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NEWS > SEC Filings for NEWS > Form 10-K on 14-Mar-2014All Recent SEC Filings

Show all filings for NEWSTAR FINANCIAL, INC.

Form 10-K for NEWSTAR FINANCIAL, INC.


14-Mar-2014

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion contains forward-looking statements. Important factors that may cause actual results and circumstances to differ materially from those described in such statements is contained below and in Item 1A. "Risk Factors" of this report.

Overview

We are a specialized commercial finance company focused on meeting the complex financing needs of companies and private investors in the middle market. We focus primarily on the direct origination of loans and equipment leases through teams of credit-trained bankers and marketing officers organized around key industry and market segments. Our marketing and direct origination efforts target private equity sponsors, mid-sized companies, corporate executives, regional banks, real estate investors and a variety of other referral sources and financial intermediaries to source new customer relationships and lending opportunities. Our emphasis on direct origination is an important aspect of our marketing and credit strategy because it provides us with direct access to our customers' management teams and enhances our ability to conduct detailed due diligence and credit analysis of prospective borrowers. It also allows us to negotiate transaction terms directly with borrowers and, as a result, we have significant input into our customers' financial strategies and capital structures. We also participate in loans as a member of a lending group. The mix of our originations may vary from period to period. We employ highly experienced bankers, marketing officers and credit professionals to identify and structure new lending opportunities and manage customer relationships. We believe that the quality of our professionals, the breadth of their relationships and referral networks, and their ability to develop creative solutions for customers position us to be a valued partner and preferred lender for mid-sized companies.

We operate as a single segment, and we derive revenues from four specialized lending groups that target market segments in which we believe that we have a competitive advantage:

Leveraged Finance, provides senior, secured cash flow loans and, to a lesser extent, second lien loans, which are primarily used to finance acquisitions of mid-sized companies with annual cash flow (EBITDA) typically between $5 million and $30 million by private equity investment funds managed by established professional alternative asset managers;

Business Credit, provides senior, secured asset-based loans primarily to fund working capital needs of mid-sized companies with sales typically totaling between $25 million and $500 million;

Real Estate, manages a portfolio of first mortgage debt which was sourced primarily to finance acquisitions of commercial real estate properties typically valued between $10 million and $50 million by professional commercial real estate investors; and

Equipment Finance, provides leases, loans and lease lines to finance equipment purchases and other capital expenditures typically for companies with annual sales of at least $25 million.

Market Conditions

As a specialized commercial finance company, we compete in various segments of the loan market to extend credit to mid-sized companies through our national specialized lending platforms. We rely primarily on large banks for warehouse lines of credit to partially fund new loan origination and the capital markets for longer term funding through the issuance of asset-backed notes that are used to refinance bank lines and provide funding with matched duration for our leveraged loan portfolio.

Market conditions in most segments of the loan market that we target remained relatively unchanged in the fourth quarter compared to the prior quarter. Overall middle market loan demand remained steady and new issuance volume of approximately $50 billion in the fourth quarter pushed total loan volume for 2013 to a record $204 billion. Despite record volume, however, the markets remained highly liquid and competitive as volume


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was dominated by refinancing of existing loans and the supply of new capital outpaced demand for new financing for growth or acquisitions. According to Thomson Reuters, 64% of total middle market lending in 2013 was represented by refinancing activity.

We believe that modest M&A activity and related demand for new financing combined with inflows of capital into loan funds, new CLO issuance, and new fund formation continued to drive a weaker pricing environment as lenders competed for a limited universe of deals. These conditions also led to increasing pressure on deal structures reflected by somewhat higher leverage levels and weaker lender protections. Despite that trend, however, we believe that conditions in the middle market compared favorably to other credit markets including large corporate loans as a hyper-competitive environment pushed yields even lower throughout the year and arrangers loosened deal structures more aggressively. Loan yields in the large corporate market, for example, tightened to 4.6% in December as new middle market loan yields widened to 6.1%. With most of the new money flowing into the loan market from CLO issuance and retail loan funds targeted for broadly syndicated loans, we believe that market conditions will continue to be challenging for large corporate lenders and that the middle market will continue to compare favorably.

In this type of environment, our different lending platforms provide us with certain flexibility to allocate capital and redirect our origination focus to market segments with the most favorable conditions in terms of demand and relative value. As the pricing environment for larger, more liquid loans weakened further in the fourth quarter and loan demand among private equity firms in the lower middle market remained somewhat firmer, we continued to emphasize direct lending to smaller companies during the quarter. We believe that the yields on our new loan origination will continue to reflect a combination of these broad market trends and shifts in the mix of loans we originate.

Conditions in our core funding markets were somewhat mixed, but remained supportive in the fourth quarter as many fixed income investors continued to target structured investment alternatives such as CLOs to meet their return objectives. The market was somewhat more unsettled, however, as regulatory headwinds from the Volcker Rule dampened demand for CLOs among banks as they worked through how the rule would apply to them and how it would impact their ability to continue investing in CLO debt. The broader fixed income markets were active in the quarter as the market adjusted to changes in the Federal Reserve's monetary policies. As a result, we believe that investors will be more cautious about holding fixed rate debt, leading to less capital flowing into the high yield market in favor of high yielding investments with shorter duration, including floating rate bank loans and CLO bonds. This rotation into floating rate debt was evident in 2013 as investors funded a record $63 billion into mutual funds and ETFs targeting the floating rate loan markets.

Despite headwinds at the end of the year, new CLO issuance exceeded $81 billion in 2013, up from $55 billion in 2012 and 2011's total of $12 billion. After trending down through the first half of the year, CLO credit spreads continued to trend higher through the second half, however, reflecting the impact of a steepening yield curve and regulatory concerns, including an FDIC surcharge for deposit insurance and future risk retention rules in addition to the Volcker Rule. As a result, we believe marginal funding costs will be somewhat range bound at current levels until investors reset rate expectations and resolve regulatory issues. Despite this trend in the pricing environment, we believe that market conditions remain supportive for us to issue new CLOs as demonstrated by the transaction we completed in September 2013. We also believe the availability and cost of warehouse financing among banks has continued to improve as more banks have begun to provide this type of financing and existing providers have increased their lending activity. As a result, we believe that the terms and conditions for financings available to established firms like NewStar have improved, as shown by our ability to refinance our existing corporate debt through a new $200 million financing on significantly improved terms and at lower cost in the second quarter.

Loan demand in the middle market is strongly influenced by the level of refinancing, acquisition activity and private investment, which is driven largely by changes in the perceived risk environment, prevailing borrowing rates and private investment activity. Overall activity increased in the fourth quarter after a seasonally slow third quarter, pushing new loan volume in 2013 to approximately $1.3 billion.


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We originated nearly $550 million of new loans in the fourth quarter at yields that were generally below our historical averages for comparably rated loans, but consistent with the prior quarter. Yields reflected a combination of continued pricing pressure in a muted M&A volume environment and a continuation of the shift in the mix of origination toward loans directly originated with smaller middle market companies. Pricing remained thin and leverage continued to trend higher in the broad loan market. Conditions in our primary target markets, however, remained somewhat more favorable with pricing and leverage stabilizing at levels that compare favorably to the broader loan market, in which larger corporations typically borrow from syndicates of banks and loans are issued, priced and traded in a bond-style market that is more highly correlated with the high yield debt market.

We believe that demand for new middle market loans and credit products will remain relatively consistent with current levels in the near term and exhibit usual seasonality. Over the long-term, we believe that demand will improve because private equity firms have substantial un-invested capital, which we believe that they will deploy through investment strategies that emphasize investments in mid-sized companies. We also believe that a significant and lasting impact of the credit crisis that began in 2008 has been a reduction in the number and capacity of lenders in the markets in which we compete. As a result of these factors, we anticipate that demand for loans and leases offered by the Company and conditions in our lending markets will remain relatively consistent overall through the balance of 2013, but continue to provide opportunities for us to increase our origination volumes.

Recent Developments

Liquidity

On March 6, 2014, as permitted under our corporate credit facility with Fortress Credit Corp., we requested and received an increase of $28.5 million to the Initial Funding under this credit facility. We borrowed the entire $28.5 million on March 6, 2014.

On December 12, 2013, we entered into an amendment to our credit facility with Wells Fargo Bank, National Association to fund new equipment lease origination. The amendment extended the provision for optional termination of the revolving period from January 16, 2014 to March 17, 2014, and extends the Turbo Event (as defined in the Note Purchase Agreement) from January 16, 2014 to March 17, 2014.

On December 27, 2013, the NCOF paid off the outstanding notes of its term debt securitization at par. As of December 31, 2013, we had purchased $217.9 million of the $276.5 million of outstanding loans previously owned by the NCOF.

On November 26, 2013, we entered into an amendment to our credit facility with Wells Fargo Bank, National Association to fund leveraged finance loans. The amendment increased the commitment amount under the credit facility from $175.0 million to $275.0 million, increased the amount by which the commitment amount may be increased to up to $325.0 million, and modified certain concentration amounts and specified threshold amounts, among other things.

Stock Repurchase Program

On November 19, 2012, our Board of Directors authorized the repurchase of up to $10 million of the Company's common stock from time to time on the open market or in privately negotiated transactions. The timing and amount of any shares purchased was determined by the Company's management based on its evaluation of market conditions and other factors. The repurchase program expired on December 31, 2013. As of December 31, 2013, we had repurchased 17,665 shares of our common stock at a weighted average price per share of $12.22.

RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2013, 2012 AND 2011

NewStar's basic and diluted income per share for 2013 was $0.51 and $0.46, respectively, on net income of $24.6 million compared to basic and diluted income per share for 2012 of $0.51 and $0.45, respectively, on net income of $24.0 million, and basic and diluted income per share for 2011 of $0.29 and $0.27, respectively, on net


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income of $14.1 million. Our managed loan portfolio was $2.5 billion at December 31, 2013 compared to $2.4 billion at December 31, 2012 and $2.4 billion at December 31, 2011. As of December 31, 2013, loans owned by Arlington Fund and the NCOF were $172.6 million and $93.3 million, respectively.

Loan portfolio yield

Loan portfolio yield, which is interest income on our loans and leases divided by the average balances outstanding of our loans and leases, was 6.68% for 2013, 6.54% for 2012 and 6.50% for 2011. The increase in loan portfolio yield from 2012 to 2013 was primarily driven by the recognition of deferred paid-in-kind interest on certain impaired loans, and the average yield on loans which were repaid subsequent to December 31, 2012 was lower than the average yield on loans in our average total loan portfolio for 2013. Additionally, subsequent to December 31, 2012, the outstanding balance of lower yielding commercial real estate loans decreased $54.4 million. The increase in loan portfolio yield from 2011 to 2012 was primarily driven by an increase in our average yield on interest earning assets from new loan and lease origination and re-pricings subsequent to December 31, 2011, and the average yield on loans which were repaid during 2012 was lower than the average yield on loans in our total loan portfolio. During 2012, the outstanding balance of lower yielding commercial real estate loans decreased $93.9 million.

Net interest margin

Net interest margin, which is net interest income divided by average interest earning assets, was 3.90% for 2013, 4.34% for 2012 and 4.28% for 2011. The primary factors impacting net interest margin for 2013 were the composition of interest earning assets, the recognition of deferred paid-in-kind interest on certain impaired loans, non-accrual loans, changes in three-month LIBOR, credit spreads and cost of borrowings. The primary factors impacting net interest margin for 2012 were accelerated loan deferred fee recognition due to a prepayment of loans, non-accrual loans, changes in three-month LIBOR, credit spreads and cost of borrowings. The primary factors impacting net interest margin for 2011 were non-accrual loans, the accelerated amortization of deferred financing fees and unamortized discount resulting from the call of the 2009-1 CLO, changes in three-month LIBOR, credit spreads and cost of borrowings.

Efficiency ratio

Our efficiency ratio, which is total operating expenses divided by net interest income before provision for credit losses plus total non-interest income, was 49.30% for 2013, 46.46% for 2012 and 51.81% for 2011. The increase in our efficiency ratio for 2013 as compared to 2012 was primarily due to an increase in operating expenses. The decrease in our efficiency ratio during 2012 as compared to 2011 was primarily due to an increase in non-interest income and net interest income, partially offset by an increase in operating expenses during 2012.

Allowance for credit losses ratio

Allowance for credit losses ratio, which is allowance for credit losses divided by outstanding gross loans and leases excluding loans held-for-sale, was 1.80% at December 31, 2013, 2.78% as of December 31, 2012 and 3.52% as of December 31, 2011. The decrease in the allowance for credit losses ratio is primarily due to a decrease in the balance of the specific allowance for credit losses, the NCOF portfolio purchase, which was acquired on December 17, 2013 at fair value and no allowance was required at year end, the consolidation of the Arlington Fund as a VIE, for which no allowance was needed at year end, positive credit migration, improving economic conditions, and charge offs of impaired loans. The allowance for credit losses ratio excluding the NCOF portfolio purchase was 1.99% at December 31, 2013. During 2013, we recorded $11.2 million of net specific provision for credit losses on previously identified impaired loans and had net charge offs totaling $17.8 million. At December 31, 2013, the specific allowance for credit losses was $23.3 million, and the general allowance for credit losses was $18.6 million. At December 31, 2012, the specific allowance for credit losses was $30.2 million, and the general allowance for credit losses was $19.8 million. We continually evaluate our


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allowance for credit losses methodology. If we determine that a change in our allowance for credit losses methodology is advisable, as a result of the rapidly changing economic environment or otherwise, the revised allowance methodology may result in higher or lower levels of allowance. Moreover, actual losses under our current or any revised methodology may differ materially from our estimate.

Delinquent loan rate

Delinquent loan rate, which is total delinquent loans that are 60 days or more past due, divided by outstanding gross loans and leases, was 0.22% as of December 31, 2013 as compared to 3.59% as of December 31, 2012. We expect the delinquent loan rate to correlate to current economic conditions. During times of economic expansion we expect the rate to decline, and during times of economic contraction, we expect the rate to increase.

Delinquent loan rate for accruing loans 60 days or more past due

Delinquent loan rate for accruing loans 60 days or more past due, which is total delinquent accruing loans net of charge offs that are 60 days or more past due and less than 90 days past due, divided by outstanding gross loans and leases, was 1.17% as of December 31, 2012. We did not have any delinquent accruing loans as of December 31, 2013. We expect the delinquent accruing loan rate to correlate to current economic conditions. During times of economic expansion we expect the rate to decline, and during times of economic contraction, we expect the rate to increase.

Non-accrual loan rate

Non-accrual loan rate is defined as total balances outstanding of loans on non-accrual status divided by the total outstanding balance of our loans and leases held for investment. Loans are put on non-accrual status if they are 90 days or more past due or if management believes it is probable that the Company will be unable to collect contractual principal and interest in the normal course of business. The non-accrual loan rate was 3.04% as of December 31, 2013 and 4.05% as of December 31, 2012. As of December 31, 2013 and 2012, the aggregate outstanding balance of non-accrual loans was $70.7 million and $72.7 million, respectively and total outstanding loans and leases held for investment was $2.3 billion and $1.8 billion, respectively. The slight decline in non-accrual loans during 2013 was primarily the result of the resolution of loans classified as non-accrual at December 31, 2012, partially offset by loans being placed on non-accrual during 2013. We expect the non-accrual loan rate to correlate to economic conditions. During times of economic expansion we expect the rate to decline, and during times of economic contraction, we expect the rate to increase.

Non-performing asset rate

Non-performing asset rate is defined as the sum of total balances outstanding of loans on non-accrual status and other real estate owned, divided by the sum of the total outstanding balance of our loans and leases held for investment and other real estate owned. The non-performing asset rate was 3.60% as of December 31, 2013 and 4.77% as of December 31, 2012. As of December 31, 2013 and 2012, the sum of the aggregate outstanding balance of non-performing assets was $84.2 million and $86.3 million, respectively. The decline in non-performing assets during 2013 was primarily the result of the resolution of assets classified as non-accrual at December 31, 2012.We expect the non-performing asset rate to correlate to economic conditions. During times of economic expansion we expect the rate to decline, and during times of economic contraction, we expect the rate to increase.

Net charge off rate (end of period loans and leases)

Net charge-off rate as a percentage of end of period loan and lease portfolio is defined as annualized charge-offs net of recoveries divided by the total outstanding balance of our loans and leases held for investment. A


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charge-off occurs when management believes that all or part of the principal of a particular loan is no longer recoverable and will not be repaid. Typically a charge off occurs in a period after a loan has been identified as impaired and a specific allowance has been established. For 2013, 2012 and 2011, the net charge off rate was 0.77%, 1.49% and 2.09%, respectively. Charge-offs during 2013, were primarily the result of the resolution of previously impaired loans. We expect the net charge-off rate (end of period loans and leases) to fluctuate if economic conditions continue to impair certain borrowers' ability to fully repay principal and interest under the terms of their loan agreement.

Net charge off rate (average period loans and leases)

Net charge off rate as a percentage of average period loan and lease portfolio is defined as annualized charge offs net of recoveries divided by the total outstanding balance of our loans and leases held for investment. A charge off occurs when management believes that all or part of the principal of a particular loan is no longer recoverable and will not be repaid. Typically a charge off occurs in a period after a loan has been identified as impaired and a specific allowance has been established. For 2013, 2012 and 2011, the net charge off rate was 0.91%, 1.43% and 2.15%, respectively. Charge-offs during 2013, were primarily the result of the resolution of previously impaired loans. We expect the net charge-off rate (end of period loans and leases) to fluctuate if economic conditions continue to impair certain borrowers' ability to fully repay principal and interest under the terms of their loan agreement.

Return on average assets

Return on average assets, which is net income divided by average total assets was 1.08% for 2013, 1.17% for 2012, and 0.75% for 2011.

Return on average equity

Return on average equity, which is net income divided by average equity, was 4.07% for 2013, 4.14% for 2012, and 2.52% for 2011.


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Review of Consolidated Results

A summary of NewStar's consolidated financial results for the years ended
December 31, 2013, 2012 and 2011 follows:



                                                                   Year Ended December 31,
                                                            2013            2012            2011
                                                                      ($ in thousands)
Net interest income:
Interest income                                           $ 127,684       $ 123,945       $ 115,680
Interest expense                                             42,971          35,591          34,953

Net interest income                                          84,713          88,354          80,727
Provision for credit losses                                   9,738          12,651          17,312

Net interest income after provision for credit losses        74,975          75,703          63,415
Non-interest income:
Fee income                                                    3,670           4,619           3,070
Asset management income                                       2,482           2,984           2,635
Gain (loss) on derivatives                                     (143 )          (315 )           242
Gain on sale of loans                                            72             335             128
Other income (loss)                                           7,431           3,948          (2,008 )

Total non-interest income                                    13,512          11,571           4,067
Operating expenses:
Compensation and benefits                                    32,672          31,139          30,144
General and administrative expenses                          16,726          15,158          13,787

Total operating expenses                                     49,398          46,297          43,931

Operating income before income taxes                         39,089          40,977          23,551
Results of Consolidated Variable Interest Entity:
Interest income                                               5,321              --              --
Interest expense-credit facilities                            1,879              --              --
Interest expense-Fund membership interest                     1,353              --              --
Other income                                                     51              --              --
Operating expenses                                               78              --              --

Net results from Consolidated Variable Interest Entity        2,062              --              --
Income before income taxes                                   41,151          40,977          23,551
Income tax expense                                           16,556          17,000           9,403

Net income                                                $  24,595       $  23,977       $  14,148

Comparison of the Years Ended December 31, 2013 and 2012

Interest income. Interest income increased $9.1 million, to $133.0 million for 2013 from $123.9 million for 2012. The increase was primarily due to an increase in average balance of our interest earning assets to $2.2 billion from $2.0 billion, the recognition of $2.0 million of deferred paid-in-kind interest on certain impaired loans, the acceleration of amortization of deferred fees from loans that paid off during 2013, and the consolidation of interest income from Arlington Fund, partially offset by a decrease in the yield on average interest earning assets to 5.98% from 6.09% primarily due to a decrease in contractual interest rates from new loan origination and re-pricing subsequent to December 31, 2012.

Interest expense. Interest expense increased to $46.2 million for 2013 from $35.6 million for 2012. The increase is primarily due to an increase in the average balance of our interest bearing liabilities and an increase in the average cost of funds, the additional $100.0 million of debt under our amended corporate credit facility, and the consolidation of interest expense from Arlington Fund.


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Net interest margin. Net interest margin decreased to 3.90% for 2013 from 4.34% . . .

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