you have a subject matter expert on your industry to focus on the underlying equipment that you’re financing,” Tabone says. “Some of the questions you’d be asking are whether it’s essential use, revenue generating, or cost savings involved with that equipment technology. Another question to ask is how will these industries and equipment usage be impacted by sudden and unexpected disruption in the economy?”
Taking the industries that your company serves into account should also influence credit practices.
“One of the things to remember, especially in what we hope remains a time of expanding opportunities, is to avoid lending concentrated too heavily in industries based on short-term demand fluctuations,” Beard says. “It’s tempting to set aside discipline and planning in pursuit of these kinds of opportunities, but you face increased risk when economic conditions change. So, it’s important to keep your credit practices aligned with scores, portfolio performance by aging buckets, early-stage delinquency and other fundamental metrics. For smaller companies whose monitoring capabilities may not be as robust or support continuous, wide-ranging monitoring, manually auditing a percentage of transactions at certain cadences is an effective strategy.”
“We can’t ignore the impact the pandemic had on businesses and our customers. Some companies saw improved revenues, while others saw a decrease. Financial statements for 2020 (and likely 2021) probably won’t reflect or predict post-pandemic performance,” Breg and VanderLinden say. “Similar to when entering the pandemic, you need to be mindful of financial statements being backward looking and you need to understand how current events affect performance. So, when analyzing 2020 financials, factor in the impact of the pandemic. How well did they adapt/mitigate impact and were they able to navigate the challenges? Look at historical performance (2019) to normalize results and analyze forecasts. It is also important to keep in mind that there is still a lot of uncertainty as the pandemic carries on. We need to determine what is the post-pandemic normal and when will business be at that normal.”
“This really gets back to credit 101,” Carroll says. “Making sure that the customers and the obligors that you’re booking are good credits, that they are passing reasonable credit standards. Remember also that data remains predictive. Changing economic times doesn’t make old data non-predictive.” To illustrate this point, Carroll says credit scoring continued to effectively differentiate performance during the Great Recession. Although default rates increased for all score bands, inferior score bands continued to have worse performance than better score bands.
Tabone suggests looking at short-term performance and long-term trends that can impact industries of focus. “It’s critical to model the portfolio within each industry of focus through a hypothetical recession, determine how it will perform and ensure that the portfolio will be resilient enough to withstand any unperceived disruption or a significant economic downturn,” Tabone says. “Carefully forecasting potential delinquency, lessee defaults, reviewing the process for repossessing or remarketing of assets, these are all key components to sound portfolio management that must be considered. And then, finally, comparing the performance of the portfolio, the macroeconomic environment and how it is performing are also very important.”
In the current environment, what should be top of mind for the leaders of small equipment finance companies?
“First and foremost is to protect the health and safety of your employees in this fluid Delta COVID environment,” Beard says. “This will probably be via a hybrid onsite remote work model. Manage personnel resources and processes to achieve the appropriate service levels desired by your origination sources. The remote working environment has driven enhancements in IT capabilities. Stay disciplined on your key risk management principles to achieve the appropriate return to investors or ownership.”
“Automation is key,” Breg and VanderLinden say. “The processing of small-ticket transactions should be automated with very few touches, from application entry to a validated and closely managed scorecard to documentation and funding. Enhancing digital capabilities and ensuring robust data and reporting should also be priorities.”
“In the hubris of the 2021 economic conditions, it’s important that we don’t lose sight of traditional risk management,” Carroll says. “We know we’re going to hit another economic cycle in the future. We’ve lived through 2008, we’ve lived through 2020. We will face another economic cycle, so in the excitement of booking these loans and chasing this demand, we need to ensure that we maintain our credit standards.”
Carroll also suggests making sure your portfolio is priced from a risk pricing perspective to survive through the entire credit cycle.
“Make sure that the underwriting standards that you’re using, the customers that you’re putting into your portfolio, are customers who are going to be there long term and who are going to be able to fully pay off the obligations that you’re giving them.”
“Frequently evaluate the industries you currently serve,” Tabone says. “Growth and expansion opportunities should be considered, and the underlying risks associated with both. So, it’s both about evaluating the current businesses you’re in and constantly be looking for those new growth opportunities and really understanding the risks associated with both. Consider how these industries will be impacted by once-in-a-lifetime events, like we saw with the pandemic.”
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