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KFN > SEC Filings for KFN > Form 10-Q on 8-Nov-2012All Recent SEC Filings

Show all filings for KKR FINANCIAL HOLDINGS LLC

Form 10-Q for KKR FINANCIAL HOLDINGS LLC


8-Nov-2012

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

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. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and related notes included elsewhere in this Quarterly Report on Form 10-Q. Certain information contained in this Quarterly Report on Form 10-Q constitutes "forward-looking" statements within the meaning of Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934, as amended, that are based on our current expectations, estimates and projections. Statements that are not historical facts, including statements about our beliefs and expectations, are forward-looking statements. The words "believe," "anticipate," "intend," "aim," "expect," "strive," "plan," "estimate," and "project," and similar words identify forward-looking statements. Such statements are not guarantees of future performance, events or results and involve potential risks and uncertainties. Accordingly, actual results and the timing of certain events could differ materially from those addressed in forward-looking statements due to a number of factors including, but not limited to, changes in interest rates and market values, financing and capital availability, changes in prepayment rates, general economic and political conditions and events, changes in market conditions, particularly in the global fixed income, credit and equity markets, the impact of current, pending and future legislation, regulation and legal actions, and other factors not presently identified. Other factors that may impact our actual results are discussed under "Risk Factors" in Item 1A of the Company's Annual Report on Form 10-K filed with the Securities Exchange Commission, or the SEC, on February 28, 2012. We do not undertake, and specifically disclaim, any obligation to publicly release the result of any revisions that may be made to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements, except for as required by federal securities laws.

Executive Overview

We are a specialty finance company with expertise in a range of asset classes. Our core business strategy is to leverage the proprietary resources of our manager with the objective of generating both current income and capital appreciation by deploying capital to our strategies, which include bank loans and high yield securities, natural resources, special situations, mezzanine, commercial real estate and private equity. Our holdings across these strategies primarily consist of below investment grade syndicated corporate loans, also known as leveraged loans, high yield debt securities, private equity, interests in joint ventures and partnerships, and working and royalty interests in oil and gas properties. The corporate loans that we hold are purchased via assignment or participation in the primary or secondary market.

The majority of our holdings consist of corporate loans and high yield debt securities held in collateralized loan obligation ("CLO") transactions that are structured as on-balance sheet securitizations and are used as long term financing for our investments in corporate debt. The senior secured debt issued by the CLO transactions is primarily owned by unaffiliated third party investors and we own the majority of the subordinated notes in the CLO transactions. Our CLO transactions consist of six CLO transactions, KKR Financial CLO 2005-1, Ltd. ("CLO 2005-1"), KKR Financial CLO 2005-2, Ltd. ("CLO 2005-2"), KKR Financial CLO 2006-1, Ltd. ("CLO 2006-1"), KKR Financial CLO 2007-1, Ltd. ("CLO 2007-1"), KKR Financial CLO 2007-A, Ltd. ("CLO 2007-A"), and KKR Financial CLO 2011-1, Ltd. ("CLO 2011-1") (collectively the "Cash Flow CLOs"). We execute our core business strategy through our majority-owned subsidiaries, including CLOs.

We are a Delaware limited liability company and were organized on January 17, 2007. We are the successor to KKR Financial Corp., a Maryland corporation. Our common shares are publicly traded on the New York Stock Exchange ("NYSE") under the symbol "KFN". 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 publicly traded partnership taxable as a corporation.

We are managed by KKR Financial Advisors LLC (our "Manager"), a wholly-owned subsidiary of KKR Asset Management LLC ("KAM"), pursuant to a management agreement (the "Management Agreement"). KAM is a wholly-owned subsidiary of Kohlberg Kravis Roberts & Co. L.P. ("KKR").

Business Environment

During the third quarter, buoyed by open-ended reflationary policy measures from central banks globally, the markets witnessed an increased appetite for risk from certain investors in the search for yield, leading to price appreciation for certain riskier assets as evidenced through the leveraged loan and high yield bond indices. Specifically, the S&P/LSTA Loan Index returned 3.4% for the third quarter of 2012 (as compared to -3.9% for the third quarter of 2011 and 0.7% for the second quarter of 2012) and 8.1% for the nine months ended September 30, 2012 (as compared to -1.3% for the nine months ended September 30, 2011) while the Bank of America Merrill Lynch U.S. High Yield Master II index returned 4.6% for the third quarter of


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2012 (as compared to - 6.3% for the third quarter of 2011 and 1.8% for the second quarter of 2012) and 12.0% for the nine months ended September 30, 2012 (as compared to -1.7% for the nine months ended September 30, 2011).

The rally in both indices drove unrealized mark-to-market gains, which had a positive impact on certain of our equity holdings carried at estimated fair value and loans held for sale, which are carried at the lower of cost or estimated fair value. In addition, interest rates in the U.S. remained low during the third quarter of 2012 with the three-month London interbank offered rate ("LIBOR") at 0.36% as of September 30, 2012 compared to 0.37% as of September 30, 2011 and 0.46% as of June 30, 2012. As a result of the low interest rates, we saw an increase of assets, both through new issue and amendments of existing facilities, offering a LIBOR floor. While the credit markets improved comparatively year over year, the significant predicted reduction in the U.S. budget deficit and corresponding projected slow down of the economy if specific laws are allowed to expire is becoming an increasing source of market uncertainty, which may cause heightened volatility and the potential for a near-term correction.

In addition to our financial assets consisting primarily of bank loans and high yield securities, which are impacted by the factors above, we hold real assets including oil and natural gas properties, which are impacted by the relevant commodity prices. The Henry Hub spot natural gas prices decreased to $3.02 per million British thermal units ("mmBtu") as of September 28, 2012 from $3.76 per mmBtu as of September 30, 2011 and increased from $2.81 per mmBtu as of June 29, 2012. Separately, the WTI Cushing crude oil spot prices increased to $92.18 per barrel as of September 28, 2012 from $78.93 per barrel as of September 30, 2011 and $85.04 per barrel as of June 29, 2012. Revenue earned on our oil and natural gas properties are dependent on volume as well as price. As such, commodity price volatility will impact our net income through other investment income and net realized and unrealized gains and losses on our commodity swaps.

Consolidated Summary of Results

Our net income for the three and nine months ended September 30, 2012 totaled $112.0 million (or $0.61 per diluted common share), and $271.2 million (or $1.48 per diluted common share), respectively, as compared to net income of $39.8 million (or $0.22 per diluted common share), and $241.1 million (or $1.32 per diluted common share), respectively, for the three and nine months ended September 30, 2011. Net income for the three months ended September 30, 2012 consisted of net investment income of $90.0 million, other income totaling $73.3 million and non-investment expenses of $51.0 million. Comparatively, net income for the three months ended September 30, 2011 consisted of net investment income of $86.6 million, other loss totaling $29.3 million and non-investment expenses of $17.9 million. Net income for the nine months ended September 30, 2012 consisted of net investment income before a provision for loan losses of $259.9 million, a provision for loan losses of $46.5 million, other income totaling $171.7 million and non-investment expenses of $117.5 million. Comparatively, net income for the nine months ended September 30, 2011 consisted of net investment income before a provision for loan losses of $269.0 million, a provision for loan losses of $14.2 million, other income totaling $79.7 million and non-investment expenses of $85.1 million.

Net investment income is comprised of total investment income, net of interest expense and provision for loan losses. Total investment income consists primarily of interest income and discount accretion from our investment portfolio, as well as oil and gas revenue from our working and royalty interests in oil and gas properties. Net investment income increased $3.3 million from the three months ended September 30, 2011 to 2012 primarily due to $11.5 million of incremental oil and gas revenue, partially offset by an increase in interest expense of $7.8 million related to our senior note offerings from November 2011 and March 2012. Net investment income before a provision for loan losses decreased $9.1 million from the nine months ended September 30, 2011 to 2012 primarily due to $26.1 million of interest expense on our senior notes offerings and a reduction in loan and securities interest income of $5.4 million, partially offset by $24.8 million of incremental oil and gas revenue generated from additional oil and natural gas properties acquired during 2011 and 2012.

For the nine months ended September 30, 2012, we recorded a provision for loan losses of $46.5 million as compared to $14.2 million for the same period in 2011. Reflecting the $46.5 million provision we recorded, our allowance for loan losses totaled $225.9 million as of September 30, 2012. Of this amount, $76.7 million reflected our allocated reserve and $149.2 million reflected our unallocated reserve.

Other income increased $102.6 million for the three months ended September 30, 2011 to 2012 and $92.0 million for the nine months ended September 30, 2011 to 2012, primarily as a result of larger realized gains on sales and paydowns of certain individual investments during 2012, combined with the fact that the three months ended September 30, 2011 included a $43.8 million lower of cost or estimated fair value charge as a result of overall declines in asset prices leading to unrealized mark-to-market losses.

The components of net income for our reportable segments for the three and nine month periods ended September 30, 2012 and 2011 are detailed further below under "Results of Operations."

Book value per share increased $0.68 from $9.41 as of December 31, 2011, and increased $0.30 from $9.79 as of June 30, 2012 to $10.09 as of September 30, 2012. The increase in book value per share from June 30, 2012 to September 30, 2012 was


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attributable to (i) earnings for the third quarter of $0.63 per basic common share, partially offset by (ii) an increase in accumulated other comprehensive loss, a component of shareholders' equity, of $0.12 per share primarily as a result of reclassification adjustments for gains realized in net income from the sale of certain corporate debt securities and (ii) the distribution to shareholders for the second quarter 2012 of $0.21 per common share.

Cash Distributions to Shareholders

On October 25, 2012, our board of directors declared a cash distribution for the quarter ended September 30, 2012 on our common shares of $0.21 per share. The distribution is payable on November 21, 2012 to common shareholders of record as of the close of business on November 7, 2012.

The amount and timing of our distributions to our common shareholders, including quarterly distributions or any special distributions, is determined by our board of directors and is based upon a review of various factors including current market conditions, existing restrictions under borrowing agreements, the amount of ordinary taxable income or loss earned by us, gains or losses recognized by us on the disposition of assets and our liquidity needs. For this purpose, we will generally determine gains or losses based upon the price we paid for those assets. We note, however, because of the tax rules applicable to partnerships, the gains or losses recognized by a shareholder on the sale of assets held by us may be higher or lower depending upon the purchase price the shareholder paid for our shares. Shareholders may have taxable income or tax liability attributable to our shares for a taxable year that is greater than our cash distributions for such taxable year. See "Non-Cash 'Phantom' Taxable Income" for further discussion about taxable income allocable to holders of our common shares and "Sources of Funds-Credit Facilities" for further discussion about the restrictions on the amount of cash distributions we can pay.

Consolidation

CLO 2005-1, CLO 2005-2, CLO 2006-1, CLO 2007-1, CLO 2007-A and CLO 2011-1 are all variable interest entity ("VIEs") that we consolidate as we have determined we have the power to direct the activities that most significantly impact these entities' economic performance and we have both the obligation to absorb losses of these entities and the right to receive benefits from these entities that could potentially be significant to these entities.

As our condensed consolidated financial statements in this Quarterly Report on Form 10-Q are presented to reflect the consolidation of the Cash Flow CLOs we hold investments in, the information contained in this Management's Discussion and Analysis of Financial Condition and Results of Operations reflects the Cash Flow CLOs on a consolidated basis, which is consistent with the disclosures in our condensed consolidated financial statements.

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 generally other taxes, such as state, local and foreign income taxes, 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 (which are treated as partnerships or disregarded entities 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. In addition, we have recognized and may recognize in the future cancellation of indebtedness income upon the retirement of our debt at a discount. Consequently, in some taxable years, holders of our shares may recognize taxable income in excess of our cash distributions. Furthermore, even if we did not pay cash distributions with respect to a taxable year, holders of our shares may still have a tax liability attributable to their allocation of our taxable income from us during such year.

Investment Portfolio Overview

Our core business strategy is to leverage the proprietary resources of our Manager with the objective of generating both current income and capital appreciation by deploying capital to different strategies that reflect the opportunity set that our Manager specializes in. These strategies and a summary of each are as follows:

Bank loans and high yield: We deploy capital to this strategy primarily through our CLO subsidiaries. This strategy primarily consists of senior secured corporate loans and debt securities, but also includes second lien, unsecured and subordinated corporate loans and debt securities.


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Natural resources: Our natural resources strategy primarily consists of deploying capital to oil and gas opportunities by acquiring working interests in conventional and unconventional producing properties, acquiring mineral and overriding royalty interests in both producing properties and unconventional resource developments (i.e. emerging shale plays) and deploying capital to private equity, joint venture and partnership opportunities focused on the oil and gas sector.

Special situations: Special situations opportunities may take the form of debt and/or equity and generally consist of deploying capital to deeply discounted secondary market opportunities, debtor-in-possession and exit facilities, rescue financing transactions and other distressed opportunities.

Mezzanine: Mezzanine opportunities generally represent the private debt instruments located in the middle of a company's capital structure, senior to common or preferred equity but subordinate to senior secured debt. Generally, mezzanine securities take the form of privately negotiated subordinated debt, and, to a lesser extent, senior notes or preferred stock, with some form of equity participation either through common or preferred stock, options or warrants.

Commercial real estate: Our commercial real estate strategy consists of deploying capital to domestic and foreign opportunities through debt or equity interests, as well as participation in joint ventures and partnerships in commercial real estate properties and fixed income instruments.

Private equity: Our private equity strategy consists of deploying capital to private equity opportunities primarily on a side-by-side basis with KKR's private equity funds.

Refer to "Investment Portfolio" below for a reconciliation of these six core strategies to the line items on our condensed consolidated balance sheets.

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 residual economic interests in the transaction through the subordinated notes in the transaction. As of September 30, 2012, our Cash Flow CLOs, which were structured as financing vehicles engaged in holding primarily corporate debt investments, held $6.4 billion par amount or $6.1 billion estimated fair value of corporate debt investments. Our corporate debt investments held through our Cash Flow CLOs consist of the following as of September 30, 2012:

Corporate loans: Corporate loans consist of bank loans that are held through our CLOs with an aggregate par value of $6.0 billion and estimated fair value of $5.7 billion. Corporate loans held through our CLO transactions have a weighted average coupon of 5.1%, of which 99.9% of the corporate loans are floating rate with a weighted average coupon spread to LIBOR of 4.2%. The remaining 0.1% are fixed rate with a weighted average coupon of 11.5%.

Corporate debt securities: Corporate debt securities consist of high yield bonds held through our CLOs with an aggregate par amount of $393.2 million and estimated fair value of $389.5 million. Corporate debt securities held through our CLO transactions have a weighted average coupon of 9.0%, of which 90.9% of the corporate debt securities are fixed rate with a weighted average coupon of 9.6%. The remaining 9.1% are floating rate with a weighted average coupon spread to LIBOR of 2.6%.

Weighted average coupon and coupon spreads are calculated based on par values. Fixed and floating percentages are also calculated based on par values.

In addition to the corporate debt portfolio, we hold two pay-fixed, receive-variable interest rate swaps through certain of our CLOs. These interest rate derivatives consist of swaps to hedge a portion of the interest rate risk associated with our borrowings under the CLO senior secured notes. As of September 30, 2012, the contractual notional balance of our amortizing interest rate swaps was $383.3 million.

These Cash Flow CLOs had aggregate secured debt outstanding totaling $5.0 billion held by unaffiliated third parties and aggregate junior secured notes outstanding totaling $296.9 million 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. As we hold the majority or all of the subordinated notes in each of the Cash Flow CLOs, we consolidate all of the Cash Flow CLOs and reflect all income and losses related to the assets in these Cash Flow CLOs on our condensed consolidated statement of operations even though there are minority interests in two of our CLO transactions that we do not hold.


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The indentures governing the CLO transactions stipulate the reinvestment period during which the collateral manager, an affiliate of our Manager, can generally sell or buy assets at its discretion and can reinvest principal proceeds into new assets. CLO 2007-A ended its reinvestment period during the fourth quarter of 2010, both CLO 2005-1 and CLO 2005-2 ended their reinvestment periods in the second quarter of 2011 and CLO 2006-1 ended its reinvestment period in the third quarter of 2012. As a result, principal proceeds from the assets held in each of these transactions are generally used to amortize the outstanding balance of senior notes outstanding. During the three and nine months ended September 30, 2012, $114.9 million and $636.7 million, respectively, of original CLO 2007-A, CLO 2005-1 and CLO 2005-2 senior notes were repaid. During the three and nine months ended September 30, 2011, $253.1 million and $474.7 million, respectively, of original CLO 2007-A, CLO 2005-1 and CLO 2005-2 senior notes were repaid. CLO 2007-1 will end its respective reinvestment period during May 2014. CLO 2011-1 does not have a reinvestment period and all principal proceeds from holdings in CLO 2011-1 will be used to amortize the transaction. During the three and nine months ended September 30, 2012, $10.9 million and $66.1 million, respectively, of original CLO 2011-1 senior notes were repaid. Accordingly, absent any new CLO transactions that we may enter into, our total investments held through CLOs will continue to decline as investments are paid down or paid off once the reinvestment period ends. In addition, pursuant to the terms of the indentures governing our CLO transactions, we have the ability to call in a CLO transaction by redeeming the notes and reinvesting the proceeds into a new CLO.

On an unconsolidated basis, which reflects our interests in our CLO subsidiaries as notes versus actual corporate loans and high yield securities on a consolidated basis, our investment portfolio primarily consists of the following holdings as of September 30, 2012:

CLO note holdings: We hold $1.1 billion par amount and $1.3 billion estimated fair value of mezzanine and subordinated notes in our six Cash Flow CLO transactions. As our Cash Flow CLOs are consolidated under accounting principles generally accepted in the United States of America ("GAAP"), these holdings are not reflected on our condensed consolidated balance sheet as the assets and liabilities of our CLO subsidiaries are consolidated and our ownership interests in the Cash Flow CLOs are eliminated for consolidation.

Corporate loans: Our corporate loans consist of bank loans that are held outside of our CLO transactions. These corporate loans have an aggregate par value of $207.8 million and estimated fair value of $146.4 million. These loans have a weighted average coupon of 5.9% and are all floating rate with a weighted average coupon spread to LIBOR of 5.4%. In addition, we hold equity from two issuers with an aggregate estimated fair value of $34.9 million, which were restructured from debt instruments to equity.

Corporate debt securities: Our corporate debt securities consist of high yield bonds. These corporate debt securities have an aggregate par value of $18.1 million and estimated fair value of $18.4 million. These debt securities have a weighted average coupon of 15.0% and our floating rate corporate debt security has a weighted average coupon spread to LIBOR of 15.0%.

Natural resources: Our natural resources holdings consist of (i) oil and gas working interests in proved developed and proved undeveloped properties with a carrying amount of $257.5 million, partially financed with $107.8 million borrowed under a non-recourse, asset-based credit facility, (ii) overriding royalty interests with a carrying amount of $48.3 million, and (iii) private equity and joint venture transactions focused on the oil and gas sector with an aggregate cost basis of $98.3 million and an estimated fair value of $103.4 million.

Special situations: Our special situations holdings consist of
(i) $179.9 million par amount of debt investments with an $111.6 million amortized cost and estimated fair value of $126.6 million, (ii) $39.7 million amortized cost of equity, including warrants, with an estimated fair value of $46.3 million, and (iii) $16.7 million amortized cost of other investments with an estimated fair value of $18.3 million. The $179.9 million par amount of debt has a weighted average coupon of 7.2%.

Mezzanine: Our mezzanine holdings consist of (i) $97.0 million par amount of debt with an estimated fair value of $96.1 million and
(ii) $6.7 million amortized cost of equity with an estimated fair value of $7.4 million. The $97.0 million par amount of mezzanine debt has a weighted average coupon of 14.8%.

Commercial real estate: Our commercial real estate holdings consist of three investments with a carrying value of $44.7 million, all of which were acquired during 2012.


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Private equity: Our private equity holdings, excluding those related to the oil and gas sector, have an aggregate cost basis of $51.2 million with an estimated fair value of $58.8 million.

Residential mortgage-backed securities ("RMBS"): Our RMBS have an aggregate par amount of $161.0 million with an estimated fair value of $86.9 million.

Critical Accounting Policies

Our condensed 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.

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