Brent Ferrin,
Managing Director,
Houlihan Lokey

Following the first year of the COVID-19 pandemic, M&A activity in the equipment leasing space accelerated in 2021. As James Jackson of The Alta Group wrote in an article from earlier this year on that very subject, “Due in part to the strength of the economy prior to the pandemic and deliberate steps taken by the government and the Federal Reserve to stimulate economic growth, the economy was once again well-positioned to promote a robust M&A environment in 2021.”

Unfortunately, that robust growth has petered off through the first nine to 10 months of 2022, with expectations for a similar trickle into 2023, according to Brent Ferrin, a managing director in Houlihan Lokey’s Financial Services Group.

“Activity has definitely slowed down a bit,” Ferrin says. “Part of it was inevitable because we all knew that with rising macro interest rates, the banks were going to be able to make more money with their core businesses in their organic loan/lease portfolios, and therefore, at some point, turn to be a little less aggressive with inorganic expansion and M&A. I think we’re starting to see that play out.”

Even with the marketplace slowing down this year, there have still been several headline-grabbing deals that have gone through. The year got off to a strong start, as in January, First Financial completed its acquisition of Summit Funding Group, American Bank acquired ACG Equipment Finance and two business development companies advised by Benefit Street Partners acquired all the equity interests in Encina Equipment Finance. Then, over the summer, Eastern Funding merged with Macrolease, Wingspire Capital agreed to acquire Liberty Commercial Finance and Gulf Coast Bank & Trust acquired the assets of KLC Financial. Plus, in March, Peoples Bank closed its acquisition of Vantage Financial, and throughout the year, TimePayment, a financial technology company that provides sales financing for specialty equipment sellers, has been very active in the M&A space.

Demanding Due Diligence

Acquiring or merging with another company is never a quick process, but as Ferrin explains, part of the decline in activity this year is due to even more protracted transaction processes, whether that be during conversations at the negotiating table, while attaining final regulatory approvals or anywhere in between.

External economic hurdles have no doubt played a role in slowing down the M&A process for buyers and sellers alike. Rising inflation, a still weakened supply chain, spiking interest rates and the war in Ukraine have created an environment where taking risks is even less attractive than usual. According to Ferrin, in today’s environment, these factors and others have led to more scrutinizing due diligence and harsher portfolio assessments. In addition, with many of today’s economic headwinds pushing the U.S. economy toward a seemingly inevitable recession, it is imperative for companies looking to acquire to take such an economic downturn into consideration.

“Buyers are definitely taking a harder look and a deeper dive into current portfolios, and using third parties to come in and dig in even more than they were previously to try to extrapolate on how these portfolios would perform in a recessionary scenario,” Ferrin says.

Such intensified due diligence and portfolio evaluation means companies with elevated credit quality are even more attractive than usual, leading to higher earnings multiples for such potential acquisition targets, while those with more challenged credits in their portfolios are having to settle for less. This overarching trend has led to a slight decrease in overall multiples across the entire marketplace, according to Ferrin, especially as banks tighten purse strings to stave off the potential dangers of getting too risky right before a recession.

“I think the environment where bank buyers were somewhat sight unseen paying north of 10x pretax and 2.5-3x+ book multiples for any leasing business that could fog a mirror is not the case anymore,” Ferrin says.

Funding Access Hampered

As interest rates have increased, with the Federal Reserve enacting four rate hikes already this year, access to capital has become a bit trickier, particularly for companies with tighter spreads, according to Ferrin, who says while warehouse facilities and the asset-backed securitization market will always be around, they are becoming more expensive and less efficient avenues to fund a business. As Ferrin explains, this trend could lead to demand for more junior capital, especially for high growth businesses that choose not to take their foot off the gas. Ferrin also notes that access to unsecured corporate notes is getting more expensive and harder to come by, creating less of an arbitrage for such products vis a vis equity.

A dwindling supply of capital on the open market could be a potential driver of M&A activity, with smaller leasing companies potentially looking to be acquired in order to eliminate the stress of having to find funds in an increasingly challenging environment.

“Access to capital and challenges getting capital within all of specialty finance has historically been a cause for management throwing their hands in the air and saying, ‘I need to do a deal. I’m sick of having to fund every single deal that comes in the door,’” Ferrin says. “Without the ability to access junior capital beneath the warehouse lines as easily as it has been over the last two years, independents may just say, ‘You know what? It is getting a bit hard for me to fund this business.’”

Don’t Lose Your Shirt

Even as the M&A market has performed differently in 2022 than it did in 2021, Ferrin says the characteristics that make one leasing platform attractive versus another have remained pretty consistent. He says asset class and where a company falls on the credit spectrum are vitally important, with banks looking for better credit, while credit funds and private equity sponsors are typically more interested in higher yielding opportunities.

“As I think we all know, your bank buyers find it a lot easier to buy higher credit quality, lower yielding platforms than your higher yielding, lower credit quality platforms, which typically go to your non-bank strategics, credit funds or private equity sponsors,” Ferrin says.

Despite some level of consistency, there are still some unique wrinkles in today’s marketplace, especially considering the enhanced due diligence and more intensified portfolio assessments taking place in 2022 (and likely in 2023 and 2024). Firstly, Ferrin says diversification is important, particularly when it comes to confronting more exacting portfolio evaluations. In addition, as always, companies must prove they have a stable loss history and consistent underwriting.

“The buyer needs to feel comfortable that the team knows what they’re doing and has underwriting models in place, such that they’re not going to lose their shirt the day after they buy the business,” Ferrin says.

2023 and Beyond

The more sluggish M&A activity of 2022 is likely going to continue throughout the rest of the year and into 2023 and maybe even 2024, according to Ferrin, who expects a small handful of transactions to close before the end of this year. Ferrin is especially bullish on future activity when it comes to financial technology firms.

“I think there may be some opportunity for your more traditional buyers to partake in fintech or tech-enabled lending deals that would allow them to perhaps buy into a tangential asset class that gives them some automation on the front end and the ability to underwrite smaller deals, perhaps working capital or small business solutions, to tack on to the equipment leasing offering,” Ferrin says.

In 2023, Ferrin expects to see some of the more quickly scaling independent equipment leasing companies try to find buyers as they start to reach a size that would lead to a “nice exit event” for owners. If such companies have diversified or play in a unique niche, they’ll have even more opportunities to sell. Ultimately, the primary deciding factor will always be performance, and that won’t change no matter the economic environment.

“For profitable leasing platforms with strong and stable credit history, particularly if they’re in nice niche spaces like medical or others, there’s always going to be bank buyers and, frankly, other strategic buyers for those businesses at nice multiples,” Ferrin says.

Phil Neuffer is senior editor of Monitor.