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Pricing Efficiencies and Inefficiencies in Equipment Finance

Date: Apr 04, 2016 @ 07:00 AM
Filed Under: Industry Trends

With movements in the economic and regulatory fronts on the horizon, it’s a good time to examine how these, and other factors, could affect the equipment finance market in the near term.

Equipment Finance Advisor recently spoke with Mark Mooney, Syndicator at BMO Transportation Finance, to discuss the current pricing dynamics in the equipment finance market. Mooney offered his opinions on what’s driving pricing across market segments, touching on issues such as management review, tax benefits and the regulatory environment. He also provided guidance on what lenders can do to take advantage of the current situation, and how they can be poised to succeed in the event of rising interest rates.

Mooney boasts more than 35 years of experience in the equipment finance industry. For 25 years he was in charge of the Capital Markets Equipment Syndications Sales Desk at GE Capital. His syndicated transactions covered diverse product and collateral types, including large-ticket, middle-market and small-ticket transactions. Prior to GE Capital, Mooney was a capital markets equipment syndicator at Maryland National Leasing and Equitable Life Leasing.

Equipment Finance Advisor: From your perspective, what are the pricing dynamics for financing large-ticket, middle-market and small-ticket products?

Photo of Mark Mooney - Managing Director - BMO Transportation Finance

Mark Mooney: The large-ticket market tends to be more efficient from a relative value standpoint because those transactions typically receive higher level executive management review. The middle market, on the other hand, tends to be much less efficient for three reasons:

For one, the size of the transaction reduces the number of lenders required to satisfy the customer’s need. Second, the customers tend to be privately-held companies where the relative value analysis becomes less clear. Finally, lenders’ concerns over protecting the customer relationship can lead them to drive prices down. When just one lender can cover a customer’s needs, you often see overly aggressive pricing.

For the small-ticket market, it’s really all about speed and the ability to analyze exceptions. The small-ticket market tends to be more “indirect,” meaning a vendor tends to be the customer versus the actual end-user. Therefore, enabling a vendor to give quick approval to a customer is the key to success in the small-ticket market.

Equipment Finance Advisor: What pricing structures are most prevalent in the large- and middle-ticket markets? For example, FMV leases, conditional sales contracts and operating leases. Also, what’s driving the demand for these specific structures?

Mooney: We’re still seeing a higher percentage of transactions structured as tax-motivated leases -- as opposed to straight debt products -- with some sort of early purchase option, capped FMV or Split TRAC. Since bonus depreciation was extended into 2016, we expect lessees to take advantage of this benefit. With the accounting rules changing, effectively requiring tax leases to be reflected on the balance sheet of the lessee, the primary motivation for entering into tax leases seems to be the passing of the tax benefits.

In the middle market, we’re seeing increased demand for straight-term debt financing because of the accounting treatment issue mentioned above, the fact that many customers can use the tax benefits and customers who are motivated to take advantage of the low rate environment.

Equipment Finance Advisor: How does credit quality drive pricing behavior?

Mooney: With the increasingly tighter regulatory environment, lenders have been encouraged to pursue higher credit-quality customers. This has exacerbated the supply-demand imbalance we see in the equipment finance marketplace. The result is that the spread between a BB-equivalent rated credit and an A-rated credit is as tight now as I have ever seen it over my 35-year career. The B-rated credit market is where the supply-demand imbalance is less prevalent. It’s also the segment that affords lenders the opportunity to improve their overall portfolio spread.

However, the regulatory environment limits a bank’s ability to participate in the B-rated space, causing the supply-demand imbalance to be less acute. Lenders that are able to participate in the B-rated space are rewarded for their ability to underwrite these leases by being able to secure returns more in line with relative value comparatives. We see B-rated companies utilizing various alternative options to fund their working capital and capex requirements, either through private or high-yield bond issues, second lien, mezzanine tranches or through the use of asset-based revolving credit facilities.

Lenders that can effectively underwrite and structure equipment finance products to serve this B-rated space can come away with solidly structured transactions -- many containing stand-alone financial covenants -- with strong collateral which, when taken together, allows the lender (or in many cases the lessor) to mitigate or manage the credit risk to a significant extent.

Equipment Finance Advisor: There’s a lot of expectations that interest rates will rise. What effect could that have on pricing dynamics?

Mooney: Once rates finally start to rise, lenders will eventually be unable to sell exposure off of their books. High-exposure customer accounts will require lenders to employ a syndication capital markets strategy to maintain a lending relationship with these important customers.

But with rates rising and the current tight pricing environment, this capital markets strategy could certainly prove to be a challenge. One result could be that we may finally see spreads widen. But again, with the current supply-demand imbalance, I’m skeptical that we’ll see much improvement in the tight pricing environment.

The large-ticket market may see some improvement before the middle market does. Fortunately, with respect to the middle market, the market is inefficient. Lenders will need to manage their resources to find where those pockets of inefficiency exist and move quickly through its underwriting and capital markets processes. The institutions that are able to move quickly will thrive as rates rise, and those that are less efficient will be challenged to maintain reasonable spreads and offset portfolio runoff.

Banking products and services are subject to bank and credit approval. BMO Harris Bank N.A. Member FDIC

Equipment Finance Advisor Staff Writer
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