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| KFN > SEC Filings for KFN > Form 10-K on 28-Feb-2013 | All Recent SEC Filings |
28-Feb-2013
Annual Report
Management's discussion and analysis is comprised of the following sections:
Page
EXECUTIVE OVERVIEW 65
Business Environment 65
Consolidated Summary of Results 66
Cash Distributions to Shareholders 66
Funding Activities 67
Investment Portfolio 69
CRITICAL ACCOUNTING POLICIES 71
RESULTS OF OPERATIONS 79
Consolidated Results 79
Segment Results 81
Credit Segment 82
Natural Resources Segment 86
Other Segments 91
Income Tax Provision 92
Investment Portfolio 93
Corporate Loans 94
Corporate Debt Securities 99
Other Holdings 100
Shareholders' Equity 105
LIQUIDITY AND CAPITAL RESOURCES 106
Sources of Funds 106
Off-Balance Sheet Commitments 110
Contractual Obligations 111
PARTNERSHIP TAX MATTERS 112
OUR INVESTMENT COMPANY ACT STATUS 114
OTHER REGULATORY ITEMS 119
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 119
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 Part II, Item 6, "Selected Consolidated Financial Data" and our consolidated financial statements included elsewhere in this Annual Report on Form 10-K. In addition to historical data, this discussion contains forward-looking statements about our business, operations and financial performance based on current expectations that involve risks, uncertainties and assumptions. Our actual results may differ materially from those in this discussion as a result of various factors, including but not limited to those discussed in "Item I, Part 1A. Risk Factors" included elsewhere in this Annual Report on Form 10-K.
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 typically 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 seven 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"), KKR Financial CLO 2011-1, Ltd. ("CLO 2011-1") and KKR Financial CLO 2012-1, Ltd. ("CLO 2012-1") (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 that we 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
Throughout 2012, we witnessed spread tightening in the high yield debt markets and overall increased appetite for risk from certain investors in the search for yield, which led to price appreciation for certain riskier assets as evidenced through the leveraged loan and high yield bond indices. In comparison, 2011 experienced significant market swings with constrained liquidity and wider credit spreads triggered by downside macroeconomic and political concerns. Specifically, the S&P/LSTA Loan
Index returned 9.7% for 2012 (as compared to 1.5% for 2011) while the Bank of America Merrill Lynch U.S. High Yield Master II index returned 15.6% for 2012 (as compared to 4.4% for 2011).
The rally in both indices drove unrealized mark-to-market gains, which had a positive impact on certain of our equity investments carried at estimated fair value and loans held for sale, which are carried at the lower of cost or estimated fair value. The price appreciation also drove substantially higher net realized gains on investments relative to the prior year period as we disposed of certain assets, most notably from our high yield bond portfolio.
As the majority of our assets and liabilities include floating interest rate provisions indexed to three-month London interbank offered rate ("LIBOR"), changes in interest rates impact our net income through interest income and expense. Interest rates in the U.S. remained low during 2012 with the three-month LIBOR ending at 0.31% as of December 31, 2012 compared to 0.58% the year before. However, the average three-month LIBOR rate increased to 0.43% for the year ended December 31, 2012, from 0.34% for the year ended December 31, 2011. As a result of the low interest rates, we saw an increase of assets available on the market, both through new issue and amendments of existing facilities, offering a LIBOR floor.
In addition to our financial assets consisting primarily of bank loans and high yield bonds, 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 price increased to $3.41 per million British thermal units ("MMBtu") as of December 31, 2012, from $3.03 per MMBtu as of December 31, 2011. Separately, the WTI Cushing crude oil spot price decreased to $91.83 per barrel ("Bbl") as of December 30, 2012, from $98.83 per Bbl as of December 30, 2011. Revenue earned on our oil and natural gas properties are dependent on volumes produced as well as price. As such, commodity price volatility will impact our net income through total revenues and net realized and unrealized gains and losses on our commodity swaps.
Consolidated Summary of Results
Our net income for the year ended December 31, 2012 totaled $348.2 million (or $1.87 per diluted common share), as compared to net income of $318.1 million (or $1.75 per diluted common share) and $371.1 million (or $2.32 per diluted common share) for the years ended December 31, 2011 and 2010, respectively. Additional discussion around our consolidated results, as well as the components of net income for our reportable segments for the years ended December 31, 2012, 2011 and 2010 are detailed further below under "Results of Operations."
Book value per share increased $0.90 from $9.41 as of December 31, 2011 to $10.31 as of December 31, 2012. The increase in book value per share from December 31, 2011 was attributable to (i) earnings for the year ended December 31, 2012 of $1.95 per basic common share, partially offset by (ii) an increase in accumulated other comprehensive loss, a component of shareholders' equity, of $0.19 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 during the year ended December 31, 2012 of $0.86 per common share.
Cash Distributions to Common Shareholders
During 2012, we paid aggregate cash distributions totaling $153.4 million. The amount and timing of our distributions to our common shareholders, including any special distributions, is determined by our board of directors and is based upon a review of various factors including current market conditions, our liquidity needs, legal and contractual restrictions on the payment of distributions, including those under the terms of our preferred shares, 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 common shares. Shareholders may have taxable income or tax liability attributable to our common shares for a taxable year that is greater than our cash distributions for such taxable year. See "Non-Cash 'Phantom' Taxable Income" below for further discussion about taxable income allocable to holders of our common shares. We may not declare or pay distributions on our common shares unless all accrued distributions have been declared and paid, or set aside for payment, on our 7.375% Series A LLC Preferred Shares ("Series A LLC Preferred Shares").
Funding Activities
Senior Notes Offering
On March 20, 2012, we issued $115.0 million par amount of 7.500% senior notes due March 20, 2042 ("7.500% Senior Notes"), resulting in net proceeds of $111.4 million. The notes trade under the ticker symbol "KFI" on the NYSE. Interest on the 7.500% Senior Notes is payable quarterly in arrears on June 20, September 20, December 20 and March 20 of each year.
Credit Facilities
On November 30, 2012, we entered into a credit agreement for a three-year $150.0 million revolving credit facility (the "2015 Facility"), maturing on November 30, 2015. We may obtain additional commitments under the 2015 Facility so long as the aggregate amount of commitments at any time does not exceed $350.0 million. We have the right to prepay loans under the 2015 Facility in whole or in part at any time. In connection with entering into the 2015 Facility, we terminated the commitments under our existing asset-based revolving credit facility. Loans under the 2015 Facility bear interest at a rate equal to, at our option, LIBOR plus 2.25% per annum, or an alternate base rate plus 1.25% per annum. The 2015 Facility contains customary covenants, including ones that require us to satisfy a net worth financial test and maintain certain ratios relating to leverage and consolidated total assets. In addition, the 2015 Facility contains customary negative covenants applicable to us.
On December 7, 2012, our five-year non-recourse, asset-based revolving credit facility (the "2015 Natural Resources Facility"), maturing on November 5, 2015, was adjusted and reduced to $126.1 million, that is subject to, among other things, the terms of a borrowing base derived from the value of eligible specified oil and gas assets. The borrowing base is subject to certain caps and concentration limits customary for financings of this type. We have the right to prepay loans under the 2015 Natural Resources Facility in whole or in part at any time. Loans under the 2015 Natural Resources Facility bear interest at a rate equal to LIBOR plus a tiered applicable margin ranging from 1.75% to 2.75% per annum. The 2015 Natural Resources Facility contains customary covenants applicable to us. As of December 31, 2012, we had $107.8 million of borrowings outstanding under the 2015 Natural Resources Facility.
CLOs
On December 21, 2012, we closed CLO 2012-1, a $412.4 million secured financing transaction maturing December 16, 2024. We issued $367.5 million par amount of senior secured notes to unaffiliated investors, of which $342.5 million was floating rate with a weighted-average coupon of three-month LIBOR plus 2.09% and $25.0 million was fixed rate at 2.39%. We also issued $21.5 million of subordinated notes. The investments that are owned by CLO 2012-1 collateralize the CLO 2012-1 debt, and as a result, those investments are not available to us, our creditors or shareholders.
Preferred Offering
On January 17, 2013, we issued 14.95 million of Series A LLC Preferred Shares for gross proceeds of $373.8 million, and net proceeds of $362.0 million. The Series A LLC Preferred Shares trade on the New York Stock Exchange under the ticker symbol "KFN.PR" and began trading on January 28, 2013. Distributions on the Series A LLC Preferred Shares are cumulative and are payable, when, as, and if declared by our board of directors, quarterly on January 15, April 15, July 15 and October 15 of each year, beginning April 15, 2013, at a rate per annum equal to 7.375%.
Convertible Debt
On January 18, 2013, in accordance with the indenture relating to our $172.5 million of 7.5% convertible senior notes due January 15, 2017 (the "7.5% Notes"), we issued a conversion rights termination notice ("Termination Notice") to holders of the 7.5% Notes whereby we terminated the right to convert the 7.5% Notes to common shares. Holders of $172.5 million 7.5% Notes submitted their notes for conversion for which we satisfied by physical settlement with 26.1 million common shares, or 151.0580 shares per $1,000 principal amount of 7.5% Notes.
Consolidation
Our Cash Flow CLOs are all variable interest entities ("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 consolidated financial statements in this Annual Report on Form 10-K are presented to reflect the consolidation of the 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 consolidated financial statements.
Non-Cash "Phantom" Taxable Income
We intend to continue to operate so that we 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, disregarded entities or foreign corporations for United States federal income tax purposes), partnerships generally and debt securities, may produce taxable income without corresponding distributions of cash to us or may 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. We generally allocate our taxable income and loss using a monthly convention, which means that we determine our taxable income and losses for the taxable year to be allocated to our shares and then prorate that amount on a monthly basis. 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:
º •
º 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.
º •
º Natural resources: Our natural resources strategy primarily consists
of deploying capital to oil and gas opportunities by acquiring
non-operated working interests in conventional and unconventional
areas, 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.
º •
º 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.
º •
º 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.
º •
º 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.
º •
º 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 "Results of Operations-Investment Portfolio" below for a reconciliation of these six core strategies, which differs from our reportable segments, to the line items on our 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 December 31, 2012, our Cash Flow CLOs, which were structured as financing vehicles engaged in holding primarily corporate debt investments, held $6.3 billion par amount or $6.0 billion estimated fair value of corporate debt investments. Our corporate debt investments held through our Cash Flow CLOs consist of the following as of December 31, 2012:
º •
º 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 $5.6 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 4.3%. The remaining 0.1% are fixed rate with a weighted average coupon of 11.5%.
º •
º Corporate debt securities: Corporate debt securities consist of high
yield bonds held through our CLOs with an aggregate par amount of
$361.0 million and estimated fair value of $354.1 million. Corporate
debt securities held through our CLO transactions have a weighted
average coupon of 8.8%, of which 90.3% of the corporate debt
securities are fixed rate with a weighted average coupon of 9.5%. The
remaining 9.7% 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 December 31, 2012, the contractual notional balance of these amortizing interest rate swaps was $378.8 million.
As of December 31, 2012, these Cash Flow CLOs had aggregate secured debt outstanding totaling $5.1 billion held by unaffiliated third parties and aggregate junior secured notes outstanding totaling $296.6 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. We hold the majority or all of the subordinated notes in each of the Cash Flow CLOs and we consolidate all of the Cash Flow CLOs. All income and losses related to the assets in these Cash Flow CLOs are reflected on our consolidated statement of operations even though a minority interest in three of our CLO transactions is not held by us.
An affiliate of our Manager has entered into separate management agreements with our Cash Flow CLOs and is entitled to receive fees for the services performed as collateral manager. The indentures governing the CLO transactions stipulate the reinvestment period during which the collateral 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 year ended December 31, 2012, $886.6 million of original CLO 2007-A, CLO 2005-1, CLO 2005-2 and CLO 2006-1 senior notes were repaid. CLO 2007-1 and CLO 2012-1 will end their reinvestment periods during May 2014 and December 2016, respectively. 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 year ended December 31, 2012, $93.0 million 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 December 31, 2012:
º •
º CLO note holdings: We hold $1.1 billion par amount and $1.3 billion
estimated fair value of mezzanine and subordinated notes in our seven
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 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.
º •
º 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 $299.7 million and estimated fair value of
$250.5 million. These loans have a weighted average coupon of 5.8%,
and all are floating rate with a weighted average coupon spread to
LIBOR of 5.1%. Of the $299.7 million par amount of corporate loans,
$118.1 million par amount and $117.8 million estimated fair value of
corporate loans were held on our balance sheet as of December 31,
2012, designated for CLO 2012-1. In addition, we hold equity
investments with an estimated fair value of $32.9 million, which were
restructured from debt instruments to equity.
º •
º 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 $18.7 million.
These debt securities have a weighted average coupon of 14.9% and our
floating rate corporate debt security has a weighted average coupon
spread to LIBOR of 15.0%.
º •
º Natural resources: Our natural resources holdings consist of
(i) non-operated oil and gas working interests in proved developed and
proved undeveloped properties with a carrying amount of $249.7
million, partially financed with $107.8 million borrowed under a
. . .
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