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| KFN > SEC Filings for KFN > Form 10-K on 2-Mar-2009 | All Recent SEC Filings |
2-Mar-2009
Annual Report
Except where otherwise expressly stated or the context suggests otherwise, the terms "we," "us" and "our" refer to KKR Financial Holdings LLC and its subsidiaries.
Executive Overview
We are a specialty finance company that uses leverage with the objective of generating competitive risk-adjusted returns. We invest in financial assets consisting primarily of below investment grade corporate debt, including senior secured and unsecured loans, mezzanine loans, high yield corporate bonds, distressed and stressed debt securities, marketable and non-marketable equity securities and credit default and total rate of return swaps. The majority of our investments are in senior secured loans of large capitalization companies. The corporate loans we invest in are generally referred to as syndicated bank loans, or leveraged loans, and are purchased via assignment or participation in either the primary or secondary market. The majority of our corporate debt investments are held in collateralized loan obligation ("CLO") transactions that are structured as on-balance sheet securitizations and are used as long term financing for these investments. The senior secured notes issued by the CLO transactions are generally owned by unaffiliated third party investors and we own the majority of the mezzanine and subordinated notes in the CLO transactions.
Our income is generated primarily from (i) net interest income and dividend income, (ii) realized and unrealized gains and losses on our derivatives that are not accounted for as hedges, (iii) realized gains and losses from the sales of investments, and (iv) realized and unrealized gains and losses on securities sold, not yet purchased.
We are a Delaware limited liability company and were organized on January 17, 2007. We are the successor to KKR Financial Corp. (the "REIT Subsidiary"), a Maryland corporation. The REIT Subsidiary was originally incorporated in the State of Maryland on July 7, 2004 and elected to be treated as a real estate investment trust ("REIT") for United States federal income tax purposes. On May 4, 2007, we completed a restructuring transaction (the "Restructuring Transaction"), pursuant to which the REIT Subsidiary became our subsidiary and each outstanding share of the REIT Subsidiary's common stock was converted into one of our common shares, which are publicly traded on the New York Stock Exchange ("NYSE") under the symbol "KFN". Although we have not elected to be treated as a REIT for United States federal income tax purposes, we intend to continue to operate so as to qualify as a partnership, and not as an association or publicly traded partnership taxable as a corporation, for United States federal income tax purposes. On June 30, 2008, we completed the sale of a controlling interest in the REIT Subsidiary to Rock Capital 2 LLC, which did not result in a gain or loss.
We are managed by KKR Financial Advisors LLC (our "Manager"), a wholly-owned subsidiary of Kohlberg Kravis Roberts & Co. (Fixed Income) LLC (previously known as KKR Financial LLC), pursuant to a management agreement (the "Management Agreement"). The Manager is an affiliate of Kohlberg Kravis Roberts & Co. L.P. ("KKR"). In June 2008, Kohlberg Kravis Roberts & Co. (Fixed Income) LLC became a wholly-owned subsidiary of KKR.
Our financial performance is highly dependent on the underlying performance of the companies that we hold investments in, primarily in the form of corporate loans and high yield securities. During 2008, credit conditions worsened and the United States entered into a recession (as announced by the National Bureau of Economic Research). The landscape of the United States financial services industry changed dramatically during 2008 as some of the world's largest investment and commercial banks filed
for bankruptcy while others consolidated or restructured their businesses. The current credit crisis led to historic asset price declines during the year across most fixed income and equity asset classes.
The deteriorating economic environment impacted our business in many ways during 2008. Most notably, many of the companies that we hold investments in experienced deteriorating financial performance, which has led us to materially increase our allowance for loan losses, specifically during the fourth quarter of 2008, and record impairment charges for investments in certain securities that we deemed other-than-temporarily impaired. Asset price declines also resulted in material losses on certain derivative transactions where we finance loan investments through total rate of return swaps. In addition, asset price declines coupled with rating agency downgrades of several of our investments have led to many of the CLO transactions we own, through which the majority of our investments in loans and high yield securities are held and financed, to fail certain of their respective over-collateralization tests ("OC Tests"). Due to the failure of these OC Tests, the cash flows we normally receive from our CLOs have been materially reduced. In addition, declining asset prices required us to post material amounts of cash collateral to our market value CLO transaction, Wayzata Funding LLC ("Wayzata"). Additionally, Wayzata's market value features have resulted in cash being effectively trapped in the facility and not being paid to the junior noteholders, including us, because the net asset value of Wayzata did not meet certain limits. As discussed below under "Liquidity", subsequent to year end, we amended Wayzata to, among other changes, remove the market value provisions contained within the transaction.
On November 10, 2008, we and certain of our subsidiaries (collectively, the "Borrowers") entered into a Credit Agreement (the "Credit Agreement") with Bank of America, N.A. and Citicorp North America, Inc., as lenders. The Credit Agreement provides for a two-year $300.0 million senior secured asset-based revolving credit facility (the "Facility"). The Facility is subject, among other things, to the terms of a borrowing base derived from the value of eligible specified financial assets. The borrowing base is subject to certain reserves and caps customary for financings of this type. Prior to the one-year anniversary of the closing of the credit agreement (the "Adjustment Date"), the Borrowers (i) may borrow, prepay and reborrow amounts in excess of the borrowing base availability and (ii) must prepay loans with net cash proceeds from certain types of asset sales to the extent aggregate amounts outstanding under the Facility exceed the borrowing base then in effect. On and after the Adjustment Date, if at any time the aggregate amounts outstanding under the Facility exceed the borrowing base then in effect, a prepayment of an amount sufficient to eliminate such excess is required to be made.
The Borrowers have the right to prepay loans under the Facility in whole or in part at any time. All amounts borrowed under the Credit Agreement must be repaid on or before November 10, 2010. Initial borrowings under the Credit Agreement are subject to, among other things, the substantially concurrent repayment by the Borrowers of all amounts due and owing under the existing credit facility and such facility's effective termination.
Loans under the Credit Agreement bear interest, at the Borrowers' option, at
a rate equal to LIBOR plus 3.00% per annum or an alternate base rate. Ongoing
extensions of credit under the Credit Agreement are subject to customary
conditions, including, after the Adjustment Date, sufficient availability under
the borrowing base. The Credit Agreement also contains covenants that require
the Borrowers to satisfy a net worth financial test and maintain a certain
leverage ratio. In addition, the Credit Agreement contains customary negative
covenants applicable to the Borrowers and their subsidiaries, including negative
covenants that restrict the ability of such entities to, among other things,
(i) incur additional indebtedness or engage in certain other types of financing
transactions, (ii) allow certain liens to attach to such entities' assets, and
(iii) pay dividends to our shareholders or make certain other restricted
payments. The Credit Agreement also includes other covenants, representations,
warranties, indemnities and events of default, that are customary for facilities of this type, including events of default relating to a change of control.
On November 10, 2008, the Borrowers also entered into an agreement for a two-year $100.0 million standby unsecured revolving credit agreement (the "Standby Agreement") with our Manager and Kohlberg Kravis Roberts & Co. (Fixed Income) LLC, the parent of our Manager. The borrowing facility matures in December 2010 and bears interest at a rate equal to LIBOR for an interest period of 1, 2 or 3 months (at our option) plus 15.00% per annum. Under the terms of the agreement, we can elect to capitalize a portion of accrued interest on any loan under the agreement by adding up to 80% of the interest due and payable at a particular time in respect of such loan to the outstanding principal amount of the loan. The Borrowers have the right to prepay loans under the Standby Agreement in whole or in part at any time. The Standby Agreement includes covenants, representations, warranties, indemnities and events of default that are customary for facilities of this type.
Current market economic conditions have had a material adverse impact on our cash flows and liquidity. Asset price declines, due in significant part to material credit spread widening and deteriorating economic conditions, have negatively impacted our liquidity. Declines in asset prices coupled with ratings downgrades of many of our investments have led many of our cash flow CLOs to fail certain of their respective OC Tests. Due to the failure of these OC Tests, the cash flows we normally receive from our CLOs have been materially reduced as of December 31, 2008. While the amount of cash proceeds we expect to receive from cash flow CLOs can fluctuate materially based on interest rates and asset performance, we expect that our 2009 cash flows will be reduced by $150.0 million to $175.0 million as a result of our CLOs being out of compliance with their respective OC Tests. As the majority of our investments are held in these CLO structures, we believe that all of our cash flow CLOs will continue to cease being cash flow positive during at least intermittent periods in 2009.
In addition, during 2008 we invested an incremental $180.0 million in the
junior notes of Wayzata in response to declines in asset prices and the net
asset value of Wayzata during the year. Additionally, we significantly
deleveraged Wayzata during the fourth quarter of 2008 through asset sales
totaling approximately $628.9 million of par that resulted in net realized
losses totaling $137.5 million. On January 12, 2009, Wayzata was amended to
eliminate the market value-based covenants and, consequently, we are no longer
required to post additional cash margin as a result of declining market values
of the underlying collateral. Nevertheless, under the amended facility, cash
flow generated by the collateral will not be distributed to junior noteholders,
including us, until all senior obligations of Wayzata are paid in full or
otherwise satisfied. We cannot predict at this time how long the cessation of
cash flows will last. Several additional changes were made to Wayzata as part of
the amendment process, including, to (i) increase the coupon on the senior
secured notes to three-month LIBOR plus 3.75%, which under certain circumstances
may be increased to a maximum of three-month LIBOR plus 5.00%, (ii) reduce the
aggregate outstanding par amount of senior secured notes to approximately
$675.0 million using free cash in the structure and proceeds from the sale of
certain assets designated for liquidation by the senior noteholder,
(iii) significantly limit the Wayzata portfolio manager's right to reinvest
principal proceeds from the collateral in new assets and (iv) give the
noteholders, including us, the collective right to restructure Wayzata into a
cash flow CLO transaction. If Wayzata is restructured into a cash flow CLO
transaction, we would hold junior notes issued by the new CLO issuer having an
outstanding par amount equal to the amount we currently hold, which would be
secured primarily by the same collateral underlying Wayzata. In addition, it is
currently contemplated that under the new CLO transaction, if it closes, the
portfolio manager may be required to undertake certain asset sales to meet
leverage requirements and would have a less restrictive right to reinvest the
principal proceeds
generated from the collateral into new assets; however, like Wayzata, any cash flow generated by the collateral would not be distributed to junior noteholders until all senior obligations of the CLO issuer were paid in full or otherwise satisfied.
As of December 31, 2008, we had approximately $855.8 million of total recourse debt outstanding. Of this amount, up to $150.0 million of the $275.6 million currently outstanding on our senior secured revolving credit facility matures in November 2009 with the remainder maturity in November 2010. Under the Standby Agreement, through which we have a $100.0 million unsecured revolving credit facility from our Manager, all principal outstanding is due in December 2010. We currently have no borrowings outstanding under this facility. In addition to these amounts, we have $291.5 million principal amount of convertible notes due to mature in July 2012. We also have approximately $50.0 million in derivative liabilities related to total rate of return swaps through which we have financed certain loan investments. The majority of this amount matures during the fourth quarter of 2009. Based on our current liquidity and access to liquidity through the Standby Agreement, we believe that we are able to meet our obligations for at least the next 12 months.
During 2008, we paid aggregate cash distributions totaling $178.3 million. The amount and timing of our distributions to our common shareholders are determined by our board of directors and is based upon a review of various factors including current market conditions, existing restrictions under borrowing agreements and our liquidity needs.
As discussed above, the Credit Agreement contains negative covenants that restrict our ability, among other things, to pay dividends or make certain other restricted payments, including a prohibition on distributions to our shareholders in an amount in excess of what would be required to pay all federal, state and local income taxes arising from the taxable income and gain that our shareholders incur in connection with the ownership of our common shares. We have not declared any cash distributions to shareholders for the third or fourth quarters of 2008 and do not currently expect that any cash distributions will be made during 2009.
Non-Cash "Phantom" Taxable Income
We intend to continue to operate so as to qualify, for United States federal income tax purposes, as a partnership and not as an association or a publicly traded partnership taxable as a corporation. Holders of our shares are subject to United States federal income taxation and, in some cases, state, local and foreign income taxation, on their allocable share of our taxable income, regardless of whether or when they receive cash distributions. In addition, certain of our investments, including investments in foreign corporate subsidiaries, CLO issuers, including those treated as partnerships or disregarded as a separate entity from us for United States federal income tax purposes, and debt securities, may produce taxable income without corresponding distributions of cash to us or produce taxable income prior to or following the receipt of cash relating to such income. Consequently, in some taxable years, holders of our shares may recognize taxable income in excess of our cash distributions. Furthermore, if we did not pay cash distributions with respect to a taxable year, holders of our shares would still have a tax liability attributable to their allocation of our taxable income during such year. We expect this to be the case as we do not expect to make any cash distributions to shareholders during 2009 and potentially thereafter.
In August 2007, our board of directors approved a plan to exit our residential mortgage investment operations and sell the REIT Subsidiary. As of January 1, 2008, the REIT Subsidiary's assets and liabilities consisted solely of those held by our two asset-backed commercial paper conduits (the "Facilities"). During March 2008, we entered into an agreement with the holders of the secured
liquidity notes ("SLNs") issued by the Facilities (the "Noteholders") in order to terminate the Facilities. With respect to the agreement with the Noteholders, all of the residential mortgage-backed securities ("RMBS") funded by the SLNs were transferred to the Noteholders in satisfaction of the SLNs and we paid the Noteholders approximately $42.0 million in conjunction with this resolution. We had previously accrued $36.5 million for contingencies related to the resolution of the Facilities and as a consequence of this transaction, we recorded an incremental charge during the quarter ended March 31, 2008 for $5.5 million. The agreement with the Noteholders resulted in approximated $3.6 billion par amount of RMBS being transferred to the Noteholders in satisfaction of approximately $3.5 billion par amount of SLNs held by the Noteholders. Accordingly, we removed the RMBS and SLNs that related to the Facilities from our condensed consolidated financial statements as of March 31, 2008. Under the agreement with the Noteholders, both we and our affiliates were released from any future obligations or liabilities to the Noteholders.
As of June 30, 2008, we substantially completed our plan to exit our residential mortgage investment operations through the sale of certain of our residential mortgage-backed securities in the third quarter of 2007 and the agreement with the Noteholders related to the Facilities described above. In addition, on June 30, 2008, we completed the sale of a controlling interest in the REIT Subsidiary to Rock Capital 2 LLC, which did not result in a gain or loss. Accordingly, the REIT Subsidiary is presented as discontinued operations for financial statement purposes for all periods presented.
We have determined that a sale or transfer of our remaining residential mortgage portfolio is no longer probable. As such, our remaining residential mortgage investment operations, which were previously presented as discontinued operations, are presented as continuing operations and the associated prior period amounts presented in our consolidated financial statements relating to our existing residential mortgage assets and liabilities as of December 31, 2008 have been reclassified for comparative presentation.
As discussed above, the majority of our investments are held through CLO
transactions that are managed by an affiliate of our Manager and for which we
own the majority, and in some cases all, of the economic interests in the
transaction through the subordinated notes in the transaction. On an
unconsolidated basis, our investment portfolio primarily consists of the
following as of December 31, 2008: (i) mezzanine and subordinated tranches of
CLO transactions, excluding Wayzata, totaling a par amount of $1.3 billion;
(ii) subordinated tranches of Wayzata totaling a par amount of $500.0 million;
(iii) corporate loans and debt securities with an amortized cost of
$352.2 million and an estimated fair value of $196.7 million; (iv) residential
mortgage-backed securities ("RMBS") with a par amount of $346.6 million and
estimated fair value of $270.7 million; (v) non-marketable equity securities
with an aggregate cost basis of $22.8 million; (vi) marketable equity securities
with an aggregate estimated fair value of $2.5 million. In addition, we hold
other investments including loan investments financed under total rate of return
swaps that are accounted for as derivative transactions, long and short credit
default swap transactions, shorts on equity and debt instruments, and interest
rate swaps.
As our consolidated financial statements in the Annual Report on Form 10-K are presented to reflect the consolidation of the CLOs we hold investments in, including Wayzata, the information contained in this Management's Discussion and Analysis of Financial Condition and Results of Operations reflects the CLOs and Wayzata on a consolidated basis consistent with the disclosures in our consolidated financial statements.
Our investments in corporate debt primarily consist of investments in below investment grade corporate loans, often referred to as syndicated bank loans or leveraged loans, and corporate debt securities. These investments have a total net amortized cost of $8.8 billion or $5.7 billion estimated fair value as of December 31, 2008. Of these amounts, $8.4 billion amortized cost or $5.4 billion estimated fair value of corporate debt investments are held in CLO transactions. In accordance with accounting principles generally accepted in the United States of America ("GAAP"), loans that are not deemed to be held for sale are carried at amortized cost net of allowance for loan losses on our consolidated balance sheet. Loans that are classified as held for sale are carried at the lower of net amortized cost or estimated fair value on our consolidated balance sheet. Debt securities and marketable equity securities are carried at estimated fair value on our consolidated balance sheet.
We currently have six CLO transactions through which we finance our corporate debt investments. These transactions consist of five cash flow CLOs and one market value CLO, Wayzata. A minority interest in the subordinated notes issued by two of our cash flow CLOs totaling $530.3 million (presented as collateralized loan obligation junior secured notes to affiliates on our consolidated balance sheet) and Wayzata totaling $125.0 million (presented as subordinated notes to affiliates on our consolidated balance sheet) are held by an affiliate of our Manager. In CLO transactions, subordinated notes effectively represent the equity in such transactions as they have the first risk of loss and conversely, the residual value upside of the transactions. Under GAAP, we consolidate all six of the CLOs and reflect all income and losses related to the assets in these CLOs on our consolidated statement of operations even though an affiliate of our Manager holds a minority interest in three of our CLO transactions.
Our residential mortgage investment portfolio consists of investments in RMBS with an estimated fair value of $270.7 million as of December 31, 2008. Of the $270.7 million of RMBS investments we hold, $167.9 million are in six residential mortgage-backed securitization trusts that we consolidate under GAAP as we hold the majority of the risk of loss on these transactions. This results in us reflecting the financial position and results of these trusts in our consolidated financial statements. Consolidation of these six entities does not impact our net assets or net income; however, it does result in us showing the consolidated assets, liabilities, revenues and expenses on our consolidated financial statements. On our consolidated balance sheet as of December 31, 2008, the $270.7 million of RMBS is computed as our investments in RMBS of $102.8 million, plus $167.9 million, which represents the difference between residential mortgage loans of $2.6 billion less residential mortgage-backed securities issued of $2.5 billion plus $10.8 million of real estate owned that is included in other assets on our consolidated balance sheet.
During the year ended December 31, 2008, we retired $40.0 million of junior subordinated notes, which resulted in a gain on extinguishment of $20.3 million, partially offset by a $1.3 million write-off of unamortized debt issuance costs and $0.8 million of other associated costs.
In November 2008, we retired $8.5 million of our 7.00% convertible notes, which resulted in a gain on extinguishment of $6.2 million, partially offset by a $0.1 million write-off of unamortized debt issuance costs.
On April 8, 2008, we completed a public offering of 34.5 million common shares at a price of $11.85 per common share. Net proceeds from the transaction before expenses totaled $384.3 million.
Critical Accounting Policies
Our consolidated financial statements are prepared by management in conformity with GAAP. Our significant accounting policies are fundamental to understanding our financial condition and results of operations because some of these policies require that we make significant estimates and assumptions that may affect the value of our assets or liabilities and financial results. We believe that certain of our policies are critical because they require us to make difficult, subjective, and complex judgments about matters that are inherently uncertain. We have reviewed these critical accounting policies with our board of directors and our audit committee.
Effective January 1, 2007, we adopted SFAS No. 157, Fair Value Measurements ("SFAS No. 157"), which requires additional disclosures about our assets and liabilities that are measured at fair value.
As defined in SFAS No. 157, fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Where available, fair value is based on observable market prices or parameters or derived from such prices or parameters. Where observable prices or inputs are not available, valuation models are applied. These valuation techniques involve some level of management estimation and judgment, the degree of which is dependent on the price transparency for the instruments or market and the instruments' complexity for disclosure purposes. Beginning in January 2007, assets and liabilities recorded at fair value in the consolidated balance sheets are categorized based upon the level of judgment associated with the inputs used to measure their value. Hierarchical levels, as defined in SFAS No. 157 and directly related to the amount of subjectivity associated with the inputs to fair valuations of these assets and liabilities, are as follows:
Level 1: Inputs are unadjusted, quoted prices in active markets for identical assets or liabilities at the measurement date.
The types of assets carried at level 1 fair value generally are equity securities listed in active markets.
Level 2: Inputs other than quoted prices included in level 1 that are . . .
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