Alta’s 2023 Insights on Where We Are, What’s Ahead and What to Do

Where Are We Today?

Even while anticipating a recession in 2023 and knowing that America’s pandemic support programs were expiring, many equipment finance companies were bullish in late 2022, reporting strong business growth, although with some trepidation about the year to come. Fortunately, the pandemic downturn didn’t plunge our industry into recession, largely because there was enough federal funding in the system to help shuttered businesses and otherwise impacted borrowers and lessees to cover their payroll and basic operating expenses. 

Unfortunately, however, too many companies appear to have been more reactive than proactive in connection with market volatility. They will need to look beyond today and their past experiences to manage anticipated changing conditions and potential wildcards.

As one would expect, the more proactive companies began preparing earlier for potential trouble ahead. With some evidence of bank liquidity drying up, with a flight to quality beginning to be more apparent, and with funding of precautionary measures becoming more costly C-suite planning for these and other market changes began to dominate the agenda.

At the end of the year the industry was also coming to grips with the significance of state disclosure laws. Not only was the breadth of the first of these requirements becoming more clear (notably for deals in California and New York), but some industry participants who offer financing nationwide began to report that the ways these regulations appear to vary greatly from state to state are among their biggest current concerns.

Then, of course, there is widespread uncertainty and concern about the Consumer Financial Protection Bureau’s data collection rules under Dodd-Frank Section 1071, which are also expected to be very close to completion (and mandatory compliance for virtually everyone in the industry) sometime this year. Our industry has been talking about these rules for more than a decade since Dodd-Frank became law. These rules are expected to be burdensome, will affect all “financial companies,” and are anticipated to create confusing operational and compliance challenges concerning the collection of borrower and lessee gender, race and ethnicity, and small business data affecting both front-office procedures and back-office reporting.

Accordingly, companies will need to create training for regulatory compliance and hire staff capable of combining existing information technology (IT) systems with a 1071 compliance system that contains compartmentalization and audit capabilities. When and how the actual requirements for compliance with the 1071 rules become reality, however, remains an area of uncertainty as we proceed into the new year.

As expected, another major topic of discussion among industry leaders at the ELFA Fall Convention was the widely predicted 2023 recession — Will it happen at all? If it happens, will it be just like (or totally different from) previous downturns when considering the effects of inflation and rising rates? Andwill it be exacerbated by additional pressure  from concurrently managing new regulatory compliance requirements?

Overall, it appears that recent history isn’t really a reliable guide to what to expect going forward. The Economist recently reported, “Many observers point to similarities between today’s predicament and the early 1980s, when Paul Volcker’s Fed crushed inflation, causing a deep recession in the process. Others look at the downturn that followed the energy crises of the 1970s, echoed by the surge in oil and food prices today. Still others point to the dotcom bust in 2000, mirrored by the collapse in tech stocks in 2022.

“But these parallels have serious flaws. Inflation is nowhere near as entrenched as at the start of Mr. Volcker’s era. Growth is far less energy-intensive than in the 1970s. And the economy faces more complex crosswinds now than it did after the bust of 2000. The unusual nature of the deep Covid-induced downturn in 2020, and the roaring recovery in 2021, when fiscal and monetary stimulus flooded the economy, limits the relevance of past episodes.”

Indeed, some in the industry may remember that a different tax environment existed in the ‘70s and the early ‘80s before the federal government’s tax overhaul in the mid-‘80s (particularly the Tax Reform Act of 1986 and related adoption of the 1986 Income Tax Code, which is still in effect) had a major impact on the industry, especially income tax-based and leveraged leases. Similarly, as described in detail in The Alta Group’s seminal report following the economic slump in 2000 (“The Perfect Storm,” published by the Equipment Leasing and Finance Foundation in 2003), the failure of several equipment leasing companies during that slowdown was due to a confluence of unusual factors, including overly optimistic expectations combined with inadequate execution of operational plans during a time of uncertainty.

Many in the industry’s current workforce have limited experience with past recessions and downturns, having entered the industry after the “Great Recession” of 2008-09. The new generation expects higher salaries and greater scheduling flexibility, both of which contribute to rising costs and require relatively higher margins, even though the unemployment rate remains low and demand for workers appears high. In addition, there are macro issues that every business must address in the current economic, cultural, and financial reality, namely, bringing employees back to the office, addressing related logistical and technology details (and costs), and improving workflows in a hybrid workplace.

Finally, complicating the current financial and business markets even further are such overarching concerns as Russia’s continuing assault on Ukraine, rising authoritarianism throughout the world’s markets, on-going supply chain disruptions, political division, a weak merger and acquisition environment, and the challenges facing corporate boards in meeting ambitious but so far ambiguous Environmental, Social, Governance (ESG) standards.

Altogether, our industry is currently in a time of flux unlike any in the past that were propelled largely by economic, tax, and financial issues and forces. These are now compounded by the roiling sea of social, political, and cultural uncertainties throughout the U.S. and internationally—creating a storm that will require thoughtful, skillful, and creative leadership to navigate. In the current environment, business-as-usual will not be the usual business that successful companies must follow.

What Happens Next?

Despite the many challenging headwinds, and the assumption of a looming recession that –perhaps — hasn’t appeared yet in industry data, there seem to be developing opportunities, as well. These include the growing demand for equipment that will be needed to build out and improve America’s infrastructure and — a big one for our industry — the emergence of a multi-faceted market for financing of climate-oriented equipment that is motivating whole new asset types and categories for the industry.

This broader range of new opportunities will very likely benefit independents, especially asset-focused financing companies, and mid-size independents that have been at the leading edge of the “digital-first” revolution, while banks and bank leasing companies are likely to hold or even pull back before developing years of credit and underwriting experience in these newly emerging areas.

Our industry as a whole should also benefit because we are often the first line of financing for essential equipment, particularly through captives – equipment that is crucial to the expansion of multiple industries, that is revenue-producing, that is labor-saving, and that allows businesses to comply with increasingly stringent regulatory requirements. In addition, businesses may gain competitive advantage by refreshing their marketing and positioning to reflect increasing equipment knowledge and asset management capability.

As a result of this combination of factors, the industry may be expected to withstand another recession better than other sectors of the larger economy. Independents with a variety of funding sources, (and perhaps also a securitization engine), are likely to be in an especially good position when competing with others who are dependent upon bank lines for funding.

Though industry data may not show it quite yet–and while many lessors may still be in denial–we do expect a recession to occur. We think it likely that the downturn will not be as long-lasting or as deep as some forecasters predict, and there are certainly wild cards that make it almost impossible to accurately predict the scope and shape of the slump.

One such wildcard is sometimes referred to as the persistence of the SMB “apocalypse,” creating so-called “Zombie” companies—those small and medium businesses that were able to weather the COVID pandemic primarily thanks to federal PPP (payroll) loans or Small Business Administration (SBA) Covid Disaster Loans and provider accommodations, all of which disguised or obscured their underlying credit and financial weakness. In a December 14, 2022, article, The Wall Street Journal noted that the SBA issued roughly $390 billion in COVID disaster loans to nearly four million small businesses and nonprofits, pointing out that many small businesses are now struggling to cope with rising costs and continuing supply chain problems.

At some point, some of these businesses will not have the cashflow to service debt obligations. Are they just shells of companies that can only survive on government largesse? If so, what percentage of them will ultimately fail when the spigot runs dry, or perhaps be saved by acquisitions or turnaround strategies at bargain prices? Figures are not in yet, of course, but it is a reasonable assumption that a meaningful number of Zombie failures could still be seen. Another wildcard is the potentially massive losses in commercial real estate that are anticipated when renters withdraw from office leases because municipalities and businesses must comply with new zero emissions rules in some states. As noted above, this may provide some equipment financing opportunities; but it may also portend difficult times for current borrowers and lessees whose businesses, staffing, supply chains, and operations are disrupted or permanently altered in response to these new pressures.

Whatever we see happening to the economy overall, it is safe to say that we may expect an intensified regulatory environment to have ramifications for businesses not only in regulated financial markets but even for “unregulated” companies through disclosure, data collection, and other such requirements affecting all, even commercial, finance companies. At the same time, a changing bank funding environment with a rising cost of funds and growing selectivity of commercial banks may have the effect of reversing the margin compression we’ve seen over the last seven to nine years.

While we anticipate that disclosures will be less of an issue as many compliance requirements become commonplace, we expect that new opportunities will create new risks to manage. For example, as Alta’s Paul Bent pointed out in a recent article for the Monitor on the Internet of Things, as IoT-enabled equipment continues to create and transmit literally trillions of gigabytes of data to unknown recipients for uncertain purposes, the risk of liability claims against owner/financers of such equipment increases exponentially. (As one small example, according to a recent article in IEEE Spectrum,every Tesla automobile continually stores and transmits thousands of data points, including every time the car shifts from Neutral to Drive, the speed of the car, video files from on-board cameras, cruise control details, and much more at data rates of up to 50 times per second.)  It is likely that distracting and expensive legal issues will arise as the use and potential abuse of these massive volumes of remote personal and confidential data become more and more widespread.

Another example of new opportunities and related risks can be found in the highly regulated U.S. cannabis market, whose core product is still illegal at the federal level. This untenable situation has led to confusion and legal issues in the states where the growth and sale of cannabis products has been decriminalized but the use of customer credit cards and the financing of farming and retail equipment through federally chartered or regulated lenders remains unavailable. Many intrepid cannabis entrepreneurs are finding funding through private or unregulated resources, but we expect to see many shifts in the financing landscape to come in this sector.

Financing related to climate is already well on its way to becoming a major asset class for the industry, and this is one reason that the ELFA last year created the new Climate Finance Working Group (CFWG), which is chaired by Alta’s Patricia Voorhees. The primary mission of the CFWG is to share best practices in this area as they develop and to provide education and government advocacy on related topics. The Group also plans to include questions in the ELFA’s next annual Survey of Equipment Finance Activity (SEFA) that could show how much ELFA’s climate finance members are doing in this rapidly developing area.

The newly emerging climate finance market clearly has enormous potential. The International Energy Agency predicts that, on average through 2030, $4.3 trillion annually will be needed for all decarbonization technologies and another $300-$500 billion will be required to fund breakthrough decarbonization technologies, a great deal of which will require long-term equipment financing and leasing. What’s more, we anticipate that the market will expand further due to the continuing emergence of renewables and the transition from fossil fuels, opening still more opportunity in financing these technologies, both at utility scale and in single facility or residential applications. By 2030, electrical energy from wind and solar power are expected to increase sixfold, while transportation-related oil demand is expected to decrease by over 33 percent.

What Does That Mean for the Future?

It’s clear that equipment finance companies are (or should be) preparing to weather a recession while seeking new opportunities to exploit. They are focused on solidifying and diversifying funding sources and re-evaluating credit scoring models that have become automated but have been built and calibrated for a different time. Perhaps most importantly, forward looking businesses are actively seeking dynamic and qualified talent to carry them into the new asset classes, financing structures, and shifting landscape we foresee for the industry.

While many lessors may see their short-term productivity numbers rise, they should also prepare for a possible bump in client defaults resulting from the phasing out of “emergency” government funding and subsidies. This means shoring up reserves, positioning themselves through careful compliance planning and procedures for the increased regulatory pressures that are anticipated as commercial financing and consumer financing continue to merge from a legal and regulatory perspective, and revisiting and re-calibrating their credit scoring and underwriting processes.

Entering new markets can be rewarding and can lead to significant gains in volume, but it also means carefully studying and properly assessing new and unaccustomed risks, such as those inherent in in the meshing of consumption financing with the ownership or material interests in equipment that is integrated into the “Internet of Things,” or in those arising from investments in new markets such as cannabis, where there may be many red flags for fraud and the cost of managing for government oversight and compliance with federal and state rules.

As mentioned above, new financing products addressing such markets as climate equipment finance are likely to present very big opportunities going forward, but funding for “old” energy markets, including steam units, towers and infrastructure, motors, generators, and switchgear, for example, will remain a good financing niche even while green energy investments are getting attention and may be sweetened by government incentives and ESG directives.

While it’s natural and appropriate to become cautious during volatile times, those are also when creative executives reconsider aging business models, explore emerging markets, reassess, and realign their organizational methods and practices, and take steps to implement necessary changes in systems, processes, and company mindset.

Indications are that the business world is aware of this. A study by AlixPartners reported that 98 percent of executives said they need to fully revamp their companies in the next three years to adjust to the new business environment and leasing finance executives and management would be well advised to begin, if they haven’t already done so, moving smartly in the same direction or risk missing opportunities and falling behind by standing still.

In a recent Q&A for the Monitor, Alta Vice Chairman Jim Merrilees pointed out that equipment finance companies also must adjust their practices to attract the next generation of leaders and embrace new technological innovations stemming from artificial intelligence and imaging. It follows that if new technology applications can do a better job of forecasting, automating, and carrying out day-to-day business they can also free up executives to focus sharply on innovating, developing more business, and executing their visions for the future.