Why Aren't There More Nonprime Finance Companies

Many times, the F&I managers in dealerships become frustrated because they believe quality deals are being offered to nonprime finance companies, yet there seems to be difficulty in getting many of the deals bought. Although it seems all the published guidelines are being met, there’s something in the mysterious score cards killing deals. An obvious question is: Aren’t there any companies that like nonprime applicants any more? If not, why doesn’t someone start such a company?

Recently, there has been a general move toward consolidation of nonprime companies into depository institutions (banks), which has limited the variety of available programs. For example, what once was Auto One, Arcadia and TranSouth is now a single program handled by CitiFinancial Auto. Likewise, WFS Financial has been absorbed by Wachovia, Wells Fargo Special Finance by Wells Fargo Auto Finance, Bank One Special Finance by Chase Auto Finance, etc. In practically every case, these companies have also, more or less, abandoned the general FICO range below about 560 in favor of moving up the credit scale, seeking lower overall losses in their portfolios.

There are finance companies still buying low scoring paper, but those companies pay practically no attention to FICO scores and instead rely more on down payment and underwriter judgment for their decisions. Typical advances in those cases are significantly below 100 percent of wholesale value, many times as low as 75 percent of wholesale value. Obviously, it takes a strong down payment to make that structure work.

In the FICO range between 500 and 550, finance companies are few and far between. Yet, many successful companies started and prospered in that range. So, if they have become too loss conscious to purchase in that range, why doesn’t someone start a company that prefers that range? In the past, this was a profitable proposition.

Matching Expectations With Capabilities

An interesting fact is that investment firms, hedge funds, investment bankers and private equity firms are more interested in nonprime financing these days than in the last 10 years. So what’s the hold up? Are there no management guys out there wishing to start a company? Is there a problem getting management people together with investment finance sources? The answer to both questions is there are plenty of people who wish to start companies and there are investment sources who wish to invest. The problem seems to be one of matching expectations with capabilities.

Most investment companies look for opportunities with relatively high expected returns and relatively low risk of losing their investment. One way to judge a potential investment is to look at the track record of the company being invested in. This is where we have a disconnect as a start-up company. No matter the quality, in-depth experience and personal track records of management, it has no track record. It just hasn’t had any finance paper on its books long enough to determine what the loss picture looks like.

Consequently, financial models that attempt to forecast the success of a company are largely based on industry information instead of data that is unique to the company at hand. What makes the investors uncomfortable is that every finance company develops a culture of underwriting and collection that makes its portfolio performance somewhat different from the norm. If the new company does better with its financial result, that’s good. If it doesn’t, that costs the investor his or her return on investment, which is a bad thing. So, being able to look into the crystal ball and seeing a favorable outcome is important to investors, a difficult task without the finance company having some actual history to prove its philosophy is a profitable one.

Investors Want to See Some “Skin”

Another question that arises when attempting to attract capital is

whether the founders have enough “skin” in the game, and whether it’s enough that the founders are taking a significant personal risk. My experience has been that the investing institutions will provide great amounts of money, but they also expect the founding group of managers to have stretched their investment in the company so they will be highly motivated to make the new venture a success. In other words, if the business fails, the investment folks want the founding group to suffer in greater proportion than the investment group will. In a phrase, founding managers should have a significant portion of their personal net worth tied up in the new venture.

Typically, the management group that wishes to start a company is

composed of people who have been in exec

utive positions with successful finance companies, and who were probably holders of little to no equity in those companies. These are individuals who have become convinced that they can do it better than their current employer, the very reason behind their desire to start a new finance company. However, when they figure out how much they can pull together as beginning capital, the several tens of thousands of dollars required might put those ambitions into question. In the grand scheme of things, this may still be insignificant.

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It’s All In the Calculations

It has to do with the economics of the finance company. The general idea is to raise equity funding and then leverage that up to a larger amount by utilizing credit sources so the company can purchase significant numbers of auto finance agreements. Let’s say a management group is able to put together $500,000. With auto finance contracts in the nonprime arena now averaging at least $15,000 a piece, this amount of capital only supports the purchase of 33 contracts. Let’s assume that the interest rate on these contracts is 18 percent. That would indicate that each month, somewhere around $7,500 in interest income would come in, constantly declining as the contracts pay down. Without going into any fancy calculations, it’s clear that you couldn’t support much of a company on that income amount. So how do they get revenue up while having the capacity to continue purchasing contracts every month, and keeping their dealers interested in their new company?

You go to a friendly bank and offer your auto finance contracts as collateral along with your group’s personal guarantees in order to try and arrange a line of credit. Note that you now have probably used your savings, plus the pledge of your future income for this line of credit. A scary proposition for most people — well, I suppose that’s what makes entrepreneurs different. Hopefully, the bank likes the idea and agrees to advance 75 percent of the face amount of the contracts to the new company, leaving 25 percent of the funding to the equity of the company. In this case, that would give you leverage of four to one, which means you could purchase up to $2 million of finance contracts with your $500,000 in equity. How does that arrangement affect revenue?

Assuming the same 18-percent interest rate on the auto finance contracts, revenue would now be (the first month and declining thereafter) $30,000. Sounds much better. However, the bank is charging, say, eight percent on its line of credit. That means you would have to pay the bank $10,000 in interest on the borrowed $1.5 million, leaving the company $20,000 in net revenue.

Note that I haven’t even talked about the overhead of the company. So, we’re still pretty thin as an operating company. Consequently, let’s stop fooling around with these “little” numbers and talk about what it really takes to get going. The founding management group would be much better off putting together at least $5 million in base equity, then attempting to raise another $15 million or so from private equity or hedge fund sources, resulting in $20 million of equity. Then they could approach banks or other credit sources for portfolio funding. If you could negotiate an 80-percent advance rate from a bank or other financial institution on your purchased portfolio, you’d have a leverage of five to one and your $20 million equity would support a $100 million portfolio. That would give a new finance company the ability to support the necessary infrastructure to survive. That is a tall order for sure.

Changes Are Coming

And that tall order stops a lot of potential company formations in their tracks, or at least slows them down. However, there is hope. A rumor floating around is there is a group of five executives from a mainstream finance company in the midst of going through the capital formation very similar to what I previously described. Within the last year, Flagship Credit Corporation was formed in the Philadelphia area and is well along in their business development. There are others working diligently on capital raising as this article is being written; so don’t give up, as there will be someone coming along who will be interested in your auto finance contracts.

Keep an eye on publications such as F&I Management and Technology. If you are a member of a 20 Group, keep the discussion going. You may hear of new entrants into the market and may even hear a recommendation based upon some new finance company’s buying performance. The nonprime finance market simply holds too much investment return for it to be ignored by the investment community.