Capital equipment asset management: Know your collateral before you lend

Northwestern Financial Review, May 1-May 14, 2002 by Reese, Ed

Know your collateral before you lend

Many lenders and bank-owned lessors treat cash flow as "king" and capital equipment collateral as the "red headed stepchild." That is until credits weaken, cash flow dries up and they start looking toward their collateral to mitigate the problem. Then the stepchild is asked to provide salvation but wasn't groomed for the job. In other words, the second line of defense for the lender doesn't measure up because the collateral wasn't scrutinized, analyzed and understood in the first place. An inferior collateral position exacerbates the impact of a weakened credit and impaired cash flow, resulting in significant losses and write-offs. It doesn't have to be that way!

The best insurance policy if "king" cash flow stumbles is a vigorous examination and evaluation of collateral during business origination and transaction underwriting. Frontend collateral analysis is a critical part of a more comprehensive discipline called Capital Equipment Asset Management, or just Asset Management, in the leasing industry. In addition to the initial collateral analysis, Asset Management includes portfolio management, periodic collateral evaluations, processing terminations, negotiating renewals and workouts.

Well run leasing companies are highly motivated to understand the characteristics and risks of their capital equipment collateral before they advance funds. Here's what they do, relative to the collateral:

* They research and analyze industries and equipment to develop and understand the big picture, particularly industry cycles and trends. The impact of industry cycles can have a profound effect on the value of equipment, particularly equipment proprietary to an industry.

* They analyze capital equipment collateral on each transaction. They identify and quantify collateral issues and risks, and adjust collateral values accordingly. There is an emphasis on looking into the future and estimating annual collateral values on a conservative basis for the entire term of the financing.

* They carefully match loan or lease structures to equipment risk profiles. The structure of the financing must prudently match the estimated future collateral values of the equipment. For instance, printing prepress equipment has a collateral curve like a computer not a printing press.

They personally visit customers and physically inspect collateral, particularly when they finance used equipment. During a customer visit, they spend less time in the CFO's office and more time in the production area. They examine the collateral, check model and serial numbers, ask a lot of questions and take pictures. A picture is worth a thousand words, but an on-site inspection is worth 10 times that much. It gives you a snapshot of what's going on in that business that day. Collateral inspections should be made on a periodic basis during the term of the financing. Doing so waves the institutional flag and sends a message to your customer that you're interested in their business, and how they're treating your collateral.

They re-evaluate collateral on a regular basis. At best the initial evaluation is valid for 12 to 18 months and, in a dynamic economic environment, sometimes even less. When an industry is under stress so are your customers and your collateral values. Even if your customer is doing fine, your collateral values may be declining. If employed, collateral re-evaluations may be an opportunity to ask for additional collateral and improve your loan to value ratio.

They react quickly to credit red flags. On site collateral inspections and evaluations are a high priority when credit stress is detected. It is a pre-emptive strike that sends a clear message to your customer. In anticipation of foreclosure, a team should be organized to recover and take control of the collateral, address the need for reconditioning, decide on the most effective remarketing plan and efficiently execute the plan.

To have value to your organization, asset management must be done by personnel who understand capital equipment and know how to manage it. Temporarily throwing personnel into the fray with a credit analysis skill set won't produce optimum results. In the leasing industry, asset managers play this vital role. They are intimately involved in every phase of Asset Management from originating business to managing the portfolio, terminating transactions and default workouts.

Although the above steps describe Asset Management in a leasing company business model, there is substantial spillover value to this discipline if employed in asset-based lending. It is worth the close attention of asset-based lenders, particularly those that have capital equipment leasing activities. A small investment in capital equipment collateral analysis and underwriting before funds are advanced can reap big rewards if the credit fails and the cash stops flowing.

Ed Reese is CEO of A&E Valuation of Eden Prairie, Minn.