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KFN > SEC Filings for KFN > Form 10-Q on 7-Aug-2013All Recent SEC Filings

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Form 10-Q for KKR FINANCIAL HOLDINGS LLC


7-Aug-2013

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, 2013. 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 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 eight 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"), KKR Financial CLO 2012-1, Ltd. ("CLO 2012-1") and KKR Financial CLO 2013-1, Ltd. ("CLO 2013-1") (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

The second quarter of 2013 saw lower high yield credit index returns compared to 2012 sparked by uncertainty about the end of a government monetary stimulus program. During the second quarter of 2013, the United States Federal Reserve Chairman hinted that the central bank may begin tapering its monthly purchase of approximately $85 billion of bonds, which led to increased volatility across debt asset classes. Specifically, the S&P/LSTA Loan Index returned 0.2% for the second quarter of 2013 (as compared to 0.7% for the second


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quarter of 2012) and 2.3% for the first half of 2013 (as compared to 4.5% for the first half of 2012), while the Merrill Lynch High Yield Master II index returned -1.4% for the second quarter of 2013 (as compared to 1.8% for the second quarter of 2012) and 1.5% for the first half of 2013 (as compared to 7.1% for the first half of 2012). During the second quarter of 2013, interest rates remained low, as evidenced by the average three-month London interbank offered rate ("LIBOR") rate decreasing to 0.27% for the three months ended June 30, 2013 from 0.46% for the three months ended June 30, 2012, and have pushed yields in many fixed income instruments to near record lows. In order to meet investor demand however, consistent with the past few quarters, we saw the majority of leveraged loans offering an income premium, or LIBOR floor. As of June 30, 2013, 56.5% of our floating corporate debt portfolio had a weighted average LIBOR floor of 1.2% compared to 51.6% with a weighted average floor of 1.4% as of December 31, 2012 and 42.4% with a weighted average floor of 1.4% as of June 30, 2012.

In addition to our financial assets consisting primarily of bank loans and high yield bonds, which are impacted by factors such as LIBOR, we hold oil and natural gas assets, which are impacted by the relevant commodity prices. Commodity price volatility will impact our net income through total revenues and net realized and unrealized gains and losses on our commodity swaps. In addition, revenue earned on our oil and natural gas properties are dependent on volumes produced. The Henry Hub spot natural gas price increased to $3.73 per million British thermal units ("MMBtu") as of June 28, 2013, from $2.81 per MMBtu as of June 29, 2012. Separately, the WTI Cushing crude oil spot price increased to $96.36 per barrel ("Bbl") as of June 28, 2013, from $85.04 per Bbl as of June 29, 2012.

Summary of Results

Our net income available to common shareholders for the three months ended June 30, 2013 totaled $79.2 million (or $0.39 per diluted common share), as compared to net income of $71.2 million (or $0.39 per diluted common share), for the three months ended June 30, 2012. Our net income available to common shareholders for the six months ended June 30, 2013 totaled $170.8 million (or $0.85 per diluted common share), as compared to net income of $159.3 million (or $0.87 per diluted common share), for the six months ended June 30, 2012. Additional discussion around our results, as well as the components of net income for our reportable segments for the three and six months ended June 30, 2013 and 2012 are detailed further below under "Results of Operations."

Book value per common share increased $0.10 to $10.41 as of June 30, 2013 from $10.31 as of December 31, 2012, and increased $0.25 from $10.16 as of March 31, 2013. The increase in book value per common share from March 31, 2013 to June 30, 2013 was attributable to the earnings for the second quarter of 2013 of $0.39 per common share and a decrease in accumulated other comprehensive loss of $0.07 per common share, partially offset by the distribution to shareholders during the second quarter of 2013 of $0.21 per common share.

Cash Distributions to Shareholders

On July 23, 2013, our board of directors declared a cash distribution for the quarter ended June 30, 2013 on our common shares of $0.21 per common share. The distribution is payable on August 20, 2013 to common shareholders of record as of the close of business on August 6, 2013.

On June 26, 2013, our board of directors declared a cash distribution of $0.460938 per share on our 7.375% Series A LLC Preferred Shares ("Series A LLC Preferred Shares"). The distribution was paid on July 15, 2013 to preferred shareholders as of the close of business on July 8, 2013.

The amount and timing of our distributions to our common and preferred shareholders, including any special distributions to our common shareholders, 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 which would impact common shareholders, 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 common 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. Holders of Series A LLC Preferred Shares will not be allocated any gains or loss from any sale of our assets. 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" below for further discussion about taxable income allocable to holders of our 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 Series A LLC Preferred Shares.


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Funding Activities

CLOs

On June 25, 2013, we closed CLO 2013-1, a $519.4 million secured financing transaction maturing on July 15, 2025. We issued $458.5 million par amount of senior secured notes to unaffiliated investors, of which $442.0 million was floating rate with a weighted-average coupon of three-month LIBOR plus 1.67% and $16.5 million was fixed rate at 3.73%. The investments that are owned by CLO 2013-1 collateralize the CLO 2013-1 debt, and as a result, those investments are not available to us, our creditors or shareholders.

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 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 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. If the amount of cash distributed to our Series A LLC Preferred Shares in any year exceeds our gross ordinary income for such year, additional gross ordinary income will be allocated to the Series A LLC Preferred Shares in future years until such excess is eliminated. 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 common 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.

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.


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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 "Results of Operations-Investment Portfolio" below for a reconciliation of these six core strategies, which differ from our reportable segments, 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 June 30, 2013, our Cash Flow CLOs, which were structured as financing vehicles engaged in holding primarily corporate debt investments, held $6.0 billion par amount or $5.6 billion estimated fair value of corporate debt investments. Our corporate debt investments held through our Cash Flow CLOs consist of the following as of June 30, 2013:

Corporate loans: Corporate loans consist of bank loans that are held through our CLOs with an aggregate par value of $5.7 billion and estimated fair value of $5.4 billion. Corporate loans held through our CLO transactions have a weighted average coupon of 4.7%, of which 99.0% of the corporate loans are floating rate with a weighted average coupon spread to LIBOR of 3.9%. The remaining 1.0% are fixed rate with a weighted average coupon of 7.3%.

Corporate debt securities: Corporate debt securities consist of high yield bonds held through our CLOs with an aggregate par amount of $294.3 million and estimated fair value of $279.6 million. Corporate debt securities held through our CLO transactions have a weighted average coupon of 8.8%, of which 95.8% of the corporate debt securities are fixed rate with a weighted average coupon of 9.1%. The remaining 4.2% are floating rate with a weighted average coupon spread to LIBOR of 2.2%.

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 June 30, 2013, the contractual notional balance of our amortizing interest rate swaps was $366.8 million.

As of June 30, 2013, 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 $193.9 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. 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 condensed consolidated statement of operations.

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


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outstanding balance of senior notes outstanding. During the three and six months ended June 30, 2013, an aggregate $360.2 million and $506.3 million, respectively, of original CLO 2007-A, CLO 2005-1, CLO 2005-2 and CLO 2006-1 senior notes were repaid. CLO 2007-1, CLO 2012-1 and CLO 2013-1 will end their reinvestment periods during May 2014, December 2016 and July 2017, 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 three and six months ended June 30, 2013, $24.0 million and $45.5 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 our CLO transactions after the end of the respective non-call periods.

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 June 30, 2013:

CLO note holdings: We hold $1.1 billion par amount and $1.3 billion estimated fair value of mezzanine and subordinated notes in our eight 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 $155.5 million and estimated fair value of $139.5 million. These loans have a weighted average coupon of 4.5%, and all are floating rate with a weighted average coupon spread to LIBOR of 3.8%. Of the $155.5 million par amount of corporate loans, $91.4 million par amount and $90.5 million estimated fair value of corporate loans were held on our balance sheet as of June 30, 2013, which are designated for transfer to CLO 2013-1. The transfer of assets is expected to occur during the third quarter of 2013. In addition, we hold equity instruments with an estimated fair value of $46.0 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 $41.5 million and estimated fair value of $41.5 million. These debt securities have a weighted average coupon of 6.4% and include one fixed rate corporate debt security with a coupon of 13.0%, one zero-coupon corporate debt security and one floating rate corporate debt security with a coupon spread to LIBOR of 15.0%.

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 $275.4 million, partially financed with $46.1 million borrowed under a non-recourse, asset-based credit facility, (ii) overriding royalty interests with a carrying amount of $44.6 million, and (iii) private equity and interests in joint ventures and partnerships focused on the oil and gas sector with an aggregate cost basis of $91.4 million and an estimated fair value of $88.1 million.

Special situations: Our special situations holdings consist of
(i) $222.7 million par amount of debt investments with an $165.4 million amortized cost and estimated fair value of $183.9 million, (ii) $50.4 million aggregate cost of equity, including warrants and interests in joint ventures and partnerships with an estimated fair value of $56.2 million, and (iii) $8.3 million aggregate cost of other investments with an estimated fair value of $8.3 million. The $222.7 million par amount of debt investments has a weighted average coupon of 9.0%.

Mezzanine: Our mezzanine holdings consist of (i) $59.3 million par amount of debt with an estimated fair value of $59.8 million and (ii) $6.0 million aggregate cost of equity with an estimated fair value of $7.2 million. The $59.3 million par amount of mezzanine debt are all floating rate with a weighted average coupon of 15.2%.

Commercial real estate: Our commercial real estate holdings consist of investments with a carrying value of $147.7 million.

Private equity: Our private equity holdings, excluding those related to the oil and gas sector, have an aggregate cost basis of $55.7 million with an estimated fair value of $76.9 million.

Residential mortgage-backed securities ("RMBS"): Our RMBS have an aggregate par amount of $134.9 million with an estimated fair value of $83.0 million.


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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.

Fair Value of Financial Instruments

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. Assets and liabilities in the condensed consolidated balance sheets are categorized based upon the level of judgment associated with the inputs used to measure their value. Hierarchical levels, as defined under GAAP, are directly related to the amount of subjectivity associated with the inputs to fair valuations of these assets and liabilities, and are as follows:

Level 1: Inputs are unadjusted, quoted prices in active markets for identical assets or liabilities at the measurement date.

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