Capital Talk: And here's what we did NXT

NXT Capital's top three executives are no strangers to building a lending business from the ground up. Their first was Heller Financial in the late 1990s and when that business was bought by GE in 2001 they moved on to found Merrill Lynch Capital, the bank's lending practice, before GE came calling again.

Neil Rudd, NXT's chief financial officer says that while he had the option of moving to GE with the transaction, he was more interested in building a business from scratch, as he went on to do with his colleagues, NXT's chief executive Robert Radway and chief credit and risk officer Mike Litwin.

“I always enjoyed building or fixing things, it's how I have spent most of my career,” Rudd tells PDI. “So the appeal of creating something yourself and building it from scratch was a much more interesting proposition than going to work for a very large company and being a small part of a bigger business.”

FOUNDATION

NXT was launched in 2010 with $300 million in equity capital from Connecticut private equity firm Stone Point Capital and a $300 million credit line from Wells Fargo. Radway says Stone Point was introduced to the team as the Merrill Lynch Capital sales process got underway, before it was sold to GE in 2008. At the time, Stone Point was interested in backing Radway and his team in the launch of a new firm, but when the financial crisis hit, the deal stalled, getting back on track in 2010.

Stone Point executives say they were attracted to the opportunity presented by NXT because banks were exiting the lending space and Radway's group had tenure and a track record behind them. “We thought there was going to be a lot of money and capital receding from this area and it's not as if the need for their services was going to go away, so it seemed to be a good time to be marching to the sound of the cannons and building a commercial finance company,” Stone Point's chairman Steve Friedman tells PDI.

Since then, NXT has grown quickly. It has $5.5 billion in assets under management across corporate finance, equipment finance, real estate and CLOs. The firm invests two-thirds of its committed capital (which stands at almost $8 billion with leverage) from its own balance sheet, with the rest raised from third-party investors via closed-ended vehicles. It closed its latest NXT Capital Senior Loan Fund III in January on $800 million, with $291 million in equity commitments from investors and $509 million in bank credit lines.

CAPITAL STRUCTURE

NXT's capital arrangements are complicated. The firm's balance sheet is leveraged with three times debt to equity. It has grown its credit lines and now has $2.3 billion in credit facilities from 17 banks. The firm has three sources of equity: Stone Point, the Ontario Teachers' Pension Plan (OTPP) and management investment. Stone Point owns a little less than 50 percent of the company and is its controlling investor. The PE firm plans to exit eventually.

Since injecting $300 million in 2010, Stone Point has since raised more equity capital for NXT through its Trident funds and its own LPs, including OTPP. Those combined stakes now stand at $850 million and should reach $1 billion by year-end, Stone Point executives tell PDI.

“Obviously there are complications, the more lenders you add,” says Rudd. But he adds that NXT's credit facilities are syndicated, with an agent managing the group and leading communication with NXT.

While the capital arrangements are probably uncommon for an alternative lender, Rudd says it makes sense for NXT because half of its activities involve lending through its own balance sheet. The firm's CLOs, for instance, are risk retention compliant by nature as NXT holds all the equity of the CLOs it has issued and consolidates the loans and the CLO debt. The firm has issued four CLOs since 2012, with the latest closing at $408 million in May. That transaction brought the firm to a total of $1.4 billion in CLO issuance.

NXT also works with Wells Fargo on CLO underwriting and Rudd says they like the fact that the bank is integrated across its platform. It means the firm is likely to be dealing with the same people or departments for both its borrowing and CLO underwriting.

“In some cases, there might be different individuals involved, but normally they are working very closely together and are probably staring at each other from across the trading desk,” Rudd says. “Someone might be working on managing our credit facilities, someone else is looking at the term-out but, almost inevitably, they have to be working hand in glove.”

When money markets and bank lending seized up during the global financial crisis, it was short-term (ie two-month) credit lines that ran into refinancing difficulties. NXT's debt is generally long-dated, typically five-year facilities, that Rudd says are well matched to the tenor of loans made by the firm.

“We have, in effect, multiple sources of stable capital, and a liability profile that closely matches the amortisation and pre-payment profile of our loans, so if the capital markets close and we're unable to issue securitisations, we can continue to operate and grow the business using our bank credit facilities, and eventually we can term these facilities out if necessary,” Rudd says.

“We have plenty of time to manage down the size of the portfolio to the point where we can pay off the loan, as opposed to having a gun to our head in a situation where you've reached the maturity date of the credit facility and you're faced with a substantial bullet payment.”

Rudd says it's difficult to compare the firm's balance sheet structure with competitors, as there are few independent commercial finance companies around that use a hybrid model of balance sheet lending and asset management. “Some competitors in the real estate world use the same financing sources we do, such as bank credit facilities, securitization and private equity, but there are competitors like banks who have access to deposit funding and BDCs, who have access to the public market for permanent capital, who are funded quite differently than us,” Rudd says.

While NXT's balance sheet leverage is low when compared with a deposit-taking bank, within the world of private corporate lenders it is unusual. BDCs are limited to one times debt to equity, though some are trying to find a way around that cap by investing through joint ventures that sit outside the BDC structure. The Carlyle Group and Madison Capital are working on one such venture. While most alternative lenders have, or plan to start, BDCs, Radway says he's not interested in one particularly because of the limit on leverage.

NXT's loans are rated by Standard & Poor's and Moody's. The latter upgraded NXT's B2 loans from neutral to a positive outlook in June. The decision was made to “reflect the firm's profitable operations, disciplined growth, well-managed asset quality and strong capital position”, a statement from Moody's said on 26 June.

“During the past two years, NXT has pursued reasonable and balanced growth in its corporate finance, commercial real estate and equipment finance segments, extending its record of profitable operations, though like other commercial lenders, its net interest margin has narrowed in response to competitive conditions,” the agency added.

INVESTMENT STRATEGY

Mike Litwin, the firm's credit traffic cop, has to approve all credits that go into any of the portfolios. Of the three top execs, he's been in the business the longest – 45 years – and has a keen eye for potential credit problems. He estimates that over his career he has looked at over $3 trillion worth of lending deal volume. At NXT, he says that the firm only does around 5 percent of the thousands of deals they look at each year.

“It ain't a deal until I say it's a deal,” he tells PDI, noting that NXT is yet to lose money on any of its loans. “In reality, it's a pretty inefficient business because we have to look at so much business to ultimately book it. But the business we book is very predictable and pretty high quality. We've been in business for five-and-a-half years and haven't taken a write-off yet.”

Litwin, like many industry participants, estimates we're somewhere in the seventh inning [of nine – for PDI's non-baseball fans] in terms of the credit cycle, though regardless of that, he looks for businesses that are predictable through a market cycle.

“We seem to think we know what we're doing through a cycle. And it doesn't mean we're never going to take write-offs, because I'm sure we will, but the write-offs have to be within acceptable limits and the amount of deals we have trouble with have to be predictable,” he says.

“We're experienced enough now and we've made enough mistakes through various economic cycles, and our goal is to not make those mistakes again. It's OK to make new mistakes – ones that were unforeseen – but let's not make mistakes we have made in the past.”

The firm looks for businesses that have attributes that can carry them through a market cycle. “It doesn't mean they're not going to go down when the economy goes down, but it probably means that they're going to keep their market share and come back stronger when the economy improves,” Litwin says.

Characteristics Litwin avoids include companies that have a single product or those with concentrated customer relationships. Borrowers that need rapid technology updates or where capital expenditure is significant are also a red flag. Businesses that have a product they can only sell to a customer once are also a non-starter.

Radway adds that NXT tends to avoid cyclical industries. “There are things that we won't touch that are very cyclical, for example the automotive industry, which tends to be less predictable in terms of performance over a cycle. We also don't lend into energy and avoid defence, to some degree,” Radway says. “But overall, our portfolio is very representative of business activity across the US economy.”

NXT's corporate lending investments are spread across business services, healthcare, software, light manufacturing and distribution. Most of its corporate loans are in senior secured investments (80 percent), with the balance in stretch senior or unitranche transactions.

Radway says the firm's biggest focus is currently on increasing the size of the cheques the firm can write. Typically, NXT lends between $50 million to $70 million in a single deal but is aiming to build its underwriting capacity to compete on deals in the $125 million to $250 million range. “We're expanding our asset management programme to accommodate a higher percentage of those deals in terms of what we can speak for,” Radway says.

“This way, we can serve a broader range of clients and become more relevant across the spectrum of sponsors. It's really a client driven strategy and about meeting the demands of the people we do business with.”

Almost all – 95 percent – of NXT's corporate finance deals are sponsor backed.

The firm uses 2:1 leverage on its closed-end funds, while the leverage on underlying loans ranges from 3.5x to 5.5x debt to EBITDA. The levered returns, net of all fees and expenses, on the Senior Loan Fund II are currently about 10 percent. The third fund has the same performance goals.

ABL AND WILLING

NXT's equipment and real estate finance units lend from the firm's balance sheet. The equipment finance business is focused on larger corporate credits, typically with a credit rating of B or lower, Radway says. “We use our structuring and collateral expertise to provide term financing on what we call 'critical use assets' like manufacturing equipment, information technology equipment and transportation assets,” he adds.

In real estate, the firm has a first mortgage product that's focused on acquisition financing. The firm works with sponsors and developers that are targeting a particular market or property. NXT mainly works on multi-family, industrial and office assets, with some retail and hotel exposure.

“In our real estate products, we only focus on the larger geographic markets. We don't want to be in very small towns, for example, or towns with a single industry that can affect the quality of the real estate pretty dramatically,” says Litwin.

He thinks about real estate investments strategically, in terms of geographies or certain types of assets that might be in or out of favour at a given time in a market cycle. The bulk of the firm's portfolio is in multi-family units, a high-growth sector since the housing market collapsed six years ago. “Real estate is truly a local market. Multi-family is strong in the Southwest, for example, but miserable in the Midwest. So you make sure you do business accordingly and where you think the opportunities are,” he says.

UNCERTAIN FUTURE

NXT's lending strategy, concentrated as it is on protected sectors with seniority in the capital structure, seems to be sound – albeit highly levered compared with some peers. When looking at the firm, industry observers inevitably point to the uncertainty around future ownership. Stone Point will eventually exit its stake and how that capital will be replaced is as yet unknown.

The firm currently has an eight-member board comprised of three members from Stone Point, two from OTPP, Radway and two independent directors.

“They [Stone Point] operate as very constructive members of the board, but the day-to-day operations are left to Robert and the team. They're not investors that are making demands, they're not telling you how to run the business, their attitude is much more 'how can we help?'” Rudd says, adding that Stone Point has introduced NXT to a number of its own LPs that then invested with the lender.

Rudd acknowledges that there will be a change of control, but claims that Stone Point are patient capital and happy with the growth of the business and agree with Radway and his team that there is a lot of runway in terms of building value. “There is no fixed timetable in terms of the sale of the business, but the way I look at it is: we've been for sale since the day we were founded and it's just a question of when is the right time,” Rudd says.

Stone Point invested in NXT through its Trident IV and V funds, a 2006 and 2010 vintage, respectively. And the executives tell PDI that the usual life-cycle of their investments ranges from five to seven years, although there are outliers on both ends. “We're happy to stay with investments for a long period of time when we're happy with the way that are performing, as we are with this one. On the other hand our investors do expect us to monetise our investments at some point,” says Friedman.

Friedman and Stone Point principal Chris Doody say that, in addition to the theme of banks reducing lending activities, GE Capital's exit is also creating more opportunities for alternative lenders and commercial finance companies like NXT. And with NXT specifically, there is more value to be generated, given Radway's plan to grow the asset management platform and write bigger tickets. “You're in a market today where the banks can't participate and compete against NXT and its peers like they used to. In addition to that, GE Capital is going through a transformation and a wind-down, so all of that provides an opportunity to continue building on NXT's market share,” Doody says.

Still, when Stone Point eventually exits, both Rudd and Radway surmise it could involve a public listing or a sale to another organisation. With OTPP as the second largest stakeholder in the firm, NXT, in a similar vein to GE Antares, already has a nod from a prominent Canadian institution. OTPP's Teachers Private Capital, the pension fund's in-house private equity investment unit, bought a stake in the firm in 2010, later increasing it.

While the final outcome is anyone's guess for now, one thing is certain, Radway's shop won't be bought by GE Capital third time around.