Recent Mergers and Acquisitions Activity in the Leasing Industry

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1 Recent Mergers and Acquisitions Activity in the Leasing Industry By Martin Shames Despite declines in 1998,mergers and acquisitions activity should pick up in the second half of this year. Banks will continue to be big players, according to this industry analyst. Mergers and acquisitions activity with equipment leasing and finance companies was at record levels for the total year This category is often described as commercial finance. M&A activity declined after a 30 percent average drop in stock prices of publicly owned commercial finance companies in the summer of M&A activity has started to recover, and we expect a pickup in announced deals during the second half of The major factor contributing to the decline in M&A activity was the decline in the valuation of publicly owned financial service companies that were active in acquiring leasing companies. Stock prices are down by an average of 30 percent, median price-earnings ratios have declined from in mid-1998 to the current level of 11.91, and median price-to-book ratios have declined from 237 percent in mid-1998 to a current depressed 114 percent. Other factors contributing to a decline in M&A activity include concerns about accounting practices and valuations of assets and the growth rate of new business. We believe that many of the forces that fueled the strong M&A activity during 1997 and 1998 continue to motivate owners of leasing companies to sell and other financial service companies to buy. Adding to the attractiveness of selling in 1999 or 2000 is the proposed elimination or restriction of accounting for mergers as poolings of interest. Many people expect the new regulations to go into effect after December 31, In general, because of the effect of the amortization of goodwill on earnings, acquirers are typically able to pay 10 percent to 20 percent more in a pooling transaction than in a purchase transaction.

2 REVIEW OF CURRENT CONDITIONS AND 1998 ACTIVITY Strong Leasing Marketplace Several recent reports provide strong evidence that the leasing business continues to grow. The Performance Indicators Report issued by the Equipment Leasing Association (ELA) for the first quarter of 1999 tracks the performance of 17 leading leasing companies in six key areas. The report shows that total net portfolio was up by 15 percent over a year ago; that new business volume was up by 8 percent for the first quarter of 1999 versus a year ago; and that delinquencies at March 1999 were at 3 percent compared to 5.2 percent a year earlier. 1 The ELA 1999 Survey of Industry Activity showed another robust year of growth in 1998 for the 161 members of the association who responded to the annual survey. The report indicated that annual volume booked in 1998 was approximately $126 billion, up $21 billion or 20 percent versus a year ago. Total industry new business volume in 1998 is estimated at approximately $183 billion. Year-end 1999 industry volume is estimated to increase at a double-digit pace when compared to (Responding members represented most of the leading equipment leasing organizations in the United States.) 2 Stock Market Valuation of Commercial Finance Companies Key factors in the public stock market valuations of financial service companies are strong growth in revenues and profits, projected continued strong growth in revenues and profits, and confidence in the accuracy and reliability of the accounting practices and estimates used in preparing the financial statements. High and growing valuations of the stock of publicly owned companies are important contributors to increased M&A activity. It is also an important factor in providing added value to owners of leasing companies that motivates them to sell. This is how the market worked during 1997 and through the first half of 1998.There was a significant change during the summer of 1998 as a result of turmoil in the economic and financial affairs of Russia, Asia, and other parts of the world; problems in the subprime consumer finance market; disruption of the securitization market; concern about gain-on-sale accounting treatment; and financial problems encountered by several major leasing companies. Plunge in P/E Ratios and Price-to-Book Valuations The results of the changes in the market s analysis and valuation of publicly owned leasing and finance companies are dramatically shown in the following data. 3 The average price of a group of 19 publicly owned leasing and finance companies declined by 29.4 percent between June 30 and December 31, Sixteen of the 19 companies declined in price, with six of the companies declining by more than 50 percent in value. For the six months between December 31, 1998, and June 30, 1999, the average stock price has declined by 1.3 percent, during a time when the Standard & Poor s 500 has increased by percent. During this same period, the NASDAQ bank index has increased by a modest 1.59 percent. The median price-to-earnings ratio of a group of 27 publicly owned commercial finance companies showed the following roller-coaster ride during the past three years. Q Q Q Q Median Price-Earnings Ratio The price-earnings increased by 20 percent during the first six months of 1998, reaching its peak level of 18.35x after tax earnings and then the P/E ratio plunged by 26 percent during the six months to December 31, The decline has continued during the first six months of 1999 and the P/E ratio has declined by 13 percent. The decline in P/E ratios totals 35 percent for the 12 months to June The decline in P/E ratios has more than wiped out the approximately 10 percent increase in earnings, leading to a 30 percent drop in price. High and growing valuations of the stock of publicly owned companies are important contributors to increased M&A activity. J O U R N A L O F E Q U I P M E N T L E A S E F I N A N C I N G F A L L V O L. 1 7 / N O

3 The 1998 M&A activity was dominated by roll-up and consolidation activities and an unusually high number of large, highly publicized transactions. As a result of the drop in stock prices, the price-to-book value ratio has also declined significantly, as shown below. Q Q Q Q Median Price to: Book Value 230.0% 236.7% 140.2% 114.3% Tangible Book Value 257.5% 268.4% 148.7% 131.5% These declines occurred during a period when we believe that the quality of earnings and book values has improved as a result of a decline in the use of gain-on-sale accounting; a greater scrutiny of reserves and estimated residual values by company management and outside accountants; and an increased attention to credit quality. Review of M&A Activity in 1998 We previously reported that 1998 was a boom year for acquisitions of leasing companies. Our study of 100 transactions showed the following M&A breakdown by acquirer: 4 Smaller Public Companies 37 Banks 21 Large Companies 16 GE Capital 9 All Others 17 The 1998 M&A activity was dominated by roll-up and consolidation activities of UniCapital Corp., First Sierra Financial, and LINC Capital, who used their high P/E valued stock to acquire almost 30 companies. There also were an unusually high number of large, highly publicized transactions, including Newcourt/ AT&T, Conseco/GreenTree Financial, GE/MetLife Capital, GE/Colonial Pacific, Heller Financial/Dana Commercial Technology Group, Fleet Bank/Sanwa Business Credit, Firstar Leasing/ Cargill Leasing, and Fidelity Leasing/JLA Credit. Decline in M&A Activity TRENDS IN 1999 There has been a significant decline in M&A activity during the first six months of 1999 compared to the same period in The ELA reports 37 announced transactions in its Mergers & Acquisitions Table 5 for the first six months of 1999, compared to 75 during the first six months of However, it should be noted that during the second six months of 1998, the ELA reported only 32 transactions, a decline of 43, or 57 percent, versus the first half. The 37 M&A transactions announced during the first half of 1999 therefore represents a pickup in M&A activity compared to the second half of 1998, despite the absence of any transactions by UniCapital or First Sierra and a lower number of larger transactions. GE Capital continued to be active, with seven acquisitions all overseas or purchases of foreign owned U.S. operations. The large transactions announced included Heller Financial/ Healthcare Financial Partners, De Lage Landen International/ Tokai Financial Services, GE/Phoenixcor, and CIT/Newcourt Credit Group. The June SNL Securities Specialty Lender 6 reports that through May 19, 1999, there were a total of 57 announced M&A deals, compared to 90 during the same period in 1998, broken down as follows: Industry Segment (Decrease) Commercial Finance Consumer Finance Mortgage Banking Total Adoption of More Conservative Accounting Procedures During the past year there have been wellpublicized announcements by UniCapital Corp., First Sierra Financial, and LINC that they have eliminated or reduced the use of gain-on-sale accounting in favor of the more conservative practice of recording profits over the term of the lease. These changes led to a significant decline in profits during the first half of 1999 for all three. The lower earnings distorted comparisons to prior years results and the calculation of meaningful price-to-earnings ratios for these companies. The accounting changes also reduce the confidence and predictability of leasing 1 6 J O U R N A L O F E Q U I P M E N T L E A S E F I N A N C I N G F A L L V O L. 1 7 / N O. 2

4 companies to both investors and buyers during this period. These factors have contributed to a reduced level of interest in the publicly owned leasing companies, to their valuation, and to their stock prices. Bank Profitability Declines for the First Time in Nine Years The U.S. banking industry s return on assets (ROA), a common measure of bank profitability, recorded its first decline in nine years, according to Weiss Ratings Inc., a leading bank rating agency. For 1998, the industry reported an ROA of 1.23 percent compared to a 1997 ROA of 1.31 percent. The industry s return on equity (ROE) saw an even more dramatic decline, from percent to percent in Evidence of Increased Bank Interest in M&A of Leasing Companies We have seen increasing signs of banks interest in entering into or expanding in the commercial equipment leasing business. Much of this interest is not readily visible: it is often handed privately, without the use of outside advisers, and is not always publicized. Examples include the following: The U.S. subsidiary of a major European bank, one with diversified operations in the leasing business and an active acquirer, purchased a privately owned Midwestern based equipment finance company early this year. The transaction was handled privately and there has been no public announcement. A midsized Midwestern bank that had acquired a privately owned leasing company many years ago has undertaken to significantly expand the business. They are developing an acquisition strategy that is targeted to cover a significant part of the growth. Sovereign Bank recently announced the acquisition of Network Companies. The negotiations and transaction were privately handled. A recent offering of an equipment finance company serving a niche market attracted serious interest from eight banks. We are working with three banks that are actively seeking to acquire an equipment leasing company. Attendance by bank personnel at seminars and conferences on leasing is high and growing. The increasing interest of banks in the equipment leasing business is being stimulated by a variety of factors, including the following: 1. The opportunity to generate a higher yielding asset portfolio as interest margins continue to be squeezed. As noted above, there has been a reduction in profitability as measured by ROA. 2. Expansion opportunity to existing customers and cross-selling opportunities to new specialty finance customers, in contrast to slow growth and increased competition in traditional bank markets. 3. Increased competition for loans to small- to midsized businesses, which are creating most of the growth in revenues and jobs in the economy. 4. Increased ability to diversify risk: geographically, by borrower type, and by industry segment. 5. Increased understanding and confidence in being able to manage and control the risk elements of the equipment leasing business. In the ELA 1999 Survey of Industry Activity, the association reported a median full year loss of 0.2 percent for middle market portfolios and an overall delinquency (i.e., over 30 days) rate of 2.1 percent. 7 The use of credit scoring systems and of credit policies and programs that are consistent with bank practices have contributed to the increased comfort. 6. Increased understanding of, and confidence in, working with and compensating leasing executives and sales personnel. Increased confidence in the honesty and integrity of the people and their business practices. 7. Opportunity to increase strategic value to stockholders. In addition to the compelling business factors, there is the attraction of the differential between the public market valuation of banks and specialty finance companies. The median price-to-earn- We have seen increasing signs of banks interest in entering into or expanding in the commercial equipment leasing business. J O U R N A L O F E Q U I P M E N T L E A S E F I N A N C I N G F A L L V O L. 1 7 / N O

5 We see strong evidence of increased attraction by banks as the acquirer of choice for many segments of the leasing industry, particularly in the small- to middle-ticket transaction size. ings and price-to-book ratios for banks nationwide stands as follows. Asset Size Price/Earnings* Price/Book) <$0.5 billion $0.5 - $5 billion $5 - $20 billion >$20 billion *Price to latest 12 months earnings These valuation ratios are significantly higher than the median P/E of 11.91x and median price-to-book of for publicly owned commercial finance companies. Valuations of privately held companies are typically lower for comparable situations. Increased Attraction of Banks as an Acquirer Many privately owned equipment leasing and finance companies are examining the most effective and financially rewarding way to expand their businesses, to work in a satisfying arrangement, and to achieve the highest and best value. A report in the Independent (Eastern Association of Equipment Lessors) 8 had the challenging title of, Leasing 2000: Who Says You Have to Sell to Survive? The issues raised by owners of leasing companies included the bureaucratic environment and the focus on internal operations rather than on the consumer. We also hear about owner concerns about the opportunity to receive a fair reward for future growth; lack of understanding by the acquirer about the business areas served by the company; and excessively conservative approaches to compensation, selling, and credit. However, we see strong evidence of increased attraction by banks as the acquirer of choice for many segments of the leasing industry, particularly in the small- to middle-ticket transaction size (defined as $25,000 to $250,000). Among the attractions are: 1. Recognition by bank management that leasing needs to be evaluated and operated as a separate and distinct business, not as a product line or extension of the banking business. 2. Willingness to compensate leasing executives and sales personnel consistent with leasing industry practices. Increased acceptance of leasing executives as finance professionals with welldeveloped, highly desirable skills. 3. Comfort with credit policies of leasing companies and establishment of credit review procedures that are not overly cumbersome. 4. Availability of low-cost funds. 5. Strong desire to expand the business on a geographic, customer, and industry basis and to build an in-house portfolio. 6. Ability to pay cash or reasonably priced, dividend paying stock to make the acquisition. 7. Ability to pay an attractive price because of the higher P/E and P/B ratios that bank stocks enjoy and the benefits of lower funding costs and higher volumes that are expected. The combination of factors causing banks to see commercial equipment leasing companies as attractive additions and causing owners of leasing companies to view banks as preferred acquirers is leading to increased M&A activity. Pricing an Acquisition of Privately Owned Leasing Companies Although the valuation of publicly owned financial service companies is volatile and we have noted a significant decline in price-earnings ratios over the past year, the valuation and prices paid for privately owned companies have been relatively stable. Prices paid for privately owned companies have generally been in the range of 6 to 8x adjusted, normalized earnings. Companies operating in strategically attractive markets, with strong franchises, proven vendor programs, and a sound record of growth in originations, revenues, and profits have been able to command higher values in selected cases. The decline in publicly traded stock valuations has led to a modest decline in prices being offered for privately owned companies. More noticeable is the absence of high priced stock transactions and aggressive buyers using highly valued stock. Sellers of privately owned companies with strong origination and growth capabilities are seeking acquisition structures 1 8 J O U R N A L O F E Q U I P M E N T L E A S E F I N A N C I N G F A L L V O L. 1 7 / N O. 2

6 that will enable them to realize significant premiums if they successfully achieve strong growth and profitability over a three- to fiveyear period. LOOKING FORWARD The forces that fueled the strong M&A activity during the period continue to receive a great deal of attention by owners of privately owned leasing companies and by the boards of publicly owned leasing companies. These forces include the need for increased capital, lower priced funding, added technology, economies of scale, skilled personnel in all areas, and for larger size to service vendors. Vendor programs are the targets of choice of many of the larger leasing companies. This increased competition for vendor programs has led to the need to provide the latest technology, higher levels of service, wider geographic coverage, expanded product offerings, and very competitive pricing. To meet these competitive factors, leasing companies need more technology, more people, and more capital, and this is adding to M&A activity. The need for these added resources is increasingly restricting companies from growing to desired levels or to service existing customers or prospects. That in turn is leading to a profit squeeze and raising concerns about future values. We often hear that owners are working harder and enjoying it less. We therefore anticipate a continuing strong interest in finding capital at lower costs and in an environment that will facilitate the rewards and satisfaction of growth. This interest should lead to a pickup in M&A activity in the second half of We further expect that an increasing and significant amount of acquisition of leasing companies will be by banks. Endnotes 1 Did You Know? Performance Indicators Report, Equipment Leasing Today, June/July 1999, Survey of Industry Activity, Equipment Leasing Association. 3 Based on analyses prepared by Hovde Financial Inc. 4 M&A in the Leasing Industry, Leader s Equipment Leasing Newsletter, January Mergers and acquisitions table from ELA Web site, elaonline.com. 6 SNL Specialty Lender, June Survey of Industry Activity, Equipment Leasing Association, Burdick, Barry, Leasing 2000: Who Says You Have to Sell to Survive? The Independent (Eastern Association of Equipment Lessors), Winter Vendor programs are the targets of choice of many of the larger leasing companies. The author s biography may be found on page 39. J O U R N A L O F E Q U I P M E N T L E A S E F I N A N C I N G F A L L V O L. 1 7 / N O