“The higher rates are coming! The higher rates are coming!”

An interview with Equipment Finance leader David Gnade on the risk and opportunities of impending rate hikes.

You don’t need Paul Revere to ride by your house with a personal warning about rising interest rates. News media pundits everywhere opine daily on the impact FED interest rate increases already made and those pending. Inflation and rate hikes are topics that comes up frequently in discussions we have with individuals across the equipment finance industry.

At a recent Advisory Board meeting we were reviewing applications of Tamarack.ai, our business intelligence and AI technology platform. David Gnade commented that with the coming rate hikes portfolio managers needed to be on the ball with several situations within their portfolios. David is a 30-year veteran of equipment finance as a sales leader with a specialization in vender-financing. David is a managing partner of Fairway Capital, LLC which provides leasing and fleet management services to the golf industry, and we are pleased to have David as a member of the Tamarack Technology Advisory Board.

I was curious how future rate hikes could affect past deals but also knew from experience that David was thinking ahead – looking to be proactive and take advantage of the situation, not suffer its consequences. So, I asked David if he would be willing to discuss the topic in more detail and share his insights with our readers.

What are you expecting from the fed in terms of rate hikes? What have you heard?

I see a bitter pill for all of us. Inflation is at a 40-year high of 8.9% and historically interest rates are usually above inflation rates. Today we have the inverse: interest rates in the 5-7% range with inflation pushing 9-10%. The Federal Reserve guidance is 50 bps hikes in the next few months and then continued 25 bps hikes until inflation is under control. The rate hikes could be even higher if inflation continues to rise this year.

I have read that 40% of economists are now predicting recession. Businesses cannot grow because they cannot source the equipment and supplies needed for production. Combine these supply constraints with the Federal Reserve implementing aggressive rate increases and we will see both wholesale and consumer prices continue to increase throughout 2022.

What are some of the tactics to deal with the rapid rate hikes?

I wasn’t in the business during the early 1980’s, the last time there was this kind of inflationary pressure, but in the 2000’s during the Dot.Com bust we had to deal with rapid interest rate hikes and become nimbler to protect profit margins. Finance companies did not have the tools we have today to deal with rapid rate hikes. Machine learning models and AI predictors can help inform us on how to address pricing, backlog and delinquency challenges more quickly.

Raw materials, microchips and supply chain issues are increasing the costs to produce goods. Manufacturer equipment quotes today are limited to 30 days to protect their margins. Delivery of equipment is being delayed and Finance companies are going to have to the ability to raise pricing or be faced with honoring deals that may not be profitable.

The supply side effect seems to be a new complication driving toward recession. How should lessors be thinking about that?

The 2007-2009 recession was created by overly aggressive credit default swaps and the ultimate collapse of Lehman Brothers. The Federal Reserve began slashing rates to stimulate the economy. The primary issue then was banks were not lending and access to capital was limited to the best credits. Banks didn’t trust each other and lessors had to preserve capital. Small businesses couldn’t get the capital they needed and many failed. The businesses that did survive had developed excellent relationships with lending partners who continued to lend them capital through the recession.

This time the issue is equipment. Capital is available – we have seen almost $3T pumped into the economy – but supply is constrained. The finance companies who have developed relationships with vendors will have the advantage.

In looking at the market, what consequences will there be for finance companies who are complacent in this rising rate environment?

There is less risk for larger financing companies that have risk and compliance departments to manage to interest rates and margins. Smaller finance companies often have warehouse lines that have short term variable interest rates that are subject to monthly interest rate fluctuation. They will fund the manufacturer, commence the lease, and then hold and age leases for a period to maximize profits. Many times, they sell larger tranches of deals to get better pricing. It is easy to lose track of transactions and holding transactions too long in a rising interest rate environment is a major risk to margins and profitability.

For lessors using warehouse lines they must develop policies and procedures to timely review the transactions to protect margins and maximize profits. Having a solid base of diverse lenders is critical to success as lenders will tighten credit in a rising interest rate environment. The usual matches may no longer work and lender prediction using Tamarack AI can find the matches critical to maintaining margins.

One view of this market is that smart businesses are going to realize that both equipment prices and leasing rates are the lowest they are going to be for quite a while so they will try to move quickly. This should mean a rush on new applications and deals. Based on your experience, what opportunities do you see for lessors?

I see three opportunities for lessors.

The first is to rewrite or extend financing of existing equipment on lease. New equipment is not readily available and refinancing existing equipment will be safer for the lessee than trying to buy new. The lessee that is willing to take the risk for new equipment is subject to delivery delays, renewal rental payments, price increases and interest rate increases until delivery of the equipment. Rising used equipment prices show that demand is there, but supply is not. Lessors who are agile enough to capture the renewals and opportunities with used equipment will benefit from the fear of the lessee losing access to mission critical equipment.

Second, those companies with strong partnerships with equipment vendors (new and used) will have better access to equipment and thus could benefit from the supply side shortages.

Third, leasing companies who manage risk with a time-based approach are going to be most successful. They are already proficient with time-stamped data and trend analysis to support quick decisions in a dynamic rate environment.

When it comes to time-based data, who has the advantage when things must happen fast – those with smaller portfolios who can change terms or those large portfolios that can absorb mistakes?

Big banks will tighten credit and lend to the best credits, maintain margins and buckle down to weather the storm. Small lessors can be more agile. Small nimble lessors can change their policies and procedures to accommodate both the lessee’s struggling to find supply and the fast-changing interest rates. 90-day interest locks will have to be revisited as a 30k deal at 5% today could be $34k deal at 7.5% 60 days from now. The supply side of the situation means pricing must accommodate delivery delays. Modelling and predictive thinking will help avoid the consequences of the Fed’s coming actions.

Small lessors should be able to outmaneuver big companies and steal business. This is an opportunity to capture share – sustain customer engagement. It’s a great time to be out selling.

What other actions have you taken in the past during these high inflation periods? What data did you find critical to managing the risk?

Depends upon the focus of the business, of course, but several things quickly come to mind.

• Price with market – raise prices as the rates increase. But also consider the risk inflation creates for each segment and price accordingly.
• Look at the impact of inflation on your market segments- both portfolio and originations. Understand the impact on new deals, but also risk change in portfolio.
• Operating leases (FMVs) may become more attractive, but they bring more risk for the lessor via residual uncertainty. FMVs can be an opportunity to grab market share for smaller lessors.
• Residual value data becomes critical both to support lease demand and keep track of inflation effects.
• Effective management of warehouse lines. Manage pricing, aging, and timely funding to best lending partners to maximize profits.
• Portfolio delinquency reports by lessee, vendor and funding source. Data driven decision to exit portfolios that are not profitable or trending poorly.

What parting advice do you have for companies in the equipment finance industry?

The number one thing is to add value: become a valued partner by solving problems for vendors to become a key part of their business plan rather than just a source of funding. Hold quarterly business reviews, change the program to drive business, help vendor to close deals. In essence, offer more services than a bank to earn higher rates in return. Choose to do business with companies that lead with leasing vs a cash sale or financing as an option. Companies that lead with leasing have immediate business and higher margins. Programs are more successful and make more margin when leasing is part of the vendors sales culture versus just an option.

Author’s Note: Thank you to David Gnade for responding to our questions.