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, 2013

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 1, 2013, 48,670,415 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, 2013 and December 31, 2012      3   
 

Condensed Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2013 and 2012

     5   
 

Condensed Consolidated Statements of Comprehensive Income for the Three and Nine Months Ended September 30, 2013 and 2012

     6   
 

Condensed Consolidated Statements of Changes in Stockholders’ Equity for the Nine Months ended September 30, 2013 and 2012

     7   
  Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2013 and 2012      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      55   

Item 4.

  Controls and Procedures      56   
 

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      58   

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;

 

   

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;

 

   

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, 2012.

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,
2013
     December 31,
2012
 
     (unaudited)         
    

($ in thousands, except share

and par value amounts)

 

Assets:

     

Cash and cash equivalents

   $ 87,972       $ 27,212   

Restricted cash

     274,299         208,667   

Investments in debt securities, available-for-sale

     22,032         21,127   

Loans held-for-sale, net

     15,793         51,602   

Loans and leases, net

     1,828,193         1,720,789   

Deferred financing costs, net

     21,949         19,064   

Interest receivable

     9,952         9,003   

Property and equipment, net

     323         433   

Deferred income taxes, net

     30,658         42,463   

Income tax receivable

     8,102         4,311   

Other assets

     32,181         52,399   
  

 

 

    

 

 

 

Subtotal

     2,331,454         2,157,070   

Assets of Consolidated Variable Interest Entity:

     

Restricted cash

     2,009         0   

Loans, net

     129,218         0   

Deferred financing costs, net

     1,011         0   

Interest receivable

     898         0   

Other assets

     4,290         0   
  

 

 

    

 

 

 

Total assets of Consolidated Variable Interest Entity

     137,426         0   
  

 

 

    

 

 

 

Total assets

   $ 2,468,880       $ 2,157,070   
  

 

 

    

 

 

 

Liabilities:

     

Credit facilities

   $ 162,280       $ 229,941   

Term debt

     1,502,700         1,221,764   

Repurchase agreements

     27,476         30,583   

Accrued interest payable

     3,182         3,330   

Accounts payable

     1,486         404   

Other liabilities

     42,585         76,231   
  

 

 

    

 

 

 

Subtotal

     1,739,709         1,562,253   

Liabilities of Consolidated Variable Interest Entity:

     

Credit facilities

     93,048         0   

Accrued interest payable – credit facilities

     368         0   

Subordinated debt - Fund membership interest

     25,061         0   

Accrued interest payable – Fund membership interest

     766         0   
  

 

 

    

 

 

 

Total liabilities of Consolidated Variable Interest Entity

     119,243         0   
  

 

 

    

 

 

 

Total liabilities

     1,858,952         1,562,253   
  

 

 

    

 

 

 

 

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

 

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Table of Contents

NEWSTAR FINANCIAL, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS, continued

 

     September 30,
2013
    December 31,
2012
 
     (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 2013 and 2012;

    

Shares outstanding 48,670,677 in 2013 and 49,311,008 in 2012

     487        493   

Additional paid-in capital

     654,003        646,299   

Accumulated deficit

     (3,149     (20,726

Common stock held in treasury, at cost $0.01 par value; 4,602,239 in 2013 and 3,646,290 in 2012

     (42,576     (31,243

Accumulated other comprehensive income (loss), net

     505        (6
  

 

 

   

 

 

 

Total NewStar Financial, Inc. stockholders’ equity

     609,270        594,817   

Retained earnings of Consolidated Variable Interest Entity

     658        0   
  

 

 

   

 

 

 

Total stockholders’ equity

     609,928        594,817   
  

 

 

   

 

 

 

Total liabilities and stockholders’ equity

   $ 2,468,880      $ 2,157,070   
  

 

 

   

 

 

 

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,  
     2013     2012     2013     2012  
     ($ in thousands, except per share amounts)  

Net interest income:

        

Interest income

   $ 30,370      $ 30,812      $ 95,401      $ 90,945   

Interest expense

     11,703        9,074        30,798        26,607   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income

     18,667        21,738        64,603        64,338   

Provision for credit losses

     2,381        3,712        7,429        6,752   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income after provision for credit losses

     16,286        18,026        57,174        57,586   

Non-interest income:

        

Fee income

     1,050        1,074        2,591        3,398   

Asset management income – related party

     592        718        1,971        2,188   

Loss on derivatives

     (45     (57     (131     (258

Gain (loss) on sale of loans

     0        0        72        (418

Other income

     3,534        1,451        5,192        2,866   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total non-interest income

     5,131        3,186        9,695        7,776   

Operating expenses:

        

Compensation and benefits

     7,405        7,832        25,020        23,101   

General and administrative expenses

     4,120        2,843        12,185        11,627   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total operating expenses

     11,525        10,675        37,205        34,728   
  

 

 

   

 

 

   

 

 

   

 

 

 

Operating income before income taxes

     9,892        10,537        29,664        30,634   

Results of Consolidated Variable Interest Entity:

        

Interest income

     1,991        0        2,891        0   

Interest expense – credit facilities

     692        0        1,026        0   

Interest expense – Fund membership interest

     433        0        782        0   

Other income

     18        0        34        0   

Operating expenses

     10        0        14        0   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net results from Consolidated Variable Interest Entity

     874        0        1,103        0   

Income before income taxes

     10,766        10,537        30,767        30,634   

Income tax expense

     4,329        4,471        12,532        12,869   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income

   $ 6,437      $ 6,066      $ 18,235      $ 17,765   
  

 

 

   

 

 

   

 

 

   

 

 

 

Basic income per share

   $ 0.13      $ 0.13      $ 0.38      $ 0.38   

Diluted income per share

     0.12        0.11        0.34        0.34   

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

 

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Table of Contents

NEWSTAR FINANCIAL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

Unaudited

 

     Three Months Ended September 30,      Nine Months Ended September 30,  
     2013      2012      2013      2012  
     ($ in thousands, except per share amounts)  

Net income

   $ 6,437       $ 6,066       $ 18,235       $ 17,765   

Other comprehensive income, net of tax:

           

Net unrealized securities gains, net of tax expense of $359,$969,$298 and $1,136, respectively

     519         1,442         439         1,680   

Net unrealized derivative gains, net of tax expense of $16, $23,$56 and $93, respectively

     21         35         72         117   
  

 

 

    

 

 

    

 

 

    

 

 

 

Other comprehensive income

     540         1,477         511         1,797   
  

 

 

    

 

 

    

 

 

    

 

 

 

Comprehensive income

   $ 6,977       $ 7,543       $ 18,746       $ 19,562   
  

 

 

    

 

 

    

 

 

    

 

 

 

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  
    Common
Stock
    Additional
Paid-in
Capital
    Accumulated
Deficit
    Treasury
Stock
    Accumulated
Other
Comprehensive
Income

(Loss), net
    Retained Earnings
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   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
    NewStar Financial, Inc. Stockholders’ Equity  
    Common
Stock
    Additional
Paid-in
Capital
    Accumulated
Deficit
    Treasury
Stock
    Accumulated
Other
Comprehensive
Loss, net
    Retained Earnings
of Consolidated
VIE
    Common
Stockholders’
Equity
 
    ($ in thousands)  

Balance at January 1, 2012

  $ 494      $ 635,389      $ (44,703   $ (25,420   $ (1,998   $ 0      $ 563,762   

Net income

    0        0        17,765        0        0        0        17,765   

Other comprehensive income

    0        0        0        0        1,797        0        1,797   

Issuance of restricted stock

    1        (1     0        0        0        0        0   

Net shares reacquired from employee transactions

    0        0        0        (40     0        0        (40

Tax benefit from vesting of restricted common stock awards

    0        98        0        0        0        0        98   

Repurchase of common stock

    (2     2        0        (2,596     0        0        (2,596

Exercise of common stock options

    1        663        0        0        0        0        664   

Amortization of restricted common stock awards

    0        4,813        0        0        0        0        4,813   

Amortization of stock option awards

    0        373        0        0        0        0        373   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at September 30, 2012

  $ 494      $ 641,337      $ (26,938   $ (28,056   $ (201   $ 0      $ 586,636   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

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

 

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Table of Contents

NEWSTAR FINANCIAL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

Unaudited

 

     Nine Months Ended September 30,  
     2013     2012  
     ($ in thousands)  

Cash flows from operating activities:

    

Net income

   $ 18,235      $ 17,765   

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

    

Provision for credit losses

     7,429        6,752   

Depreciation and amortization and accretion

     (9,219     (6,539

Amortization of debt issuance costs

     4,877        3,223   

Equity compensation expense

     3,507        5,186   

Loss (gain) on sale of loans

     (72     418   

Gain on repurchase of debt

     (442     (2,215

Losses (gains) from equity method investments

     (988     629   

Losses on other real estate owned

     0        324   

Net change in deferred income taxes

     11,805        1,466   

Loans held-for-sale originated

     (26,752     (81,979

Proceeds from sale and repayment of loans held-for-sale

     62,561        71,723   

Net change in interest receivable

     (949     940   

Net change in other assets

     17,548        (6,328

Net change in accrued interest payable

     (148     324   

Net change in accounts payable and other liabilities

     (33,039     43,216   

Consolidated Variable Interest Entity:

    

Amortization of debt issuance costs

     99        0   

Depreciation and amortization and accretion

     (126     0   

Net change in interest receivable

     (898     0   

Net change in other assets

     (4,290     0   

Net change in accrued interest payable

     1,134        0   
  

 

 

   

 

 

 

Net cash provided by operating activities

     50,272        54,905   
  

 

 

   

 

 

 

Cash flows from investing activities:

    

Net change in restricted cash

     (65,632     (67,572

Net change in loans

     (104,341     (62,531

Acquisition of property and equipment

     (86     (167

Consolidated Variable Interest Entity:

    

Net change in loans

     (130,149     0   

Net change in restricted cash

     (2,009     0   
  

 

 

   

 

 

 

Net cash used in investing activities

     (302,217     (130,270
  

 

 

   

 

 

 

Cash flows from financing activities:

    

Proceeds from exercise of stock options

     309        663   

Tax benefit from vesting of restricted stock

     3,882        98   

Borrowings on credit facilities

     739,143        410,978   

Repayment of borrowings on credit facilities

     (806,804     (229,371

Issuance of term debt

     303,600        0   

Borrowings on term debt

     172,572        93,400   

Repayment of borrowings on term debt

     (194,794     (154,337

Repayment of borrowings on repurchase agreements

     (3,107     (24,090

Payment of deferred financing costs

     (7,762     (3,632

Purchase of treasury stock

     (11,333     (2,636

Consolidated Variable Interest Entity:

    

Borrowings on credit facilities

     98,548        0   

Repayment of borrowings on credit facilities

     (5,500     0   

Borrowings on subordinated debt

     25,061        0   

Payment of deferred financing costs

     (1,110     0   
  

 

 

   

 

 

 

Net cash provided by financing activities

     312,705        91,073   
  

 

 

   

 

 

 

Net increase in cash during the period

     60,760        15,708   

Cash and cash equivalents at beginning of period

     27,212        18,468   
  

 

 

   

 

 

 

Cash and cash equivalents at end of period

   $ 87,972      $ 34,176   
  

 

 

   

 

 

 

 

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,  
     2013      2012  
     ($ in thousands)  

Supplemental cash flows information:

     

Interest paid

   $ 31,620       $ 26,284   

Taxes paid

     943         10,809   

Increase in fair value of investments in debt securities

     737         2,816   

Transfer of asset to OREO

     0         14,884   

Transfer of loans, net to loans held-for-sale

     0         14,587   

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

 

   

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

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, 2012.

Principles of Consolidation

These interim condensed consolidated financial statements include the financial statements of NewStar and Arlington Fund (defined below), its variable interest entity (“VIE”) for which the Company is deemed to be the primary beneficiary.

On April 8, 2013, the Company announced that it had 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 retains full discretion over Arlington Fund’s investment decisions, subject to usual and customary limitations, and earns management fees as compensation for its services. Consolidation of the financial results of Arlington Fund with the Company’s results of operations and statements of financial position began in April 2013.

 

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Note 3. Loans Held-for-Sale, Loans 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, manages an existing portfolio of first mortgage debt which was 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 NewStar Arlington Fund LLC (“Arlington Fund”), a credit fund managed by the Company formed in April 2013) or impaired loans for which a sale of the loan is expected as a result of a workout strategy. At September 30, 2013 loans held-for-sale were $15.8 million and consisted of leveraged finance loans to two 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, 2013 and December 31, 2012, loans held-for-sale consisted of the following:

 

     September 30,
2013
    December 31,
2012
 
     ($ in thousands)  

Leveraged Finance

   $ 15,829      $ 52,120   
  

 

 

   

 

 

 

Gross loans

     15,829        52,120   

Deferred loan fees, net

     (36     (518
  

 

 

   

 

 

 

Total loans, net

   $     15,793      $ 51,602   
  

 

 

   

 

 

 

The Company sold loans with an outstanding balance totaling $28.5 million for an aggregate gain of $0.1 million to entities other than the NewStar Credit Opportunities Fund, Ltd. (“NCOF”) or the Arlington Fund during the nine months ended September 30, 2013. The Company sold loans with an aggregate outstanding balance of $33.1 million for a loss of $0.4 million to entities other than the NCOF during the nine months ended September 30, 2012.

As of September 30, 2013 and December 31, 2012, loans and leases consisted of the following:

 

     September 30,
2013
    December 31,
2012
 
     ($ in thousands)  

Leveraged Finance

   $ 1,626,181      $ 1,422,415   

Business Credit

     277,657        196,952   

Real Estate

     110,211        177,478   
  

 

 

   

 

 

 

Gross loans and leases

     2,014,049        1,796,845   

Deferred loan fees, net

     (16,641     (26,420

Allowance for loan and lease losses

     (39,997     (49,636
  

 

 

   

 

 

 

Total loans and leases, net

   $ 1,957,411      $ 1,720,789   
  

 

 

   

 

 

 

As of September 30, 2013 and December 31, 2012, Equipment Finance leases totaled $29.4 million and $17.3 million, respectively, and are included in the Business Credit balances.

 

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Table of Contents

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. 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 below a specified threshold are typically classified as “Pass”, and loans and leases rated above that threshold are typically classified as “Criticized”, a characterization that may apply to impaired loans, including TDR. As of September 30, 2013, $210.4 million of the Company’s loans were classified as “Criticized”, including $184.5 million of the Company’s impaired loans, and $1.8 billion were classified as “Pass”. As of December 31, 2012, $267.2 million of the Company’s loans were classified as “Criticized”, including $237.6 million of the Company’s impaired loans, and $1.5 billion were classified as “Pass”.

When the Company rates a loan above a certain risk rating threshold, 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, 2013, the Company had impaired loans with an aggregate outstanding balance of $310.8 million. Impaired loans with an aggregate outstanding balance of $263.9 million have been restructured and classified as TDR. As of September 30, 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 $41.7 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, 2013, the Company charged off $0.9 and $14.9 million, respectively, of outstanding non-accrual loans. During the nine months ended September 30, 2013, the Company placed loans with an aggregate outstanding balance of $14.6 million on non-accrual status and took loans with an aggregate outstanding balance of $17.8 million off of non-accrual status. During the three and nine months ended September 30, 2013, the Company recorded $2.4 million and $9.3 million, respectively, of net specific provisions for impaired loans. At September 30, 2013, the Company had a $22.4 million specific allowance for impaired loans with an aggregate outstanding balance of $147.4 million. At September 30, 2013, additional funding commitments for impaired loans totaled $22.4 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, 2013, $6.3 million of loans on non-accrual status were greater than 60 days past due and classified as delinquent by the Company. Included in the $22.4 million specific allowance for impaired loans was $1.7 million related to delinquent loans.

 

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Table of Contents

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 fair value of $13.0 million as of September 30, 2013 and as of December 31, 2012.

As of December 31, 2012, the Company had impaired loans with an aggregate outstanding balance of $324.4 million. Impaired loans with an aggregate outstanding balance of $263.7 million have been restructured and classified as TDR. As of December 31, 2012, the aggregate carrying value of equity investments in certain of the Company’s borrowers in connection with troubled debt restructurings totaled $7.7 million. Impaired loans with an aggregate outstanding balance of $72.7 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 2012, the Company charged off $19.1 million of outstanding non-accrual loans and recovered $1.6 million of previously charged-off impaired loan outstanding balances. During 2012, the Company took previously identified non-accrual loans with an aggregate outstanding balance of $16.2 million as of December 31, 2011 off non-accrual status and placed loans with an aggregate outstanding balance of $22.7 million as of December 31, 2012 on non-accrual status. During 2012, the Company recorded $16.7 million of net specific provisions for impaired loans. At December 31, 2012, the Company had a $30.2 million specific allowance for impaired loans with an aggregate outstanding balance of $192.1 million. At December 31, 2012, additional funding commitments for impaired loans totaled $33.6 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 December 31, 2012, $62.7 million of loans on non-accrual status were greater than 60 days past due and classified as delinquent by the Company. Included in the $30.2 million specific allowance for impaired loans was $6.4 million related to delinquent loans.

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, 2013

           

Leveraged Finance

   $ 238,848       $ 286,942       $ 117,830       $ 121,018   

Business Credit

     466         616         0         466   

Real Estate

     71,451         71,540         29,575         41,876   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 310,765       $ 359,098       $ 147,405       $ 163,360   
  

 

 

    

 

 

    

 

 

    

 

 

 

December 31, 2012

           

Leveraged Finance

   $ 214,359       $ 277,702       $ 131,261       $ 83,098   

Business Credit

     1,821         2,652         0         1,821   

Real Estate

     108,188         117,054         60,871         47,317   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $     324,368       $     397,408       $ 192,132       $ 132,236   
  

 

 

    

 

 

    

 

 

    

 

 

 

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 months ended September 30, 2012 the Company recorded recoveries of previously charged-off loans of $0.3 million. During the nine months ended September 30, 2012 the Company recorded net partial charge-offs of $11.8 million. The Company’s general policy is to record a specific allowance for an impaired loan when the Company determines that it is doubtful that it will be able to collect all amounts due according to the contractual terms of the 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, charge-offs lower the level of the allowance for loan losses; and, as a result, reduce the percentage of allowance for loans to total loans, and the percentage of allowance for loan losses to non-performing loans.

 

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Table of Contents

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  

September 30, 2013

   Investment      Allowance      Investment      Allowance      Investment      Allowance  
     ($ in thousands)  

Collectively evaluated (1)

   $ 1,387,333       $ 16,178       $ 277,191       $ 1,013       $ 38,760       $ 436   

Individually evaluated (2)

     238,848         18,657         466         0         71,451         3,713   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 1,626,181       $ 34,835       $ 277,657       $ 1,013       $ 110,211       $ 4,149   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

     Leveraged Finance      Business Credit      Real Estate  

December 31, 2012

   Investment      Allowance      Investment      Allowance      Investment      Allowance  
     ($ in thousands)  

Collectively evaluated (1)

   $ 1,208,056       $ 18,063       $ 195,131       $ 707       $ 69,290       $ 653   

Individually evaluated (2)

     214,359         21,578         1,821         0         108,188         8,635   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 1,422,415       $ 39,641       $ 196,952       $ 707       $ 177,478       $ 9,288   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

(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 5.0 based on the Company’s internally developed 12 point scale at September 30, 2013 and 5.1 at December 31, 2012.
(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, 2013      December 31, 2012  
     ($ in thousands)  

Leveraged Finance

   $ 33,545       $ 66,407   

Business Credit

     466         1,821   

Real Estate

     7,648         4,458   
  

 

 

    

 

 

 

Total

   $ 41,659       $ 72,686   
  

 

 

    

 

 

 

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 upon 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.

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 charge-offs

 

   

  partial forgiveness

 

   

  conversion of debt to equity

 

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Table of Contents

A summary of the types of concessions that the Company made with respect to TDRs at September 30, 2013 and December 31, 2012 is provided below:

 

     Group I      Group II  
     ($ in thousands)  

September 30, 2013

   $  263,884       $  175,621   

December 31, 2012

   $ 263,670       $ 145,328   

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, 2013, the Company had partial charge-offs totaling $0 and $8.4 million, respectively related to loans previously classified as TDR. As of September 30, 2013, the Company had not removed the TDR classification from any loan previously identified as such.

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 level of impairment on the loan.

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

 

For the Three Months Ended

September 30, 2013

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

Leveraged Finance

   $ 18,124       $ 18,124       $ 0   

Business Credit

     0         0         0   

Real Estate

     0         0         0   
  

 

 

    

 

 

    

 

 

 

Total

   $ 18,124       $ 18,124       $ 0   
  

 

 

    

 

 

    

 

 

 

For the Nine Months Ended

September 30, 2013

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

Leveraged Finance

   $ 23,580       $ 23,580       $ 1,855   

Business Credit

     0         0         0   

Real Estate

     0         0         8,976   
  

 

 

    

 

 

    

 

 

 

Total

   $ 23,580       $ 23,580       $ 10,831   
  

 

 

    

 

 

    

 

 

 

For the Year Ended

December 31, 2012

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

Leveraged Finance

   $ 22,190       $ 22,190       $ 21,668   

Business Credit

     0         0         0   

Real Estate

     47,544         47,544         0   
  

 

 

    

 

 

    

 

 

 

Total

   $ 69,734       $ 69,734       $ 21,668   
  

 

 

    

 

 

    

 

 

 

 

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Table of Contents

The following sets forth a breakdown of troubled debt restructurings at September 30, 2013 and December 31, 2012:

 

As of September 30, 2013    Accrual Status                    For the nine
months
 

($ in thousands)

Loan Type

   Accruing      Nonaccrual      Impaired
Balance
     Specific
Allowance
     Charged-
off
 

Leveraged Finance

   $ 189,605       $ 32,402       $ 222,007       $ 18,190       $ 8,447   

Business Credit

     0         0         0         0         0   

Real Estate

     34,229         7,648         41,877         0         0   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 223,834       $ 40,050       $ 263,884       $ 18,190       $ 8,447   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 
As of December 31, 2012    Accrual Status                    For the
year
 

($ in thousands)

Loan Type

   Accruing      Nonaccrual      Impaired
Balance
     Specific
Allowance
     Charged-
off
 

Leveraged Finance

   $ 135,757       $ 57,703       $ 193,460       $ 18,475       $ 12,614   

Business Credit

     0         0         0         0         0   

Real Estate

     65,768         4,442         70,210         1,969         5,612   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 201,525       $ 62,145       $ 263,670       $ 20,444       $ 18,226   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

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

An aged 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, 2013

                 

Leveraged Finance

   $ 0       $ 5,839       $ 5,839       $ 1,620,342       $ 1,626,181       $ 0   

Business Credit

     0         0         0         277,657         277,657         0   

Real Estate

     0         466         466         109,745         110,211         0   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 0       $ 6,305       $ 6,305       $ 2,003,744       $ 2,014,049       $ 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, 2012

                 

Leveraged Finance

   $ 2,997       $ 55,277       $ 58,274       $ 1,364,141       $ 1,422,415       $ 21,003   

Business Credit

     0         1,821         1,821         195,131         196,952         0   

Real Estate

     0         4,458         4,458         173,020         177,478         0   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 2,997       $ 61,556       $ 64,553       $ 1,732,292       $ 1,796,845       $ 21,003   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

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 or profile.

For Leveraged Finance loans and equipment finance 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.

 

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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 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.

If the Company determines that additional 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. 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 for all loans for which we have serious doubts as to the ability of the borrowers to comply with the present loan repayment terms.

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

 

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

Balance, beginning of period

   $ 32,166      $ 805      $ 5,988       $ 38,959   

Provision for credit losses—general

     137        232        (434      (65

Provision for credit losses—specific

     3,849        0        (1,403      2,446   

Loans charged off, net of recoveries

     (871     (24     0         (895
  

 

 

   

 

 

   

 

 

    

 

 

 

Balance, end of period

   $ 35,281      $ 1,013      $ 4,151       $ 40,445   
  

 

 

   

 

 

   

 

 

    

 

 

 

Balance, end of period—specific

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

 

 

   

 

 

   

 

 

    

 

 

 

Balance, end of period—general

   $ 16,624      $ 1,013      $ 438       $ 18,075   
  

 

 

   

 

 

   

 

 

    

 

 

 

Average balance of impaired loans

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

Interest recognized from impaired loans

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

Loans and leases

         

Loans individually evaluated with specific allowance

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

Loans individually evaluated with no specific allowance

     121,018        466        41,876         163,360   

Loans acquired with deteriorating credit quality

     0        0        0         0   

Loans and leases collectively evaluated without specific allowance

     1,387,333        277,191        38,760         1,703,284   
  

 

 

   

 

 

   

 

 

    

 

 

 

Total loans and leases

   $ 1,626,181      $ 277,657      $ 110,211       $ 2,014,049   
  

 

 

   

 

 

   

 

 

    

 

 

 

 

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

Balance, beginning of period

   $ 39,971      $ 707      $ 9,286      $ 49,964   

Provision for credit losses—general

     (1,781     330        (434     (1,885

Provision for credit losses—specific

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

Loans charged off, net of recoveries

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

 

 

   

 

 

   

 

 

   

 

 

 

Balance, end of period

   $ 35,281      $ 1,013      $ 4,151      $ 40,445   
  

 

 

   

 

 

   

 

 

   

 

 

 

Average balance of impaired loans

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

Interest recognized from impaired loans

   $ 11,566      $ 80      $ 2,013      $ 13,659   
     Three Months Ended September 30, 2012  
     Leveraged
Finance
    Business
Credit
    Real Estate     Total  
     ($ in thousands)  

Balance, beginning of period

   $ 43,975      $ 672      $ 10,687      $ 55,334   

Provision for credit losses—general

     (881     6        (24     (899

Provision for credit losses—specific

     4,834        0        (223     4,611   

Loans charged off, net of recoveries

     305        0        0        305   
  

 

 

   

 

 

   

 

 

   

 

 

 

Balance, end of period

   $ 48,233      $ 678      $ 10,440      $ 59,351   
  

 

 

   

 

 

   

 

 

   

 

 

 

Balance, end of period—specific

   $ 32,382      $ 0      $ 5,280      $ 37,662   
  

 

 

   

 

 

   

 

 

   

 

 

 

Balance, end of period—general

   $ 15,851      $ 678      $ 5,160      $ 21,689   
  

 

 

   

 

 

   

 

 

   

 

 

 

Average balance of impaired loans

   $ 236,786      $ 2,393      $ 75,279      $ 314,458   

Interest recognized from impaired loans

   $ 3,722      $ 0      $ 1,079      $ 4,801   

Loans

        

Loans individually evaluated with specific allowance

   $ 153,370      $ 0      $ 43,503      $ 196,873   

Loans individually evaluated with no specific allowance

     73,557        0        39,394        112,951   

Loans previously acquired with deteriorating credit quality

     0        1,822        0        1,822   

Loans collectively evaluated without specific allowance

     1,219,361        195,002        122,309        1,536,672   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total loans and leases

   $ 1,446,288      $ 196,824      $ 205,206      $ 1,848,318   
  

 

 

   

 

 

   

 

 

   

 

 

 
     Nine Months Ended September 30, 2012  
     Leveraged
Finance
    Business
Credit
    Real Estate     Total  
     ($ in thousands)  

Balance, beginning of period

   $ 44,553      $ 374      $ 19,185      $ 64,112   

Provision for credit losses—general

     (950     304        (1,404     (2,050

Provision for credit losses—specific

     7,127        0        1,675        8,802   

Loans charged off, net of recoveries

     (2,497     0        (9,016     (11,513
  

 

 

   

 

 

   

 

 

   

 

 

 

Balance, end of period

   $ 48,233      $ 678      $ 10,440      $ 59,351   
  

 

 

   

 

 

   

 

 

   

 

 

 

Average balance of impaired loans

   $ 237,258      $ 2,620      $ 88,377      $ 328,255   

Interest recognized from impaired loans

   $ 10,914      $ 0      $ 2,456      $ 13,370   

Included in the allowance for credit losses at September 30, 2013 and December 31, 2012 is an allowance for unfunded commitments of $0.4 million and $0.3 million, 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.

 

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During the nine months ended September 30, 2013, the Company recorded a total provision for credit losses of $7.4 million. The Company decreased its allowance for credit losses to $40.4 million as of September 30, 2013 from $50.0 million at December 31, 2012. The Company had $16.9 million of net charge-offs of impaired loans with a specific allowance and reduced its allowance for credit losses by 77 basis points during the nine months ended September 30, 2013, offset by new specific provisions for credit losses. 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 15% as of September 30, 2013 and 19% as of December 31, 2012.

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, 2013 in light of the estimated known and inherent risks identified through its analysis.

Note 4. Restricted Cash

Restricted cash as of September 30, 2013 and December 31, 2012 was as follows:

 

     September 30,
2013
     December 31,
2012
 
     ($ in thousands)  

Collections on loans pledged to credit facilities

   $ 85,408       $ 47,944   

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

     190,205         159,257   

Customer escrow accounts

     695         1,466   
  

 

 

    

 

 

 

Total

   $ 276,308       $ 208,667   
  

 

 

    

 

 

 

As of September 30, 2013, the Company had the ability to use $11.6 million of restricted cash to fund new or existing loans. At December 31, 2012, $78.6 million of restricted cash was designated to fund loans for the Company’s 2012-2 CLO, which were funded during the three months ended March 31, 2013.

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

Amortized cost of investments in debt securities as of September 30, 2013 and December 31, 2012 was as follows:

 

     September 30,
2013
    December 31,
2012
 
     ($ in thousands)  

Investments in debt securities—gross

   $ 25,298      $ 25,298   

Unamortized discount

     (4,154     (4,322
  

 

 

   

 

 

 

Investments in debt securities—amortized cost

   $ 21,144      $ 20,976   
  

 

 

   

 

 

 

 

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The amortized cost, gross unrealized holding gains, gross unrealized holding losses, and fair value of available-for-sale securities at September 30, 2013 and December 31, 2012 were as follows:

 

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

September 30, 2013:

          

Collateralized loan obligations

   $ 21,144       $ 1,262      $ (374   $ 22,032   
  

 

 

    

 

 

    

 

 

   

 

 

 
   $ 21,144       $ 1,262      $ (374   $ 22,032   
  

 

 

    

 

 

    

 

 

   

 

 

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

December 31, 2012:

          

Collateralized loan obligations

   $ 20,976       $ 1,105       $ (954   $ 21,127   
  

 

 

    

 

 

    

 

 

   

 

 

 
   $ 20,976       $ 1,105      $ (954   $ 21,127   
  

 

 

    

 

 

    

 

 

   

 

 

 

 

The Company did not sell any debt securities during the nine months ended September 30, 2013 and 2012.

The Company did not record any Other-Than-Temporary Impairment charges during the nine months ended September 30, 2013 and 2012.

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, 2013 and December 31, 2012:

 

     September 30, 2013  
     Less than
12 Months
     Greater than
or Equal to
12 Months
     Total  
     ($ in thousands)  

Number of positions

     0         2         2   

Fair value

   $ 0       $ 8,259       $ 8,259   

Amortized cost

     0         8,633         8,633   
  

 

 

    

 

 

    

 

 

 

Unrealized loss

   $ 0       $ 374       $ 374   
  

 

 

    

 

 

    

 

 

 
     December 31, 2012  
     Less than
12 Months
     Greater than
or Equal to
12 Months
     Total  
     ($ in thousands)  

Number of positions

     0         4         4   

Fair value

   $ 0       $ 13,247       $ 13,247   

Amortized cost

     0         14,201         14,201   
  

 

 

    

 

 

    

 

 

 

Unrealized loss

   $ 0       $ 954       $ 954   
  

 

 

    

 

 

    

 

 

 

As a result of the Company’s evaluation of the securities, management concluded that the unrealized losses at September 30, 2013 and December 31, 2012 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 September 30, 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, 2013 and December 31, 2012 (maturities of asset-backed and mortgage-backed securities have been allocated based upon estimated maturities, assuming no change in the current interest rate environment):

 

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     September 30, 2013      December 31, 2012  
     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

     21,144         22,032         20,976         21,127   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 21,144       $ 22,032       $ 20,976       $ 21,127   
  

 

 

    

 

 

    

 

 

    

 

 

 

Note 6. Borrowings

Credit Facilities

As of September 30, 2013 the Company had four credit facilities: (i) a $175 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 $75 million credit facility with Wells Fargo to fund asset-based loans, and (iv) a $75 million credit facility with Wells Fargo to fund new equipment lease origination. As of September 30, 2013, Arlington Fund had one credit facility, consisting of a $147.0 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 is eliminated in consolidation in accordance with GAAP.

The Company has a $175.0 million credit facility with Wells Fargo to fund leverage finance loans with the ability to further increase the commitment amount to $200.0 million, subject to lender approval and other customary conditions. The credit facility had an outstanding balance of $21.0 and unamortized deferred financing fees of $3.0 million as of September 30, 2013. The facility provides for a revolving reinvestment period which ends on November 5, 2015 with a two-year amortization period. The Company must comply with various covenants, the breach of which could result in a termination event if not cured. These covenants include, but are not limited to, failure to service debt obligations, failure to maintain minimum levels of liquidity, and failure to meet tangible net worth covenants and overcollateralization tests. At September 30, 2013, the Company was in compliance with all such covenants. Interest on this facility accrued at a variable rate per annum.

The Company has a $125.0 million credit facility with DZ Bank that had an outstanding balance of $77.6 million and unamortized fees of $0.8 million as of September 30, 2013. 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 matures on June 30, 2015.

The Company has a $75.0 million credit facility with Wells Fargo to fund asset-based loan origination. The credit facility had an outstanding balance of $57.7 million and unamortized deferred financing fees of $0.4 million as of September 30, 2013. Interest on this facility accrues at a variable rate per annum. The credit facility may be increased to an amount up to $150.0 million subject to lender approval and other customary conditions. The credit facility matures on December 7, 2015. The Company must comply with various covenants, the breach of which could result in a termination event if not cured. These covenants include, but are not limited to, failure to service debt obligations, net worth covenants, interest coverage ratios, minimum excess availability and violations of pool default and charged off tests.

The Company has a note purchase agreement with Wells Fargo under the terms of which Wells Fargo agreed to provide a $75.0 million credit facility to fund new equipment lease originations. The credit facility matures on November 16, 2016 subject to early termination or extension. The Company must comply with various covenants, the breach of which could result in a termination event if not cured. These covenants include, but are not limited to, failure to service debt obligations, failure to maintain minimum levels of liquidity, failure to meet tangible net worth covenants and violations of pool default and delinquency tests. The credit facility had an outstanding balance of $6.0 million and unamortized deferred financing fees of $1.0 million as of September 30, 2013.

On April 4, 2013, Arlington Fund entered into an agreement establishing $147.0 million of Class A Notes and $28.0 million of Class B Notes to partially fund eligible middle market loan origination. Wells Fargo has committed to fund the Class A Notes as the initial Class A lender and the Company has committed to fund the Class B Notes as the initial Class B lender. Advances under the Class A Notes and the Class B Notes may be drawn, repaid, and drawn again subject to availability under the a borrowing base. The Class A Notes and the Class B Notes provide for a reinvestment period of one year ending on April 4, 2014, unless a one year extension is requested, followed by a three year amortization period. The Class A Notes had an outstanding balance of $93.0 million and unamortized deferred financing fees of $1.0 million as of September 30, 2013. The liability under the Class B Notes is eliminated in consolidation in accordance with GAAP.

 

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The Company had a $175.0 million credit facility agreement with NATIXIS. Interest on this facility accrued at a variable rate per annum. On August 20, 2013, the Company entered into an amendment to this credit facility which among other things increased the commitment amount from $150.0 million to $175.0 million and extended the reinvestment period to the earlier of September 30, 2013 or the closing date of a collateralized loan obligation. The credit facility matures on February 16, 2019. On September 11, 2013, the credit facility was refinanced into the 2013-1 CLO Trust (see below) and borrowing under the credit facility was terminated.

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. The credit facility, as amended, consists of a $200.0 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 $70.0 million (the “Initial Funding”), and two subsequent borrowings, of $5.0 million (the “Delay Draw Term A”) and $25.0 million (the “Delay Draw Term B”). The Existing Funding, the Initial Funding, and the Delay Draw Term A 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 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 subject to a prepayment fee of 1.00% which is payable in the case of certain prepayments made prior to May 13, 2014. The term note may be prepaid at par in the event of a change of control. As of September 30, 2013, the term note had an outstanding principal balance of $200.0 million and unamortized deferred financing fees of $5.3 million.

Subordinated debt – Fund membership interest

As of September 30, 2013, the Company had purchased membership interests totaling $4.2 million in Arlington Fund and a third-party investor had purchased membership interests totaling $25.1 million. As a result of consolidating Arlington Fund as a variable interest entity, or VIE, the membership interests representing equity ownership of Arlington Fund are characterized as debt in the Company’s consolidated statement of financial position. The Company applies an imputed interest rate to that debt and records the resulting interest expense in its consolidated statement of operations. The actual return on investments in Arlington Fund’s membership interests may or may not equal the imputed rate applied to the membership interests that are characterized as debt. In the consolidation, the Company eliminates 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.

Term Debt Securitizations

In August 2005 the Company completed a term debt transaction. In conjunction with this transaction we established a separate single-purpose bankruptcy-remote subsidiary, NewStar Trust 2005-1 (the “2005 CLO Trust”) and contributed $375 million in loans and investments (including unfunded commitments), or portions thereof, to the 2005 CLO Trust. The Company remains the servicer of the loans and investments. Simultaneously with the initial contributions, 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%. At September 30, 2013, the $56.7 million of outstanding notes were collateralized by the specific loans and investments, principal collections account cash and principal payment receivables totaling $88.3 million. At September 30, 2013, deferred financing fees were $0. The 2005 CLO Trust permitted reinvestment of collateral principal repayments for a three-year period which ended in October 2008. During the nine months ended September 30, 2013, the Company repurchased $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 repurchased $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 repurchased $3.9 million of the 2005 CLO Trust’s Class E notes. During 2010, the Company repurchased $4.6 million of the 2005 CLO Trust’s Class D notes. During 2009, the Company repurchased $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 repurchased $5.8 million of the 2005 CLO Trust’s Class E notes. During 2007, the Company repurchased $5.0 million of the 2005 CLO Trust’s Class E notes. During 2009, Moody’s downgraded all of the notes of the 2005 CLO Trust. As a result of the downgrades, amortization of the 2005 CLO Trust changed from pro rata to sequential, resulting in scheduled principal payments made in order of the notes seniority until all available funds are exhausted for each payment. During 2010, Standard and Poor’s downgraded all of the notes of the 2005 CLO Trust. During the first quarter of 2012, Moody’s upgraded the Class A-1 notes, the Class A-2 notes, the Class B notes, the Class C notes, and the Class D notes, and downgraded the Class E notes of the 2005 CLO Trust. During the third quarter of 2012, Fitch affirmed its ratings of all of the notes of the 2005 CLO Trust. During the fourth quarter of 2012, Standard and Poor’s upgraded the Class A-1 notes, the Class A-2 notes and the Class B notes and affirmed the rating of the Class C notes, the Class D notes and the Class E notes of the 2005 CLO Trust. 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.

 

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The Company received loan collateral management fees and excess interest spread. The most recent quarterly report of the 2005 CLO Trust dated July 13, 2013 identified $84.6 million in cumulative charged-off loans in the 2005 CLO Trust as delinquent or charged-off under the terms of the trust indenture. As a result, the excess interest spread from the 2005 CLO Trust was redirected and combined with recoveries and was used to repay a portion of the outstanding notes. As of the July 13, 2013 report, the cumulative amount redirected was $20.9 million.

The following table sets forth selected information with respect to the 2005 CLO Trust:

 

     Notes
originally
issued
     Outstanding
balance
September 30,
2013
     Interest
rate
  Original
maturity
   Ratings
(S&P/Moody’s/
Fitch)(1)
     ($ in thousands)                

2005 CLO Trust:

             

Class A-1

   $ 156,000       $ 0       Libor + 0.28%   July 25, 2018    AAA/Aaa/AAA

Class A-2

     80,477         0       Libor + 0.30%   July 25, 2018    AAA/Aaa/AAA

Class B

     18,750         9,027       Libor + 0.50%   July 25, 2018    AA+/Aa1/AA

Class C

     39,375         34,252       Libor + 0.85%   July 25, 2018    B+/A2/BB

Class D

     24,375         5,979       Libor + 1.50%   July 25, 2018    CCC-/Ba2/CCC

Class E

     24,375         7,471       Libor + 4.75%   July 25, 2018    CCC-/Caa3/CC
  

 

 

    

 

 

         
   $ 343,352       $ 56,729           
  

 

 

    

 

 

         

 

(1) The ratings were initially given in August 2005, are unaudited and are subject to change from time to time. During the first quarter of 2009, Fitch affirmed its ratings and downgraded the Class D notes and Class E notes. The Fitch downgrade did not have a material impact on the 2005 CLO Trust. During the first quarter of 2009, Moody’s downgraded the Class C notes, the Class D notes and the Class E 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 all of the notes. During the third quarter of 2010, Fitch downgraded the Class C notes, the Class D notes and the Class E notes to the ratings shown above. During the first quarter of 2012, Moody’s upgraded the Class A-1 notes, the Class A-2 notes, the Class B notes, the Class C notes, and the Class D notes, and downgraded the Class E notes to the ratings shown above. Fitch affirmed its ratings during the third quarter of 2012. During the fourth quarter of 2012, Standard and Poor’s upgraded the Class A-1 notes, the Class A-2 notes to the ratings shown above and the Class B notes and affirmed the rating of the Class C notes, the Class D notes and the Class E notes (source: Bloomberg Finance L.P.).

In June 2006 the Company completed a term debt 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 contributed $500 million in loans and investments (including unfunded commitments), or portions thereof, to the 2006 CLO Trust. The Company remains the servicer of the loans. Simultaneously with the initial contributions, 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. At September 30, 2013, the $180.7 million of outstanding drawn notes were collateralized by the specific loans and investments, principal collection account cash and principal payment receivables totaling $224.5 million. At September 30, 2013, deferred financing fees were $0. The 2006 CLO Trust permitted reinvestment of collateral principal repayments for a five-year period which ended in June 2011. During 2011, the Company repurchased $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 repurchased $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 repurchased $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 repurchased $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. During 2009, Moody’s downgraded all of the notes of the 2006 CLO Trust. As a result of the downgrade, amortization of the 2006 CLO Trust changed from pro rata to sequential, resulting in future scheduled principal payments 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, the Class D notes and the Class E notes of the 2006 CLO Trust. The downgrade did not have any material consequence as the amortization of the 2006 CLO Trust changed from pro rata to sequential after the Moody’s downgrade in 2009. During 2011, Moody’s upgraded its ratings of all of the notes of the 2006 CLO Trust. During the third quarter of 2012, Fitch affirmed its ratings of all of the notes of the 2006 CLO Trust. During the fourth quarter of 2012, Standard and Poor’s upgraded the Class D notes and the Class E notes and affirmed the rating of the Class A-1 notes, the Class A-2 notes, the Class B notes and the Class C notes of the 2006 CLO Trust.

The Company receives a loan collateral management fee and excess interest spread. The Company expects to receive a principal distribution when the term debt is retired. The most recent quarterly report of the 2006 CLO Trust dated September 13, 2013 identified $22.7 million in cumulative charged-off loans in the 2006 CLO Trust as delinquent or charged-off under the terms of the trust indenture. As a result, the excess interest spread from the 2006 CLO Trust will be redirected and combined with recoveries and will be

 

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used to repay the outstanding notes until note redemptions equal the underlying non-accrual loan balances or until the Company purchases such loans. During 2011, the Company elected to purchase $11.1 million of defaulted collateral from the 2006 CLO Trust to reduce the amount of excess interest spread that otherwise would have been required to be redirected. As of the September 13, 2013 quarterly report, the entire $22.7 million had been redirected or repurchased. The Company may have additional defaults in the 2006 CLO Trust in the future. If the Company does not elect to remove any future defaulted loans, it would not expect to receive excess interest spread payments until the undistributed cash plus any recoveries equal the outstanding balances of defaulted loan collateral.

The following table sets forth the selected information with respect to the 2006 CLO Trust:

 

     Notes
originally
issued
     Outstanding
balance
September 30,
2013
     Interest
rate
  Original
maturity
   Ratings
(S&P/Moody’s/
Fitch)(1)
   ($ in thousands)                

2006 CLO Trust

             

Class A-1

   $ 320,000       $ 105,377       Libor +0.27%   March 30, 2022    AA+/Aaa/AAA

Class A-2

     40,000         14,103       Libor +0.28%   March 30, 2022    AA+/Aaa/AAA

Class B

     22,500         22,500       Libor +0.38%   March 30, 2022    AA/Aa2/AA

Class C

     35,000         28,000       Libor +0.68%   March 30, 2022    BBB+/A3/A

Class D

     25,000         6,250       Libor +1.35%   March 30, 2022    B+/Baa3/BBB

Class E

     13,750         4,500       Libor +1.75%   March 30, 2022    CCC+/Ba1/BB
  

 

 

    

 

 

         
   $ 456,250       $ 180,730           
  

 

 

    

 

 

         

 

(1) These ratings were initially given in June 2006, are unaudited and are subject to change from time to time. During the first quarter of 2009, Fitch affirmed its ratings. During the first quarter of 2009, Moody’s downgraded the Class C notes, the Class D notes and the Class E notes. During the third quarter of 2009, Moody’s downgraded the Class A-1 notes, the Class A-2 notes and the Class B note. 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, the Class D notes and the Class E notes. During the fourth quarter of 2011, Moody’s upgraded all of the notes to the ratings shown above. During the third quarter of 2012, Fitch affirmed its ratings. During the fourth quarter of 2012, Standard and Poor’s upgraded the Class D notes and the Class E notes to the ratings shown above and affirmed the rating of the Class A-1 notes, the Class A-2 notes, the Class B notes and the Class C notes (source: Bloomberg Finance L.P.).

In June 2007 the Company completed a term debt 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 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 contributions, 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, 2013, the $498.3 million of outstanding drawn notes were collateralized by the specific loans and investments, principal collection account cash and principal payment receivables totaling $552.3 million. At September 30, 2013, deferred financing fees were $1.5 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 repurchased $0.2 million of the 2007-1 CLO Trust’s Class C notes. During 2010, the Company repurchased $5.0 million of the 2007-1 CLO Trust’s Class D notes. During 2009, the Company repurchased $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 future scheduled principal payments 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.

The Company receives a loan collateral management fee and excess interest spread. The Company expects to receive a principal distribution 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. The Company may have defaults in the 2007-1 CLO Trust in the future. If the Company does not elect to remove any future defaulted loans, it would not expect to receive excess interest spread payments until the undistributed cash plus any recoveries equal the outstanding balances of any potential defaulted loan 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,
2013
     Interest
rate
  Original
maturity
   Ratings
(S&P/Moody’s/
Fitch)(1)
   ($ in thousands)                

2007-1 CLO Trust

             

Class A-1

   $ 336,500       $ 300,514       Libor +0.24%   September 30, 2022    AA+/Aaa/AAA

Class A-2

     100,000         94,534       Libor +0.26%   September 30, 2022    AA+/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    BBB+/A2/A

Class D

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

 

 

    

 

 

         
   $ 546,000       $ 498,341           
  

 

 

    

 

 

         

 

 

(1) These ratings were initially given in June 2007, are unaudited and are subject to change from time to time. Fitch affirmed its ratings on February 24, 2009. 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 to the ratings shown above, and also downgraded 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 to the rating shown above. During the fourth quarter of 2011, Moody’s upgraded all of the notes. During the third quarter of 2012, Fitch affirmed its ratings. 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 (source: Bloomberg Finance L.P.).

On December 18, 2012, the Company completed a term debt 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 Trust”) and contributed $325.9 million in loans and investments (including unfunded commitments), or portions thereof, to the 2012-2 CLO Trust. The Company remains the servicer of the loans. Simultaneously with the initial contributions, the 2012-2 CLO Trust issued $263.3 million of notes to institutional investors. The Company retained $40.4 million, comprising 100% of the 2012-2 CLO Trust’s trust certificates in addition to the entire $22.2 million of subordinated notes. At September 30, 2013, 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, 2013, deferred financing fees were $3.1 million. The 2012-2 CLO Trust 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 expects to receive a principal distribution when the term debt is retired. If loan collateral in the 2012-2 CLO Trust is in default under the terms of the indenture, the excess interest spread from the 2012-2 CLO Trust may not be distributed if the overcollateralization ratio, or if other collateral quality tests, are not satisfied. The Company may have defaults in the 2012-2 CLO Trust in the future. If the Company does not elect to remove any future defaulted loans, it may not receive excess interest spread payments until the overcollateralization ratio, or other collateral quality tests, are cured.

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

 

     Notes
originally
issued
     Outstanding
balance
September 30,
2013
     Interest
rate
  Original
maturity
   Ratings
(Moody’s/
S&P)(1)
   ($ in thousands)                

2012-2 CLO Trust

             

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 transaction through its separate single-purpose bankruptcy-remote subsidiary, NewStar Commercial Loan Funding 2013-1 LLC (the “2013-1 CLO Trust”) and contributed $247.6 million in loans and investments (including unfunded commitments), or portions thereof, to the 2013-1 CLO Trust. The Company remains the servicer of the loans. Simultaneously with the initial contributions, the 2013-1 CLO Trust issued $338.6 million of notes to institutional investors. The Company retained $61.4 million, comprising 100% of the 2013-1 CLO Trust’s trust certificates in addition to the entire $32.6 million of subordinated notes. At September 30, 2013, the $303.6 million of outstanding drawn notes were collateralized by the specific loans and investments, principal collection account cash and principal payment receivables totaling $365.0 million. At September 30, 2013, deferred financing fees were $5.6 million. The 2013-1 CLO Trust 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 expects to receive a principal distribution when the term debt is retired. If loan collateral in the 2013-1 CLO Trust is in default under the terms of the indenture, the excess interest spread from the 2013-1 CLO Trust may not be distributed if the overcollateralization ratio, or if other collateral quality tests, are not satisfied. The Company may have defaults in the 2013-1 CLO Trust in the future. If the Company does not elect to remove any future defaulted loans, it may not receive excess interest spread payments until the overcollateralization ratio, or other collateral quality tests, are cured.

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

 

     Notes
originally
issued
     Outstanding
balance
September 30,
2013
     Interest
rate
    Original
maturity
   Ratings
(S&P/
Moody’s)(2)
   ($ in thousands)                  

2013-1 CLO Trust

             

Class A-T

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

Class A-R

     35,000         0         (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       $ 303,600           
  

 

 

    

 

 

         

 

(1) Class A-R Notes will 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.

Note 7. Repurchase Agreement

 

Loans sold under agreements to repurchase

   Nine Months  Ended
September 30, 2013
    Year Ended
December 31, 2012
 
     ($ in thousands)  

Outstanding at end of period

   $ 27,476      $ 30,583   

Maximum outstanding at any month end

     30,416        60,500   

Average balance for the period

     28,696        48,817   

Weighted average rate at end of period

     5.18     5.21

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 (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

 

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$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 5.18% as of September 30, 2013. As of September 30, 2013, unamortized deferred financing fees were $1.1 million and the outstanding balance was $27.5 million. During the nine months ended September 30, 2013, the Company made principal payments totaling $3.1 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, 2013 and December 31, 2012, the Company’s authorized capital consists of preferred and common stock and the following was authorized and outstanding:

 

     September 30, 2013      December 31, 2012  
     Shares
authorized
     Shares
outstanding
     Shares
authorized
     Shares
outstanding
 
     (In thousands)  

Preferred stock

     5,000         0        5,000         0  

Common stock

     145,000         48,671         145,000         49,311   
  

 

 

    

 

 

    

 

 

    

 

 

 

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

In connection with the Company’s initial public offering on December 13, 2006, the Company issued and sold 12,000,000 shares of its common stock. On December 19, 2006, the underwriters of the initial public offering purchased an additional 1,800,000 shares of the Company’s common stock.

On November 12, 2007, the Company entered into a definitive agreement with institutional investors to issue 12.5 million shares of the Company’s common stock in a private placement at a price per share of $10.00. The gross proceeds from the offering, which closed in two tranches, were $125 million. The first tranche of 7.25 million shares closed on November 29, 2007. The second tranche of 5.25 million shares was subject to the Company obtaining stockholder approval, and was approved at a special meeting of stockholders held on January 15, 2008. The second tranche closed on January 18, 2008.

In connection with the private placement, the Company entered into a Registration Rights Agreement with the institutional investors, whereby the Company agreed to register common stock as defined in the agreement. The Company registered the stock on Form S-3 on May 1, 2008, and the SEC deemed the registration effective on May 8, 2008.

On January 25, 2010, the Company announced that its Board of Directors had authorized the repurchase of up to $10 million of the Company’s common stock from time to time on the open market or in privately negotiated transactions. On December 3, 2010, the Company had repurchased the entire $10 million allotment of its stock. The timing and amount of any shares purchased were determined by management based on its evaluation of market condition and other factors and required use of cash. Upon completion of the stock repurchase program, the Company had repurchased 1,372,300 shares of its common stock under the program at a weighted average price per share of $7.26.

On May 4, 2011, the Company announced that its Board of Directors had authorized the repurchase of up to $10 million of the Company’s common stock from time to time on the open market or in privately negotiated transactions. On September 16, 2011, the Company had repurchased the entire $10 million allotment of its stock. The timing and amount of any shares purchased were determined by management based on its evaluation of market condition and other factors and required use of cash. Upon completion of the stock repurchase program, the Company had repurchased 1,042,208 shares of its common stock under the program at a weighted average price per share of $9.60.

On September 29, 2011, the Company’s Board of Directors authorized the repurchase of up to $10 million of the Company’s common stock from time to time on the open market or in privately negotiated transactions. The timing and amount of any shares purchased were determined by management based on its evaluation of market conditions and other factors and required use of cash. The repurchase program expired on September 29, 2012. Upon completion of the stock repurchase program, the Company had repurchased 252,450 shares of its common stock under the program at a weighted average price per share of $10.26.

 

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On November 19, 2012, the Company’s Board of Directors authorized the repurchase of up to $10 million of the Company’s common stock from time to time on the open market or in privately negotiated transactions. The timing and amount of any shares purchased will be determined by the company’s management based on its evaluation of market condition and other factors. The repurchase program, which will expire on December 31, 2013 unless extended by the Board of Directors, may be suspended or discontinued at any time without notice. As of September 30, 2013, the Company had repurchased 17,665 shares of its common stock under the program at a weighted average price per share of $12.22.

Restricted Stock

During the nine months ended September 30, 2013, the Company issued 165,950 shares of restricted stock to certain employees of the Company pursuant to the Company’s 2006 Incentive Plan, as amended and 45,376 shares of restricted stock to certain 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, 2013 was as follows:

 

     Shares     Grant-date
fair  value
 
           ($ in thousands)  

Non-vested as of December 31, 2012

     2,418,860      $ 19,810   

Granted

     211,326        2,825   

Vested

     (2,126,149     (17,013

Forfeited

     (20,295     (242
  

 

 

   

 

 

 

Non-vested as of September 30, 2013

     483,742      $ 5,380   
  

 

 

   

 

 

 

The Company’s compensation expense related to restricted stock was $0.7 million and $3.4 million, respectively, for the three and nine months ended September 30, 2013 and $1.7 million and $4.8 million, respectively, for the three and nine months ended September 30, 2012. The unrecognized compensation cost of $2.4 million at September 30, 2013 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, 2013 was as follows:

 

     Options  

Outstanding as of January 1, 2013

     5,618,819   

Granted

     0   

Exercised

     (60,267

Forfeited

     (14,167
  

 

 

 

Outstanding as of September 30, 2013

     5,544,385   
  

 

 

 

Vested as of September 30, 2013

     5,543,551   
  

 

 

 

Exercisable as of September 30, 2013

     5,543,551   
  

 

 

 

As of September 30, 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, and $0 and $0.4 million, respectively, for the three and nine months ended September 30, 2012.

Note 9. Income Per Share

The computations of basic and diluted income per share for the three and nine months ended September 30, 2013 and 2012 are as follows:

 

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     Three Months Ended September 30,      Nine Months Ended September 30,  
     2013      2012      2013      2012  
     (In thousands)  

Numerator:

           

Net income

   $         6,437       $         6,066       $         18,235       $         17,765   

Denominator:

           

Denominator for basic income per common share

     48,613         47,380         47,984         47,358   
  

 

 

    

 

 

    

 

 

    

 

 

 

Denominator:

           

Denominator for diluted income per common share

     48,613         47,380         47,984         47,358   

Potentially dilutive securities - options

     3,713         3,390         3,575         3,213   

Potentially dilutive securities – restricted stock

     0         2,000         1,018         2,000   

Potentially dilutive securities - warrants

     392         152         304         44   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total weighted average diluted shares

     52,718         52,922         52,881         52,615   
  

 

 

    

 

 

    

 

 

    

 

 

 

Note 10. Consolidated Variable Interest Entity

On April 8, 2013, the Company announced that it had 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 retains full discretion over Arlington Fund’s investment decisions, subject to usual and customary limitations, and earns management fees as compensation for its services. For the three and nine months ended September 30, 2013, the management fee was $0.2 million and $0.3 million, respectively. The Company is deemed to be the primary beneficiary of Arlington Fund. Consolidation of the financial results of Arlington Fund with the Company’s results of operations and statements of financial position began in April 2013.

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 has committed to fund the Class A Notes as the initial Class A lender and the Company has committed to fund the Class B Notes as the initial Class B lender. Advances under the Class A Notes and the Class B Notes may be drawn, repaid, and drawn again subject to availability under the a borrowing base. The Class A Notes and the Class B Notes provide for a reinvestment period of one year ending on April 4, 2014, unless a one year extension is requested, followed by a three year amortization period. For the three and nine months ended September 30, 2013 interest expense on the Class B Notes totaled $0.2 million and $0.4 million, respectively.

Although the Company consolidates all of the assets and liabilities of Arlington Fund, its maximum exposure to loss is 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 define the Company’s economic relationship with Arlington Fund but are eliminated upon consolidation. The Company manages the assets of Arlington Fund solely for the benefit of its lenders and investors. If the Company were to liquidate, the assets of Arlington Fund would not be available to the Company's general creditors, and as a result, the Company does not consider Arlington Fund's assets to be part of the Company. As such, the Company has not included these assets in its allowance for credit losses. Conversely, the investors in the debt of Arlington Fund have no recourse to the Company's general assets. Therefore, this debt is not the Company's obligation.

As of September 30, 2013, the Company had purchased membership interests totaling $4.2 million in Arlington Fund and a third-party investor had purchased membership interests totaling $25.1 million. As a result of consolidating Arlington Fund as a variable interest entity, or VIE, the membership interests representing equity ownership of Arlington Fund are characterized as debt in the Company’s consolidated statement of financial position. The Company applies an imputed interest rate to that debt and records the resulting interest expense in its consolidated statement of operations. The actual return on investments in Arlington Fund’s membership interests may or may not equal the imputed rate applied to the membership interests that are characterized as debt. In the consolidation, the Company eliminates 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.

 

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The following tables present the unconsolidated, stand alone balance sheet of Arlington Fund.

 

     As of
September 30, 2013
 
    

(unaudited)

($ in thousands)

 

Restricted cash

   $ 2,009   

Loans, net

     129,218   

Other assets

     6,199   
  

 

 

 

Total assets

   $ 137,426   
  

 

 

 

Credit facilities – Class A Notes

   $ 93,048   

Class A Notes interest payable

     368   

Class B Notes payable

     13,344   

Class B Notes interest payable

     128   

Other liabilities

     116   
  

 

 

 

Total liabilities

     107,004   

Equity

     30,422   
  

 

 

 

Total equity and liabilities

   $ 137,426   
  

 

 

 

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 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, 2013, the Company had $293.7 million of unused lines of credit. Of these unused lines of credit, unfunded commitments related to revolving credit facilities were $239.9 million and unfunded commitments related to delayed draw term loans were $45.7 million. $8.1 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 $239.9 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, 2013, the Company categorized $179.5 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, 2013, the Company had $60.4 million of unfunded unrestricted revolving commitments.

During the three months ended September, 2013, revolver usage averaged approximately 46%, which is in line with the average of 49% 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, 2013, revolving commitments increased $44.8 million.

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 in corporate loans or for tenant improvements in commercial real estate loans. During the three months ended September 30, 2013, delayed draw credit facility commitments increased $1.8 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.

 

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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 at September 30, 2013 and December 31, 2012.

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

 

     September 30, 2013      December 31, 2012  
     ($ in thousands)  

Unused lines of credit

   $ 293,740       $ 245,483   

Standby letters of credit

     6,287         4,497   

Interest rate mitigation products

     0         0   

 

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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.

The following table presents recorded amounts of assets and liabilities measured at fair value on a recurring and nonrecurring basis as of September 30, 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     $ 22,032      $ 22,032   
 

 

 

   

 

 

   

 

 

   

 

 

 

Total assets recorded at fair value on a recurring basis

  $ 0     $ 0      $ 22,032      $ 22,032   
 

 

 

   

 

 

   

 

 

   

 

 

 

Nonrecurring Basis:

       

Loans, net

  $ 0     $ 0     $ 25,914      $ 25,914   

Loans held-for-sale, net

    0        0        15,793        15,793   
 

 

 

   

 

 

   

 

 

   

 

 

 

Total assets recorded at fair value on a nonrecurring basis

  $ 0      $ 0      $ 41,707      $ 41,707   
 

 

 

   

 

 

   

 

 

   

 

 

 

At September 30, 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 September 30, 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 the nine months ended September 30, 2013, the Company released $4.7 million of specific allowance for credit losses related to “Loans, net” measured at fair value.

At September 30, 2013, “Loans held-for-sale, net” consisted of leveraged finance loans intended to be sold to third parties. The fair values of these loans are based on contractual selling prices, quoted market prices, cost or third-party appraisals.

 

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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, 2013.

 

     Fair value     

Valuation Techniques

  

Unobservable Input

   Range  
     ($ in thousands)  

Financial assets:

           

Investments in debt securities, available-for-sale

   $ 22,032       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

     25,914       Market comparables    Cost to sell      3% - 7%   
      Valuation model    Marketability discount      5% - 30%   

Loans held-for-sale, net

     15,793       Market comparables    Cost to sell      3% - 7%   
  

 

 

          
      Valuation model    Marketability discount      5% - 30%   

Total:

   $ 63,739            
  

 

 

          

The following table presents recorded amounts of assets and liabilities measured at fair value on a recurring and nonrecurring basis as of December 31, 2012, 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     $ 21,127      $ 21,127   
 

 

 

   

 

 

   

 

 

   

 

 

 

Total assets recorded at fair value on a recurring basis

  $ 0     $ 0      $ 21,127      $ 21,127   
 

 

 

   

 

 

   

 

 

   

 

 

 

Nonrecurring Basis:

       

Loans, net

  $ 0     $ 0     $ 99,500      $ 99,500   

Loans held-for-sale, net

    29,782        0       21,820        51,602   

Other real estate owned

    0        0        13,012        13,102   
 

 

 

   

 

 

   

 

 

   

 

 

 

Total assets recorded at fair value on a nonrecurring basis

  $ 29,782      $ 0      $ 134,332      $ 164,204   
 

 

 

   

 

 

   

 

 

   

 

 

 

At December 31, 2012, “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, 2012, “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 2012, the Company recorded a $10.3 million of specific provision for credit losses related to “Loans, net” measured at fair value.

At December 31, 2012, “Loans held-for-sale, net” consisted of leveraged finance loans intended to be sold to the NCOF and to other third parties where the carrying value approximated fair value. The fair values of the loans are based on contractual selling prices, quoted market prices, cost, or third party appraisals.

At December 31, 2012, “Other real estate owned” consisted of two commercial real estate properties. The fair value of other real estate owned is estimated using one of several methods, including collateral value, market value of similar properties, liquidation value and discounted cash flows.

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, 2012.

 

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     Fair value     

Valuation Techniques

  

Unobservable Input

   Range  
     ($ in thousands)  

Financial assets:

           

Investments in debt securities, available-for-sale

   $ 21,127       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

     99,500       Market comparables    Cost to sell      3% - 7%   
      Valuation model    Marketability discount      5% - 30%   

Loans held-for-sale, net

     21,820       Market comparables    Cost to sell      3% - 7%   
      Valuation model    Marketability discount      5% - 30%   

Other real estate owned

     13,012       Market comparables    Cost to sell      3% - 7%   
      Valuation model    Marketability discount      10% - 20%   
  

 

 

          

Total:

   $ 155,459            
  

 

 

          

Changes in level 3 recurring fair value measurements

The table below illustrates the change in balance sheet amounts during the three months ended March 31, 2013 and 2012 (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 nine months ended September 30, 2013 or 2012.

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   
  

 

 

 

 

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For the three months ended September 30, 2012:

 

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

Balance as of June 30, 2012

   $ 18,335   

Total gains or losses (realized/unrealized)

  

Included in earnings

     57   

Included in other comprehensive income

     2,411   

Purchases

     0   

Issuances

     0   

Settlements

     0   
  

 

 

 

Balance as of September 30, 2012

   $ 20,803   
  

 

 

 

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   
  

 

 

 

For the nine months ended September 30, 2012:

 

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

Balance as of December 31, 2011

   $ 17,817   

Total gains or losses (realized/unrealized)

  

Included in earnings

     170   

Included in other comprehensive income

     2,816   

Purchases

     0   

Issuances

     0   

Settlements

     0   
  

 

 

 

Balance as of September 30, 2012

   $ 20,803   
  

 

 

 

 

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The following table presents the carrying amounts and estimated fair values of the Company’s financial instruments at September 30, 2013 and December 31, 2012. 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, 2013      December 31, 2012  
     Carrying
amount
     Fair value      Carrying
amount
     Fair value  
     ($ in thousands)  

Financial assets:

           

Cash and cash equivalents

   $ 87,972       $ 87,972       $ 27,212       $ 27,212   

Restricted cash

     276,308         276,308         208,667         208,667   

Loans held-for-sale

     15,793         15,793         51,602         51,602   

Loans and leases, net

     1,957,411         1,973,683         1,720,789         1,751,939   

Investments in debt securities available-for-sale

     22,032         22,032         21,127         21,127   

Other assets

     7,955         7,955         7,771         7,771   

Financial liabilities:

           

Credit facilities

   $ 255,328       $ 255,328       $ 229,941       $ 229,941   

Term debt

     1,527,761         1,483,726         1,221,764         1,173,635   

Repurchase agreements

     27,476         27,051         30,583         30,102   

 

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, 2013 and December 31, 2012. 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, 2013

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

Financial assets:

              

Loans and leases, net

   $ 1,931,497       $ 1,947,769       $ 0       $ 0       $ 1,947,769   

Financial liabilities:

              

Term debt

     1,527,761         1,483,726         0         1,483,726         0   

Repurchase agreements

     27,476         27,051         0         27,051         0   
                   Fair Value Measurements  

December 31, 2012

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

Financial assets:

              

Loans and leases, net

   $ 1,621,289       $ 1,652,439       $ 0       $ 0       $ 1,652,439   

Loans held-for-sale

     51,602         51,602         29,782         0         21,820   

Financial liabilities:

              

Term debt

     1,221,764         1,173,635         0         1,173,635         0   

Repurchase agreements

     30,583         30,102         0         30,102         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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Table of Contents

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. Employee Benefit Plans

The Company maintains a contributory 401(k) plan covering all full-time employees. The Company matches 100% of an employee’s voluntary contributions up to a limit of 6% of the employee’s base salary, subject to IRS guidelines. Expense for the three and nine months ended September 30, 2013 was $0.2 million and $0.6 million, respectively and $0.2 million and $0.5 million for the three and nine months ended September 30, 2012, respectively.

Note 14. 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. The Fund pays 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, and $0.7 million and $2.2 million for the three and nine months ended September 30, 2012, respectively.

During 2006, the Company made a loan based on market terms to a company with a director who is a relative of one of the Company’s officers. At September 30, 2013, the loan balance outstanding and amount of committed funds were $3.7 million and $5.7 million, respectively.

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 one member of the Company’s Board of Directors is affiliated. At September 30, 2013, the loan balance outstanding and amount of committed funds were $13.1 million and $13.5 million, respectively.

 

 

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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, 2012, 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 bank loans and equipment leases through teams of credit-trained bankers and marketing officers organized around key industry and market segments. Our marketing and direct origination efforts target private equity sponsors, mid-sized companies, corporate executives, regional banks, real estate investors and a variety of other referral sources and financial intermediaries to source new customer relationships and lending opportunities. Our emphasis on direct origination is an important aspect of our marketing and credit strategy because it provides us with direct access to our customers’ management teams and enhances our ability to conduct detailed due diligence and credit analysis of prospective borrowers. It also allows us to negotiate transaction terms directly with borrowers and, as a result, we have significant input into our customers’ financial strategies and capital structures. We also participate in loans as a member of a lending group. The mix of our originations may vary from period to period. We employ highly experienced bankers, marketing officers and credit professionals to identify and structure new lending opportunities and manage customer relationships. We believe that the quality of our professionals, the breadth of their relationships and referral networks, and their ability to develop creative solutions for customers position us to be a valued partner and preferred lender for mid-sized companies.

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

 

   

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

 

   

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

 

   

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

 

   

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

Market Conditions

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

Market conditions in targeted segments of the loan market softened somewhat, but remained constructive in the third quarter after a solid second quarter and weak first quarter following a surge of refinancing, M&A and dividend recapitalization activity at the end of 2012. Somewhat weaker loan demand and volumes in the third quarter left the loan markets highly liquid and competitive. Because a large part of loan volume continued to represent refinancing of existing loans, demand for new financing for growth or acquisitions also remained somewhat muted. We believe that modest M&A activity and related demand for new financing combined with inflows of capital into loan funds, new CLO issuance, and new fund formation has led to a weaker pricing environment as lenders competed for a limited universe of deals. In this type of environment, our different lending platforms provide us the flexibility to allocate capital and redirect our origination focus to market segments with the most favorable conditions in terms of demand and relative value. As the pricing environment for larger, more liquid loans weakened further in the 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.

Conditions in our core funding markets were somewhat mixed, but remained supportive in the third quarter as fixed income investors continued to target structured investment alternatives such as CLOs to meet their return objectives. The broader fixed income markets continued to experience some volatility through the quarter due to lingering uncertainty about the Federal Reserve’s commitment to accommodative monetary policies, which we believe led investors to change their expectations about the future direction of interest rates. As a result, we believe that investors became more cautious about holding fixed rate debt, which led to less capital flowing into the high yield market in favor of higher yielding investments with shorter duration, including floating rate bank loans and CLO bonds.

 

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New CLO issuance exceeded $55 billion in 2012, exceeding most forecasts and 2011’s total of $12 billion by a significant margin. We believe that CLO issuance through September 2013 has already surpassed 2012 levels and is at approximately $58 billion. CLO credit spreads trended higher through most of the quarter, however, reflecting the impact of yield curve steepening on relative value and lingering regulatory concerns such as the FDIC surcharge for deposit insurance and future risk retention rules. As a result, we believe marginal funding costs will be somewhat range bound at current levels until investors reset rate expectations and resolve regulatory concerns. Despite the slight increase in pricing during the quarter, we believe that market conditions remain supportive for us to issue new CLOs as demonstrated by the transaction we completed in September 2013. We also believe the availability and cost of warehouse financing among banks has continued to improve as more banks have begun to provide this type of financing and existing providers have increased their lending activity. As a result, we believe that the terms and conditions for financings available to established firms like NewStar have improved, as shown by our ability to refinance $100 million of existing corporate debt through a new $200 million financing on significantly improved terms and at lower cost in the second quarter.

Loan demand in the middle market is strongly influenced by the level of refinancing, acquisition activity and private investment, which is driven largely by changes in the perceived risk environment, prevailing borrowing rates and private investment activity. Overall activity slowed in the third quarter after a strong second quarter and a slow start to 2013 when dividend recapitalization and leveraged buyout style acquisition activity among private equity firms declined sharply from a heightened level of activity in the fourth quarter of 2012.

Total middle market loan issuance in the third quarter was down from the second quarter with a combination of dividend recapitalizations and refinancing of existing loans as the dominant uses of proceeds. Loan demand derived from merger and acquisition activity and private equity deal volume also weakened in the third quarter but was higher than the third quarter of last year.

We originated nearly $285 million of new loans in the third quarter at yields that were generally below our historical averages for comparably rated loans, but consistent with the prior quarter. Yields reflected a combination of continued pricing pressure in a muted M&A volume environment and a continuation of the shift in the mix of origination toward loans directly originated with smaller middle market companies. Pricing remained thin and leverage continued to trend higher in the broad loan market. Conditions in our primary target markets, however, remained somewhat more favorable with pricing and leverage stabilizing at levels that compare favorably to the broader loan market, in which larger corporations typically borrow from syndicates of banks and loans are issued, priced and traded in a bond-style market that is more highly correlated with the high yield debt market.

We believe that demand for new middle market loans and credit products will be relatively consistent with current levels in the short-term as the pace of transaction activity has normalized after the disruption caused by changes in the tax code and the lingering uncertainty about the Federal Reserve’s commitment to accommodative monetary policies. Over the long-term, we believe that demand will improve because private equity firms have substantial un-invested capital, which we believe that they will deploy through investment strategies that emphasize investments in mid-sized companies. We also believe that a significant and lasting impact of the credit crisis that began in 2008 has been a reduction in the number and capacity of lenders in the markets in which we compete. As a result of these factors, we anticipate that demand for loans and leases offered by the Company and conditions in our lending markets will remain relatively consistent overall through the balance of 2013, but continue to provide opportunities for us to increase our origination volumes.

Recent Developments

Liquidity

On October 25, 2013, we called the 2005 CLO Trust and redeemed the notes at par.

On October 2, 2013, we entered into an amendment to our financing arrangement with Macquarie Bank Limited. The amendment extended the maturity date from June 7, 2016 to June 7, 2017, increased the minimum aggregate interest margin payment from $8.2 million to $9.2 million, provides for $25.5 million of additional advances for existing eligible assets owned by us, allows for the advance of up to $15.0 million to fund an additional commercial mortgage loan, and released $41.1 million of principal payments related to previously purchased assets to us as unrestricted cash.

On September 11, 2013, we completed a $400.0 million term debt transaction. As part of the securitization, investors purchased approximately $338.6 million of the floating-rate asset-backed notes. We retained all of the remaining notes and equity, which totaled approximately $61.4 million. The notes are expected to mature on September 20, 2023.

On August 20, 2013, we entered into an amendment to our revolving credit facility with NATIXIS Financial Products, Inc. (“NATIXIS”) to fund leveraged finance loans. The amendment increased the commitment amount under this credit facility from $150.0 million to $175.0 million and extended the reinvestment period to the earlier of September 30, 2013 or the closing date of a collateralized loan obligation among other things. This credit facility was refinanced into the term debt securitization completed on September 11, 2013 and borrowing under this credit facility was terminated.

 

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RESULTS OF OPERATIONS FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2013 AND 2012

NewStar’s basic and diluted income per share for the three months ended September 30, 2013 was $0.13 and $0.12 respectively, and $0.38 and $0.34 for the nine months ended September 30, 2013, respectively, on net income of $6.4 million and $18.2 million, respectively, compared to basic and diluted income per share for the three months ended September 30, 2012 of $0.13 and $0.11, respectively, and $0.38 and $0.34 for the nine months ended September 30, 2012, respectively, on net income of $6.1 million and $17.8 million, respectively. Our managed loan portfolio was $2.5 billion at September 30, 2013 compared to $2.4 billion at December 31, 2012. As of September 30, 2013, loans owned by Arlington Fund and the NCOF were $130.1 million and $416.4 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 6.33% and 6.69% for the three and nine months ended September 30, 2013 and 6.45% and 6.32% for the three and nine months ended September 30, 2012. The decrease in the loan portfolio yield from the three months ended September 30, 2012 to the three months ended September 30, 2013 was primarily driven by a decrease in our average yield on interest earning assets primarily due to re-pricings and new loan and lease originations subsequent to September 30, 2012. The increase in loan portfolio yield from the nine months ended September 30, 2012 to the nine months ended September 30, 2013 was primarily driven by,the recognition of deferred paid-in-kind interest on certain impaired loans, and the average yield on loans which were repaid subsequent to September 30, 2012 was lower than the average yield on loans in our average total loan portfolio for the nine months ended September 30, 2013. Additionally, subsequent to September 30, 2012, the outstanding balance of lower yielding commercial real estate loans decreased $86.6 million. The portfolio yield for accruing loans was 6.47% and 6.91% for the three and nine months ended September 30, 2013.

Net interest margin

Net interest margin, which is net interest income divided by average interest earning assets, was 3.35% and 4.02% for the three and nine months ended September 30, 2013 and 4.22% for each of the three and nine months ended September 30, 2012. The primary factors impacting net interest margin for 2013 were the composition of interest earning assets, the recognition of deferred paid-in-kind interest on certain impaired loans, non-accrual loans, changes in three-month LIBOR, credit spreads and cost of borrowings. The primary factors impacting net interest margin for the three and nine months ended September 30, 2012 were 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 46.73% and 49.31% for the three and nine months ended September 30, 2013 and 42.95% and 48.29% for the three and nine months ended September 30, 2012. The increase in our efficiency ratio for 2013 was primarily due to an increase in operating expenses.

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 2.01% at September 30, 2013 and 2.78% as of December 31, 2012. The decrease in the allowance for credit losses ratio is primarily due to a decrease in the balance of the specific allowance for credit losses, positive credit migration, improving economic conditions, and charge offs of impaired loans. During the three and nine months ended September 30, 2013, we recorded $2.4 million and $9.3 million of net specific provision for credit losses on previously identified impaired loans and had net charge offs totaling $0.9 million and $16.9 million. At September 30, 2013, the specific allowance for credit losses was $22.4 million, and the general allowance for credit losses was $18.1 million. At December 31, 2012, the specific allowance for credit losses was $30.2 million, and the general allowance for credit losses was $19.8 million. We continually evaluate our allowance for credit losses methodology. If we determine that a change in our allowance for credit losses methodology is advisable, as a result of the rapidly changing economic environment or otherwise, the revised allowance methodology may result in higher or lower levels of allowance. Moreover, actual losses under our current or any revised methodology may differ materially from our estimate.

Delinquent loan rate

Delinquent loan rate, which is total delinquent loans that are 60 days or more past due, divided by outstanding gross loans and leases, was 0.31% as of September 30, 2013 as compared to 3.59% as of December 31, 2012. We expect the delinquent loan rate to correlate to current economic conditions. During times of economic expansion we expect the rate to decline, and during times of economic contraction, we expect the rate to increase.

 

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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 that are 60 days or more past due and less than 90 days past due, divided by outstanding gross loans and leases, was 1.17% as of December 31, 2012. We did not have any accruing loans 60 days or more past due as of September 30, 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 2.07% as of September 30, 2013 and 4.05% as of December 31, 2012. As of September 30, 2013 and December 31, 2012, the aggregate outstanding balance of non-accrual loans was $41.7 million and $72.7 million, respectively and total outstanding loans and leases held for investment was $2.0 billion and $1.8 billion, respectively. The decline in non-accrual loans during the nine months ended September 30, 2013, was primarily the result of the resolution of loans classified as non-accrual at December 31, 2012. 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 2.69% as of September 30, 2013 and 4.77% as of December 31, 2012. As of September 30, 2013 and December 31, 2012, the sum of the aggregate outstanding balance of non-performing assets was $54.6 million and $86.3 million, respectively. The decline in non-performing assets during the nine months ended September 30, 2013, was primarily the result of the resolution of assets classified as non-accrual at December 31, 2012.We expect the non-performing asset rate to correlate to economic conditions. During times of economic expansion we expect the rate to decline, and during times of economic contraction, we expect the rate to increase.

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

Net charge-off rate as a percentage of end of period loan and lease portfolio is defined as annualized charge-offs net of recoveries divided by the total outstanding balance of our loans and leases held for investment. A 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. The net charge-off rate was 0.18% and 1.13% for the three and nine months ended September 30, 2013, respectively, and (0.07)% and 0.83% for the three and nine months ended September 30, 2012. Charge-offs during the three and nine months ended September 30, 2013, were primarily the result of the resolution of previously impaired loans. We expect the net charge-off rate (end of period loans and leases) to fluctuate if economic conditions continue to impair certain borrowers’ ability to fully repay principal and interest under the terms of their loan agreement.

Net charge-off rate (average period loans and leases)

Net charge off rate as a percentage of average period loan and lease portfolio is defined as annualized charge offs net of recoveries divided by the total outstanding balance of our loans and leases held for investment. A charge off occurs when management believes that all or part of the principal of a particular loan is no longer recoverable and will not be repaid. Typically a charge off occurs in a period after a loan has been identified as impaired and a specific allowance has been established. The net charge-off rate was 0.18% and 1.17% for the three and nine months ended September 30, 2013, respectively, and (0.06)% and 0.82% for the three and nine months ended September 30, 2012, respectively. Charge-offs during the three and nine months ended September 30, 2013, were primarily the result of the resolution of previously impaired loans. 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 1.10% for each of the three and nine months ended September 30, 2013, and 1.16% and 1.17% for the three and nine months ended September 30, 2012, respectively.

Return on average equity

Return on average equity, which is net income divided by average equity, was 4.24% and 4.05% for the three and nine months ended September 30, 2013, respectively, and 4.15% and 4.13% for the three and nine months ended September 30, 2012, 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, 2013 and 2012 follows:

 

    Three Months Ended September 30,     Nine Months Ended September 30,  
  2013     2012     2013     2012  
    ($ in thousands)  

Net interest income:

   

Interest income

  $ 30,370      $ 30,812      $ 95,401      $ 90,945   

Interest expense

    11,703        9,074        30,798        26,607   
 

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income

    18,667        21,738        64,603        64,338   

Provision for credit losses

    2,381        3,712        7,429        6,752   
 

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income after provision for credit losses

    16,286        18,026        57,174        57,586   
 

 

 

   

 

 

   

 

 

   

 

 

 

Non-interest income:

       

Fee income

    1,050        1,074        2,591        3,398   

Asset management income

    592        718        1,971        2,188   

Loss on derivatives

    (45     (57     (131     (258

Gain (loss) on sale of loans

    —          —          72        (418

Other income

    3,534        1,451        5,192        2,866   
 

 

 

   

 

 

   

 

 

   

 

 

 

Total non-interest income

    5,131        3,186        9,695        7,776   
 

 

 

   

 

 

   

 

 

   

 

 

 

Operating expenses:

       

Compensation and benefits

    7,405        7,832        25,020        23,101   

General and administrative expenses

    4,120        2,843        12,185        11,627   
 

 

 

   

 

 

   

 

 

   

 

 

 

Total operating expenses

    11,525        10,675        37,205        34,728   
 

 

 

   

 

 

   

 

 

   

 

 

 

Operating income before income taxes

    9,892        10,537        29,664        30,634   

Results of Consolidated Variable Interest Entity

       

Interest income

    1,991        —          2,891        —     

Interest expense – credit facilities

    692        —          1,026        —     

Interest expense – Fund membership interest

    433        —          782        —     

Other income

    18        —          34        —     

Operating expenses

    10        —          14