In our last newsletter, we discussed some of the key messages arising from the Equipment Leasing and Finance Foundation’s State of the Industry Report and its potential implications for the overall banking industry. In summary:

 

• Businesses have an increasing range of financing options, including the capital markets, venture capital, and private equity firms, as well as cash stockpiled during the recent economic downturn.

 

• Increased competition, as well as excess market liquidity, is causing downward pricing pressures, even as cost of funds continues to rise. As a result, Net Interest Margin continues to decline.

 

• In reaction to these changes, banks should increase their focus on non-lending activities (cash management and wealth management), use account planning tools to proactively offer solutions to customers, and develop ways to differentiate themselves in the market.

 

This week’s newsletter looks at examples of how some bank and non-bank players have successfully differentiated their commercial offers. Areas of differentiation include industry focus, equipment expertise, and credit grade specialization.

 

Industry Segment Focus

Building an industry expertise allows a company to provide insights to its customers and build a marketing advantage by becoming known to the key buyers within a segment.

 

One equipment financing player has created a niche in the “environmental industry”, trash haulers.  While this is an unglamorous industry, it has been highly profitable for this lender. The company’s lenders regularly attend industry events, advertise in industry publications, and participate in events important to the industry. As a result, this bank has become the first choice for many when a trash hauler needs a new truck, and they are able to command pricing 25-50bps over the competition. Importantly, the company entered this market by hiring a sales manager known to the industry who both brought clients with him and convinced other salespeople to join the team.

 

Equipment Expertise

Some players have differentiated themselves through equipment expertise, particularly in the technology field. A number of players, both bank and non-bank, have successfully developed an expertise, and a market reputation, in asset categories that many banks avoid, such as construction equipment, trucks and trailers, and gaming equipment.

 

Operating in niches that traditional banks avoid allows a lender to provide added value to its borrowers, often results in higher returns, and creates an internal expertise that distinguishes the lender from other players. Lenders pursuing this approach hire experienced sales people, but also develop specialized underwriting skills and asset management capabilities to support the equipment focus. An initial investment in people, processes, and systems is required and can be justified by the market advantage they provide.

 

Credit Grade Focus

A number of bank and non-bank competitors have created a niche focusing on customers of a risk grade with which some banks are uncomfortable.

 

One large bank targets B or BB non-investment grade credits: “We focus on large companies with good long-term prospects that may have stubbed their toe along the way. These companies may have three or four years of losses and may be in an industry that is in the downside of its cycle. They are companies that most banks are typically not going to look at.”

 

This bank’s approach is to generate above-average revenue through well-mitigated credit risk. The company mitigates its risk through strong and thorough underwriting as well as through structuring.

 

“Every deal we do has a 20-30 page credit write-up. We look at the company’s current and past performance, its dependence on raw materials, the price fluctuation of its products, etc. Our analysis includes, for example, how much the price of plastic resin must increase before the company’s products are no longer generating the cash flow required to service its debt.”

 

Part of this bank’s underwriting process includes an analysis of how the borrower will use the equipment in its business. “For example, we look at whether the equipment will be used to produce gas-guzzling SUVs, which may not sell well with gasoline priced at $3 per gallon, or to produce hybrid vehicles for which there is a nine-month waiting list of buys.” He went on to say, “We want to finance equipment that the borrower will affirm in a bankruptcy procedure.”

 

Deal structuring is also important: “We use the standard structuring tool, down payments, letters of credit, guaranties, etc. But, we make sure that structure fits both the type and intended use of the equipment as well as the risk profile of the company.”

 

This approach is not for the faint of heart or those without extensive underwriting and risk management experience. The streets are littered with the carcasses of those who thought they were better risk analysts than the crowd. Nevertheless, leveraging a lender’s risk management capabilities can lead to excellent returns, for the few who are able to pull it off successfully. Efforts in this area need to be planned out with great care and some skepticism.

 

Concluding Thoughts

Differentiation is a requirement for economic success. The basis of differentiation will rest on exploiting existing internal capabilities or by buying/building expertise to satisfy a need in the market. Money-over-money lending leads to diminishing returns, unsustainable share, and an undistinguished market image. The equipment finance companies that have survived and succeeded through the difficult operating environment of the past few years realized that and responded effectively. All financial services providers will have to do the same.