In Buy Here Pay Here auto finance, the dynamic of fixed interest contracts for consumers and variable rate credit facilities for the independent dealerships (and finance companies) providing the loans, is creating challenges. Something’s gotta give.
The current interest rate environment is pushing a significant number of dealerships and subprime finance companies to wind down portfolios, and in some cases failure, because of the contraction of yield spread.
The unprecedented rate of the rise in interest rates was unexpected and caught both borrowers and lenders by surprise. Spread-based pricing has been the norm for credit facilities backed by sub-prime auto loans in the past couple of years. A credit facility entered in January 2022, when 30-Day SOFR was at 0.05%, today is costing the originator over 5% per annum more at today’s 30-Day SOFR Rate of 5.3%. Without these rates being passed on to the consumer, the originator is generating little or no excess spread to continue to grow.
Many originators are not generating enough cash to fund the advance rate on its credit facility and so are unable to continue to draw on their facilities to keep originating and growing. An originator that is not growing is in wind-down.
The BHPH dealers have few levers to pull as sub-prime auto loans are typically fixed interest rate contracts. The choices are to increase interest rates on new loans or tighten underwriting to reduce defaults. Both take time for the impact to be seen in cash flows and raising rates increases default risk. Similarly raising interest rates and tightening underwriting reduces competitiveness and origination volumes.
The other lever for the dealership (or finance company) to pull is to seek concessions from its credit provider to re-set interest rates to share the burden of the rapid rise in the SOFR base rate or defer cash payments through PIKs and other mechanisms.
If the credit provider is unable or unwilling to provide concessions, then what?
Re-financing is a complex process and obtaining concessions needs to be properly planned and presented. Lexant is aware of multiple cases of finance companies trying but failing to re-finance or obtain concessions and ultimately passing their portfolios back to their credit provider to be wound down, leaving experienced management teams orphaned.
Lexant understands the complex and delicate commercial and legal issues involved. Issues arising typically include portfolio valuation, subordination of security interests, and pre-payment penalties. Lexant has proven success and experience in this refinancing process.
Opportunities in the High-Interest Rate Environment
Despite these challenges, we see opportunities for savvy operators to thrive in the current market.
With originators passing portfolios back to credit providers, or failing, there is likely to be increased consolidation in the sub-prime auto lending market. The winners will absorb portfolios and platforms, creating opportunity for rapid and transformational growth.
At a portfolio level, we also expect 2024 vintages to outperform due to credit score migration: Prime auto loan originators have similarly been tightening their underwriting with the effect that formerly prime customers are pushed to near-prime credit scoring tiers and near- prime consumers are pushed into the subprime market. Consumers credit scores are moving from higher credit tiers to lower credit tiers. This is particularly the case where consumers who had a bump up in credit tiers while benefiting from Covid related government stimulus and are now returning to their previous credit tier levels. With consumers credit tiers being migrated, there is opportunity for effective underwriters “to find the prime in the sub-prime” as our good friends at TrustScience.com put it.
Historical performance from similar periods of rising rates and macroeconomic contraction demonstrates that these consumers that have slipped down the credit spectrum perform significantly better than traditional subprime auto consumers. This experience can be seen in the out-performance of sub-prime auto following the 2007-9 recession.
In short, loans to subprime consumers put on the books today are expected to perform better, and statistically have in the past, than the loans put on the books at this same time last year.
Be Pro-Active in Restructuring Credit Facilities
Lexant Advisors is working with its clients to find solutions to improve cash flow and profitability in the current high interest rate environment.
Our approach is to work constructively with our clients' current credit providers to find a solution that works for all. In the case where the current lender is a credit fund, a solution that Lexant is finding success with is to bring in a senior bank participant to blend down the total effective cost of capital. There is give and take required, however the result is to de-risk the credit by improving profitability and cash flow and allowing the originator to continue to grow, which ultimately is what all parties want.
There is opportunity for originators to withstand and benefit from the shake out caused by the current market dynamics. The key action point is to be pro-active in engaging with lenders and taking the right steps to re-structure your credit facility. Lexant Advisors can help get this done efficiently and effectively, and intermediate to facilitate difficult discussions.
With rates expected to stay higher for longer, now is the time to get in touch.
Alan Keate: Senior Advisor, Head of Auto Finance, Lexant Advisors, Inc akeate@lexantadvisors.com
Alan has held leadership roles in the auto lending industry serving as CEO of a multi-state, 17 store BHPH dealership with 300 employees. He has also founded and served as CEO of two subprime auto finance companies.
About Lexant Advisors, Inc
Lexant Advisors is a boutique advisory firm focused on growth stage specialty finance companies. We source and provide debt and equity capital to our clients through our network of financial partners and invest our own capital on a case-by-case basis.
Lexant has significant sector expertise in fintech, commercial credit, consumer credit and specialty lending. We also have proven expertise in debt settlement negotiations, restructurings, recapitalizations, and balance sheet optimization.
Our team has decades of collective experience, with clients ranging from regional banks to early-stage start-ups seeking capital and strategic advice.
Contact Peter Stokes: pstokes@lexantadvisors.com
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