Running a BHPH Finance Company

Running A BHPH Finance Company

Your biggest asset is your BHPH portfolio, and running a finance company is a complicated endeavor.  I know it is challenging, because I have managed sub-prime auto finance companies.  One thing for sure, there is no training manual for doing this successfully, so I thought I would share a comparison of the BHPH finance company model versus what I experienced, hopefully giving you a perspective to compare with how you are building and managing your BHPH portfolio.

The easiest comparison is a simple Return On Assets (ROA) model, so we can compare the similar moving parts of the businesses.  The data is directional, but it leads us into the key components for revenue generation, cost of doing business, risk management and the ultimate goal of building equity, as well as making profit.  Do not get confused with the 3% ROA bottom line, as it translates to a 15% to 20% return on equity.

Revenue

A primary revenue stream for both businesses is interest income from performing loans.  The word performing is critical, and we will discuss more about this later.  The one enormous advantage in the BHPH Finance Company model is the ability to “collect” (another important point to discuss later) gross profit.  In this example, I assumed the gross profit based on a selling price that is 150% of the vehicle cost (recon included), which we will reference as LTV.  With great power comes great responsibility . . . meaning there is a reasonable limit to how much you mark up the selling price of the vehicle.  Much of the performance data I have reviewed indicates losses substantially increase when you get above 150%.  The stress it puts on customer performance essentially creates a loss accelerant, driving earlier and materially greater losses.

Losses

The subprime auto finance company model has much lower losses for two key reasons:  1) They manage to an even lower LTV at acquisition, and 2) They buy the paper at a discount.  This model must control losses, because interest income is the only true revenue stream.  The BHPH model has the benefit of “collecting” the gross profit. The two most predictive underwriting characteristic became very clear during my finance company risk management work.  They were payment to income ratio (PTI) and LTV.  The brilliance of a PTI is it is simple to execute and a really powerful measure to control defaults.  Essentially it controls the frequency of losses:  If they cannot afford the vehicle, they will default. The elegance of PTI is simplicity:  The customer’s monthly payment is divided by their gross monthly (validated) income.  PTI of 12% is optimal, 15% is workable, but once you hit 18% or higher you are swimming in loss infested waters.  There is also a gut-check required:  Is a monthly payment of $500 or more realistic? With the payment and LTV managed, the term is a simple output of what makes the payment and the LTV come together. LTV controls the severity of losses.  Why must LTV be capped at 150%?  I have worked with BHPH data, as well as your feedback, and it is very clear the vehicle must be a survivor and warrior, significantly influencing the performance of the loan.  If it does not break, it will help a great to weak customer perform.  If there is a mechanical breakdown, it will drive practically all customers to default with significantly higher losses.  Key reasons:
  • Customers drive 25,000-plus miles a year: It is the primary vehicle of the household and never stops running.
  • No maintenance: Customers just do not change the oil.  $30 for an oil change equates to a week’s worth of lunches, therefore they avoid this critical expense.  Consider providing them an oil change, for free, every four months to hedge this risk.
The first loss is the best loss.  Do not create your own Ponzi Scheme, reconditioning and reselling vehicles that broke down and didn’t survive a prior customer loan.  It was not a Darwinian vehicle.  Take it to auction, sell it for cash, but, whatever you do, don’t press the prior loss forward into the next loan.  Each loan, its performance and loss must stand on its own.  If the milk is spoiled, don’t put it back in the fridge, expecting it will taste better next week. Your profit comes from collecting payments, not repossessions.  If the customer will not respond to your repeated calls, falls a full month behind and/or the vehicle is at risk, protect your asset.  But, did you define a path for success:
  • Pre-delivery discussion of payment expectations: 1) Payments are due on or before the due date, 2) There is no grace period for late payments, 3) If you are having issues, call before we ever have to call you, 4) If you are reaching out to us, we can work through issues, 5) if you are unresponsive to our calls, we will have few options, 6) Your car allows you to work and make a living to pay for your life, therefore paying your car payment is the key to your job and your life—it is the first payment priority.
  • Life events happen, and typical customers are able to transition to comparable income if job loss occurs. Working them through challenges is critical to success.  Keep them focused on making payments–You do not want the car.
  • Avoid repair side notes and/or other post-delivery product sales, which will drive up PTI and payment default.
  • Payment activity is best early in the life of loans, so do not have false expectations that payment cashflow will always follow suit. A general rule of thumb:  1) 20% of losses will happen by the 6th month, 2) 50% of losses will happen by the 12th month, and 3) 75% of losses will happen by the 18th
  • Reserve 25% to 35% for losses at the time the loan is originated. It is inevitable, cannot be avoided and should go on the books never expecting more than 65% collectability.
  • Define a successful customer payment path to qualify to trade-up for their next vehicle with you. Isn’t this the ultimate goal, creating a repeat and referral customer for life?

Operating Expense

The finance company model leverages size and scale to manage costs, and it is materially lower than its BHPH cousin.  But, the BHPH model bears a heavier load of the sales origination expense, specifically flooring, TT&L, advertising, commissions, etc.  Down payments are the key offset for this, but everyone knows how hard it is to pry down from customers, but more down covers more expenses, which translates to more profit.

I do want to dispel an urban legend:  Very rarely, if ever, was down payment a powerful, predictive characteristic for defining loan performance in any of the risk analysis I have participated in.

Interest Cost

Whether you plunked down your life savings, borrowed against your house, ran up credit cards, brought in friends/family investors or all of the above, capital is not cheap, it is hard earned and incredibly hard to replace if your strategies don’t vigilantly protect it.  It also does not spread very far, so bringing in a senior lender with a line of credit allows you to leverage your portfolio to expand and grow.

Believe it or not, finding leverage as a subprime finance company is not any easier than a BHPH finance company, especially when you need a consistent, fair partner who is aligned with your path for success. 

For most BHPH operations, the cost is significant, therefore loan structure, underwriting and collections (see above) drive the cashflow that is critical to bear this load:  How much interest income do you make on a loan you repossessed?

Comparing One Model To The Other

As a subprime auto finance lender, I never had the advantage of engaging with the customer from the beginning to the end of the loan lifecycle, nor did I have the ability to navigate the customer to their trade-in and next purchase (the Holy Grail repeat sale).

The subprime finance company model has scale and lower costs, but maximizing the collection of gross margin through the effective use of data and basic risk management techniques can make the BHPH model a far superior return on assets.

You want to collect payments, not cars, therefore Darwinian cars (the fittest), attention to customer capacity and loss containment strategies will lead the BHPH finance company to the ultimate goal:  Wealth creation and ample profits.

Agora Team | Chris Barry
Chris Barry

Chris’ mission is to help BHPH dealers maximize their dealership investment with industry-changing analytics and financial strategies that put them on a level playing field with all automotive dealers. He is an experienced automotive finance leader with an extensive history of success in lending, servicing, and ancillary products with AmeriCredit, JP Morgan Chase, American Credit Acceptance, and GWC Warranty.

Have Any Questions?

We’d love to hear from you.
Send us a message and we’ll respond as soon as possible.