Funding Independent Finance Companies By Chris Enbom, CEO Allegiant Partners Incorporated I was asked to write an article about “funding.” My initial thought was, ”sounds like asking a farmer to write about dirt.” The subject is simultaneously a) on its face uninteresting, b) incredibly broad, and c) everyone is familiar with it because they use it every day. Funding, however, is the soil of the equipment finance professional. But unlike soil, money is completely fungible. One dollar is as good as the next. So the soil analogy is not complete until one couples funding with the platform over which the funding is built – the product being sold, the processes involved – how the money is being utilized. Are we growing a crop that produces lots the first year or two but depletes the soil, or is a crop that will sustain the soil? How much dirt do we need to add in the future? How do we get the dirt in the first place? This article will focus primarily on obtaining the dirt, but ultimately what you do with the dirt is the most important factor in getting more of it. HOW ARE WE GETTING OUR DIRT? Bank-owned leasing companies are obviously funding through their bank parents. Assuming the bank is healthy, obtaining cheap funding is not difficult. Independent companies, both vendor-controlled and non-vendor independents, have different ways of funding themselves. Most companies can be lumped into two different models: a) ON BALANCE SHEET MODEL Many equipment finance companies fund 100 percent on balance sheet. The companies, depending on the risk profile of the underlying assets, are 2.5:1 to 5:1 leveraged, with most being at the higher end of the leverage scale. For companies with under $150 million (or so) in assets, the leverage is primarily in the form of bank debt and/or fixed rate loans negotiated with insurance companies. For companies with over $150 million (or so) in assets, companies use a mix of bank debt, privately negotiated insurance company debt, and asset-backed securities (or pseudo-asset backed securities issued by banks on balance sheet but rated by S&P, Moody’s, etc.). Equity is usually a mix of a) “true” equity (either contributed common equity capital and/or retained earnings) or b) preferred stock and/or subordinated debt (most commonly looks more like debt than stock). As a general rule, lenders like to see at least 50 percent of the equity as “true” equity. Independent companies who utilize this “model A” include many of the long-standing independent finance companies from very large companies like ILFC (aircraft) to Allegiant Partners, and everything in between….including Financial Pacific Leasing, Pawnee Leasing, Direct Capital (direct also sells transactions) and Dakota Financial, Atrium, Great America, Marlin, LEAF (although equity funding is different with LEAF). GECC has evolved to becoming more of this “model A” funding structure, as it does not rely nearly as heavily on gain-on-sale funding transactions as in the past. b) OFF BALANCE SHEET MODEL As a general rule, there are two types of companies who utilize off balance sheet financing. The first is companies who are primarily “residual players”. Their basic business model is to invest as little possible in order to control equipment at or near the end of its lease term. An example is a lease of $100,000 to a school district for computers. Assuming a two-year lease with the option to either return the equipment or to purchase the equipment at its “FAIR MARKET VALUE” (this is simplified…most leases will have a host of other potential occurrences including replacing the computers with new computers), the leasing company will hope to invest a small amount, sell the two- year lease stream to a bank, and then collect money at the end of the lease either by a) selling the equipment or continuing to lease the equipment. The second type of off balance sheet funding structure is the “gain-on-sale” model, the popularity of which peaked in the “dot com” era until about 2000. This model has an originator bundling leases originated, and “selling” the leases to a bank or other institution but retaining servicing and often continuing to be on the hook for various levels of guaranties. This model generally proves to be very attractive as long as volume continues to grow and underlying portfolio quality is good. When troubles begin, this model quickly disintegrates as revenue drops and costs rise. How easy is it to get dirt these days? The bottom line…for farmers who have survived the financial crisis…it is easy to get dirt. Breaking it down for you farmers… RECOURSE DEBT There are a number of established providers of recourse bank lines to established equipment finance companies who are eagerly expanding their relationships. Most of the banks lend off a spread over LIBOR (1, 2, 3 or 6 month) and finance companies then hedge their interest rate risk with options or swaps. The banks, such as BIMO Harris, Wells Fargo, Capital One and others, generally will only work with extremely well capitalized start-ups (i.e. $50 million in equity) or with equipment finance companies with histories over 10 years. The companies are generally limiting leverage to 4:1 or 5:1. When loan needs exceed $100 million, it is possible to borrow on a cost-effective basis utilizing structures that are like bankruptcy remote, off balance sheet securitization vehicles but due to accounting, Frank-Dodd and other rule considerations are actually often on balance sheet. Larger transaction amounts are needed in order to cover the costs of at least one rating agency and substantial legal fees. Recently transactions have closed with Atrium and LEAF. Some of the larger equipment finance companies, such as Great America, have used insurance company money to fund their operations in privately-negotiated financing transactions. By going to an insurance company (or a club of 2 or 3) and negotiating a transaction on a one-on-one basis, the legal expenses and complexity of documentation is greatly reduced. There is sometimes not a need for a rating of the underlying loan instrument created, or a “desktop” or other less expensive rating can be used. NON-RECOURSE DEBT Non-recourse debt is created when a finance company sells rent receivables to another finance company, and the seller is released of any liability related to the lessee/payee. In the small ticket world, transactions are normally “brokered” to the second finance company by the broker, and the creation of non-recourse debt is less common. In the middle market and large ticket markets, however, non-recourse debt is a common way for the original lessor to retain control of the customer and/or the residual value of the asset while retaining the ability to fund a larger number of transactions. The non-recourse debt market for middle and large ticket transactions is very liquid. Investment-grade credits are purchased by banks at historically very low rates. Transactions are traded at 3% all-in rates and lower. With one month LIBOR hovering at .2 percent and two-year swap rates low, there are low rates available. Small-ticket transactions are being purchased in bulk or on a one-off basis at historically low rates as well. Transactions over $150,000 for good credits are being purchased for under 4 percent fixed rates, and smaller transactions good credits are often traded in the 4 percent to 6 percent range. SUBORDINATED DEBT Subordinated debt is often used to assist finance companies in obtaining enough “equity” capital to ensure debt, equity and other ratios required by lenders are met. The debt is subordinated to all other debt holders, but ranks ahead of common equity (or other forms of equity) in the capital structure. Subordinated debt is generally issued either by wealthy individuals interested in obtaining a constant cash return, or by firms that specialize in issuance of subordinated debt. The rates and structures vary, but a market starts at approximately 6% coupon (with conversion options/warrants) and goes up to high teens or 20 percent rates. It is important to note that some subordinated debt issuers require a blanket second lien (behind the primary lenders) to be filed, but many lenders are not willing to live with a second lien holder in order to completely control the disposition of assets in the case of a bankruptcy of the lessor. EQUITY The equity market IS BACK! Largely due to the lack of independent finance companies and the desire of banks to increase the number of product offerings and diversify their portfolios, independent finance companies with the ability to potentially produce bank-quality assets are attractive as an equity “play”. Specialty private equity firms and wealthy individuals are interested in investing in solid equity opportunities, and banks are actively looking again for attractive platforms that can be “plugged in and grown”. BACK TO THE DIRT We now see the dirt and where it comes from. The key differentiator, as always, is the way in which the dirt will be used. This is where the world becomes very interesting, and the story really begins. Financing for established finance companies is not difficult. The difficulty is competing in a marketplace that is highly competitive, has technology that changes daily, is increasingly reliant on scoring models, related to a product which is difficult to differentiate. Being able to maintain attractive financing ultimately is determined by your ability to grow crops that will survive in the long term. As an independent my cost of funds will always be higher than a bank’s. But I have less bureaucracy, and I am able to be more nimble. There must be other added value I am bringing to the table, however, in order for us to compete against lower funding costs. It could be an ability to be slightly more flexible, to take residuals, to offer better technology, to be more responsive, to allow greater access to credit. In other cases, it is an ability to charge very high rates for bad credits, or bundle services, or offer rental programs. What kind o’ dirt farmer is you?
Posted on: Mon, 15 Jul 2013 11:28:41 +0000
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