A Primer on Portfolio Management Options for Parents and Captives

Imagine receiving a call from corporate indicating that your captive team has done a wonderful job of providing financing for your manufacturer parent organization. In fact, as a result of this excellent performance the parent company's leverage ratio is reaching the point that its financial rating may be reduced by the rating agencies. This is the type of good news/bad news call most captive managers would rather not receive.

Often corporate's response to threats to its credit rating is to sell or refinance the portfolio. In fact, in the past 9 months a number of captive managers have faced this challenge. What are a captive executive's options? How does one balance the parent's needs with the captive's and the customers'?

Portfolio Valuation

Before any decisions are made, the lessor must determine the portfolio's true value. If this were a home sale, calculating the value would be easy. You would call several real estate agents to inform them you are considering selling your home. They would visit and make suggestions on how to enhance the property value as well as tell you what comparable home sales in your area have been. And with that information in hand, you'd be ready to go to market.

Portfolio sales should follow the same process to optimize value. Lessors may hire an outside consultant to perform due diligence on the portfolio from the perspective of a potential buyer. While this process can also be tackled internally, it needs individuals who are totally objective to ensure its accuracy and credibility.

Parent Company Drivers

To achieve the best result for the parent and the captive, it is critical to determine the parent's key concerns. If the primary concern is the parent's credit rating, the next step is to determine the amount of debt or leverage increase that would cause a lower rating. Taken into consideration with the portfolio's expected growth rate, this information provides a timeline for selling or refinancing the portfolio. It will also help decide if other alternatives can be explored.

If balance sheet treatment under FIN 46 is the parent's top priority, then there are a number of potential solutions to consider. First, though, the salability of the portfolio needs to be determined ASAP so a winning strategy can be formulated.

Operations Review

The operations review (due diligence) should at a minimum cover credit, collections, systems, personnel and documentation.

The credit review should encompass:

• policies and procedures;
• portfolio quality;
• the re-underwriting of selected credits to determine if policies and procedures were followed as well as their current quality compared to their rating at the time of their original approval.

The collections review should include:

• a review of policies and procedures;
• the examination of the delinquency history of the past 9 to 12 months;
• the re-underwriting of key delinquent accounts;
• an analysis of selected bankrupt and charged-off accounts to determine trends;
• a review of all extensions and account rewrites to determine the reasons for their approval.

The system's review should demonstrate the information system's ability to “slice and dice” the portfolio. This will help provide answers to buyer questions. The ease of transferring data to a buyer could facilitate or hamper a sale. It's also important to be aware of the system's growth capacity if the option of continuing to service the portfolio after its sale is being considered.

The quality of personnel will be an important selling point if you wish to convince a buyer that the servicing should be continued by the seller.

Documentation can make the difference in having a profitable sale or one where the seller is required to provide onerous and costly indemnifications. Areas examined should include:

• UCC filing policy;
• possession of original signed leases;
• favorable assignment language;
• signed personal guarantees;
• documentation of additional collateral.

Valuing Portfolio Options

After completing the operations review, the seller will need to determine the number of potential buyers and the current market for their industry paper and portfolio credit quality. As in the home sale scenario cited above, pricing expectations need to be realistic.

If there are portfolio quality issues, a partial sale may be the best short-term solution. This will provide the seller time to resolve the quality issues or provide additional portfolio seasoning.

The subject of reserves or holdbacks will need to be analyzed after receiving proposals. However, be aware this is usually a very contentious area in the negotiation process.

Servicing the Portfolio

How important is it for the captive to retain servicing of the portfolio? If there is a high percentage of repeat business, this may be a deal point and needs to be addressed at the outset with potential buyers. Customer relations concerns may add to the need to retain servicing. In some cases the buyer prefers that the seller retain servicing, especially if the portfolio has shown excellent performance with the current servicer.

If the buyer will take over the servicing, the captive should perform due diligence related to the buyer's servicing capability. The captive has an obligation to ensure their customers will be handled well or the captive risks the loss of a significant customer relationship. In cases where there is an impasse on servicing, agreeing to engage a third-party servicer can move the deal forward.

Alternatives to Sale

The value of the due diligence process extends beyond determining a portfolio's value. It can also uncover viable alternatives to an outright asset sale, including securitizing the portfolio or entering into a joint venture or a virtual joint venture with a financial services partner.

Securitization can produce either off-balance sheet treatment or remain on the balance sheet as non-recourse debt. A conversation with the rating agencies and external accountants should determine the viability of this alternative, which would still allow the captive to service the portfolio and maintain customer relationships.

A joint venture's benefits can include retaining an interest in the portfolio but not requiring showing the assets or liabilities on the balance sheet. The captive could maintain servicing and remarketing functions.

The downside is that the captive retains the portfolio's performance risk to the extent of the captive's equity interest. If there were a change in accounting rules, the joint venture agreement would need to provide for a change in equity interest and a formula for determining equity value. The amount of additional equity to be required based on portfolio growth could have an impact on the parent company rating and would need to be explored. Finally, the documentation process for the joint venture could take as long as 6 months, which could be a problem depending on the parent company's sense of urgency.

A virtual joint venture provides all the benefits of a joint venture except the share of profits is reduced based on the cost of equity negotiated by the joint venture partners. While there is less risk than in a joint venture, there is also less reward. On the plus side, the documentation is much less time consuming. Some organizations have voted to initially form a virtual joint venture with the understanding it will convert to a full joint venture during a predetermined time frame.

Funding Source Opportunities

The concern by manufacturers regarding their leverage and ratings affords significant opportunities for niche and generalist funding sources to develop vendor relationships and purchase portfolios.

Only high-volume vendors are likely candidates for gaining attention from funding sources because without a substantial portfolio, concerns over leverage and ratings would probably not exist. This vendor opportunity also has potential for a program with meaningful annual business flow.

For portfolio purchasers, the opportunity exists to address industry gaps in maintaining a diversified portfolio and meet budget shortfalls.

Joint venture opportunities exist for those manufacturers who still want to participate in portfolio profits but need to reduce balance sheet debt.

The need for structuring flexibility by the funding source is the most often-mentioned requirement by manufacturer clients. The flexibility concerns are not normally related to credit issues but to other business matters. Structuring flexibility is a big plus.

Summary

Concerns over a parent company's leverage ratios and credit ratings should not catch a captive finance manager unaware or cause undue anxiety. There are several options for balancing the parent-captive relationship and getting the most from the existing portfolio. Successful results depend upon:

• Using thorough and objective measures to determine the portfolio's salability;
• Recognizing that there are numerous alternatives to explore and no one-size-fits-all solution; and
• Pursuing funding source opportunities and flexible solutions.

Imagine receiving a call from corporate indicating that your captive team has done a wonderful job of providing financing for your manufacturer parent organization. In fact, as a result of this excellent performance the parent company's leverage ratio is reaching the point that its financial rating may be reduced by the rating agencies. This is the type of good news/bad news call most captive managers would rather not receive.

Often corporate's response to threats to its credit rating is to sell or refinance the portfolio. In fact, in the past 9 months a number of captive managers have faced this challenge. What are a captive executive's options? How does one balance the parent's needs with the captive's and the customers'?

Portfolio Valuation

Before any decisions are made, the lessor must determine the portfolio's true value. If this were a home sale, calculating the value would be easy. You would call several real estate agents to inform them you are considering selling your home. They would visit and make suggestions on how to enhance the property value as well as tell you what comparable home sales in your area have been. And with that information in hand, you'd be ready to go to market.

Portfolio sales should follow the same process to optimize value. Lessors may hire an outside consultant to perform due diligence on the portfolio from the perspective of a potential buyer. While this process can also be tackled internally, it needs individuals who are totally objective to ensure its accuracy and credibility.

Parent Company Drivers

To achieve the best result for the parent and the captive, it is critical to determine the parent's key concerns. If the primary concern is the parent's credit rating, the next step is to determine the amount of debt or leverage increase that would cause a lower rating. Taken into consideration with the portfolio's expected growth rate, this information provides a timeline for selling or refinancing the portfolio. It will also help decide if other alternatives can be explored.

If balance sheet treatment under FIN 46 is the parent's top priority, then there are a number of potential solutions to consider. First, though, the salability of the portfolio needs to be determined ASAP so a winning strategy can be formulated.

Operations Review

The operations review (due diligence) should at a minimum cover credit, collections, systems, personnel and documentation.

The credit review should encompass:

• policies and procedures;
• portfolio quality;
• the re-underwriting of selected credits to determine if policies and procedures were followed as well as their current quality compared to their rating at the time of their original approval.

The collections review should include:

• a review of policies and procedures;
• the examination of the delinquency history of the past 9 to 12 months;
• the re-underwriting of key delinquent accounts;
• an analysis of selected bankrupt and charged-off accounts to determine trends;
• a review of all extensions and account rewrites to determine the reasons for their approval.

The system's review should demonstrate the information system's ability to “slice and dice” the portfolio. This will help provide answers to buyer questions. The ease of transferring data to a buyer could facilitate or hamper a sale. It's also important to be aware of the system's growth capacity if the option of continuing to service the portfolio after its sale is being considered.

The quality of personnel will be an important selling point if you wish to convince a buyer that the servicing should be continued by the seller.

Documentation can make the difference in having a profitable sale or one where the seller is required to provide onerous and costly indemnifications. Areas examined should include:

• UCC filing policy;
• possession of original signed leases;
• favorable assignment language;
• signed personal guarantees;
• documentation of additional collateral.

Valuing Portfolio Options

After completing the operations review, the seller will need to determine the number of potential buyers and the current market for their industry paper and portfolio credit quality. As in the home sale scenario cited above, pricing expectations need to be realistic.

If there are portfolio quality issues, a partial sale may be the best short-term solution. This will provide the seller time to resolve the quality issues or provide additional portfolio seasoning.

The subject of reserves or holdbacks will need to be analyzed after receiving proposals. However, be aware this is usually a very contentious area in the negotiation process.

Servicing the Portfolio

How important is it for the captive to retain servicing of the portfolio? If there is a high percentage of repeat business, this may be a deal point and needs to be addressed at the outset with potential buyers. Customer relations concerns may add to the need to retain servicing. In some cases the buyer prefers that the seller retain servicing, especially if the portfolio has shown excellent performance with the current servicer.

If the buyer will take over the servicing, the captive should perform due diligence related to the buyer's servicing capability. The captive has an obligation to ensure their customers will be handled well or the captive risks the loss of a significant customer relationship. In cases where there is an impasse on servicing, agreeing to engage a third-party servicer can move the deal forward.

Alternatives to Sale

The value of the due diligence process extends beyond determining a portfolio's value. It can also uncover viable alternatives to an outright asset sale, including securitizing the portfolio or entering into a joint venture or a virtual joint venture with a financial services partner.

Securitization can produce either off-balance sheet treatment or remain on the balance sheet as non-recourse debt. A conversation with the rating agencies and external accountants should determine the viability of this alternative, which would still allow the captive to service the portfolio and maintain customer relationships.

A joint venture's benefits can include retaining an interest in the portfolio but not requiring showing the assets or liabilities on the balance sheet. The captive could maintain servicing and remarketing functions.

The downside is that the captive retains the portfolio's performance risk to the extent of the captive's equity interest. If there were a change in accounting rules, the joint venture agreement would need to provide for a change in equity interest and a formula for determining equity value. The amount of additional equity to be required based on portfolio growth could have an impact on the parent company rating and would need to be explored. Finally, the documentation process for the joint venture could take as long as 6 months, which could be a problem depending on the parent company's sense of urgency.

A virtual joint venture provides all the benefits of a joint venture except the share of profits is reduced based on the cost of equity negotiated by the joint venture partners. While there is less risk than in a joint venture, there is also less reward. On the plus side, the documentation is much less time consuming. Some organizations have voted to initially form a virtual joint venture with the understanding it will convert to a full joint venture during a predetermined time frame.

Funding Source Opportunities

The concern by manufacturers regarding their leverage and ratings affords significant opportunities for niche and generalist funding sources to develop vendor relationships and purchase portfolios.

Only high-volume vendors are likely candidates for gaining attention from funding sources because without a substantial portfolio, concerns over leverage and ratings would probably not exist. This vendor opportunity also has potential for a program with meaningful annual business flow.

For portfolio purchasers, the opportunity exists to address industry gaps in maintaining a diversified portfolio and meet budget shortfalls.

Joint venture opportunities exist for those manufacturers who still want to participate in portfolio profits but need to reduce balance sheet debt.

The need for structuring flexibility by the funding source is the most often-mentioned requirement by manufacturer clients. The flexibility concerns are not normally related to credit issues but to other business matters. Structuring flexibility is a big plus.

Summary

Concerns over a parent company's leverage ratios and credit ratings should not catch a captive finance manager unaware or cause undue anxiety. There are several options for balancing the parent-captive relationship and getting the most from the existing portfolio. Successful results depend upon:

• Using thorough and objective measures to determine the portfolio's salability;
• Recognizing that there are numerous alternatives to explore and no one-size-fits-all solution; and
• Pursuing funding source opportunities and flexible solutions.