BloombergMarkets 5 Subprime Auto Defaults Are Soaring, and PE Firms Have No Way Out f t lh s
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Private-equity frms that plunged headlong into subprime auto lending are discovering
just how hard it might be to get out.
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A Perella Weinberg Partners fund has been sitting on an IPO of Flagship Credit
https://www.bloomberg.com/news/articles/2017-12-21/subprime-auto-defaults-are-soaring-and-pe-firms-have-no-way-out[12/21/2017 7:58:27 AM]
Subprime Auto Defaults Are Soaring, and PE Firms Have No Way Out - Bloomberg
Acceptance for two years as bad loan write-offs push it into the red. Blackstone Group LP
has struggled to make Exeter Finance proftable, despite sinking almost a half-billion
dollars into the lender since 2011 and shaking up the C-suite multiple times. And Wall
Street bankers in private say others would love to cash out too, but there’s currently no
market for such exits.
In the years after the fnancial crisis, buyout frms poured billions into auto fnance,
angling for the big profts that come with offering high-interest loans to buyers with the
weakest credit. At rates of 11 percent or more, there was plenty to be made as sales
boomed. But now, with new car demand waning, they’ve found the intense competition --
and the lax underwriting standards it fostered -- are taking a toll on profts.
Delinquencies on subprime loans made by non-bank lenders are soaring toward crisis
levels. Fresh investment has dried up and some of the big banks, long seen as potential
suitors, have pulled back from the auto lending business. To top it off, state regulators are
circling the industry, asking whether it preyed on borrowers and put them in cars they
couldn’t afford.
“The PE guys sailed into this thing with stars in their eyes. Some of the businesses have
done fne and some haven’t,” said Chris Gillock, managing director at Colonnade
Advisors, a boutique investment bank. But right now, “it’s about as out-of-favor a sector as
I can think of.”
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The apparent turnabout represents a sobering shift in what has been a booming market.
Since the turn of the decade, buyout frms, hedge funds and other private investors have
staked at least $3 billion on non-bank auto lenders, according to Colonnade. Among PE
frms, everyone from Blackstone and KKR & Co. to Lee Equity Partners, Altamont Capital
and CIVC Partners waded in.
Many targeted smaller fnance companies that often catered to the least creditworthy
borrowers with nowhere else to turn. Overall, subprime car loans -- those extended to
people with credit scores of 620 or lower -- have increased 72 percent since 2011. Last
year, about 20 percent of all new car loans went to subprime borrowers.
It usually works like this. Subprime fnance companies frst borrow money from the big
banks and then compete for loans from car dealers. They make their margin from the
spread between their funding costs and the interest they can charge, minus operating
expenses and whatever losses occur when borrowers can’t pay. What they don’t keep on
their books usually gets bundled into bonds and sold as asset-backed securities. Some will
also sell loans to banks or brokers to raise cash.
For many PE-backed subprime lenders, which invested heavily to expand, margins have
In some ways, buyout frms can only blame themselves. Because of the limited time to
show a return on their investments, usually four to six years, there was immense pressure
to grow. That led many fnance companies to loosen their standards -- like lengthening
repayment periods and lending to borrowers with lower credit scores -- to gain an edge as
car sales roared back from the depths of the recession and competitors jumped in. Many
pushed into “deep subprime,” the riskiest part of the business that’s grown in recent years.
Not Pretty
Take Exeter. The company, which is licensed in all 50 states and works with roughly
10,000 dealerships, hasn’t been proftable since 2011, when Blackstone took a majority
stake, an S&P Global Ratings report in September showed. That’s after the PE frm
invested $472 million to help Exeter expand and cycled through three CEOs at the lender.
On a pretax basis, Exeter turned a proft in 2016 and 2017, according to Matthew
Anderson, a spokesman at Blackstone. He added the New York-based frm hasn’t tried to
sell the lender.
Blackstone may look to unload Exeter later next year, said a person familiar with the
matter, who asked not to be identifed because it’s private.
Bad loans remain an issue. This year, a rash of delinquencies in two bonds stuffed with
loans that Exeter made in 2015 caused the securities to dip into their extra collateral to
keep investors whole.
‘Satisfactory Return’
As its loan portfolio surged to almost $3 billion from just $89 million in 2011, bad loan
write-offs mounted and left the company with losses last year. Since then, it’s been forced
to cut back origination and tighten underwriting standards. Kroll Bond Rating Agency said
in November it expects Flagship to post another loss this year before returning to
proftability in 2018.
“We’re concerned about the company’s ability to earn a satisfactory return,” S&P said in
August.
That might not bode well for Flagship’s initial public offering, which could potentially
provide an exit for its owners. The IPO has languished and its prospectus hasn’t been
updated since July 2015.
In hindsight, the planned sale may have come a year too late.
Perfectly Timed
“Tom Dundon at SC timed it perfectly,” said Dan Parry, co-founder of Exeter who now
runs TruDecision, a fntech frm that serves car dealers and lenders. “Others haven’t been
that fortunate.”
Indeed, while subprime delinquencies of 90 days or more have stabilized at banks, the rate
at non-banks is close to the highest since 2009, according to the Federal Reserve Bank of
New York, which noted the industry’s hasty underwriting standards.
Many of the large banks that provide funding to subprime auto lenders have taken notice
and become far more conservative in doling out credit lines, says David Knightly, a vice-
president at Innovate Auto Finance, which buys loans from dealerships and auto fnance
companies to help them raise cash.
“From a standpoint of subprime auto right now, if you’re small, people aren’t lining up,”
he said. “Everybody’s trying to guess when the next 2008 is.”
Bigger subprime auto lenders can still turn to the capital markets. Sales of subprime auto
ABS have reached $25 billion, topping last year’s total and almost triple the amount in
2010. They’ve also shored up fnances by lending to borrowers with stronger credit, said
Amy Martin, an analyst at S&P. That in turn has buoyed shares of some of the biggest ones
in recent months.
Martin expects a lot of mergers as car sales slow. In the meantime, PE frms have largely
lowered their expectations for a big exit and are trying to make their companies leaner to
extract a dividend or sell the loan portfolios.
“Nobody wants to pay much more than book value” for these companies, said Colonnade’s
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