NEW YORK--(BUSINESS WIRE)--Fitch Ratings has affirmed NewStar Financial, Inc.'s (NewStar) long- and short-term Issuer Default Ratings (IDRs) at 'BB-' and 'B', respectively, as well as the senior unsecured debt at 'BB-' and subordinated debt ratings at 'B'. A full list of rating actions follows at the end of this press release.
KEY RATING DRIVERS
IDRs, SENIOR DEBT AND SUBORDINATED DEBT
The rating affirmations and Stable Outlook reflect NewStar's established business as a direct middle-market lender, the well-diversified portfolio of senior secured loans, demonstrated track record of underwriting middle-market credit, a modest but growing asset management platform, improved funding profile and experienced management team.
The ratings also reflect benefits from NewStar's strategic partnership with GSO Capital Partners (GSO), a subsidiary of The Blackstone Group L.P. (long-term IDR 'A+'/Outlook Stable) and Franklin Square Capital Partners (Franklin Square; FSIC I long-term IDR 'BBB-'/Outlook Stable). Fitch believes the partnership enhances the company's overall franchise, improves deal flow and sponsor relationships, and supports NewStar's growth aspirations.
The ratings are constrained by NewStar's concentrated business model, outsized exposure to middle-market borrowers, a high mix of secured funding, a weak but improving earnings profile relative to stated targets, inconsistent strategic direction over time and planned rapid growth supported by increased leverage. These constraints are set against a backdrop of a highly competitive middle market underwriting environment, which could pressure asset quality in the coming years, particularly in the context of NewStar's growth.
Fitch believes NewStar has an experienced executive team having worked together for over 11 years. The leadership team includes many of the founding members, averaging more than 20 years of experience in loan origination, credit underwriting, capital markets and asset management.
NewStar's investment portfolio is well-diversified and is comprised predominately of senior secured loans, with first-lien loans representing 95.2% of the total portfolio by net book value (NBV), at Dec. 31, 2015. No single obligor represented greater than 1.1%, with the top 10 obligors representing 9.3% by NBV. The investment portfolio was also well-diversified from an industry perspective, with no single industry representing greater than 14.7%. NewStar was not materially exposed to sectors currently experiencing stress, including energy/chemical services (2.9%) and retail (3.1%). That said; similar to other middle market lenders, NewStar has high concentration to recent vintages, driven by elevated refinancing volumes and recent growth, as 84% of the total owned portfolio was originated between 2013 and 2015. This vintage was originated in a highly competitive operating environment, which could yield asset quality pressures down the road.
The loan portfolio amounted to $3.8 billion as of Dec. 31, 2015, 83.9% of which was represented by the Leveraged Finance lending segment. Portfolio growth was 46% in 2015, driven by more than $3 billion of new funded originations, up 71% year-over-year. Growth in the investment portfolio has been driven by capitalizing on referrals from and co-investment opportunities with GSO/Franklin Square, while also utilizing increased capital from the strategic partnership to undertake larger investment positions. Fitch views cautiously NewStar's outsized portfolio growth in the current highly competitive underwriting environment.
Fitch believes NewStar's strong credit culture and disciplined underwriting are evidenced by the strong relative performance of the investment portfolio over time. Net charge-offs amounted to 0.11% in 2015, which compares favorably to the long-term average of 1.64% since 2007 and peak charge-offs of 3.4% in 2010. Loans on non-accrual status amounted to 3.43% in 2015, which has been relatively consistent with the long-term average of 3.94%. Despite current strong asset quality performance, Fitch expects NewStar's credit costs will increase modestly over the near to medium term, reflecting the recent competitive underwriting environment, as well as the potential for increased debt service burdens for underlying borrowers once interest rates rise. As of Dec. 31, 2015, NewStar has not realized any credit losses on its Leveraged Finance portfolio on loans originated post-credit crisis (2009-2015 vintages).
Despite strong underlying credit performance, NewStar's financial performance remains weak relative to peers and below stated targets with pre-tax returns on average equity (ROE) amounting to 4.38% in 2015. NewStar has communicated a path to improved operating performance by year-end 2016, which includes steps to enhance operating leverage, improve yields, generate additional asset management fees, and lower its cost of funds. At the same time, the company expects credit costs to gradually normalize. If successful, NewStar expects to generate pre-tax ROE of between 7.5% and 10% in 2016. Fitch views the targets as appropriate given the risk profile of the investment portfolio and achievable should NewStar's targeted growth and cost rationalization plans be achieved.
Over the last two years, NewStar has undertaken several shifts in strategic direction, including the partnership with GSO/Franklin Square in November 2014, the acquisition of Boston-based asset manager, Feingold O'Keefee Capital in October 2015 and most recently, the sale of its asset-based lending business to Sterling National Bank in March 2016. Fitch views these transactions as a continuation of NewStar's transformation from a bank-styled diversified commercial finance company to a more specialized, middle market lender with a focus on managing assets for institutional investors.
NewStar's funding profile has improved in recent years but remains highly reliant on wholesale funding and is confidence sensitive, comprised of medium-term warehouse credit facilities, term securitizations, and corporate unsecured and subordinated debt. Fitch views NewStar's access to the unsecured markets as a positive step, as it reduces concentration risk, although the funding is relatively expensive compared to its term securitizations. NewStar accessed the unsecured markets in April 2015 and again in November 2015, issuing $380 million of senior unsecured debt in aggregate, with a coupon of 7.25%. The company also issued $300 million, in aggregate, of subordinated debt, with a coupon of 8.25%, over the course of 2014 through 2016.
Fitch calculates leverage on the basis of total debt-to-tangible equity, which amounted to 5.26x, as of Dec. 31, 2015, and below management's articulated target of up to 6.0x. Fitch believes NewStar's leverage could continue to increase toward its stated target over the near term, as the company plans to use incremental borrowings to fund net portfolio growth and improve shareholder returns. Fitch's leverage calculation does not give equity credit to the $300 million in outstanding subordinated notes due to the potential for a liquidity event resulting from the required applicable high yield discount obligations (AHYDO) prepayment and the change of control provisions. Although Fitch believes the quality of NewStar's loan portfolio allows for a higher degree of leverage relative to peers, the company's growth targets and evolving business model present uncertainty and execution risk which constrain the ratings in the near to medium term.
The ratings of the senior unsecured debt are aligned with NewStar's long-term IDR, reflecting Fitch's expectation of sufficient unencumbered assets in a stressed scenario relative to outstanding unsecured debt. Fitch would envision potential future senior unsecured debt issuance to be similarly equalized with NewStar's long-term IDR, provided that it ranked pari passu with existing senior unsecured debt and that the issuance served to improve unencumbered asset coverage relative to unsecured debt outstanding.
The rating of the subordinated debt is two-notches below NewStar's long-term IDR, reflecting Fitch's assessment of the instrument's respective non-performance and relative loss severity risk profile. The two-notches represent incremental risk relative to the IDR, which is a function of increased loss severity due to subordination and heightened risk of non-performance relative to other (e.g. senior) obligations.
RATING SENSITIVITIES
IDRs, SENIOR DEBT AND SUBORDINATED DEBT
Fitch views positive rating momentum as likely limited to one-notch, given the concentrated business model and wholesale funding profile. Still, positive momentum could be driven by demonstration of stable asset quality performance which needs to be evaluated over an extended period of time, particularly for recent vintages originated under increasingly competitive underwriting conditions, improved profitability toward stated targets, successful execution of the planned growth strategy, and ability to realize synergies arising from the GSO/Franklin Square relationship. Reduced leverage relative to current targets and improved funding flexibility could also contribute to positive rating momentum.
Conversely, negative rating momentum could be driven by material deterioration in asset quality performance, a migration away from the primary focus on senior secured loans and towards more junior investment positions, an increase in leverage beyond management's articulated level, and/or an inability to improve earnings performance. The provision of financial support to non-recourse funding sources (i.e. warehouse facilities and CLOs) that impairs NewStar's financial position could also contribute to negative rating momentum.
The ratings of the senior unsecured debt and subordinated debt are sensitive to changes in NewStar's IDR. In addition, the ratings of the senior unsecured debt are sensitive to the level of unencumbered balance sheet assets in a stressed scenario relative to outstanding unsecured debt. A decline in the level of unencumbered asset coverage combined with a material increase in secured debt could result in the notching between the IDR and the senior unsecured debt.
Founded in 2004 and based in Boston, MA, NewStar is a specialty commercial finance company with a focus on direct lending to middle market companies in the U.S. Through its asset management platform, NewStar also offers a range of investment products employing credit-oriented strategies focused on both the middle market loans and liquid, tradeable credit. As of Dec. 31, 2015, had $6.9 billion of assets under management, including $3.8 billion of loans and credit investments on balance sheet. The company's stock is traded on the NASDAQ under the ticker, 'NEWS'.
Fitch affirms the ratings as follows:
NewStar Financial Inc.
--Long-term IDR at 'BB-';
--Short-term IDR at 'B'
--Senior unsecured debt at 'BB-';
--Subordinated debt at 'B'.
The Rating Outlook is Stable.
Date of Relevant Committee: April 14, 2016
Additional information is available on www.fitchratings.com
Applicable Criteria
Global Non-Bank Financial Institutions Rating Criteria (pub. 28 Apr 2015)
https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=865351
Treatment and Notching of Hybrids in Non-Financial Corporate and REIT Credit Analysis (pub. 29 Feb 2016)
https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=878264
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