The Quest for Increased Spreads: Changes Ahead for the Buy Desk
by Lisa A. Miller March/April 2017
Monitor contributor Lisa Miller catches up with three buy-desk executives to discuss the capital markets environment. While they faced unrelenting competition and tighter spreads in 2016, they remain optimistic about the year ahead as we begin to enter a rising rate environment.
You have to give capital markets executives a lot of credit. Year after year, they face the same obstacles — tight margins, stiff competition and lack of supply — yet somehow they manage to meet and exceed budget requirements. As they flip the calendar page to January, they once again switch on their optimism and focus all their energy on creating solutions that will propel them toward success.
We sat down with three buy-desk executives to review last year, the current market environment and what’s ahead. Though the lenders took different paths, they all did well in 2016. Wells Fargo Equipment Finance showed nice year-over-year growth and beat its budget by an even greater margin than in 2014 and 2015. MB Equipment Finance hit its 2016 origination goals and built a strong pipeline of transactions available for syndication in 2017 and beyond. Fifth Third Equipment Finance exceeded its budget and had a great year for volume.
“We did a number of deals over $25 million, and our credit folks were willing to support higher exposure levels on the larger investment grade names,” says Scott Kiley, vice president, territory manager of Indirect Originations at Fifth Third Equipment Finance. “Since we are willing to hold a higher amount, we were able to bite off more of those larger deals that came to market in telecom and IT. These were lower rate transactions. To offset that, on the other end, we increased our volume of the non-investment BB- and B-grade space and doubled our volume in that category in 2016.
“When you go down the credit curve, you have to be much more attentive to structure and collateral valuations that play a much bigger role in the underwriting,” Kiley says. “You stress projections and do more sensitivity analysis. We thrived this year, because we are buying a broader spectrum of deals now. It takes more time: We have to look at a lot, and we often say no. We look for secured transactions that are well collateralized or for essential-use equipment and it’s a direction we plan to pursue.”
Bob Wright, senior vice president at Wells Fargo Equipment Finance’s Capital Markets Buy Desk, has been expanding business in the area of participations. “We were never a major player in participations and preferred purchasing whole transactions. From an industry standpoint, participations weren’t done very much, but that seems to be changing. We found that, with certain whole transactions, it was sometimes difficult
to break the transaction into pieces that were fair for everyone. For example, if a transaction has multiple asset types, who gets what they view as the better assets and who gets the less desirable ones? Participations take that aspect of the deal off the plate. It can be more challenging to put participation agreements in place, but they can alleviate some of the discomfort that goes along with breaking a deal into individual transactions.”
MB Equipment Finance saw 2016 as a transition year. “We refined our business model to focus more on direct origination and syndication versus indirect originations,” says Eric Staczek, senior vice president, Capital Markets for MB. “To that end, we hired six new sales managers and one capital markets veteran, each with more than 20 years of experience. Hiring talent of this high caliber was a key part of our strategy and definitely influenced our performance by generating a significant amount of on-book volume and syndication opportunities.”
Kiley points out that his team saw fewer deals come to market in 2016, but there were some large transactions that helped tremendously in meeting budgets. “There was a big demand for deals but a lackluster supply for sale. I attribute that lack of supply to constrained capital expenditures, banks that want to grow assets, less refinancing activity and slow growth in industries that had been the mainstay of large-ticket assets.”
The Balancing Act
Risk and reward, equipment valuations in declining sectors, competition, interest rates, terms and pricing add pressure to every transaction with various outcomes.
“With a receptive public and private debt market, non-investment grade credits have had good access to cheap funding and good terms that allowed them to refinance when they needed to,” Kiley says. “Many of these deals have five- to 10-year maturities with big balloons that come due; as long as you can get those refinanced, everybody chugs along. However, if interest rates increase rapidly or a recession occurs, highly leveraged credits that can operate OK at the current level will not be able to refinance if their profits decline. If you are locked into a fixed rate deal, your reward will not go up, but your risk will. For the last few years, risks and rewards have come down as is evidenced by the fact that bank’s charge-offs across the industry are lower. If a recession hits, those companies can become risky very quickly.”
Wright likes to take time to review the past year to see if he can spot any trends. “Over the course of 2016, I saw a flattening in the margins we were getting on our transactions. There was still a slight downward trend, but it was much flatter over the course of the year, and that is a really good thing. An uptrend would be even better, but a flattening is good.”
“The trends from 2015 continued into 2016,” Staczek says. “There were new market entrants on both the buy and sell sides, heavy competition for secondary market transactions and pricing pressure. It was a great year to be a seller as the high demand created strong fee opportunities. MB Equipment Finance was successful bringing in several new funding sources in 2016, helping us manage exposure for our customers.”
“The spreads have declined and have even squeezed out some of the non-bank financing sources that started up after the financial crisis,” Kiley says. “Many non-bank equipment financing sources have formed in the last several years, with some backed by private equity, to go after tougher credits. They expected to get much higher returns and higher spreads. While some of these new players are having success, others have found that the volume and spreads didn’t materialize as planned — many bank lessors expanded their credit box and took some of those deals off the market at lower spreads.”
“Competition to win deals with customers drives rates down and that translates into thinner rates for the secondary market,” Staczek says. “The rising interest rate environment towards the end of the year made portfolio sales difficult. The economic uncertainty seemed to continue, and the increase in market rates did not have a noticeable impact on companies’ decisions to finance equipment.”
“Pricing stabilized, but it is still very competitive, unless you are willing to go down the credit curve, stretch on credit or increase residuals,” Kiley says. “There are enough players in the market that can absorb deals, so you have to do a combination of those things while still being prudent. If you can get some of the higher spread business, you can make some money and offset the lower spread deals.”
There has been little change in the balance of risk to reward. “It’s still out of whack in places, and there’s still a lot of money out there chasing the business,” Wright says. “If the economy grows at a faster pace, that might help because there would be more deals for the dollars that are out there.”
Kiley stresses that most businesses are still conservative on their equipment purchases and continue to do routine replacement rather than huge expansion purchases. “Refinancing activity has been a big part of the capital markets syndication world for the last several years, but it slowed dramatically in 2016, because most of the deals had already flushed through the system. Because asset growth and retention were key to a lot of banks, you didn’t see that many portfolio deals come to market. Historically, large-ticket assets such as corporate aircraft, rail and marine were the big contributors to volume. All of those industries were weaker in 2016. When those types of deals are down in our marketplace, because the purchasing of them is off, it trickles down to our volume.”
“I had hoped that the competitive environment might be less competitive, but I was wrong,” Wright says. “However, I do feel optimistic that spreads may have the opportunity to move up this year. I don’t anticipate them going down. I may be proven wrong, but I am hopeful that we will see a steady state and maybe an uptick as rates rise.”
“Secondary market pricing continued to be extremely competitive due to the imbalance between supply and demand,” Staczek says. “This imbalance resulted from originators holding more deals on book and the low pricing needed to win deals directly with customers. Terms continue to be stretched, especially on transportation and manufacturing assets.”
“The trends were positive for us in 2016, but I noticed something else in my annual analysis,” Wright says. “There was a change in the volume curve. Similar to other lenders of our type, our budget is back-end loaded, yet the volume curve was pretty flat. We still did more transactions in December than in any other month, but the volume levels over the course of the year were much more even than in prior years. I don’t know if that is a trend or an anomaly, but I find it interesting.”
When considering industry sectors in decline, a discussion of oil and gas is essential. “Our energy portfolio performed well due to our strong underwriting,” Staczek says. “Our selectivity in the industry continued, and we did deeper dives on credits that had indirect exposure to the industry such as transportation, construction and marine. We will continue to look at these deals in 2017, but we will not relax our underwriting standards.”
With extended volatility in the oil and gas industry, lenders practice caution in that space. “We had a few credit hiccups in the space in 2016, but overall we are comfortable with our exposure to the oil and gas industry,” Kiley says. “We focus on the larger, well capitalized players that can typically weather the downturns. A lot of the stress was with the smaller companies, some of which were start-ups that grew quickly during the fracking phase. When that activity stopped, some lenders were left reeling. There are still pockets of deal opportunity in refining and pipeline transportation. It’s the production end that suffered. If oil gets back up to $60 to $70 a barrel, some of these production activities will pick up, but I think we have seen a flushing of the weak players in that space.”
Wright claims that Wells Fargo will try to participate in the oil and gas space, but carefully. “We are very selective about what we do in this space. We are not alone in having some assets in our portfolio that are presently challenged, but we are not the kind of organization that flips the switch on or off based on whether things are going well or not in an industry. It helps that the price of oil is up to $50 a barrel, but that doesn’t change our stance drastically, and I don’t expect our view to change in 2017.”
Other sectors with strained equipment valuations were corporate aircraft, coal cars and tankers. “Tractors and trailers started coming down in values, too,” Kiley says. “I don’t know if the outlook in those categories will change much in 2017.”
What to Watch For
“Generating fee income from capital markets syndication is a bigger part of everyone’s budget,” Kiley says. “Growing assets and generating fee income is a balancing act, but fee income goes right to the bottom line. When I talk to my customers, who are the syndicators at all of the big banks, they tell me their fee budgets are going up. That’s a good sign for me, because that means they will have to sell more business.”
With a Republican-controlled Congress and executive branch, many people in the industry are hopeful that there will be some lightening of the regulatory rules. Wright predicts that Wells Fargo will continue to operate as if there will be no changes there. “If there is a change that benefits us, that would be great, but we are not counting on that.”
Kiley believes Congress will put Dodd-Frank under the microscope to look at its provisions closely. “All banks have significantly increased their costs for staffing and IT to implement the regulations, so a decrease could be a good thing. However, there is a counter side to the issues around tax rates. If you lower tax rates, there may be questions around the deductibility of interest, depreciation and how that expense may change. This could lead to other consequences that may not be positive for equipment financing, but that is yet to be determined.”
Wright warns that we’ve been operating in a decreasing or flat rate environment for some time, but that is starting to change. His concern is that newer people in the industry have not experienced a rising rate environment. “There are some unique challenges to managing the business in a rising rate environment. Companies need to focus on how they service their clients while not getting caught in a situation where they cannot get the expected return out of a piece of business. Rising rates present a significant challenge to people on the sell side, and that has a direct impact on the buy side in terms of their ability to originate a deal and obtain a profit when they sell it. If you aren’t prepared and well-versed in what you need to do to match business properly, it can cause some strain on an organization.”
In last year’s roundtable, Staczek told us that MB Equipment Finance hoped to fill some of the void created by GE’s divestiture of GE Capital. “We think we have achieved that goal with our new hires that increase our market penetration in the Midwest, especially in the manufacturing industry. We also just opened a new office near Austin, TX, which will be great for new business development in Southern Texas and Louisiana.”
Opportunities and Challenges
“Some of the bank lessors that we do business with have active vendor programs, and we’ll try to increase buying into that type of business,” Kiley says. “We did more healthcare-related deals in 2016 and plan to do more, though changes in healthcare laws could be disruptive in 2017.”
Wells Fargo’s acquisition of some of the GE Capital businesses in 2016 allowed it to broaden its platform and product offerings. “That is a big benefit for us,” Wright says. “Rather than focusing on an industry or geography, our challenge is to bring our broad platform and product range to bear on the marketplace. We have a lot of options, but we want to go to places where the opportunities are large enough to make us money.”
“Our biggest opportunity to develop new business in 2017 is through our expanded direct sales force and continuing to serve the middle market with our relationship-based approach,” Staczek says. “Given the expertise of our direct sales force, we’re able to serve as a trusted advisor to business owners and managers, which is the foundation of all new business for us. Pricing will continue to be a challenge, but we will not trade volume for rate.”
Wright’s challenge is to stay focused. “With our product breadth and range of transaction sizes — from small ticket to very large ticket — it is easy to get distracted. With so much out there, we really have to focus. If we do see an area of good opportunity, we need to focus on it rather than do something that appears one way one day and then pursue something very different the next day.”
Kiley reminds us of two major events looming over the industry. “Lease accounting changes may complicate decision-making, and changes to the corporate tax code may affect deductibility of interest and accelerated depreciation. Those can have major impacts on our industry, and we’ll have to follow it closely and respond accordingly. The lease accounting changes have been rolled out, but they don’t become official for public companies and their accounting statements until 2019. Because they’ll have to go back a few years, companies will look at the leases on their books and assess how they will come onto the balance sheet under the new accounting rules. That could change decision-making as companies decide whether to do a lease or a loan and how that gets analyzed.”
The Equipment Leasing and Finance Association minimized some of the impacts and limited the scope of some of the lease accounting changes that were going to be made. “Thanks to ELFA, we still have an operating lease expense where you get to expense the full lease payment on your income statement,” Kiley says. “That is huge, and we got that exception in the U.S. only. In every other part of the world, a lease will be treated like a loan with frontloaded interest deductions and depreciation as if the lessor owns the equipment.”
All three of our participants feel good about the year ahead. “I think there is plenty of opportunity out there for us, given the breadth and depth of our product offerings,” Wright says. “I feel hopeful about the rate environment, and the economy seems to be doing as well, if not slightly better, than it has for the last couple of years.”
Fifth Third’s widened credit box lets it play in some of the credits it didn’t before. “We have to increase spreads and the yields in this business to bring the proper returns,” Kiley says. “Our quality portfolio is good right now, so we don’t have any surprises looming. Things are positive. If there are more capital expenditures, there will be more equipment loans and leases. Banks will not be able to hold everything, so that will increase syndication opportunities.”
“Hopefully 2017 will be the year where pricing discipline returns to the market,” Staczek says.
senior vice president & national manager,
Wells Fargo Equipment Finance
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