ARTICLE
7 October 2024

Preparing For The Return Of Dealer Distress

Over the last five years, auto and equipment dealers experienced a period of low inventory levels with high margins on the limited inventory they had for sale and lease.
United States Insolvency/Bankruptcy/Re-Structuring

Over the last five years, auto and equipment dealers experienced a period of low inventory levels with high margins on the limited inventory they had for sale and lease. Used automotive and equipment wholesale and retail prices surged. At the same time, merger and acquisition activity drove dealer valuations to record highs especially in the automotive segment.

Dealer merger and acquisition activity has started to cool even though valuations and activity remain elevated above pre-pandemic levels1. New automotive inventory levels have risen during 2024 to the point that Ford's CFO, John Lawler, expressed worry regarding rising new car inventory levels in June2. Used automotive and equipment wholesale prices have declined from their pandemic era highs as well.

Record profits, low inventory levels, and strong merger and acquisition activity led to low delinquency and default levels in the dealer lending space, but current trends indicate those days may be coming to an end. For floor plan lenders, they should be thinking about dealer distress happening again. While times are still good, there are some steps lenders can take to prepare for distress down the road.

Review Your Documents and Security Interests

It is always easier to fix documentation and security interest deficiencies when times are good. Lenders should be checking to make sure their loan documents are correct and most importantly, their security interest position reflects their expectations. One area of particular concern is making sure no other parties have filed security interests against the dealer including merchant cash advance, factoring and other "short term" funding sources that might not show up as debt on financial statements. Even other lenders providing longer term debt financing secured by other assets like real estate may be taking a security interest in your inventory as well.

Insurance

As part of your documentation review, you should verify the dealer's insurance meets the requirements of your loan documents, lists your interest properly, and is adequate for the dealer's exposure. Insurance coverage tied to inventory levels can become insufficient if inventory levels rise faster than the coverage limits increase. Also ensuring the insurance covers all collateral locations is a requirement that might slip through the cracks especially if collateral locations change frequently.

Where is Your Collateral?

One benefit of low inventory levels was that dealers stopped storing inventory at satellite lots. The practice of old is starting to return as inventory levels build. Lenders want to make sure they know of these locations (they should if they are on top of the audits) and obtain landlord waivers if necessary to access the inventory upon a default.

Keeping Up on Audits

Anyone who knows the floor plan business knows the importance of audits. Low inventory levels and well performing dealers made audits easy. With increasing inventory levels, audit complexity is returning to pre-pandemic norms. Audit issues are often one of the first signs of dealer distress. A prominent example of a dealer issue recently being unearthed through audits involves a boat dealer who allegedly sold boats, but stored them for the customers and alleged the boats were still for sale3.

Financial Reporting and Covenants

Financial reporting deficiencies and financial covenant violations are also warning signs of potential distress on the horizon. Dealers rarely go bad overnight. Financial reporting and covenants going downhill are an obvious warning sign.

Taxes

Not just limited to dealers, but tax delinquencies are always a big red flag. Confirming the payment of taxes and the existence of no tax liens should be part of reviewing any dealer relationship especially one showing other signs of distress.

Used Inventory Levels and Advance Rates

During the pandemic when used vehicle and equipment prices shot through the roof, lenders became permissive of advancing beyond their standard advance rates. As used inventory values decline for vehicles4 and agricultural equipment5, dealers can be underwater on used inventory.

Manufacturer Specific Issues

Not all dealers are equal and the same is true for manufacturers. Monthly inventory level data from Cox Automotive6 shows inventory levels being substantially higher among some vehicle brands compared to others. Keeping an eye on your dealer and the average inventory levels of the brands they carry should be on your radar.

Explaining What You Do

As someone who spent a decade as lead counsel at two different financial institutions being lead counsel for floor plan businesses, I spent a lot of time explaining to others outside the floor plan businesses the nuances of floor plan lending. If things start going downhill with a dealer, be prepared for the inevitable basic questions from those not used to the dealer business.

Conclusion – Hope for the Best, Prepare For The Worst

One of the best credit people I ever worked with described a dealer failure as like a war. When a dealer failure occurs, most likely through a selling inventory out of trust, you don't have time to learn what to do. You got to know what to do. You must have someone ready to take command and quarterback the response. You got to know who will help you accomplish your ends. If you don't act quickly, your inventory will be gone and your losses can be in the millions within days.

Footnotes

1. "Dealership Buy-Sell Activity and Blue Sky Values are declining, but are elevated well above pre-pandemic levels", The Haig Report, August 29, 2024 (2024-Q2-Haig-Report-Press-Release-FINAL.pdf (haigpartners.com))

2. "Ford CFO says growing dealer inventory 'worries me'", Breana Noble, The Detroit News, June 11, 2024 (Ford CFO John Lawler says growing dealer inventory 'worries me' (detroitnews.com))

3. "Lender Alleges Dealer Diverted Millions in Sales Proceeds", Kim Kavin, Soundings Trade Only, April 16, 2024 (https://www.tradeonlytoday.com/manufacturers/lender-alleges-dealer-diverted-millions-in-sales-proceeds)

4. "Wholesale Used-Vehicle Prices Decrease in First Half of September", Cox Automotive, September 17, 2024 (Wholesale Used-Vehicle Prices Decrease in First Half of September - Cox Automotive Inc. (coxautoinc.com))

5. "Lower Used Equipment Prices Are Another Sign of the Challenges in the Ag Sector", Jim Wiesenmeyer, Farm Journal, August 14, 2024 (Lower Used Equipment Prices Are Another Sign of the Challenges in the Ag Sector | AgWeb).

6. "New-Vehicle Inventory Stabilizes as Sales Incentives Increase and Model Year 2025 Vehicles Arrive", Cox Automotive, September 19, 2024 (New-Vehicle Inventory Stabilizes as Sales Incentives Increase and Model Year 2025 Vehicles Arrive - Cox Automotive Inc. (coxautoinc.com))

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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