The third coming of Steve Hudson

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To hear Steve Hudson tell it, he was summoned back to Bay Street to help save Canada's economy. It was the fall of 2009, when he heard from Stanley Hartt, the very well-connected Toronto lawyer and investment banker who was federal deputy finance minister and chief of staff to Brian Mulroney in the late 1980s.

The economy was still reeling from the 2008-2009 global financial meltdown and then-finance minister Jim Flaherty had appointed Hartt to chair the Advisory Committee on Financing, a blue-chip panel of 10 business leaders. They were looking for ways to untangle Canada's snarled credit markets and get stimulus to businesses and consumers. Hartt quickly discovered that it was still easy for corporate giants to borrow. But there was one group that financial markets were failing: smaller equipment and vehicle dealers trying to lease or sell their wares to corporate and individual clients. "The market for those people literally disappeared," Hartt says.

Enter—or rather, re-enter—Hudson. Back in the 1980s and 1990s, he was one of North America's kings of vehicle and equipment financing. He built Toronto-based Newcourt Credit Group into the world's second-largest non-bank lending company – providing financing for big stuff like planes, railcars, construction gear, office computers and fleets of cars and trucks. But the 1998 Russian ruble crisis caused chaos in world markets and sideswiped Newcourt, exposing all of Hudson's borrowing and accounting excesses. In 1999, he had to sell the company to New Jersey-based rival CIT Group for $2.4-billion (U.S.), giving Newcourt shareholders less than a quarter of the company's peak stock market value the year before. The debacle made Hudson's name mud—for a while.

"Stanley reached out to me and said, 'Wouldn't it be great if you came back?'" says Hudson. It was the "aha" moment he had been waiting for.

Hudson is now indeed back in the leasing-financing game as chairman and CEO of fast-growing Element Financial Corp. Since 2011, Element has raised $1.6-billion from investors, and its share price has tripled since it listed on the TSX in December of that year. About half of the company's 80 corporate staff—and six out of seven top executives—are Newcourt alumni.

Although Element has been on a tear, Hudson vows that it will be much more conservative than Newcourt. Age and experience have made him a humbler guy. "We no longer believe that trees grow to the sky," he says.

Some old habits die hard, however. In the 1990s, it was often difficult to tell from Newcourt's financial statements just how much money the company was making—or how little. Veteran Toronto forensic accountant Al Rosen, founder of Accountability Research Corp., was a prominent critic, arguing that the company often structured deals and accounted for them in ways that goosed short-term earnings, share price and pay for senior executives. Looking at Element's first two full years of results, he's more curious than alarmed, so far. "They certainly are creative," he says.

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Hudson, whose father was a mechanic, grew up in a blue-collar section of the Toronto suburb of Scarborough. In 1982, Hudson and Brad Nullmeyer, now Element's president, were articling accountants working on an audit for Manulife. They had no burning interest in vehicles and office equipment per se, but the potential they presented jumped out at them simply from looking at the giant insurer's numbers. Over beers in a faux-English pub, they drew some simple diagrams—not on napkins, but sheets of paper.

When an insurance company writes policies, or sells annuities or other products, it needs to invest the premiums it collects in instruments that will generate enough returns to pay claims or benefits as they arise—plus some profit, of course. Traditionally, insurers chose to buy government bonds or commercial mortgages with terms that matched their expected payouts over time—one year, five years, 10 years and so on.

But vehicle and equipment leases also generate income month after month, year after year, just like bonds. Sketching a line for me across a graph, as he had done with Nullmeyer in the pub, Hudson says, "This is the annuity, pension or segregated-fund business." Then he draws another line slightly above it, and says, "This is a railcar lease." By investing in leases, insurers could diversify their holdings beyond bonds and commercial mortgages, boost their returns a bit, but not take on as much volatility as they would with stocks. Different vehicles and equipment could cover different time horizons—say, fleet-car leases for five-year obligations, railcars or business aircraft for a decade or two.

Later in 1982, Hudson moved to a job in operations management at Toronto General Hospital, which was strapped for cash to buy expensive technology such as MRI and CAT scanners. By age 26, he'd scraped up $400,000 in venture capital and founded a medical equipment lease-financing company to help TGH and other hospitals. Two years later, having left TGH, he brought in Nullmeyer, and named the company Healthgroup Financial Corp.

Life insurers were early investors in lease financings, and in ownership stakes in the then-private company, which soon expanded beyond medical equipment. Hudson renamed it Newcourt and, in 1994, took it public. At that point, Newcourt had lease assets of about $2-billion. But Hudson says the company was still financially cautious. Insurers remained big sources of funding, and Newcourt kept the terms of its investments matched to its obligations. "For the first 12 or 13 years the business was around, we went to bed every night perfectly matched," he says.

But Newcourt then took off on an acquisitions spree. From 1994 to 1998, it bought more than a dozen companies, capped by a $1.6-billion (U.S.) purchase of another leasing outfit, AT&T Capital Corp. That deal boosted Newcourt's lease assets under management to about $30-billion. Now Newcourt ranked as No. 2 in new financings, behind only GE Capital Corp.

Revenue and profits swelled as well. Part of that was due to accounting practices. Instead of keeping all the leases itself, and booking the monthly payments from borrowers as they came in over several years, Newcourt syndicated many of them in bundles to other lenders or sold them off as asset-backed securities. As Rosen explains, those deals often allowed Newcourt to report hefty gains and fee income up front.

Yet Bay Street cheered and Newcourt's share price soared from $6.75 (after adjusting for a subsequent split) to a peak of almost $80 in March, 1998. The value of Hudson's personal stake in the company climbed to more than $200-million. He bought a mansion in tony Rosedale and an apartment in New York's Trump Tower. He drove around in a Ferrari and flew around in a Falcon private jet.

Newcourt also began selling short-term commercial paper—essentially, bonds with terms of just a few months – to raise even more cash for lease financings, rather than relying only on long-term matched funding from insurers and banks. Interest rates were low, after all, and markets seemed to have an unlimited appetite for the stuff. "Some guy–me–turned to commercial paper, because I knew better, because you could get more profit by borrowing cheaper," says Hudson. He now refers to commercial paper as "heroin," yet it worked brilliantly at first. "Everyone was doing it," adds Nullmeyer. "It was a very liquid market."

But commercial paper markets are often the first to freeze up in an international panic. In March, 1998, Russian President Boris Yeltsin abruptly dismissed his prime minister and cabinet. "What did it mean to us? It meant our funding costs went up 240 basis points overnight," says Hudson.

Stock markets were hammered, too, and skidded for months. In Toronto and New York, short sellers took a closer look at Newcourt and smelled blood. They helped drive down the share price to $31 by October. When Hudson announced the share-swap deal to sell to CIT in March, 1999, the price valued Newcourt's shares at about $26 (U.S.). After Newcourt shares took more of a beating over the summer and fall, CIT ended up paying about $16 (U.S.). "I must answer to those shareholders who bought at $40, $50, even $70," Hudson said at the time. "I did, too."

Looking back today, Hudson prefers, understandably, to focus on Newcourt's 15-year ascent from $400,000 to the eventual sale price of $2.4-billion (U.S.). "There were a lot of guys and girls from Scarborough and Etobicoke who became millionaires," he says.

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In the early 2000s, Hudson went into an exile of sorts in Florida to run the Hair Club for Men and Women. The detour seemed odd–but Hudson's second marriage was breaking up and he wanted to stay out of Toronto for a while. There was a business rationale as well. "We had developed processes at Newcourt that we thought were unique," he says. "I literally just took that playbook and overlaid it on a different business."

Hudson and a Toronto private equity firm, EdgeStone Capital Partners, acquired Hair Club in several steps, from 2000 to 2002, from founder Sy Sperling, spending about $25-million (U.S.). Hudson took over as CEO, and Hair Club's profits tripled. In November, 2004, he and EdgeStone sold the company to salon franchiser Regis Corp. for $210-million (U.S.), and he returned to Toronto soon after.

Nullmeyer also took a detour. At Newcourt, he'd been in charge of vendor financing, dealing with leasing partners that included computer-maker Dell, truck manufacturer Western Star and tool-and-equipment maker Snap-on. In 1997, he moved to Newcourt's office in New York City, and after CIT bought the company, it kept him on as president of its worldwide vendor finance unit.

But CIT struggled and its share price declined by about half. In 2001, Tyco International, the electronics and alarm-system company, bought CIT for $9.2 billion (U.S.), part of a bizarre expansion drive by Tyco's now-notorious former CEO, Dennis Kozlowski. Nullmeyer quit and moved back to Toronto. "I took a time out–ran a small water company and spent time with the kids."

Yet both Hudson and Nullmeyer say they retained their "passion" for equipment finance–yes, passion. "I understand what a Class 8 truck is, and what a 9/16 railcar is," says Hudson. The two longed to get back into the business. To that end, in 2011 Hudson became CEO of Element, then a small leasing company.

Fortunately for them, the financial world, including pretty much all of Newcourt's former rivals, and the large insurers and banks that had invested in leases, had got caught up in the euphoria in global financial markets in the early 2000s. In the United States, GE Capital, CIT and other finance companies had expanded into subprime mortgages, student loans and other high-risk vehicles. Insurers and banks plunged into soaring stock and derivatives markets, and leveraged themselves to the hilt.

When markets melted down in 2008 and early 2009, it left a gaping hole in Canada: CIT, Wells Fargo and other U.S.-based lease finance giants folded their tents and went home. That left those insurers and banks that wanted to return to investing in lease financing in Canada with no way to do it.

Stanley Hartt knew who to speak to. "The financial crisis basically drew a map for Steve by saying, 'There is an opportunity right in the sweet spot where you used to be, and you know it better than anyone else,'" he says.

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It didn't take Hudson long to re-establish himself. He began in earnest in April, 2011, with a $75-million private-equity offering in Element. In December, 2011, the company went public via a reverse takeover, having already raised $175-million in October. Six more share issues have brought the total raised to $1.6-billion. By the summer of 2012, Element was already a leading vehicle and equipment finance company in Canada, and was turning its attention to the U.S.

Like Newcourt, much of Element's growth has come from buying other companies or lines of business. It has completed seven major acquisitions since August, 2011, when it bought Montreal-based Alter Moneta, a specialist in financing for transportation equipment. Last December, Element announced a "strategic alliance" with Dallas-based Trinity Industries, the biggest railcar manufacturer in North America and an old Newcourt ally. Element will provide up to $2-billion (U.S.) worth of lease financing over the next two years; it also bought more than 5,500 railcars, worth $619-million (U.S.).

To use a corporate cliché, much of the lease finance business comes down to relationships. Element has re-established ties that date back to Newcourt, with equipment and vehicle manufacturers and dealers on one side, and insurers, banks and other "funding partners" on the other.

About a third of Element's employees work directly with manufacturers and dealers. Say you're a small construction contractor, and you want to lease a Bobcat loader. "If you walk into a Bobcat dealer today, there would be a finance person there along with the sales guy, and that would be our person," says Nullmeyer. "We don't have branch networks. We don't have to wake up in the morning and hope that someone comes to our website to ask for a loan."

Helping to "originate" the leases—weeding out the shakiest prospects for full payment—also helps control risks for the funding partners, he says. "We originate them on the basis that they are an annuity-like, flow-like business." As of Dec. 31 last year, just 0.3 per cent of the payments on Element's leases were past due.

Hudson wants to keep expanding quickly. Some of his competitors still haven't recovered from the financial crisis, but they will soon. Element had just $417-million in assets when it went public in December, 2011. The total had climbed to $3.5-billion at the end of last year. Hudson would like to hit $10-billion to $12-billion by the end of 2015.

At that point, he says, Element will likely be fully built. It's a long way short of the $36.2-billion in assets that Newcourt had at the end of 1998. But Hudson says he's determined to keep things under control this time around. Element won't expand beyond North America, and it won't branch into other lines besides its four "silos": fleets of cars and trucks, railcars, aircraft and a broad category of commercial equipment.

All that sounds less ambitious and less risky than the way Newcourt worked, but Rosen says that investors should still be wary. Hudson's strategy may be more conservative this time around, but Rosen notes that new Canadian accounting rules took effect in 2011: International Financial Reporting Standards (IFRS) replaced Canadian Generally Accepted Accounting Principles (GAAP). He argues that IFRS is generally "a real loosey-goosey set of rules" that gives managers much more discretion than GAAP in how they account for transactions and holdings.

Based on Newcourt's track record and Element's results so far, Rosen has concerns. One is whether so-called front-ending of revenue will become an issue again. Newcourt sold off many of its leases or syndicated them to other financial institutions and then engaged in "gain-on-sale" accounting. It could book the revenue, costs and profits associated with the leases in the first year, rather than spreading them over the life of the arrangements—say, five years. That often pumped up Newcourt's results in the short term.

Element took in $52.1-million in cash from syndication financings in the last fiscal year. The company purchased two large portfolios of leases and loans as part of major acquisitions, and then arranged matched funding for the leases and loans by securitizing them. In late 2012, Element bought Pennsylvania-based CoActiv Capital Partners. Element then funded CoActiv's portfolio of leases and loans by selling participation in it to institutional investors for $247.8-million. Last June, Element bought the fleet portfolio of GE Capital Canada, and securitized $430.6-million of its leases and loans.

In both cases, to enable the process to work, a "special purpose entity" was created to hold the leases and loans. This entity then funds itself by selling tranches of secured debt to institutional investors—mainly life insurance companies and pension funds. Element maintained a minority equity investment in both portfolios. The cash flow generated by the loans and leases is used to make monthly payments to the investors. In both securitizations, an independent third party, an affiliate of a Canadian Schedule I bank, was hired to administer the process from inception through to the last payment of the last lease.

John Sadler, a Newcourt alumnus who is Element's head of investor relations, argues that, contrary to Rosen, IFRS rules for sales and syndications are "more restrictive than those under Canadian GAAP." There are now more circumstances, he says, in which the gains and costs have to be spread out over the life of the leases.

Rosen, however, says that still leaves two issues. One is the value of leases recorded on the company's books. IFRS requires that they be carried at market value, but that value can vary widely, depending on what estimates management is allowed to use. If the leases are then syndicated or sold, the price recorded may be excessively high. There's also the risk that the leases that the company keeps on its own balance sheet may not be as solid.

Another of Rosen's concerns is how much executive pay at Element is based on profits and share-price performance. In the 1990s, Newcourt paid relatively meagre base salaries—about $100,000 or so—but often added stock options and bonuses of another couple of million dollars or more, as well as low-interest loans to buy more shares. Last year, pay for Element's top managers and its board of directors (a total of 12 people) jumped from $10.7-million to $56.6-million, of which $40.1-million was stock-based compensation; $14.9-million of that was specifically paid to managers "in connection with" closing the GE Capital deal.

The company has also granted executives and directors loans at about 3 per cent to buy options to buy shares, while it pays closer to 4 per cent on money it has borrowed for operations. But Sadler makes no apologies for the share– and performance-based compensation. That's the whole idea—to have the lion's share of executives' pay "at risk," he says.

Of course, there won't be many alarms raised so long as Element's share price continues to climb steadily. Investors and gung-ho brokerage-firm analysts haven't raised too many concerns about a replay of Newcourt's downfall.

As for Hudson, he's savouring Element's honeymoon. It's not every entrepreneur who gets to relive his youth (nor enjoy a full head of blond hair at 55—"I'm a client," he quips, harking back to Hair Club's old TV spots).

But he also knows that the first tough test probably won't come until there's another upheaval in capital markets. "Mine was the ruble crisis of 1998. The next one was subprime in 2007. I'm sure there'll be a third and a fourth. We could have one with Russia and Ukraine," he says. "The only thing you can do is to make sure you have a foundation of solid, long-term matched funding in place."

Al Rosen might have to agree.

An earlier online version of this story and the original magazine version of this story incorrectly stated that GE Capital exited Canada in 2009. The article also incorrectly stated that GE Capital sold operations other than its fleet portfolio to Element Financial. This online version has been corrected.