The Capital Market

 The Art of Turning Cars into Cash

“The next 24 months will be the best the buy here pay here dealers have had in the past 25 years,” said Jim Neubauer, national marketing director of Vehicle Acceptance Corporation (VAC). Customers are going to – and in some cases, going back to – BHPH lots because they are unable to obtain traditional financing through the mass of finance companies and banks that were heavily competing for their paper 18 months ago. So, what happens when customers return to BHPH lots? Cash demands rise for the dealers.

More lot traffic usually means more sales. More sales demand more inventory, which in turn demands more cash. Most BHPH dealers do not have access to floorplan opportunities found in franchise operations; therefore, they must invest large amounts of operating capital into inventory. Unlike traditional financing, where a dealer earns his profit at the time of sale, BHPH dealers earn their profits over long periods of time. This business model, on more than a very small-scale operation, can quickly drive a dealer out of cash and business. The solution for many BHPH dealers is asset-based loans.

Asset-based loans allow the BHPH dealer to sell their notes in bulk at a discount to buyers/financial institutions. It’s similar to what finance companies providing indirect financing do, although they call it asset-backed securities or securitizations.

Many finance companies dependent on securitizations for capital have either exited the market or tightened up because securitizations have taken quite a hit in 2008, and so has the asset-based loan market, according to Mike Sheridan, president of Global Debt Network Automotive (GDN Auto), an online marketplace where dealers can sell their portfolios to financial institutions. Sheridan estimated that the total bulk purchases for the first nine months of 2008 amounted to 13 to 27 percent of the 2007 total. That equates to a lot less capital flowing from buyers to BHPH dealers—tens of billions of dollars less.

Companies that are still purchasing portfolios now have less competition, allowing them to be selective about the portfolios they purchase. Gary Perdue, president of Southside Financial Group, said, “In terms of the paper we’re buying, are we more selective? Well, yes, because there’s more out there than any one company can digest … we’re going to attempt to buy the best paper we can buy. In one way, I’d say we’ve probably been more aggressive, and in another way, we are buying better portfolios.”

Today, because the number of selling dealers remains virtually unchanged, there’s increased competition amongst them to get their portfolios purchased. While BHPH dealers should see an influx of traffic due to consumers’ inability to obtain other methods of financing, dealers will have to be more meticulous in their underwriting in order to have a portfolio that financial institutions want to purchase.

Current Trends
One question Small Dealers Assistance (SDA) regularly asks its dealers is what percent of their business is BHPH and what percent is point-of-sale. President Gary Page said many dealers who once reported 50/50 are now reporting closer to 80/20 in favor of BHPH. “The point-of-sale side is shrinking, and it’s being taken over by buy here pay here, and the issue that these dealers have is … buy here pay here takes a ton of cash to make it work.”

However, he added that this BHPH trending isn’t occurring in areas hardest hit by unemployment and that dealers who are highly leveraged could find themselves in financial trouble. Page said, “If you don’t have anything that’s yours, one hiccup and you’re out.”

Sheridan, who has a front-row seat in the BHPH bulk purchase market because of GDN Auto, has noticed a few trends in the market during the last half of 2008. “What we’ve seen recently [September and October 2008] is that there are more hedge funds looking and swirling around this marketplace in hopes that they can get in because other asset classes like equities and mortgages have really been closed to them at this stage. Obviously, they can’t get the returns there.”

In an effort to try to get some of the hedge funds active in the market, Sheridan and GDN Auto are marketing to them and trying “to educate them about this market … to make sure their entry into this market is efficient … so they come back and understand that the auto market truly is a good place for them to earn returns and put money to work.”

Sheridan has also noticed adjustments in selling portfolios based on what financial institutions are focusing more on. “[Buyers] really want to see more pay history,” he said; the standard today is “at least six to nine months of pay history on these portfolios.” Before the market upheaval, he said portfolios containing notes with three months pay history were standard. “That doesn’t exclude getting portfolios with less pay history to sell, but I think you’re going to get a lower price for them,” he added.

Pete Agostinelli, president of Clearwater, Fla.-based Mid-Atlantic Finance Company (MAF), added to Sheridan’s viewpoint, “The notes that make the most sense to us are the notes with the shortest remaining term.” While notes with more seasoning, theoretically, should have the shortest remaining term, that’s not always the case.

To Agostinelli, length of the remaining term is just as important as seasoning. He feels his company buys portfolios “in stark contrast to what the industry has been trying to accomplish over the last five years, which was keep the terms longer, thereby lowering the customer’s payment and the customer will have the ability to pay for the vehicle longer.” To mitigate risk, he said he prefers a shorter term with a higher payment, as long as the payment is still affordable for the customer.

Also under the buyer’s microscope is the quality of the asset. An asset’s quality is contingent on many factors, but two factors mentioned more than once were the vehicle and the due diligence the dealer performs before underwriting. Sheridan said due diligence has become “the predominant factor in making a decision in buying these portfolios.” Buyers want verification of the employer, job length and income. They also want to know what they can recover in the event that they have to repossess and sell the vehicle.

Sheridan said, “When there was a lot of liquidity in the marketplace, some dealers [were not] diligent in putting their loans together. Because there was such competition for every loan, they knew they could get it sold if they needed to. That just isn’t the case anymore.”

The last and possibly most obvious trend in the BHPH capital market is the difference in price financial institutions are willing to pay. Sheridan said, “There’s been a pretty significant deterioration in price.” He said a portfolio that was worth 85 cents for every dollar a year ago might only sell for 70 cents today.

Future Trends
According to the industry professionals, one trend buyers may begin to see in 2009 is higher-quality BHPH portfolios. If the subprime customer who once qualified for indirect financing is now a BHPH customer, the average credit profile of the BHPH customer should be higher than in the past.

Exactly what that means for the industry is uncertain because in the BHPH industry, greater emphasis is placed on ability and willingness to pay than on credit profiles. However, it should make BHPH portfolios more attractive to buyers, like Southside Financial, who prefer a little higher credit quality than the current average BHPH portfolio offers. Perdue said, “There’s really a great opportunity for buy here pay here dealers to buy … upstream from where they used to be.”

Agostinelli, whose company hasn’t scaled back bulk purchasing in 2008, agreed that in the long run, dealers may have better quality portfolios for him to look at. He said, “Long term, I think it’s highly positive for the market. It’s just, how does everybody navigate their way through what’s going on right now?”

Sheridan added, “I am a big believer that this marketplace is going to see a significant volume increase when consumers come back to the table, and that this is going to be a great growth opportunity if dealers can survive during this very tough time. I think, because of that, it’s going to attract a lot of new investors to this marketplace and could be a really great opportunity for dealers over the next six to 24-plus months.”

The market may also see increased usage of GPS and starter interrupt devices on BHPH inventory, a topic that tends to polarize some. “Right now, [opinions on GPS and starter interrupt devices] are pretty split, but I think the trend is we’re going to see more of that,” said Sheridan, “My personal belief is that the trend, longer term, is [portfolio buyers] are going to want to see [GPS] devices in place … because they understand the value to them.” He also said he thinks dealers will be more willing to install GPS because the are more affordable now.

“We love GPS devices just due to the fact that it will allow you to locate the collateral,” said Agostinelli. “Starter interrupts, we like, but … if the customer’s loan is going to go bad and if the customer doesn’t have the ability to pay …  it doesn’t allow you to locate the car.”

One thing Perdue has noticed is that vehicles with starter interrupt devices are more prone to tampering. “We have bought some portfolios that had [GPS and starter interrupt devices] on them, and on the ones with just the GPS, we don’t find nearly as much tampering because you’re not shutting [the vehicle] off. They don’t have to figure out a way to get the car to run,” he said. He prefers GPS devices, adding if there’s only a starter interrupt on a vehicle, “that becomes very high maintenance.”

Page took a rather practical approach on GPS and starter interrupt devices, saying, “Anything that helps the dealer collect is a good thing.”

Tips for BHPH Dealers
While BHPH dealers can rejoice about attracting more customers to their lots, the experts did have some advice for dealers to make their portfolios more enticing to potential buyers when they’re ready to sell. The first bit of advice is no surprise: Get bigger down payments.

Page suggested dealers currently getting 10 to 15 percent down, try to get 5 percent more. He also advised BHPH dealers to be “very conservative” in today’s economy and “just kind of tighten up because that’s what the purchasers are looking at as well.” He said dealers will be protecting themselves by tightening up because there’s more risk in purchasing today.

Larger down payments should allow for shorter terms, which is the second thing the experts advised dealers on. Agostinelli stated, “The shorter the term, the less problems can come up.” More aging on accounts coupled with shorter terms typically means dealers can get a better price for their portfolios.

As far as inventory, Neubauer advised, “Don’t sell the customer too much car … it’s very difficult for buy here pay here dealers to be successful with $10,000 and $15,000 ACV cars,” adding that vehicles in the $3,000 to $5,000 ACV range are better suited for the BHPH lot.

Agostinelli warned against overcharging for vehicles, calling it the “biggest pitfall most dealers fall into.” He said some dealers buy vehicles from auction and more than double their cost to arrive at a sale price. If dealers who overcharge for their vehicles need to raise capital, they may wind up with a high-risk portfolio. Higher risk means it will sell at a discounted price. Agostinelli said such portfolios create “a tremendous amount of risk for any finance company that’s looking [to buy them] just due to the fact that the loan-to-value is way out of whack.”

On the subject of inventory, Sheridan suggested dealers keep a good mix. “Buyers don’t want to see a portfolio loaded with SUVs, and if it is, it’s going to be priced accordingly … It doesn’t exclude a portfolio from getting sold or looked at, but it certainly is severely affecting the prices out there.” However, he made a point to add that dealers shouldn’t shun SUVs because “there’s a large section of the population, no matter the gas price, who are always going to want SUVs.”

Since the due diligence dealers perform before writing each note is being closely scrutinized, Sheridan suggested dealers have a “set standard underwriting process that they run every deal through” and recommended they be diligent about verifying customer information. He said, “It may take a little bit longer, a little more work, but it is certainly going to make their portfolios more sellable.”

Understanding the market and having the right expectations for a portfolio is also important. BHPH dealers need to cultivate ongoing relationships with companies that buy portfolios because you can’t always predict when someone will buy. According to Sheridan, current buyers are taking on significantly more risk than they were a year or two ago, which is what caused the deterioration in the price of portfolios. He cited increasing unemployment and the fact that there “could be a significant jolt to the consumer market over the next six to 12 months” as justification for the decline in price.

Sheridan said if buyers are willing to take that risk, portfolios should sell at a discount, adding, “Sellers need to come to a portfolio buyer with the right expectations that their portfolio might not be worth as much as they think it is and if they really need to sell it, they have to work with buyers.”