What’s the best way to handle commercial lease and loan charge-offs? It depends upon the preferences of the finance company, but a combination of strategies may be favored, including litigating accounts with balances over a certain threshold. One strategy that equipment lessors, banks and alternative lenders use is to sell all or a portion of their non-performing paper to a commercial debt buyer. That option did not exist before 1998, when equipment lessors helped pioneer commercial debt selling and buying.

Here’s a look at trends in commercial debt, defaults and charge-offs. Considerations for sellers and best practices for buyers will also be covered.

A Changing Market

A commercial debt buyer purchases portfolios of non-performing paper from finance companies. While consumer debt buyers dabbled in commercial accounts decades ago and continue to do so, the commercial debt buying profession can be traced to 1998 with the founding of TBF Financial.

Twenty years ago, however, few if any bank boards would authorize selling their non-performing commercial paper. Certainly, there were bank collections managers who were interested in selling charge-offs and felt the prices offered were reasonable. They realized the bank did not have the time or resources to continue chasing the accounts. But the deals were inevitably nixed by their bank boards. Board members reasoned that the bank could eventually recoup some of the money, somehow. It was the heyday of the banks.

Equipment lessors with small-ticket transactions were quicker to understand the value of commercial debt selling. Some lessors began selling their non-performing paper, after having first managed it in-house and handed it over to collections agencies for extended periods. By 2005, more lessors were using commercial debt buying services and most were doing so soon after charge-off, the prevailing practice that continues today.

Then the Great Recession changed everything. From 2008 to 2010, equipment lessors were dealing with a growing volume of non-performing paper, especially accounts connected with the real estate and construction industries. But the paper was not very collectible because so many lessees had failing businesses. Commercial debt buying and selling in equipment finance dropped dramatically after lessors tried to clean the defaults from their books. Volume began picking back up in 2015 and since then has been building gradually.

Interestingly, the recession piqued banking interest in commercial debt buying. Banks were dealing with an avalanche of defaults. Problems also emerged with business lines of credit secured by first mortgages. Foreclosures could take a year or more, the market for them was weak and bank reputations were being tarnished. Banks began selling their write-offs to save time and make quick money.

The recession also caused banks to pull back on small business lending due to regulatory restrictions. Entrepreneurs stepped into the breach with merchant cash advance services. In recent years, online alternative lenders have entered the financing marketplace. They are now using commercial debt buying services in the same way equipment lessors have for the past 20 years and banks have since the Great Recession.

Credit Risk Trends

In general, commercial debt selling and buying activity increases as defaults and charge-offs rise. But as we saw with the equipment leasing industry in the aftermath of the Great Recession, abnormally high defaults and charge-offs coupled with poor economic conditions can sometimes dampen the market. Very low defaults and charge-offs can be a problem, too, if they indicate companies are not booking enough business and/or are too risk averse.

The sweet spot is when the numbers are slightly low, as they are now, or within striking range of historical industry averages. Good sources for data on delinquencies, defaults and charge-offs include PayNet and Thomson Reuters, the Equipment Leasing and Finance Association (ELFA) and the Federal Reserve.

PayNet findings show the average default rate across industries was 1.8% in 2016 and 2017 and is forecast to rise to 2.0% through 2019. That compares favorably with historical averages of 3% and the recession of 2009, which spiked a 6.3% default rate.

A charge-off occurs when a past due payment remains unpaid for 180 days. Defaults are higher than charge-offs because some accounts get back on track before charge-off. The ELFA Monthly Leasing and Finance Index reports charge-offs were 0.34 percent in January 2018, down from 0.48 percent the previous month, and down from 0.43 percent in the year-earlier period. The ELFA also noted that delinquencies past 30 days have been rising and bear watching but are still below historical levels.

With new business volume in equipment leasing expanding as it is now, in a few years we will begin seeing charge-offs from leases booked in the past year that performed well for a while but then went into default.

Federal Reserve’s seasonally adjusted data for commercial banks shows commercial and industrial (C&I) loan charge-offs were 0.35 and leases 0.14 in Q4 2017, lower or the same as in Q4 2016 (0.41 for C&I loans, 0.14 for leases) and much lower than the 2.27 C&I loan and 0.97 lease charge-off rate in Q4 2009 during the recession.

Seller Strategies

In selling non-performing paper, no one-size-fits-all formula applies. Some companies find it is more efficient and cost-effective to sell all their charge-offs. That way, they can focus on booking and resolving newer business. Other companies litigate balances above a certain threshold and sell charge-offs below that amount. Every company has a threshold where it no longer makes financial sense to chase the account. That’s the point where it is better to take the cash now by selling charge-offs.

Should you consider commercial debt buyer services for your business? First determine the value of your paper. Commercial debt buyers will price your paper after evaluating the portfolio. The purchase price is a percentage of the balance on the accounts, and it can vary based on the merchant and personal guarantor. Usually, the percentage paid is higher for smaller balances since larger-balance accounts are often more difficult to collect.

Buyer Best Practices

Pricing is key, but other considerations are important when using the services of a commercial debt buyer.

Is the buyer highly experienced in commercial debt? Handling commercial accounts with sensitivity is much different than dealing with consumer accounts. The buyer should provide references from satisfied sellers similar to your company.

Very important: have the buyer (and any brokers working on his/her behalf) sign non-disclosure agreements before providing them with proprietary financial information.

How will the buyer communicate with your customers? Make sure that debts will be collected over time in a professional, non-threatening way and that the buyer will not misrepresent himself/herself as part of your company.

Ask for assurances in writing that the buyer/broker will never resell the debt without your permission. That way, your company has the option of repurchasing the accounts should any changes later occur.

Verify that any broker you deal with has an established relationship with a specific buyer. Ask who will see the portfolio information, how it will be shared, and whether the broker gets signed non-disclosure agreements from all parties.

Buyers and brokers should demonstrate these best practices that protect your company and its reputation with customers.