Oct 14 2013
Effective lending risk assessment is critical to the success of equipment leasing and financing (EL&F) firms. While the EL&F arm of major commercial banks can access in-house research, many small regional boutique EL&F firms lack the resources to provide their credit analysts and portfolio managers with extensive risk and industry data. Even large firms’ in-house research may lack information on niche industries and markets. As such, EL&F professionals must devote more time to background research, rather than assessing lease opportunities and expanding their portfolios. Having effective industry and risk information on hand allows EL&F professionals to quickly evaluate lending risk, easily identify growth markets and effectively strengthen thought leadership and build client loyalty.
Industry information is an effective tool for EL&F professionals to assess lending risks because prospective leases can be benchmarked against the industry fundamentals, including revenue growth and profitability. Additionally, credit analysts can quickly take into account the competitive, regulatory and supply chain risks that portfolio companies must contend with. EL&F firms can build balanced lease portfolios by identifying the similarities and differences across businesses with a methodical approach.
EL&F firms can also use industry reports to more easily identify leasing opportunities and allocate business development budget. EL&F firms can target companies operating in high growth industries or industries poised for growth. Furthermore, leasing professionals can quickly develop a solid background knowledge of clients’ operating environment, which improves the effectiveness of business development and customer services efforts.
EL&F firms mitigate default risks through portfolio diversification. Portfolio companies may all operate within a single industry or be affected by the same macroeconomic drivers. For example, a portfolio of road and highway construction contractors may experience heightened risks as industrial production or government funding slows. Similarly, a portfolio of heavy construction contractors, residential housing contractors and utility contractors are all likely to experience a drop in demand when interest rates rise. By identifying supply chain linkages and key macroeconomic drivers, leasing professionals can build a lease portfolio that comprises companies operating in different industries and supply chains, thereby minimizing the portfolio’s exposure to isolated macroeconomic fluctuations. To this end, business environment reports are powerful tools for portfolio risk management. Business environment reports provide detailed analysis of an industry’s key external drivers. EL&F firms can easily utilize business environment reports to identify industries that are positively and negatively affected by macroeconomic fluctuations.
Industry reports also provide critical information for portfolio diversification by highlighting key challenges for individual companies within an industry and supply chain. Factors such as industry competition, globalization, regulation and technological development all contribute to the overall riskiness of an industry’s operating environment. Industry reports allow EL&F firms to compare the impact of qualitative factors, such as regulation and technological development, across multiple industries. For instance, EL&F professionals can effectively build a diversified portfolio of leases by analyzing the competitive landscape and operating conditions of various industries.
IBISWorld compiles industry-level information to develop risk scores that can be used to compare distinct industries. IBISWorld’s Risk scores are calculated based on an industry’s current and expected operating environment. These scores, which were developed in collaboration with the Risk Management Association, account for the three components of risk: structural risk, growth risk and sensitivity risk. Structural risk is calculated using an industry’s fundamental operating environment, including barriers to entry, competition and technology change; growth risk is based on changes in revenue; and sensitivity risk is tied to an industry’s external drivers. Risk scores take the guesswork out of evaluating the risk for an overall industry and can be used alongside company statements and evaluations to show a complete picture to credit analysts and portfolio managers.
Building a construction portfolio
According to a January 2013 survey conducted by the Independent Equipment Company, an Alta Group company, and the Equipment Leasing and Finance Association, EL&F professionals anticipate that construction sector deals are the most likely to increase in value in 2013, beating out medical and oil, gas and energy equipment leases. In this example, IBISWorld demonstrates how to effectively construct a portfolio of leases from the construction sector, particularly with the Road and Highway Construction industry(IBISWorld report 23411a).
The Road and Highway Construction industry grew at an estimated annualized rate of 2.8% during the past five years to total $49.7 billion in 2013, and it is projected to continue expand steadily at an average annual rate of 1.6% to $53.7 billion in the five years to 2018. The industry was relatively resilient during the recession, contracting only 2.0% in 2008 before growing 6.8% in 2009. Industry growth was driven by the American Recovery and Reinvestment Act of 2009, which provided $48.1 billion for transportation infrastructure funding. As such, road and highway contractors have provided a steady market for EL&F firms during the past five years.
Although the stimulus and other short-term funding initiatives will taper off in the coming years, government highway funding is projected to recover strongly as state tax revenue rebounds. In particular, aging US highways will require considerable repair and maintenance work. Competition for contracts will heat up as construction activity accelerates, which will contribute to a medium-high level of structural risk for the industry. Because most road and highway contractors are small regional firms, competition is particularly fierce within regional markets. Therefore, EL&F firms can minimize risks associated with internal competition by leasing equipment to contractors operating in distinct markets. For example, EL&F firms can lease equipment to contractors located in two different counties, ensuring that the bulk of its clients are not in direct competition for revenue.
Additionally, EL&F firms can identify growth markets within the industry to mitigate a moderate level of growth risk. Road reconstruction and expansion is estimated to contribute to 35.0% of industry revenue in 2013. Due to the United States’ aging infrastructure, demand for road reconstruction and expansion is projected to grow strongly during the five years to 2018, and at a faster rate than demand for new highway and street construction. As a result, EL&F firms can target road and highway contractors that specialize in road reconstruction and expansion work.
Lastly, EL&F can analyze the industry’s supply chain to build a balanced portfolio that hedges against risks in the Road and Highway Construction industry.
The Land Development industry (IBISWorld report 23721) and the Airport Operations industry (48811) are two important downstream markets for the Road and Highway Construction industry. The Land Development industry is projected to grow strongly at an annualized rate of 5.6% to $32.0 billion in the five years to 2018, while the Airport Operations industry is projected to grow an average of 2.9% per year to $7.6 billion. Land development firms rely on road and highway contractors to build streets and sidewalks on new land subdivisions. Airports outsource runway and taxiway construction projects to road and high contractors. As competition drives down road and highway construction costs, airports and land developers will benefit from lower operating costs and greater profit margins. Therefore, EL&F firms can hedge against competitive risks in the Road and Highway Construction industry by leasing vehicles and equipment to airports and land developers. Although land developers require minimal capital machinery, airports are moderately capital-intensive and require specialized vehicles and machinery. Furthermore, the Airport Operations industry has a low level of overall risk, providing a buffer against the riskiness of the Road and Highway Construction industry.
Business development and customer services
Industry research allows EL&F firms to efficiently allocate marketing and business development efforts toward growth markets. Leasing professionals can quickly identify potential clients by matching their lending criteria with industry performance; for example, EL&F firms can screen for industries exhibiting a certain level of profitability, capital intensity, risk, competiveness, technological change and other criteria. Industry research can provide a timely solution for EL&F firms looking to identify and understand such industries, and it can also help them to quickly target clients within certain industries to diversify their existing lease portfolios. Effective industry research reduces the amount of time credit analysts, portfolio managers and business development executives need to spend on background research, making it particularly useful to smaller EL&F firms with more limited time and resources.
Industry research also enables companies to take advantage of opportunities within their clients’ space by identifying key success factors, growth drivers, and growing markets or product segments. When trying to determine a borrower’s ability to repay a loan, EL&F firms can look to industry research to understand market conditions. Firms can determine whether their portfolio companies are doing what is necessary to remain competitive and successful. Industry information helps clients prepare for the challenges they may face, including but not limited to understanding market size, competitors, drafting business plans, pitch books, benchmarking, forecasting, business valuation, litigation support and due diligence. With industry research, EL&F firms are better able to understand an industry’s potential successes or failures.
Importance of industry research
Several studies have found that industry-wide performance contribute directly and significantly to the success of an individual business. According to a paper authored by Schmalensee in 1985, industry performance accounts for 20.0% of the overall fluctuations in business-segment profitability. A comprehensive data and enhanced statistical analysis by McGahan and Porter at Harvard University in 1997 came up with a similar figure of 19.0% (please refer to the individual studies for specific results). Therefore, EL&F firms are able to efficiently diversify their portfolios with unbiased information by viewing equipment leases in the scope of industry research, considering the degree of influence such information has on each business’s ability to make loan payments.
Harnessing industry data and business environment statistics allow EL&F firms to mitigate risk through improved portfolio diversification and client retention. Industry research, including risk information, allows employees to promptly examine industries in a precise and simple manner to understand their clients’ operating environment. By using industry analysis, EL&F firms can save time and money while observing risk, business development and customer services.