Despite a rocky and, at times, bleak outlook, some independents are now in a position to choose between continuing on the path of organic growth and forging a strategic partnership with a bank. Charles Wendel of Financial Institutions Consulting provides insights into the benefits of sticking to the status quo versus those of joining the “enemy.”
Charles Wendel, President, Financial Institutions Consulting
Just a few years ago the likely future scenario for Independents appeared bleak at best. Net margins were falling, losses were increasing, operating expenses were too high and many bank-funding sources (for Independents oftentimes their life blood) were disappearing, as commercial banks exited or reduced their credit exposure to equipment finance companies. As of year-end 2012, Independents’ share of new business volume shrank to 12.9%, having declined each of the past five years from 24.7% in 2008. Independents also continued to operate with the handicap of a higher weighted average cost of funds (COF); for 2012 Independents COF stood at 2.67% versus 1.28% for banks.
Today, the picture has become considerably brighter. Despite the banking industry’s increased focus on equipment finance for revenues, Independents are effectively meeting competitive challenges and generating substantial organic growth. Several Independents we know cite 2014 as likely being a record year. At the same time many Independents, once dismissed by banks as little more than dinosaurs, are currently being pursued for acquisition by their sometimes bank competitors.
Many Independents face a choice between two rosy scenarios: continue to focus on what they have been doing and increase their income or benefit from the growing interest in their business by banks and others and sell out at an attractive earnings multiple.
Organic Growth & Improving Returns for Independents
At least three factors have resulted in the apparent resurgence among Independents:
Stable or slow growth economy — While no one would characterize our economy as fast growth, a negative operating environment has been replaced by stability and some measure of predictability. End users now appear willing to commit to at least replacing old equipment rather than trying to coax out another year. While the entire industry benefits from this change, many Independents lack the intra-bank or company relationships that generate leads even in poor markets. Even more than banks or captives, Independents may depend more on a positive macro-environment to fuel their growth.
Funding availability — No more than three-four years ago, banks cut back on loans to equipment finance companies, saving their constrained liquidity for “core” customers. However, many banks now operate with high liquidity and capital that they need to put to work. Independents are seeing the return of lenders who were reticent or nonexistent in the recent past (an experience few are likely to forget). In addition private equity players have seen a gap in the market and rushed to fill it, particularly by investing in equipment finance start-ups.
For most players, funding is no longer an issue. The head of one Independent specializing in relatively risky small-ticket transactions observed that banks like to fund him because it allows them to generate higher than usual margins. Banks would be unwilling to lend directly to that borrower’s end customers for two reasons. First, the operation requirements supporting these transactions are complex and necessitate proprietary knowledge that demands a time and dollar investment most banks are unwilling to make. The second, and more critical, reason involves the fact that given the risk characteristics of these loans they would be immediately classified by the regulators. Therefore, in effect going through the Independent gives them some of the returns that the Independent captures while meeting compliance needs.
Of course, as in the past, funding availability could decrease. However, even during the downturn, the strongest Independents, most of which were working with the strongest banks, found that the relationships that they had worked hard to develop over the years resulted in continued access to debt financing. Strong players will continue to obtain funds.
The “credit box” — Beyond the above factors, the narrowing credit box in which banks operate provides Independents with a substantial opportunity. By this we mean that while banks proclaim their interest in lending to businesses, recent losses and current regulatory pressures have resulted in banks limiting the types of companies they will lend to. In addition, in many cases the information they request of the borrower has also become more onerous to the company seeking a loan. In a recent conversation one banker commented that it was difficult for his bank and other banks to lend to companies that were viewed internally as “B” credits or below, limiting his focus to the arena where most other banks also operate.
The good news for Independents is that banks view most potential borrowers as below “B” in quality. In addition merchant advance lenders and similar “alternative” players have demonstrated that banks are ignoring quality borrowers and that these borrowers are willing to pay higher than bank interest rates to obtain a loan more quickly and with less hassle than banks require. Independents can respond more quickly than most banks to customer requests; many operate with greater flexibility in structuring a transaction; the need to customize is often an advantage for them rather than an impediment to a deal; and, the ability and willingness they exhibit to develop sophisticated structures for their customers differentiates them from many banks.
Independents appear to be in a strengthening competitive position because of increased availability of funding, the limits that banks have created for themselves in where and how they compete, and their willingness and ability to develop attractive niches and embrace, rather than avoid, complexity. In short Independents can succeed where banks either cannot or will not play. And even if funding or other factors turn against the Independent, those that made it through the rigors of the last downturn should be able to sustain themselves through future challenges. They can also consider another route.
Joining the “Enemy”
Independents face another attractive way to generate income, one they may want to act on sooner rather than later. Today, more banks find the equipment finance business attractive and are attempting to determine how best to enter it; acquiring Independents has a high priority at many regional and larger banks.
Banks that decide they want to establish or build out an equipment finance capability often acquire firms. For example, while both Umpqua Bank and City National Bank already had small equipment finance groups, they each acquired significant players: Financial Pacific and First American Equipment Finance, respectively.
Several factors drive a bank’s interest in acquiring versus building a de novo operation. First, an acquisition provides immediate expertise and a profit-generating portfolio that banks believe can build earnings rapidly by leveraging bank relationships. In contrast, some bankers commented that the portfolios promised by lift-out teams never materialized. Further, in part due to the significantly lower cost of funds that banks offer some acquisitions such as Umpqua’s deal can be immediately accretive to earnings. One Independent we know estimates that its bottom line would increase by three to four times with bank funding.
However, the enthusiasm that banks now exhibit for equipment finance may be short lived. At the moment banks operate with limited growth paths; for example, revenues from areas such as “free” checking and mortgages are down, and the Consumer Financial Protection Board appears to view all retail and perhaps even small business activities as part of its domain. Equipment finance, as an area that can put high yielding and well-performing assets on a bank’s books without the regulatory headaches of retail banking, has become a key growth area at many banks. Executives at bank-owned companies have noted that the same executives who told them three years ago to eliminate portfolio growth and maintain status quo now request growth that exceeds other areas of the commercial bank.
Nonetheless, Independents considering sale should move with alacrity. For example, several years ago branch banking was the favored child within a bank while many viewed commercial banking as a dangerous business run by cowboys. Banks also once viewed commercial real estate as highly attractive versus their more cautionary approach today. Factors that could impact banks’ enthusiasm for equipment finance include the new accounting rules that remain under consideration and the forthcoming new OCC Comptrollers’ Handbook on Lease Financing. While experts believe when finally adopted the new accounting rules will have marginal impact on most companies, the new OCC requirements may be another story. The OCC issued its last handbook in January 1999 with a revised handbook expected “soon.” The OCC and other regulators are well aware of banking’s new or renewed emphasis on equipment finance, and comments from the regulators suggest they intend to put a brighter spotlight on this business and how it is conducted, perhaps lessening its attractiveness.
For reasons outside of their control, the favored status of many equipment finance groups could disappear (as has happened in the past). Independents that want to link up with a bank should consider what actions they need to take to become more attractive to a buyer and begin down that path immediately while their currency is at its strongest.
Despite recent history, today may be a good time to be an Independent. Many Independents have not only survived the downturn but have future opportunities whether they continue to go it alone or decide to join up with a partner.
Charles Wendel is the president of Financial Institutions Consulting.
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