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FOUR PHASES OF CAPITALIZATION FOR BUY HERE-PAY HERE DEALERS

By Christopher Leedom

Lately we find that we are talking to buy here-pay here dealers about capitalization as much as any other topic. For many dealers this is the single biggest issue that stands in the way of success. As the market has changed over the past two years many dealers find themselves in the unenviable position of searching for capital to fund the business. I thought it might be helpful to analyze the four phases of capitalization we see dealers go through in order to help all dealers better understand their capitalization options.
Many dealer-owners have become millionaires or multi-millionaires in the buy here-pay here business. With respect to capitalization virtually all of these operators typically fall into one of four distinct phases of capitalization. By understanding the nature of each of these phases, a dealer can properly prepare for the transition form one level to the next. It requires very careful planning to go through each level but the reward is growth and profitability. The phases are as follows:

Phase One – Initial Capitalization and Start-Up

The nature of the buy here-pay here business is deeply rooted in entreprenuerism. Like any other fledgling business the first phase of capitalization is usually comprised of the dealer-owner’s own capital or that of friends and family. The typical start-up operation will consume $250M to $500M in capital during the first twelve to eighteen months. A significant majority of this negative cash flow occurs in the first six months as an operator begins to grow and develop a loan portfolio. During this first year the owner can expect pre-tax profits of between $200M to $300M. Many dealers will then be able to obtain a signature line of credit based on their net worth and credit worthiness. Typically this is in the range of $500M. This line of credit is usually obtained through a local or regional bank and is often secured by real estate, the outstanding loan portfolio, and/or inventory of the dealership or simply the owner-operators personal guarantee. This access to capital allows the operator to grow the business and move to the next phase of capital need.

Phase Two – The Asset-based Credit Line

Quite often the dealer-owner reaches their maximum borrowing capacity for a signature loan and begins the task of securing an asset-based credit line. For most operations the single biggest asset on the balance sheet is the outstanding automobile loans. By the time an owner-operator reaches this level, we are able to predict cash flow, portfolio liquidation and loss experience. It is not uncommon for savvy operators to perform routine static pool loss analysis to determine the true value of the portfolio. A more astute buy here-pay here dealer recognizes predictability with respect to cash flow, portfolio liquidation and knows the exact value of their portfolio through the application of static pool analysis. Static pool analysis takes the guesswork out of understanding loss experience and is the most reliable analytical tool for monitoring the quality of the loan portfolio. It is driven by pure empirical data and eliminates guesswork.

Based on our industry statistics most dealers experience static pool loss rates of between 16.0 and 28.5 percent. While we have observed some operations several points below this range it is the exception rather than the norm. Based on this knowledge an owner-operator or potential lender can value the portfolio. This is illustrated by the following hypothetical example:

Outstanding loan portfolio $8,000,000

Provision for future loss $1,760,000
based on 22% loss rate

Net value of portfolio $6,240,000

In the above example the buy here-pay here operator has an outstanding portfolio of $8,000,000. Over a period of time the static pool loss rate has been 22%. By applying the historic loss rate to the outstanding loan portfolio one can determine the reasonable value of the asset.

Many local and regional financial institutions are able to extend an asset-based loan that is collateralized by the portfolio and the personal guarantee of the owner-operator. The advance rate of this asset-based loan is determined by a formula set forth by the lender that defines eligible receivables and then applies a factor to arrive at a lending amount within the parameters set by the lender. As a result the business now has access to capital that is driven by a very specific formula. This allows entrepreneurial ingenuity to take over and continue the growth of the business.

This approach typically provides a line of credit of between $1.0MM and $2.5MM. While some regional financial institutions certainly have the ability to go beyond this range we normally find that between $2.0MM and $3.0MM of exposure these lenders say “uncle”. They, the lender, will typically thank the owner for his or her business, let them know the relationship has been profitable, but encourage them to consider other financing if they wish to grow the business. At the $3.0MM level most owner operators then move to the next phase – an asset-based loan with a national lender.

Phase Three – Asset-based Credit Line with a National Lender

This third phase of maturity is very similar to phase two but the lender is typically a national financial institution or a consortium of participating banks. When an operation moves to this level it is typically after three to five years of borrowing experience at the phase two level. The asset-based credit line is very similar in structure. Usually the only noticeable change is an increase in the frequency of audits and more intense monitoring and the overall amount of the credit facility is greater. Most operations make this adjustment without any difficulty.
The playing field of lenders providing this type of financing has thinned out considerably over the past eighteen months. The Finovas (bankrupt) and BankOnes (strategic redirection) are no longer serving this market. There are a few institutions that provide this level of asset-based financing for the more sophisticated buy here-pay here dealer, however it is clearly a lenders market. Usually these lines of credit are in the range of $3MM to $30MM. Currently, there are a limited number of institutions serving this market.

Phase Four – Commercial Financing – The Next Frontier

We believe that for the larger, mature operation the next stage of financing will be a commercial financing structure. This involves going directly to the market and offering commercially rated investment instruments. Currently our firm is purusing a commitment from a European firm to fund $300 million of financing at this level but there is still work to do. For those of you at this level you are at the very forefront of industry development and pioneering. The challenge is to create a viable option for the buy here-pay here operation that can fund growth beyond phase three capitalization.

Currently many dealers progress through the stages outlined above until they are “out of options” or fail to establish eligibility at the next level. I would recommend that each and every dealer-owner determine which phase they are currently at and develop a clear plan as to what it will take to go to the next level. It will not “just happen”. It requires a great deal of planning and execution. But the reward is successful growth of the business by moving through these various phases. That is, unless your lucky enough to have unlimited personal resources! But that does not happen often. Hopefully this information will help you, the dealer, determine your next step with respect to capitalizing your operation.