Liquidity buys little when deals are scarce
Talk with funding experts who worked their way through 2017
, and you get the feeling they’re happy to have escaped with only minor injuries. “It was a free-for-all, a financial food fight,” says Henry Frommer, Senior Vice President and Managing Director at Wells Fargo Equipment Finance in New York City. “Anyone who had deals to sell did extremely well, and buyers had a really tough time. And I’m not sure that 2018 will be markedly different.”
Not everyone who wanted a piece of the leasing-equipment pie got it in 2017. Of those who did manage to buy transactions, many got fewer than they wanted or settled for lower credits as originators kept the best morsels for themselves. Observes Frommer, “For the deals that were available, the spreads were greatly compressed, and to some extent there were weaker structures in the deal themselves: longer terms, perhaps, or no down payment.”
“When we saw a regular deal-flow transaction, buyers jumped all over it,” adds Sera Oliver, Vice President, Capital Markets, at Key Equipment Finance in Albany. “I even encountered cases where I went back to a source to say yes, we could do the pricing, and was told that someone got back to them the day before with an offer to do 20 basis points better.”
An Improving Landscape
This year’s pickings could be equally slim if interest rates remain relatively flat and demand for money doesn’t grow. Pricing is also expected to remain extremely competitive as strong originators command top dollar for the deals they choose to sell. But markets change, and therein lies hope—even whispered optimism.
“I think we’ll see certain market segments start to rebound, such as energy, with lenders more willing to lend to those companies,” says Doug Ducray, Senior Vice President, Capital Markets, at MB Equipment Finance in Hunt Valley, Maryland. If the economy remains healthy, Ducray also expects a continued increase in production-manufacturing equipment. “We’re already seeing investment in hard-hit manufacturing areas,” he says. “So whether we’re looking at automobile manufacturing or food processing, I believe these markets will strengthen. MB Equipment Finance holds particular expertise in these sectors, and we’re seeing strong activity.”
Frommer looks for yellow iron, rail and commercial air to pick up if Congress passes an infrastructure bill. He also thinks renewable energy could soon stand on its own merits. “You can’t rely on a tax credit forever,” he says. “At some point there has to be a real reason to buy the equipment, and renewable energy is becoming more efficient and more economical all the time.” Because his comments came just days before the Administration announced a 30% tariff on solar panels from China, we went back to Frommer and asked if his thoughts about renewable energy had changed. “I think the tariffs would have a modestly negative effect,” he responded.
Stronger markets produce more equipment financing, which in turn grows the need for funding and the sale of transactions to produce that funding. Oliver believes new tax legislation could lead to higher prices for oil and gas, which could stimulate a bevy of markets. “In rail and marine, a lot of companies that get syndicated are tied to oil and gas, directly or indirectly,” she says. “We’ve been watching that space closely—not just the oil companies, but the suppliers, transporters and other businesses servicing the market, which have also been very tight.”
Tom Forbes, Senior Vice President and Group Head, Capital Markets, at Wintrust Commercial Finance in Frisco, Texas, agrees that lenders will slowly return to the energy space after a significant retrenchment. He also thinks the transportation industry will remain strong this year and include continued activity in corporate aircraft. “But I think these deals will continue to be a bit more conservative than before the Recession,” he says. “There were some pretty expensive lessons learned.”
He is less certain about the healthcare market. “It’s always an enigma,” Forbes says. “I think large captives in the business will continue to be successful, but we no longer see the specialty lenders we once did. You have to know how reimbursements are made to make good investment decisions, and although the Affordable Care Act has been in place since 2010, tax reform could make a difference. It’s always a ‘follow the money’ game.”
Discipline and Survival
When considering 2018 overall, Forbes joins those who believe this year will be much like last, with buyers leaping for the meatiest morsels that sellers offer. But he sees several reasons for concern. “Middle-market companies are leveraging up significantly, consumer debt is at historical highs, lending standards are stretching, and documentation is getting looser,” he says. “In fact, information from a Carl Marks Advisor survey indicates that 48% of lenders believe the documents being negotiated today are looser than those negotiated before the financial crisis.”
Some of this deterioration in discipline stems from new market entrants. “There are a lot of new entrants in the structured-credit environment, and they’re looking for more volume and better returns than they can get in higher-rated credits,” says Ducray. “Some have already come and gone. They opened shop thinking they’d get a higher return than on other investments, but then looked at the risk profile of some transactions and realized they couldn’t get the returns they needed, so some have pulled back.” He sees smaller banks investing more heavily in equipment financing, either by opening buy desks or purchasing equipment finance companies as ways to diversify.
Yet, Oliver says new players have become an important part of the investor pool on Key Equipment Finance’s sell side. “A lot of them are small companies with open balance sheets, and they’re writing fairly large checks,” she says. “They have no exposure issues, their turnaround time is fast and they become repeat customers,” she adds. “And while this is all positive on the syndication side, these are also the companies I compete with on the buy side.”
30th Annual National Funding Conference set for April 10-12
Learn more about the funding landscape at the ELFA National Funding Conference, the annual forum for connecting funding sources with leasing and finance industry organizations looking to establish relationships to fulfill their funding needs. See www.elfaonline.org/events/2018/NFC/
Looking for a Funding Source?
In addition to attending the National Funding Conference, check out ELFA’s online Funding-Source Database. Search by type of company, types of lease structures, funding programs, equipment types and/or credit criteria: https://apps.elfaonline.org/Directories/FundSource/
New Foundation Study
Learn more in the new Foundation study The State of Credit Quality: Where We Have Been and Where We Are Going
, available from www.LeaseFoundation.org
Although sources for this story agree that funding availability should remain strong in 2018, they disagree on cost-of-funds forecasts. “If the economy remains strong, the [Federal Reserve Bank] will continue to increase interest rates throughout the year for fear of rising inflation,” says Ducray. “One component of interest cost embedded in the cost of funds is market interest rates, which could increase. I think we’ll see an increase in the cost of funds for banks, just because there’s more pressure on profitability and due to federal regulation. We’re in an environment where the Administration is trying to reduce regulation, but our industry is already subject to new accounting rules and new tax laws, so I don’t see the cost of funds staying constant.”
Oliver thinks differently. “We don’t see anything that will increase our cost of funds,” she says. “I do believe interest rates will rise modestly, but because of competitive pressures and the amount of liquidity in the market, I don’t think it will translate to a change in the cost of funds.”
Frommer agrees but posits a scenario that could add meat to the market: “The Fed is shrinking its balance sheet, which will supposedly take a trillion dollars out of the market. That should dry up some liquidity as the Fed gets rid of bonds, investors buy those bonds and interest rates rise because there’s less liquidity.” But equipment finance companies still need demand, and a strong infrastructure bill could provide it. Says Frommer, “Then it’s possible that spreads will widen and buyers will have better deals.”
Accounting Changes and Tax Reform
Meanwhile, equipment finance companies are readying themselves and their customers for changes required under the new lease accounting standard. The new requirements aren’t expected to make a difference this year, though, because domestic companies have until 2019 to enter all leases on the balance sheet. “To the extent that we’re dealing with international companies, it could make a difference,” Frommer qualifies. “But in reality, the changes simply mean that everyone will now look at leverages differently. The changes will be quite expensive for equipment finance companies to comply with, but in terms of cutting back on demand or not looking at a credit because there’s a leasing debt on the balance sheet, I don’t see it as a long-term issue.”
Forbes concurs. “There’s always going to be a need for capital outside of revolving credit and senior debt facilities, and companies will determine which products fit the new standards best,” he says. “I think at the end of the day, the lease accounting changes will normalize and our industry will adjust.”
Accounting changes notwithstanding, it’s much too soon to know how tax reform will affect the industry and how equipment finance companies will adjust. At Key Equipment Finance, Oliver says tax leases show favorably in the company’s post–tax reform lease vs. buy analysis. “However, with the lower tax rate and 100% expensing, leasing companies may have less tax capacity overall,” she notes. “So we’re wondering if we’ll see more tax deals in the capital-market space. If equipment finance companies can’t hold as much tax business, they’ll have to take some of it to market.”
Forbes wonders if borrowers will demand lower rates. He also questions whether banks and leasing entities will use state and/or city taxes to increase their rate from 21% and pass along the impact to their customers in the form of lower lease rate factors. Either way, he thinks most leasing companies will respond in ways that take care of their customers and maintain their profitability.
“We ran models on how leasing will be affected and we determined, in our view, that the difference between the old tax methodology and new isn’t so great that it will have a major negative or positive impact on leasing,” he says. As with lease accounting changes, Forbes believes the market will adjust to tax reform.
Andy Fishburn, ELFA Vice President of Federal Government Relations, sums up the situation: “The tax bill is fresher than some perishable items still on the shelf at the grocery store, and companies are still figuring out how to adapt,” he says. “Many are expecting the impact on the capital expenditures marketplace to be overall positive, with equipment leasing and financing experiencing growth as a result, but that doesn’t mean that it’s positive for all verticals or business models. The impact of the simultaneous, seismic and interconnected changes of 100% bonus depreciation, limitations on interest deductibility and a rate reduction is going to take some time to sort out.”