“Just as ripples spread out when a single pebble is dropped into water, the actions of individuals can have far-reaching effects.” When the Dalai Lama uttered those words, he wasn’t talking about the challenges facing today’s asset managers. Yet when you consider how one small change in the economy can send a ripple through market sectors, you begin to realize the integral role played by asset managers in their far-reaching valuation of equipment.

We asked three asset management executives to share their insights regarding today’s marketplace and the growing role of asset management.

“One of the greatest differences in the asset manager role today is our increasingly proactive engagement with our bank credit-risk partners,” says Thorb Towles, SVP, director of Equipment Management at BMO Harris Equipment Finance. “On a daily basis, asset managers are asked to opine on most transactions, regardless of financing structure. Our role has slowly transitioned to more of a credit centric focus with a much greater touch point to determine the useful lifetime of any asset in any financing structure, residual or not.”

Current evaluation practices are not likely to change in 2018, but our panelists are aware of the need to make adjustments with the changing marketplace. “Our starting point always focuses on long-term market performance, and then we adjust for technological and market developments,” says Dennis Bolton, SVP, head of Equipment Management Group at Wells Fargo Equipment Finance. “We make competitive-based adjustments as a business decision, but our primary evaluation models are mainly consistent year over year.”

“Most of our evaluation practices will carry over into 2018,” says Amy Paine, SVP, Asset Management, Key Equipment Finance. “However, we need to understand the new tax law and accounting rules to see how they might affect certain asset classes or financial structures. There will be 100% expensing, for example, and we don’t yet know how that will play out. We may have to change some of our risk assessments accordingly.”

“We have to understand more than just the asset,” Towles says. “We need to know whether this asset can be liquidated within a certain timeframe and what that marketing timeframe might be. In the case of corporate aircraft, we need to understand the lifecycle of that particular make and model, how many years it’s been in active production and if the vendor already has the replacement model available. You have to take the past, present and future into account, and that creates a smorgasbord of understanding. The days in which asset management input was exclusive to residual-based transactions are over.”

Performers & Non-Performers

For Wells Fargo, the strong performers in 2017 were construction, transportation and technology. “Marine and corporate aircrafts remain anemic,” Bolton says. “We expect similar trends to continue through 2018, although the potential for some soft recovery is possible in the lagging sectors. A lot will depend on fundamental economic drivers to these sectors. While construction has been good for us, there has not been broad-based expansion across the entire sector. Private construction is going gangbusters, but infrastructure-related construction has been more anemic, because that’s heavily tied to what’s happening with the infrastructure proposals on Capitol Hill.”

“A significant portion of our volume has always been in information technology, and 2017 was no exception,” Paine says. “There was significant demand for networking equipment, cyber-security solutions, laptops, tablets and more. We expect growth in managed service contract financing as more companies outsource their IT operations to service providers who will, in turn, need to expand their operations. The amount of servers that a company like Amazon Web Services buys is astounding. Also, as the Internet of Things continues to grow, there will be increasing needs for IT solutions.”

“Technology investment was the surprising leader as witnessed by the RFP demand by various technology, insurance and financial service companies,” Towles says. “I anticipate much of the same for 2018. On the other end of the spectrum, aircraft investment was a bit more challenging in 2017, due to the fact that aircraft lessors experienced multiple pockets of volatility related to specific make, model and vintage of select business aircraft.”

The alternative energy and transportation markets were also standouts for Key Equipment Finance, and Paine expects these sectors to be strong in 2018. “Investments in solar energy were driven by lower costs for equipment, state mandates for renewable energy and tax incentives. Other energy investments included back-up power, distributed power and off-the-grid power solutions. There was increased demand in the trucking industry for both replacement and expansion. We saw limited demand for financing in mining and traditional energy — oil, gas and coal — and the related industries such as supply boats and coal cars.”

“In transportation, the inland marine and offshore oil support markets have really suffered,” Bolton says. “It’s much more expensive to develop an offshore well when compared to a non-conventional onshore well. Additionally, the current price of oil makes it difficult for companies that invest heavily off shore. This has created a huge oversupply in the Offshore Supply Vessel PSB AHTS markets. Short of a dramatic rise in the price of oil, I don’t see that correcting itself anytime soon.”

Continued pullback and retirement of coal-burning plants, with lower export requirements, resulted in an oversupply of open hoppers. “Because the grain market was good, many operators converted the open barges to grain and other covered services, dramatically increasing supply even as many new builds were coming online,” Bolton says. “Then commodity prices dropped on grain, and people started to sit on their stores and not move them. The combination of the converted open hoppers and the new capacity that came to market created a 10% to 20% oversupply that is probably going to take until 2019 or 2020 to work itself out. On the other hand, something has to happen with grain, because all the silos and storage facilities are busting at the seams. It is all connected, and asset managers have to keep an eye on all these factors.”

Further illustrating the complexities of interplay between markets and the ripple effects within an industry, Towles tells us more about the volatility of the corporate aircraft industry. “We’re dealing with very expensive assets and a specific base of clients. We are not only working with CEOs who must answer to their shareholders but who also have specific wants and needs within that asset. This is part of the balance of understanding the trends occurring within a particular industry such as buying habits, desired assets and the sales forecast for those assets.”

In 2008, when corporate CEOs from the big three automakers were called on the carpet for their costly use of corporate jets, there was a backlash that ultimately forced CEOs to adjust their travel and buying habits. “As a result, lessee behavior changed, and end users began returning assets instead of using them to trade up to the next big model,” Towles says. “This trend, in conjunction with deteriorating credit conditions, led to losses for those lessors that had taken significant residual investment and were not able to resell the asset for their original value projection. This is a good example of how things can change very quickly within an industry space.”

Relaxed Regulations

“Much of the strength of the economy can be attributed to a significant drop in the number of regulations implemented in 2017,” Paine says. “Through the end of the third quarter, 45,678 pages of regulations were added to the federal registry. That’s a drop from the 95,894 pages added in 2016. The cost of complying with regulations is large, so slowing the rate is a benefit to business. In the case of banking, the big banks can afford the cost of compliance, but smaller banks need to allocate a disproportionate amount of resources to be compliant — putting them at a competitive disadvantage.”

There are positive and negative impacts from the relaxed regulatory environment. “Mining and coal-fire generation have seen some relief, although the question remains whether it’s too little, too late,” Bolton says. “The dispatch curve continues to shift to renewables that are becoming more economically feasible. I expect the shift may be moderate but without any recovery or reversal in the progress already made. The electronic driver log mandate will impact the trucking sector, but it’s too early to know exactly how. It will require greater control in management to make sure everybody’s complying, and that will add a level of expense as well as compliance.”

“Asset managers can never be at an information deficit regarding any regulatory matters that may affect the assets we finance,” Towles says. “There are many regulations regarding rail cars, and there are potential liabilities related to the cargo they transport. Banks and leasing companies are naturally wary of potential litigation as well as any reputational risk as it pertains to hazards associated with those regulations. Our team must keep a watchful eye on any and all market information and routinely attend various trade and industry events to stay abreast of upcoming guidelines that may impact our current and future portfolio investment.”

If she were granted a regulatory wish, Paine would like to revisit the tank car regulations. “Clearly we need to protect against the consequences of derailments, but track conditions also play a role. These particular retrofits are very expensive, and as a lessor there can be issues when the documentation has not been worded broadly enough to cover changes in the regulations after the lease was booked. It may not be clear whether the retrofits are the responsibility of the lessee or the lessor.”

New requirements are coming into effect for corporate aircraft in 2020, too. “To be compliant with the FAA, the required updates may cost anywhere from $500,000 to $1 million per aircraft,” Bolton says. “This must be taken into consideration as we develop future outlooks and current valuations.”

Replacement or Expansion

All of our participants saw both replacement demand and capacity expansion in 2017 and expect the trend to continue. “In the IT space, many companies extended the refresh cycle on their hardware and software updates in order to pay for cyber-security programs,” Paine says. “Now they have reached the point where they need to replace the hardware but must also keep up with the cyber-security programs. In that case, there will be both replacement and expansion.”

“There has been expansion in construction and trailers, but it’s been more replacement for construction related to road-building,” Bolton says. “If Congress can pass the whole infrastructure bill, and we start making investments in infrastructure, that market growth will convert from replacement to expansion. On a broad basis across most industries, I would suggest that we’re in an expansion cycle.”

“We expect the tremendous growth in e-commerce, cloud computing and mobility to continue, so that will lead to expansion,” Paine says. “There is expansion in the solar industry with new installations. Other energy financing included expansion to support off-the-grid or distributed energy solutions for data centers, banks and hospitals.”

“People were waiting to see what would happen with interest rates and regulatory controls, and CEOs for the most part, kept their powder dry on CAPEX spending,” Towles says. “For commodity-based assets such as construction equipment, machine tools and the like, businesses are ready to expand. They held onto their equipment — extending then-current leases on a monthly basis — before placing a major purchase order to acquire replacement equipment. Now they are ready to go and are well-positioned for growth.”

Bolton reports that replacement and expansion buying drove investment, but it depends on the sector. “In some industries, we saw production levels just getting back to pre-recession levels. The tax reform impact should drive further investment beyond what anyone would have expected six months ago. This should marginally improve the low investment growth rate we have been experiencing, but I do not expect significant economic growth rate change. It will continue to be slow and steady.”

“In 2017 many companies were waiting to see what would happen with tax reform,” Paine says. “It was still a good year for investments in new equipment. The new tax law with 100% expensing will be a big factor in 2018.”

Looking Forward

Towles is looking for balance in 2018. “My goal is to continually identify target industries and assets for investment that are consistent with BMO Harris core credit principles whilst respectively challenging our team to look beyond our traditional comfort zone of providing commodity-based equipment financing products for our clients.”

Paine’s goal involves new laws and rules. “You always need to understand what products and structures most effectively mitigate asset risk. In 2018, it will be very important to understand the changes in the tax law and the accounting rules and how those changes may cause people to behave in different ways.”

Paine worries about transactions with long tenors. “The pace of technological obsolescence has changed dramatically, and it is difficult to see eight, 10 and 12 years out. The impact of self- driving trucks will be huge. When will that happen and how quickly? Ten years ago, anyone would have thought investing in coal cars was a good idea, but now coal supplies half as much power as it did then. It becomes very difficult to determine the residual asset risk on those longer lived assets.”

Bolton’s main goal and biggest worry are the same. “Talent attraction, development and retention are absolutely critical! This affects our industry as a whole and is the issue of the future. When you look at the Monitor 100 today, you can see how much the industry has consolidated. Every time there is a recession, people leave the industry and never return. That puts us further and further behind the eight ball for getting good people.”

Towles is passionate about diversity as a way to build greater bench strength. “I’m greatly encouraged by the leadership and action plan implemented by our division President Jud Snyder. He has made a personal commitment toward addressing the dearth of minority and women leaders within our organization to ensure that his team comprises different types of people with different backgrounds and experience levels.

“I believe our business would greatly benefit from an infusion of diversity of opinion and personnel across the analyst, mid-level and senior ranks. To that end, it’s imperative upon the collective executive leadership team of finance and leasing companies across the country to lead by example in regard to recruitment, training and retention of qualified men and women who were not previously considered for these roles.”

“When you look at any business that operates in this sector, everyone is aware of the people shortage and is trying to address it,” Bolton says. “In the equipment management field, it’s a five-to-10 year endeavor to fully develop people into well-rounded, experienced contributors. It takes five years to learn to speak the language and another five years to truly understand it. Once you have them trained, you have to work to keep them. It is so important to attract, develop and retain people as well as to create an environment where people want to be.”