In 2012, equipment replacement demand overshadowed capacity expansion, leaving the asset managers assembled for this year’s Monitor roundtable discussion anticipating increased, but not dramatic, growth in equipment investment in 2013.
As they reflect on the equipment leasing and finance industry’s performance in 2012, the asset managers participating in this year’s Monitor roundtable express confidence in the overall stability of the industry, although equipment replacement trumped capacity expansion and will likely continue to do so in 2013.
Equipment and software investment is expected to grow at a below-average rate of 2.9%, stymied by weak demand and fiscal uncertainty, according to the Equipment Leasing & Finance Foundation’s 2013 Equipment Leasing & Finance U.S. Economic Outlook. The report noted that equipment and software investment dropped significantly in Q3/12, declining at annualized rate of 2.7%, after a 4.8% increase in the second quarter.
“I think most would conclude that 2012 equipment financing activity was supporting replacement demand. Until the economy is on much firmer footing, I do not expect the markets to heal such that we are financing expansion investments,” says James Grace, senior vice president, equipment management executive at Bank of America Merrill Lynch.
Terese Kramer, vice president, equipment group manager at BMO Harris Equipment Finance, adds, “Definitely there was more replacement demand. Slowly we are seeing more capacity demand, and I expect that to continue. We are going to see a positive, but not dramatic, recovery in 2013. We are, as they say, cautiously optimistic that this growth is going to continue and many sectors will trend positively.”
Scott Schauer, vice president, asset management at Key Equipment Finance notes, “Financing demand varies somewhat by asset category. For example, there was more replacement demand in trucking and construction and mining, while capacity expansion was more typical in manufacturing, food processing, rail and energy. For 2013, there remains significant uncertainty in many markets particularly in mid-size businesses, so we are anticipating some ‘wait and see’ with regard to expansion.”
According to the Equipment Leasing & Finance Foundation’s December 2012 Monthly Confidence Index for the Equipment Finance Industry, only 8.8% of survey respondents believe demand for leases and loans to fund capital expenditures will increase over the next four months, while 58.8% believe demand will “remain the same” during the same period and 32.4% believe demand will decline.
William Tefft, senior vice president, Asset Management at CapitalSource concurs, “Most of the demand we have seen has been replacement CAPEX rather than broad and sustained growth CAPEX. We believe that trend will continue in 2013. ”
Stretching Life Out of Equipment
Factors affecting the decision to invest in new equipment vary among different industries.
However, the primary driver of equipment investment decisions is corporate perception of the economy, according to the U.S. Equipment Finance Market Study 2012-2013, released by the Equipment Leasing & Finance Foundation and conducted by IHS. The study finds that equipment finance volumes are expected to expand modestly over the next 12 to 18 months, as uncertainties at home and abroad continue to stifle equipment investment.
Schauer says, “In many industries, the opportunity to stretch a little more life out of existing equipment appeared to be the more popular option over the last couple years. However, at some point increasing maintenance and reliability issues negatively affect production and drive the economics of acquiring new and replacement equipment.”
Kramer adds, “Our customer base tends to take good care of its equipment, so it lasts a lot longer. That, of course, is good news for us in terms of the value of the assets. There were strong values associated with used equipment through the downturn, in part because manufacturers were not pushing new equipment out. I think that cycle has changed now, and people are beginning to look for increased efficiencies that newer equipment would bring while also continuing to replace critical-use equipment.”
For equipment demand to regain sustained growth, the economy has to be on much firmer ground, notes Grace. “As we look at our markets, there is so much doubt and lack of clarity, companies are reticent to spend additional money to start building capacity without a definite uptick in demand for the product,” he explains.
Tefft concurs: “Our customers in manufacturing are cautious with respect to their projections of growth. We think that these companies are pausing to reassess where the market is going before they commit dollars to additional equipment.”
Asset Management Philosophy
In this economy lacking robust growth, the roundtable participants agree that their organizations are best served by adhering to proven asset management approaches, while at the same time being flexible enough to recognize market trends.
Grace said his group’s asset management philosophy in 2012 was very similar to previous years and likely consistent with that used by many of his peers. “We take market risk on assets, understand the application, consider the use of the asset to our client and closely monitor industry changes and how they impact our portfolio,” he explains.
Schauer says that throughout 2012 he and his colleagues have remained consistent in their approach to residuals and portfolio risk management with only minor adjustments reflecting the evolution and dynamics of the various markets in which they finance equipment. He adds, “As a philosophy, particularly on residual or collateral value risk assessment, we look beyond just the asset itself. We have specialists who keep their finger on the pulse of the industries in which we finance equipment.”
Tefft, noting a bit of a shift from prior years, says, “Lease terms — the number of months — are getting shorter for the longest lived equipment. It’s counter-intuitive, but I think it reflects a macro level re-pricing of risk away from credit and towards the asset. In the future, equipment managers will face new challenges as equipment with longer remaining useful lives and higher residual values comes off-lease.”
Sound research and prudent analysis of equipment have remained consistent approaches for Kramer throughout the economic cycle and when BMO Financial Group acquired M&I and merged it with its Chicago-based Harris Bank, which resulted in the rebranding of M&I Equipment Finance as BMO Harris Equipment Finance. “The culture in the two companies is customer focused and has blended well because we take a collaborative advisory role with our clients,” she explains.
Underwriting Practices Into 2013
As the soft economic recovery stretches into 2013, the roundtable participants will tend to stick to their established underwriting practices. Tefft explains that the equipment leasing and finance industry is characterized by its stability over multiple decades, and the equipment finance product is perhaps less volatile than other lending products. “As such, I don’t think that the underwriting practices are susceptible to immediate changes. What we tend to see are more consistent policies being carried forward from year to year, with perhaps some adjustment for trends in the market that are evolving,” he adds.
Schauer explains that Key’s underwriting practices have proven to be very effective — as evidenced by positive audit reviews and portfolio performance — and that his group will continue with these proven practices through 2013. “We always evaluate changes in the market and monitor trends. We would think long and hard before we made any radical changes to an existing portfolio; the process is more evolutionary,” he says.
Likewise, Grace and his group will carry over their underwriting policies, while keeping a watchful eye on any changes in industry sectors. In addition, they will continue to improve on how to analyze opportunities or risks. “We are always looking to develop technology that helps us more accurately project value volatility within industries,” he explains.
Kramer adds: “We carefully measure the risk we take, while at the same time remain competitive. It’s a delicate balance.”
2012 Residual Realization Trends
Regarding residual realization trends in a modestly improving economy, Schauer notes that at Key 201 was similar to 2011 in terms of portfolio performance and residual realization gains, with both years well in excess of 2007 through 2010 gains. In particular, manufacturing and rail were areas of significant gains, he says, adding that his group’s larger ticket portfolio consists of fairly substantial number of long-term leveraged leases with harder assets like railcars, locomotives, marine equipment and some large energy installations, the gains of which have little to do with the present economy. “We continually evaluate that portfolio, and then comb through everything on a transaction a year or two before it matures. Or, if there is an early buyout option, we will review the asset dates, the industry dates and the probability of the customer either exercising its EBO or returning its equipment,” he explains.
Grace adds, “We have seen a fairly steady improvement in equipment markets and corresponding value recovery. Another trend we have seen steadily improving over the last couple of years has been lessee retention at the end of a lease term. And when our lessees retain their equipment, obviously it yields the highest value to us as well.”
At BMO Harris, Kramer notes that although the portfolio has not matured for the most part, she has seen positive residual realization in those deals that have come to maturity. “Lessees were holding on to their equipment in the downturn, which had a positive impact on good used equipment. As equipment is being replaced, we expect this to level out a little bit more, so we may see more returned off-lease equipment. We have been careful and taken prudent residual positions, so we expect our residual realization to remain positive,” she points out.
Asset Class Demand Ups & Downs
While the roundtable participants agree that economic improvement was not robust in 2012, they perceive asset demand ups and downs somewhat differently. Kramer notes that manufacturing, production and construction have been slower to recover and that the medical equipment market has suffered because of uncertainty about the election and new medical regulations. Tefft notes declines in coal mining equipment, hydraulic fracturing equipment, the semiconductor market and the mature corporate aircraft market. Schauer sees challenges in the trucking, energy, plastics and printing industries. Grace observes a slackening of demand in blue-water shipping.
On the brighter side, Schauer says medical, marine, manufacturing and construction/mining proved to be good performers in terms of new business reviews and bookings. Tefft adds that willingness to finance new aircraft and newer-used aircraft continues to be relatively stable.
Tefft continues, “Trucks and trailers continued to be very strong in 2012, and I think that will moderate in 2013. We also saw strength in the inland tank barge market, as well as the automotive parts manufacturing segment, typified by machine tools and plastic injection molding equipment.”
Similarly, Kramer sees strong activity in the transportation sector for 2013. “Under the transportation umbrella we include business aviation, marine, rail and truck & trailer,” she explains.
For Grace, trucking and rail showed the most improvement, driven by pent up replacement demand and some consumer demand as well. “As we look at 2013, we expect that recovery to continue, albeit at a relatively modest rate. I don’t see one industry standing out with exceptional growth potential,” he adds.
Competition for Desirable Deals
These asset managers have seen varying degrees of competition for deals, depending on the asset type and size of the transactions. Grace notes, “Over the last two years we have seen steady growth in the amount of competitors in the equipment finance field. More capital has returned to the market, appetite has grown and risk-taking has increased.”
According to Tefft, “It was a competitive year, but I would not place it at the extreme end of the scale. In terms of the broader market, most equipment finance companies, anecdotally, attained their volume and margin objectives. This marks the third year, counting 2010, that this has been the case.”
Schauer says he has seen substantial competition on larger transactions, particularly with good credits. “We do our best to analyze the specifics of the assets, transaction structure, return and maintenance language, consider or develop ‘out of the box’ return or remarketing options, structural tweaks, and so on, to compete. However, our overall asset risk profile needs to remain consistent and at the forefront of all asset risk decisions.”
Adds Tefft, “Some asset managers may take more or less aggressive positions on varying equipment types, and that’s what makes for a market — all of the varying perspectives. We are differentiating the equipment types and markets that our respective companies are choosing to participate in and how aggressive or conservative our stances are in each of those markets.”
Grace explains, “The ability of the asset manager to seek the correct risk/reward balance based on the circumstances of the transaction really dictates the posture that the leasing company is willing to take from a residual perspective and ultimately will determine the ability to be the winning bidder on that transaction.”
Kramer agrees, “There continues to be pressure in the marketplace for quality transactions with strong credit and critical use equipment. The role of the equipment manager is as important as ever as we look for new and creative ways to structure and document transactions.”
Anticipating Accounting Changes?
While the industry awaits the outcome of the lease accounting convergence project, there is a consensus among the group that asset managers will have to evolve in order to continue to provide the type of service leasing companies need based on the new accounting rules.
“Although the exact nature of the accounting changes remains to be seen, our approach will be to act as an advisor to our customers in making good decisions about their capital expenditures for equipment and develop creative products to match the new set of rules,” Kramer says.
Schauer explains, “From an asset manager’s perspective, I think the need to clearly understand the transaction structure, overall economics and specific terms and conditions of maintenance and return language are of greater importance than ever as the lease accounting changes actually unfold.”
Grace says, “I am not anticipating a major impact for asset managers. However, our sophistication in managing equipment risk must improve every day. The accounting changes will add a significant amount of complexity to how leasing companies report transactions, and it could lead to turmoil for them. In many respects, the asset manager is the rudder steering the leasing boat through turbulent waters.”
Asset Management in New Business Development
When it comes to generating new business, these leaders agree that within their respective organizations, it’s all about teamwork. “Collaboration is critical to growing a business and continuing to manage risk in a challenging environment. We have a culture of collaboration both within our asset management group as well as a good deal of interaction with credit, sales/BD, portfolio management, legal, operations and our parent bank,” Key’s Schauer says.
Tefft concurs, “Every equipment finance company relies heavily upon its asset management group for perspective on the equipment, the market for the equipment and the projections of value. At CapitalSource, those perspectives help the business development effort remain focused and productive.”
Likewise, Grace notes that at Bank of America Merrill Lynch, “We are constantly being asked to guide our new business development teams to growing markets or assets with long lives and high value retention. Similarly, we advise them of industries and assets where obsolescence and volatility present a challenge to doing attractive business. We are there in the conceptual stage as well as the execution stage.”
Thanks to the merger, BMO Harris Equipment Finance has moved into new markets and larger corporate transactions, including energy, transportation, manufacturing and healthcare. Regarding business development, Kramer notes, “We have a strong consultative relationship with sales that includes involvement in a transaction in the early days so we can focus on the equipment side as well as on the financial structuring side simultaneously. We enjoy working side by side with our sales team to bring this dynamic and focus of the whole team being ‘equipment curious’ early on.”
Challenges and Opportunities
Discussing challenges and opportunities facing asset managers, each of the participants emphasized different, yet significant, points. Schauer cites the economy as a lingering obstacle: “A robust recovery in equipment demand and acquisitions — and the subsequent need for equipment financing — is probably still in the very early stages with a lot of challenges facing smaller and mid-size businesses.”
Tefft points toward regulatory compliance as one of the greater challenges that asset managers will address going forward, as the equipment leasing and finance market has become dominated by the bank-funded model. “We have witnessed a thinning of the herd of independent finance companies. With the dominance of the bank-deposit funded equipment lending and leasing companies comes regulatory oversight. Over time that focus will find its way into our product,” he says.
Regulatory risk is another challenge that Tefft cites, specifically the potential impact of legislative and regulatory authorities that govern our collective customers. He explains, “For example, the 2010 Macondo well incident in the Gulf of Mexico resulted initially in a moratorium and later in tighter regulations that changed the landscape for participants in that industry. Over time, those actions ripple through to the equipment they use and we finance. It can create unforeseen changes in markets and values.”
For Grace, developing the next generation of asset managers is a major issue for the industry. “Many of my fellow asset managers are entering their 50s and 60s and are not planning for the future of the organization. We tend to be nimble organizations with heavy workloads and not much time devoted to training our less experienced associates. We need to reprioritize how we plan for the future. Industry conferences, seminars and inspections provide a critical experience base with which the individual can grow. Budget for it and plan it. The investment will pay major dividends,” he stresses.
Kramer, who along with Tefft, is a member of the ELFA’s Equipment Management Committee agrees, “One of the challenges for those of us who have been in the business for 25-plus years is to find ways to attract people to this discipline by getting young professionals to see equipment management as an exciting and interesting career path. The ELFA does a good job in that regard. Our annual equipment management conference is well attended, and we believe it is one way to attract quality people to this discipline.”
She continues, “Over the years equipment management has evolved into a more proactive, collaborative role. We work with a multitude of disciplines within the company in order to win business. Our hope is that as equipment managers become more visible and integral to successful leasing and finance companies, the role will attract more bright, young people.”
Lisa M. Goetz is an editor of the Monitor.
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