Kevin Prykull, CLFP,
Director,
The Alta Group

1. How concerned should the industry be about rising inflation’s effect upon the equipment finance business?

We certainly need to be concerned about inflation, especially since we haven’t seen its effect on our economy or our industry for a quite a while. The degree of concern will depend on the extent and severity of inflation and its resulting impact on increasing interest rates and the recessionary environment it likely spawns.

Resiliency is a word that we constantly use in our industry because we really “are” resilient. The way I look at it, it is all about how we put together the basic three lenses of leasing: accounting, tax and legal. It is very much like a Rubik’s Cube. We can adjust our products and services to suit the environment and meet our clients’ equipment and financing needs, irrespective of inflation, higher interest rates or recessionary conditions.

2. What has the industry learned from the past?

When I first entered the industry in the late 70s and early 80s, I worked for a de novo captive leasing company owned by a large Fortune 500 manufacturer that produced underground mining equipment. I got to see it all. Inflation went off the charts, interest rates soon followed and the economy tanked. Parent company sales were materially impacted. However, leasing became an even more important sales aid and offered tremendous value for our clients and the parent company. With the falloff in the economy, we had to work through refinancing and lease extension discussions. However, we continued to lease new equipment to the industry. Finally, we landed in a good place that positioned the leasing subsidiary and the parent company for future growth. Also, the residual upside created at the time with FMV purchase options, didn’t hurt the bottom line either. Our younger employees have never experienced these severe conditions firsthand, so they will need to adapt accordingly.

Our industry is adept at adapting to grow and thrive. When the Investment Tax Credit went away in the mid 80s or tax rates fell with the Tax Reform Act, there were major concerns about the demise of equipment leasing. This was the same with the most recent accounting rules changes. But we and our clients have adapted. Now, with inflation rising again, maybe it’s time we resurrect some previous products and introduce new ones that help clients better manage their equipment purchases and financing needs.

The Great Recession did create a huge drop in equipment demand, and we saw record credit charge-offs and losses far greater than what we have seen since. But attesting to the resiliency of the industry, we recovered from those times.

3. How prepared is the industry going into today’s inflationary environment?

As best as we can be prepared. We haven’t seen material inflation for quite a while. Equipment finance has transitioned into a stable and mature industry with lots of regulatory controls. The fundamentals remain good. It is human nature to be reactive rather than proactive. However, now is the time to plan for these rapidly changing conditions to weather whatever storms come our way.

We can extrapolate from the past about inflation’s future impact. However, I would be reluctant to draw an exact parallel to prior recessionary bouts that contained sizeable upticks in inflation. It is not necessarily identical with today’s environment. We need to be forward-looking as we apply what we have learned, but adjust for current factors and events. We want to be proactive, but not be overly aggressive and of course remain diligent.

4. In what ways will equipment demand be affected?

The demand for capex should not diminish in the short run. We have a backlog on equipment deliveries and continued delays with supply chain matters. We had to extend our credit approvals to accommodate delayed shipments. I think that lessees would rather use today’s dollars versus future dollars to lock in equipment costs and the cost of financing before rates rise even more. I remain positive.

Depending on the depth and breadth of inflation, rising interest rates and recessionary conditions, this could all change. But at this juncture, we still have a lot of clients that want equipment and financing sooner rather than later.

5. What are some of the developing risks to monitor and manage at this time?

We still have COVID-19, geopolitical risks, fluctuating energy prices, stress on economy, supply chain issues, etc. Now add in inflation, rising interest rates and recessionary conditions. We are starting to see erosion of consumer confidence, too. However, let’s not panic.

We just need to be more thoughtful in our approach to managing risk and maintaining our appropriate risk appetite. As seasoned risk professionals, we operate like a skilled surgeon rather than as a general practitioner in managing risk within our portfolios. Don’t arbitrarily start shutting down on new business originations.

6. What steps should companies be taking to bolster their risk position?

New originations and underwriting. This is a good time to stick to your knitting, as they say, and selectively look at areas to adjust your underwriting standards as needed. For example. the retail industry is generally challenging. We have seen major retailers adjust their inventory mix thus causing write-downs. We have also seen the majority of companies move from “just -in-time” inventory to “just-in-case” inventory requiring additional working capital financing.

It is time to relook at liquidity, maturing debt loads and ongoing access to the capital markets for our lessees/obligors. We need to be sensitizing companies’ financial results and prepare relevant projections that adjust for rising interest rates, increasing costs, revenue shortfalls and address the level of variable rate debt on their balance sheets. We should further assess specific company factors like cost creep, supply chain matters, margin squeeze — all need to be monitored closely. Single “B” credits will require even more scrutiny, as a slight “hiccup” in performance can bring the company crashing down.

Portfolio management. Let’s be on guard as we move into this new world of high inflation, high interest rates and recession. Step up the monitoring of your portfolio. Review low pass credits and be proactive with deteriorating ones. Rescore your small-ticket portfolio with greater frequency and look for outliers and trends that might give concern. We can also quickly look at equipment types and identify risk factors. Credit quality is going to deteriorate. Now it comes down to how we manage it.

Equipment and residuals. In the short run, there are some advantages to inflation for our industry in the way of residual gains and improved current collateral values and coverage. However, let’s not get lulled to sleep with the security blanket of all of this so-called collateral coverage. Are you putting the same residual percentage on a piece of equipment costing say 10% more, as compared to last year? While the percentages will remain unchanged the dollars at risk will be much more — think of a large $50 million corporate jet like a Global Express that now costs $60 million. If so, what happens when inflation is under control and starts to come down with your portfolio of inflated asset values and residuals?

7. Are there resources the industry can use to better prepare?

ELFA has done a good job creating the Knowledge Hub. There is a lot of valuable free information that helps us from that site. So, we need to avail ourselves to such resources. For example, the annual Credit Managers Survey is very relevant on credit metrics but includes forward looking comments and opinions from equipment financing credit professionals. It is very insightful. So is the Collections Survey. The Summary of Equipment Finance Activity (SEFA) has incredible data sliced and diced into a variety of categories. There is so much research data both from the ELFA and the foundation. Of course, paid services as well, like D & B, Equifax, Moodys, S & P, RMA — just to name a few. Despite all of these resources, it is incumbent upon risk professionals to apply data and information to specifically address the risk appetite of your own firm, which may be quite different from others. Let’s have common sense prevail!

8. What have we not asked that we should be inquiring about?

I just want to stress this current period is not necessarily a re-do of the 1970s or early 80s. Going forward, companies should carefully set residuals and assess equipment values. We need to monitor LGDs (loss given default) and PDs (probability of defaults) more than ever.
We know in the long run, massive inflation can destroy economies. So, let’s prepare for the worst and anticipate that our results and outcomes will be far, far better.

Author’s Note: This article was written in early August 2022.

Kevin P. Prykull is an expert in credit risk management strategy and a director at The Alta Group, who helps clients develop appropriate risk profiles, credit policies and procedures, as well as best practices for managing inflation and other risk factors affecting the business of equipment finance. He is an equipment leasing and finance professional with experience in all major aspects of the industry, working in banks, captive and independent leasing companies. His previous positions include more than 30 years at PNC Equipment Finance, most recently as senior vice president and credit underwriting executive.