Form 10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2014

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                  to                 

Commission File Number 001-33211

 

 

NewStar Financial, Inc.

(Exact name of registrant as specified in its charter)

 

 

 

Delaware   54-2157878

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

500 Boylston Street, Suite 1250,

Boston, MA

  02116
(Address of principal executive offices)   (Zip Code)

(617) 848-2500

(Registrant’s telephone number, including area code)

N/A

(Former name, former address and former fiscal year, if changed since last report)

 

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer   ¨    Accelerated filer   x
Non-accelerated filer   ¨    Smaller reporting company   ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

As of November 3, 2014, 47,701,177 shares of common stock, par value of $0.01 per share, were outstanding.

 

 

 


Table of Contents

TABLE OF CONTENTS

 

          Page  
   

PART I

FINANCIAL INFORMATION

      

Item 1.

  Financial Statements (Unaudited)      3   
  Condensed Consolidated Balance Sheets as of September 30, 2014 and December 31, 2013      3   
 

Condensed Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2014 and 2013

     5   
 

Condensed Consolidated Statements of Comprehensive Income for the Three and Nine Months Ended September 30, 2014 and 2013

     6   
 

Condensed Consolidated Statements of Changes in Stockholders’ Equity for the Nine Months Ended September 30, 2014 and 2013

     7   
  Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2014 and 2013      8   
  Notes to Condensed Consolidated Financial Statements      10   

Item 2.

  Management’s Discussion and Analysis of Financial Condition and Results of Operations      38   

Item 3.

  Quantitative and Qualitative Disclosures About Market Risk      56   

Item 4.

  Controls and Procedures      57   
 

PART II

OTHER INFORMATION

  

Item 1.

  Legal Proceedings      57   

Item 1A.

  Risk Factors      57   

Item 2.

  Unregistered Sales of Equity Securities and Use of Proceeds      57   

Item 6.

  Exhibits      59   

SIGNATURES

     60   

 

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Table of Contents

Note Regarding Forward Looking Statements

This Quarterly Report on Form 10-Q of NewStar Financial, Inc., contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These are statements that relate to future periods and include statements about:

 

   

our anticipated financial condition, including estimated loan losses;

 

   

our expected results of operation;

 

   

the anticipated timing of the closings of the investment by the Franklin Square Funds;

 

   

our growth and market opportunities;

 

   

trends and conditions in the financial markets in which we operate;

 

   

our future funding needs and sources and availability of funding;

 

   

our involvement in capital-raising transactions;

 

   

our ability to meet draw requests under commitments to borrowers under certain conditions;

 

   

our competitors;

 

   

our provision for credit losses;

 

   

our future development of our products and markets;

 

   

our ability to compete; and

 

   

our stock price.

Generally, the words “anticipates,” “believes,” “expects,” “intends,” “estimates,” “projects,” “plans” and similar expressions identify forward-looking statements. These forward-looking statements involve known and unknown risks, uncertainties and other important factors that could cause our actual results, performance, achievements or industry results to differ materially from any future results, performance or achievements expressed or implied by these forward-looking statements. These risks, uncertainties and other important factors include, among others:

 

   

acceleration of deterioration in credit quality that could result in levels of delinquent or non-accrual loans that would force us to realize credit losses exceeding our allowance for credit losses and deplete our cash position;

 

   

risks and uncertainties relating to the financial markets generally, including disruptions in the global financial markets;

 

   

the market price of our common stock prevailing from time to time;

 

   

our ability to obtain external financing;

 

   

the regulation of the commercial lending industry by federal, state and local governments;

 

   

risks and uncertainties relating to our limited operating history;

 

   

our ability to minimize losses, achieve profitability, and realize our deferred tax asset; and

 

   

the competitive nature of the commercial lending industry and our ability to effectively compete.

For a further description of these and other risks and uncertainties, we encourage you to carefully read section Item 1A. “Risk Factors” of our Annual Report on Form 10-K for the year ended December 31, 2013.

The forward-looking statements contained in this Quarterly Report on Form 10-Q speak only as of the date of this report. We expressly disclaim any obligation or undertaking to disseminate any updates or revisions to any forward-looking statement contained in this Quarterly Report to reflect any change in our expectations with regard thereto or any change in events, conditions or circumstances on which any forward-looking statement is based, except as may be required by law.

 

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Table of Contents

PART I. FINANCIAL INFORMATION

 

Item 1. Financial Statements.

NEWSTAR FINANCIAL, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

 

     September  30,
2014
     December  31,
2013
 
     (unaudited)         
    

($ in thousands, except share

and par value amounts)

 

Assets:

     

Cash and cash equivalents

   $ 111,611       $ 43,401   

Restricted cash

     131,805         167,920   

Investments in debt securities, available-for-sale

     21,023         22,198   

Loans held-for-sale, net

     46,863         14,831   

Loans and leases, net

     2,045,338         2,095,250   

Deferred financing costs, net

     21,207         21,386   

Interest receivable

     5,236         7,415   

Property and equipment, net

     698         833   

Deferred income taxes, net

     25,427         30,238   

Income tax receivable

     5,216         2,007   

Other assets

     32,530         24,983   
  

 

 

    

 

 

 

Subtotal

     2,446,954         2,430,462   

Assets of Consolidated Variable Interest Entity:

     

Restricted cash

     0         1,950   

Loans, net

     0         171,427   

Deferred financing costs, net

     0         997   

Interest receivable

     0         1,079   

Other assets

     0         946   
  

 

 

    

 

 

 

Total assets of Consolidated Variable Interest Entity

     0         176,399   
  

 

 

    

 

 

 

Total assets

   $ 2,446,954       $ 2,606,861   
  

 

 

    

 

 

 

Liabilities:

     

Credit facilities

   $ 284,348       $ 332,158   

Term debt

     1,464,153         1,412,374   

Repurchase agreements

     57,371         67,954   

Accrued interest payable

     7,426         6,333   

Accounts payable

     615         588   

Other liabilities

     24,947         19,623   
  

 

 

    

 

 

 

Subtotal

     1,838,860         1,839,030   

Liabilities of Consolidated Variable Interest Entity:

     

Credit facilities

     0         120,344   

Accrued interest payable—credit facilities

     0         434   

Subordinated debt—Fund membership interest

     0         30,000   

Accrued interest payable—Fund membership interest

     0         843   
  

 

 

    

 

 

 

Total liabilities of Consolidated Variable Interest Entity

     0         151,621   
  

 

 

    

 

 

 

Total liabilities

     1,838,860         1,990,651   
  

 

 

    

 

 

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

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NEWSTAR FINANCIAL, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS, continued

 

     September 30,
2014
    December 31,
2013
 
     (unaudited)        
    

($ in thousands, except share

and par value amounts)

 

Stockholders’ equity:

    

Preferred stock, par value $0.01 per share (5,000,000 shares authorized; no shares outstanding)

     0        0   

Common stock, par value $0.01 per share:

    

Shares authorized: 145,000,000 in 2014 and 2013;

    

Shares outstanding 47,773,549 in 2014 and 48,658,606 in 2013

     478        487   

Additional paid-in capital

     673,662        655,143   

Retained earnings

     13,237        2,624   

Common stock held in treasury, at cost $0.01 par value; 6,354,039 in 2014 and 4,642,202 in 2013

     (79,769     (43,271

Accumulated other comprehensive income, net

     486        569   
  

 

 

   

 

 

 

Total NewStar Financial, Inc. stockholders’ equity

     608,094        615,552   

Retained earnings of Consolidated Variable Interest Entity

     0        658   
  

 

 

   

 

 

 

Total stockholders’ equity

     608,094        616,210   
  

 

 

   

 

 

 

Total liabilities and stockholders’ equity

   $ 2,446,954      $ 2,606,861   
  

 

 

   

 

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

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NEWSTAR FINANCIAL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

Unaudited

 

     Three Months  Ended
September 30,
    Nine Months  Ended
September 30,
 
   2014     2013     2014     2013  
     ($ in thousands, except per share amounts)  

Net interest income:

      

Interest income

   $   33,907      $   30,370      $   100,570      $   95,401   

Interest expense

     14,304        11,703        40,673        30,798   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income

     19,603        18,667        59,897        64,603   

Provision for credit losses

     3,369        2,381        21,828        7,429   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income after provision for credit losses

     16,234        16,286        38,069        57,174   

Non-interest income:

        

Fee income

     740        1,050        1,972        2,591   

Asset management income – related party

     488        592        543        1,971   

Loss on derivatives

     (10     (45     (27     (131

Gain (loss) on sale of loans, net

     (23     0        (189     72   

Other income (loss), net

     2,066        3,534        9,176        5,192   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total non-interest income

     3,261        5,131        11,475        9,695   

Operating expenses:

        

Compensation and benefits

     7,721        7,405        23,283        25,020   

General and administrative expenses

     3,260        4,120        11,481        12,185   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total operating expenses

     10,981        11,525        34,764        37,205   
  

 

 

   

 

 

   

 

 

   

 

 

 

Operating income before income taxes

     8,514        9,892        14,780        29,664   

Results of Consolidated Variable Interest Entity:

        

Interest income

     0        1,991        5,268        2,891   

Interest expense – credit facilities

     0        692        2,865        1,026   

Interest expense – Fund membership interest

     0        433        1,292        782   

Other income

     0        18        229        34   

Operating expenses

     0        10        249        14   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net results from Consolidated Variable Interest Entity

     0        874        1,091        1,103   

Income before income taxes

     8,514        10,766        15,871        30,767   

Income tax expense

     3,494        4,329        6,503        12,532   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income

   $ 5,020      $ 6,437      $ 9,368      $ 18,235   
  

 

 

   

 

 

   

 

 

   

 

 

 

Basic income per share

   $ 0.10      $ 0.13      $ 0.19      $ 0.38   

Diluted income per share

     0.10        0.12        0.18        0.34   

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

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NEWSTAR FINANCIAL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

Unaudited

 

     Three Months  Ended
September 30,
     Nine Months  Ended
September 30,
 
     2014     2013      2014     2013  
     ($ in thousands, except per share amounts)  

Net income

   $ 5,020      $ 6,437       $ 9,368      $ 18,235   

Other comprehensive income, net of tax:

         

Net unrealized securities gains (losses), net of tax expense (benefit) of $(78), $359, $(54) and $298, respectively

     (108     519         (79     439   

Net unrealized derivative gains (losses), net of tax expense of $4, $16, $0 and $56, respectively

     5        21         (4     72   
  

 

 

   

 

 

    

 

 

   

 

 

 

Other comprehensive income

     (103     540         (83     511   
  

 

 

   

 

 

    

 

 

   

 

 

 

Comprehensive income

   $   4,917      $   6,977       $   9,285      $   18,746   
  

 

 

   

 

 

    

 

 

   

 

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

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NEWSTAR FINANCIAL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

Unaudited

 

     NewStar Financial, Inc. Stockholders’ Equity
For the Nine Months Ended September 30, 2014
 
     Common
Stock
    Additional
Paid-in
Capital
    Retained
Earnings
    Treasury
Stock
    Accumulated
Other
Comprehensive
Income, net
    Retained
Earnings of
Consolidated
VIE
    Common
Stockholders’
Equity
 
     ($ in thousands)  

Balance at January 1, 2014

   $ 487      $ 655,143      $ 2,624      $ (43,271   $ 569      $ 658      $ 616,210   

Net income

     0       0       8,726        0        0        642        9,368   

Other comprehensive loss

     0       0       0        0        (83     0        (83

Issuance of restricted stock

     1       (1     0        0        0        0        0   

Net shares reacquired from employee transactions

     0       0       0        (525     0        0        (525

Tax benefit from vesting of stock awards

     0       134        0        0        0        0        134   

Repurchase of common stock

     (16     5       0        (21,725     0        0        (21,736

Exercise of warrants

     3        15,244        0        (14,248     0        0        999   

Exercise of common stock options

     3        279        0        0        0        0        282   

Tax benefit from exercise of common stock awards

     0       1,062        0        0        0        0        1,062   

Reclassification of VIE Dividend

     0        0       0        0        0        587        587   

Deconsolidation of VIE

     0        0       1,887        0        0        (1,887     0   

Amortization of restricted common stock awards

     0       1,796       0        0        0        0        1,796   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at September 30, 2014

   $ 478      $ 673,662      $ 13,237      $ (79,769   $ 486      $ 0      $ 608,094   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
     NewStar Financial, Inc. Stockholders’ Equity
For the Nine Months Ended September 30, 2013
 
     Common
Stock
    Additional
Paid-in
Capital
    Accumulated
Deficit
    Treasury
Stock
    Accumulated
Other
Comprehensive
Loss, net
    Retained
Deficit of
Consolidated
VIE
    Common
Stockholders’
Equity
 
     ($ in thousands)  

Balance at January 1, 2013

   $ 493      $ 646,299      $ (20,726   $ (31,243   $ (6   $ 0      $ 594,817   

Net income

     0       0       17,577        0        0        658        18,235   

Other comprehensive income

     0       0       0        0        511        0        511   

Issuance of restricted stock

     1       (1     0        0        0        0        0   

Net shares reacquired from employee transactions

     (8 )     8       0        (11,117     0        0        (11,117

Tax benefit from vesting of restricted common stock awards

     0       3,882        0        0        0        0        3,882   

Repurchase of common stock

     0        0       0        (216     0          (216

Exercise of common stock options

     1        309       0        0        0        0        310   

Amortization of restricted common stock awards

     0       3,415       0        0        0        0        3,415   

Amortization of stock option awards

     0       91       0        0        0        0        91   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at September 30, 2013

   $ 487      $ 654,003      $ (3,149   $ (42,576   $ 505      $ 658      $ 609,928   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

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NEWSTAR FINANCIAL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

Unaudited

 

      Nine Months Ended September 30,  
     2014     2013  
     ($ in thousands)  

Cash flows from operating activities:

    

Net income

   $ 9,368      $ 18,235   

Adjustments to reconcile net income to net cash used for operations:

    

Provision for credit losses

     21,828        7,429   

Depreciation and amortization and accretion

     (9,062     (9,219

Amortization of debt issuance costs

     4,796        4,877   

Equity compensation expense

     1,796        3,507   

Loss (gain) on sale of loans

     189        (72

Gain on repurchase of debt

     0        (442

Loss (gain) from equity method investments

     845        (988

Net change in deferred income taxes

     3,551        11,805   

Loans held-for-sale originated

     (169,104     (26,752

Proceeds from sale of loans held-for-sale

     137,072        62,561   

Net change in interest receivable

     2,179        (949

Net change in other assets

     (10,354     17,548   

Net change in accrued interest payable

     659        (148

Net change in accounts payable and other liabilities

     5,233        (33,039

Consolidated Variable Interest Entity:

    

Amortization of debt issuance costs

     1,244        99   

Depreciation and amortization and accretion

     (315     (126

Net change in interest receivable

     1,079        (898

Net change in other assets

     946        (4,290

Net change in accrued interest payable

     (172     1,134   

Net change in accounts payable

     587        0   
  

 

 

   

 

 

 

Net cash provided by operating activities

     2,365        50,272   
  

 

 

   

 

 

 

Cash flows from investing activities:

    

Net change in restricted cash

     36,115        (65,632

Net change in loans

     37,681        (104,341

Purchase of debt securities, available-for-sale

     (5,000     0   

Proceeds from debt securities, available-for-sale

     6,000        0   

Acquisition of property and equipment

     (59     (86

Consolidated Variable Interest Entity:

    

Net change in loans

     171,427        (130,149

Net change in restricted cash

     1,950        (2,009

VIE cash dividends

     (671     0   
  

 

 

   

 

 

 

Net cash provided by (used in) investing activities

     247,443        (302,217
  

 

 

   

 

 

 

Cash flows from financing activities:

    

Proceeds from exercise of stock options

     1,896        309   

Taxes paid from exercise of stock options

     (1,614     0   

Proceeds from exercise of warrants

     999        0   

Tax benefit from exercise of stock options

     1,062        0   

Tax benefit from vesting of stock awards

     134        3,882   

Borrowings on credit facilities

     1,026,523        739,143   

Repayment of borrowings on credit facilities

     (1,074,333     (806,804

Issuance of term debt

     289,500        303,600   

Borrowings on term debt

     94,100        172,572   

Repayment of borrowings on term debt

     (331,821     (194,794

Repayment of borrowings on repurchase agreements

     (10,583     (3,107

Payment of deferred financing costs

     (4,617     (7,762

Purchase of treasury stock

     (22,250     (11,333

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

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NEWSTAR FINANCIAL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS, continued

Unaudited

 

     Nine Months Ended September 30,  
     2014     2013  
     ($ in thousands)  

Consolidated Variable Interest Entity:

    

Borrowings on credit facilities

     0        98,548   

Repayment of borrowings on credit facilities

     (120,344     (5,500

Borrowings on subordinated debt

     0        25,061   

Repayment of borrowings on subordinated debt

     (30,000     0   

Payment of deferred financing costs

     (250     (1,110
  

 

 

   

 

 

 

Net cash provided by (used in) financing activities

     (181,598     312,705   
  

 

 

   

 

 

 

Net increase in cash during the period

     68,210        60,760   

Cash and cash equivalents at beginning of period

     43,401        27,212   
  

 

 

   

 

 

 

Cash and cash equivalents at end of period

   $ 111,611      $ 87,972   
  

 

 

   

 

 

 

Supplemental cash flows information:

    

Interest paid

   $ 39,581      $ 31,620   

Interest paid by VIE

     4,763        0   

VIE cash distribution

     671        0   

Taxes paid

     3,664        943   

Increase (decrease) in fair value of investments in debt securities

     (133     737   

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

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NEWSTAR FINANCIAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Unaudited

Note 1. Organization

NewStar Financial, Inc. (the “Company”), a Delaware corporation, is a specialized commercial finance company focused on meeting the complex financing needs of companies and private investors in the middle market. The Company focuses 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. The Company’s 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. The Company’s emphasis on direct origination is an important aspect of its marketing and credit strategy because it provides direct access to customers’ management teams and enhances the Company’s ability to conduct detailed due diligence and credit analysis of prospective borrowers. It also allows the Company to negotiate transaction terms directly with borrowers and, as a result, it has significant input into customers’ financial strategies and capital structures. The Company also participates in loans as a member of a lending group. The mix of the Company’s originations may vary from period to period. The Company employs highly experienced bankers, marketing officers and credit professionals to identify and structure new lending opportunities and manage customer relationships. The Company believes that the quality of its professionals, the breadth of their relationships and referral networks, and their ability to develop creative solutions for customers position it to be a valued partner and preferred lender for mid-sized companies.

The Company operates as a single segment, and it derives revenues from four specialized lending groups that target market segments in which it believes that it has 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, provides first mortgage debt which is 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.

Note 2. Summary of Significant Accounting Policies

Basis of Presentation

These interim condensed consolidated financial statements include the accounts of the Company and its subsidiaries (collectively, “NewStar”) and have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”). All significant intercompany transactions have been eliminated in consolidation. These interim condensed financial statements include adjustments of a normal and recurring nature considered necessary by management to fairly present NewStar’s financial position, results of operations and cash flows. These interim condensed financial statements may not be indicative of financial results for the full year. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect certain reported amounts and disclosure of contingent assets and liabilities. Actual results could differ from those estimates. The estimates most susceptible to change in the near-term are the Company’s estimates of its (i) allowance for credit losses, (ii) recorded amounts of deferred income taxes, (iii) fair value measurements used to record fair value adjustments to certain financial instruments, (iv) valuation of investments and (v) determination of other than temporary impairments and temporary impairments. The interim condensed consolidated financial statements and notes thereto should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2013.

Principles of Consolidation

On June 26, 2014, the NewStar Arlington Senior Loan Program LLC (the “Arlington Program”) completed a $409.4 million term debt securitization comprised of all of the loans of NewStar Arlington Fund LLC (“Arlington Fund”) as well as a portion of the Company’s loans classified as held-for-sale. A portion of the proceeds from this term debt securitization were used to repay all advances under the Class A Notes and the Class B Notes. Following repayment, the Class A Notes and the Class B Notes were redeemed. The Company’s membership interests in Arlington Fund were also redeemed and new membership interests in the Arlington Program were issued to its equity investors. The Company acts as collateral manager for the Arlington Program. As a result of the repayment of the Company’s advances as the Class B lender under the warehouse facility and the redemption of its membership interests in the Arlington Fund, the Company has no ownership or financial interests in the Arlington Fund or its successors except to the extent that it receives management fees as collateral manager of the Arlington Program. As a result, the Company deconsolidated the Arlington Fund from its statement of financial position beginning on June 26, 2014. The Company is not the primary beneficiary of the Arlington Program and will not consolidate the Arlington Program’s operating results or statements of financial position as of that date.

 

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Prior Period Reclassifications

Certain prior period disclosure amounts have been reclassified to conform to current period presentation. Equipment Finance balances are no longer included with Business Credit and are presented separately in the footnote disclosures.

Note 3. Loans Held-for-Sale, Loans, Leases and Allowance for Credit Losses

The Company operates as a single segment, and derives revenues from four specialized lending groups that target market segments in which it believes it has 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 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;

 

   

Real Estate, provides first mortgage debt which is sourced primarily to finance acquisitions of commercial real estate properties; and

 

   

Equipment Finance, provides leases, loans and lease lines to finance equipment purchases and other capital expenditures.

The Company’s loan portfolio consists primarily of loans to small and medium-sized, privately-owned companies, most of which do not publicly report their financial condition. Compared to larger, publicly traded firms, loans to these types of companies may carry higher inherent risk. The companies that the Company lends to generally have more limited access to capital and higher funding costs, may be in a weaker financial position, may need more capital to expand or compete, and may be unable to obtain financing from public capital markets or from traditional sources, such as commercial banks.

Loans classified as held-for-sale may consist of loans originated by the Company and intended to be sold or syndicated to third parties (including credit funds managed by the Company) or impaired loans for which a sale of the loan is expected as a result of a workout strategy. At September 30, 2014 loans held-for-sale were $47.1 million and consisted of leveraged finance loans to 13 borrowers.

These loans are carried at the lower of aggregate cost, net of any deferred origination costs or fees, or market value.

As of September 30, 2014 and December 31, 2013, loans held-for-sale consisted of the following:

 

     September 30,
2014
    December 31,
2013
 
     ($ in thousands)  

Leveraged Finance

   $ 47,107      $ 14,897   
  

 

 

   

 

 

 

Gross loans held-for-sale

     47,107        14,897   

Deferred loan fees, net

     (244     (66
  

 

 

   

 

 

 

Total loans held-for-sale, net

   $ 46,863      $ 14,831   
  

 

 

   

 

 

 

At September 30, 2014, loans held-for-sale include loans with an aggregate outstanding balance of $29.2 million that were intended to be sold to credit funds managed by the Company. As of October 31, 2014, the Company had not sold any of the loans intended to be sold to credit funds managed by the Company. The Company sold loans with an aggregate outstanding balance of $17.9 million for an aggregate loss of $0.2 million to entities other than the NewStar Credit Opportunities Fund, Ltd. (“NCOF”), the Arlington Fund, or the Arlington Program during the nine months ended September 30, 2014. The Company sold loans with an outstanding balance of $28.5 million for an aggregate gain of $0.1 million to entities other than the NCOF or the Arlington Fund during the nine months ended September 30, 2013.

As of September 30, 2014 and December 31, 2013, loans and leases consisted of the following:

 

     September 30,
2014
    December 31,
2013
 
     ($ in thousands)  

Leveraged Finance

   $ 1,693,199      $ 1,965,130   

Business Credit

     225,650        182,633   

Real Estate

     109,283        123,029   

Equipment Finance

     75,726        54,352   
  

 

 

   

 

 

 

Gross loans and leases

     2,103,858        2,325,144   

Deferred loan fees, net

     (17,235     (17,064

Allowance for loan and lease losses

     (41,285     (41,403
  

 

 

   

 

 

 

Total loans and leases, net

   $ 2,045,338      $ 2,266,677   
  

 

 

   

 

 

 

 

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The Company provides commercial loans, commercial real estate loans, and leases to customers throughout the United States. The Company’s borrowers may be susceptible to economic slowdowns or recessions and, as a result, may have a lower capacity to make scheduled payments of interest or principal on their borrowings during these periods. Adverse economic conditions also may decrease the estimated value of the collateral, particularly real estate, securing some of the Company’s loans. Although the Company has a diversified loan and lease portfolio, certain events may occur, including, but not limited to, adverse economic conditions and adverse events affecting specific clients, industries or markets, that could adversely affect the ability of borrowers to make timely scheduled principal and interest payments on their loans and leases.

The Company internally risk rates loans based on individual credit criteria on at least a quarterly basis. Borrowers provide the Company with financial information on either a quarterly or monthly basis. Loan ratings as well as identification of impaired loans are dynamically updated to reflect changes in borrower condition or profile. A loan is considered to be impaired when it is probable that the Company will be unable to collect all amounts due to it according to the contractual terms of the loan agreement. Impaired loans include all non-accrual loans, loans with partial charge-offs and loans which are troubled debt restructurings (“TDR”).

The Company utilizes a number of analytical tools for the purpose of estimating probability of default and loss given default for its four specialized lending groups. The quantitative models employed by the Company in its Leveraged Finance and Equipment Finance businesses utilize Moody’s KMV RiskCalc credit risk model in combination with a proprietary qualitative model, which generates a rating that maps to a probability of default estimate. Real Estate utilizes a proprietary model that has been developed to capture risk characteristics unique to the lending activities in that line of business. The model produces an obligor risk rating which corresponds to a probability of default and also produces a loss given default. In each case, the probability of default and the loss given default are used to calculate an expected loss for those lending groups. Due to the nature of its borrowers and the structure of its loans, Business Credit utilizes a proprietary model that produces a rating that corresponds to an expected loss, without calculating a probability of default and loss given default. For variable interest entities for which the Company is providing transitional capital, a qualitative analysis is used to determine expected loss during the determined loss emergence period. In each case, the expected loss is the primary component in a formulaic calculation of general reserves attributable to a given loan.

Loans and leases which are rated at or better than a specified threshold are typically classified as “Pass”, and loans and leases rated worse than that threshold are typically classified as “Criticized”, a characterization that may apply to impaired loans, including TDRs. As of September 30, 2014, $141.1 million of the Company’s loans were classified as “Criticized”, including $129.7 million of the Company’s impaired loans, and $2.0 billion were classified as “Pass”. As of December 31, 2013, $190.6 million of the Company’s loans were classified as “Criticized”, including $177.5 million of the Company’s impaired loans, and $2.1 billion were classified as “Pass”.

When the Company rates a loan above a certain risk rating threshold and determines that it is impaired, the Company will establish a specific allowance, and the loan will be analyzed and may be placed on non-accrual. If the asset deteriorates further, the specific allowance may increase, and ultimately may result in a loss and charge-off.

A TDR that performs in accordance with the terms of the restructuring may improve its risk profile over time. While the concessions in terms of pricing or amortization may not have been reversed and further amended to “market” levels, the financial condition of the Borrower may improve over time to the point where the rating improves from the “Criticized” classification that was appropriate immediately prior to, or at, restructuring.

As of September 30, 2014, the Company had impaired loans with an aggregate outstanding balance of $228.1 million. Impaired loans with an aggregate outstanding balance of $182.1 million have been restructured and classified as TDR. As of September 30, 2014, the aggregate carrying value of equity investments in certain of the Company’s borrowers in connection with troubled debt restructurings totaled $15.7 million. Impaired loans with an aggregate outstanding balance of $77.1 million were also on non-accrual status. For impaired loans on non-accrual status, the Company’s policy is to reverse the accrued interest previously recognized as interest income subsequent to the last cash receipt in the current year. The recognition of interest income on the loan only resumes when factors indicating doubtful collection no longer exist and the non-accrual loan has been brought current. During the three and nine months ended September 30, 2014, the Company recovered $0.04 million and charged off $18.7 million, respectively of outstanding non-accrual loans. During the three and nine months ended September 30, 2014, the Company placed loans with an aggregate outstanding balance of $2.7 million and $28.2 million on non-accrual status. During the three months ended September 30, 2014, the Company returned loans with an outstanding balance of $1.9 million to performing status. During the three and nine months ended September 30, 2014, the Company recorded $1.8 million and $19.7 million, respectively, of net specific provisions for impaired loans. At September 30, 2014, the Company had a $21.8 million specific allowance for impaired loans with an aggregate outstanding

 

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balance of $137.5 million. At September 30, 2014, additional funding commitments for impaired loans totaled $16.3 million. The Company’s obligation to fulfill the additional funding commitments on impaired loans is generally contingent on the borrower’s compliance with the terms of the credit agreement and the borrowing base availability for asset-based loans, or if the borrower is not in compliance additional funding commitments may be made at the Company’s discretion. As of September 30, 2014, $22.5 million of loans on non-accrual status were greater than 60 days past due and classified as delinquent by the Company. Included in the $21.8 million specific allowance for impaired loans was $4.0 million related to delinquent loans.

As of December 31, 2013, the Company had impaired loans with an aggregate outstanding balance of $271.0 million. Impaired loans with an aggregate outstanding balance of $240.3 million have been restructured and classified as TDR. As of December 31, 2013, the aggregate carrying value of equity investments in certain of the Company’s borrowers in connection with troubled debt restructurings totaled $6.9 million. Impaired loans with an aggregate outstanding balance of $70.7 million were also on non-accrual status. During 2013, the Company charged off $15.8 million of outstanding non-accrual loans. During 2013, the Company placed loans with an aggregate outstanding balance of $48.9 million on non-accrual status and took loans with an aggregate outstanding balance of $34.8 million off of non-accrual status. During 2013, the Company recorded $11.2 million of net specific provisions for impaired loans. At December 31, 2013, the Company had a $23.3 million specific allowance for impaired loans with an aggregate outstanding balance of $154.7 million. At December 31, 2013, additional funding commitments for impaired loans totaled $17.6 million. As of December 31, 2013, $5.1 million of loans on non-accrual status were greater than 60 days past due and classified as delinquent by the Company. Included in the $23.3 million specific allowance for impaired loans was $1.2 million related to delinquent loans.

During 2012, as part of the resolution of two impaired commercial real estate loans, the Company took control of the underlying commercial real estate properties. The Company recorded a partial charge-off of $2.7 million and classified the commercial real estate properties as other real estate owned. The commercial real estate properties had an aggregate carrying value of $12.9 million and $13.5 million as of September 30, 2014 and as of December 31, 2013, respectively. Subsequent to September 30, 2014, the Company sold one of the commercial real estate properties for $9.5 million.

A summary of impaired loans is as follows:

 

     Investment      Unpaid
Principal
     Recorded Investment with a
Related Allowance for
Credit Losses
     Recorded Investment
without a Related Allowance
for Credit Losses
 
                   ($ in thousands)         

September 30, 2014

  

Leveraged Finance

   $ 171,350       $ 206,452       $ 106,402       $ 64,948   

Business Credit

     236         577         236         0   

Real Estate

     56,544         56,549         30,871         25,673   

Equipment Finance

     0         0         0         0   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 228,130       $ 263,578       $ 137,509       $ 90,621   
  

 

 

    

 

 

    

 

 

    

 

 

 

December 31, 2013

  

Leveraged Finance

   $ 208,626       $ 238,522       $ 124,560       $ 84,066   

Business Credit

     287         476         287         0   

Real Estate

     62,106         62,110         29,870         32,236   

Equipment Finance

     0         0         0         0   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 271,019       $ 301,108       $ 154,717       $ 116,302   
  

 

 

    

 

 

    

 

 

    

 

 

 

During the three and nine months ended September 30, 2014, the Company recorded net partial charge-offs of $0.6 million and $21.2 million, respectively, and during the three and nine months ended September 30, 2013, the Company recorded net partial charge-offs of $0.9 million and $16.9 million, respectively. During the three and nine months ended September 30, 2013, the Company did not record any recoveries of previously charged off loans. The Company’s general policy is to record a specific allowance for an impaired loan to cover the identified impairment of that loan. Any partial charge-off of such loan would typically occur in a subsequent period. The Company may record the initial specific allowance related to an impaired loan in the same period as it records a partial charge-off in certain circumstances such as if the terms of a restructured loan are finalized during that period. When a loan is determined to be uncollectible, the specific allowance is charged off, and reduces the gross investment in the loan.

While charge-offs typically have no net impact on the carrying value of net loans and leases, charge-offs lower the level of the allowance for loan and lease losses; and, as a result, reduce the percentage of allowance for loans and leases to total loans and leases, and the percentage of allowance for loan and leases losses to non-performing loans.

 

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Below is a summary of the Company’s evaluation of its portfolio and allowance for loan and lease losses by impairment methodology:

 

     Leveraged Finance      Business Credit      Real Estate      Equipment Finance  

September 30, 2014

   Investment      Allowance      Investment      Allowance      Investment      Allowance      Investment      Allowance  
     ($ in thousands)  

Collectively evaluated (1)

   $ 1,521,849       $ 17,594       $ 225,414       $ 1,057       $ 52,739       $ 257       $ 75,726       $ 552   

Individually evaluated (2)

     171,350         18,305         236         200         56,544         3,320         0         0   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 1,693,199       $ 35,899       $ 225,650       $ 1,257       $ 109,283       $ 3,577       $ 75,726       $ 552   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

     Leveraged Finance      Business Credit      Real Estate      Equipment Finance  

December 31, 2013

   Investment      Allowance      Investment      Allowance      Investment      Allowance      Investment      Allowance  
     ($ in thousands)  

Collectively evaluated (1)

   $ 1,756,504       $ 16,524       $ 182,346       $ 773       $ 60,923       $ 377       $ 54,352       $ 425   

Individually evaluated (2)

     208,626         19,828         287         200         62,106         3,276         0         0   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 1,965,130       $ 36,352       $ 182,633       $ 973       $ 123,029       $ 3,653       $ 54,352       $ 425   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) Represents loans and leases collectively evaluated for impairment in accordance with ASC 450-20, Loss Contingencies, and pursuant to amendments by ASU 2010-20 regarding allowance for unimpaired loans and leases. These loans and leases had a weighted average risk rating of 5.1 and 5.0 based on the Company’s internally developed 12 point scale at each of September 30, 2014 and December 31, 2013, respectively.
(2) Represents loans individually evaluated for impairment in accordance with ASU 310-10, Receivables, and pursuant to amendments by ASU 2010-20 regarding allowance for impaired loans.

Below is a summary of the Company’s investment in nonaccrual loans.

 

Recorded Investment in
Nonaccrual Loans

   September 30, 2014      December 31, 2013  
     ($ in thousands)  

Leveraged Finance

   $ 72,848       $ 63,553   

Business Credit

     236         287   

Real Estate

     4,049         6,865   

Equipment Finance

     0         0   
  

 

 

    

 

 

 

Total

   $ 77,133       $ 70,705   
  

 

 

    

 

 

 

Loans being restructured typically develop adverse performance trends as a result of internal or external factors, the result of which is an inability to comply with the terms of the applicable credit agreement governing their obligations to the Company. In order to mitigate default risk and/or liquidation, assuming that liquidation proceeds are not viewed as a more favorable outcome to the Company and other lenders, the Company will enter into negotiations with the borrower and its shareholders on the terms of a restructuring. When restructuring a loan, the Company undertakes an extensive diligence process which typically includes (i) construction of a financial model that runs through the tenor of the restructuring term, (ii) meetings with management of the borrower, (iii) engagement of third party consultants and (iv) internal analysis. Once a restructuring proposal is developed, it is subject to approval by both the Company’s Underwriting Committee and the Company’s Investment Committee. Loans will only be removed from TDR classification after a period of performance following the refinancing of outstanding obligations on terms which are determined to be “market” in all material respects, or upon full payoff of the loan. The Company may modify loans that are not determined to be a TDR. Where a loan is modified or restructured but loan terms are considered market and no concessions were given on the loan terms, including price, principal amortization or obligation, or other restrictive covenants, a loan will not be classified as a TDR.

 

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The Company has made the following types of concessions in the context of a TDR:

Group I:

 

   

  extension of principal repayment term

 

   

  principal holidays

 

   

  interest rate adjustments

Group II:

 

   

  partial forgiveness

 

   

  conversion of debt to equity

A summary of the types of concessions that the Company made with respect to TDRs at September 30, 2014 and December 31, 2013 is provided below:

 

     Group I      Group II  
     ($ in thousands)  

September 30, 2014

   $  182,063       $ 141,154   

December 31, 2013

   $ 240,319       $ 164,150   

Note: A loan may be included in both restructuring groups, but not repeatedly within each group.

For the three and nine months ended September 30, 2014, the Company had partial charge-offs totaling $0 and $18.6 million, respectively related to loans previously classified as TDR. As of September 30, 2014, the Company had not removed the TDR classification from any loan previously identified as such, but had charged-off, sold and received repayments of outstanding TDRs.

The Company measures TDRs similarly to how it measures all loans for impairment. The Company performs a discounted cash flow analysis on cash flow dependent loans and we assess the underlying collateral value less reasonable costs of sale for collateral dependent loans. Management analyzes the projected performance of the borrower to determine if it has the ability to service principal and interest based on the terms of the restructuring. If a charge-off is taken on a restructured loan, interest will typically move to a “cash basis” where it is taken into income only upon receipt or be placed on non-accrual. Loans will typically not be returned to accrual status until at least six months of contractual payments have been made in a timely manner. Additionally, at the time of a restructuring and quarterly thereafter, an impairment analysis is undertaken to determine the measurement of specific reserve, if any, on each impaired loan.

 

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Below is a summary of the Company’s loans which were classified as TDR.

 

For the Three Months Ended

September 30, 2014

   Pre-Modification
Outstanding
Recorded
Investment
     Post-Modification
Outstanding
Recorded
Investment
     Investment in TDR
Subsequently
Defaulted
 
     ($ in thousands)  

Leveraged Finance

   $ 0       $ 0       $ 0   

Business Credit

     0         0         0   

Real Estate

     0         0         0   

Equipment Finance

     0         0         0   
  

 

 

    

 

 

    

 

 

 

Total

   $ 0       $ 0       $ 0   
  

 

 

    

 

 

    

 

 

 

For the Nine Months Ended

September 30, 2014

   Pre-Modification
Outstanding
Recorded
Investment
     Post-Modification
Outstanding
Recorded
Investment
     Investment in TDR
Subsequently
Defaulted
 
     ($ in thousands)  

Leveraged Finance

   $ 0       $ 0       $ 10,589   

Business Credit

     0         0         0   

Real Estate

     0         0         0   

Equipment Finance

     0         0         0   
  

 

 

    

 

 

    

 

 

 

Total

   $ 0       $ 0       $ 10,589   
  

 

 

    

 

 

    

 

 

 

For the Year Ended

December 31, 2013

   Pre-Modification
Outstanding
Recorded
Investment
     Post-Modification
Outstanding
Recorded
Investment
     Investment in TDR
Subsequently
Defaulted
 
     ($ in thousands)  

Leveraged Finance

   $ 23,580       $ 23,580       $ 27,872   

Business Credit

     0         0         0   

Real Estate

     0         0         8,976   

Equipment Finance

     0         0         0   
  

 

 

    

 

 

    

 

 

 

Total

   $ 23,580       $ 23,580       $ 36,848   
  

 

 

    

 

 

    

 

 

 

 

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The following sets forth a breakdown of troubled debt restructurings at September 30, 2014 and December 31, 2013:

 

As of September 30, 2014

   Accrual Status                    For the nine
months
 

($ in thousands)

Loan Type

   Accruing      Nonaccrual      Impaired
Balance
     Specific
Allowance
     Charged-
off
 

Leveraged Finance

   $ 98,502       $ 57,888       $ 156,390       $ 17,256       $ 18,620   

Business Credit

     0         0         0         0         0   

Real Estate

     21,624         4,049         25,673         0         0   

Equipment Finance

     0         0         0         0         0   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 120,126       $ 61,937       $ 182,063       $ 17,256       $ 18,620   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

As of December 31, 2013

   Accrual Status                    For the year  

($ in thousands)

Loan Type

   Accruing      Nonaccrual      Impaired
Balance
     Specific
Allowance
     Charged-
off
 

Leveraged Finance

   $ 145,073       $ 63,010       $ 208,083       $ 19,713       $ 8,759   

Business Credit

     0         0         0         0         0   

Real Estate

     25,371         6,865         32,236         0         0   

Equipment Finance

     0         0         0         0         0   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 170,444       $ 69,875       $ 240,319       $ 19,713       $ 8,759   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

The Company classifies a loan as past due when it is over 60 days delinquent.

An age analysis of the Company’s past due receivables is as follows:

 

     60-89 Days
Past Due
     Greater than
90 Days
     Total Past
Due
     Current      Total Loans
and Leases
     Investment in
> 60 Days &
Accruing
 
     ($ in thousands)  

September 30, 2014

  

Leveraged Finance

   $ 0       $ 22,228       $ 22,228       $ 1,670,971       $ 1,693,199       $ 0   

Business Credit

     0         236         236         225,414         225,650         0   

Real Estate

     0         0         0         109,283         109,283         0   

Equipment Finance

     0         0         0         75,726         75,726         0   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 0       $ 22,464       $ 22,464       $ 2,081,394       $ 2,103,858       $ 0   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 
     60-89 Days
Past Due
     Greater than
90 Days
     Total Past
Due
     Current      Total Loans
and Leases
     Investment in
> 60 Days &
Accruing
 
     ($ in thousands)  

December 31, 2013

  

Leveraged Finance

   $ 0       $ 4,788       $ 4,788       $ 1,960,342       $ 1,965,130       $ 0   

Business Credit

     0         287         287         182,346         182,633         0   

Real Estate

     0         0         0         123,029         123,029         0   

Equipment Finance

     0         0         0         54,352         54,352         0   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 0       $ 5,075       $ 5,075       $ 2,320,069       $ 2,325,144       $ 0   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

A general allowance is provided for loans and leases that are not impaired. The Company employs a variety of internally developed and third-party modeling and estimation tools for measuring credit risk, which are used in developing an allowance for loan and lease losses on outstanding loans and leases. The Company’s allowance framework addresses economic conditions, capital market liquidity and industry circumstances from both a top-down and bottom-up perspective. The Company considers and evaluates changes in economic conditions, credit availability, industry and multiple obligor concentrations in assessing both probabilities of default and loss severities as part of the general component of the allowance for loan and lease losses.

On at least a quarterly basis, loans and leases are internally risk-rated based on individual credit criteria, including loan and lease type, loan and lease structures (including balloon and bullet structures common in the Company’s Leveraged Finance and Real Estate cash flow loans), borrower industry, payment capacity, location and quality of collateral if any (including the Company’s Real Estate loans). Borrowers provide the Company with financial information on either a monthly or quarterly basis. Ratings, corresponding assumed default rates and assumed loss severities are dynamically updated to reflect any changes in borrower condition and/or profile.

 

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For Leveraged Finance loans and Equipment Finance loans and leases, the data set used to construct probabilities of default in its allowance for loan losses model, Moody’s CRD Private Firm Database, primarily contains middle market loans that share attributes similar to the Company’s loans. The Company also considers the quality of the loan or lease terms in determining a loan loss in the event of default.

For Business Credit loans, the Company utilizes a proprietary model to risk rate the loans on a monthly basis. This model captures the impact of changes in industry and economic conditions as well as changes in the quality of the borrower’s collateral and financial performance to assign a final risk rating. The Company has also evaluated historical net loss trends by risk rating from a comprehensive industry database covering more than twenty-five years of experience of the majority of the asset based lenders operating in the United States. Based upon the monthly risk rating from the model, the reserve is adjusted to reflect the historical average for expected loss from the industry database.

For Real Estate loans, the Company employs two mechanisms to capture the impact of industry and economic conditions. First, a loan’s risk rating, and thereby its assumed default likelihood, can be adjusted to account for overall commercial real estate market conditions. Second, to the extent that economic or industry trends adversely affect a substandard rated borrower’s loan-to-value ratio enough to impact its repayment ability, the Company applies a stress multiplier to the loan’s probability of default. The multiplier is designed to account for default characteristics that are difficult to quantify when market conditions cause commercial real estate prices to decline.

For consolidated VIEs to which the Company is providing transitional capital, we utilize a qualitative analysis which considers the business plans related to the entity, including expected hold periods, the terms of the agreements related to the entity, the Company’s historical credit experience, the credit migration of the entity’s loans in determining expected loss, as well as conditions in the capital markets.

The Company was providing capital on a transitional basis to the Arlington Fund, prior to the completion of its term debt securitization on June 26, 2014. During the transitional hold period, the expected loss on Arlington Fund was zero and no allowance was recorded.

If the Company determines that changes in its allowance for credit losses methodology are advisable, as a result of changes in the economic environment or otherwise, the revised allowance methodology may result in higher or lower levels of allowance. Moreover, given uncertain market conditions, actual losses under the Company’s current or any revised allowance methodology may differ materially from the Company’s estimate.

Additionally, when determining the amount of the general allowance, the Company supplements the base amount with a judgmental amount which is governed by a score card system comprised of ten individually weighted risk factors. The risk factors are designed based on those outlined in the Comptrollers of the Currency’s Allowance for Loan and Lease Losses Handbook. The Company also performs a ratio analysis of comparable money center banks, regional banks and finance companies. While the Company does not rely on this peer group comparison to set the level of allowance for credit losses, it does assist management in identifying market trends and serves as an overall reasonableness check on the allowance for credit losses computation.

A loan is considered impaired when it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. The measurement of impairment of a loan is based upon (i) the present value of expected future cash flows discounted at the loan’s effective interest rate, (ii) the loan’s observable market price, or (iii) the fair value of the collateral if the loan is collateral dependent, depending on the circumstances and our collection strategy. Impaired loans are identified based on the loan-by-loan risk rating process described above. It is the Company’s policy during the reporting period to record a specific provision for credit losses to cover the identified impairment on a loan.

 

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A summary of the activity in the allowance for credit losses is as follows:

 

     Three Months Ended September 30, 2014  
     Leveraged
Finance
    Business
Credit
     Real Estate     Equipment
Finance
    Total  
     ($ in thousands)  

Balance, beginning of period

   $ 33,786      $ 1,060       $ 3,634      $ 619      $ 39,099   

Provision for credit losses—general

     1,506        197         (50     (67     1,586   

Provision for credit losses—specific

     1,791        0         (8     0        1,783   

Loans charged off, net of recoveries

     (558     0         0        0        (558
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Balance, end of period

   $ 36,525      $ 1,257       $ 3,576      $ 552      $ 41,910   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Balance, end of period—specific

   $ 18,305      $ 200       $ 3,320      $ 0      $ 21,825   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Balance, end of period—general

   $ 18,220      $ 1,057       $ 256      $ 552      $ 20,085   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Average balance of impaired loans

   $ 180,581      $ 572       $ 56,759      $ 0      $ 237,912   

Interest recognized from impaired loans

   $ 2,465      $ 0       $ 561      $ 0      $ 3,026   

Loans and leases

    

Loans individually evaluated with specific allowance

   $ 106,402      $ 236       $ 30,871      $ 0      $ 137,509   

Loans individually evaluated with no specific allowance

     64,948        0         25,673        0        90,621   

Loans and leases collectively evaluated without specific allowance

     1,521,849        225,414         52,739        75,726        1,875,728   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Total loans and leases

   $ 1,693,199      $ 225,650       $ 109,283      $ 75,726      $ 2,103,858   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 
     Nine Months Ended September 30, 2014  
     Leveraged
Finance
    Business
Credit
     Real Estate     Equipment
Finance
    Total  
     ($ in thousands)  

Balance, beginning of period

   $ 36,803      $ 973       $ 3,653      $ 425      $ 41,854   

Provision for credit losses—general

     1,801        284         (120     127        2,092   

Provision for credit losses—specific

     19,693        0         43        0        19,736   

Loans charged off, net of recoveries

     (21,772     0         0        0        (21,772
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Balance, end of period

   $ 36,525      $ 1,257       $ 3,576      $ 552      $ 41,910   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Average balance of impaired loans

   $ 177,904      $ 525       $ 57,641      $ 0      $ 236,070   

Interest recognized from impaired loans

   $ 8,356      $ 0       $ 1,611      $ 0      $ 9,967   

 

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Table of Contents
     Three Months Ended September 30, 2013  
     Leveraged
Finance
    Business
Credit
    Real Estate     Equipment
Finance
     Total  
     ($ in thousands)  

Balance, beginning of period

   $ 32,166      $ 623      $ 5,988      $ 182       $ 38,959   

Provision for credit losses—general

     137        130        (434     102         (65

Provision for credit losses—specific

     3,849        0        (1,403     0         2,446   

Loans charged off, net of recoveries

     (871     (24     0        0         (895
  

 

 

   

 

 

   

 

 

   

 

 

    

 

 

 

Balance, end of period

   $ 35,281      $ 729      $ 4,151      $ 284       $ 40,445   
  

 

 

   

 

 

   

 

 

   

 

 

    

 

 

 

Balance, end of period—specific

   $ 18,657      $ 0      $ 3,713      $ 0       $ 22,370   
  

 

 

   

 

 

   

 

 

   

 

 

    

 

 

 

Balance, end of period—general

   $ 16,624      $ 729      $ 438      $ 284       $ 18,075   
  

 

 

   

 

 

   

 

 

   

 

 

    

 

 

 

Average balance of impaired loans

   $ 235,596      $ 703      $ 71,380      $ 0       $ 307,679   

Interest recognized from impaired loans

   $ 4,510      $ 0      $ 688      $ 0       $ 5,198   

Loans and leases

     

Loans individually evaluated with specific allowance

   $ 117,830      $ 0      $ 29,575      $ 0       $ 147,405   

Loans individually evaluated with no specific allowance

     121,018        466        41,876        0         163,360   

Loans and leases collectively evaluated without specific allowance

     1,437,333        190,119        38,760        37,072         1,703,284   
  

 

 

   

 

 

   

 

 

   

 

 

    

 

 

 

Total loans and leases

   $ 1,676,181      $ 190,585      $ 110,211      $ 37,072       $ 2,014,049   
  

 

 

   

 

 

   

 

 

   

 

 

    

 

 

 
     Nine Months Ended September 30, 2013  
     Leveraged
Finance
    Business
Credit
    Real Estate     Equipment
Finance
     Total  
     ($ in thousands)  

Balance, beginning of period

   $ 39,971      $ 529      $ 9,286      $ 178       $ 49,964   

Provision for credit losses—general

     (1,781     224        (434     106         (1,885

Provision for credit losses—specific

     11,598        2,402        (4,686     0         9,314   

Loans charged off, net of recoveries

     (14,507     (2,426     (15     0         (16,948
  

 

 

   

 

 

   

 

 

   

 

 

    

 

 

 

Balance, end of period

   $ 35,281      $ 729      $ 4,151      $ 284       $ 40,445   
  

 

 

   

 

 

   

 

 

   

 

 

    

 

 

 

Average balance of impaired loans

   $ 238,290      $ 2,794      $ 71,569      $ 0       $ 312,653   

Interest recognized from impaired loans

   $ 11,566      $ 80      $ 2,013      $ 0       $ 13,659   

Included in the allowance for credit losses at September 30, 2014 and December 31, 2013 is an allowance for unfunded commitments of $0.6 million and $0.5 million, respectively, which is recorded as a component of other liabilities on the Company’s consolidated balance sheet with changes recorded in the provision for credit losses on the Company’s consolidated statement of operations. The methodology for determining the allowance for unfunded commitments is consistent with the methodology for determining the allowance for loan and lease losses.

During the nine months ended September 30, 2014, the Company recorded a total provision for credit losses of $21.8 million. The Company maintained its allowance for credit losses at $41.9 million as of September 30, 2014 and December 31, 2013. The Company had $21.2 million of net charge-offs of impaired loans with a specific allowance, increased its general allowance for credit losses by 15 basis points during the nine months ended September 30, 2014, and recorded new specific provisions for credit losses of $19.7 million. The general allowance for credit losses covers probable losses in the Company’s loan and lease portfolio with respect to loans and leases for which no specific impairment has been identified. When a loan is classified as impaired, the loan is evaluated for a specific allowance and a specific provision may be recorded, thereby removing it from consideration under the general component of the allowance analysis. Loans that are deemed to be uncollectible are charged off and deducted from the allowance, and recoveries on loans previously charged off are netted against loans charged off. A specific provision for credit losses is recorded with respect to impaired loans for which it is probable that the Company will be unable to collect all amounts due in accordance with the contractual terms of the loan agreement for which there is impairment recognized. The outstanding balance of impaired loans, which include all of the outstanding balances of the Company’s delinquent loans and its troubled debt restructurings, as a percentage of “Loans and leases, net” was 11% as of September 30, 2014 and 12% as of December 31, 2013. The decrease is primarily due to charge offs of impaired loans, improving credit migration, and the better credit quality of the acquired NCOF portfolio purchased during December 2013.

 

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Table of Contents

The Company closely monitors the credit quality of its loans and leases which is partly reflected in its credit metrics such as loan delinquencies, non-accruals and charge-offs. Changes in these credit metrics are largely due to changes in economic conditions and seasoning of the loan and lease portfolio.

The Company continually evaluates the appropriateness of its allowance for credit losses methodology. Based on the Company’s evaluation process to determine the level of the allowance for loan and lease losses, management believes the allowance to be adequate as of September 30, 2014 in light of the estimated known and inherent risks identified through its analysis.

Note 4. Restricted Cash

Restricted cash as of September 30, 2014 and December 31, 2013 was as follows:

 

     September 30,
2014
     December 31,
2013
 
     ($ in thousands)  

Collections on loans pledged to credit facilities

   $ 39,318       $ 62,231   

Principal and interest collections on loans held in trust and prefunding amounts

     92,357         107,402   

Customer escrow accounts

     130         237   
  

 

 

    

 

 

 

Total

   $     131,805       $ 169,870   
  

 

 

    

 

 

 

As of September 30, 2014, the Company had the ability to use $40.5 million of restricted cash to fund new or existing loans.

Note 5. Investments in Debt Securities, Available-for-Sale

Amortized cost of investments in debt securities as of September 30, 2014 and December 31, 2013 was as follows:

 

     September 30,
2014
    December 31,
2013
 
     ($ in thousands)  

Investments in debt securities—gross

   $ 24,298      $ 25,298   

Unamortized discount

     (4,137     (4,095
  

 

 

   

 

 

 

Investments in debt securities—amortized cost

   $     20,161      $ 21,203   
  

 

 

   

 

 

 

The amortized cost, gross unrealized holding gains, gross unrealized holding losses, and fair value of available-for-sale securities at September 30, 2014 and December 31, 2013 were as follows:

 

     Amortized
cost
     Gross
unrealized
holding gains
     Gross
unrealized
holding losses
    Fair value  
     ($ in thousands)  

September 30, 2014:

          

Collateralized loan obligations

   $ 20,161       $ 916      $ (54   $ 21,023   
  

 

 

    

 

 

    

 

 

   

 

 

 
   $ 20,161       $ 916      $ (54   $ 21,023   
  

 

 

    

 

 

    

 

 

   

 

 

 

 

     Amortized
cost
     Gross
unrealized
holding gains
     Gross
unrealized
holding losses
    Fair value  
     ($ in thousands)  

December 31, 2013:

          

Collateralized loan obligations

   $ 21,203       $ 1,270       $ (275   $ 22,198   
  

 

 

    

 

 

    

 

 

   

 

 

 
   $ 21,203       $ 1,270      $ (275   $ 22,198   
  

 

 

    

 

 

    

 

 

   

 

 

 

 

During the nine months ended September 30, 2014, the Company purchased $5.0 million of debt securities.

During the nine months ended September 30, 2014, $6.0 million of investments in debt securities paid off at par.

The Company did not sell any debt securities during the nine months ended September 30, 2014 and 2013.

 

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Table of Contents

The Company did not record any net Other-Than-Temporary Impairment charges during the nine months ended September 30, 2014 and 2013.

The following is an analysis of the continuous periods during which the Company has held investment positions which were carried at an unrealized loss as of September 30, 2014 and December 31, 2013:

 

     September 30, 2014  
     Less than
12 Months
     Greater than
or Equal to
12 Months
     Total  
     ($ in thousands)  

Number of positions

     3         0         3   

Fair value

   $ 10,349       $ 0       $ 10,349   

Amortized cost

     10,403         0         10,403   
  

 

 

    

 

 

    

 

 

 

Unrealized loss

   $ 54      $ 0       $ 54   
  

 

 

    

 

 

    

 

 

 

 

     December 31, 2013  
     Less than
12 Months
     Greater than
or Equal to
12 Months
     Total  
     ($ in thousands)  

Number of positions

     0         2         2   

Fair value

   $ 0       $ 8,370       $ 8,370   

Amortized cost

     0         8,645         8,645   
  

 

 

    

 

 

    

 

 

 

Unrealized loss

   $ 0      $ 275       $ 275   
  

 

 

    

 

 

    

 

 

 

As a result of the Company’s evaluation of the securities, management concluded that the unrealized losses at September 30, 2014 and December 31, 2013 were caused by changes in market prices driven by interest rates and credit spreads. The Company’s evaluation of impairment include quotes from third party pricing services, adjustments to prepayment speeds, delinquency, an analysis of expected cash flows, interest rates, market discount rates, other contract terms, and the timing and level of losses on the loans and leases within the underlying trusts. At December 31, 2013, the Company has determined that it is not more likely than not that it will be required to sell the securities before the Company recovers its amortized cost basis in the security. The Company has also determined that there has not been an adverse change in the cash flows expected to be collected. Based upon the Company’s impairment review process, and the Company’s ability and intent to hold these securities until maturity or a recovery of fair value, the decline in the value of these investments is not considered to be “Other Than Temporary.”

Maturities of debt securities classified as available-for-sale were as follows at September 30, 2014 and December 31, 2013:

 

     September 30, 2014      December 31, 2013  
     Amortized
cost
     Fair value      Amortized
cost
     Fair value  
     ($ in thousands)  

Available-for-sale:

           

Due one year or less

   $ 0      $ 0      $ 0      $ 0  

Due after one year through five years

     0        0        0        0  

Due after five years through ten years

     20,161         21,023         21,203         22,198   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 20,161       $ 21,023       $ 21,203       $ 22,198   
  

 

 

    

 

 

    

 

 

    

 

 

 

Note 6. Borrowings

Credit Facilities

As of September 30, 2014 the Company had four credit facilities through certain of its wholly-owned subsidiaries: (i) a $275 million credit facility with Wells Fargo Bank, National Association (“Wells Fargo”) to fund leveraged finance loans, (ii) a $125 million credit facility with DZ Bank AG Deutsche Zentral-Genossenschaftbank Frankfurt (“DZ Bank”) to fund asset-based loans, (iii) a $100 million credit facility with Wells Fargo to fund asset-based loans, and (iv) a $75 million credit facility with Wells Fargo to fund equipment leases and loans. Prior to the completion of its term debt securitization on June 26, 2014, the Arlington Fund had one credit facility, which consisted of a $147 million of Class A Notes (as defined below) with Wells Fargo and $28.0 million of Class B Notes (as defined below) with the Company. The liability under the Class B Notes was eliminated in consolidation in accordance with GAAP.

 

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Table of Contents

The Company must comply with various covenants under these facilities. The breach of certain of these covenants could result in a termination event and the exercise of remedies if not cured. At September 30, 2014, the Company was in compliance with all such covenants. These covenants are customary and vary depending on the type of facility. These covenants include, but are not limited to, failure to service debt obligations, failure to meet liquidity covenants and tangible net worth covenants, and failure to remain within prescribed facility portfolio delinquency, charge-off levels, and overcollateralization tests. In addition, the Company is required to make termination or make-whole payments in the event that certain of its existing credit facilities are prepaid. These termination or make-whole payments, if triggered, could be material to the Company individually or in the aggregate, and in the case of certain facilities, could be caused by factors outside of the Company’s control, including as a result of loan prepayment by the borrowers under the loan facilities that collateralize these credit facilities.

The Company has a $275 million credit facility with Wells Fargo to fund leveraged finance loans with the ability to further increase the commitment amount to $325.0 million, subject to lender approval and other customary conditions. The credit facility had an outstanding balance of $105.8 million and unamortized deferred financing fees of $2.7 million as of September 30, 2014. Interest on this facility accrues at a variable rate per annum. The facility provides for a revolving reinvestment period which ends on November 5, 2015 with a two-year amortization period.

The Company has a $125 million credit facility with DZ Bank that had an outstanding balance of $97.3 million and unamortized deferred financing fees of $0.4 million as of September 30, 2014. Interest on this facility accrues at a variable rate per annum. As part of the agreement, there is a minimum interest charge of $1.9 million per annum. If the facility is not utilized to cover this minimum requirement, then a make-whole fee is assessed to satisfy the minimum requirement. The Company is permitted to use the proceeds of borrowings under the credit facility to fund advances under asset-based loan commitments. The commitment amount under the credit facility provides for reinvestment until it matures on June 30, 2015 with no amortization period.

The Company has a $100 million credit facility with Wells Fargo to fund asset-based loan origination. The credit facility had an outstanding balance of $65.6 million and unamortized deferred financing fees of $0.4 million as of September 30, 2014. On April 1, 2014, the Company entered into an amendment which increased the commitment amount under this credit facility to $100.0 million from $75.0 million. The credit facility may be increased to an amount up to $150.0 million subject to lender approval and other customary conditions. Interest on this facility accrues at a variable rate per annum. The credit facility provides for reinvestment until it matures on December 7, 2015 with no amortization period.

The Company has a note purchase agreement with Wells Fargo under the terms of which Wells Fargo agreed to provide a $75 million credit facility to fund equipment leases and loans. The credit facility had an outstanding balance of $15.6 million and unamortized deferred financing fees of $1.2 million as of September 30, 2014. Interest on this facility accrues at a variable rate per annum. The credit facility matures on November 16, 2016.

On April 4, 2013, Arlington Fund entered into an agreement establishing $147 million of Class A Notes and $28 million of Class B Notes to partially fund eligible leveraged loans. Wells Fargo funded the Class A Notes as the initial Class A lender and the Company funded the Class B Notes as the initial Class B lender. On June 26, 2014, the Class A Notes and the Class B notes were redeemed in connection with the completion of the Arlington Program term debt securitization.

Corporate Credit Facility

On January 5, 2010, the Company entered into a note agreement with Fortress Credit Corp., which was subsequently amended on August 31, 2010, January 27, 2012, November 5, 2012, and December 4, 2012. The agreement was amended and restated on May 13, 2013 and further amended on June 3, 2013. On March 6, 2014, as permitted under the corporate credit facility with Fortress Credit Corp., the Company requested and received an increase of $28.5 million to the Initial Funding under this credit facility. On May 15, 2014, as permitted under the corporate credit facility with Fortress Credit Corp., the Company requested and received a new $10.0 million term loan (the “Term C Loan”). The credit facility, as amended, consists of a $238.5 million term note with Fortress Credit Corp. as agent, which consists of the existing outstanding balance of $100.0 million (the “Existing Funding”), an initial funding of $98.5 million (the “Initial Funding”), and three subsequent borrowings, of $5.0 million (the “Delay Draw Term A”), $25.0 million (the “Delay Draw Term B”) and the $10.0 million Term C Loan. The Existing Funding, the Initial Funding, the Delay Draw Term A, and the Term C Loan mature on May 11, 2018. The Delay Draw Term B matures on June 3, 2016. The Initial Funding, the Existing Funding and the Delay Draw Term A accrue interest at the London Interbank Offered Rate (LIBOR) plus 4.50% with an interest rate floor of 1.00%. The Delay Draw Term B accrues interest at LIBOR plus 3.375% with an interest rate floor of 1.00%. The Term C Loan accrues interest at LIBOR plus 4.25% with an interest rate floor of 1.00%.

The Company is permitted to use the proceeds of borrowings under the credit facility for general corporate purposes including, but not limited to, funding loans, working capital, paying down outstanding debt, acquisitions and repurchasing capital stock and dividend payments up to $37.5 million, The $37.5 million may be adjusted upward by the amount of fiscal year-end net income excluding depreciation and amortization expense.

The term note may be prepaid at any time without a prepayment penalty. The term note may be prepaid at par in the event of a change of control. As of September 30, 2014, the term note had an outstanding principal balance of $238.5 million and unamortized deferred financing fees of $4.4 million.

 

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Table of Contents

Subordinated debt – Fund membership interest

Prior to the completion of the Arlington Program’s term debt securitization on June 26, 2014, the Company had purchased membership interests totaling $5.0 million in the Arlington Fund and a third-party investor had purchased membership interests totaling $30.0 million. The Company was the primary beneficiary of the Arlington Fund, and as a result of consolidating the Arlington Fund as a variable interest entity, or VIE, the membership interests representing equity ownership of Arlington Fund were characterized as debt in the Company’s consolidated statement of financial position. The Company applied an imputed interest rate to that debt and recorded the resulting interest expense in its consolidated statement of operations. In the consolidation, the Company eliminated the economic results of its related portion of the membership interests and the applied interest expense from its results of operations and statements of financial position. A portion of the proceeds from the Arlington Program’s term debt securitization were used to redeem the membership interests in the Arlington Fund. As a result the Company deconsolidated the Arlington Fund from its statements of financial position beginning on June 26, 2014 and will not consolidate the Arlington Program’s operating results or statements of financial position as of that date.

Term Debt Securitizations

In June 2007 the Company completed a term debt securitization transaction. In conjunction with this transaction the Company established a separate single-purpose bankruptcy-remote subsidiary, NewStar Commercial Loan Trust 2007-1 (the “2007-1 CLO Trust”) and sold and contributed $600 million in loans and investments (including unfunded commitments), or portions thereof, to the 2007-1 CLO Trust. The Company remains the servicer of the loans. Simultaneously with the initial sale and contribution, the 2007-1 CLO Trust issued $546.0 million of notes to institutional investors. The Company retained $54.0 million, comprising 100% of the 2007-1 CLO Trust’s trust certificates. At September 30, 2014, the $344.6 million of outstanding drawn notes were collateralized by the specific loans and investments, principal collection account cash and principal payment receivables totaling $398.6 million. At September 30, 2014, deferred financing fees were $0.7 million. The 2007-1 CLO Trust permitted reinvestment of collateral principal repayments for a six-year period which ended in May 2013. During 2012, the Company purchased $0.2 million of the 2007-1 CLO Trust’s Class C notes. During 2010, the Company purchased $5.0 million of the 2007-1 CLO Trust’s Class D notes. During 2009, the Company purchased $1.0 million of the 2007-1 CLO Trust’s Class D notes.

During 2009, Moody’s downgraded all of the notes of the 2007-1 CLO Trust. As a result of the downgrade, amortization of the 2007-1 CLO Trust changed from pro rata to sequential, resulting in scheduled principal payments thereafter made in order of the notes seniority until all available funds are exhausted for each payment. During 2010, Standard and Poor’s downgraded the Class A-1 notes, the Class A-2 notes, the Class C notes and the Class D notes of the 2007-1 CLO Trust. The downgrade did not have any material consequence as the amortization of the 2007-1 CLO Trust changed from pro rata to sequential after the Moody’s downgrade in 2009. During the second quarter of 2011, Moody’s upgraded the Class C notes, the Class D notes, and the Class E notes. During 2011, Standard and Poor’s upgraded the Class D notes. During the fourth quarter of 2011, Moody’s upgraded all of the notes of the 2007-1 CLO Trust. During the third quarter of 2012, Fitch affirmed its ratings of all of the notes of the 2007-1 CLO Trust. During the second quarter of 2013, Moody’s upgraded the Class B notes, the Class C notes, the Class D notes, and the Class E notes and affirmed its ratings of the Class A-1 notes and the Class A-2 notes of the 2007-1 CLO Trust. During the third quarter of 2013, Fitch affirmed its ratings on all of the notes of the 2007-1 CLO Trust. During the first quarter of 2014, Standard and Poor’s upgraded its ratings on all notes of the 2007-1 CLO Trust. During the second quarter of 2014, Moody’s affirmed the ratings of the Class B notes, the Class C notes, and the Class D notes of the 2007-1 CLO Trust. During the third quarter of 2014, Fitch affirmed its ratings of all of the notes of the 2007-1 CLO Trust.

The Company receives a loan collateral management fee and excess interest spread. The Company also receives payments with respect to the classes of notes it owns in accordance with the transaction documents. The Company expects to receive a principal distribution as owner of the trust certificates when the term debt is retired. If loan collateral in the 2007-1 CLO Trust is in default under the terms of the indenture, the excess interest spread from the 2007-1 CLO Trust could not be distributed until the undistributed cash plus recoveries equals the outstanding balance of the defaulted loan or if the Company elected to remove the defaulted collateral.

 

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The following table sets forth selected information with respect to the 2007-1 CLO Trust:

 

     Notes
originally
issued
     Outstanding
balance
September 30,
2014
     Interest
rate
    Original
maturity
     Ratings
(S&P/Moody’s/
Fitch)(1)
   ($ in thousands)                    

2007-1 CLO Trust

             

Class A-1

   $ 336,500       $ 183,527         Libor+0.24     September 30, 2022       AAA/Aaa/AAA

Class A-2

     100,000         57,733         Libor+0.26     September 30, 2022       AAA/Aaa/AAA

Class B

     24,000         24,000         Libor+0.55     September 30, 2022       AA+/Aa1/AA

Class C

     58,500         58,293         Libor+1.30     September 30, 2022       A-/A2/A

Class D

     27,000         21,000         Libor+2.30     September 30, 2022       BBB-/Baa2/BBB+
  

 

 

    

 

 

         
   $ 546,000       $ 344,553           
  

 

 

    

 

 

         

 

(1) These ratings were initially given in June 2007, are unaudited and are subject to change from time to time. During the first quarter of 2009 Fitch affirmed its ratings on all of the notes. During the first quarter of 2009, Moody’s downgraded the Class C notes and the Class D notes. During the third quarter of 2009, Moody’s downgraded the Class A-1 notes, the Class A-2 notes and the Class B notes. During the second quarter of 2010, Standard and Poor’s downgraded the Class A-1 notes, the Class A-2 notes, the Class C notes, and the Class D notes. During the second quarter of 2011, Moody’s upgraded the Class C notes and the Class D notes. During the second quarter of 2011, Standard and Poor’s upgraded the Class D notes. During the fourth quarter of 2011, Moody’s upgraded all of the notes. During the third quarter of 2012, Fitch affirmed its ratings on all of the notes. During the second quarter of 2013, Moody’s upgraded the Class B notes, the Class C notes, the Class D notes and the Class E notes to the ratings shown above, and affirmed its ratings of the Class A-1 notes and the Class A-2 notes. During the third quarter of 2013, Fitch affirmed its ratings on all of the notes. During the first quarter of 2014, Standard and Poor’s upgraded its ratings on all notes to the ratings shown above. During the second quarter of 2014, Moody’s affirmed the above ratings of the Class B notes, the Class C notes, and the Class D notes. During the third quarter of 2014, Fitch affirmed its ratings on all of the notes. (source: Bloomberg Finance L.P.).

On December 18, 2012, the Company completed a term debt securitization transaction. In conjunction with this transaction the Company established a separate single-purpose bankruptcy-remote subsidiary, NewStar Commercial Loan Funding 2012-2 LLC (the “2012-2 CLO”) and sold and contributed $325.9 million in loans and investments (including unfunded commitments), or portions thereof, to the 2012-2 CLO. The Company remains the servicer of the loans. Simultaneously with the initial sale and contribution, the 2012-2 CLO issued $263.3 million of notes to institutional investors. The Company retained $62.6 million, comprising 100% of the 2012-2 CLO’s membership interests, Class E notes, Class F notes, and subordinated notes. At September 30, 2014, the $263.3 million of outstanding drawn notes were collateralized by the specific loans and investments, principal collection account cash and principal payment receivables totaling $325.9 million. At September 30, 2014, deferred financing fees were $2.4 million. The 2012-2 CLO permits reinvestment of collateral principal repayments for a three-year period ending in January 2016. Should the Company determine that reinvestment of collateral principal repayments are impractical in light of market conditions or if collateral principal repayments are not reinvested within a prescribed timeframe, such funds may be used to repay the outstanding notes.

The Company receives a loan collateral management fee and excess interest spread. The Company also receives payments with respect to the classes of notes it owns in accordance with the transaction documents. The Company expects to receive a principal distribution as owner of the membership interests when the term debt is retired. If loan collateral in the 2012-2 CLO is in default under the terms of the indenture, the excess interest spread from the 2012-2 CLO may not be distributed if the overcollateralization ratio, or if other collateral quality tests, are not satisfied.

The following table sets forth selected information with respect to the 2012-2 CLO:

 

     Notes
originally
issued
     Outstanding
balance
September 30,
2014
     Interest
rate
    Original
maturity
     Ratings
(Moody’s/
S&P)(1)
   ($ in thousands)                    

2012-2 CLO

             

Class A

   $ 190,700       $ 190,700         Libor+1.90     January 20, 2023       Aaa/AAA

Class B

     26,000         26,000         Libor+3.25     January 20, 2023       Aa2/N/A

Class C

     35,200         35,200         Libor+4.25     January 20, 2023       A2/N/A

Class D

     11,400         11,400         Libor+6.25     January 20, 2023       Baa2/N/A
  

 

 

    

 

 

         
   $ 263,300       $ 263,300           
  

 

 

    

 

 

         

 

(1) These ratings were initially given in December 2012, are unaudited and are subject to change from time to time.

 

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On September 11, 2013, the Company completed a term debt securitization transaction through its separate single-purpose bankruptcy-remote subsidiary, NewStar Commercial Loan Funding 2013-1 LLC (the “2013-1 CLO”) and sold and contributed $247.6 million in loans and investments (including unfunded commitments), or portions thereof, to the 2013-1 CLO. The Company remains the servicer of the loans. Simultaneously with the initial sale and contribution, the 2013-1 CLO issued $338.6 million of notes to institutional investors. The Company retained $61.4 million, comprising 100% of the 2013-1 CLO’s membership interests, Class F notes, Class G notes, and subordinated notes. At September 30, 2014, the $328.3 million of outstanding drawn notes were collateralized by the specific loans and investments, principal collection account cash and principal payment receivables totaling $389.7 million. At September 30, 2014, deferred financing fees were $4.8 million. The 2013-1 CLO permits reinvestment of collateral principal repayments for a three-year period ending in September 2016. Should the Company determine that reinvestment of collateral principal repayments are impractical in light of market conditions or if collateral principal repayments are not reinvested within a prescribed timeframe, such funds may be used to repay the outstanding notes.

The Company receives a loan collateral management fee and excess interest spread. The Company also receives payments with respect to the classes of notes it owns in accordance with the transaction documents. The Company expects to receive a principal distribution as owner of the membership interests when the term debt is retired. If loan collateral in the 2013-1 CLO is in default under the terms of the indenture, the excess interest spread from the 2013-1 CLO may not be distributed if the overcollateralization ratio, or if other collateral quality tests, are not satisfied.

The following table sets forth selected information with respect to the 2013-1 CLO:

 

     Notes
originally
issued
     Outstanding
balance
September 30,
2014
     Interest
rate
   Original
maturity
   Ratings
(S&P/
Moody’s)(2)
   ($ in thousands)                 

2013-1 CLO

              

Class A-T

   $ 202,600       $ 202,600       Libor+1.65%    September 20, 2023    AAA/Aaa

Class A-R

     35,000         24,700       (1)    September 20, 2023    AAA/Aaa

Class B

     38,000         38,000       Libor+2.30%    September 20, 2023    AA/N/A

Class C

     36,000         36,000       Libor+3.80%    September 20, 2023    A/N/A

Class D

     21,000         21,000       Libor+4.55%    September 20, 2023    BBB/N/A

Class E

     6,000         6,000       Libor+5.30%    September 20, 2023    BBB-/N/A
  

 

 

    

 

 

          
   $ 338,600       $ 328,300            
  

 

 

    

 

 

          

 

(1) Class A-R Notes accrue interest at the Class A-R CP Rate so long as they are held by a CP Conduit, and otherwise will accrue interest at the Class A-R LIBOR Rate or, in certain circumstances, the Class A-R Base Rate, but in no event shall interest rate payable pari passu with the Class A-T Notes exceed the Class A-R Waterfall Rate Cap.
(2) These ratings were initially given in September 2013, are unaudited and are subject to change from time to time.

On April 17, 2014, the Company completed a term debt securitization transaction through its separate single-purpose bankruptcy-remote subsidiary, NewStar Commercial Loan Funding 2014-1 LLC (the “2014-1 CLO”) and sold and contributed $249.6 million in loans and investments (including unfunded commitments), or portions thereof, to the 2014-1 CLO. The Company remains the servicer of the loans. Simultaneously with the initial sale and contribution, the 2014-1 CLO issued $289.5 million of notes to institutional investors. The Company retained $58.9 million, comprising 100% of the 2014-1 CLO’s membership interests, Class E notes, Class F notes, and subordinated notes. At September 30, 2014, the $289.5 million of outstanding drawn notes were collateralized by the specific loans and investments, principal collection account cash and principal payment receivables totaling $348.4 million. At September 30, 2014, deferred financing fees were $3.3 million. The 2014-1 CLO permits reinvestment of collateral principal repayments for a four-year period ending in April 2018. Should the Company determine that reinvestment of collateral principal repayments are impractical in light of market conditions or if collateral principal repayments are not reinvested within a prescribed timeframe, such funds may be used to repay the outstanding notes.

The Company receives a loan collateral management fee and excess interest spread. The Company also receives payments with respect to the classes of notes it owns in accordance with the transaction documents. The Company expects to receive a principal distribution as owner of the membership interests when the term debt is retired. If loan collateral in the 2014-1 CLO is in default under the terms of the indenture, the excess interest spread from the 2014-1 CLO may not be distributed if the overcollateralization ratio, or if other collateral quality tests, are not satisfied.

 

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The following table sets forth selected information with respect to the 2014-1 CLO:

 

     Notes
originally
issued
     Outstanding
balance
September 30,
2014
     Interest
rate
    Original
maturity
     Ratings
(Moody’s)(2)
   ($ in thousands)                    

2014-1 CLO

             

Class A

   $ 202,500       $ 202,500         Libor+1.80     April 20, 2025       Aaa

Class B-1

     20,000         20,000         Libor+2.60     April 20, 2025       Aa2

Class B-2

     13,250         13,250         (1)        April 20, 2025       Aa2

Class C

     30,250         30,250         Libor+3.60     April 20, 2025       A2

Class D

     23,500         23,500         Libor+4.75     April 20, 2025       Baa3
  

 

 

    

 

 

         
   $ 289,500       $ 289,500           
  

 

 

    

 

 

         

 

(1) Class B-2 Notes accrue interest at a fixed rate of 4.902%.
(2) These ratings were initially given in April 2014, are unaudited and are subject to change from time to time.

In June 2006 the Company completed a term debt securitization transaction. In conjunction with this transaction the Company established a separate single-purpose bankruptcy remote subsidiary, NewStar Commercial Loan Trust 2006-1 (the “2006 CLO Trust”) and sold and contributed $500 million in loans and investments (including unfunded commitments), or portions thereof, to the 2006 CLO Trust. Simultaneously with the initial sale and contribution, the 2006 CLO Trust issued $456.3 million of notes to institutional investors. The Company retained $43.8 million, comprising 100% of the 2006 CLO Trust’s trust certificates. The 2006 CLO Trust permitted reinvestment of collateral principal repayments for a five-year period which ended in June 2011. During 2011, the Company purchased $7.0 million of the 2006 CLO Trust’s Class C notes, $6.0 million of the 2006 CLO Trust’s Class D notes and $2.0 million of the 2006 CLO Trust’s Class E notes. During 2010, the Company purchased $3.0 million of the 2006 CLO Trust’s Class D notes and $3.0 million of the 2006 CLO Trust’s Class E notes. During 2009, the Company purchased $6.5 million of the 2006 CLO Trust’s Class D notes and $1.8 million of the 2006 CLO Trust’s Class E notes. During 2008, the Company purchased $3.3 million of the 2006 CLO Trust’s Class D and $2.5 million of the 2006 CLO Trust’s Class E notes, respectively. On September 30, 2014, the Company called the 2006 CLO Trust and redeemed the notes at par. In conjunction with the call, we received a principal distribution of $9.7 million.

In August 2005 the Company completed a term debt securitization transaction. In conjunction with this transaction the Company established a separate single-purpose bankruptcy-remote subsidiary, NewStar Trust 2005-1 (the “2005 CLO Trust”) and sold and contributed $375 million in loans and investments (including unfunded commitments), or portions thereof, to the 2005 CLO Trust. Simultaneously with the initial sale and contribution, the 2005 CLO Trust issued $343.4 million of notes to institutional investors and issued $31.6 million of trust certificates of which the Company retained 100%. The 2005 CLO Trust permitted reinvestment of collateral principal repayments for a three-year period which ended in October 2008. During 2013, the Company purchased $5.0 million of the 2005 CLO Trust’s Class C notes and $2.4 million of the Class D notes. During 2012, the Company purchased $9.8 million of the 2005 CLO Trust’s Class D notes and $0.9 million of the Class E notes. During 2011, the Company purchased $3.9 million of the 2005 CLO Trust’s Class E notes. During 2010, the Company purchased $4.6 million of the 2005 CLO Trust’s Class D notes. During 2009, the Company purchased $1.4 million of the 2005 CLO Trust’s Class D notes and $1.2 million of the Class E notes. During 2008, the Company purchased $5.8 million of the 2005 CLO Trust’s Class E notes. During 2007, the Company purchased $5.0 million of the 2005 CLO Trust’s Class E notes. On October 25, 2013, the Company called the 2005 CLO Trust and redeemed the notes at par. In conjunction with the call, the Company received a principal distribution of $9.2 million.

Note 7. Repurchase Agreement

 

Loans sold under agreements to repurchase

   Nine Months  Ended
September 30, 2014
    Year Ended
December 31, 2013
 
     ($ in thousands)  

Outstanding at end of period

   $ 57,371      $ 67,954   

Maximum outstanding at any month end

     57,891        67,954   

Average balance for the period

     58,146        35,280   

Weighted average rate at end of period

     5.16     5.17

On June 7, 2011, the Company entered into a five-year, $68.0 million financing arrangement with Macquarie Bank Limited backed primarily by a portfolio of commercial mortgage loans previously originated by the Company. The financing was structured as a master repurchase agreement under which the Company sold the portfolio of commercial mortgage loans to Macquarie for an aggregate purchase price of $68.0 million. The Company also agreed to repurchase the commercial mortgage loans from time to time

 

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(including a minimum quarterly amount), and agreed to repurchase all of the commercial mortgage loans by June 7, 2016. Upon the repurchase of a commercial mortgage loan, the Company is obligated to repay the principal amount related to such mortgage loan plus accrued interest (at a rate based on LIBOR plus a margin) to the date of repurchase. The Company will continue to service the commercial mortgage loans. On October 2, 2013, the Company entered into an amendment to this financing arrangement which, among other things, extended the date it had agreed to repurchase all of the commercial mortgage loans by one year to June 7, 2017, provided for $25.5 million of additional advances for existing eligible assets owned by the Company, allowed for the advance of up to $15.0 million to fund an additional commercial mortgage loan, and released $41.1 million of principal payments to the Company as unrestricted cash. The facility accrues interest at a variable rate per annum, which was 5.16% as of September 30, 2014. As of September 30, 2014, unamortized deferred financing fees were $1.0 million and the outstanding balance was $57.4 million. During 2014, the Company made principal payments totaling $10.6 million. As part of the amended agreement, there is a minimum aggregate interest margin payment of $9.2 million required to be made over the life of the facility. The Company cannot control the rate at which the underlying commercial mortgage loans are repaid. If the facility is not utilized to cover this minimum requirement, then a make-whole fee is required to be made to satisfy the minimum aggregate interest margin payment.

Note 8. Stockholders’ Equity

Stockholders’ Equity

As of September 30, 2014 and December 31, 2013, the Company’s authorized capital consists of preferred and common stock and the following was authorized and outstanding:

 

     September 30, 2014      December 31, 2013  
     Shares
authorized
     Shares
outstanding
     Shares
authorized
     Shares
outstanding
 
     (In thousands)  

Preferred stock

     5,000         0        5,000         0  

Common stock

     145,000         47,774         145,000         48,659   
  

 

 

    

 

 

    

 

 

    

 

 

 

Preferred Stock

Since the completion of the Company’s initial public offering on December 13, 2006, the Company’s authorized capital stock has included 5,000,000 shares of preferred stock with a par value of $0.01 per share, all of which remain undesignated.

Common Stock

On August 13, 2014, the Company’s Board of Directors authorized the repurchase of up to $10.0 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 are determined by the Company’s management based on its evaluation of market conditions and other factors. The repurchase program, which will expire on August 15, 2015 unless extended by the Board of Directors, may be suspended or discontinued at any time without notice. As of September 30, 2014, the Company had repurchased 155,654 shares of its common stock under this program at a weighted average price per share of $11.29.

On May 5, 2014, the Company’s Board of Directors authorized the repurchase of up to $20.0 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 were determined by the Company’s management based on its evaluation of market conditions and other factors. The Company completed repurchase program during July 2014. Under this stock repurchase program, the Company repurchased 1,519,615 shares of its common stock at a weighted average price per share of $13.13 in the aggregate.

On November 19, 2012, the Company’s Board of Directors authorized the repurchase of up to $10.0 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 were determined by the Company’s management based on its evaluation of market conditions and other factors. The repurchase program expired on December 31, 2013. Upon completion of the stock repurchase program, the Company had repurchased 17,665 shares of its common stock at a weighted average price per share of $12.22.

 

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Restricted Stock

During the nine months ended September 30, 2014, the Company issued 91,360 shares of restricted stock to certain employees of the Company pursuant to the Company’s 2006 Incentive Plan, as amended and 43,648 shares of restricted stock to non-employee members of the Board of Directors. The fair value of the shares of restricted stock is equal to the closing price of the Company’s stock on the date of issuance. The shares of restricted stock vest in three equal installments on each of the first three anniversaries of the date of grant.

Restricted stock activity for the nine months ended September 30, 2014 was as follows:

 

     Shares     Grant-date
fair  value
 
           ($ in thousands)  

Non-vested as of December 31, 2013

     366,134      $ 4,341   

Granted

     135,008        1,915   

Vested

     (174,682     (2,014

Forfeited

     (10,320     (140
  

 

 

   

 

 

 

Non-vested as of September 30, 2014

     316,140      $ 4,102   
  

 

 

   

 

 

 

The Company’s compensation expense related to restricted stock was $0.6 million and $1.8 million, respectively, for the three and nine months ended September 30, 2014 and $0.7 million and $3.4 million, respectively, for the three and nine months ended September 30, 2013. The unrecognized compensation cost of $1.8 million at September 30, 2014 is expected to be recognized over the next three years.

Stock Options

Under the Company’s 2006 Incentive Plan, the Company’s compensation committee may grant options to purchase shares of common stock. Stock options may either be incentive stock options (“ISOs”) or non-qualified stock options. ISOs may only be granted to officers and employees. The compensation committee will, with regard to each stock option, determine the number of shares subject to the stock option, the manner and time of exercise, vesting, and the exercise price, which will not be less than 100% of the fair market value of the common stock on the date of the grant. The shares of common stock issuable upon exercise of options or other awards or upon grant of any other award may be either previously authorized but unissued shares or treasury shares.

Stock option activity for the nine months ended September 30, 2014 was as follows:

 

     Options  

Outstanding as of January 1, 2014

     5,544,385   

Granted

     0   

Exercised

     (698,946

Forfeited

     (5,000
  

 

 

 

Outstanding as of September 30, 2014

     4,840,439   
  

 

 

 

Vested as of September 30, 2014

     4,840,439   
  

 

 

 

Exercisable as of September 30, 2014

     4,840,439   
  

 

 

 

As of September 30, 2014 and December 31, 2013, the total unrecognized compensation cost related to nonvested options granted was $0. The Company’s compensation expense related to its stock options was $0 and $0.1 million, respectively, for the three and nine months ended September 30, 2013.

 

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Note 9. Income Per Share

The computations of basic and diluted income per share for the three and nine months ended September 30, 2014 and 2013 are as follows:

 

     Three Months Ended
September 30,
     Nine Months Ended
September 30,
 
     2014      2013      2014      2013  
     (In thousands)  

Numerator:

           

Net income

   $ 5,020       $ 6,437       $ 9,368       $ 18,235   

Denominator:

           

Denominator for basic income per common share

     47,900         48,613         48,501         47,984   
  

 

 

    

 

 

    

 

 

    

 

 

 

Denominator:

           

Denominator for diluted income per common share

     47,900         48,613         48,501         47,984   

Potentially dilutive securities - options

     2,903         3,713         3,278         3,575   

Potentially dilutive securities - restricted stock

     0         0         0         1,018   

Potentially dilutive securities - warrants

     0         392         118         304   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total weighted average diluted shares

     50,803         52,718         51,897         52,881   
  

 

 

    

 

 

    

 

 

    

 

 

 

Note 10. Consolidated Variable Interest Entity

In April 2013, the Company formed a new managed credit fund, NewStar Arlington Fund LLC (“Arlington Fund”) in partnership with an institutional investor to co-invest in middle market commercial loans originated by the Company’s Leveraged Finance group. As the managing member of Arlington Fund, the Company retained full discretion over Arlington Fund’s investment decisions, subject to usual and customary limitations, and earned management fees as compensation for its services. For the six months ended June 30, 2014, the management fee was $0.5 million which was eliminated in consolidation.

On April 4, 2013, Arlington Fund entered into an agreement establishing $147.0 million of Class A variable funding notes (the “Class A Notes”) and $28.0 million of Class B variable funding notes (the “Class B Notes”) to partially fund eligible middle market loan origination for Arlington Fund. Wells Fargo Bank, National Association funded the Class A Notes as the initial Class A lender and the Company funded the Class B Notes as the initial Class B lender. For the months ended June 30, 2014 interest expense on the Class B Notes totaled $0.7 million. For the six months ended June 30, 2014 and for the year ended December 31, 2013 the Fund distributed excess cash to its institutional investor totaling $0.7 million and $0.6 million, respectively.

From inception, the Company was deemed to be the primary beneficiary of Arlington Fund and, therefore, consolidated the financial results of Arlington Fund with the Company’s results of operations and statements of financial position since April 2013.

On June 26, 2014, the NewStar Arlington Senior Loan Program LLC (the “Arlington Program”) completed a $409.4 million term debt securitization comprised of all of the Arlington Fund’s loans as well as a portion of the Company’s loans classified as held-for-sale. A portion of the proceeds from this term debt securitization were used to repay all advances under the Class A Notes and the Class B Notes. Following repayment, the Class A Notes and the Class B Notes were redeemed. As a result the amortization of $1.1 million of deferred financing fees was accelerated and recognized during the three months ended June 30, 2014. The Company’s membership interests in Arlington Fund were also redeemed and new membership interests in the Arlington Program were issued to its equity investors. The Company did not recognize a gain or a loss on the redemption of its membership interests in the Arlington Fund. The Company acts as collateral manager for the Arlington Program. As a result of the repayment of the Company’s advances as the Class B lender under the warehouse facility and the redemption of its membership interests in the Arlington Fund, the Company has no ownership or financial interests in the Arlington Fund or its successors except to the extent that it receives management fees as collateral manager of the Arlington Program. As a result, the Company deconsolidated the Arlington Fund from its statements of financial position beginning on June 26, 2014. The Company determined that it is not the primary beneficiary of the Arlington Program and will not consolidate the Arlington Program’s operating results or statements of financial position as of that date.

Although the Company consolidated all of the assets and liabilities of Arlington Fund, during the period from April 4, 2013 through June 26, 2014, its maximum exposure to loss was limited to its investments in membership interests in Arlington Fund, its Class B Note receivable, as well as the management fee receivable from Arlington Fund. These items defined the Company’s economic relationship with Arlington Fund but were eliminated upon consolidation. The Company managed the assets of Arlington Fund solely for the benefit of its lenders and investors. If the Company were to have liquidated, the assets of Arlington Fund would not have been available to the Company’s general creditors. Conversely, the investors in the debt of Arlington Fund had no recourse to the Company’s general assets. Therefore, the Company did not consider this debt its obligation.

 

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During the period from April 4, 2013 through June 26, 2014 when the Company consolidated the Arlington Fund as a variable interest entity, or VIE, the membership interests representing equity ownership of Arlington Fund were characterized as debt in the Company’s consolidated statement of financial position. The Company applied an imputed interest rate to that debt and recorded the resulting interest expense in its consolidated statement of operations. In the consolidation, the Company eliminated the economic results of its related portion of the membership interests and the applied interest expense from its results of operations and statements of financial position.

The following tables present the unconsolidated, stand alone balance sheet of Arlington Fund as of December 31, 2013.

 

     As of
December 31, 2013
 
    

(unaudited)

($ in thousands)

 

Restricted cash

   $ 1,950   

Loans, net

     171,427   

Other assets

     3,022   
  

 

 

 

Total assets

   $ 176,399   
  

 

 

 

Credit facilities—Class A Notes

   $ 120,344   

Class A Notes interest payable

     434   

Class B Notes payable

     19,375   

Class B Notes interest payable

     183   

Other liabilities

     173   
  

 

 

 

Total liabilities

     140,509   

Equity

     35,890   
  

 

 

 

Total equity and liabilities

   $ 176,399   
  

 

 

 

Note 11. Financial Instruments with Off-Balance Sheet Risk

The Company is party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its borrowers. These financial instruments include unfunded commitments, standby letters of credit and interest rate mitigation products. The instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheet. The contract or notional amounts of those instruments reflect the extent of involvement we have in particular classes of financial instruments.

The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for standby letters of credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.

Unused lines of credit are commitments to lend to a borrower if certain conditions have been met. These commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Because certain commitments may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each borrower’s creditworthiness on a case-by-case basis. The amount of collateral required is based on factors that include management’s credit evaluation of the borrower and the borrower’s compliance with financial covenants. Due to their fluctuating nature, the Company cannot know with certainty the aggregate amounts that will be required to fund its unfunded commitments. The aggregate amount of these unfunded commitments currently exceeds the Company’s available funds and will likely continue to exceed its available funds in the future.

At September 30, 2014, the Company had $303.6 million of unused lines of credit. Of these unused lines of credit, unfunded commitments related to revolving credit facilities were $269.3 million and unfunded commitments related to delayed draw term loans were $27.4 million. $6.9 million of the unused revolving commitments are unavailable to the borrowers, which may be related to the borrowers’ inability to meet covenant obligations or other similar events.

Revolving credit facilities allow the Company’s borrowers to draw up to a specified amount, subject to customary borrowing conditions. The unfunded revolving commitments of $269.3 million are further categorized as either contingent or unrestricted. Contingent commitments limit a borrower’s ability to access the revolver unless it meets an enumerated borrowing base covenant or other restrictions. At September 30, 2014, the Company categorized $185.2 million of the unfunded commitments related to revolving credit facilities as contingent. Unrestricted commitments represent commitments that are currently accessible, assuming the borrower is in compliance with certain customary loan terms and conditions. At September 30, 2014, the Company had $84.1 million of unfunded unrestricted revolving commitments.

During the three months ended September 30, 2014, revolver usage averaged approximately 46%, which is in line with the average of 43% over the previous four quarters. Management’s experience indicates that borrowers typically do not seek to exercise their entire available line of credit at any point in time. During the three months ended September 30, 2014, revolving commitments increased $31.1 million.

 

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Delayed draw credit facilities allow the Company’s borrowers to draw predefined amounts of the approved loan commitment at contractually set times, subject to specific conditions, such as capital expenditures or acquisitions in corporate loans or for tenant improvements in commercial real estate loans. During the three months ended September 30, 2014, delayed draw credit facility commitments increased $8.8 million.

Standby letters of credit are conditional commitments issued by us to guarantee the performance by a borrower to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending credit to our borrowers.

Interest rate risk mitigation products are offered to enable customers to meet their financing and risk management objectives. Derivative financial instruments consist predominantly of interest rate swaps, interest rate caps and floors. The interest rate risks to the Company of these customer derivatives is mitigated by entering into similar derivatives having offsetting terms with other counterparties.

These interest rate risk mitigation products do not qualify for hedge accounting treatment. These interest rate swaps and caps contracts are recorded at fair value on the Company’s balance sheet in either “Other assets” or “Other liabilities.” Gains and losses on derivatives not designated as cash flow hedges, including any cash payments made or received are reported as gains or losses on derivatives in the consolidated statements of operations. The Company’s outstanding interest rate mitigation products had a fair value of $0.04 million at September 30, 2014 and $0 at December 31, 2013.

Financial instruments with off-balance sheet risk are summarized as follows:

 

     September 30,
2014
     December 31,
2013
 
     ($ in thousands)  

Unused lines of credit

   $ 303,643       $ 326,231   

Standby letters of credit

     8,637         6,880   

Note 12. Fair Value

ASC 820, Fair Value Measurements (“ASC 820”) establishes a three-level valuation hierarchy for disclosure of fair value measurements. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. The three levels are defined as follows:

 

   

Level 1 – inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets.

 

   

Level 2 – inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.

 

   

Level 3 – inputs to the valuation methodology are unobservable and significant to the fair value measurement.

A financial instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement.

 

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The following table presents recorded amounts of assets and liabilities measured at fair value on a recurring and nonrecurring basis as of September 30, 2014, by caption in the consolidated balance sheet and by ASC 820 valuation hierarchy (as described above).

 

     Quoted Prices
in Active
Markets for
Identical Assets
(Level 1)
     Significant
Other
Observable
Inputs
(Level 2)
     Significant
Unobservable
Inputs
(Level 3)
     Total
Carrying
Value in
Consolidated
Balance Sheet
 
     ($ in thousands)  

Recurring Basis:

           

Investments in debt securities, available-for-sale

   $ 0      $ 0      $ 21,023       $ 21,023   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total assets recorded at fair value on a recurring basis

   $ 0      $ 0       $ 21,023       $ 21,023   
  

 

 

    

 

 

    

 

 

    

 

 

 

Nonrecurring Basis:

           

Loans, net

   $ 0      $ 0      $ 27,639       $ 27,639   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total assets recorded at fair value on a nonrecurring basis

   $ 0       $ 0       $ 27,639       $ 27,639   
  

 

 

    

 

 

    

 

 

    

 

 

 

At September 30, 2014, “Investments in debt securities, available-for-sale” consisted of collateralized loan obligations. The fair value measurement is obtained through a third party pricing service or by using internally developed financial models.

At September 30, 2014, “Loans, net” measured at fair value on a nonrecurring basis consisted of impaired collateral-dependent commercial real estate loans. The fair values of these loans are based on third party appraisals of the underlying collateral value as well as the Company’s internal analysis. During the nine months ended September 30, 2014, the Company recorded $0.04 million of specific allowance for credit losses related to “Loans, net” measured at fair value at September 30, 2014.

The following table presents a summary of significant unobservable inputs and valuation techniques of the Company’s Level 3 fair value measurements at September 30, 2014.

 

     Fair value     

Valuation Techniques

  

Unobservable Input

   Range  
     ($ in thousands)  

Financial assets:

           

Investments in debt securities, available-for-sale

   $ 21,023       Third-party pricing    Pricing assumptions such as prepayment rates, interest rates, loss assumptions, cash flow projections, and comparisons to similar financial instruments   

Loans and leases, net

     27,639       Market comparables    Cost to sell      3% - 7%   
      Valuation model    Marketability discount      5% - 30%   
  

 

 

          

Total:

   $ 48,662         
  

 

 

          

 

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The following table presents recorded amounts of assets and liabilities measured at fair value on a recurring and nonrecurring basis as of December 31, 2013, by caption in the consolidated balance sheet and by ASC 820 valuation hierarchy (as described above).

 

      Quoted Prices
in Active
Markets for
Identical Assets
(Level 1)
     Significant
Other
Observable
Inputs
(Level 2)
     Significant
Unobservable
Inputs
(Level 3)
     Total
Carrying
Value in
Consolidated
Balance Sheet
 
     ($ in thousands)  

Recurring Basis:

           

Investments in debt securities, available-for-sale

   $ 0      $ 0      $ 22,198       $ 22,198   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total assets recorded at fair value on a recurring basis

   $ 0      $ 0       $ 22,198       $ 22,198   
  

 

 

    

 

 

    

 

 

    

 

 

 

Nonrecurring Basis:

           

Loans, net

   $ 0      $ 0      $ 26,671       $ 26,671   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total assets recorded at fair value on a nonrecurring basis

   $ 0       $ 0       $ 26,671       $ 26,671   
  

 

 

    

 

 

    

 

 

    

 

 

 

At December 31, 2013, “Investments in debt securities, available-for-sale” consisted of collateralized loan obligations. The fair value measurement is obtained through a third party pricing service or by using internally developed financial models.

At December 31, 2013, “Loans, net” measured at fair value on a nonrecurring basis consisted of impaired collateral-dependent commercial real estate loans. The fair values of these loans are based on third party appraisals of the underlying collateral value as well as the Company’s internal analysis. During 2013, the Company released $3.2 million of specific allowance for credit losses related to “Loans, net” measured at fair value at December 31, 2013.

The following table presents a summary of significant unobservable inputs and valuation techniques of the Company’s Level 3 fair value measurements at December 31, 2013.

 

     Fair value     

Valuation Techniques

  

Unobservable Input

   Range  
     ($ in thousands)  

Financial assets:

           

Investments in debt securities, available-for-sale

   $ 22,198       Third-party pricing    Pricing assumptions such as prepayment rates, interest rates, loss assumptions, cash flow projections, and comparisons to similar financial instruments   

Loans and leases, net

     26,671       Market comparables    Cost to sell      3% - 7%   
      Valuation model    Marketability discount      5% - 30%   
  

 

 

          

Total:

   $ 48,869         
  

 

 

          

Changes in level 3 recurring fair value measurements

The table below illustrates the change in balance sheet amounts during the three and nine months ended September 30, 2014 and 2013 (including the change in fair value), for financial instruments measured on a recurring basis and classified by the Company as level 3 in the valuation hierarchy. When a determination is made to classify a financial instrument as level 3, the determination is based upon the significance of the unobservable parameters to the overall fair value measurement. However, level 3 financial instruments typically include, in addition to the unobservable or level 3 components, observable components (that is, components that are actively quoted and can be validated to external sources); accordingly, the gains and losses in the table below include changes in fair value due in part to observable factors that are part of the valuation methodology. The Company did not transfer any financial instruments in or out of level 1, 2, or 3 during the three or nine months ended September 30, 2014 and 2013.

 

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For the three months ended September 30, 2014:

 

      Investments in
Debt Securities,
Available-for-sale
 
     ($ in thousands)  

Balance as of June 30, 2014

   $ 16,545   

Total gains or losses (realized/unrealized)

  

Included in earnings

     55   

Included in other comprehensive income

     (186

Purchases

     4,609   

Issuances

     0   

Settlements

     0   
  

 

 

 

Balance as of September 30, 2014

   $ 21,023   
  

 

 

 

For the three months ended September 30, 2013:

 

      Investments in
Debt Securities,
Available-for-sale
 
     ($ in thousands)  

Balance as of June 30, 2013

   $ 21,099   

Total gains or losses (realized/unrealized)

  

Included in earnings

     55   

Included in other comprehensive income

     878   

Purchases

     0   

Issuances

     0   

Settlements

     0   
  

 

 

 

Balance as of September 30, 2013

   $ 22,032   
  

 

 

 

For the nine months ended September 30, 2014:

 

      Investments in
Debt Securities,
Available-for-sale
 
     ($ in thousands)  

Balance as of December 31, 2013

   $ 22,198   

Total gains or losses (realized/unrealized)

  

Included in earnings

     349   

Included in other comprehensive income

     (133

Purchases

     4,609   

Issuances

     0   

Settlements

     (6,000
  

 

 

 

Balance as of September 30, 2014

   $ 21,023   
  

 

 

 

For the nine months ended September 30, 2013:

 

      Investments in
Debt Securities,
Available-for-sale
 
     ($ in thousands)  

Balance as of December 31, 2012

   $ 21,127   

Total gains or losses (realized/unrealized)

  

Included in earnings

     168   

Included in other comprehensive income

     737   

Purchases

     0   

Issuances

     0   

Settlements

     0   
  

 

 

 

Balance as of September 30, 2013

   $ 22,032   
  

 

 

 

 

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The following table presents the carrying amounts and estimated fair values of the Company’s financial instruments at September 30, 2014 and December 31, 2013. The fair value of a financial instrument is the amount at which the instrument could be exchanged in a current transaction between willing parties.

 

     September 30, 2014      December 31, 2013  
      Carrying
amount
     Fair value      Carrying
amount
     Fair value  
     ($ in thousands)  

Financial assets:

           

Cash and cash equivalents

   $ 111,611       $ 111,611       $ 43,401       $ 43,401   

Restricted cash

     131,805         131,805         169,870         169,870   

Loans held-for-sale

     46,863         46,863         14,831         14,831   

Loans and leases, net

     2,045,338         2,078,014         2,266,677         2,301,053   

Investments in debt securities available-for-sale

     21,023         21,023         22,198         22,198   

Other assets

     17,975         17,975         7,955         7,955   

Financial liabilities:

           

Credit facilities

   $ 284,348       $ 284,348       $ 452,502       $ 452,502   

Term debt

     1,464,153         1,437,031         1,442,374         1,402,900   

Repurchase agreements

     57,371         63,666         67,954         66,911   

 

 

The carrying amounts shown in the table are included in the consolidated balance sheets under the indicated captions.

The following table presents the carrying amounts, estimated fair values, and placement in the fair value hierarchy of the Company’s financial instruments at September 30, 2014 and December 31, 2013. The table excludes financial instruments for which the carrying amount approximates fair value such as cash and cash equivalents, restricted cash, loans held-for-sale (as applicable), investments in debt securities available-for-sale, credit facilities, and financial information disclosed above.

 

                   Fair Value Measurements  

September 30, 2014

   Carrying
amount
     Fair value      Level 1      Level 2      Level 3  
     ($ in thousands)  

Financial assets:

              

Loans and leases, net

   $ 2,017,699       $ 2,050,375       $ 0       $ 0       $ 2,050,375   

Financial liabilities:

              

Term debt

     1,464,153         1,437,031         0         1,437,031         0   

Repurchase agreements

     57,371         63,666         0         63,666         0   

 

                   Fair Value Measurements  

December 31, 2013

   Carrying
amount
     Fair value      Level 1      Level 2      Level 3  
     ($ in thousands)  

Financial assets:

              

Loans and leases, net

   $ 2,240,006       $ 2,274,382       $ 0       $ 0       $ 2,274,382   

Financial liabilities:

              

Term debt

     1,442,374         1,402,900         0         1,402,900         0   

Repurchase agreements

     67,954         66,911         0         66,911         0   

The following methods and assumptions were used to estimate the fair value of each class of financial instruments:

Cash and cash equivalents and restricted cash: The carrying amounts approximate fair value because of the short maturity of these instruments.

Loans held-for-sale, net: The fair values are based on quoted prices, where available, cost, or are determined by discounting estimated cash flows using model-based valuation techniques. Inputs into the model-based valuations can include changes in market indexes, selling prices of similar loans, management’s assumption related to credit rating of the loan, prepayment assumptions and other factors, such as credit loss assumptions.

Loans and leases, net: The fair value was determined as the present value of expected future cash flows discounted at current market interest rates offered by similar lending institutions for loans with similar terms to companies with comparable credit risk. This method of estimating fair value does not incorporate the exit price concept of fair value and is based on significant unobservable inputs. The amount included in the above table excludes impaired collateral-dependent commercial real estate loans.

 

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Investments in debt securities: The fair values of debt securities are based on quoted market prices, when available, at the reporting date for those or similar investments. When no market data is available, we estimate fair value using various valuation tools including cash flow models that utilize financial statements and business plans, as well as qualitative factors.

Credit facilities: Due to the adjustable rate nature of the borrowings, the fair values of the credit facilities are estimated to be their carrying values. Rates currently are comparable to those offered to the Company for similar debt instruments of comparable maturities by the Company’s lenders.

Term debt: The fair value was determined by applying prevailing term debt market interest rates to the Company’s current term debt structure.

Repurchase agreements: The fair value was determined by applying prevailing repurchase agreement market interest rates to the Company’s current repurchase agreement structure.

Other assets: Comprised of non-public investments which are initially valued at transaction price and subsequently adjusted when evidence is available to support such adjustments when appropriate. The estimated fair value was determined based on the Company’s valuation techniques, including discounting estimated cash flows and model-based valuations.

Note 13. Related-Party Transactions

Pursuant to an Investment Management Agreement dated August 3, 2005, the Company serves as investment manager of the NewStar Credit Opportunities Fund, Ltd. (the “Fund”), a Cayman Islands exempted company limited by shares incorporated under the provisions of The Companies Law of the Cayman Islands. Prior to December 6, 2013 when the Fund called the notes of its term debt securitization, the Fund paid the Company a management fee, payable monthly in arrears, based on the carrying value of the total gross assets attributable to the applicable series of each class of shares at the end of each month. For the three and nine months ended September 30, 2013, the Fund’s asset management fees were $0.6 million and $2.0 million, respectively. Subsequent to December 6, 2013, the Fund pays the Company a fee when cash is distributed to its investors. For the three and nine months ended September 30, 2014, the Fund paid the Company $0 and $0.06 million, respectively.

Pursuant to a Collateral Management Agreement dated June 26, 2014, the Company serves as collateral manager of the Arlington Program. The Company is entitled to receive a fee, which will accrue quarterly based on the fee basis amount in arrears payable on each payment date. For the three months ended September 30, 2014, the Arlington Program’s collateral management fee was $0.5 million.

During 2011, the Company made a loan based on market terms to a company that is 40% owned by a major stockholder of the Company and with respect to which two members of the Company’s Board of Directors are affiliated. This loan was paid off in its entirety in September 2014.

Note 14. Subsequent Event

On November 4, 2014, the Company entered into an investment agreement with FS Investment Corporation, FS Investment Corporation II, and FS Investment Corporation III (collectively the “Franklin Square Funds”) pursuant to which the Company has agreed to issue $300 million of 8.25% subordinated notes due 2024 and warrants exercisable for 12 million shares of the Company’s common stock at an exercise price of $12.62 per share (the “Warrants”). The strategic investment is expected to be completed in multiple closings with $200 million of the subordinated notes expected to be issued at an initial closing on or before December 31, 2014, subject to customary closing conditions. The Company expects to issue an additional $100 million of 8.25% subordinated notes due 2024 within one year of the initial purchase. The Warrants will be issued and sold in two tranches with the first tranche, which will be exercisable for approximately 9.5 million shares of common stock, expected to be issued at the initial closing. The second tranche, which will be exercisable for approximately 2.5 million shares of common stock, is subject to approval by the Company’s stockholders.

 

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Item 2. 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 are described in Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2013, as well as throughout this Item 2. You are cautioned not to place undue reliance on the forward-looking statements contained in this document. These statements speak only as of the date of this document, and we undertake no obligation to update or revise these statements, except as may be required by law.

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, provides first mortgage debt which is 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 held steady in the third quarter compared to the prior quarter. Overall middle market loan demand in the third quarter decreased as compared to the second quarter and as compared to the same period last year, with volume of $38 billion, but was a slight decrease relative to the same period last year. The markets remained highly competitive and liquid as the supply of new capital continued to outpace demand for new financing for growth or acquisitions. The volume represented by new middle market transactions decreased in the third quarter to $16 billion. New transactions also decreased as a percentage of total volume as refinancing activity increased slightly to 59% compared to 55% in the prior quarter, according to Thomson Reuters.

We believe the pricing environment in the broader loan market weakened throughout 2014 due primarily to 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 as lenders competed for a limited universe of deals. These conditions also led to increasing pressure on deal structures reflected by higher leverage levels and weaker lender protections. Despite that trend, however, we believe that conditions in the middle market have remained somewhat insulated from the impact of excessive liquidity evident in the broader loan markets as yields remained relatively stable through the first half of 2014 and into the third quarter of 2014. Loan yields in both the large corporate market and middle market have increased in the third quarter, large corporate to 5.4% from 5.0% and middle market to 6.0% from 5.8%. 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.

 

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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 has remained relatively weak in the third 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 have remained steady in the third quarter as many fixed income investors continued to target structured investment alternatives such as CLOs to meet their return objectives. The market had been unsettled through much of the year, 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 remained active in the quarter as the market seems to have 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.

Despite a slower start to the year as compared to 2013, new CLO issuance of over $93 billion through September has eclipsed total 2013 issuance of $87 billion and is up 54% as compared to the same period last year. Total CLO issuance is well above 2012 and 2011 levels of $55 billion and $12 billion, respectively. After trending slightly downward through the first half of 2014, CLO credit spreads have trended upward through the third quarter, however, reflecting the impact of a steepening yield curve and regulatory concerns, including FDIC surcharge for deposit insurance and 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. 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.

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. These factors were generally favorable in the third quarter as we originated $409 million of new loans at yields that were generally below our historical averages for comparably rated loans. After declining through the first half of 2013 in a muted M&A volume environment, yields have largely stabilized. Although pricing remained thin and leverage continued to trend higher in the broad loan market, conditions in our primary target markets 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. 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 increase through the balance of 2014 and continue to provide opportunities for us to increase our origination volumes modestly.

Recent Developments

Franklin Square Funds Transaction

On November 4, 2014, we entered into an investment agreement with FS Investment Corporation, FS Investment Corporation II, and FS Investment Corporation III (collectively the “Franklin Square Funds”) pursuant to which we have agreed to issue $300 million of 8.25% subordinated notes due 2024 and warrants exercisable for 12 million shares of the Company’s common stock at an exercise price of $12.62 per share (the “Warrants”). The strategic investment is expected to be completed in multiple closings with $200 million of the subordinated notes expected to be issued at an initial closing on or before December 31, 2014, subject to customary closing conditions. We expect to issue an additional $100 million of 8.25% subordinated notes due 2024 within one year of the initial purchase. The Warrants will be issued and sold in two tranches with the first tranche, which will be exercisable for approximately 9.5 million shares of common stock, expected to be issued at the initial closing. The second tranche, which will be exercisable for approximately 2.5 million shares of common stock, is subject to approval by the Company’s stockholders.

Liquidity

On September 30, 2014, we called the 2006 CLO Trust and redeemed the notes at par.

Stock Repurchase Program

On August 13, 2014, our Board of Directors authorized the repurchase of up to $10.0 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 are determined by our management based on its evaluation of market conditions and other factors. The repurchase program, which will expire on August 15, 2015 unless extended by the Board of Directors, may be suspended or discontinued at any time without notice. As of September 30, 2014, we had repurchased 155,654 shares of our common stock under this program at a weighted average price per share of $11.29.

On May 5, 2014, our Board of Directors authorized the repurchase of up to $20.0 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 were determined by our management based on its evaluation of market conditions and other factors. We completed this repurchase program during July 2014. Under this stock repurchase program, we repurchased 1,519,615 shares of our common stock at a weighted average price per share of $13.13 in the aggregate.

 

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RESULTS OF OPERATIONS FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2014 AND 2013

NewStar’s basic and diluted income per share for the three months ended September 30, 2014 was $0.10 on a net income of $5.0 million, and basic and diluted income per share of $0.19 and $0.18, respectively, for the nine months ended September 30, 2014, on net income of $9.4 million, compared to basic and diluted income per share for the three months ended September 30, 2013 of $0.13 and $0.12, respectively, on net income of $6.4 million, and $0.38 and $0.34, respectively, for the nine months ended September 30, 2013, on net income of $18.2 million. Our managed loan portfolio was $2.6 billion at September 30, 2014 compared to $2.5 billion at December 31, 2013. As of September 30, 2014, loans owned by the Arlington Program and the NCOF were $337.3 million and $48.2 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 6.13% and 6.12% for the three and six months ended September 30, 2014 and 6.33% and 6.69% for the three and nine months ended September 30, 2013. The decrease in loan portfolio yield was primarily driven by a decrease in our average yield on interest earning assets from new loan and lease origination and re-pricings subsequent to September 30, 2013, and the average yield on loans which were repaid subsequent to September 30, 2013 was higher than the average yield on loans in our total loan portfolio.

Net interest margin

Net interest margin, which is net interest income divided by average interest earning assets, was 3.24% for each of the three and nine months ended September 30, 2014 and 3.35% and 4.02% for the three and nine months ended September 30, 2013. The primary factors impacting net interest margin for 2014 were the acceleration of amortization of $1.1 million of deferred financing fees related to the Arlington Fund’s payoff of its credit facility with a portion of the proceeds from the Arlington Program’s term debt securitization, the composition of interest earning assets, non-accrual loans, changes in three-month LIBOR, credit spreads and cost of borrowings. 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.

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 48.03% and 48.15% for the three and nine months ended September 30, 2014 and 46.73% and 49.31% for the three and nine months ended September 30, 2013. The efficiency ratio excluding the results of the Arlington Fund was 48.43% and 50.08% for the three and nine months ended September 30, 2013.The increase in our efficiency ratio for the three months ended September 30, 2014 as compared to the three months ended September 30, 2013 was primarily due to a decrease in net interest income, partially offset by a decrease in operating expenses. The decrease in net interest income was primarily due to the deconsolidation of the Arlington Fund in June 2014. The decrease in our efficiency ratio for the nine months ended September 30, 2014 as compared to the nine months ended September 30, 2013 is primarily due to the accelerated amortization of deferred financing fees totaling $1.1 million related to the repayment of the Arlington Fund’s credit facility.

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 1.99% at September 30, 2014 and 1.80% as of December 31, 2013. The allowance for credit losses ratio excluding the loans owned by the Arlington Fund was 1.94% as of December 31, 2013. The increase in the allowance for credit losses ratio is primarily due to the deconsolidation of the assets of the Arlington Fund on June 26, 2014, which did not carry a related allowance. During the three and nine months ended September 30, 2014, we recorded $1.8 million and $19.7 million of net specific provision for credit losses on impaired loans and had net charge offs totaling $0.6 million and $21.8 million, respectively. At September 30, 2014, the specific allowance for credit losses was $21.8 million, and the general allowance for credit losses was $20.1 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. We continually evaluate our 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 net of charge offs with outstanding cash receivables that are 60 days or more past due, divided by outstanding gross loans and leases, was 1.07% as of September 30, 2014 as compared to 0.22% as of December 31, 2013. The increase in the delinquent loan rate is primarily due to two previously identified impaired loans being classified as delinquent during the nine months ended September 30, 2014, and the deconsolidation of the outstanding gross loans of the Arlington Fund on June 26, 2014. 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.

 

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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 with outstanding cash receivables that are 60 days or more past due and less than 90 days past due, divided by outstanding gross loans and leases. We did not have any delinquent accruing loans as of September 30, 2014 or 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 3.67% as of September 30, 2014 and 3.04% as of December 31, 2013. The non-accrual rate excluding the loans owned by the Arlington Fund was 3.28% as of December 31, 2013. As of September 30, 2014 and December 31, 2013, the aggregate outstanding balance of non-accrual loans was $77.1 million and $70.7 million, respectively and total outstanding loans and leases held for investment was $2.1 billion and $2.3 billion, respectively. 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 4.25% as of September 30, 2014 and 3.60% as of December 31, 2013. The non-performing asset rate excluding the loans owned by the Arlington Fund was 3.89% as of December 31, 2013. As of September 30, 2014 and December 31, 2013, the sum of the aggregate outstanding balance of non-performing assets was $90.0 million and $84.2 million, respectively. 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 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. The net charge-off rate was 0.11% and 1.38% for the three and nine months ended September 30, 2014, respectively, and 0.18% and 1.13% for the three and nine months ended September 30, 2013. Net charge offs were $0.6 million and $21.8 million for the three and nine months ended September 30, 2014, respectively, as compared to $0.9 million and $16.9 million for the three and nine months ended September 30, 2013, respectively. We expect the net charge-off rate (end of period loans and leases) 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 (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 average total outstanding balance of our loans and leases held for investment for the period. The net charge-off rate was 0.10% and 1.27% for the three and nine months ended September 30, 2014, respectively, and 0.18% and 1.17% for the three and nine months ended September 30, 2013, respectively. We expect the net charge-off rate (average period loans and leases) 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.

Return on average assets

Return on average assets, which is net income divided by average total assets, was 0.82% and 0.50% for the three and nine months ended September 30, 2014, respectively, and 1.10% for the each of the three and nine months ended September 30, 2013, respectively.

Return on average equity

Return on average equity, which is net income divided by average equity, was 3.28% and 2.03% for the three and nine months ended September 30, 2014, respectively, and 4.24% and 4.05% for the three and nine months ended September 30, 2013, respectively.

 

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Review of Consolidated Results

A summary of NewStar Financial’s consolidated financial results for the three and nine months ended September 30, 2014 and 2013 follows:

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
   2014     2013     2014     2013  
     ($ in thousands)  

Net interest income:

    

Interest income

   $ 33,907      $ 30,370      $ 100,570      $ 95,401   

Interest expense

     14,304        11,703        40,673        30,798   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income

     19,603        18,667        59,897        64,603   

Provision for credit losses

     3,369        2,381        21,828        7,429   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income after provision for credit losses

     16,234        16,286        38,069        57,174