The Transforming World of Vendor Captive Finance

By Paul W. Frechette, Valerie L. Gerard, and David S. Wiener
The Alta Group

Captive and vendor equipment finance organizations are transforming themselves in ways that were unpredictable even five years ago.

Transforming World of Vendor Captive Finance With growth back at pre-recession levels, the sector is increasingly focused on offering bundled managed solutions transactions (MSTs) to maintain and expand market share. However, captives are also grappling with the changes in funding, technology, and sales methods needed to offer more dynamic service. Some captives find themselves in the position of having to justify their shifting strategies to parent manufacturers whose expectations are based on older equipment finance models.  Similarly, new product development activities emanating from manufacturers are causing captives and vendor equipment finance organizations to research and develop methods to provide customer financing for MSTs, formerly known to some as “financing the cloud.”

This article discusses the size and scope of the sector, changes taking place in captive and vendor leasing, new challenges as well as evergreen concerns, and financing innovations being introduced by captive lessors. Throughout the article, the term “captives” refers to manufacturer captive lessors, and the terms “vendors” or “vendor programs” refer to the vendor finance activities of other lessors.

Size and Scope

Captive lessors and vendor programs have increased their share of the U.S. equipment finance industry in the past decade. They now are responsible for a majority of industry activity, and their growth in originations has been particularly impressive. Together, captives and vendors generated 53% of industry volumes in 2015 compared with 47% in 2005. Their originations grew 33% over the same time frame, from $49 billion to $65 billion in the representative annual Survey of Equipment Finance Activity conducted by the Equipment Leasing and Finance Association (ELFA).

A broader underlying trend is also evident in the 2005-2015 data. Financing decisions are being made nearer the time of equipment selection than they were in the past, and may be delegated to procurement or the plant or office management – not centralized by the Treasury/CFO office as may be the case with direct originated activity.

Additionally, equipment finance activity noted during the Great Recession years of 2008-2009 evidenced that captives and vendors stepped up originations as a means of promoting their products during the economic downturn. Even today, as a class of lessors, captives tend to approve a higher proportion of lease and loan applications than do their industry peers.  With a primary mission to be aligned with the sales objectives of their manufacturer parent and the dealers they serve, captives must also pay closer attention to portfolio management.

Captive and vendor equipment finance organizations in the U.S. represent a range of vertical industries including agriculture, information technology, office products, construction, mining, trucks/trailers, buses, and medical products. The most recent Monitor 100 ranked the largest captives in the U.S. as John Deere Financial, Caterpillar Financial, IBM Global Financing, Volvo Financial, CNH Capital, Hewlett-Packard, PACCAR Financial, Dell Financial Services, and Canon Financial. There are at least 20 other important captives also operating in the country who are not reported among the list in the Monitor 100.

Captive finance organizations can have varying structures. In a true captive, the vendor/manufacturer itself provides financing, complete with all traditional leasing company functions including underwriting, documentation, billing, and collection. In other cases, the captive is an internal department of the parent. Alternatively, some parents fund all or some of their captive business through financing partners, and may construct a “virtual joint venture” or “virtual captive” with that company. The partner may provide funding and administration, while the manufacturer may provide asset management expertise and may share in credit and operational risks.

Vendor programs, too, can come in different flavors. In a manufacturer/dealer vendor program, the manufacturer/dealer originates the financing business, structures payments, and prepares and executes documents with customers. Financing instruments are then either sold outright to financing partners, including payments and residuals, or the payment streams alone are sold to partners. Credit and operational risks are borne by the funders, but program agreements are structured to protect funders from document and administrative risks since the manufacturer/dealer is the one preparing documents and dealing directly with customers.

Referral programs represent a kind of vendor program in which the manufacturer/dealer offers financing to customers but does not have the capabilities to develop or administer the financing. When financing opportunities arise, the prospective customer is referred to a third-party funder. In these cases, the funder pays the manufacturer/dealer for the equipment, and the financing contract commences with the funder providing all administration, assuming all credit and operational risks, and typically assuming all risks and rewards related to residuals.

Lastly, companies can provide financing through private label vendor programs. This usually occurs when a larger vendor wants to offer financing services in its own name. Funding partners develop documents to create the private label structure, (typically) name the captive/manufacturer/vendor as the lessor, and outline terms where the financing instrument may be sold or assigned to others. Private label structures can be evident in captive finance programs, dealer/manufacturer programs, and sometimes in referral programs.

Changes and Challenges

Recently, captives were primarily focused on accounting sales treatment and strategies to help parent companies take control of their assets. This is shifting as more captives enter the world of MSTs, which bundle products with related services into a single transaction for the customer.  MSTs represent a distinct growth opportunity that could generate more than 22% of equipment leasing and finance industry volumes in the next three to five years, according to an Equipment Leasing & Finance Foundation study by The Alta Group.

Some captives refer to MSTs as “managed services” or “cloud financing.” Whatever the terminology, MSTs are placing new demands on captives, vendors, and parent manufacturers.

MSTs allow customers to pay over time for services and assets that are not always documented on the captive’s own books. In some cases, the user may be able to cancel subscriptions with little notice, at any time. These issues can certainly be seen as legal liabilities by bank funding sources. When moving forward with MSTs to maintain and grow market share, then, it is important for captives to identify potential problems up front and determine whether or not their MST products have the ability to be funded by outside parties. In some cases, for example, captives will need to be able to show outside partners that the parent can provide certain performance guarantees that will better enable financing partners to book transactions.

Setting aside MSTs, captives and vendors have been facing mounting pressures from parent companies eager for results in promoting product sales. The need for training sales teams to sell equipment finance to customers – not just sell “products” – is an ongoing issue.

Certainly, most captives would agree that enabling product sales remains a top priority, but the equation is more complicated for companies moving toward MST offerings. A product that is now part of a $5,000/month, 60-month MST can look like weaker sales to the parent company, because MSTs often generate revenue that can only be realized as payments are received. Some captives say that their parent companies are questioning why they are costing them the same amount of money for seemingly lower sales. So, educating parent companies about MST trends and their implications is imperative for today’s captives.

Captives are also reporting a greater need for technology solutions and, again, the issue is complicated by the increase in MSTs. Some captives that sell most of their transactions to banks may not have in-house digital lease management systems to manage and track the customer financing business, and they are challenged to secure budget approval to acquire and implement these systems. As MSTs grow in size, these captives are realizing that they have fallen behind in acquiring systems to manage and evaluate the complexities of their equipment financing offering. They are now at a critical stage, having to scrutinize available lease management system options that will integrate with the parent’s general ledger systems – under tight deadlines. Further, MST portfolios have a different set of risks to manage, however the tools to do so are not readily available on the market.

Captives also face evergreen challenges such as the quest to retain employees. Often the stiffest competition is the captive’s own parent company. Some employees take positions in captive departments or subsidiaries as a door into the parent company and their real interests lie in the equipment’s industries such as technology, agriculture, or healthcare. These employees, and those seeking advancement not readily available in the captive, can be lured away by other jobs within and outside the parent company. To stem the tide and attract long-term employees, captives often need to refresh what they offer in terms of incentives and professional development.

Another continuing need for multinational captives is entering new international markets. Even if their parents are already operating in target areas, captives can identify the legal, administrative, and compliance issues involved in expanding into new geographic regions that are quite difficult to navigate. In doing so they can become a better partner to the parent. Expert help may be needed to successfully grow equipment finance offerings internationally.

An analysis of the top captives operating in the U.S. shows that other challenges they face include recessions within their vertical industries, such as agriculture and mining at this time, flat sales, and/or organizational developments within the company such as division spin-offs.  Captive finance companies with equipment specialties dependent on the health of the sectors served by their parent companies may experience the risk of more turbulent volume fluctuations due to specific industry downturns or recessions.  For example, commodity prices for coal, oil, and farm products adversely affected mining and farm equipment sales respectively for the likes of John Deere Financial, Caterpillar Financial and CNH Industrial Capital.  Business retooling such as the breakup of HP and the IBM focus on software development and solutions consulting impacted the new volume trends of their respective captive subsidiaries.

Innovation

Some captives are rethinking their long-standing selling strategies and developing new, in-house equipment finance capabilities as various markets evolve. For one captive, this has meant reevaluating a major product that has been offered for cash or rented through a third party for decades.

Realizing that the third party was making significant profits by renting out the product, and controlling the financed asset if/when it was ultimately returned, the captive decided to research the possibility of offering its own equipment financing in a way that had never been attempted with similar products in the industry. The company worked with advisors to evaluate the market, pricing, and train their sales teams on selling equipment financing. They now have also improved asset management capabilities to maintain and maximize the product throughout its lifecycle.

Closing Thoughts

To be successful in offering financing for products sold directly or through dealers there must be goal alignment between the manufacturer and the captive or vendor program.  The manufacturer that is assessing the utilization of an internal captive or third-party vendor program must clearly understand the drivers and criteria for success of a companion equipment finance product, including key financial metrics, capital structure constraints, desired financial product features, essential operational functions, equipment issues, and client profiles in terms of current state and future state characteristics.  With continued changes, challenges, and competition facing the contemporary manufacturer seeking to serve customers with innovative financial product solutions, an ongoing assessment of the captive and vendor program arsenal is essential to remain customer centric and relevant. 

Captive/Vendor Resources

Consulting/Advisory Support

The Alta Group’s Vendor and Captive Finance Practice is managed by professionals with decades of experience and expertise working in this sector. Alta assists clients in determining market drivers and building strategic plans to form captive finance companies, joint ventures, or third-party financing programs. The group includes consultants in the U.S., Canada, Latin America, Europe, the Middle East and Africa (EMEA), China, and Asia Pacific.

“A Holistic Approach for Vendors and Captives” (Podcast)

“Captive & Vendor Equipment Finance: What is Keeping Executives Up at Night?”

“Building a Successful Captives Infrastructure – and Lessons Learned” (EMEA Article)

“Captives’ Health Check – How Fit is Your Business” (EMEA Article)

About the Authors

Valerie L. Gerard is a managing director of The Alta Group and head of its vendor and captive finance practice as well as its management consulting practice. She can be reached at +1 917 664 4192 or contact vgerard@thealtagroup.com.

Paul W. Frechette is a director of client relations and consulting for The Alta Group whose career has spanned captive/vendor leasing experience. He can be contacted at +1 707 395 0634 (office), +1 707 799 3060 (mobile) or emailed at pfrechette@thealtagroup.com.

David S. Wiener. a managing director of client relations for The Alta Group, researched captive/vendor industry data for this article.  He can be reached at + 1 410 939 1300 (office), +1 410 371 6028 (mobile) or emailed at dwiener@thealtagroup.com.

 

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