Acquisition Opportunities in Specialty Consumer Finance
The credit crunch is generating unexpected acquisition opportunities in the speciality consumer finance sector. Alan Gullan, an interim executive who recently led a financial restructuring project within the sector, explains the complexities and potential returns.
My client was a private equity-owned UK business that provides non-prime consumers with hire purchase (HP) finance, to fund the purchase of used vehicles. With an average loan origination size of £6,000 and term of four years, it has a platform to service in excess of 50,000 loans. It’s a sophisticated business that uses wholesale bank funding to finance its receivables, with advanced underwriting, collections and treasury capabilities. Funders rate the company highly and it was able to continue raising significant amounts of new funding even after the credit crisis had broken in 2007.
The facilities make use of off balance sheet structures, in terms of which Special Purpose Vehicles, or SPVs, purchase the receivables post-origination, using senior bank debt at an agreed advance rate.
Repayments from customers belong to the SPVs and the company, which as subordinated lender, is entitled to the ‘spread’ that remains in each SPV after paying down senior debt and funding costs. The company uses the spread to repurchase delinquent loans from the SPV.
These arrangements work very well when the originator is in growth mode and funders have appetites for more lending. But when this changes, there is no quick or easy exit for senior lenders, because the SPVs’ assets are future cash inflows far into the future, which cannot be accelerated unless customers default. Even in the event of an SPV defaulting, the senior lenders’ alternatives are very limited.
Fortunately for the company, its experienced CEO had had the foresight to seek a battle-hardened restructuring interim several months before the credit crisis struck. I went in as finance director and had the rare luxury of time to tighten cash controls and introduce robust, bottom-up forecasting before the crisis struck.
When, in September 2008, the credit crisis overtook the company’s main funders, I took on the CRO role as well and led a project to restructure the three bilateral bank facilities. These ranged in size from £125m to £145m and were supported by a significant warehouse line from the private equity parent.
It was vital to appoint advisers with recent and relevant experience in this specialised field, who would have credibility with the banks. Through my relationships in the restructuring community, I was able to quickly set up a credible beauty parade, which resulted in the engagement of restructuring and legal advisers.
The restructuring was one of the most complex that any of us had ever undertaken, not least because lender distress was new territory for all parties involved. With cash already stable and tightly controlled, the first challenge was to understand the detailed rights and obligations of the parties. While the company and its lenders had been in growth mode, the focus had been elsewhere. The legal advisers quickly filled in the gaps, in the process refreshing the corporate memory of provisions in the documentation that proved to be critical for the company’s survival.
The second was to model the expected performance of the individual portfolios, six years into the future. The advisers were exploring new and difficult territory, because small movements in factors, such as early settlement and loss rates, can cause significant variations in outcomes.
There were unusual structural elements to contend with as well: no bank was a creditor of the operating companies; the parent held the security over the operating companies’ assets; and each bank lent to a different borrower. To complicate matters, the forecast outcomes for individual banks were dependent on the pool of loans their facilities funded and as such were significantly different.
It was agreed at an early stage that the banks would work together to agree a common position and that they would make use of the company’s data, rather than each appoint their own restructuring advisers.
Both the solution and the negotiations were fascinating. The strong symbiosis between the company and the funders meant that counter-intuitive solutions offered the best means of minimising value destruction, one example being the lenders continuing to support new originations as the best means of achieving a soft landing in terms of future losses on the portfolios.
Suffice to say, the company continues to be supported by all of its funders and is now well placed to take advantage of the current market conditions. It is one of the few players still originating in the non-prime automotive sector, with some significant competitors having disappeared.
This brings me to the topic of acquisition opportunities. Bank funding for new originators in this space does not presently exist. Existing funders are in a difficult place because, aside from the liquidity and capital allocation consequences of staying involved, they have to support the existing originator and servicer.
Auto loans have a relatively short life. The spread they generate runs out quite quickly after a certain point in their life. To maintain the benefit of credit enhancement,it is in the existing funders’ interests to recycle capitalfor origination. In other words, suddenly jumping off the carousel they’re on could cause significant losses. Their only option is to slow it down gradually, for a soft landing in a couple of years.
Having decided to lend only the minimum, at some future point they all will face the decision of selling the sub-economic rump of the portfolio. Then there is the issue of a servicer focussed on cash collection not being motivated to keep accounts up to date, only to collect something.
On the other hand, the subordinated lenders to these bank funded portfolios are enjoying massive margins, with high fixed income and low variable funding costs.
There exists a significant opportunity for a portfolio buyer to generate high returns within a relatively short time frame, through discounted purchases from trapped bank lenders and consolidation in order to achieve scale. At the same time, maintaining a motivated servicing platform and keeping the portfolios refreshed to some degree, by refinancing existing customers at good rates of return.
Looking back on the assignment, a positive outcome was by no means the likely answer and getting decisions right on a number of apparently small issues helped the company to avoid the fate of its competitors: the experienced CEO selecting an interim who could step up to the CRO role and sticking rigidly to relevant and recent experience when selecting advisers being two of them. It was important for everyone on our team to remain unflappable in the face of tremendous pressure from the lenders, who were facing serious issues of their own through the process.
Alan can be contacted at alan@gullan.com
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