OREANDA-NEWS. Fitch Ratings has assigned a long-term Issuer Default Rating (IDR) of 'BB-', short-term IDR of 'B', and subordinated debt rating of 'B' to NewStar Financial, Inc. (NewStar). Fitch also expects to rate NewStar's proposed senior unsecured debt issuance 'BB-'. The Rating Outlook is Stable. A full list of ratings is provided at the end of this release.

KEY RATING DRIVERS - IDRs, Senior Unsecured Debt, Subordinated Debt

The ratings and Stable Outlook reflect NewStar's established middle market direct lending franchise, well diversified portfolio of senior secured loans, demonstrated underwriting track record, modest but growing asset management platform, diversified funding profile and seasoned management team. Ratings also reflect the expected benefits of NewStar's strategic partnership with GSO Capital Partners (GSO), a subsidiary of The Blackstone Group L.P. (long-term IDR 'A+'; Stable Outlook) and Franklin Square Capital Partners (Franklin Square).

These strengths are counterbalanced by NewStar's concentrated business model, outsized exposure to middle market borrowers, high mix of secured funding, lackluster financial performance relative to stated targets, shifting strategic direction over time and planned rapid growth supported by increased leverage. These constraints are set against the 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 aspirations.

NewStar's investment portfolio is predominantly senior secured and highly diverse, consisting 97% of first-lien loans with the single largest and top 10 borrowers accounting for 1.4% and 10.2%, respectively, of the overall portfolio as of Dec. 31, 2014. Exposure to energy sectors was limited to approximately 1% of the portfolio at Dec. 31, 2014. That said, like many middle market lenders, NewStar has high concentration to recent vintages, driven by elevated refinancing volume, as 44% and 22% of the total owned loan portfolio were originated in 2014 and 2013, respectively.

Fitch believes NewStar's strong credit culture and disciplined underwriting are evidenced by the strong relative performance of the company's loan portfolio over time. Net charge-offs represented 1.1% of average loans in 2014, with a peak of 3.4% in 2010, and 1.65% average since 2007. Despite the strong current performance, Fitch expects NewStar's credit costs to increase over the near to intermediate term, reflecting the competitive underwriting environment and the increased debt service burden for underlying borrowers once interest rates rise. To date, NewStar has not realized any credit losses on leveraged finance loan originations post 2008 (i.e. 2009-2014 vintages).

NewStar has access to a diverse mix of funding sources including term credit facilities, securitizations and corporate debt, which Fitch views positively as it reduces concentration risk and provides more funding flexibility in the event that some sources dry up or become cost prohibitive. Fitch views the proposed unsecured debt issuance positively, as it would further diversify the company's funding sources and improve financial flexibility by increasing unencumbered assets. That said, NewStar remains highly reliant on wholesale funding sources which Fitch views as more sensitive to changes in economic conditions and investor risk appetite.

Despite strong credit performance, NewStar's operating performance remains lackluster and below stated targets. Lackluster performance was at least partly attributable to the economic downturn and dislocation in the capital markets, which had a material adverse impact on origination volumes and funding. Low interest rates and a benign credit environment have also led to higher than expected refinancing activity and portfolio amortization. Fitch believes these factors have contributed to multiple shifts in the strategic direction of the company, although NewStar has maintained a consistent underwriting approach with a primary focus on originating senior secured middle market loans.

NewStar has communicated a path to improved profitability 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 a pre-tax return on average equity (ROE) of between 13%-15% in 2016.

In November 2014, NewStar announced a strategic partnership with GSO and Franklin Square, which included a capital investment by Franklin Square's business development companies, in the form of an 8.25% \$300 million 10-year subordinated note (of which \$200 million was issued as of Dec. 31, 2014), in addition to equity warrants. Fitch believes the equity warrants provide Franklin Square funds with additional potential upside and further align interests. Fitch believes the partnership enhances the NewStar franchise, could improve deal flow and sponsor relationships, and support NewStar's growth aspirations.

NewStar's total owned loan portfolio amounted to \$2.6 billion at Dec. 31, 2014, 81% of which was attributable to the Leveraged Finance segment. The total portfolio grew 11% in 2014 and 26% in 2013, and management expects compounded annual portfolio growth in excess of 30% through 2017, primarily driven by capitalizing on referrals from and co-investment opportunities with GSO/Franklin Square, while also utilizing the increased capital base to take larger investment positions. Fitch cautiously views outsized portfolio growth in the highly competitive underwriting environment.

The ratings assigned to NewStar incorporate an expectation that leverage will meaningfully increase over the next two years, as the company plans to use incremental borrowings to fund net portfolio growth and improve shareholder returns. Management has articulated a leverage target of 4.0x-4.5x on a debt-to-tangible common equity basis, while affording 100% equity credit to the subordinated notes in their calculation.

Conversely, Fitch calculates NewStar's leverage on the basis of debt-to-tangible common equity, without affording any equity credit to NewStar's subordinated notes. On this basis, Fitch calculates that NewStar's leverage amounted to 3.3x on a GAAP basis at Dec. 31, 2014, but based on the company's leverage target, would be 6.0x-6.5x. Fitch does not afford equity credit to the 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 degree of higher leverage relative to peers, the company's growth targets and evolving business model present uncertainty and execution risk which constrain ratings in the near to intermediate term.

NewStar's expected unsecured debt rating is equalized with the entity's long-term IDR, reflecting Fitch's expectation of the sufficiency of stressed unencumbered assets relative to unsecured debt. Fitch would envision that potential future unsecured debt issuance would be similarly equalized with NewStar's IDR, provided that it ranked pari passu with existing unsecured debt and that the issuance served to improve unencumbered assets relative to unsecured debt.

NewStar's subordinated debt rating is two notches below the entity's long-term IDR in accordance with Fitch's assessment of the instrument's respective non-performance and relative loss severity risk profile. The notches represent incremental risk relative to the IDR, which is a function of increased loss severity due to subordination and heightened risk of nonperformance relative to other (e.g., senior) obligations.

RATING SENSITIVITIES - IDRs, Senior Unsecured Debt, Subordinated Debt
Positive rating drivers could include continued demonstration of stable asset performance, particularly for more recent vintages underwritten under increasingly competitive conditions, increased funding diversity, and successful execution of the strategy to grow the portfolio, improve profitability, and realize synergies from the GSO relationship. Reduced leverage relative to current targets, although not expected based on management's articulated strategy, could also contribute to positive rating momentum.

Negative rating drivers would include material deterioration in asset quality, a migration away from the primary focus on senior secured loans and towards more junior investment positions, or an increase in leverage beyond the forecasted level. The provision of financial support to non-recourse funding sources which impairs NewStar's financial position would also be viewed negatively.

COMPANY PROFILE

NewStar, founded in 2004, is a specialized commercial finance company with a focus on lending to small and mid-sized businesses in the U.S. The company's primary businesses include: Leveraged Finance (middle market cash flow loans), Business Credit (middle market asset based lending), Real Estate (commercial real estate lending), Equipment Finance (loan and lease financing to middle market companies) and Asset Management. As of Dec. 31, 2014, the company had \$2.8 billion in assets. The company's stock is listed on the NASDAQ under the ticker 'NEWS'.

Fitch has assigned the following ratings with a Stable Outlook:

--Long-term Issuer Default Rating (IDR) at 'BB-';
--Short-term IDR at 'B';
--Proposed senior unsecured debt at 'BB-(EXP)';
--Subordinated debt rating at 'B'