So far in 2014, the commercial finance merger and acquisition marketplace can be described as one in which more deals are getting done, various buyers are seeking acquisition candidates and more sellers in turn have come into the market looking to solicit liquidity for shareholders while better positioning their platform for the future. While there is no shortage of buyers looking for acquisitions in the equipment lending and leasing, asset-based lending (ABL) and factoring sectors on the whole, the reality continues to be that it’s not quite as easy as just calling a bunch of bank buyers and selling to the highest bidder.
In today’s post-recession depository environment, most banks are simply unwilling to test regulators with a non-bank finance company acquisition. There are exceptions to this of course, but the greater trend going forward may be the emergence of other non-bank buyers, such as business development companies (BDCs), and the increase in private equity buyer interest.
Bank Interest: Is it Real or Isolated to a Few Recent Deals?
There certainly are examples of recent transactions involving banks acquiring commercial finance companies, including highly experienced acquirer CIT’s recent acquisition of Direct Capital in the leasing sector; Crestmark Bank’s acquisition of TIP Capital, also in the leasing space; and Independent Bank in Memphis, TN, acquiring Goodman Factors in the accounts receivable financing sector. In addition, a variety of banks continue to build out new commercial specialty lending businesses or add on to existing lending platforms. For example, Hudson Valley Bank announced the formation of a new equipment leasing business in early 2014. Additionally, Triumph Bancorp completed the acquisition of Doral Healthcare Finance in June 2014, bringing a healthcare ABL product to their existing ABL platform.
This all adds up to just some of the recent activity for the commercial finance M&A market, but how aggressive will banks be in M&A transactions for these companies going forward? There is no question that many banks have excess capital, little or no loan growth, and deteriorating net interest margins and fee income. In fact, the FDIC noted in its Q2/14 Quarterly Banking Profile that the average net interest margin of banks reporting earnings in the second quarter fell to 3.15% from 3.25% in Q2/13. This is the lowest quarterly margin for the industry since Q3/89, according to the FDIC.
It would make sense for more banks to look at acquiring specialty finance businesses to combat these issues while also adding a complementary loan product that can be offered to other customers of the bank. However, two recent, active Houlihan Lokey sell-side engagements in the commercial specialty finance sector show a different trend in the buyer universe.
We are currently advising an equipment leasing company that hired us to run a full sell-side auction process, reaching out to a plethora of buyers across the bank, finance company, BDC, private equity and family investment office sectors. Given that this transaction is ongoing, we can’t disclose details or the identity of our client, but we have received non-binding indications of interest from various parties and are deep into the confirmatory due diligence phase of the transaction with a select group of buyers.
Of the proposals we received, nearly 80% of the buyers are not banks. Some banks showed interest, but the overwhelming majority of the interested buyers are private equity firms, BDCs and finance companies that are excited to find new verticals to expand into, while also generating an acceptable rate of return. Separately, a Houlihan Lokey client in the asset-based lending sector solicited a variety of offers from different types of buyers. Despite banks accounting for approximately 75% of the targeted buyer universe, only 10% of the proposals came from banks.
What gives? While this is a small sample size of sell-side M&A transactions in the commercial finance sector, we believe that most banks are unwilling or unable to clear various hurdles, both internally with management and board of directors, and externally with regulators. Many banks and their boards would prefer to just focus on bank M&A transactions for growth rather than thinking outside the box.
Also, many banks continue to be concerned about credit quality in the wake of the recession. An independent commercial finance company might not have the same underwriting parameters needed to survive in a regulated environment. An independent might not maintain proper credit files or have a reliable credit grading system that would be deemed “bank quality.” These are concerns that many banks either can’t overcome or are afraid to try to overcome.
Likewise, in March 2014 the Office of the Comptroller of the Currency published new lending guidelines aimed at banks operating in the asset-based lending sector. Many non-bank asset-based lenders don’t think their type of lending will ever fit inside of a bank, if those guidelines are the rules they need to uphold. If the independent lender is worried about the fit, so too must banks, which may look at acquiring the independent platform.
Closing the sale of a commercial finance company to a bank requires finding either a unique bank that is willing to take the time to understand the merits and risks of acquiring and operating a commercial finance business (like Independent, which acquired Goodman), or a bank that is already in the leasing, ABL or factoring business today (like CIT or Crestmark). To be fair, there are plenty of banks operating in the leasing and ABL sectors today with excellent credit quality, but not all banks are willing to look at acquiring a non-bank finance business.
Enter the BDCs
This dynamic leads to the aforementioned trend of heightened interest from the BDC market in acquiring or investing in commercial finance platforms. Following up on last year’s transactions whereby Solar Senior Capital acquired Gemino Healthcare Finance, and Fifth Street Finance acquired Healthcare Finance Group, Ares Management recently closed on the acquisition of Keltic Financial Services of Tarrytown, NY, an asset-based lender providing $1 million to $10 million credit facilities secured by accounts receivable, inventory and equipment.
The BDC community generally focuses on originating senior loans with attractive cash coupons across a variety of industries in order to generate cash-flow that, ultimately, net of expenses, is paid out to shareholders. Commercial finance businesses offer a logical product offering that meshes with the typical BDC loan offering. On top of that, investing in the equity of commercial finance platforms can provide additional upside over and above the typical senior debt returns that BDC loan portfolios will generally produce.
But the other big part of the BDC story goes back to the banks. Given the picture painted above regarding banks and their predisposition to avoid straying far afield from their core lending operations into new asset classes, a meaningful opportunity may in fact exist for non-bank lenders with access to capital to serve as an outlet for small and medium-sized businesses seeking financing. If banks are going to be guarded with the financing they are willing to provide, who is going to fill the void? BDCs, among others, may have the best shot.
While BDCs and other non-bank lenders do not enjoy the same low-cost source of funding as banks, we believe their access to significant capital, flexibility on structure and willingness to move quickly to a loan closing will position BDCs and non-bank lenders to not only be competitive with bank lenders, but also steal market share from the banks. Therefore, BDCs who are examining the commercial lending continuum for holes in their product offering continue to peruse the ABL, factoring and equipment lending sectors for platform bolt-ons and experienced management teams.
Many BDCs are willing to allow the management teams they acquire to continue operating with autonomy, similar to the way many private equity buyers manage their portfolio company acquisitions. Unlike private equity buyers, however, most BDCs, utilizing their permanent capital, are not looking to sell their acquired businesses in three to five years. Therefore, despite an immaterial funding synergy when selling to a BDC, many commercial finance company sellers find the BDC model to be attractive. The lack of the funding synergy from BDC buyers, however, naturally limits their ability to pay as high a purchase price for an acquisition as their bank counterparts.
Financial Buyers Showing Greater Interest
Despite a higher investor return hurdle, private equity buyers and other types of financial buyers, including family investment offices and hedge funds, have shown an increased interest in commercial finance acquisitions in 2014. The ABL and factoring industries have traditionally been challenging sectors for private equity investors who often need their portfolio companies to experience significant growth so that upon a liquidity event, they can generate an adequate internal rate of return. Non-bank ABL companies and factoring companies often struggle to find year-over-year net asset growth due to the higher rates they charge their borrowers, versus their bank counterparts. This is certainly the case in today’s hyper-competitive market for new business.
Many leasing companies, on the other hand, have experienced significant growth as the economy has recovered and more small businesses are willing to invest in fixed assets or essential business use equipment, such as trucks, trailers, modular storage units or machine tools. The prospects for growth coupled with the multitude of senior lenders to the equipment finance sector and the re-emergence of the asset securitization market make equipment leasing a better fit for the private equity community because of the better opportunity to achieve required equity returns.
Much like we’ve witnessed in the uber-sexy merchant cash advance, online lending and P2P lending sectors recently, in which private equity buyers have made significant investments, we believe the top independent equipment finance companies will have opportunities to take on meaningful private capital to assist in attaining continued growth, which in turn positions a business for an ultimate exit to a strategic buyer down the road. Many financial buyers are itching to invest capital in good sectors with good growth opportunities, and the leasing space has companies focused on attractive industry niches, such as healthcare, IT, transportation and construction, where pockets of growth opportunities may exist due to some remaining dislocation from the recession.
The M&A environment for commercial finance companies is certainly vibrant with a variety of buyers showing interest: large finance companies, BDCs, family investment offices, private equity firms and select banks. And while we see certain banks as likely candidates to continue assessing commercial finance company acquisitions (mostly equipment leasing and to a lesser extent ABL and factoring), we believe they will not be the dominant buyer of commercial finance platforms as we move forward through the remainder of 2014 and into 2015, due to the regulatory pressures in the sector and predisposition toward regular bank M&A.
Tim Stute is a managing director in Houlihan Lokey’s Financial Institutions Group. He has 15 years of experience providing capital markets and M&A advisory services to the financial institutions sector, with a particular emphasis on the specialty finance industry, including equipment leasing companies, asset-based lenders, accounts receivable factoring companies and non-mortgage consumer lenders.
Statements and opinions expressed herein are solely those of the author and may not coincide with those of Houlihan Lokey.