Asset Finance: coping with the slings and arrows of an outrageous world
By Lindsay Town, Chief Executive, IAA Advisory Ltd
We managed the “Great Crash” of 2008, just. We managed our way through Covid, we dealt with the great liquidity experiment that was QE, we face into the challenge of Russia’s warmongering,
we manage our way through supply chain crises.
And then inflation and probable recession arrive together with the reality of global energy and food security. And then we have a change of Prime Minister in the UK. And then a major fraud in Arena Television. One could be forgiven at times for thinking that there are few bright spots. Let us first look at the journey in the UK since the “Great Financial Crash” in terms of headline data in Table 1.
The industry had been repairing itself following the “crash of 2008 but huge amounts of liquidity and “new” money were fuelling future problems. Recovery was gathering steam and then Covid took the wind out of our sails, but a degree of bounce back came in 2021, muted in many ways by supply chain issues.
The latter part of 2021 and into 2022 we also have the issues of Russia and general economic malaise to contend with. Issues related to BREXIT and Covid fade somewhat under the weight of the other issues surrounding us; they are not gone, merely diluted in the face of bigger, or at least more immediate, challenges.
The data presents a picture not of collapse, but one of “bounce back” capability and based on the latest data the industry is still financing around 33% of all capital expenditure on business assets. Even with the issues emerging, the industry managed to record a 2% growth between the first halves of 2021 and 2022.
The make-up of the “core” industry remains stable in terms of product and route to market. Over 55% of the volume written in 2021 relates to “assets with wheels” and this has only marginally varied over the years. Broker-based business accounts for circa 23%, up slowly from years past. The main market remains at about 70% in full pay-out products with “pay per use” or similar making little headway in the equipment side.
In practical terms, the UK asset finance industry currently faces a period of political uncertainty; the highest inflation in over 40 years; uncertain energy security; supply chain challenges and rising interest rates. However, the industry is not a homogenous “blob” and different segments face their own specific challenges. For the purposes of this article, I ignore the worlds of auto finance and the high value sectors, which have their own unique challenges.
As always, the industry is tied to the wider economy and capital expenditure generally is impacted by many factors, and especially for our purposes, the propensity to invest by SME entities. Wider business confidence has been at a low ebb and whilst there have been brighter moments, the atmosphere at the time of writing is generally less than positive.
We can see some pattern to the investment by UK businesses over the years in Table 2 which illustrates some of the impact of “crisis events”.
It is inevitable that the UK now faces relatively high inflation and increasing interest rates, it is considerably more than an academic exercise to consider what the near future may possibly hold. The usual weapon of choice used to counter inflation is the general interest rate. To counter inflation rates of more than 10% would in classical thinking require interest rates to be considerably higher (they hit 17% in 1979).
However, to impose such a level, or even near it would force the UK into a major recession and cause untold damage to the consumer sector including massive upticks in credit default. The effect on the asset finance industry could be no less dramatic as business generally would curtail investment, less credit worthy enterprises would collapse and wholesale funding would tighten in supply and rise considerably in cost.
Adding to this heady mix, the rising cost of servicing the public sector debt would further constrain the government’s ability to address pressing social issues.
However, our current inflation rate is not yet near as devastating as it has been in the past, albeit driven by different events, and Table 3 illustrates how benign the last 20 years or so has been, right until now.
Looking at this multi-year picture of inflation and interest rates, it is very hard to expect anything other than 5%+ interest rates in the near term. The overall impact on businesses and consumers
may become devastating at many levels. Sustained high interest rates and other “anti-inflation” policies may create the conditions for a strong and possibly long-lasting recessionary trend.
In the near term, we have seen the uptick in business investment, and this is partly driven by pent up demand resulting from the exit from pandemic conditions. However, that uptick could rapidly falter under the pressure of rising interest rates, reduced consumer spending, increasing wage demands and the all-round economic hit of increased energy costs and any additional fallout from the war in Ukraine.
Several economic commentators are now projecting that the UK will enter a recessionary period. It would not be hard to forecast a drop in business expenditure if the current conditions continue for a reasonably long period.
For asset finance in the UK, we could see the following:
(1) Availability and cost of funding: The wholesale banks may suffer their own pressures and maybe tighten credit conditions. Funding rates, in terms of both margin and absolute cost, will rise. This may be able to be priced in, but if interest rates continue to rise regularly there arises the risk of “Gap and ReFi”, i.e., deals written today may not be able to be funded at the anticipated rate and any future refinance could be considerably more costly and limited. We have not had to deal with that risk in any material way for some years. Equally, if supply of wholesale funds becomes constrained it may easily limit the growth of many UK asset finance companies.
In mitigation, there is a considerable amount of liquidity looking for a “sensible” home. Accessing this liquidity requires a very much more comprehensive approach to data and analytics than previously was required. Some have managed to achieve the required standards and have accessed the broader capital markets, but they are currently in a minority. What may become tested is the quality of the industry data and the ability of many providers to offer enough scale and robustness of process to attract well priced external funds.
(2) Risk appetite: Pressure on the corporate sector will only increase and we are already seeing in the UK a return to more militant labour practices which will either disrupt broad economic activity or add to wage pressure, or both. The SME community will particularly feel these impacts and where many are just emerging from the pandemic conditions there must be a material risk that lending decision processes will need to be materially toughened up, thus reducing the supply of credit.
The biggest potential risk is that providers of funding do not revise risk appetites or modify process. Such an approach would almost inevitably lead to deterioration in risk performance. A credit crunch may very well be on the way, despite the availability of liquidity.
Perhaps obviously, but certainly unhelpfully, historic credit data may be becoming less relevant. Asset finance providers will need to pay additional attention to non-historic information to make safe decisions. At a time when the push is to automate process, there is a distinct risk that such automation may not produce the expected results.
On the brighter side, with bank unsecured or traditional lending facing a potential degree of constraint, the asset finance industry may pick up a bigger slice of the overall pie through focussing on the hard asset collateral areas and becoming even more astute at informed lending decisions. Such a strategy would require very strong risk and credit analysis together with close monitoring and the ability to react rapidly in the face of any changing circumstances.
(3) Credit quality: Hand in glove with risk appetite is credit quality, both at inception and in-life. In the UK, it seems hard to expect no deterioration in credit quality and risk performance in the near term, mitigated slightly by temporarily higher than usual second-hand asset values for some asset classes. What will be a further test for the industry will be how corporate credit performs as government stimulus from years past starts to unwind and the impacts of inflation make themselves felt more keenly.
Inflationary pressures through energy and input costs cannot be wholly absorbed in output margin compression so further prices rises are nearly inevitable. The impact on margins and reduced demand will fuel liquidity and capital challenges for many businesses and this will translate not just into demand for asset finance but in the performance of existing books. The “winners” in our industry will be the ones not necessarily with the fastest, most digitalised, products and processes but those with the strongest credit insight, clarity of risk appetite and top line collections/recovery management.
(4) Operating systems: The tip of the iceberg in systems and process is seen as the efficiency of front-end systems, those which gives the best customer experience. However, the equally vital aspect is the accuracy and speed of data for risk management as much as customer experience perception. Analysing, and acting on, risk trends, collections, delinquency data, funding gaps and matching etc. may be the difference between winning and losing.
The UK has worked very much on legacy systems and is now in the process of playing catch up, but this is expensive and never quite as quick a process as some may want. Newer players are less burdened by legacy systems and so have led the pack in developing and implementing new approaches. However, critically, the underlying process and approach needs to be spot on before attempting change.
Automating, or digitalising, a poor underlying approach does not help a lot.
Whilst not entirely an operating system issue we can see in the case of the Arena Television fraud that a fast and responsive front-end process does nothing if the underlying transactions are wrong.
Operating systems that support the prevention and detection of such “incidents” are going to be critical in this next cycle as fraudulent activity increases when subjected to economic pressure. We are no longer in the “benign environment” that we felt that we have had for some years and our systems need to be robust enough to support the changing times, not just provide a good “user experience”.
(5) Leadership: There is some truly excellent leadership in the UK market at many levels, but very few have, as a leader, had to face into rapidly rising interest rates and inflation together with supply crises and labour strife. Some of us were working in the industry in the late 1970’s and in the 1980’s, but those memories fade.
Over the decades it seems that the “survive and thrive” DNA of strong leadership is a combination of excellent and honest communication, the ability to be versatile when faced with a “new normal”, to be able to effectively challenge and change the status quo when circumstances demand it and keep the business having a strong future vision.
Leadership in peaceful times produces little that is outstanding; strife, turmoil and near catastrophe produce the best (and expose the worst).
(6) Training and recruitment: We need to equip our current and next generation teams with very high skills to thrive, both for them and for the business, even though the mantra of “Cost Savings” will be heard a lot. It is a fact that high quality training attracts new recruits and the hardest part for a business, but the most important one, is to train people to be equipped to be able to leave your company and then create the type of culture in your company so that they do not want to leave.
Those that manage this balancing act tend to have the strongest internal advocates and the most committed people at all levels, and that has rarely been as important as it is now.
The skill sets needed for the next generation will be different from those that we have now. Leadership and general personal skills are ever present, but we must be focussing on far more digital and risk-based skills to be able to set the right path. If automation is the future, then we need to adapt our perceived “valued skills” to match that future.
(7) Regulation: Whilst most of the UK regulatory effort has been directed to the consumer markets, the corporate world is not untouched. Regulatory intrusion will continue to accelerate in our industry and especially for activity with the “s” end of the SME markets. The fact that many providers are not directly regulated by the Bank of England/PRA has been a benefit in many ways through lack of red tape. However, the trends in the UK are to capture an increasing swathe of entities into the regulatory regime, both customer types and lenders/providers/intermediaries, both from the FCA and the Bank of England/PRA.
The specific issue for the industry is not just complying with the rule book (which at around 10,000 pages plus regular updates, is not a weekend read), but it is more a systems and infrastructure point to be able to have the data, monitoring and analytics to comply. Smaller providers, whilst efficient and serving a specific need well, may find that their costs and management resource are strained.
This concern will also apply to the large number of independent intermediaries in the UK who have often been “light touch” or not at all regulated.
Irrespective of views about the merits or otherwise of the UK regulatory regime, the trend for the near term is for a tightening of controls and a widening of scope.
(8) Product: The UK industry has really “stuck to the knitting” for several decades. Whilst the auto market has developed rapidly to a personal contract hire style of product and is starting to embrace areas such as subscription, the equipment market has stuck well to older products, even the core form of funding a small leasing company has stuck for decades with “block discounting” as its tool of choice. As was mentioned earlier, the product mix sticks to around 70% full pay out style.
However, increasing “noise” is emerging around “life cycle”, “pay per use” and similar products. It is feasible that the pressure on businesses in the next few years may provide a stimulus to the development of these types of products as cash conservation and asset efficiency will be even more at the forefront of customers’ minds. The issue remains turning the debate into hard products.
The UK industry, in common with many, has an inbuilt “hell or high water” approach to asset finance. The fundamental aspect of the “new” products is that this may substantially be eroded. To avoid that risk, early products emerged that created a hybrid model, with a minimum payment or floor approach. They may not meet the strict standards of IFRS 16 in terms of off-balance sheet for users, but they mark a move in the right direction. The additional impetus is now the ESG agenda that makes developing circular economy focussed products far more attractive.
The issue for the UK industry is how to square the historic “hell or high water” approach with the new emerging models. Regulatory capital allocations, risk analysis, resourcing for asset management and skill requirements all need a degree of fixing. However, if there is any bright spot in the current somewhat gloomy climate it is that there is a bigger incentive than ever to move the products along.
The impact of moving away from traditional products will also be felt in the wholesale funding side and here we have seen little move away from the traditional mostly bilateral models. The advent of new stakeholder types such as Hedge and PE has helped shake up some thinking, but it remains early days. Therefore, the UK faces an excellent opportunity to develop new sources of funds and improved capital raising. We see some starts to those trends and it can be hoped that the developments will gather pace in the medium term.
(9) ESG: ESG and “Green” have been rising topics and are taken very seriously in the UK. We are now moving away from the early “greenwashing” approach and heading towards more practical and valid application. The challenge for the UK asset finance industry revolves around both product and policy.
For example, would a provider turn away business on ESG grounds? In large scale corporate finance such things do happen, but in the wider market especially SME, it is not a well-trodden path yet.
Supporting ESG friendly assets is right but where does the industry move after that? Notably, some have become crusaders for circular economy and ESG activities and this is laudable, and some have looked to funding partnerships with ESG supportive manufacturers. However, the question remains what more can be done and how far will the industry develop. We have seen some capital market facilities written with price linked to ESG outcomes and in the high value leasing market some “Green Certified” leases have been written. Could the return linked approach move into the main asset finance market? I would like to think that it could albeit it is not an easy step, though there are possible solutions.
Conclusion. Recent times have set the UK on the path to a potential multiyear recession. For the asset finance industry, whilst there is bound to be some short-term pain, there is, as always,
great opportunity to reset the model and come out in better shape.