Navigating Inflation’s Choppy Waters in the Equipment Finance Industry

By Gary W. LoMonaco

As we hopefully approach the end of the pandemic, most of us are weary of seeing and hearing the word, “unprecedented.”  In the case of COVID-related inflation, it is a truly appropriate way to describe the pandemic’s present and future effects on the economy.  We haven’t experienced a pandemic of this magnitude in over a hundred years. Policy makers and businesses are scrambling to assess the long-term impact we will see as a result.  In the near term, most policy makers and economists agree that temporary factors will drive inflation in the US over the next few months ─ and they don’t dismiss the possibility of longer-term issues.

Some inflation is expected over the coming months simply because of the distortion created by comparing a period with generally weak prices to a period of growth. As the economy recovers, it will be compared to a pandemic period in which fuel prices, transportation costs and non-essential goods were affected by lower demand caused by unemployment and under-employment.  Supply chain disruptions, such as the current lumber shortage,  semiconductor shortages, especially in the automotive and tech industries, and truck driver shortages, have already driven prices higher and are expected to continue in the near future.  Pent-up demand reflects the return to consumption allowed by the easing of restrictions, rising employment and the ability for families to spend pandemic-related savings on services forgone during the pandemic.

When combined, these factors point to inflation in the range of 2.5% at the low end to 5% or higher, according to numerous published reports, with that inflationary period lasting anywhere from the balance of 2021 to 2022 and beyond.

What does a recovery look like?

Equipment finance customers are facing myriad issues as they head into recovery activity, some of which will depend on their own customers and the size of their businesses.  Small businesses that sell to other SMBs and consumers have to address how their clients have fared during the pandemic.  A number of economists depict a “K-shaped recovery,” in which the upper tier of the economy (e.g., technology and large-cap firms) experiences a relatively quick, strong rebound while the lower tier (e.g., SMBs, service-based and cyclical businesses) has a much slower, more shallow recovery curve.

Some of the ways smaller businesses will need to address inflation are as follows:

• Businesses that had to downsize staff at the height of the pandemic are finding it difficult to replace workers temporarily laid off. This is causing wage inflation as companies compete to attract the best staff in a tight market.  This labor situation may make it an opportune time to invest in automation.
• Selling to other businesses experiencing shrinking margins limits a company’s ability to pass along increasing costs. Equipment finance companies can provide benefit to these companies by allowing them to conserve scarce working capital.  As many organizations return to growth, demands on working capital will increase.  Equipment financing will become a more attractive alternative as companies utilize working capital to fuel expansion. New technology and applications utilized by providers of financing are also making it easier to identify sources of funding and gain quick approvals.

How are larger firms affected?

A steeper recovery curve bodes well for longer term success, but comes with issues that larger firms will need to address.  Steep growth puts demands on working capital regardless of business size or industry.  Also, with the current global semiconductor shortage, demand for equipment will likely outstrip supply for a while.  Many firms deferred investment in needed infrastructure, only to find that if equipment is available, it is being sold at inflated prices.

Other concerns for larger firms include the following:

• Despite sophisticated forecasting by businesses and the government, the recovery and its attendant inflation will have unforeseen consequences and opportunities. As is true with smaller firms, larger businesses will need to be agile to take advantage of the recovery.
• Inflation reduces purchasing power over time. A key selling point of equipment financing is that it affords clients the opportunity to pay for equipment with future dollars, whose value would be reduced by the effects of inflation.
• For businesses that sell outside the US, inflation rates in those jurisdictions will vary depending on the local economic climate and pace of recovery, which will, in turn, drive currency fluctuation. These companies will need to pay close attention to exchange rates and take advantage of risk hedging opportunities.

What do equipment finance businesses need to know?

Inflation can be tricky for an equipment finance company.  On one hand, it makes the leasing/financing option a much more attractive means to acquire equipment necessary to take full advantage of the opportunities that recovery can bring.  On the other hand, it requires diligence to make sure that business is being added profitably and sustainably.

Some issues to be aware of include the following:

• Temporary inflation and rising equipment prices necessitate increased diligence when setting residuals. Assumptions will need to be adjusted to make sure future values are in line with business profitability goals.
• Capital spend that was deferred during the pandemic represents a significant opportunity to participate in the growth economy. Each equipment finance customer will have its own set of issues to address, and it will be more important than ever to be a strong financial partner to your lessees and vendors by listening and structuring around such issues where possible.
• The Federal Reserve has indicated that for the time being, inflation will not result in increased interest rates, but market rates and the Fed do not always move in lock step. Equipment finance companies need to be diligent in managing float risk between quote and close, particularly those that depend on discounting as a means of funding new business.
• As equipment prices rise, marginal credits will be seeking longer terms and lower down payments, increasing credit default risk. Lenders will need to pay more attention to inflation’s effects on risk-reward.
• Demand has already shifted toward used equipment due to the price and availability of new product. Future collateral values of such used equipment will be adversely affected as supply of new product catches up with demand.
• Rating agencies are considering downgrades for issuers particularly sensitive to inflationary pressures, which will impact hold positions on larger borrowers/lessees.
• Margin compression is likely to continue into the foreseeable future due to the high degree of liquidity in the market.

Clearly, the current inflationary environment creates some choppy waters that require skill to navigate.  Equipment finance businesses have traditionally been very adept at charting a path through those waters, and with care and planning, will be positioned to manage through those challenges and the attendant risk.

The Alta Group stands ready to advise your firm through these challenges and position you for success

Gary W. LoMonaco is a director of The Alta Group who primarily works with the consultancy’s Strategy & Competitive Alignment Practice. He draws on his extensive industry experience, recent executive leadership, and passion for new challenges to help Alta clients succeed. His areas of expertise in a wide-ranging career include captive and vendor finance, and credit management.