Table of
Contents
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington,
D.C. 20549
FORM 10-Q
(Mark One)
x
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QUARTERLY
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
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For the quarterly period ended March 31, 2010
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or
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o
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TRANSITION
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
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For the transition period from
to
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Commission
file number: 001-33437
KKR FINANCIAL HOLDINGS LLC
(Exact name of registrant as
specified in its charter)
Delaware
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11-3801844
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(State or other jurisdiction of
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(I.R.S. Employer
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incorporation or organization)
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Identification No.)
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555 California Street, 50
th
Floor
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San Francisco, CA
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94104
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(Address of principal executive offices)
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(Zip Code)
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Registrants telephone
number, including area code:
(415) 315-3620
Indicate by check mark whether the registrant (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities
Exchange Act of 1934 during the preceding 12 months (or for such shorter
period that the registrant was required to file such reports), and (2) has
been subject to such filing requirements for the past 90 days.
x
Yes
o
No
Indicate by check mark whether the registrant has submitted
electronically and posted on its corporate Web site, if any, every Interactive
Data File required to be submitted and posted pursuant to Rule 405 of
Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or
for such shorter period that the registrant was required to submit and post
such files). Yes
o
No
o
Indicate by check mark whether the registrant is a large accelerated
filer, an accelerated filer, a non-accelerated filer, or a smaller reporting
company. See the definitions of large accelerated filer, accelerated filer
and smaller reporting company in Rule 12b-2 of the Exchange Act.
(Check one):
Large accelerated filer
o
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Accelerated filer
x
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Non-accelerated filer
o
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Smaller reporting company
o
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(Do not check if a smaller reporting company)
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Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Act).
o
Yes
x
No
The number of shares of the registrants common shares outstanding as
of April 22, 2010 was 158,359,757.
Table of Contents
PART I. FINANCIAL
INFORMATION
Item 1.
Financial Statements
KKR Financial Holdings LLC and Subsidiaries
Condensed Consolidated Balance Sheets
(Unaudited)
(Amounts in thousands, except share information)
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March 31,
2010
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December 31,
2009
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Assets
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Cash and cash equivalents
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$
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240,529
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$
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97,086
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Restricted cash and cash equivalents
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381,298
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342,706
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Securities available-for-sale, $806,860 and
$740,949 pledged as collateral as of March 31, 2010 and December 31,
2009, respectively
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829,691
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755,686
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Corporate loans, net of allowance for loan losses
of $216,080 and $237,308 as of March 31, 2010 and December 31,
2009, respectively
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5,691,751
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5,617,925
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Corporate loans held for sale
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733,072
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925,718
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Residential mortgage-backed securities, at
estimated fair value, $114,023 and $47,572 pledged as collateral as of March 31,
2010 and December 31, 2009, respectively
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114,023
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47,572
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Residential mortgage loans, at estimated fair
value
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2,097,699
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Equity investments, at estimated fair value,
$44,154 and $110,812
pledged as collateral as of March 31, 2010
and December 31, 2009, respectively
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63,488
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120,269
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Derivative assets
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1,303
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15,784
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Interest and principal receivable
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64,221
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98,313
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Reverse repurchase agreements
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80,250
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Other assets
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152,613
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100,997
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Total assets
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$
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8,271,989
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$
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10,300,005
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Liabilities
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Collateralized loan obligation secured notes
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$
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5,631,866
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$
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5,667,716
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Collateralized loan obligation junior secured
notes to affiliates
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380,343
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533,786
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Senior secured credit facility
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150,000
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175,000
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Convertible senior notes
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343,303
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275,800
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Junior subordinated notes
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283,517
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283,517
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Residential mortgage-backed securities issued, at
estimated fair value
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2,034,772
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Accounts payable, accrued expenses and other
liabilities
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83,768
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7,240
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Accrued interest payable
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16,597
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25,297
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Accrued interest payable to affiliates
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2,150
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2,911
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Related party payable
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14,827
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3,367
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Securities sold, not yet purchased
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77,971
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Derivative liabilities
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49,998
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45,970
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Total liabilities
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6,956,369
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9,133,347
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Shareholders Equity
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Preferred shares, no par value, 50,000,000 shares
authorized and none issued and outstanding at March 31, 2010 and December 31,
2009
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Common shares, no par value, 500,000,000 shares
authorized, and 158,359,757 and 158,359,757 shares issued and outstanding at March 31,
2010 and December 31, 2009, respectively
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Paid-in-capital
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2,576,501
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2,563,634
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Accumulated other comprehensive income
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170,413
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152,728
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Accumulated deficit
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(1,431,294
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)
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(1,549,704
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)
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Total shareholders equity
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1,315,620
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1,166,658
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Total liabilities and
shareholders equity
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$
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8,271,989
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$
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10,300,005
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See notes to condensed
consolidated financial statements.
3
Table of Contents
KKR
Financial Holdings LLC and Subsidiaries
Condensed
Consolidated Statements of Operations
(Unaudited)
(Amounts in thousands, except per share information)
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For the three
months ended
March 31,
2010
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For the three
months ended
March 31,
2009
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Net investment income:
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Loan interest income
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$
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91,996
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$
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129,204
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Securities interest income
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27,261
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28,852
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Other interest income
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93
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|
617
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Total investment income
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119,350
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158,673
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Interest expense
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(31,500
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)
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(89,882
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)
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Interest expense to affiliates
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(4,541
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)
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(5,805
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)
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Provision for loan losses
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(26,987
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)
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Net investment income
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83,309
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35,999
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Other income (loss):
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Net realized and unrealized gain (loss) on
investments
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35,423
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(60,204
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)
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Net realized and unrealized (loss) gain on
derivatives and foreign exchange
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(1,418
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)
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12,396
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Net realized and unrealized loss on residential
mortgage-backed securities, residential mortgage loans, and residential
mortgage-backed securities issued, carried at estimated fair value
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(5,145
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)
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(19,419
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)
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Net realized and unrealized (loss) gain on
securities sold, not yet purchased
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(756
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)
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1,437
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Net gain on restructuring and extinguishment of
debt
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39,999
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34,571
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Other income
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3,004
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1,333
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Total other income (loss)
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71,107
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(29,886
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)
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Non-investment expenses:
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Related party management compensation
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20,491
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11,212
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General, administrative and directors expenses
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3,350
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|
2,403
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Professional services
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1,064
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3,385
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Loan servicing
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2,136
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Total non-investment expenses
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24,905
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19,136
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Income (loss) before income tax
expense (benefit)
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129,511
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(13,023
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)
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Income tax expense (benefit)
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16
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|
(47
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)
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Net income (loss)
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$
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129,495
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$
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(12,976
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)
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|
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Net income (loss) per common share:
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Basic
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$
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0.82
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$
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(0.09
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)
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Diluted
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$
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0.82
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$
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(0.09
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)
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|
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Weighted-average number of common shares
outstanding:
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Basic
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156,997
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149,714
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Diluted
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156,997
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149,714
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See notes to condensed
consolidated financial statements.
4
Table of Contents
KKR
Financial Holdings LLC and Subsidiaries
Condensed
Consolidated Statement of Changes in Shareholders Equity
(Unaudited)
(Amounts in thousands)
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|
Common
Shares
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Paid-In
Capital
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Accumulated Other
Comprehensive
Income
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Accumulated
Deficit
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Comprehensive
Income
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|
Total
Shareholders
Equity
|
|
Balance at January 1, 2010
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158,360
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|
$
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2,563,634
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$
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152,728
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$
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(1,549,704
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)
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$
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1,166,658
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Net
income
|
|
|
|
|
|
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|
129,495
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$
|
129,495
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129,495
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Net
change in unrealized loss on cash flow hedges
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(4,892
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)
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(4,892
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)
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(4,892
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)
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Net
change in unrealized gain on securities available-for-sale
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22,577
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22,577
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22,577
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Comprehensive
income
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|
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|
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$
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147,180
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|
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|
Cash
distributions on common shares
|
|
|
|
|
|
|
|
(11,085
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)
|
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|
(11,085
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)
|
Equity
component of convertible notes issuance
|
|
|
|
9,973
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|
|
|
|
|
|
|
9,973
|
|
Share-based
compensation expense related to restricted common shares
|
|
|
|
2,894
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|
|
|
|
|
|
|
2,894
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|
Balance at March 31, 2010
|
|
158,360
|
|
$
|
2,576,501
|
|
$
|
170,413
|
|
$
|
(1,431,294
|
)
|
|
|
$
|
1,315,620
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|
See notes to
condensed consolidated financial statements.
5
Table of Contents
KKR Financial Holdings LLC and Subsidiaries
Condensed
Consolidated
Statements of Cash Flows
(Unaudited)
(Amounts in thousands)
|
|
For the three months
ended March 31, 2010
|
|
For the three months
ended March 31, 2009
|
|
Cash flows from operating
activities:
|
|
|
|
|
|
Net income (loss)
|
|
$
|
129,495
|
|
$
|
(12,976
|
)
|
Adjustments to reconcile net income (loss) to net
cash provided by operating activities:
|
|
|
|
|
|
Net realized and unrealized loss (gain) on
derivatives, foreign exchange, and securities sold, not yet purchased
|
|
2,174
|
|
(13,833
|
)
|
Net gain on restructuring and extinguishment of
debt
|
|
(39,999
|
)
|
(34,571
|
)
|
Write-off of debt issuance costs
|
|
1,679
|
|
|
|
Lower of cost or estimated fair value adjustment on
corporate loans held for sale
|
|
(3,720
|
)
|
14,037
|
|
Provision for loan losses
|
|
|
|
26,987
|
|
Impairment on securities available-for-sale
|
|
1,140
|
|
33,764
|
|
Share-based compensation
|
|
2,894
|
|
(3
|
)
|
Net realized and unrealized loss on residential
mortgage-backed securities, residential mortgage loans, and liabilities at
estimated fair value
|
|
5,145
|
|
19,419
|
|
Net realized and unrealized (gain) loss on
investments
|
|
(32,843
|
)
|
12,403
|
|
Deferred
interest expense
|
|
2,707
|
|
6,558
|
|
Depreciation and net amortization
|
|
(23,623
|
)
|
(10,872
|
)
|
Changes in assets and liabilities:
|
|
|
|
|
|
Interest receivable
|
|
6,718
|
|
34,929
|
|
Other assets
|
|
(4,835
|
)
|
(5,232
|
)
|
Related party payable
|
|
11,460
|
|
149
|
|
Accounts payable, accrued expenses and other
liabilities
|
|
509
|
|
(27,233
|
)
|
Accrued interest payable
|
|
(8,700
|
)
|
(31,368
|
)
|
Accrued interest payable to affiliates
|
|
(761
|
)
|
(880
|
)
|
Net cash provided by operating activities
|
|
49,440
|
|
11,278
|
|
Cash flows from investing
activities:
|
|
|
|
|
|
Principal payments from investments
|
|
554,723
|
|
248,254
|
|
Proceeds from sale of investments
|
|
482,985
|
|
320,570
|
|
Purchases of investments
|
|
(881,776
|
)
|
(221,490
|
)
|
Net proceeds, purchases, and settlements of
derivatives
|
|
13,748
|
|
10,336
|
|
Net change in reverse repurchase agreements
|
|
80,250
|
|
8,096
|
|
Net change to restricted cash and cash equivalents
|
|
(38,592
|
)
|
854,753
|
|
Net cash provided by investing activities
|
|
211,338
|
|
1,220,519
|
|
Cash flows from financing
activities:
|
|
|
|
|
|
Repayment of senior secured credit facility
|
|
(25,000
|
)
|
(8,064
|
)
|
Repayment of residential mortgage-backed securities
issued
|
|
|
|
(105,526
|
)
|
Retirement of collateralized loan obligation
secured notes
|
|
(102,002
|
)
|
(1,104,037
|
)
|
Retirement of collateralized loan obligation junior
secured notes to affiliates
|
|
(51,654
|
)
|
|
|
Proceeds from convertible senior notes
|
|
167,325
|
|
|
|
Repayment of convertible senior notes
|
|
(93,922
|
)
|
|
|
Distributions on common shares
|
|
(11,085
|
)
|
|
|
Other capitalized costs
|
|
(997
|
)
|
(237
|
)
|
Net cash used in financing activities
|
|
(117,335
|
)
|
(1,217,864
|
)
|
Net increase in cash and cash
equivalents
|
|
143,443
|
|
13,933
|
|
Cash and cash equivalents at
beginning of period
|
|
97,086
|
|
41,430
|
|
Cash and cash equivalents at
end of period
|
|
$
|
240,529
|
|
$
|
55,363
|
|
Supplemental cash flow
information:
|
|
|
|
|
|
Cash paid for interest
|
|
$
|
37,387
|
|
$
|
119,393
|
|
Cash paid for income taxes
|
|
$
|
6
|
|
$
|
227
|
|
Non-cash investing and
financing:
|
|
|
|
|
|
Deconsolidation of residential mortgage loans
|
|
$
|
2,034,772
|
|
$
|
|
|
Deconsolidation of residential mortgage-backed
securities issued
|
|
$
|
(2,034,772
|
)
|
$
|
|
|
Subordinate tranche of the residential mortgage
loan securitization trusts included in residential mortgage-backed securities
|
|
$
|
74,366
|
|
$
|
|
|
Equity component of the 7.5% convertible senior
notes
|
|
$
|
9,973
|
|
$
|
|
|
See notes to condensed consolidated financial statements.
6
Table of Contents
KKR
Financial Holdings LLC and Subsidiaries
Notes to
Condensed Consolidated Financial Statements
(Unaudited)
Note 1.
Organization
KKR Financial Holdings LLC together with its subsidiaries (the Company
or KKR Financial) is a specialty finance company with expertise in a range of
asset classes. The Company primarily invests in financial assets including
below investment grade corporate debt, including senior secured and unsecured
loans, mezzanine loans, high yield corporate bonds, distressed and stressed
debt securities, marketable equity securities, private equity and credit
default swaps. Additionally, the Company has made or may make investments in
other asset classes including natural resources and real estate. The corporate
loans the Company invests 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 the Companys corporate
debt investments are held in collateralized loan obligation (CLO)
transactions that the Company uses as long term financing for these
investments. The Companys CLO transactions are structured as on-balance sheet
securitizations of corporate loans and high yield debt securities. The senior
secured notes issued by the CLO transactions are generally owned by third party
investors who are unaffiliated with the Compa
ny and the Company owns the majority of the
subordinated notes in the CLO transactions.
The Company executes its
core business strategy through majority-owned subsidiaries, including CLOs.
KKR Financial
Advisors LLC (the Manager), a wholly owned subsidiary of Kohlberg Kravis
Roberts & Co. (Fixed Income) LLC, manages the Company
pursuant to a management agreement (the Management Agreement). Kohlberg
Kravis Roberts & Co. (Fixed Income) LLC is a wholly-owned
subsidiary of Kohlberg Kravis Roberts & Co. L.P. (KKR).
Note 2.
Summary of Significant Accounting Policies
Basis of
Presentation
The accompanying condensed
consolidated financial statements have been prepared in conformity with
accounting principles generally accepted in the United States of America (GAAP).
The condensed consolidated financial statements include the accounts of the
Company and entities established to complete secured financing transactions
that are considered to be variable interest entities and for which the Company
is the primary beneficiary.
These condensed consolidated
financial statements should be read in conjunction with the consolidated
financial statements and notes thereto included in the Companys Annual Report
on Form 10-K for the year ended December 31, 2009. The Companys
results for any interim period are not necessarily indicative of results for a
full year or any other interim period. In the opinion of management, all normal
recurring adjustments have been included for a fair statement of this interim
financial information.
Use of
Estimates
The preparation of financial
statements in conformity with GAAP requires management to make estimates and
assumptions that affect the amounts reported in the Companys condensed
consolidated financial statements and accompanying notes. Actual results could
differ from managements estimates.
Consolidation
Effective January 1, 2010, the Company adopted new guidance which
amended the accounting for the transfers of financial assets, eliminated the
concept of a qualified special purpose entity (QSPE) and significantly
changed the criteria by which an enterprise determines whether or not it must
consolidate a variable interest entity (VIE). Under the new guidance,
consolidation of a VIE requires both the power to direct the activities that
most significantly impact the VIEs economic performance and the obligation to
absorb losses of the VIE or the right to receive benefits of the VIE that could
potentially be significant to the VIE.
As a result of the adoption
of new guidance regarding the amended consolidation model to be based on power
and economics, the Company determined that six residential mortgage loan
securitization trusts, which were previously consolidated by the Company as it
was deemed to be the primary beneficiary, were required to be deconsolidated.
The Company determined that it did not have the power to direct the activities
that most significantly impact the economic performance of the securitization
trusts or the performance of the securitization trusts underlying assets.
As the Company was never the
servicer of the trusts nor did it participate in any servicing activities, the
Company did not have the power to direct the activities which most
significantly impact the economic performance of the securitization trusts.
Accordingly, the Company determined that it was no longer the primary
beneficiary of the securitization trusts under the new guidance.
7
Table of Contents
Effective January 1,
2010, the Company deconsolidated the six residential mortgage loan
securitization trusts, which resulted in the reduction of both assets and
liabilities of approximately $2.0 billion. In addition, loan interest
income, interest expense, loan servicing expense, and net unrealized and
realized gain (loss) associated with the residential mortgage loan
securitization trusts will no longer be reported on the Companys condensed
consolidated financial statements. The deconsolidation of the six residential
mortgage loan securitization trusts had no net impact on the Companys
shareholders equity, results of operations and cash flows. Refer to Note 6 to
these condensed consolidated financial statements for further discussion of the
Companys residential mortgage-backed securities (RMBS) and to Note 7 to
these condensed consolidated financial statements for the impact of the
deconsolidation.
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) and KKR Financial CLO
2007-A, Ltd. (CLO 2007-A), are entities established to complete
secured financing transactions. These entities are VIEs which the Company
consolidates as the Company has determined it has the power to direct the
activities that most significantly impact these entities economic performance
and the Company has 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.
These five CLOs, through which the Company finances
the majority of its corporate debt investments, include $7.3 billion par
amount, or $6.7 billion estimated fair value of investments. The assets in each
CLO can be used only to settle the related entities debt which in aggregate
total $5.6 billion of senior and junior secured notes outstanding and in
aggregate total $380.3 million of junior notes outstanding that are held by an
affiliate of the Companys manager. In CLO transactions, subordinated notes
have the first risk of loss and conversely, the residual value upside of the
transactions. As such, these CLOs are considered non-recourse leverage.
In addition, the Company continues to consolidate
all non-VIEs in which it holds a greater than 50 percent voting interest.
All inter-company balances
and transactions have been eliminated in consolidation.
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
recorded at fair value 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.
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, are observable for the asset or
liability, either directly or indirectly. Level 2 inputs include quoted
prices for similar instruments in active markets, and inputs other than quoted
prices that are observable for the asset or liability.
Fair value assets and
liabilities that are generally included in this category are certain corporate
debt securities, certain corporate loans held for sale, certain equity investments
at estimated fair value, certain securities sold, not yet purchased and certain
financial instruments classified as derivatives.
Level 3: Inputs are
unobservable inputs for the asset or liability, and include situations where
there is little, if any, market activity for the asset or liability. In certain
cases, the inputs used to measure fair value may fall into different levels of
the fair value hierarchy. In such cases, the level in the fair value hierarchy
within which the fair value measurement in its entirety falls has been
determined based on the lowest level input that is significant to the fair
value measurement in its entirety. The Companys assessment of the significance
of a particular input to the fair value measurement in its entirety requires
judgment and consideration of factors specific to the asset.
8
Table of Contents
Assets and liabilities
carried at fair value and included in this category are certain corporate debt
securities, certain corporate loans held for sale, certain equity investments
at estimated fair value, RMBS, residential mortgage loans, residential
mortgage-backed securities issued (RMBS Issued) and certain derivatives.
A significant decrease in the volume and level of
activity for the asset or liability is an indication that transactions or
quoted prices may not be representative of fair value because in such market
conditions there may be increased instances of transactions that are not
orderly. In those circumstances, further analysis of transactions or quoted
prices is needed, and a significant adjustment to the transactions or quoted
prices may be necessary to estimate fair value.
The availability of
observable inputs can vary depending on the financial asset or liability and is
affected by a wide variety of factors, including, for example, the type of
product, whether the product is new, whether the product is traded on an active
exchange or in the secondary market, and the current market condition. To the
extent that valuation is based on models or inputs that are less observable or
unobservable in the market, the determination of fair value requires more
judgment. Accordingly, the degree of judgment exercised by the Company in
determining fair value is greatest for instruments categorized in level 3.
In certain cases, the inputs used to measure fair value may fall into different
levels of the fair value hierarchy. In such cases, for disclosure purposes, the
level in the fair value hierarchy within which the fair value measurement in
its entirety falls is determined based on the lowest level input that is
significant to the fair value measurement in its entirety.
Many financial assets and
liabilities have bid and ask prices that can be observed in the marketplace.
Bid prices reflect the highest price that the Company and others are willing to
pay for an asset. Ask prices represent the lowest price that the Company and
others are willing to accept for an asset. For financial assets and liabilities
whose inputs are based on bid-ask prices, the Company does not require that
fair value always be a predetermined point in the bid-ask range. The Companys
policy is to allow for mid-market pricing and adjusting to the point within the
bid-ask range that meets the Companys best estimate of fair value.
Depending on the relative
liquidity in the markets for certain assets, the Company may transfer assets to
level 3 if it determines that observable quoted prices, obtained directly
or indirectly, are not available. The valuation techniques used for the assets
and liabilities that are valued using level 3 of the fair value hierarchy are
described below.
Residential
Mortgage-Backed Securities, Residential Mortgage Loans, and Residential
Mortgage-Backed Securities Issued:
Residential mortgage-backed securities,
residential mortgage loans, and residential mortgage-backed securities issued
are initially valued at transaction price and are subsequently valued using
industry recognized models (including Intex and Bloomberg) and data for similar
instruments (e.g., nationally recognized pricing services or broker
quotes). The most significant inputs to the valuation of these instruments are
default and loss expectations and market credit spreads.
Corporate
Debt Securities:
Corporate
debt securities are initially valued at transaction price and are subsequently
valued using market data for similar instruments (e.g., recent
transactions or broker quotes), comparisons to benchmark derivative indices or
valuation models. Valuation models are based on discounted cash flow
techniques, for which the key inputs are the amount and timing of expected
future cash flows, market yields for such instruments and recovery assumptions.
Inputs are determined based on relative value analyses, which incorporate
similar instruments from similar issuers.
Over-the-counter
(OTC) Derivative Contracts:
OTC derivative contracts include forward,
swap and option contracts related to interest rates, foreign currencies, credit
standing of reference entities, and equity prices. The fair value of OTC
derivative products can be modeled using a series of techniques, including
closed-form analytic formulae, such as the Black-Scholes option-pricing model,
and simulation models or a combination thereof. Many pricing models do not
entail material subjectivity because the methodologies employed do not
necessitate significant judgment, and the pricing inputs are observed from
actively quoted markets, as is the case for generic interest rate swap and
option contracts.
Cash and
Cash Equivalents
Cash and cash equivalents
include cash on hand, cash held in banks and highly liquid investments with
original maturities of three months or less. Interest income earned on cash and
cash equivalents is recorded in other interest income.
Restricted
Cash and Cash Equivalents
Restricted cash and cash
equivalents represent amounts that are held by third parties under certain of
the Companys financing and derivative transactions. Interest income earned on
restricted cash and cash equivalents is recorded in other interest income.
9
Table of Contents
On the condensed
consolidated statement of cash flows, net additions or reductions to restricted
cash and cash equivalents are classified as an investing activity as restricted
cash and cash equivalents reflect the receipts from collections or sales of
investments, as well as payments made to acquire investments held by third
parties.
Residential
Mortgage-Backed Securities
The Company carries its residential mortgage-backed
securities at estimated fair value with unrealized gains and losses reported in
income.
The Company elected the fair value option for its
residential mortgage investments for the purpose of enhancing the transparency
of its financial condition as fair value is consistent with how the Company
manages the risks of its residential mortgage investments.
Securities
Available-for-Sale
The Company classifies its
investments in securities as available-for-sale as the Company may sell them
prior to maturity and does not hold them principally for the purpose of selling
them in the near term. These investments are carried at estimated fair value,
with unrealized gains and losses reported in accumulated other comprehensive
income (loss). Estimated fair values are based on quoted market prices, when
available, on estimates provided by independent pricing sources or dealers who
make markets in such securities, or internal valuation models when external
sources of fair value are not available. Upon the sale of a security, the
realized net gain or loss is computed on a weighted-average cost basis.
Purchases and sales of securities are recorded on the trade date.
The Company monitors its available-for-sale
securities portfolio for impairments. A loss is recognized when it is
determined that a decline in the estimated fair value of a security below its
amortized cost is other-than-temporary. The Company considers many factors in
determining whether the impairment of a security is deemed to be
other-than-temporary, including, but not limited to, the length of time the
security has had a decline in estimated fair value below its amortized cost and
the severity of the decline, the amount of the unrealized loss, recent events
specific to the issuer or industry, external credit ratings and recent changes
in such ratings. In addition, for debt securities, the Company considers its
intent to sell the debt security, the Companys estimation of whether or not it
expects to recover the debt securitys entire amortized cost if it intends to
hold the debt security, and whether it is more likely than not that the Company
will be required to sell the debt security before its anticipated recovery. For
equity securities, the Company also considers its intent and ability to hold
the equity security for a period of time sufficient for a recovery in value.
The amount of the loss that
is recognized when it is determined that a decline in the estimated fair value
of a security below its amortized cost is other-than-temporary is dependent on
certain factors. If the security is an equity security or if the security is a debt
security that the Company intends to sell or estimates that it is more likely
than not that the Company will be required to sell before recovery of its
amortized cost, then the impairment amount recognized in earnings is the entire
difference between the estimated fair value of the security and its amortized
cost. For debt securities that the Company does not intend to sell or estimates
that it is not more likely than not to be required to sell before recovery, the
impairment is separated into the estimated amount relating to credit loss and
the estimated amount relating to all other factors. Only the estimated credit
loss amount is recognized in earnings, with the remainder of the loss amount
recognized in other comprehensive income (loss).
Unamortized premiums and
unaccreted discounts on securities available-for-sale are recognized in
interest income over the contractual life, adjusted for actual prepayments, of
the securities using the effective interest method.
Equity Investments, at Estimated Fair Value
The Company has elected the fair value option of
accounting for certain marketable and private equity investments. The Company
elects the fair value option of accounting for private equity investments
received through restructuring debt transactions or owned through an entity in
which the Company has significant influence.
The Company elected the
fair value option for certain equity investments for the purpose of enhancing
the transparency of its financial condition as fair value is consistent with how
the Company manages the risks of these equity investments. Equity investments,
at estimated fair value, are managed based on overall value and potential
returns.
Investments carried at fair value are presented separately on the
condensed consolidated balance sheets with unrealized gains and losses reported
in net realized and unrealized gains and losses on investments on the condensed
consolidated statements of operations.
10
Table of Contents
Private Equity Investments, at Cost
Private equity investments
are accounted for under either the cost method or at fair value if the fair
value option of accounting has been elected, (see Equity Investments, at
Estimated Fair Value above). The Company evaluates its investments accounted
for under the cost method on a quarterly basis for possible
other-than-temporary impairment. The Company reduces the carrying value of the
investment and recognizes a loss when the Company considers a decline in
estimated fair value below the cost basis of the security to be
other-than-temporary. Private equity investments recorded at cost are included
in other assets on the condensed consolidated balance sheets.
Securities
Sold, Not Yet Purchased
Securities sold, not yet
purchased consist of equity and debt securities that the Company has sold
short. In order to facilitate a short sale, the Company borrows the securities
from another party and delivers the securities to the buyer. The Company will
be required to cover its short sale in the future through the purchase of the
security in the market at the prevailing market price and deliver it to the
counterparty from which it borrowed. The Company is exposed to a loss to the
extent that the security price increases during the time from when the Company
borrowed the security to when the Company purchases it in the market to cover
the short sale.
Corporate
Loans
The Company purchases
participations and assignments in corporate loans in the primary and secondary
market. Loans are held for investment and the Company initially records loans
at their purchase prices. The Company subsequently accounts for loans based on
their outstanding principal plus or minus unaccreted purchase discounts and
unamortized purchase premiums. Interest income on loans includes interest at
stated coupon rates adjusted for accretion of purchase discounts and the
amortization of purchase premiums. Unamortized premiums and unaccreted
discounts are recognized in interest income over the contractual life, adjusted
for actual prepayments, of the loans using the effective interest method.
A loan is typically placed
on non-accrual status at such time as: (i) management believes that
scheduled debt service payments may not be paid when contractually due; (ii) the
loan becomes 90 days delinquent; (iii) management determines the
borrower is incapable of, or has ceased efforts toward, curing the cause of the
impairment; or (iv) the net realizable value of the underlying collateral
securing the loan decreases below the Companys carrying value of such loan. As
such, loans placed on non-accrual status may or may not be contractually past
due at the time of such determination. While on non-accrual status, previously
recognized accrued interest is reversed if it is determined that such amounts
are not collectible and interest income is recognized using the cost-recovery
method, cash-basis method or some combination of the two methods. A loan is
placed back on accrual status when the ultimate collectability of the principal
and interest is not in doubt.
Corporate
Loans Held for Sale
Corporate loans held for
sale consist of loans that the Company has determined to no longer hold for
investment. Corporate loans held for sale are stated at lower of cost or
estimated fair value.
Allowance
for Loan Losses
The Companys allowance for loan losses represents
its estimate of probable credit losses inherent in its corporate loan portfolio
held for investment as of the balance sheet date. Estimating the Companys
allowance for loan losses involves a high degree of management judgment and is
based upon a comprehensive review of the Companys loan portfolio that is
performed on a quarterly basis. The Companys allowance for loan losses
consists of two components, an allocated component and an unallocated
component. The allocated component of the allowance for loan losses pertains to
specific loans that the Company has determined are impaired. The Company
determines a loan is impaired when management estimates that it is probable
that the Company will be unable to collect all amounts due according to the
contractual terms of the loan agreement. On a quarterly basis, the Company
performs a comprehensive review of its entire loan portfolio and identifies
certain loans that it has determined are impaired. Once a loan is identified as
being impaired, the Company places the loan on non-accrual status, unless the
loan is already on non-accrual status, and records a reserve that reflects
managements best estimate of the loss that the Company expects to recognize
from the loan. The expected loss is estimated as being the difference between
the Companys current cost basis of the loan, including accrued interest
receivable, and the loans estimated fair value.
11
Table of Contents
The unallocated component of the Companys allowance
for loan losses reflects its estimate of probable losses inherent in the loan
portfolio as of the balance sheet date where the specific loan that the loan
loss relates to is indeterminable. The Company estimates the unallocated
component of the allowance for loan losses through a comprehensive review of
its loan portfolio and identifies certain loans that demonstrate possible
indicators of impairment. This assessment excludes all loans that are
determined to be impaired and as a result, an allocated reserve has been
recorded. Such indicators include, but are not limited to, the current and/or
forecasted financial performance and liquidity profile of the issuer, specific
industry or economic conditions that may impact the issuer, and the observable trading
price of the loan if available. Loans that demonstrate possible indicators of
impairment are aggregated on a watch list for monitoring and are sub-divided
for categorization based on the seniority of the loan in the issuers capital
structure, whether the loan is secured or unsecured, and the nature of the
collateral securing the loan, for purposes of applying possible default and
loss severity ranges based on the nature of the issuer and the specific loan.
The Company applies a range of default and loss severity estimates in order to
estimate a range of loss outcomes upon which to base its estimate of probable
losses that results in the determination of the unallocated component of the
Companys allowance for loan losses.
Leasehold
Improvements and Equipment
Leasehold improvements and
equipment are carried at cost less depreciation and amortization and are
reviewed for impairment whenever events or changes in circumstances indicate
that the carrying amount of the assets might not be recoverable. Equipment is
depreciated using the straight-line method over the estimated useful lives of
the respective assets of three years. Leasehold improvements are amortized on a
straight-line basis over the shorter of their estimated useful lives or lease
terms. Leasehold improvements and equipment, net of accumulated depreciation
and amortization, are included in other assets.
Borrowings
The Company finances the
acquisition of its investments, including loans, residential mortgage-backed
securities and securities available-for-sale, primarily through the use of
secured borrowings in the form of securitization transactions structured as
secured financings and other secured and unsecured borrowings. The Company
recognizes interest expense on all borrowings on an accrual basis.
Trust
Preferred Securities
Trusts formed by the Company
for the sole purpose of issuing trust preferred securities are not consolidated
by the Company as the Company has determined that it is not the primary
beneficiary of such trusts. The Companys investment in the common securities
of such trusts is included in other assets on the Companys condensed
consolidated financial statements.
Derivative
Financial Instruments
The Company recognizes all
derivatives on the condensed consolidated balance sheet at estimated fair
value. On the date the Company enters into a derivative contract, the Company
designates and documents each derivative contract as one of the following at
the time the contract is executed: (i) a hedge of a recognized asset or liability
(fair value hedge); (ii) a hedge of a forecasted transaction or of the
variability of cash flows to be received or paid related to a recognized asset
or liability (cash flow hedge); (iii) a hedge of a net investment in a
foreign operation; or (iv) a derivative instrument not designated as a
hedging instrument (free-standing derivative). For a fair value hedge, the
Company records changes in the estimated fair value of the derivative
instrument and, to the extent that it is effective, changes in the fair value
of the hedged asset or liability in the current period earnings in the same
financial statement category as the hedged item. For a cash flow hedge, the
Company records changes in the estimated fair value of the derivative to the
extent that it is effective in other comprehensive (loss) income and
subsequently reclassifies these changes in estimated fair value to net income
in the same period(s) that the hedged transaction affects earnings. The
effective portion of the cash flow hedges is recorded in the same financial
statement category as the hedged item. For free-standing derivatives, the
Company reports changes in the fair values in other (loss) income.
The Company formally
documents at inception its hedge relationships, including identification of the
hedging instruments and the hedged items, its risk management objectives,
strategy for undertaking the hedge transaction and the Companys evaluation of
effectiveness of its hedged transactions. Periodically, the Company also
formally assesses whether the derivative it designated in each hedging
relationship is expected to be and has been highly effective in offsetting
changes in estimated fair values or cash flows of the hedged item using either
the dollar offset or the regression analysis method. If the Company determines
that a derivative is not highly effective as a hedge, it discontinues hedge
accounting.
Foreign
Currency
The Company makes
investments in non-United States dollar denominated securities and loans. As a
result, the Company is subject to the risk of fluctuation in the exchange rate
between the United States dollar and the foreign currency in which it makes an
investment. In order to reduce the currency risk, the Company may hedge the
applicable foreign currency. All investments denominated in a foreign currency
are converted to the United States dollar using prevailing exchange rates on
the balance sheet date. Income, expenses, gains and losses on investments
denominated in a foreign currency are converted to the United States dollar
using the prevailing exchange rates on the dates when they are recorded.
Foreign exchange gains and losses are recorded in the condensed consolidated
statements of operations.
12
Table of Contents
Manager
Compensation
The Management Agreement
provides for the payment of a base management fee to the Manager, as well as an
incentive fee if the Companys financial performance exceeds certain
benchmarks. Additionally, the Management Agreement provides for the Manager to
be reimbursed for certain expenses incurred on the Companys behalf. See
Note 13 to these condensed consolidated financial statements for
additional discussion on the payment of the base management fee and incentive
fee. The base management fee and the incentive fee are accrued and expensed
during the period for which they are earned by the Manager.
Share-Based
Compensation
The Company accounts for
share-based compensation issued to its directors and to its Manager using a
fair value based methodology prescribed.
Compensation cost related to
restricted common
shares issued to the Companys directors is
measured at its estimated fair value at
the grant date, and is
amortized and expensed over the
vesting period on a
straight-line basis. Compensation cost related
to restricted common shares
and common
share options issued to the Manager is initially measured at estimated fair
value at the grant date, and is remeasured on subsequent dates to the extent
the
awards are unvested. The Company has elected to use the graded vesting
attribution method to amortize compensation expense for the restricted common
shares and common share options granted to the Manager.
Income Taxes
The Company intends to
continue to operate so as to qualify as a partnership, and not as an
association or publicly traded partnership that is taxable as a corporation,
for United States federal income tax purposes. Therefore, the Company is not
subject to United States federal income tax at the entity level, but is subject
to limited state income taxes. Holders of the Companys shares will be required
to take into account their allocable share of each item of the Companys
income, gain, loss, deduction, and credit for the taxable year of the Company
ending within or with their taxable year.
During 2010, the Company
owned an equity interest in KKR Financial Holdings II, LLC (KFH II)
which elected to be taxed as a REIT under the Internal Revenue Code of 1986, as
amended (the Code). KFH II holds certain real estate mortgage-backed
securities. A REIT is not subject to United States federal income tax to the
extent that it currently distributes its income and satisfies certain asset,
income and ownership tests, and recordkeeping requirements, but it may be
subject to some amount of federal, state, local and foreign taxes based on its
taxable income.
KKR TRS Holdings, Ltd. (TRS
Ltd.), KKR Financial Holdings, Ltd. (KFH Ltd.), KFH III Holdings Ltd. (KFH
III Ltd.), KFN PEI VII, LLC (PEI VII), KFH PE Holdings I LLC (PE I),
KFH PE Holdings II LLC (PE II), and KKR Financial Holdings, Inc. (KFH Inc.)
are wholly-owned subsidiaries of the Company and are taxable as corporations
for United States federal income tax purposes and thus are not consolidated
with the Company for United States federal income tax purposes. For financial
reporting purposes, current and deferred taxes are provided for on the portion
of earnings recognized by the Company with respect to its interest in PEI VII,
PE I, PE II, and KFH Inc., all domestic taxable corporate subsidiaries, because
each is taxed as a regular corporation under the Code. Deferred income tax assets
and liabilities are computed based on temporary differences between the GAAP
consolidated financial statements and the United States federal income tax
basis of assets and liabilities as of each consolidated balance sheet date. CLO
2005-1, CLO 2005-2, CLO 2006-1, CLO 2007-1, CLO 2007-A and KKR Financial CLO
2009-1, Ltd. (CLO 2009-1) are foreign subsidiaries of the Company that
elected to be treated as disregarded entities or partnerships for United States
federal income tax purposes. These subsidiaries were established to facilitate
securitization transactions, structured as secured financing transactions. TRS
Ltd., KFH Ltd. and KFH III Ltd. are foreign corporate subsidiaries that were
formed to make certain foreign and domestic investments from time to time. TRS
Ltd., KFH Ltd. and KFH III Ltd. are organized as exempted companies
incorporated with limited liability under the laws of the Cayman Islands, and
are anticipated to be exempt from United States federal and state income tax at
the corporate entity level because they restrict their activities in the United
States to trading in stock and securities for their own account. However, the
Company will be required to include their current taxable income in the Companys
calculation of its taxable income allocable to shareholders.
Earnings
Per Share
The Company calculates
earnings per share (EPS) using the two-class method which is an earnings
allocation formula that determines EPS for common shares and participating
securities. Unvested share-based payment awards that contain non-forfeitable
rights to dividends or dividend equivalents (whether paid or unpaid) are
participating securities and shall be included in the computation of EPS using
the two-class method. Accordingly, all earnings (distributed and undistributed)
are allocated to common shares and participating securities based on their
respective rights to receive dividends.
13
Table of Contents
The Company presents both
basic and diluted earnings (loss) per common share in its condensed
consolidated financial statements and footnotes thereto. Basic earnings (loss)
per common share (Basic EPS) excludes dilution and is computed by dividing
net income or loss by the weighted-average number of common shares, including
vested restricted common shares, outstanding for the period. Diluted earnings
(loss) per share (Diluted EPS) reflects the potential dilution of common
share options and unvested restricted common shares using the treasury method,
as well as the potential dilution of convertible senior notes using the number
of shares it would take to satisfy the excess conversion obligation (average
Company share price for the period in excess of the conversion price related to
the Companys convertible senior notes), if they are not anti-dilutive. See Note 3 to these condensed consolidated
financial statements for earnings (loss) per common share computations.
Recent
Accounting Pronouncements
Consolidation
In February 2010, the Financial Accounting
Standards Board (FASB) issued new guidance deferring the application of the
amended consolidation requirements related to VIEs for a reporting entitys
interest in an entity that has all the attributes of an investment company or
for which it is applies measurement principles that are consistent with those
followed by investment companies. The guidance was expected to most
significantly affect reporting entities in the investment management industry.
Entities including, but not limited to, securitization entities or entities
with multiple levels of subordinated investors such as a CLO for which the
primary purpose of the capital structure of the entity is to provide credit
enhancement to senior interest holders, will not qualify for the deferral. The guidance was effective for interim and
annual reporting periods beginning after November 15, 2009. The adoption
did not have an affect on the Companys condensed consolidated financial
statements.
Note 3. Earnings per Share
The following table presents
a reconciliation of basic and diluted net income per common share, as well as
the distributions declared per common share for the three months ended March 31,
2010 and 2009 (amounts in thousands, except per share information):
|
|
Three months ended
March 31, 2010
|
|
Three months ended
March 31, 2009
|
|
Net income (loss)
|
|
$
|
129,495
|
|
$
|
(12,976
|
)
|
Less: Dividends and
undistributed earnings allocated to participating securities
|
|
1,106
|
|
(100
|
)
|
Net income (loss)
applicable to common shareholders
|
|
$
|
128,389
|
|
$
|
(12,876
|
)
|
|
|
|
|
|
|
Basic:
|
|
|
|
|
|
Basic weighted-average
shares outstanding
|
|
156,997
|
|
149,714
|
|
Net income (loss) per
share
|
|
$
|
0.82
|
|
$
|
(0.09
|
)
|
|
|
|
|
|
|
Diluted:
|
|
|
|
|
|
Diluted weighted-average
shares outstanding (1)
|
|
156,997
|
|
149,714
|
|
Net income (loss) per
share
|
|
$
|
0.82
|
|
$
|
(0.09
|
)
|
|
|
|
|
|
|
Distributions declared per
common share
|
|
$
|
0.07
|
|
$
|
|
|
(1)
Potential
anti-dilutive common shares were excluded from diluted earnings per share
related to convertible senior notes for the three months ended March 31,
2010 and 2009, as the conversion price on the convertible senior notes was
greater than the average market price of the Companys shares. Potential anti-dilutive common shares
excluded from diluted earnings per share related to common share options were
1,932,279 for both the three months ended March 31, 2010 and 2009.
14
Table of Contents
Note 4.
Securities Available-for-Sale
The following table summarizes the Companys
securities classified as available-for-sale as of March 31, 2010 and December 31,
2009, which are carried at estimated fair value (amounts in thousands):
|
|
March 31, 2010
|
|
December 31, 2009
|
|
|
|
Amortized
Cost
|
|
Gross
Unrealized
Gains
|
|
Gross
Unrealized
Losses
|
|
Estimated
Fair Value
|
|
Amortized
Cost
|
|
Gross
Unrealized
Gains
|
|
Gross
Unrealized
Losses
|
|
Estimated
Fair Value
|
|
Corporate debt securities
|
|
$
|
612,778
|
|
$
|
220,418
|
|
$
|
(3,505
|
)
|
$
|
829,691
|
|
$
|
560,637
|
|
$
|
198,242
|
|
$
|
(4,470
|
)
|
$
|
754,409
|
|
Common and preferred stock
|
|
|
|
|
|
|
|
|
|
713
|
|
564
|
|
|
|
1,277
|
|
Total
|
|
$
|
612,778
|
|
$
|
220,418
|
|
$
|
(3,505
|
)
|
$
|
829,691
|
|
$
|
561,350
|
|
$
|
198,806
|
|
$
|
(4,470
|
)
|
$
|
755,686
|
|
The following table shows
the gross unrealized losses and fair value of the Companys available-for-sale
securities, aggregated by length of time that the individual securities have
been in a continuous unrealized loss position, as of March 31, 2010 and December 31,
2009 (amounts in thousands):
|
|
Less Than 12 months
|
|
12 Months or More
|
|
Total
|
|
|
|
Estimated
Fair Value
|
|
Unrealized
Losses
|
|
Estimated
Fair Value
|
|
Unrealized
Losses
|
|
Estimated
Fair Value
|
|
Unrealized
Losses
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
March 31, 2010
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Corporate debt securities
|
|
$
|
36,168
|
|
$
|
(833
|
)
|
$
|
36,102
|
|
$
|
(2,672
|
)
|
$
|
72,270
|
|
$
|
(3,505
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
December 31, 2009
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Corporate debt securities
|
|
$
|
8,437
|
|
$
|
(113
|
)
|
$
|
70,967
|
|
$
|
(4,357
|
)
|
$
|
79,404
|
|
$
|
(4,470
|
)
|
The unrealized losses in the table above are
considered to be temporary impairments due to market factors and are not
reflective of credit deterioration. The Company considers many factors when
evaluating whether an impairment is other-than-temporary. For corporate debt
securities included in the table above, the Company does not intend to sell
them and does not believe that it is more likely than not that the Company will
be required to sell any of its corporate debt securities prior to recovery. In
addition, based on the analyses performed by the Company on each of its
corporate debt securities, the Company believes that it is able to recover the
entire amortized cost amount of the corporate debt securities included in the
table above.
During the three months
ended March 31, 2010, the Company recognized a loss totaling $1.1 million
for corporate debt securities that it determined to be other-than-temporarily
impaired based on the criteria above. During the three months ended March 31,
2009, the Company recognized a loss totaling $33.8 million for corporate
debt securities that it determined to be other-than-temporarily impaired based
on the criteria above. The Company intends to sell these securities and as a
result, the entire amount is recorded through earnings in net realized and
unrealized gain (loss) on investments in the condensed consolidated statements
of operations.
As of March 31, 2010
and December 31, 2009, the Company had no corporate debt securities in
default.
The following table shows
the net realized gains (losses) on the sales of securities (amounts in
thousands):
|
|
Three months ended
March 31, 2010
|
|
Three months ended
March 31, 2009
|
|
Gross realized gains
|
|
$
|
7,530
|
|
$
|
912
|
|
Gross realized losses
|
|
|
|
(5,773
|
)
|
Net realized gains (losses)
|
|
$
|
7,530
|
|
$
|
(4,861
|
)
|
Note 8 to these condensed
consolidated financial statements describes the Companys borrowings under
which the Company has pledged securities available-for-sale for borrowings. The
following table summarizes the estimated fair value of securities
available-for-sale pledged as collateral as of March 31, 2010 and December 31,
2009 (amounts in thousands):
|
|
As of
March 31, 2010
|
|
As of
December 31, 2009
|
|
Pledged as collateral for
borrowings under senior secured credit facility
|
|
$
|
107,145
|
|
$
|
107,845
|
|
Pledged as collateral for
collateralized loan obligation secured notes and junior secured notes to
affiliates
|
|
699,715
|
|
633,104
|
|
Total
|
|
$
|
806,860
|
|
$
|
740,949
|
|
15
Table of Contents
Note 5.
Corporate Loans and Allowance for Loan Losses
The following table
summarizes the Companys corporate loans as of March 31, 2010 and December 31,
2009 (amounts in thousands):
|
|
March 31, 2010
|
|
December 31, 2009
|
|
|
|
Corporate
Loans
|
|
Corporate Loans
Held for Sale
|
|
Total Corporate
Loans
|
|
Corporate
Loans
|
|
Corporate Loans
Held for Sale
|
|
Total Corporate
Loans
|
|
Principal(1)
|
|
$
|
6,272,646
|
|
$
|
762,926
|
|
$
|
7,035,572
|
|
$
|
6,180,028
|
|
$
|
1,033,383
|
|
$
|
7,213,411
|
|
Unamortized discount
|
|
(364,815
|
)
|
(23,783
|
)
|
(388,598
|
)
|
(324,795
|
)
|
(76,028
|
)
|
(400,823
|
)
|
Total amortized cost
|
|
5,907,831
|
|
739,143
|
|
6,646,974
|
|
5,855,233
|
|
957,355
|
|
6,812,588
|
|
Lower of cost or fair value adjustment
|
|
|
|
(6,071
|
)
|
(6,071
|
)
|
|
|
(31,637
|
)
|
(31,637
|
)
|
Allowance for loan losses
|
|
(216,080
|
)
|
|
|
(216,080
|
)
|
(237,308
|
)
|
|
|
(237,308
|
)
|
Net carrying value
|
|
$
|
5,691,751
|
|
$
|
733,072
|
|
$
|
6,424,823
|
|
$
|
5,617,925
|
|
$
|
925,718
|
|
$
|
6,543,643
|
|
(1)
Principal amount
is net of charge-offs and other adjustments totaling $99.3 million and $158.8
million as of March 31, 2010 and December 31, 2009, respectively.
The following table
summarizes the changes in the allowance for loan losses for the Companys
corporate loan portfolio during the three months ended March 31, 2010 and
2009 (amounts in thousands):
|
|
For the three
months ended
March 31, 2010
|
|
For the three
months ended
March 31, 2009
|
|
Balance at beginning of
period
|
|
$
|
237,308
|
|
$
|
480,775
|
|
Provision for loan losses
|
|
|
|
26,987
|
|
Charge-offs
|
|
(21,228
|
)
|
|
|
Balance at end of period
|
|
$
|
216,080
|
|
$
|
507,762
|
|
As of March 31, 2010 and December 31,
2009, the Company recorded an allowance for loan loss of $216.1 million and
$237.3 million, respectively. As described in Note 2 to these condensed
consolidated financial statements, the allowance for loan losses represents the
Companys estimate of probable credit losses inherent in its loan portfolio as
of the balance sheet date. The Companys allowance for loan losses consists of
two components, an allocated component and an unallocated component. The
allocated component of the allowance for loan losses consists of individual
loans that are impaired. The unallocated component of the allowance for loan
losses represents the Companys estimate of losses inherent, but not
identified, in its portfolio as of the balance sheet date.
As of March 31, 2010, the allocated component
of the allowance for loan losses totaled $82.4 million and relates to
investments in loans issued by six issuers with an aggregate par amount of
$216.7 million and an aggregate amortized cost amount of $118.3 million. As of December 31,
2009, the allocated component of the allowance for loan losses totaled $81.7
million and relates to investments in loans issued by six issuers with an
aggregate par amount of $223.6 million and an aggregate amortized cost amount
of $121.2 million. The unallocated component of the allowance for loan losses
totaled $133.7 million and $155.6 million as of March 31, 2010 and December 31,
2009, respectively. During the three months ended March 31, 2010, the
Company recorded charge-offs totaling $21.2 million comprised primarily of
loans transferred to loans held for sale. There were no charge-offs recorded
during the three months ended March 31, 2009.
The Company reduced the
lower of cost or market valuation allowance by $3.7 million for certain loans
held for sale during the quarter ended March 31, 2010 which had a carrying
value of $733.1 million as of March 31, 2010. The Company recorded a
$14.0 million charge to earnings during the quarter ended March 31,
2009 for the lower of cost or estimated fair value adjustment for corporate
loans held for sale which had a carrying value of $259.9 million as of March 31,
2009.
16
Table of Contents
As of March 31, 2010
and December 31, 2009, the Company had loans on non-accrual status with a
total carrying value of $253.3 million and $439.9 million, respectively. The average recorded investment in the
impaired loans included in non-accrual loans during the three months ended March 31,
2010 and 2009 was $346.6 million and $565.2 million, respectively. As of March 31,
2010 and 2009, the allocated component of the allowance for loan losses
included all impaired loans for the respective periods. The amount of interest
income recognized using the cash-basis method during the time within the period
that the loans were impaired was $5.6 million and $2.1 million for the three
months ended March 31, 2010 and 2009, respectively.
As of March 31, 2010,
the Company held corporate loans that were in default with a total carrying
value of $209.7 million from four issuers. As of December 31, 2009, the
Company held loans that were in default with a total amortized cost of $392.5
million from seven issuers. The majority of corporate loans in default during
2010 and 2009 were included in the loans for which the allocated component of
the Companys allowance for losses was related to, or for which the Company
determined were loans held for sale as of March 31, 2010 and December 31,
2009, respectively.
Note 8 to these condensed
consolidated financial statements describes the Companys borrowings under
which the Company has pledged loans for borrowings. The following table
summarizes the amortized cost of total corporate loans, including corporate
loans held for sale, pledged as collateral as of March 31, 2010 and December 31,
2009 (amounts in thousands):
|
|
As of
March 31, 2010
|
|
As of
December 31, 2009
|
|
Pledged as collateral for
borrowings under senior secured credit facility
|
|
$
|
296,987
|
|
$
|
425,740
|
|
Pledged as collateral for
collateralized loan obligation secured notes and junior secured notes to
affiliates
|
|
6,241,305
|
|
6,354,382
|
|
Total
|
|
$
|
6,538,292
|
|
$
|
6,780,122
|
|
Note 6.
Residential Mortgage-Backed Securities
The
Company held RMBS with an estimated fair value of $114.0 million and $47.6
million as March 31, 2010 and December 31, 2009, respectively. As of January 1, 2010, RMBS increased
$74.4 million due to the deconsolidation of six residential mortgage loan
securitization trusts (see Consolidation under Note 2 to these condensed
consolidated financial statements). The $74.4 million represents the estimated
fair value of the Companys RMBS which were issued by these six residential
mortgage securitization trusts.
Note 8 to these condensed
consolidated financial statements describes the Companys borrowings under
which the Company has pledged RMBS. The following table summarizes the
estimated fair value of RMBS pledged as collateral as of March 31, 2010
and December 31, 2009 (amounts in thousands):
|
|
As of
March 31, 2010
|
|
As of
December 31, 2009
|
|
Pledged as collateral for
borrowings under senior secured credit facility
|
|
$
|
109,648
|
|
$
|
42,627
|
|
Pledged as collateral for
collateralized loan obligation secured notes and junior secured notes to
affiliates
|
|
4,375
|
|
4,945
|
|
Total
|
|
$
|
114,023
|
|
$
|
47,572
|
|
Note 7.
Deconsolidation of Residential Mortgage Loan Securitization Trusts
On
January 1, 2010, the Company deconsolidated six residential mortgage
securitization trusts as a result of the Companys adoption of new guidance
regarding the consolidation model for variable interest entities. The Company
has no exposure to loss in excess of the estimated fair value of the $74.4
million RMBS which were issued by these six residential mortgage securitization
trusts (see Note 6 to these condensed consolidated financial statements).
17
Table of Contents
The
following information represents the assets and liabilities removed from the
Companys condensed consolidated balance sheet as of January 1, 2010 as a
result of the deconsolidation of the six residential mortgage loan
securitization trusts (amounts in thousands):
|
|
As of
January 1, 2010
|
|
Assets
|
|
|
|
Residential mortgage
loans, at estimated fair value (1)
|
|
$
|
2,023,333
|
|
Real estate owned
(recorded within other assets on the condensed consolidated balance sheets)
|
|
11,439
|
|
Interest receivable
|
|
4,529
|
|
|
|
$
|
2,039,301
|
|
|
|
|
|
Liabilities
|
|
|
|
Residential
mortgage-backed securities issued, at estimated fair value
|
|
$
|
2,034,772
|
|
Accrued interest payable
|
|
4,529
|
|
|
|
$
|
2,039,301
|
|
(1)
Excludes $74.4
million which represents the estimated fair value of the Companys RMBS which
were issued by the six residential mortgage loan securitization trusts that
were deconsolidated under GAAP as of January 1, 2010.
As
a result of the deconsolidation of the six residential mortgage loan securitization
trusts, all references to residential mortgage loans interest income, RMBS
Issued interest expense, net realized and unrealized gain (loss) on residential
mortgage loans and RMBS Issued, and loan servicing expense relate to prior
period balances and activities.
Residential mortgage loans
The Company carried its residential mortgage loans
at estimated fair value with unrealized gains and losses reported in income.
The Company
had elected the fair value option for its residential mortgage loans for the
purpose of enhancing the transparency of its financial condition as fair value
was consistent with how the Company managed the risks of its residential
mortgage investments.
As of December 31,
2009, residential mortgage loans at estimated fair value, totaled $2.1 billion,
which excluded real estate owned (REO) as a result of foreclosure on
delinquent loans of $11.4 million as of December 31, 2009. Loans were
transferred to REO at the lower of cost or fair value. REO was recorded within
other assets on the Companys condensed consolidated balance sheets.
The following table
summarizes the estimated fair value of residential mortgage loans pledged as
collateral as of December 31, 2009 (amounts in thousands):
|
|
As of
December 31, 2009
|
|
Pledged as collateral for
borrowings under senior secured credit facility
|
|
$
|
74,366
|
|
Pledged as collateral for
residential mortgage-backed securities issued
|
|
2,023,333
|
|
|
|
$
|
2,097,699
|
|
The following is a
reconciliation of carrying amounts of residential mortgage loans for the year
ended December 31, 2009 (amounts in thousands):
|
|
2009
|
|
Beginning balance
|
|
$
|
2,620,021
|
|
Principal payments
|
|
(585,429
|
)
|
Transfers in to REO
|
|
(646
|
)
|
Net change in unrealized
and realized gain/loss and premium/discount
|
|
63,753
|
|
Ending balance
|
|
$
|
2,097,699
|
|
The following table
summarizes the delinquency statistics of the residential mortgage loans,
excluding REOs, as of December 31, 2009 (dollar amounts in thousands):
|
|
December 31, 2009
|
|
Delinquency Status
|
|
Number
of Loans
|
|
Principal
Amount
|
|
30 to 59 days
|
|
84
|
|
$
|
37,261
|
|
60 to 89 days
|
|
47
|
|
19,389
|
|
90 days or more
|
|
138
|
|
55,697
|
|
In foreclosure
|
|
139
|
|
57,497
|
|
Total
|
|
408
|
|
$
|
169,844
|
|
18
Table of Contents
As of December 31,
2009, 26 of the residential mortgage loans owned by the Company with an
outstanding balance of $11.4 million were REOs as a result of foreclosure on
delinquent loans. As of December 31, 2009, the Company had 277 loans that
were either 90 days or greater past due or in foreclosure and placed on
non-accrual status.
As of December 31,
2009, the loss exposure or uncollected principal amount related to the Companys
delinquent residential mortgage loans in the table above exceeded their fair
value by $20.2 million.
Residential mortgage-backed
securities issued
RMBS Issued consisted of the
senior tranches of six residential mortgage loan securitization trusts that the
Company previously consolidated under GAAP and for which the Company reported
the debt issued by these trusts that it did not hold on its condensed
consolidated balance sheets. The Company carried RMBS Issued at estimated fair
value with unrealized gains and losses reported in income.
The Company elected
the fair value option for its
RMBS Issued
for the
purpose of enhancing the transparency of its financial condition as fair value
was consistent with how the Company managed the risks of its residential
mortgage portfolio.
As of December 31,
2009, RMBS Issued had an outstanding amount of $2.6 billion and an estimated
fair value of $2.0 billion. As of December 31, 2009, the weighted average
coupon of the RMBS Issued was 2.3% and the weighted average years to maturity
were 25.8 years.
Note 8.
Borrowings
Certain information with
respect to the Companys borrowings as of March 31, 2010 is summarized in
the following table (dollar amounts in thousands):
|
|
Outstanding
Borrowings
|
|
Weighted
Average
Borrowing
Rate
|
|
Weighted
Average
Remaining
Maturity
(in days)
|
|
Fair Value of
Collateral(1)
|
|
Senior secured credit
facility
|
|
$
|
150,000
|
|
4.25
|
%
|
589
|
|
$
|
615,165
|
|
CLO 2005-1 senior secured
notes
|
|
832,772
|
|
0.57
|
|
2,583
|
|
890,953
|
|
CLO 2005-2 senior secured notes
|
|
800,709
|
|
0.57
|
|
2,797
|
|
909,252
|
|
CLO 2006-1 senior secured
notes
|
|
683,265
|
|
0.62
|
|
3,069
|
|
892,338
|
|
CLO 2007-1 senior secured
notes
|
|
2,075,040
|
|
0.80
|
|
4,063
|
|
2,311,189
|
|
CLO 2007-1 junior secured
notes to affiliates(2)
|
|
314,015
|
|
|
|
4,063
|
|
347,936
|
|
CLO 2007-1 junior
secured notes(3)
|
|
64,121
|
|
|
|
4,063
|
|
71,418
|
|
CLO 2007-A senior secured
notes
|
|
1,165,099
|
|
1.14
|
|
2,755
|
|
1,254,168
|
|
CLO 2007-A junior secured
notes to affiliates(4)
|
|
66,328
|
|
|
|
2,755
|
|
71,398
|
|
CLO 2007-A junior
secured notes(5)
|
|
10,860
|
|
|
|
2,755
|
|
11,690
|
|
Convertible senior notes
|
|
343,303
|
|
7.24
|
|
1,641
|
|
|
|
Junior subordinated notes
|
|
283,517
|
|
5.40
|
|
9,718
|
|
|
|
Total
|
|
$
|
6,789,029
|
|
|
|
|
|
$
|
7,375,507
|
|
(1)
|
|
Collateral for borrowings consists of RMBS, securities
available-for-sale, equity investments, at estimated fair value, private
equity investments, corporate loans and common stock warrants.
|
|
|
|
(2)
|
|
CLO 2007-1 junior secured notes to affiliates consist of
(x) $183.7 million of mezzanine notes with a weighted average borrowing
rate of 5.3% and (y) $130.3 million of subordinated notes that do
not have a contractual coupon rate, but instead receive a pro rata
amount of the net distributions from CLO 2007-1.
|
|
|
|
(3)
|
|
CLO 2007-1
junior secured notes consist of (x) $58.3 million of mezzanine
notes with a weighted average borrowing rate of 3.6% and
(y) $5.8 million of subordinated notes that do not have a
contractual coupon rate, but instead receive a pro rata amount of the
net distributions from CLO 2007-1.
|
|
|
|
(4)
|
|
CLO 2007-A junior
secured notes to affiliates consist of (x) $55.8 million of
mezzanine notes with a weighted average borrowing rate of 6.4% and
(y) $10.5 million of subordinated notes that do not have a
contractual coupon rate, but instead receive a pro rata amount of the
net distributions from CLO 2007-A.
|
19
Table of Contents
(5)
|
|
CLO 2007-A
junior secured notes consist of (x) $6.3 million of mezzanine notes
with a weighted average borrowing rate of 6.9% and (y) $4.6 million
of subordinated notes that do not have a contractual coupon rate, but instead
receive a pro rata amount of the net distributions from CLO 2007-A.
|
CLO Notes
The indentures governing the
Companys CLO transactions include numerous compliance tests, the majority of
which relate to the CLOs portfolio profile. In the event that a portfolio
profile test is not met, the indenture places restrictions on the ability of
the CLOs manager to reinvest available principal proceeds generated by the
collateral in the CLOs until the specific test has been cured. In addition to
the portfolio profile tests, the indentures for the CLO transactions include
over-collateralization tests (OC Tests) which set the ratio of the collateral
value of the assets in the CLO to the tranches of debt for which the test is
being measured, as well as interest coverage tests. If a CLO is not in
compliance with an OC Test or an interest coverage test, cash flows normally
payable to the holders of junior classes of notes will be used by the CLO to
amortize the most senior class of notes until such point as the OC test is
brought back into compliance. Due to the failure of OC Tests during the first
quarter of 2010, CLO 2007-1 senior secured notes were paid down by
$90.3 million. As of March 31, 2010, all of the Companys CLO
transactions were in compliance with their respective OC and interest coverage
tests.
Due to
the failure of OC Tests during 2009, CLO 2005-2 senior
secured notes were paid down by $9.0 million, CLO 2006-1 senior secured notes
were paid down by $32.1 million, CLO 2007-1 senior secured notes were paid down
by $149.5 million and CLO 2007-A senior secured notes were paid down by $56.1
million.
During the three
months ended March 31, 2010, in an open market auction, the Company
purchased $10.3 million of mezzanine notes issued by CLO 2007-A for $5.5
million and $72.7 million of mezzanine and subordinate notes issued by CLO
2007-1 for $38.8 million, both of which were previously held by an affiliate of
the Companys manager.
These transactions resulted in the Company recording
an aggregate gain on extinguishment of debt totaling $38.7 million.
Senior
Secured Credit Facility
In February 2010, the Company paid down $25.0 million of
borrowings outstanding under its senior secured credit facility due 2011,
reducing the amount outstanding from $175.0 million as of December 31,
2009 to $150.0 million as of March 31, 2010. As of March 31, 2010,
the Company believes it was in compliance with the senior secured credit
facility covenant requirements.
Convertible
Debt
During January and February 2010, the Company repurchased
$95.2 million par amount of its 7.0% convertible senior notes maturing on July 15,
2012 (the 7.0% Notes), reducing the amount outstanding from
$275.8 million as of December 31, 2009 to $180.6 million as of March 31,
2010. These transactions resulted in the Company recording a gain of $1.3
million, which was partially offset by a write-off of $0.6 million of
unamortized debt issuance costs during the first quarter of 2010.
On January 15, 2010, the Company issued $172.5 million of
7.5% Convertible Senior Notes due January 15, 2017 (7.5% Notes). The
7.5% Notes bear interest at a rate of 7.5% per annum on the principal amount,
accruing from January 15, 2010. Interest is payable semiannually in
arrears on January 15 and July 15 of each year, beginning on July 15,
2010. The 7.5% Notes will mature on January 15, 2017 unless previously
redeemed, repurchased or converted in accordance with their terms prior to such
date. Holders of the 7.5% Notes may convert their notes at the applicable
conversion rate at any time prior to the close of business on the business day
immediately preceding the stated maturity date subject to the Companys right
to terminate the conversion rights of the notes. The Company may satisfy its
obligation with respect to the 7.5% Notes tendered for conversion by delivering
to the holder either cash, common shares, no par value, issued by the Company
or a combination thereof. The initial conversion rate for each $1,000 principal
amount of 7.5% Notes is 122.2046 shares, which is equivalent to an initial
conversion price of approximately $8.18 per share. The conversion rate may be
adjusted under certain circumstances, including the occurrence of certain
fundamental change transactions and the payment of a quarterly cash
distribution in excess of $0.05 per share, but will not be adjusted for accrued
and unpaid interest on the 7.5% Notes. Net proceeds from the offering totaled
$167.3 million, reflecting $172.5 million from the issuance less
$5.2 million for underwriting fees.
20
Table of Contents
In
accordance with accounting for convertible debt instruments that may settled in
cash upon conversion, the Company separately accounted for the liability and
equity components to reflect the nonconvertible debt borrowing rate. The
Company determined that the equity component of the 7.5% Notes totaled $10.0
million and is included in paid-in-capital on the Companys condensed
consolidated balance sheet as of March 31, 2010. The remaining liability
component of $162.7 million, included within convertible senior notes on the
Companys condensed consolidated balance sheet as of March 31, 2010, is
comprised of the principal $172.5 million less the unamortized debt discount of
$9.8 million. The total debt discount amortization recognized for the three
months ended March 31, 2010 was $0.2 million. The debt discount will
continue to be amortized at the effective interest rate of 8.6%. For the three
months ended March 31, 2010, the total interest expense recognized on the
7.5% Notes was $2.7 million.
Certain information with respect to the Companys borrowings as of December 31,
2009 is summarized in the following table (dollar amounts in thousands):
|
|
Outstanding
Borrowings
|
|
Weighted
Average
Borrowing
Rate
|
|
Weighted
Average
Remaining
Maturity
(in days)
|
|
Fair Value of
Collateral(1)
|
|
Senior secured credit
facility(2)
|
|
$
|
175,000
|
|
4.23
|
%
|
679
|
|
$
|
739,640
|
|
CLO 2005-1 senior secured
notes
|
|
832,622
|
|
0.61
|
|
2,673
|
|
868,291
|
|
CLO 2005-2 senior secured
notes
|
|
800,504
|
|
0.58
|
|
2,887
|
|
859,457
|
|
CLO 2006-1 senior secured
notes
|
|
683,266
|
|
0.63
|
|
3,159
|
|
858,317
|
|
CLO 2007-1 senior secured
notes
|
|
2,176,805
|
|
0.82
|
|
4,153
|
|
2,337,779
|
|
CLO 2007-1 junior secured
notes to affiliates(3)
|
|
437,730
|
|
|
|
4,153
|
|
468,422
|
|
CLO 2007-1 junior
secured notes(4)
|
|
14,185
|
|
|
|
4,153
|
|
15,237
|
|
CLO 2007-A senior secured
notes
|
|
1,157,209
|
|
1.16
|
|
2,845
|
|
1,137,077
|
|
CLO 2007-A junior secured
notes to affiliates(5)
|
|
96,056
|
|
|
|
2,845
|
|
94,505
|
|
CLO 2007-A junior
secured notes(6)
|
|
3,125
|
|
|
|
2,845
|
|
3,074
|
|
Convertible senior notes
|
|
275,800
|
|
7.00
|
|
927
|
|
|
|
Junior subordinated notes
|
|
283,517
|
|
5.41
|
|
9,747
|
|
|
|
Total
|
|
$
|
6,935,819
|
|
|
|
|
|
$
|
7,381,799
|
|
(1)
|
|
Collateral
for borrowings consists of RMBS, securities available-for-sale, equity
investments, at estimated fair value, private equity investments, corporate
and residential mortgage loans and common stock warrants.
|
|
|
|
(2)
|
|
Calculated
weighted average remaining maturity based on the amended maturity date of
November 10, 2011.
|
|
|
|
(3)
|
|
CLO 2007-1
junior secured notes to affiliates consist of (x) $256.9 million of
mezzanine notes with a weighted average borrowing rate of 5.2% and
(y) $180.8 million of subordinated notes that do not have a
contractual coupon rate, but instead receive a pro rata amount of the
net distributions from CLO 2007-1.
|
|
|
|
(4)
|
|
CLO 2007-1
junior secured notes consist of (x) $8.4 million of mezzanine notes
with a weighted average borrowing rate of 5.2% and (y) $5.8 million
of subordinated notes that do not have a contractual coupon rate, but instead
receive a pro rata amount of the net distributions from CLO 2007-1.
|
|
|
|
(5)
|
|
CLO 2007-A
junior secured notes to affiliates consist of (x) $81.5 million of
mezzanine notes with a weighted average borrowing rate of 6.5% and
(y) $14.6 million of subordinated notes that do not have a
contractual coupon rate, but instead receive a pro rata amount of the
net distributions from CLO 2007-A.
|
|
|
|
(6)
|
|
CLO 2007-A
junior secured notes consist of (x) $2.6 million of mezzanine notes
with a weighted average borrowing rate of 6.5% and (y) $0.5 million
of subordinated notes that do not have a contractual coupon rate, but instead
receive a pro rata amount of the net distributions from CLO 2007-A.
|
Note 9.
Derivative Financial Instruments
The Company enters into
derivative transactions in order to hedge its interest rate risk exposure to
the effects of interest rate changes. Additionally, the Company enters into
derivative transactions in the course of its portfolio management activities.
The counterparties to the Companys derivative agreements are major financial
institutions with which the Company and its affiliates may also have other
financial relationships. In the event of nonperformance by the counterparties,
the Company is potentially exposed to losses. The counterparties to the Companys
derivative agreements have investment grade ratings and, as a result, the
Company does not anticipate that any of the counterparties will fail to fulfill
their obligations.
21
Table of Contents
Cash Flow
Hedges
The Company uses interest
rate derivatives consisting of swaps to hedge a portion of the interest rate
risk associated with its borrowings under CLO senior secured notes. The Company
designates these financial instruments as cash flow hedges.
Free-Standing
Derivatives
Free-standing derivatives
are derivatives that the Company has entered into in conjunction with its
investment and risk management activities, but for which the Company has not
designated the derivative contract as a hedging instrument for accounting
purposes. Such derivative contracts may include credit default swaps (CDS),
foreign exchange contracts, and interest rate derivatives. Free-standing
derivatives also include investment financing arrangements (total rate of
return swaps) whereby the Company receives the sum of all interest, fees and
any positive change in fair value amounts from a reference asset with a
specified notional amount and pays interest on such notional amount plus any
negative change in fair value amounts from such reference asset.
The table below summarizes
the aggregate notional amount and estimated net fair value of the derivative
instruments as of March 31, 2010 and December 31, 2009 (amounts in
thousands):
|
|
As of March 31, 2010
|
|
As of December 31, 2009
|
|
|
|
Notional
|
|
Estimated
Fair Value
|
|
Notional
|
|
Estimated
Fair Value
|
|
Cash Flow Hedges:
|
|
|
|
|
|
|
|
|
|
Interest rate swaps
|
|
$
|
383,333
|
|
$
|
(48,705
|
)
|
$
|
383,333
|
|
$
|
(43,800
|
)
|
Free-Standing Derivatives:
|
|
|
|
|
|
|
|
|
|
Interest rate swaps
|
|
83,965
|
|
(641
|
)
|
89,246
|
|
(281
|
)
|
Credit default
swapsprotection sold
|
|
51,000
|
|
225
|
|
51,000
|
|
(385
|
)
|
Total rate of return swaps
|
|
|
|
228
|
|
104,446
|
|
11,809
|
|
Common stock warrants
|
|
|
|
198
|
|
|
|
2,471
|
|
Total
|
|
$
|
518,298
|
|
$
|
(48,695
|
)
|
$
|
628,025
|
|
$
|
(30,186
|
)
|
A CDS is a contract in
which the contract buyer pays, in the case of a short position, or receives, in
the case of long position, a periodic premium until the contract expires or a
credit event occurs. In return for this premium, the contract seller receives a
payment from or makes a payment to the buyer if there is a credit default or
other specified credit event with respect to the issuer (also known as the
referenced entity) of the underlying credit instrument referenced in the CDS.
Typical credit events include bankruptcy, dissolution or insolvency of the
referenced entity, failure to pay and restructuring of the obligations of the
referenced entity.
As
of March 31, 2010 and December 31, 2009, the Comp
any had sold protection with a notional
amount of approximately $51.0 million. The Company sells protection to
replicate fixed income securities and to complement the spot market when cash
securities of the referenced entity of a particular maturity are not available
or when the derivative alternative is less expensive compared to other
purchasing alternatives.
The following table shows the net realized gains (losses) on the
Companys CDS for the three months ended March 31, 2010 and 2009 (amounts
in thousands):
|
|
Three months ended
March 31, 2010
|
|
Three months ended
March 31, 2009
|
|
Gross
realized gains
|
|
$
|
|
|
$
|
58,922
|
|
Gross realized losses
|
|
|
|
(996
|
)
|
Net realized gains (losses)
|
|
$
|
|
|
$
|
57,926
|
|
For all hedges where hedge
accounting is being applied, effectiveness testing and other procedures to
ensure the ongoing validity of the hedges are performed at least quarterly.
During the three months ended March 31, 2010 and 2009, the Company
recognized an immaterial amount of ineffectiveness in income on the condensed
consolidated statements of operations from its cash flow hedges.
22
Table of Contents
Note 8 to these condensed consolidated financial statements
describes the Companys borrowings under which the Company has pledged warrants
for borrowings. The following table summarizes the estimated fair value of
warrants pledged as collateral as of March 31, 2010 and December 31,
2009 (amounts in thousands):
|
|
As of
March 31, 2010
|
|
As of
December 31, 2009
|
|
Pledged as collateral for borrowings under senior
secured credit facility
|
|
$
|
198
|
|
$
|
1,078
|
|
Pledged as collateral for collateralized loan
obligation secured notes and junior secured notes to affiliates
|
|
|
|
1,393
|
|
Total
|
|
$
|
198
|
|
$
|
2,471
|
|
Note 10.
Accumulated Other Comprehensive Income
The components of accumulated
other comprehensive income were as follows (amounts in thousands):
|
|
As of
March 31, 2010
|
|
As of
December 31, 2009
|
|
Net unrealized gains on
available-for-sale securities
|
|
$
|
216,913
|
|
$
|
194,336
|
|
Net unrealized losses on
cash flow hedges
|
|
(46,500
|
)
|
(41,608
|
)
|
Accumulated other
comprehensive income
|
|
$
|
170,413
|
|
$
|
152,728
|
|
The components of changes in
other comprehensive income were as follows (amounts in thousands):
|
|
Three months ended
March 31, 2010
|
|
Three months ended
March 31, 2009
|
|
Unrealized gains on
securities available-for-sale:
|
|
|
|
|
|
Unrealized holding gains
arising during period
|
|
$
|
30,107
|
|
$
|
28,946
|
|
Reclassification
adjustments for (gains) losses realized in net income(1)
|
|
(7,530
|
)
|
4,861
|
|
Unrealized gains on
securities available-for-sale
|
|
22,577
|
|
33,807
|
|
Unrealized (losses) gains
on cash flow hedges
|
|
(4,892
|
)
|
9,047
|
|
Other comprehensive income
|
|
$
|
17,685
|
|
$
|
42,854
|
|
(1)
|
|
Excludes an impairment
charge of $1.1 million and $33.8 million for investments which were
determined to be other-than-temporary for the three months ended
March 31, 2010 and 2009, respectively.
|
Note 11.
Commitments and Contingencies
Loan Commitments
As part of its strategy of investing in corporate
loans, the Company commits to purchase interests in primary market loan
syndications, which obligate the Company to acquire a predetermined interest in
such loans at a specified price on a to-be-determined settlement date.
Consistent with standard industry practices, once the Company has been informed
of the amount of its syndication allocation in a particular loan by the
syndication agent, the Company bears the risks and benefits of changes in the
fair value of the syndicated loan from that date forward. As of March 31,
2010, the Company had committed to purchase corporate loans with aggregate
commitments totaling
$250.8 million.
In addition, the Company participates in certain
contingent financing arrangements, whereby the Company is committed to provide
funding of up to a specific amount at the discretion of the borrower.
As of March 31,
2010, the Company had unfunded financing commitments totaling
$42.0 million. The Company does not expect material losses related to
those corporate loans for which it committed to purchase and fund.
Contingencies
On July 10, 2009, the Company surrendered for cancellation,
without consideration, approximately $64.0 million of mezzanine notes
issued to the Company by CLO 2005-2 (the 2005-2 Notes) and approximately
$222.4 million of mezzanine and junior notes issued to the Company by CLO
2006-1 (the 2006-1 Notes), as well as certain other notes issued to the
Company by another CLO. The surrendered notes were cancelled by the trustee
under the applicable indenture, and the obligations due under such surrendered
notes were deemed extinguished.
23
Table of Contents
Holders constituting a majority of the controlling class of senior
notes of CLO 2005-2 (the 2005-2 Noteholders) notified the related trustee of
purported defaults under the indentures related to the surrender of the 2005-2
Notes. The Company announced on November 29, 2009 that it reached an
agreement on November 23, 2009 with the 2005-2 Noteholders pursuant to
which the 2005-2 Noteholders have agreed, subject to the terms and conditions
of the agreement, not to challenge the July 2009 surrender for
cancellation transaction. In exchange, the Company has agreed to certain
arrangements, including, among other things, to refrain from undertaking a
comparable surrender for cancellation, of any other mezzanine notes or junior
notes issued to it by CLO 2005-2. In addition, the Company has agreed with the
2005-2 Noteholders that, for so long as no legal action or similar challenge is
brought to the Companys prior surrender of notes in any of its CLO
transactions, the Company will not undertake a comparable surrender for
cancellation, without consideration, of any mezzanine notes or junior notes
issued to it by CLO 2005-1, CLO 2006-1, CLO 2007-1 or CLO 2007-A.
In addition, during the first quarter of 2010, certain holders of the
senior notes of CLO 2006-1 (the 2006-1 Noteholders) notified the related
trustee of purported defaults under the indenture related to the surrender of
the 2006-1 Notes. The Company does not believe based on discussions with
counsel that an event of default has occurred and is engaged in discussions
with the 2006-1 Noteholders to resolve this matter. Accordingly, the Company
does not believe that this matter will have a material effect on its financial
condition.
The parent company of the Manager
recently furnished information to the SEC, in response to an examination letter
sent to a number of investment advisers in the structured credit product
sector, regarding its trading procedures and valuation practices in the
collateral pools of CLOs for which it acts as collateral manager.
The Company has been named as a party in various legal actions which
include the matters described below. It is inherently difficult to predict the
ultimate outcome, particularly in cases in which claimants seek substantial or
unspecified damages, or where investigations or proceedings are at an early
stage and the Company cannot predict with certainty the loss or range of loss
that may be incurred. The Company has denied, or believes it has a meritorious
defense and will deny liability in the significant cases pending against the
Company discussed below. Based on current discussion and consultation with counsel,
management believes that the resolution of these matters will not have a
material impact on the Companys condensed consolidated financial statements.
On August 7, 2008, the members of the Companys board of directors
and certain of its current and former executive officers and the Company were
named in a putative class action complaint filed by Charter Township of Clinton
Police and Fire Retirement System in the United States District Court for the
Southern District of New York, or the Charter Litigation. On March 13,
2009, the lead plaintiff filed an amended complaint, which deleted as
defendants the members of the Companys board of directors and named as
defendants only the Companys former chief executive officer Saturnino S.
Fanlo, the Companys former chief operating officer David A. Netjes, the
Companys current chief financial officer Jeffrey B. Van Horn and the Company.
The amended complaint alleges that the Companys April 2, 2007
registration statement and prospectus and the financial statements incorporated
therein contained material omissions in violation of Section 11 of the
Securities Act, regarding the risks and potential losses associated with the
Companys real estate-related assets, the Companys ability to finance its real
estate-related assets and the adequacy of the Companys loss reserves for its
real estate-related assets. The amended complaint further alleges that,
pursuant to Section 15 of the Securities Act, Messrs. Fanlo, Netjes
and Van Horn each have legal responsibility for the alleged Section 11
violation. On April 27, 2009, the defendants filed a motion to dismiss the
amended complaint for failure to state a claim under the Securities Act.
On August 15, 2008, the members of the Companys board of
directors and its executive officers (collectively, the Kostecka Individual
Defendants) were named in a shareholder derivative action brought by Raymond
W. Kostecka, a purported shareholder, in the Superior Court of California,
County of San Francisco (the California Derivative Action). The Company was
named as a nominal defendant. The complaint in the California Derivative Action
asserts claims against the Kostecka Individual Defendants for breaches of
fiduciary duty, abuse of control, gross mismanagement, waste of corporate assets,
and unjust enrichment in connection with the conduct at issue in the Charter
Litigation, including the filing of the Companys April 2, 2007
registration statement with alleged material misstatements and omissions. By
order dated January 8, 2009, the Court approved the parties stipulation
to stay the proceedings in the California Derivative Action until the Charter
Litigation is dismissed on the pleadings or the Company files an answer to the
Charter Litigation.
On March 23, 2009, the members of the Companys
board of directors and certain of its executive officers (collectively, the Haley
Individual Defendants) were named in a shareholder derivative action brought
by Paul B. Haley, a purported shareholder, in the United States District Court
for the Southern District of New York (the New York Derivative Action). The
Company was named as a nominal defendant. The complaint in the New York
Derivative Action asserts claims against the Haley Individual Defendants for
breaches of fiduciary duty, breaches of the duty of full disclosure, and for
contribution in connection with the conduct at issue in the Charter Litigation,
including the filing of the Companys April 2, 2007 registration statement
with alleged material misstatements and omissions. By order dated June 18,
2009, the Court approved the parties stipulation to stay the proceedings in
the New York Derivative Action until the Charter Litigation is dismissed on the
pleadings or the Company files an answer to the Charter Litigation.
24
Table of Contents
Note 12. Share Options and Restricted Shares
On May 4, 2007, the Company adopted an amended and restated share
incentive plan (the 2007 Share Incentive Plan) that provides for the grant of
qualified incentive common share options that meet the requirements of Section 422
of the Code, non-qualified common share options, share appreciation rights,
restricted common shares and other share-based awards. The Compensation
Committee of the board of directors administers the plan. Share options and
other share-based awards may be granted to the Manager, directors, officers and
any key employees of the Manager and to any other individual or entity
performing services for the Company.
The exercise price for any share option granted under the 2007 Share
Incentive Plan may not be less than 100% of the fair market value of the common
shares at the time the common share option is granted. Each option to acquire a
common share must terminate no more than ten years from the date it is granted.
As of March 31, 2010, the 2007 Share Incentive Plan authorizes a total of
8,464,625 shares that may be used to satisfy awards under the 2007 Share Incentive
Plan.
The following table summarizes restricted common share transactions:
|
|
Manager
|
|
Directors
|
|
Total
|
|
Unvested shares as of January 1,
2010
|
|
1,097,000
|
|
255,618
|
|
1,352,618
|
|
Issued
|
|
|
|
|
|
|
|
Vested
|
|
|
|
|
|
|
|
Cancelled
|
|
|
|
|
|
|
|
Forfeited
|
|
|
|
|
|
|
|
Unvested shares as of March 31,
2010
|
|
1,097,000
|
|
255,618
|
|
1,352,618
|
|
The Company is required to value any unvested restricted common shares
granted to the Manager at the current market price. The Company valued the
unvested restricted common shares granted to the Manager at $8.21 and $0.88 per
share at March 31, 2010 and March 31, 2009, respectively. There were
$3.3 million and $1.0 million of total unrecognized compensation costs
related to unvested restricted common shares granted as of March 31, 2010
and 2009, respectively. These costs are expected to be recognized over three
years from the date of grant.
The following table summarizes common share option transactions:
|
|
Number of
Options
|
|
Weighted-Average
Exercise Price
|
|
Outstanding as of January 1,
2010
|
|
1,932,279
|
|
$
|
20.00
|
|
Granted
|
|
|
|
|
|
Exercised
|
|
|
|
|
|
Forfeited
|
|
|
|
|
|
Outstanding as of March 31,
2010
|
|
1,932,279
|
|
$
|
20.00
|
|
As of March 31, 2010 and December 31, 2009, 1,932,279 common
share options were exercisable. As of March 31, 2010, the common share
options were fully vested and expire in August 2014. For the three months
ended March 31, 2010 and 2009, the components of share-based compensation
expense are as follows (amounts in thousands):
|
|
For the three
months ended
March 31, 2010
|
|
For the three
months ended
March 31, 2009
|
|
Restricted shares granted to Manager
|
|
$
|
2,392
|
|
$
|
(140
|
)
|
Restricted shares granted to certain directors
|
|
502
|
|
137
|
|
Total share-based compensation expense
|
|
$
|
2,894
|
|
$
|
(3
|
)
|
Note 13. Management Agreement and Related Party
Transactions
The Manager manages the Companys day-to-day operations, subject to the
direction and oversight of the Companys board of directors. The Management
Agreement expires on December 31 of each year, but is automatically
renewed for a one-year term each December 31 unless terminated upon the
affirmative vote of at least two-thirds of the Companys independent directors,
or by a vote of the holders of a majority of the Companys outstanding common
shares, based upon (1) unsatisfactory performance by the Manager that is
materially detrimental to the Company or (2) a determination that the
management fee payable by the Manager is not fair, subject to the Managers
right to prevent such a termination under this clause (2) by
accepting a mutually acceptable reduction of management fees. The Manager must
be provided 180 days prior notice of any such termination and will be paid
a termination fee equal to four times the sum of the average annual base
management fee and the average annual incentive fee for the two 12-month
periods immediately preceding the date of termination, calculated as of the end
of the most recently completed fiscal quarter prior to the date of termination.
25
Table of Contents
The Management Agreement contains certain provisions requiring the
Company to indemnify the Manager with respect to all losses or damages arising
from acts not constituting bad faith, willful misconduct, or gross negligence.
The Company has evaluated the impact of these guarantees on its condensed
consolidated financial statements and determined that they are not material.
For the three months ended March 31, 2010, the Company incurred
$4.2 million in base management fees.
In addition, the Company
recognized share-based compensation expense related to restricted common shares
granted to the Manager of $2.4 million for the three months ended March 31,
2010 (see Note 12 to these
condensed consolidated financial statements
). For the three
months ended March 31, 2009, the Company incurred $3.6 million in base
management fees. In addition, the Company recognized share-based compensation
expense related to restricted common shares granted to the Manager of $(0.1)
million for the three months ended March 31, 2009 (see Note 12 to these
condensed
consolidated financial statements
).
Base management fees incurred and share-based compensation expense
relating to common share options and restricted common shares granted to the
Manager are included in related party management compensation on the condensed
consolidated statements of operations. Expenses incurred by the Manager and
reimbursed by the Company are reflected in the respective condensed
consolidated statements of operations, non-investment expense category based on
the nature of the expense.
The Manager is waiving base management fees related to the
$230.4 million common share offering and $270.0 million common share
rights offering that occurred during the third quarter of 2007 until such time
as the Companys common share closing price on the NYSE is $20.00 or more for
five consecutive trading days. Accordingly, the Manager permanently waived
approximately $2.2 million of base management fees during each of the three
months ended March 31, 2010 and 2009.
During
the three months ended March 31, 2010, the Manager earned $22.2 million of
incentive fees. Of this amount, the Manager permanently waived payment of $9.7
million of incentive fees that were related to the $38.7 million gain
recorded by the Company as a result of the repurchase of $83.0 million of
mezzanine and subordinate notes issued by CLO 2007-1 and CLO 2007-A during the
quarter ended March 31, 2010. The remaining $12.5 million, representing
the incentive fee net of the amount waived, is included in related party
management compensation on the Companys condensed consolidated statement of
operations for the quarter ended March 31, 2010 and is due and payable to
the Manager as of that date.
An affiliate of the Manager has entered into separate management
agreements with the respective investment vehicles for CLO 2005-1,
CLO 2005-2, CLO 2006-1, CLO 2007-1, CLO 2007-A and CLO
2009-1 and is entitled to receive fees for the services performed as collateral
manager. Previously, the collateral
manager had waived the fees it earned for providing management services for the
Companys CLOs. Beginning April 15, 2007, the collateral manager ceased
waiving fees for CLO 2005-1 and beginning January 1, 2009, the
collateral manager ceased waiving fees for CLO 2005-2, CLO 2006-1,
CLO 2007-1, CLO 2007-A and Wayzata Funding LLC (restructured and
replaced with CLO 2009-1 on March 31, 2009). Beginning in July 2009,
the collateral manager reinstated waiving the CLO management fees for CLO 2005-2
and CLO 2006-1. In addition, due to CLO 2007-A and CLO 2007-1 regaining
compliance with their respective OC Tests during the first quarter of 2010, the
collateral manager also reinstated waiving the CLO management fees for CLO
2007-A and CLO 2007-1. For the three months ended March 31, 2010, the
collateral manager waived an aggregate of $4.5 million for CLO 2005-2, CLO
2006-1 and CLO 2007-A. In addition, due to the deleveraging of CLO 2009-1
completed in July 2009 whereby all the senior notes were retired, the
collateral manager is no longer entitled to receive management fees from CLO
2009-1. The Company recorded an expense for CLO management fees of
$1.4 million and $7.7 million for the quarters ended March 31,
2010 and 2009, respectively.
In addition, beginning January 1, 2009, the Manager permanently
waived reimbursable general and administrative expenses allocable to the
Company in an amount equal to the incremental CLO management fees received by
the Manager. For the three months ended March 31, 2010 and 2009, the
Manager permanently waived reimbursement of $1.3 million and $2.3 million
in allocable general and administrative expenses, respectively.
26
Table of Contents
The Company has invested in corporate loans, debt securities and other
investments of entities that are affiliates of KKR. As of March 31, 2010,
the aggregate par amount of these affiliated investments totaled
$2.5 billion, or approximately 31% of the total investment portfolio, and
consisted of 24 issuers. The total $2.5 billion in affiliated investments
were primarily comprised of $2.1 billion of corporate loans and $415.2 million
of corporate debt securities available-for-sale. As of December 31, 2009,
the aggregate par amount of these affiliated investments totaled
$2.8 billion, or approximately 35% of the total investment portfolio, and
consisted of 21 issuers. The total $2.8 billion in investments were
comprised of $2.3 billion of corporate loans, $466.0 million of
corporate debt securities available for sale, and $61.8 million notional
amount of total rate of return swaps referenced to corporate loans issued by
affiliates of KKR (included in derivative assets and liabilities on the
condensed consolidated balance sheet).
Note 14. Fair Value of Financial Instruments
Fair Value of Financial Instruments
The fair value of certain instruments including securities
available-for-sale, corporate loans, derivatives, and loan commitments is based
on quoted market prices or estimates provided by independent pricing sources.
The fair value of cash and cash equivalents, interest receivable, senior
secured credit facility and interest payable, approximates cost as of March 31,
2010 and December 31, 2009, due to the short-term nature of these
instruments.
The table below discloses the carrying value and the estimated fair
value of the Companys financial instruments as of March 31, 2010 and December 31,
2009 (amounts in thousands):
|
|
As of March 31, 2010
|
|
As of December 31, 2009
|
|
|
|
Carrying
Amount
|
|
Estimated Fair
Value
|
|
Carrying
Amount
|
|
Estimated Fair
Value
|
|
Financial Assets:
|
|
|
|
|
|
|
|
|
|
Cash, restricted cash, and cash equivalents
|
|
$
|
621,827
|
|
$
|
621,827
|
|
$
|
439,792
|
|
$
|
439,792
|
|
Securities available-for-sale
|
|
829,691
|
|
829,691
|
|
755,686
|
|
755,686
|
|
Corporate loans, net of allowance for loan losses
of $216,080, and $237,308 as of March 31, 2010 and December 31,
2009, respectively
|
|
5,691,751
|
|
5,743,517
|
|
5,617,925
|
|
5,459,273
|
|
Corporate loans held for sale
|
|
733,072
|
|
753,611
|
|
925,718
|
|
954,350
|
|
Residential mortgage-backed securities
|
|
114,023
|
|
114,023
|
|
47,572
|
|
47,572
|
|
Residential mortgage loans
|
|
|
|
|
|
2,097,699
|
|
2,097,699
|
|
Equity investments, at estimated fair value
|
|
63,488
|
|
63,488
|
|
120,269
|
|
120,269
|
|
Interest and principal receivable
|
|
64,221
|
|
64,221
|
|
98,313
|
|
98,313
|
|
Derivative assets
|
|
1,303
|
|
1,303
|
|
15,784
|
|
15,784
|
|
Reverse repurchase agreements
|
|
|
|
|
|
80,250
|
|
80,250
|
|
Private equity investments, at cost
|
|
17,505
|
|
24,958
|
|
17,505
|
|
24,658
|
|
|
|
|
|
|
|
|
|
|
|
Financial Liabilities:
|
|
|
|
|
|
|
|
|
|
Collateralized loan obligation secured notes
|
|
$
|
5,631,866
|
|
$
|
5,155,656
|
|
$
|
5,667,716
|
|
$
|
4,775,364
|
|
Collateralized loan obligation junior secured
notes to affiliates
|
|
380,343
|
|
236,007
|
|
533,786
|
|
221,755
|
|
Senior secured credit facility
|
|
150,000
|
|
150,000
|
|
175,000
|
|
175,000
|
|
Convertible senior notes
|
|
343,303
|
|
395,910
|
|
275,800
|
|
259,252
|
|
Junior subordinated notes
|
|
283,517
|
|
255,520
|
|
283,517
|
|
238,154
|
|
Residential
mortgage-backed securities issued
|
|
|
|
|
|
2,034,772
|
|
2,034,772
|
|
Accounts payable, accrued expenses and other
liabilities
|
|
83,768
|
|
83,768
|
|
7,240
|
|
7,240
|
|
Accrued interest payable
|
|
16,597
|
|
16,597
|
|
25,297
|
|
25,297
|
|
Accrued interest payable to affiliates
|
|
2,150
|
|
2,150
|
|
2,911
|
|
2,911
|
|
Related party payable
|
|
14,827
|
|
14,827
|
|
3,367
|
|
3,367
|
|
Securities
sold, not yet purchased
|
|
|
|
|
|
77,971
|
|
77,971
|
|
Derivative liabilities
|
|
49,998
|
|
49,998
|
|
45,970
|
|
45,970
|
|
27
Table of Contents
Fair Value Measurements
The
following table presents information about the Companys assets and liabilities
(including derivatives that are presented net) measured at fair value on a
recurring basis as of March 31, 2010, and indicates the fair value
hierarchy of the valuation techniques utilized by the Company to determine such
fair value (amounts in thousands):
|
|
Quoted Prices in
Active Markets
for Identical Assets
(Level 1)
|
|
Significant Other
Observable Inputs
(Level 2)
|
|
Significant
Unobservable
Inputs
(Level 3)
|
|
Balance as of
March 31, 2010
|
|
|
|
|
|
|
|
|
|
|
|
Assets:
|
|
|
|
|
|
|
|
|
|
Securities available-for-sale
|
|
$
|
|
|
$
|
761,083
|
|
$
|
68,608
|
|
$
|
829,691
|
|
Residential mortgage-backed securities
|
|
|
|
|
|
114,023
|
|
114,023
|
|
Equity investments, at estimated fair value
|
|
|
|
41,789
|
|
21,699
|
|
63,488
|
|
Credit default swaps
protection sold
|
|
|
|
225
|
|
|
|
225
|
|
Total rate of return swaps
|
|
|
|
|
|
228
|
|
228
|
|
Common stock warrants
|
|
|
|
|
|
198
|
|
198
|
|
Total
|
|
$
|
|
|
$
|
803,097
|
|
$
|
204,756
|
|
$
|
1,007,853
|
|
|
|
|
|
|
|
|
|
|
|
Liabilities:
|
|
|
|
|
|
|
|
|
|
Cash
flow interest rate swaps
|
|
$
|
|
|
$
|
(48,705
|
)
|
$
|
|
|
$
|
(48,705
|
)
|
Free-standing interest
rate swaps
|
|
|
|
|
|
(641
|
)
|
(641
|
)
|
Total
|
|
$
|
|
|
$
|
(48,705
|
)
|
$
|
(641
|
)
|
$
|
(49,346
|
)
|
There were no transfers between levels 1 and 2 during the three months
ended March 31, 2010.
The following table presents information about the Companys assets
measured at fair value on a non-recurring basis as of March 31, 2010, and
indicates the fair value hierarchy of the valuation techniques utilized by the
Company to determine such fair value (amounts in thousands). There were no
liabilities measured at fair value on a non-recurring basis:
|
|
Quoted Prices in
Active Markets
for Identical Assets
(Level 1)
|
|
Significant Other
Observable Inputs
(Level 2)
|
|
Significant
Unobservable Inputs
(Level 3)
|
|
Balance as of
March 31, 2010
|
|
Loans held for sale
|
|
$
|
|
|
$
|
210,788
|
|
$
|
|
|
$
|
210,788
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(1)
As of March 31, 2010,
total loans held for sale had a carrying value of $733.1 million of which
$210.8 million was carried at estimated fair value and the remaining
$522.3 million carried at amortized cost. The $210.8 million carried
at estimated fair value was classified as level 2 given that the assets
were valued using quoted prices and other observable inputs in an active
market.
The
following table presents information about the Companys assets and liabilities
(including derivatives that are presented net) measured at fair value on a
recurring basis as of December 31, 2009, and indicates the fair value
hierarchy of the valuation techniques utilized by the Company to determine such
fair value (amounts in thousands):
|
|
Quoted Prices in
Active Markets
for Identical Assets
(Level 1)
|
|
Significant Other
Observable Inputs
(Level 2)
|
|
Significant
Unobservable Inputs
(Level 3)
|
|
Balance as of
December 31, 2009
|
|
Assets:
|
|
|
|
|
|
|
|
|
|
Securities available-for-sale
|
|
$
|
1,277
|
|
$
|
673,121
|
|
$
|
81,288
|
|
$
|
755,686
|
|
Residential mortgage-backed securities
|
|
|
|
|
|
47,572
|
|
47,572
|
|
Residential mortgage loans
|
|
|
|
|
|
2,097,699
|
|
2,097,699
|
|
Equity investments, at estimated fair value
|
|
26,483
|
|
75,497
|
|
18,289
|
|
120,269
|
|
Total rate of return swaps
|
|
|
|
|
|
11,809
|
|
11,809
|
|
Common stock warrants
|
|
|
|
|
|
2,471
|
|
2,471
|
|
Total
|
|
$
|
27,760
|
|
$
|
748,618
|
|
$
|
2,259,128
|
|
$
|
3,035,506
|
|
Liabilities:
|
|
|
|
|
|
|
|
|
|
Cash flow interest rate swaps
|
|
$
|
|
|
$
|
(43,800
|
)
|
$
|
|
|
$
|
(43,800
|
)
|
Free-standing interest rate swaps
|
|
|
|
|
|
(281
|
)
|
(281
|
)
|
Credit default swaps protection sold
|
|
|
|
(385
|
)
|
|
|
(385
|
)
|
Residential mortgage-backed securities issued
|
|
|
|
|
|
(2,034,772
|
)
|
(2,034,772
|
)
|
Securities sold, not yet purchased
|
|
|
|
(77,971
|
)
|
|
|
(77,971
|
)
|
Total
|
|
$
|
|
|
$
|
(122,156
|
)
|
$
|
(2,035,053
|
)
|
$
|
(2,157,209
|
)
|
28
Table of Contents
The
following table presents information about the Companys assets measured at
fair value on a non-recurring basis as of December 31, 2009, and indicates
the fair value hierarchy of the valuation techniques utilized by the Company to
determine such fair value (amounts in thousands). There were no liabilities
measured at fair value on a non-recurring basis. There were no liabilities
measured at fair value on a non-recurring basis:
|
|
Quoted Prices in
Active Markets
for Identical Assets
(Level 1)
|
|
Significant Other
Observable Inputs
(Level 2)
|
|
Significant
Unobservable Inputs
(Level 3)
|
|
Balance as of
December 31, 2009
|
|
Loans held for sale(1)
|
|
$
|
|
|
$
|
533,308
|
|
$
|
|
|
$
|
533,308
|
|
REO
|
|
|
|
|
|
11,439
|
|
11,439
|
|
Total
|
|
$
|
|
|
$
|
533,308
|
|
$
|
11,439
|
|
$
|
544,747
|
|
(1)
As of December 31,
2009, total loans held for sale had a carrying value of $925.7 million of
which $533.3 million was carried at estimated fair value and the remaining
$392.4 million carried at amortized cost. The $533.3 million carried
at estimated fair value was classified as level 2 given that the assets
were valued using quoted prices and other observable inputs in an active
market.
The following table presents additional information about assets,
including derivatives that are measured at fair value on a recurring basis for
which the Company has utilized level 3 inputs to determine fair value, for
the three months ended March 31, 2010 (amounts in thousands):
|
|
Fair Value Measurements Using Significant Unobservable
Inputs
(Level 3)
|
|
|
|
Securities
Available-
For-Sale
|
|
Residential
Mortgage-
Backed
Securities
|
|
Equity
Investments,
at estimated
fair value
|
|
Total rate of
return swaps
|
|
Common
stock warrants
|
|
Free-standing
derivatives
interest rate
swaps
|
|
Beginning balance as of January 1, 2010
|
|
$
|
81,288
|
|
$
|
47,572
|
|
$
|
18,289
|
|
$
|
11,809
|
|
$
|
2,471
|
|
$
|
(281
|
)
|
Transfers in from deconsolidation (1)
|
|
|
|
74,366
|
|
|
|
|
|
|
|
|
|
Total gains or losses (realized and unrealized):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Included in earnings
|
|
700
|
|
(4,124
|
)
|
(3,937
|
)
|
1,743
|
|
123
|
|
(360
|
)
|
Included in other comprehensive income
|
|
5,743
|
|
|
|
|
|
|
|
|
|
|
|
Transfers in to level 3
|
|
501
|
|
|
|
|
|
|
|
|
|
|
|
Purchases, sales, other settlements and issuances,
net
|
|
(19,624
|
)
|
(3,791
|
)
|
7,347
|
|
(13,324
|
)
|
(2,396
|
)
|
|
|
Ending balance as of March 31, 2010
|
|
$
|
68,608
|
|
$
|
114,023
|
|
$
|
21,699
|
|
$
|
228
|
|
$
|
198
|
|
$
|
(641
|
)
|
The amount of total gains or losses for the
period included in earnings attributable to the change in unrealized gains
or losses relating to assets still held at the reporting date(2)
|
|
$
|
|
|
$
|
(1,977
|
)
|
$
|
(3,937
|
)
|
$
|
|
|
$
|
123
|
|
$
|
(358
|
)
|
(1)
|
|
Represents the
subordinate tranches of the
residential mortgage loan
securitization trusts
as a result of the Companys deconsolidation
as of January 1,
2010, computed as $11.4 million of REO plus $62.9 million, which represents
the difference between the residential mortgage loans of $2.1 billion less
RMBS Issued, at estimated fair value, of $2.0 billion. See Note 2 for further
discussion.
|
(2)
|
|
Amounts
are included in net realized and unrealized (loss) gain on investments, net
realized and unrealized gain (loss) on derivatives and foreign exchange or
net realized and unrealized loss on residential mortgage-backed securities,
residential mortgage loans, and residential mortgage-backed securities
issued, carried at estimated fair value in the condensed consolidated
statements of operations.
|
29
Table of Contents
The
following table presents additional information about assets, including
derivatives, that are measured at fair value on a recurring basis for which the
Company has utilized level 3 inputs to determine fair value, for the three
months ended March 31, 2009 (amounts in thousands):
|
|
Fair Value Measurements Using Significant Unobservable Inputs
(Level 3)
|
|
|
|
Securities
Available-
For-Sale
|
|
Residential
Mortgage-
Backed
Securities
|
|
Residential
Mortgage
Loans
|
|
Equity
Investments,
at estimated
fair value
|
|
Derivatives,
net
|
|
Residential
Mortgage-
Backed
Securities
Issued
|
|
Beginning balance as of January 1, 2009
|
|
$
|
89,109
|
|
$
|
102,814
|
|
$
|
2,620,021
|
|
$
|
5,287
|
|
$
|
(76,950
|
)
|
$
|
(2,462,882
|
)
|
Total gains or losses (realized and unrealized):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Included in earnings
|
|
(6,156
|
)
|
(7,369
|
)
|
(252,653
|
)
|
|
|
7,428
|
|
243,768
|
|
Included in other comprehensive loss
|
|
1,881
|
|
|
|
|
|
|
|
|
|
|
|
Transfers out of level 3
|
|
|
|
|
|
(427
|
)
|
|
|
|
|
|
|
Purchases, sales, other settlements and issuances,
net
|
|
(8,784
|
)
|
(7,562
|
)
|
(106,182
|
)
|
|
|
67,291
|
|
105,527
|
|
Ending balance as of March 31, 2009
|
|
$
|
76,050
|
|
$
|
87,883
|
|
$
|
2,260,759
|
|
$
|
5,287
|
|
$
|
(2,231
|
)
|
$
|
(2,113,587
|
)
|
The amount of total gains or losses for the
period included in earnings attributable to the change in unrealized
gains or losses relating to assets still held at the reporting date(1)
|
|
$
|
|
|
$
|
(6,800
|
)
|
$
|
(248,213
|
)
|
$
|
|
|
$
|
36,718
|
|
$
|
244,001
|
|
(1)
|
Amounts are included in net realized and unrealized
gain (loss) on derivatives and
foreign exchange or net
realized and unrealized loss on residential mortgage-backed securities,
residential mortgage loans, and residential mortgage-backed securities
issued, carried at estimated fair value in the condensed consolidated
statements of operations.
|
Note 15. Subsequent Events
On April 29, 2010, the Companys board
of directors
declared a cash distribution for the quarter ended March 31,
2010 on the Companys common shares of $0.10 per common share. The distribution
is payable on May 28, 2010 to common shareholders of record as of the
close of business on May 14, 2010.
30
Table of Contents
Item 2.
Managements 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, or the Securities Act, and Section 21E
of the Securities Exchange Act of 1934, as amended, or the Exchange Act, 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 Companys Annual Report
on Form 10-K filed with the Securities Exchange Commission on March 1,
2010. 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. We primarily invest in financial assets including below
investment grade corporate debt, including senior secured and unsecured loans,
mezzanine loans, high yield corporate bonds, distressed and stressed debt
securities, marketable equity securities, private equity and credit default
swaps. Additionally, we have made or may make investments in other asset
classes including natural resources and real estate. The corporate loans we
invest in are primarily 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
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 five cash flow 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) and KKR Financial CLO 2007-A, Ltd.
(CLO 2007-A
and, together with CLO 2005-1, CLO 2005-2, CLO 2006-1, and CLO 2007-1, each a
Cash Flow CLO and, collectively, the Cash Flow CLOs). We execute our core
business strategy through majority-owned subsidiaries, including CLOs.
Significant Debt Transactions
On January 15, 2010, we issued $172.5 million of 7.5%
convertible senior notes due January 15, 2017 (7.5% Notes). Proceeds
from the offering totaled $167.3 million, reflecting $172.5 million
from the issuance less $5.2 million for underwriting fees.
During the three
months ended March 31, 2010, in an open market auction, we purchased $10.3
million of mezzanine notes issued by CLO 2007-A for $5.5 million and $72.7
million of mezzanine and subordinate notes issued by CLO 2007-1 for $38.8
million, both of which were previously held by an affiliate of our manager.
These
transactions resulted in us recording an aggregate gain on extinguishment of
debt totaling $38.7 million.
During the quarter ended March 31, 2010, we repurchased
$95.2 million par amount of our 7.0% convertible senior notes due 2012,
reducing the amount outstanding from $275.8 million as of December 31,
2009 to $180.6 million as of March 31, 2010. In addition, in February 2010,
we paid down $25.0 million of our senior secured credit facility due 2011,
reducing the amount outstanding from $175.0 million as of December 31,
2009 to $150.0 million as of March 31, 2010.
Distributions to Shareholders
On April 29, 2010, our board of
directors
declared a cash distribution for the quarter ended March 31, 2010
on our common shares of $0.10 per share. The distribution is payable on May 28,
2010 to common shareholders of record as of the close of business on May 14,
2010.
Our senior secured credit facility 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. In addition, no dividends shall be paid if a deficiency in the required
collateral per the agreement exists or would exist as a result of such
dividend.
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Consolidation
Effective January 1, 2010, we adopted new guidance which amended
the accounting for the transfers of financial assets, eliminated the concept of
a qualified special purpose entity (QSPE) and significantly changed the
criteria by which an enterprise determines whether or not it must consolidate a
variable interest entity (VIE). Under the new guidance, consolidation of a
VIE requires both the power to direct the activities that most significantly
impact the VIEs economic performance and the obligation to absorb losses of
the VIE or the right to receive benefits of the VIE that could potentially be
significant to the VIE.
As a result of the adoption
of new guidance regarding the amended consolidation model to be based on power
and economics, we determined that six residential mortgage loan securitization
trusts, which were previously consolidated by us as we were deemed to be the
primary beneficiary, were required to be deconsolidated. We determined that we
did not have the power to direct the activities that most significantly
impacted the economic performance of the securitization trusts or the
performance of the securitization trusts underlying assets.
Effective
January 1, 2010, we deconsolidated the six residential mortgage loan
securitization trusts, which resulted in the reduction of both assets and
liabilities of approximately $2.0 billion. In addition, loan interest
income, interest expense, loan servicing expense, and net unrealized and
realized gain (loss) associated with the residential mortgage loan
securitization trusts will no longer be reported on our condensed consolidated
financial statements. Our deconsolidation of the six residential mortgage loan
securitization trusts had no net impact on shareholders equity, results of
operations and cash flows.
CLO 2005-1, CLO 2005-2, CLO 2006-1,
CLO 2007-1,
CLO 2007-A and KKR Financial CLO 2009-1, Ltd. (CLO 2009-1) are all VIEs
which we consolidate as we 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 CLOs
we hold investments in, the information contained in this Managements
Discussion and Analysis of Financial Condition and Results of Operations
reflects the CLOs on a consolidated basis which is consistent with the
disclosures in our condensed consolidated financial statements.
Investment Portfolio
Overview
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 March 31, 2010: (i) mezzanine and subordinated
tranches of CLO transactions with an aggregate par amount of $1.1 billion;
(ii) corporate loans with an aggregate par amount of $582.8 million
and an estimated fair value of $452.6 million; (iii) corporate debt
securities with an aggregate par amount of $136.8 million and an estimated fair
value of $130.0 million; (iv) residential mortgage-backed securities (RMBS)
with a par amount of $260.5 million and estimated fair value of
$109.6 million; and (v) equity and private equity investments with an
estimated fair value of $76.7 million. In addition, we hold other
investments including long and short credit default swap transactions and
interest rate swaps.
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Table of Contents
Corporate
Debt Investments
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. Loans that are not deemed to be held for sale
are carried at amortized cost net of allowance for loan losses on our condensed
consolidated balance sheets. Loans that are classified as held for sale are
carried at the lower of net amortized cost or estimated fair value on our
condensed consolidated balance sheets. Debt securities are carried at estimated
fair value on our condensed consolidated balance sheets.
These investments have an aggregate par balance of $8.0 billion,
an aggregate net amortized cost of $7.3 billion and an aggregate estimated
fair value of $7.3 billion as of March 31, 2010. Included in these
amounts is $7.3 billion par amount or $6.7 billion estimated fair
value of investments held in our five Cash Flow CLOs through which we finance
the majority of our corporate debt investments. These Cash Flow CLOs have
aggregate secured notes outstanding totaling $5.6 billion held by us and
external parties, and an aggregate of $380.3 million of junior notes
outstanding that 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. We consolidate all five of our Cash Flow CLOs and reflect all
income and losses related to the assets in these CLOs on our condensed
consolidated statement of operations even though a minority interest in two of these
CLO transactions is held by an affiliate of our Manager.
RMBS
Investments
Our residential mortgage investment portfolio consists of investments
in RMBS with an estimated fair value of $114.0 million as of March 31,
2010.
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 recorded at fair value 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.
The types of assets carried at level 1 fair value are equity
securities listed in active markets.
Level 2: Inputs, other than quoted prices included in
level 1, are observable for the asset or liability, either directly or
indirectly. Level 2 inputs include quoted prices for similar instruments
in active markets, and inputs other than quoted prices that are observable for
the asset or liability.
Fair value assets and liabilities that are included in this category
are certain corporate debt securities, certain corporate loans held for sale,
certain equity investments at estimated fair value, certain securities sold,
not yet purchased and certain financial instruments classified as derivatives
where the fair value is based on observable market inputs.
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Table of Contents
Level 3: Inputs are unobservable inputs for the asset or
liability, and include situations where there is little, if any, market
activity for the asset or liability. In certain cases, the inputs used to
measure fair value may fall into different levels of the fair value hierarchy.
In such cases, the level in the fair value hierarchy within which the fair
value measurement in its entirety falls has been determined based on the lowest
level input that is significant to the fair value measurement in its entirety.
Our assessment of the significance of a particular input to the fair value
measurement in its entirety requires judgment and the consideration of factors
specific to the asset.
Assets and liabilities carried at fair value and included in this
category are certain corporate debt securities, certain corporate loans held
for sale, certain equity investments at estimated fair value, residential
mortgage-backed securities, residential mortgage loans, residential
mortgage-backed securities issued and certain derivatives.
A
significant decrease in the volume and level of activity for the asset or
liability is an indication that transactions or quoted prices may not be
representative of fair value because in such market conditions there may be
increased instances of transactions that are not orderly. In those
circumstances, further analysis of transactions or quoted prices is needed, and
a significant adjustment to the transactions or quoted prices may be necessary
to estimate fair value.
The
availability of observable inputs can vary depending on the financial asset or
liability and is affected by a wide variety of factors, including, for example,
the type of product, whether the product is new, whether the product is traded
on an active exchange or in the secondary market, and the current market
condition. To the extent that valuation is based on models or inputs that are
less observable or unobservable in the market, the determination of fair value
requires more judgment. Accordingly, the degree of judgment exercised by us in
determining fair value is greatest for instruments categorized in level 3.
In certain cases, the inputs used to measure fair value may fall into different
levels of the fair value hierarchy. In such cases, for disclosure purposes, the
level in the fair value hierarchy within which the fair value measurement in
its entirety falls is determined based on the lowest level input that is
significant to the fair value measurement in its entirety.
Many financial assets and liabilities have bid and ask prices that can
be observed in the marketplace. Bid prices reflect the highest price that we
and others are willing to pay for an asset. Ask prices represent the lowest
price that we and others are willing to accept for an asset. For financial
assets and liabilities whose inputs are based on bid-ask prices, we do not
require that fair value always be a predetermined point in the bid-ask range.
Our policy is to allow for mid-market pricing and adjusting to the point within
the bid-ask range that meets our best estimate of fair value.
Depending on the relative liquidity in the markets for certain assets,
we may transfer assets to level 3 if we determine that observable quoted
prices, obtained directly or indirectly, are not available. The valuation
techniques used for the assets and liabilities that are valued using
level 3 of the fair value hierarchy are described below.
Residential Mortgage-Backed Securities, Residential
Mortgage Loans, and Residential Mortgage-Backed Securities Issued:
Residential mortgage-backed securities,
residential mortgage loans, and residential mortgage-backed securities issued
are initially valued at transaction price and are subsequently valued using
industry recognized models (including Intex and Bloomberg) and data for similar
instruments (e.g., nationally recognized pricing services or broker
quotes). The most significant inputs to the valuation of these instruments are
default and loss expectations and market credit spreads.
Corporate Debt Securities:
Corporate debt securities are initially
valued at transaction price and are subsequently valued using market data for
similar instruments (e.g., recent transactions or broker quotes),
comparisons to benchmark derivative indices or valuation models. Valuation
models are based on discounted cash flow techniques, for which the key inputs
are the amount and timing of expected future cash flows, market yields for such
instruments and recovery assumptions. Inputs are determined based on relative
value analyses, which incorporate similar instruments from similar issuers.
Over-the-counter (OTC) Derivative Contracts:
OTC derivative contracts include forward,
swap and option contracts related to interest rates, foreign currencies, credit
standing of reference entities, and equity prices. The fair value of OTC
derivative products can be modeled using a series of techniques, including
closed-form analytic formulae, such as the Black-Scholes option-pricing model,
and simulation models or a combination thereof. Many pricing models do not
entail material subjectivity because the methodologies employed do not
necessitate significant judgment, and the pricing inputs are observed from
actively quoted markets, as is the case for generic interest rate swap and
option contracts.
Share-Based Compensation
We account for share-based compensation issued to members of our board
of directors and our Manager using a fair value based methodology. We do not
have any employees, although we believe that members of our board of directors
are deemed to be employees for purposes of interpreting and applying accounting
principles relating to share-based compensation. We record as compensation
costs the restricted common shares that we issued to members of our board of
directors at estimated fair value as of the grant date and we amortize the cost
into expense over the three-year vesting period using the straight-line method.
We record compensation costs for restricted common shares and common share
options that we issued to our Manager at estimated fair value as of the grant
date and we remeasure the amount on subsequent reporting dates to the extent the
awards have not vested. Unvested restricted common shares are valued using
observable secondary market prices. Unvested common share options are valued
using the Black-Scholes model and assumptions based on observable market data
for comparable companies. We amortize compensation expense related to the
restricted common share and common share options that we granted to our
Manager using the graded vesting attribution method.
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Table of Contents
Because we remeasure the amount of compensation costs associated with
the unvested restricted common shares and unvested common share options that we
issued to our Manager as of each reporting period, our share-based compensation
expense reported in our condensed consolidated financial statements will change
based on the estimated fair value of our common shares and this may result in
earnings volatility. For the three months ended March 31, 2010,
share-based compensation was $2.9 million. As of March 31, 2010,
substantially all of the non-vested restricted common shares issued are subject
to remeasurement. As of March 31, 2010, a $1 increase in the price of our
common shares would have increased our future share-based compensation expense
by approximately $1.1 million and this future share-based compensation
expense would be recognized over the remaining vesting periods of our
outstanding restricted common shares and common share options. As of March 31,
2010, the common share options were fully exercised and expire in August 2014.
As of March 31, 2010, future unamortized share-based compensation totaled
$3.3 million, of which $2.6 million, $0.6 million, and $0.1 million
will be recognized in 2010, 2011 and beyond, respectively.
Accounting for Derivative Instruments and Hedging Activities
We recognize all derivatives on our condensed consolidated balance
sheets at estimated fair value. On the date we enter into a derivative
contract, we designate and document each derivative contract as one of the
following at the time the contract is executed: (i) a hedge of a
recognized asset or liability (fair value hedge); (ii) a hedge of a
forecasted transaction or of the variability of cash flows to be received or
paid related to a recognized asset or liability (cash flow hedge); (iii) a
hedge of a net investment in a foreign operation; or (iv) a derivative
instrument not designated as a hedging instrument (free-standing derivative).
For a fair value hedge, we record changes in the estimated fair value of the
derivative instrument and, to the extent that it is effective, changes in the
fair value of the hedged asset or liability in the current period earnings in
the same financial statement category as the hedged item. For a cash flow
hedge, we record changes in the estimated fair value of the derivative to the
extent that it is effective in other comprehensive income and subsequently
reclassify these changes in estimated fair value to net income in the same
period(s) that the hedged transaction affects earnings. The effective
portion of the cash flow hedge is recorded in the same financial statement
category as the hedged item. For free-standing derivatives, we report changes
in the fair values in other (loss) income.
We formally document at inception our hedge relationships, including
identification of the hedging instruments and the hedged items, our risk
management objectives, strategy for undertaking the hedge transaction and our
evaluation of effectiveness of our hedged transactions. Periodically, we also
formally assess whether the derivative designated in each hedging relationship
is expected to be and has been highly effective in offsetting changes in
estimated fair values or cash flows of the hedged item using either the dollar
offset or the regression analysis method. If we determine that a derivative is
not highly effective as a hedge, we discontinue hedge accounting.
We are not required to account for our derivative contracts using hedge
accounting as described above. If we decide not to designate the derivative
contracts as hedges or if we fail to fulfill the criteria necessary to qualify
for hedge accounting, then the changes in the estimated fair values of our derivative
contracts would affect periodic earnings immediately potentially resulting in
the increased volatility of our earnings. The qualification requirements for
hedge accounting are complex and as a result, we must evaluate, designate, and
thoroughly document each hedge transaction at inception and perform
ineffectiveness analysis and prepare related documentation at inception and on
a recurring basis thereafter. As of March 31, 2010, the estimated fair
value of our net derivative liabilities totaled $48.7 million.
Impairments
We
monitor our available-for-sale securities portfolio for impairments. A loss is
recognized when it is determined that a decline in the estimated fair value of
a security below its amortized cost is other-than-temporary. We consider many
factors in determining whether the impairment of a security is deemed to be
other-than-temporary, including, but not limited to, the length of time the
security has had a decline in estimated fair value below its amortized cost and
the severity of the decline, the amount of the unrealized loss, recent events
specific to the issuer or industry, external credit ratings and recent changes
in such ratings. In addition, for debt
securities we consider our intent to sell the debt security, our estimation of
whether or not we expect to recover the debt securitys entire amortized cost
if we intend to hold the debt security, and whether it is more likely than not
that we will be required to sell the debt security before its anticipated
recovery. For equity securities, we also consider our intent and ability to
hold the equity security for a period of time sufficient for a recovery in
value.
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The
amount of the loss that is recognized when it is determined that a decline in
the estimated fair value of a security below its amortized cost is
other-than-temporary is dependent on certain factors. If the security is an equity security or if
the security is a debt security that we intend to sell or estimate that it is
more likely than not that we will be required to sell before recovery of its
amortized cost, then the impairment amount recognized in earnings is the entire
difference between the estimated fair value of the security and its amortized
cost. For debt securities that we do not intend to sell or estimate that we are
not more likely than not to be required to sell before recovery, the impairment
is separated into the estimated amount relating to credit loss and the
estimated amount relating to all other factors. Only the estimated credit loss
amount is recognized in earnings, with the remainder of the loss amount
recognized in other comprehensive income.
This process involves a considerable amount of subjective judgment by
our management. As of March 31, 2010, we had aggregate unrealized losses
on our securities classified as available-for-sale of approximately
$3.5 million, which if not recovered may result in the recognition of
future losses. During the three months ended March 31, 2010, we recorded
charges for impairments of securities that we determined to be
other-than-temporary totaling $1.1 million.
Allowance for Loan Losses
Our
allowance for loan losses represents our estimate of probable credit losses
inherent in our corporate loan portfolio held for investment as of the balance
sheet date. Estimating our allowance for
loan losses involves a high degree of management judgment and is based upon a
comprehensive review of our loan portfolio that is performed on a quarterly
basis. Our allowance for loan losses consists of two components, an allocated
component and an unallocated component. The allocated component of our
allowance for loan losses pertains to specific loans that we have determined
are impaired. We determine a loan is impaired when we estimate that it is
probable that we will be unable to collect all amounts due according to the
contractual terms of the loan agreement. On a quarterly basis we perform a
comprehensive review of our entire loan portfolio and identify certain loans
that we have determined are impaired. Once a loan is identified as being
impaired we place the loan on non-accrual status, unless the loan is already on
non-accrual status, and record a reserve that reflects our best estimate of the
loss that we expect to recognize from the loan. The expected loss is estimated
as being the difference between our current cost basis of the loan, including
accrued interest receivable, and the loans estimated fair value.
The
unallocated component of our allowance for loan losses reflects our estimate of
probable losses inherent in our loan portfolio as of the balance sheet date
where the specific loan that the loan loss relates to is indeterminable. We
estimate the unallocated component of our allowance for loan losses through a
comprehensive review of our loan portfolio and identify certain loans that
demonstrate possible indicators of impairment. This assessment excludes all
loans that are determined to be impaired and as a result, an allocated reserve
has been recorded as described in the preceding paragraph. Such indicators
include, but are not limited to, the current and/or forecasted financial
performance and liquidity profile of the issuer, specific industry or economic
conditions that may impact the issuer, and the observable trading price of the
loan if available. Loans that demonstrate possible indicators of impairment are
aggregated on a watch list for monitoring and are sub-divided for
categorization based on the seniority of the loan in the issuers capital
structure, whether the loan is secured or unsecured, and the nature of the
collateral securing the loan, for purposes of applying possible default and
loss severity ranges based on the nature of the issuer and the specific loan.
We apply a range of default and loss severity estimates in order to estimate a
range of loss outcomes upon which to base our estimate of probable losses that
results in the determination of the unallocated component of our allowance for
loan losses. As of March 31, 2010, the range of outcomes used to estimate
the probability of default was between 5% and 40% and the range of loss
severity assumptions for loans that may default was between 20% and 75%. The estimates
and assumptions we use to estimate our allowance for loan losses are based on
our estimated range of outcomes that are determined from industry information
providing both historical and forecasted empirical performance of the type of
corporate loans that we invest in, as well as from our own estimates based on
the nature of our corporate loan portfolio. These estimates and assumptions are
susceptible to change due to our corporate loan portfolio performance as well
as industry performance of the corporate loan asset class and general economic
conditions. Changes in the assumptions and estimates used to estimate our
allowance for loan losses could have a material impact on our financial
condition and results of operations.
As of March 31, 2010, our allowance for loan losses totaled
$216.1 million.
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Recent Accounting Pronouncements
Consolidation
In February 2010, the Financial Accounting
Standards Board (FASB) issued new guidance deferring the application of the
amended consolidation requirements related to VIEs for a reporting entitys
interest in an entity that has all the attributes of an investment company or
for which it is applies measurement principles that are consistent with those
followed by investment companies. The guidance was expected to most
significantly affect reporting entities in the investment management industry.
Entities including, but not limited to, securitization entities or entities
with multiple levels of subordinated investors such as a CLO for which the
primary purpose of the capital structure of the entity is to provide credit
enhancement to senior interest holders, will not qualify for the deferral. The
guidance was effective for interim and annual reporting periods beginning after
November 15, 2009. As we are not considered an investment company, the
adoption did not have an affect on our condensed consolidated financial statements.
Results of Operations
Summary
Our net income for the three months ended March 31, 2010 totaled
$129.5 million (or $0.82 per diluted common share), as compared to a net loss
of $13.0 million (or $(0.09) per diluted common share) for the three months
ended March 31, 2009. The increase in net income of $142.5 million from
the same quarter in 2009 was primarily a result of three key drivers: (i) an
increase in net realized and unrealized gains on investments of $95.6 million
due to a significant rise in bond and loan market values, (ii) no
provision for loan losses recorded during the first quarter of 2010, resulting
in an increase in net investment income of $27.0 million, and (iii) a
decrease in interest expense, slightly offset by a decrease in interest income
attributable to a decline in our total corporate debt portfolio.
The following table presents the components of our net investment
income for the three months ended March 31, 2010 and 2009:
Comparative Net Investment Income Components
(Amounts in
thousands)
|
|
For the three
months ended
March 31, 2010
|
|
For the three
months ended
March 31, 2009
|
|
Investment Income:
|
|
|
|
|
|
Corporate loans and
securities interest income
|
|
$
|
86,819
|
|
$
|
105,184
|
|
Residential mortgage loans
and securities interest income
|
|
7,653
|
|
39,001
|
|
Other interest income
|
|
67
|
|
356
|
|
Dividend income
|
|
26
|
|
261
|
|
Net discount accretion
|
|
24,785
|
|
13,871
|
|
Total investment income
|
|
119,350
|
|
158,673
|
|
Interest Expense:
|
|
|
|
|
|
Collateralized loan
obligation secured notes
|
|
12,582
|
|
46,415
|
|
Senior secured credit
facility
|
|
3,273
|
|
3,942
|
|
Convertible senior notes
|
|
7,254
|
|
5,246
|
|
Junior subordinated notes
|
|
3,889
|
|
4,441
|
|
Residential
mortgage-backed securities issued
|
|
|
|
25,859
|
|
Interest rate swap
|
|
4,332
|
|
2,737
|
|
Other interest expense
|
|
170
|
|
1,242
|
|
Total interest expense
|
|
31,500
|
|
89,882
|
|
Interest expense to
affiliates
|
|
4,541
|
|
5,805
|
|
Provision for loan losses
|
|
|
|
26,987
|
|
Net investment income
|
|
$
|
83,309
|
|
$
|
35,999
|
|
Due to our adoption of new guidance related to consolidation of variable
interest entities (as described above under Executive Overview), certain
amounts for the three months ended March 31, 2009, which were related to
the six residential mortgage loan securitization trusts that we deconsolidated
effective January 1, 2010, should be disregarded for comparative purposes.
For the three months ended March 31, 2009, RBMS Issued interest expense
totaled $25.9 million and residential mortgage loans interest income totaled
$28.0 million related to the six residential mortgage loan securitization
trusts which were deconsolidated.
37
Table of Contents
Excluding the amounts above, the increase in net investment income from
the three months ended March 31, 2009 to the same period in 2010 was
primarily due to the provision for loan losses recorded in the first quarter of
2009 and a reduction in total interest expense due to paydowns of our
collateralized loan obligation secured notes during 2009 and the first quarter
of 2010. In addition, during the three months ended March 31, 2010
compared to the same period in 2009, paydowns of corporate debt securities and
loans increased significantly, which resulted in additional acceleration of
discount accretion of approximately $10.6 million.
Other Income (Loss)
The following table presents the components of other income (loss) for
the three months ended March 31, 2010 and 2009:
Comparative Other Income (Loss) Components
(Amounts in
thousands)
|
|
For the three
months ended
March 31, 2010
|
|
For three
months ended
March 31, 2009
|
|
Net realized and unrealized (loss) gain on
derivatives and foreign exchange:
|
|
|
|
|
|
Interest rate swaps
|
|
$
|
(358
|
)
|
$
|
475
|
|
Credit default swaps
|
|
1,018
|
|
7,980
|
|
Total rate of return swaps
|
|
1,743
|
|
6,953
|
|
Common stock warrants
|
|
123
|
|
|
|
Foreign exchange(1)
|
|
(3,944
|
)
|
(3,012
|
)
|
Total net realized and unrealized (loss) gain on
derivatives and foreign exchange
|
|
(1,418
|
)
|
12,396
|
|
Net realized loss on residential mortgage-backed
securities and residential mortgage loans, carried at estimated fair value
|
|
(3,168
|
)
|
(8,407
|
)
|
Net unrealized loss on residential mortgage-backed
securities, residential mortgage loans, and residential mortgage-backed
securities issued, carried at estimated fair value
|
|
(1,977
|
)
|
(11,012
|
)
|
Net realized and unrealized gain (loss) on
investments(2)
|
|
36,563
|
|
(26,440
|
)
|
Net realized and unrealized (loss) gain on
securities sold, not yet purchased
|
|
(756
|
)
|
1,437
|
|
Impairment of securities available for sale
|
|
(1,140
|
)
|
(33,764
|
)
|
Net gain on restructuring and extinguishment of
debt
|
|
39,999
|
|
34,571
|
|
Other income
|
|
3,004
|
|
1,333
|
|
Total other income (loss)
|
|
$
|
71,107
|
|
$
|
(29,886
|
)
|
(1)
|
Includes
foreign exchange contracts and foreign exchange gain or loss.
|
(2)
|
Includes
lower of cost or estimated fair value adjustment to corporate loans held for
sale and unrealized gain (loss) on investments held at estimated fair value.
|
For the three months ended March 31, 2009, the aggregate realized
and unrealized gain (loss) on residential mortgage loans and residential
mortgage-backed securities issued (RMBS Issued) related to the six
residential mortgage loan securitization trusts that we deconsolidated
effective January 1, 2010. The deconsolidation had no net impact on our
results of operations for the three months ended March 31, 2010.
Total other income totaled
$71.1 million for the three months ended March 31, 2010 as compared to
other loss of $29.9 million for the three months ended March 31, 2009.
Total other income increased from the three months ended March 31, 2009 to
2010 due to primarily two factors. First, net realized and unrealized gain on
investments totaled $36.6 million for the quarter ended March 31, 2010,
compared to a loss of $26.4 million for the quarter ended March 31, 2009.
Second, losses due to the impairment of securities available for sale totaled
$1.1 million for the quarter ended March 31, 2010 compared to $33.8
million for the quarter ended March 31, 2009. The improvement with respect
to both realized and unrealized losses on investments and impairment losses was
primarily attributable to significant asset appreciation during the three
months ended March 31, 2010 compared to the same period in 2009 as demonstrated
by the increase in the weighted average market value as a percentage of face
value of our corporate debt portfolio from approximately 61% as of March 31,
2009 to 91% as of March 31, 2010.
During the three
months ended March 31, 2010, in an open market auction, we purchased $83.0
million of notes issued by CLO 2007-A and CLO 2007-1, both of which were
previously held by an affiliate of our manager.
These transactions resulted
in us recording an aggregate gain on extinguishment of debt totaling $38.7
million during the first quarter of 2010. For the three months ended March 31,
2009, the $34.6 million gain on debt restructuring reflected the reduction of
the reported amount of debt held by an affiliate of our Manager upon the
replacement of Wayzata Funding LLC (Wayzata) with CLO 2009-1 on March 31,
2009.
38
Table of Contents
Non-Investment
Expenses
The following table presents the components of non-investment expenses
for the three months ended March 31, 2010 and 2009:
Comparative Non-Investment Expense Components
(Amounts in
thousands)
|
|
For the three
months ended
March 31, 2010
|
|
For the three
months ended
March 31, 2009
|
|
Related party management compensation:
|
|
|
|
|
|
Base management fees
|
|
$
|
4,157
|
|
$
|
3,625
|
|
Incentive fees
|
|
12,500
|
|
|
|
Share-based compensation
|
|
2,392
|
|
(140
|
)
|
CLO management fees
|
|
1,442
|
|
7,727
|
|
Related party management
compensation
|
|
20,491
|
|
11,212
|
|
Professional services
|
|
1,064
|
|
3,385
|
|
Loan servicing
|
|
|
|
2,136
|
|
Insurance
|
|
637
|
|
303
|
|
Directors expenses
|
|
1,195
|
|
304
|
|
General and administrative
|
|
1,518
|
|
1,796
|
|
Total non-investment
expenses
|
|
$
|
24,905
|
|
$
|
19,136
|
|
For the three months ended March 31, 2009, the entire loan servicing
expense of $2.1 million was related to the six residential mortgage loan
securitization trusts which we deconsolidated effective January 1, 2010.
As such, the $2.1 million balance should be disregarded for comparative
purposes.
As presented in the table above, our non-investment expenses increased
by approximately $5.8 million from the three months ended March 31, 2009
to 2010. The significant components of non-investment expense are described
below.
Management compensation to related parties consists of base management
fees payable to our Manager pursuant to the Management Agreement, incentive
fees, collateral management fees, and share-based compensation related to
restricted common shares and common share options granted to our Manager.
The base management fee payable was calculated in accordance with the
Management Agreement and is based on an annual rate of 1.75% times our equity
as defined in the Management Agreement. Base management fee increased by $0.5
million from the three months ended March 31, 2009 to 2010. Our Manager is
also entitled to a quarterly incentive fee provided that our quarterly net
income, as defined in the Management Agreement, before the incentive fee
exceeds a defined return hurdle. During the three months ended March 31,
2010, our Manager earned $22.2 million of incentive fees. Of this amount, our Manager permanently
waived payment of $9.7 million of incentive fees that were related to the
$38.7 million gain recorded by us as a result of the repurchase of $83.0
million of mezzanine and subordinate notes issued by CLO 2007-1 and CLO 2007-A
during the quarter ended March 31, 2010. The remaining $12.5 million,
representing the incentive fee net of the amount waived, is included in related
party management compensation on our condensed consolidated statement of
operations for the quarter ended March 31, 2010 and is due and payable to
our Manager as of that date.
An affiliate of our Manager has entered into separate management
agreements with the respective investment vehicles CLO 2005-1, CLO 2005-2, CLO
2006-1, CLO 2007-1, CLO 2007-A and CLO 2009-1 and is entitled to receive fees
for the services performed as collateral manager. Previously, the collateral
manager had waived the fees it earned for providing management services for our
CLOs. Beginning April 15, 2007, the collateral manager ceased waiving fees
for CLO 2005-1 and beginning January 1, 2009, the collateral manager
ceased waiving fees for CLO 2005-2, CLO 2006-1, CLO 2007-1,
CLO 2007-A and Wayzata (restructured and replaced with CLO 2009-1 on March 31,
2009). Beginning in July 2009, the collateral manager reinstated waiving
the CLO management fees for CLO 2005-2 and CLO 2006-1. In addition, due to CLO
2007-A and CLO 2007-1 regaining compliance with their respective over-collateralization
tests (OC Tests) during the first quarter of 2010, the collateral manager
also reinstated waiving the CLO management fees for CLO 2007-A and CLO 2007-1.
For the three months ended March 31, 2010, the collateral manager waived
an aggregate of $4.5 million for CLO 2005-2, CLO 2006-1 and CLO 2007-A. In
addition, due to the deleveraging of CLO 2009-1 completed in July 2009
whereby all the senior notes were retired, the collateral manager is no longer
entitled to receive fees for CLO 2009-1. Accordingly, CLO management fees
decreased $6.3 million from the three months ended March 31, 2009 to 2010
to account for all six CLOs paying CLO management fees during the there months
ended March 31, 2009.
39
Table of Contents
In addition, beginning January 1, 2009, our Manager permanently
waived reimbursable general and administrative expenses allocable to us in an
amount equal to the incremental CLO management fees received by the Manager.
For the three months ended March 31, 2010, our Manager permanently waived
reimbursement of $1.3 million in allocable general and administrative expenses.
For the three months ended March 31, 2009, the Manager permanently waived
reimbursement of $2.3 million in allocable general and administrative expenses.
General and administrative expenses include expenses incurred by our
Manager on our behalf that are reimbursable to our Manager pursuant to the
Management Agreement. Professional services expenses consist of legal,
accounting and other professional services. Directors expenses represent
share-based compensation, as well as expenses and reimbursables due to the
board of directors for their services. Professional fees decreased $2.3 million
from the three months ended March 31, 2009 to 2010.
Income Tax Provision
We intend to continue to operate so as to qualify as a partnership, and
not as an association or publicly traded partnership that is taxable as a
corporation, for United States federal income tax purposes. Therefore, we
generally are not subject to United States federal income tax at the entity
level, but are subject to limited state income taxes. Holders of our shares are
required to take into account their allocable share of each item of our income,
gain, loss, deduction and credit for our taxable year end ending within or with
their taxable year.
During 2010, we owned an equity interest in KKR Financial Holdings
II, LLC (KFH II), which has elected to be taxed as a REIT under the
Internal Revenue Code of 1986, as amended (the Code). KFH II holds certain
real estate mortgage-backed securities. A REIT is not subject to United States
federal income tax to the extent that it currently distributes its income and
satisfies certain asset, income and ownership tests, and recordkeeping requirements,
but it may be subject to some amount of federal, state, local and foreign taxes
based on its taxable income.
KKR TRS Holdings, Ltd. (TRS Ltd.), KKR Financial
Holdings, Ltd. (KFH Ltd.), KFH III Holdings Ltd. (KFH III Ltd.),
KFN PEI VII, LLC (PEI VII), KFH PE Holdings I LLC (PE I), KFH PE
Holdings II LLC (PE II) and KKR Financial Holdings Inc. (KFH Inc.)
are our wholly-owned subsidiaries and are not consolidated with us for United
States federal income tax purposes. For financial reporting purposes, current
and deferred taxes are provided for on the portion of earnings recognized by us
with respect to our interest in PEI VII, PE I, PE II and KFH Inc., all domestic
taxable corporate subsidiaries, because each is taxed as a regular corporation
under the Code. Deferred income tax assets and liabilities are computed based
on temporary differences between the GAAP consolidated financial statements and
the United States federal income tax basis of assets and liabilities as of each
consolidated balance sheet date. CLO 2005-1, CLO 2005-2, CLO 2006-1, CLO
2007-1, CLO 2007-A and CLO 2009-1 are our foreign subsidiaries that elected to
be treated as disregarded entities or partnerships for United States federal
income tax purposes. Those subsidiaries were established to facilitate
securitization transactions, structured as secured financing transactions.
TRS Ltd., KFH Ltd. and KFH III Ltd. are our foreign subsidiaries and
are taxed as corporations for United States federal income tax purposes. These
entities were formed to make certain foreign and domestic investments from time
to time. TRS Ltd., KFH Ltd. and KFH III Ltd. are organized as
exempted companies incorporated with limited liability under the laws of the
Cayman Islands, and are anticipated to be exempt from United States federal and
state income tax at the corporate entity level because they restrict their
activities in the United States to trading in stock and securities for their
own account. No provisions for income taxes for the quarter ended March 31,
2010 were recorded for these entities; however, we are generally required to
include their current taxable income in our calculation of taxable income
allocable to shareholders.
While our REIT subsidiary (KFH II) is not expected to incur a 2010
federal or state tax liability, several of our domestic taxable corporate
subsidiaries are expected to incur a relatively small amount of 2010 federal
and state tax liability.
40
Table of Contents
Investment
Portfolio
Corporate Investment Portfolio
Summary
Our corporate investment portfolio primarily consists of investments in
corporate loans and debt securities. Our corporate loans primarily consist of
senior secured, second lien and subordinate loans. The corporate loans we
invest in are primarily below investment grade and are floating rate indexed to
either one-month or three-month LIBOR. Our investments in corporate debt
securities primarily consist of investments in below investment grade corporate
bonds that are senior secured, senior unsecured and subordinated. We evaluate
and monitor the asset quality of our investment portfolio by performing detailed
credit reviews and by monitoring key credit statistics and trends. The key
credit statistics and trends we monitor to evaluate the quality of our
investments include credit ratings of both our investments and the issuer,
financial performance of the issuer including earnings trends, free cash flows
of the issuer, debt service coverage ratios of the issuer, financial leverage
of the issuer, and industry trends that have or may impact the issuers current
or future financial performance and debt service ability.
Corporate
Loans
Our corporate loan portfolio totaled approximately $6.6 billion as of March 31,
2010 and $6.8 billion as of December 31, 2009. Our corporate loan
portfolio consists of debt obligations of corporations, partnerships and other
entities in the form of senior secured loans, second lien loans and subordinate
loans.
The following table summarizes our corporate loans portfolio stratified
by type as of March 31, 2010 and December 31, 2009:
Corporate Loans
(Amounts in
thousands)
|
|
March 31, 2010 (1)
|
|
December 31, 2009 (1)
|
|
|
|
Carrying
Value
|
|
Amortized
Cost
|
|
Estimated
Fair Value
|
|
Carrying
Value
|
|
Amortized
Cost
|
|
Estimated
Fair Value
|
|
Senior secured
|
|
$
|
5,939,661
|
|
$
|
5,939,661
|
|
$
|
5,814,111
|
|
$
|
6,093,463
|
|
$
|
6,093,463
|
|
$
|
5,774,248
|
|
Second lien
|
|
617,706
|
|
617,706
|
|
578,887
|
|
638,052
|
|
638,052
|
|
560,038
|
|
Subordinate
|
|
89,607
|
|
89,607
|
|
104,130
|
|
81,073
|
|
81,073
|
|
79,337
|
|
Subtotal
|
|
6,646,974
|
|
6,646,974
|
|
6,497,128
|
|
6,812,588
|
|
6,812,588
|
|
6,413,623
|
|
Lower of cost or fair value adjustment
|
|
(6,071
|
)
|
|
|
|
|
(31,637
|
)
|
|
|
|
|
Allowance for loan losses
|
|
(216,080
|
)
|
|
|
|
|
(237,308
|
)
|
|
|
|
|
Total
|
|
$
|
6,424,823
|
|
$
|
6,646,974
|
|
$
|
6,497,128
|
|
$
|
6,543,643
|
|
$
|
6,812,588
|
|
$
|
6,413,623
|
|
(1)
|
|
Includes
loans held for sale
|
As of March 31, 2010, $7.0 billion, or 98.8%, of our corporate
loan portfolio was floating rate and $0.1 billion, or 1.2%, was fixed
rate. As of December 31, 2009, $7.2 billion, or 98.3%, of our
corporate loan portfolio was floating rate and $0.1 billion, or 1.7%, was
fixed rate. Fixed and floating amounts and percentages are based on par values.
All of our floating rate corporate loans have index reset frequencies
of less than twelve months with the majority resetting at least quarterly. The
weighted-average coupon on our floating rate corporate loans was 3.8% and 3.7%
as of March 31, 2010 and December 31, 2009, respectively, and the
weighted-average coupon spread to LIBOR of our floating rate corporate loan
portfolio was 3.2% and 3.1% as of March 31, 2010 and December 31,
2009, respectively. The weighted-average years to maturity of our floating rate
corporate loans was 4.3 years as of both March 31, 2010 and December 31,
2009. As of March 31, 2010 and December 31, 2009, $0.8 billion par
amount, or 11.6%, and $0.6 billion par amount, or 8.8%, respectively, of our floating
rate corporate loan portfolio had interest rate floors.
As of March 31, 2010, our fixed rate corporate loans had a
weighted-average coupon of 13.1% and weighted-average years to maturity of
5.1 years, as compared to 13.6% and 5.4 years, respectively, as of December 31,
2009.
Loans placed on non-accrual status may or may not be contractually past
due at the time of such determination. When placed on non-accrual status,
previously recognized accrued interest is reversed and charged against current
income. While on non-accrual status, interest income is recognized using the
cost-recovery method, cash-basis method or some combination of the two methods.
A loan is placed back on accrual status when the ultimate collectability of the
principal and interest is not in doubt.
41
Table of
Contents
As of March 31, 2010 and December 31, 2009, we had loans on
non-accrual status with total carrying value of $253.3 million and $439.9
million, respectively. The average recorded investment in the impaired loans
included in non-accrual loans during the three months ended March 31, 2010
and 2009 was $346.6 million and $565.2 million, respectively. As of March 31,
2010 and 2009, the allocated component of the allowance for loan losses
included all impaired loans for the respective periods. The amount of interest
income recognized using the cash-basis method during the time within the period
that the loans were impaired was $5.6 million and $2.1 million for the three
months ended March 31, 2010 and 2009, respectively.
As of March 31, 2010, we held corporate loans that were in default
with a total carrying value of $209.7 million from four issuers. As of December 31,
2009, we held corporate loans that were in default with a total amortized cost
of $392.5 million from seven issuers. The majority of corporate loans in
default during 2010 and 2009 were included in the loans for which the allocated
component of the allowance for losses was related to or in those investments
for which we determined were loans held for sale as of March 31, 2010 and December 31,
2009, respectively.
The following table summarizes the changes in the allowance for loan
losses for the three months ended March 31, 2010 and 2009 (amounts in
thousands):
|
|
For the three
months ended
March 31, 2010
|
|
For the three
months ended
March 31, 2009
|
|
Balance at beginning of period
|
|
$
|
237,308
|
|
$
|
480,775
|
|
Provision for loan losses
|
|
|
|
26,987
|
|
Charge-offs
|
|
(21,228
|
)
|
|
|
Balance at end of period
|
|
$
|
216,080
|
|
$
|
507,762
|
|
As
of March 31, 2010 and December 31, 2009, we had an allowance for loan
loss of $216.1 million and $237.3 million, respectively. As described
under Critical Accounting Policies, our allowance for loan losses represents
our estimate of probable credit losses inherent in our corporate loan portfolio
held for investment as of the balance sheet date. Estimating our allowance for
loan losses involves a high degree of management judgment and is based upon a
comprehensive review of our loan portfolio that is performed on a quarterly
basis. Our allowance for loan losses consists of two components, an allocated
component and an unallocated component. The allocated component of our
allowance for loan losses pertains to specific loans that we have determined
are impaired. We determine a loan is impaired when we estimate that it is
probable that we will be unable to collect all amounts due according to the
contractual terms of the loan agreement. On a quarterly basis we perform a
comprehensive review of our entire loan portfolio and identify certain loans
that we have determined are impaired. Once a loan is identified as being
impaired we place the loan on non-accrual status, unless the loan is already on
non-accrual status, and record a reserve that reflects our best estimate of the
loss that we expect to recognize from the loan. The expected loss is estimated
as being the difference between our current cost basis of the loan, including
accrued interest receivable, and the loans estimated fair value.
The
unallocated component of our allowance for loan losses reflects our estimate of
probable losses inherent in our loan portfolio as of the balance sheet date
where the specific loan that the loan loss relates to is indeterminable. We
estimate the unallocated component of our allowance for loan losses through a
comprehensive review of our loan portfolio and identify certain loans that
demonstrate possible indicators of impairment. This assessment excludes all
loans that are determined to be impaired and as a result, an allocated reserve
has been recorded as described in the preceding paragraph. Such indicators
include, but are not limited to, the current and/or forecasted financial performance
and liquidity profile of the issuer, specific industry or economic conditions
that may impact the issuer, and the observable trading price of the loan if
available. Loans that demonstrate possible indicators of impairment are
aggregated on a watch list for monitoring and are sub-divided for
categorization based on the seniority of the loan in the issuers capital
structure, whether the loan is secured or unsecured, and the nature of the
collateral securing the loan, for purposes of applying possible default and
loss severity ranges based on the nature of the issuer and the specific loan.
We apply a range of default and loss severity estimates in order to estimate a
range of loss outcomes upon which to base our estimate of probable losses that
results in the determination of the unallocated component of our allowance for
loan losses.
As
of March 31, 2010, the allocated component of our allowance for loan
losses totaled $82.4 million and relates to investments in loans issued by six
issuers with an aggregate par amount of $216.7 million and an aggregate
amortized cost amount of $118.3 million. As of December 31, 2009, the
allocated component of the allowance for loan losses totaled $81.7 million and
relates to investments in loans issued by six issuers with an aggregate par
amount of $223.6 million and an aggregate amortized cost amount of
$121.2 million. The unallocated component of our allowance for loan losses
totaled $133.7 million and $155.6 million as of March 31, 2010 and December 31,
2009, respectively. During the three months ended March 31, 2010, we
recorded charge-offs totaling $21.2 million comprised primarily of loans
transferred to loans held for sale. There were no charge-offs during the three
months ended March 31, 2009.
42
Table of Contents
We reduced the lower of cost or market valuation allowance by $3.7
million for certain loans held for sale during the quarter ended March 31,
2010 which had a carrying value of $733.1 million as of March 31,
2010. We recorded a $14.0 million charge to earnings during the quarter ended March 31,
2009 for the lower of cost or estimated fair value adjustment for corporate
loans held for sale which had a carrying value of $259.9 million as of March 31,
2009.
The following table summarizes the par value of our corporate loan
portfolio stratified by Moodys Investors Service, Inc. (Moodys) and
Standard & Poors Ratings Services (Standard & Poors)
ratings category as of March 31, 2010 and December 31, 2009:
Corporate Loans
(Amounts in
thousands)
Ratings Category
|
|
As of
March 31, 2010
|
|
As of
December 31, 2009
|
|
Aaa/AAA
|
|
$
|
|
|
$
|
|
|
Aa1/AA+ through Aa3/AA-
|
|
|
|
|
|
A1/A+ through A3/A-
|
|
|
|
|
|
Baa1/BBB+ through Baa3/BBB-
|
|
9,249
|
|
22,040
|
|
Ba1/BB+ through Ba3/BB-
|
|
1,453,891
|
|
1,526,201
|
|
B1/B+ through B3/B-
|
|
4,772,006
|
|
4,610,234
|
|
Caa1/CCC+ and lower
|
|
791,909
|
|
1,120,140
|
|
Non-rated
|
|
107,846
|
|
93,550
|
|
Total
|
|
$
|
7,134,901
|
|
$
|
7,372,165
|
|
Corporate
Debt Securities
Our corporate debt securities portfolio totaled $829.7 million and
$754.4 million as of March 31, 2010 and December 31, 2009,
respectively. Our corporate debt securities portfolio consists of debt
obligations of corporations, partnerships and other entities in the form of
senior secured, senior unsecured and subordinated bonds.
The following table summarizes our corporate debt securities portfolio
stratified by type as of March 31, 2010 and December 31, 2009:
Corporate
Debt Securities
(Amounts in
thousands)
|
|
March 31, 2010
|
|
December 31, 2009
|
|
|
|
Carrying Value
|
|
Amortized Cost
|
|
Estimated Fair
Value
|
|
Carrying Value
|
|
Amortized Cost
|
|
Estimated Fair
Value
|
|
Senior secured
|
|
$
|
296,512
|
|
$
|
226,957
|
|
$
|
296,512
|
|
$
|
156,410
|
|
$
|
99,202
|
|
$
|
156,410
|
|
Senior unsecured
|
|
429,869
|
|
310,635
|
|
429,869
|
|
425,683
|
|
318,216
|
|
425,683
|
|
Subordinated
|
|
103,310
|
|
75,186
|
|
103,310
|
|
172,316
|
|
143,219
|
|
172,316
|
|
Total
|
|
$
|
829,691
|
|
$
|
612,778
|
|
$
|
829,691
|
|
$
|
754,409
|
|
$
|
560,637
|
|
$
|
754,409
|
|
As of March 31, 2010, $684.1 million, or 76.8%, of our corporate
debt securities portfolio was fixed rate and $206.2 million, or 23.2%, was
floating rate. As of December 31, 2009, $647.4 million, or 77.6%, of our
corporate debt securities portfolio was fixed rate and $186.7 million, or
22.4%, was floating rate. Fixed and floating amounts and percentages are based
on par values.
As of March 31, 2010, our fixed rate corporate debt securities had
a weighted-average coupon of 9.2% and weighted-average years to maturity of
6.5 years, as compared to 10.0% and 6.2 years, respectively, as of December 31,
2009. All of our floating rate corporate debt securities have index reset
frequencies of less than twelve months. The weighted-average coupon on our floating
rate corporate debt securities was 4.5% and 3.6% as of March 31, 2010 and December 31,
2009, respectively, and the weighted-average coupon spread to LIBOR of our
floating rate corporate debt securities was 4.1% and 3.4% as of March 31,
2010 and December 31, 2009, respectively. The weighted-average years to
maturity of our floating rate corporate debt securities was 3.8 and
4.1 years as of March 31, 2010 and December 31, 2009,
respectively. As of March 31, 2010 and December 31, 2009, $10.8
million par amount, or 5.2%, and nil, respectively, of our floating rate corporate
debt securities portfolio had interest rate floors.
43
Table of Contents
During the three months ended March 31, 2010 and 2009, we recorded
impairment losses totaling $1.1 million and $33.8 million, respectively,
for corporate debt and equity securities that we determined to be
other-than-temporarily impaired. These securities were determined to be
other-than-temporarily impaired either due to our determination that recovery
in value is no longer likely or because we decided to sell the respective
security in response to specific credit concerns regarding the issuer.
As of March 31, 2010 and December 31, 2009, we had no
corporate debt securities in default.
The following table summarizes the par value of our corporate debt
securities portfolio stratified by Moodys and Standard & Poors
ratings category as of March 31, 2010 and December 31, 2009:
Corporate Debt Securities
(Amounts in
thousands)
Ratings Category
|
|
As of
March 31, 2010
|
|
As of
December 31, 2009
|
|
Aaa/AAA
|
|
$
|
|
|
$
|
|
|
Aa1/AA+ through Aa3/AA-
|
|
|
|
|
|
A1/A+ through A3/A-
|
|
|
|
15,590
|
|
Baa1/BBB+ through Baa3/BBB-
|
|
|
|
|
|
Ba1/BB+ through Ba3/BB-
|
|
154,268
|
|
35,500
|
|
B1/B+ through B3/B-
|
|
288,091
|
|
207,162
|
|
Caa1/CCC+ and lower
|
|
414,751
|
|
557,187
|
|
Non-Rated
|
|
33,141
|
|
18,691
|
|
Total
|
|
$
|
890,251
|
|
$
|
834,130
|
|
Residential Mortgage Investment
Summary
Our residential mortgage investment portfolio consists of investments
in RMBS with an estimated fair value of $114.0 million as of March 31,
2010. The $114.0 million of RMBS is comprised of $29.2 million of
RMBS that are rated investment grade or higher and $84.8 million of RMBS
that are rated below investment grade.
As our condensed consolidated financial statements included in this
Quarterly Report on Form 10-Q are presented to reflect the deconsolidation of
the aforementioned six residential mortgage securitization trusts beginning January 1,
2010, the information contained in this Managements Discussion and Analysis of
Financial Condition and Results of Operations reflects our residential mortgage
portfolio presented on a deconsolidated basis consistent with the disclosures
in our condensed consolidated financial statements. See Executive Overview
Consolidation for further discussion.
The table below summarizes the carrying value, amortized cost and
estimated fair value of our residential mortgage investment portfolio as of March 31,
2010 and December 31, 2009. Carrying value is the value that investments
are recorded on our condensed consolidated balance sheets and is estimated fair
value for RMBS and residential mortgage loans. Estimated fair values set forth
in the tables below are based on dealer quotes, nationally recognized pricing
services and/or managements judgment when relevant observable inputs do not
exist.
44
Table of Contents
Residential Mortgage Investment Portfolio
(Amounts in thousands)
|
|
March 31, 2010
|
|
December 31, 2009
|
|
|
|
Carrying
Value
|
|
Amortized
Cost
|
|
Estimated
Fair Value
|
|
Carrying
Value
|
|
Amortized
Cost
|
|
Estimated
Fair Value
|
|
Residential Mortgage Loans(1)
|
|
$
|
|
|
$
|
|
|
$
|
|
|
$
|
2,097,699
|
|
$
|
2,772,216
|
|
$
|
2,097,699
|
|
Residential Mortgage-Backed Securities
|
|
114,023
|
|
288,762
|
|
114,023
|
|
47,572
|
|
95,483
|
|
47,572
|
|
Total
|
|
$
|
114,023
|
|
$
|
288,762
|
|
$
|
114,023
|
|
$
|
2,145,271
|
|
$
|
2,867,699
|
|
$
|
2,145,271
|
|
(1)
|
|
Excludes real estate owned
(REO) as a result of foreclosure on delinquent loans of $11.4 million as of
December 31, 2009.
|
As of December 31, 2009, 26 of our residential mortgage loans
owned by us with an outstanding balance of $11.4 million were REO as a
result of foreclosure on delinquent loans.
Shareholders Equity
Our shareholders equity at March 31, 2010 and December 31,
2009 totaled $1.3 billion and $1.2 billion, respectively. Included in our
shareholders equity as of March 31, 2010 and December 31, 2009 is
accumulated other comprehensive income totaling $170.4 million and $152.7
million, respectively.
Our average shareholders equity and return on average shareholders
equity for the three months ended March 31, 2010 were $1.2 billion
and 43.1%, respectively. Our average
shareholders equity and return on average shareholders equity for the three
months ended March 31, 2009 were $691.5 million and (7.6)%,
respectively. Return on average shareholders equity is defined as net income
(loss) divided by weighted average shareholders equity.
Our book value per share as of March 31, 2010 and December 31,
2009 was $8.31 and $7.37, respectively, and is computed based on 158,359,757
shares issued and outstanding as of both March 31, 2010 and December 31,
2009.
On February 4, 2010, our board of directors declared a cash
distribution of $0.07 per share to shareholders of record on February 18,
2010. The aggregate amount of the
distribution of $11.1 million was paid on March 4, 2010.
Liquidity and Capital Resources
We actively manage our liquidity position with the
objective of preserving our ability to fund our operations and fulfill our
commitments on a timely and cost-effective basis. As of March 31, 2010, we
had unrestricted cash and cash equivalents totaling $240.5 million.
During the first quarter of 2010, we observed signs
of recovery in market value for some assets. As a result, capital markets,
including debt and equity financing, that were previously frozen or available
only on unattractive terms, show limited signs of reopening. Although we
believe our current sources of liquidity are adequate to preserve our ability
to fund our operations and fulfill our commitments, we will continue to
evaluate opportunities to deploy incremental capital based on the terms of
capital available to us. This may include taking advantage of market timing to
issue equity or refinance or replace indebtedness, including the issuance of
new debt securities and retiring debt pursuant to privately negotiated
transactions, open market purchases or otherwise.
The majority of our investments are held in Cash Flow CLOs.
Accordingly, the majority of our cash flows have historically been received
from our investments in the mezzanine and subordinated notes of our Cash Flow
CLOs. During a portion of the quarter ended March 31, 2010, two of our
Cash Flow CLOs were out of compliance with certain compliance tests (specifically,
OC Tests) outlined in their respective indentures. During the period in which a
Cash Flow CLO is not in compliance with an OC Test, the cash flows we would
generally expect to receive from our Cash Flow CLO holdings are paid to the
senior note holders of the Cash Flow CLOs. However, by March 31, 2010,
both of these Cash Flow CLOs came into compliance with their OC Tests, resuming
cash flows to the mezzanine and subordinate note holders, including us.
Sources of Funds
Cash Flow
CLO Transactions
As of March 31, 2010, we had five Cash Flow CLOs outstanding. An
affiliate of our Manager owns an interest in the junior notes of both
CLO 2007-1 and CLO 2007-A. The aggregate carrying amount of the junior
notes in CLO 2007-1 and CLO 2007-A held by the affiliate of our Manager is
$380.3 million as of March 31, 2010 and is reflected as
collateralized loan obligation junior secured notes to affiliates on our
condensed consolidated balance sheets.
45
Table of Contents
In accordance with GAAP, we consolidate each of these Cash Flow CLOs as
we have the power to direct the activities of these VIEs, as well as the
obligation to absorb losses of the VIEs and the right to receive benefits of
the VIEs that could potentially be significant to the VIEs. We utilize CLOs to
fund our investments in corporate loans and corporate debt securities. The
indentures governing our Cash Flow CLOs include numerous compliance tests, the
majority of which relate to the CLOs portfolio profile. In the event that a
portfolio profile test is not met, the indenture places restrictions on the
ability of the CLOs manager to reinvest available principal proceeds generated
by the collateral in the CLOs until the specific test has been cured. In
addition to the portfolio profile tests, the indentures for the Cash Flow CLOs include
OC Tests which set the ratio of the collateral value of the assets in the CLO
to the tranches of debt for which the test is being measured, as well as
interest coverage tests. For purposes of the calculation, collateral value is
the par value of the assets unless an asset is in default, is a discounted
obligation, or is a CCC-rated asset in excess of the percentage of CCC-rated
asset limit specified for each Cash Flow CLO.
If an asset is in default, the indenture for each Cash Flow CLO
transaction defines the value used to determine the collateral value, which
value is the lower of market value of the asset or the recovery value
proscribed for the asset based on its type and rating by Standard &
Poors or Moodys.
A discount obligation is an asset with a purchase price of less than a
particular percentage of par. The discount obligation amounts are specified in
each Cash Flow CLO and are generally set at a purchase price of less than 80%
of par for corporate loans and 75% of par for corporate debt securities.
The indenture for each Cash Flow CLO specifies a CCC-threshold for the
percentage of total assets in the CLO that can be rated CCC. All assets in
excess of the CCC threshold specified for the respective CLO are included in
the OC Tests at market value and not par.
Defaults of assets in Cash Flow CLOs, ratings downgrade of assets in
Cash Flow CLOs to CCC, price declines of CCC assets in excess of the proscribed
CCC threshold amount, and price declines in assets classified as discount
obligations may reduce the over-collateralization ratio such that a Cash Flow
CLO is not in compliance. If a Cash Flow CLO is not in compliance with an OC
Test, cash flows normally payable to the holders of junior classes of notes
will be used by the CLO to amortize the most senior class of notes until such
point as the OC Test is brought back into compliance. As a result of the
historic declines in asset prices, particularly in the corporate loan and high
yield securities asset classes during the fourth quarter of 2008, one or more
of our Cash Flow CLOs were out of compliance with the OC Tests for periods of
time. While being out of compliance with an OC Test would not impact our
investment portfolio or results of operations, it would impact our unrestricted
cash flows available for operations, new investments and dividend
distributions. During the first quarter of 2010, however, as signs of economic
recovery appeared evidenced by appreciating market values, all of our CLO
transactions came into compliance with their OC Tests. The following table
summarizes several of the material tests and metrics for each of our Cash Flow
CLOs. This information is based on the March 2010 monthly reports
which are prepared by the independent third-party trustee for each Cash Flow
CLO:
·
Investments: The par value
of the investments in each CLO plus principal cash in the CLO.
·
Senior interest coverage (IC)
ratio minimum: Minimum required ratio of interest income earned on investments
to interest expense on the senior debt issued by the CLO per the respective CLOs
indenture.
·
Actual senior IC ratio: The
ratio is interest income earned on the investments divided by interest expense
on the senior debt issued by the CLO.
·
CCC amount: The par amount
of assets rated CCC or below (excluding defaults, if any).
·
CCC threshold percentage:
Maximum amount of assets in portfolio that are rated CCC without being subject
to being valued at fair value for purposes of the OC Tests.
·
Senior OC Test minimum:
Minimum senior over-collateralization requirement per the respective CLOs
indenture.
·
Actual senior OC Test:
Actual senior over-collateralization amount as of the March 2010 report
date.
·
Actual cushion / (excess):
Dollar amount that over-collateralization test is being passed, cushion, or failed
(excess).
·
Subordinated OC Test
minimum: Minimum subordinated over-collateralization requirement per the
respective CLOs indenture.
·
Actual subordinated OC Test:
Actual subordinated over-collateralization amount as of March 2010 report
date.
46
Table of Contents
·
Subordinate cushion /
(excess): Dollar amount that the OC Test is being passed, cushion, or failed
(excess).
(dollar amounts in thousands)
|
|
CLO 2005-1
|
|
CLO 2005-2
|
|
CLO 2006-1
|
|
CLO 2007-1
|
|
CLO 2007-A
|
|
Investments
|
|
$
|
1,041,902
|
|
$
|
1,000,240
|
|
$
|
1,039,445
|
|
$
|
3,374,940
|
|
$
|
1,525,981
|
|
Senior IC ratio minimum
|
|
115.0
|
%
|
125.0
|
%
|
115.0
|
%
|
115.0
|
%
|
120.0
|
%
|
Actual senior IC ratio
|
|
596.7
|
%
|
606.0
|
%
|
420.0
|
%
|
489.8
|
%
|
436.0
|
%
|
CCC amount
|
|
$
|
61,929
|
|
$
|
69,894
|
|
$
|
196,880
|
|
$
|
757,186
|
|
$
|
289,119
|
|
CCC percentage of portfolio
|
|
5.9
|
%
|
7.0
|
%
|
18.9
|
%
|
22.4
|
%
|
18.9
|
%
|
CCC threshold percentage
|
|
5.0
|
%
|
7.5
|
%
|
7.5
|
%
|
7.5
|
%
|
7.5
|
%
|
Senior OC Test minimum
|
|
119.4
|
%
|
123.0
|
%
|
143.1
|
%
|
159.1
|
%
|
119.7
|
%
|
Actual senior OC Test
|
|
128.7
|
%
|
134.0
|
%
|
158.7
|
%
|
170.5
|
%
|
130.9
|
%
|
Cushion / (Excess)
|
|
$
|
71,678
|
|
$
|
81,516
|
|
$
|
94,692
|
|
$
|
202,102
|
|
$
|
123,094
|
|
Subordinated OC Test minimum
|
|
106.2
|
%
|
106.9
|
%
|
114.0
|
%
|
120.1
|
%
|
109.9
|
%
|
Actual OC Test
|
|
110.0
|
%
|
118.9
|
%
|
135.4
|
%
|
117.8
|
%
|
113.2
|
%
|
Cushion / (Excess)
|
|
$
|
34,592
|
|
$
|
100,650
|
|
$
|
152,713
|
|
$
|
(58,534
|
)
|
$
|
41,887
|
|
As reflected in the table above, each of our Cash Flow CLOs is in
compliance with its respective IC ratio tests based on the March 2010 monthly
reports for the respective CLOs. In addition, all Cash Flow CLOs are also in
compliance with their respective senior OC Tests and CLO 2005-1, CLO 2005-2,
CLO 2006-1, and CLO 2007-A are in compliance with their respective subordinate
OC Tests.
On January 4, 2010, CLO 2007-A was brought into compliance with
its respective OC Tests. Also, on March 19, 2010, CLO 2007-1, our final
remaining Cash Flow CLO to be failing one or more of its respective OC Tests,
was brought into compliance with all of its respective OC Tests. The table above,
based on the March 2010 monthly report, was prepared using determination
dates as defined in each respective CLO indenture. The determination date for
CLO 2007-1 was prior to CLO 2007-1 coming into compliance and as such, its
compliance was not reflected in the test results above. As of March 31,
2010, CLO 2007-A and CLO 2007-1, both of which were previously not in
compliance and were amortizing the most senior class of notes, have already or
will resume cash flows normally payable to the holders of junior classes of
notes, including us.
During the three
months ended March 31, 2010, in an open market auction, we purchased $10.3
million of mezzanine notes issued by CLO 2007-A for $5.5 million and $72.7
million of mezzanine and subordinate notes issued by CLO 2007-1 for $38.8
million, both of which were previously held by an affiliate of our manager.
These
transactions resulted in us recording an aggregate gain on extinguishment of
debt totaling $38.7 million during the first quarter of 2010.
Senior
Secured Credit Facility
During February 2010, we paid down outstanding borrowings under
our senior secured credit facility by $25.0 million, reducing the amount
outstanding from $175.0 million as of December 31, 2009 to $150.0
million as of March 31, 2010.
Convertible
Debt
On January 15, 2010, we issued $172.5 million of 7.5%
Convertible Senior Notes due January 15, 2017. The 7.5% Notes bear
interest at a rate of 7.5% per year on the principal amount, accruing from January 15,
2010. Interest is payable semiannually in arrears on January 15 and July 15
of each year, beginning on July 15, 2010. The 7.5% Notes will mature on January 15,
2017 unless previously redeemed, repurchased or converted in accordance with
their terms prior to such date. Holders of the 7.5% Notes may convert their
notes at the applicable conversion rate at any time prior to the close of
business on the business day immediately preceding the stated maturity date
subject to our right to terminate the conversion rights of the notes. We may
satisfy its obligation with respect to the 7.5% Notes tendered for conversion
by delivering to the holder either cash, common shares, no par value, issued by
us or a combination thereof. The initial conversion rate for each $1,000
principal amount of 7.5% Notes is 122.2046 shares, which is equivalent to an
initial conversion price of approximately $8.18 per share. The conversion rate
may be adjusted under certain circumstances, including the occurrence of
certain fundamental change transactions and the payment of a quarterly cash
distribution in excess of $0.05 per share, but will not be adjusted for accrued
and unpaid interest on the 7.5% Notes. Net proceeds from the offering totaled
$167.3 million, reflecting $172.5 million from the issuance less
$5.2 million for underwriting fees.
47
Table of Contents
During the first quarter of 2010, we repurchased $95.2 million par
amount of our 7.0% convertible senior notes due 2012, reducing the amount
outstanding from $275.8 million as of December 31, 2009 to
$180.6 million as of March 31, 2010. These transactions resulted in
us recording a gain of $1.3 million, which was partially offset by a write-off
of $0.6 million of unamortized debt issuance costs during the first quarter of
2010.
As
of March 31, 2010 and as of the date of filing this Quarterly Report on Form 10-Q,
we believe we are in compliance with the covenants contained within our
respective borrowing agreements.
Off-Balance Sheet Commitments
As of March 31, 2010, we had committed to purchase corporate loans
with aggregate commitments totaling $250.8 million. In addition, we
participate in certain financing arrangements, including revolvers and delayed
draw facilities, whereby we are committed to provide funding at the discretion
of the borrower up to a specific predetermined amount. As of March 31,
2010, we had unfunded financing commitments totaling $42.0 million. We do
not expect material losses related to the corporate loans for which we commit
to purchase and fund.
Partnership Tax Matters
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, including those 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 may 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, 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 taxable income from us during such year.
Qualifying Income Exception
We intend to continue to operate so that we qualify as a partnership,
and not as an association or a publicly traded partnership taxable as a
corporation, for United States federal income tax purposes. In general, if a
partnership is publicly traded (as defined in the Code), it will be treated
as a corporation for United States federal income purposes. A publicly traded
partnership will, however, be taxed as a partnership, and not as a corporation,
for United States federal income tax purposes, so long as it is not required to
register under the Investment Company Act and at least 90% of its gross income
for each taxable year constitutes qualifying income within the meaning of Section 7704(d) of
the Code. We refer to this exception as the qualifying income exception.
Qualifying income generally includes rents, dividends, interest (to the extent
such interest is neither derived from the conduct of a financial or insurance
business nor based, directly or indirectly, upon income or profits of any
person), income and gains derived from certain activities related to minerals
and natural resources, and capital gains from the sale or other disposition of
stocks, bonds and real property. Qualifying income also includes other income
derived from the business of investing in, among other things, stocks and
securities.
If we fail to satisfy the qualifying
income exception described above, items of income, gain, loss, deduction and
credit would not pass through to holders of our shares and such holders would
be treated for United States federal (and certain state and local) income tax
purposes as shareholders in a corporation. In such case, we would be required
to pay income tax at regular corporate rates on all of our income. In addition,
we would likely be liable for state and local income and/or franchise taxes on
all of our income. Distributions to holders of our shares would constitute
ordinary dividend income taxable to such holders to the extent of our earnings
and profits, and these distributions would not be deductible by us. If we were
taxable as a corporation, it could result in a material reduction in cash flow
and after-tax return for holders of our shares and thus could result in a
substantial reduction in the value of our shares and any other securities we
may issue.
Tax
Consequences of Investments in Natural Resources
As referenced above, we may
make certain investments in natural resources.
When we make such investments, it is likely that the income from such
investments would be treated as effectively connected with the conduct of a
United States trade or business with respect to holders of our shares that are
not United States persons within the meaning of Section 7701(a)(30) of
the Code. Furthermore, any notional principal
contracts that we enter into, if any, in connection with investments in natural
resources likely would generate income that would be treated as effectively
connected income with the conduct of a United States trade or business. To the extent our income is treated as
effectively connected income, a holder who is a non-United States person
generally would be required to (i) file a United States federal
income tax return for such year reporting its allocable share, if any, of our
income or loss effectively connected with such trade or business and
(ii) pay United States federal income tax at regular United States tax
rates on any such income. Moreover, if such a holder is a corporation, it might
be subject to a United States branch profits tax on its allocable share of our
effectively connected income. In addition, distributions to such a holder would
be subject to withholding at the highest applicable tax rate to the extent of
the holders allocable share of our effectively connected income. Any amount so
withheld would be creditable against such holders United States federal income
tax liability, and such holder could claim a refund to the extent that the
amount withheld exceeded such persons United States federal income tax liability
for the taxable year. Finally, if we are engaged in a United States trade or
business, a portion of any gain recognized by an investor who is a non-United
States person on the sale or exchange of its shares may be treated for United
States federal income tax purposes as effectively connected income, and hence
such holder may be subject to United States federal income tax on the sale or
exchange.
In addition, for all of our holders, investments in natural
resources would likely constitute doing business in the jurisdictions in which
such assets are located. As a result,
holders of our shares will likely be required to file foreign, state and local
income tax returns and pay foreign, state and local income taxes in some or all
of these various jurisdictions. Further,
holders may be subject to penalties for failure to comply with those
requirements.
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Our Investment Company Act Status
Section 3(a)(1)(A) of the Investment Company Act defines an
investment company as any issuer that is, holds itself out as being, or
proposes to be, primarily engaged in the business of investing, reinvesting or
trading in securities and Section 3(a)(1)(C) of the Investment
Company Act defines an investment company as any issuer that is engaged or
proposes to engage in the business of investing, reinvesting, owning, holding
or trading in securities and owns or proposes to acquire investment securities
(within the meaning of the Investment Company Act) having a value exceeding 40%
of the value of the issuers total assets (exclusive of U.S. government
securities and cash items) on an unconsolidated basis (the 40% test).
Excluded from the term investment securities are, among others, securities
issued by majority-owned subsidiaries unless the subsidiary is an investment
company or relies on the exceptions from the definition of an investment
company provided by Section 3(c)(1) or Section 3(c)(7) of
the Investment Company Act (a fund). The Investment Company Act defines a majority-owned
subsidiary of a person as any company 50% or more of the outstanding voting
securities (i.e., those securities presently entitling the holder thereof
to vote for the election of directors of the company) of which are owned by
that person, or by another company that is, itself, a majority owned subsidiary
of that person.
We are organized as a holding company. We conduct our operations
primarily through our majority owned subsidiaries. Each of our subsidiaries is either
outside of the definition of an investment company in Sections 3(a)(1)(A) and
3(a)(1)(C), described above, or excepted from the definition of an investment
company under the Investment Company Act. We believe that we are not, and that
we do not propose to be, primarily engaged in the business of investing,
reinvesting or trading in securities and we do not believe that we have held
ourselves out as such. We intend to continue to conduct our operations so that
we are not required to register as an investment company under the Investment
Company Act.
We monitor our holdings regularly to confirm our continued compliance
with the 40% test. In calculating our position under the 40% test, we are
responsible for determining whether any of our subsidiaries is majority-owned.
We treat subsidiaries in which we own at least 50% of the outstanding voting
securities, including those that issue CLOs, as majority-owned for purposes of the
40% test. Some of our subsidiaries may rely solely on Section 3(c)(1) or
Section 3(c)(7) of the Investment Company Act. In order for us to
satisfy the 40% test, our ownership interests in those subsidiaries or any of
our subsidiaries that are not majority-owned, together with any other investment
securities that we may own, may not have a combined value in excess of 40% of
the value of our total assets on an unconsolidated basis and exclusive of U.S.
government securities and cash items. However, most of our subsidiaries either
fall outside of the general definitions of an investment company or rely on
exceptions provided by provisions of, and rules and regulations
promulgated under, the Investment Company Act (other than Section 3(c)(1) or
Section 3(c)(7) of the Investment Company Act) and, therefore, are
not defined or regulated as investment companies. In order to conform to these
exceptions, these subsidiaries are limited with respect to the assets in which
each of them can invest and/or the types of securities each of them may issue.
We must, therefore, monitor each subsidiarys compliance with its applicable
exception and our freedom of action, and that of our subsidiaries, may be
limited as a result. For example, our subsidiaries that issue CLOs generally
rely on Rule 3a-7 under Investment Company Act, while KKR Financial
Holdings II, LLC, or KFH II, our subsidiary that is taxed as a REIT for
U.S. federal income tax purposes, generally relies on Section 3(c)(5)(C) of
the Investment Company Act. Each of these exceptions requires, among other
things that the subsidiary (i) not issue redeemable securities and (ii) engage
in the business of holding certain types of assets, consistent with the terms
of the exception. Similarly, any subsidiaries engaged in the ownership of oil
and gas assets may, depending on the nature of the assets, be outside the
definition of an investment company or rely on exceptions provided by Section
3(c)(5)(C) or Section 3(c)(9) of the Investment Company Act. While Section 3(c)(9) of the Investment
Company Act does not limit the nature of the securities issued, it does impose
business engagement requirements that limit the types of assets that may be
held.
We do not treat our interests in majority-owned subsidiaries that are
outside of the general definition of an investment company or that rely on Section 3(c)(5)(C)
or Section 3(c)(9) of, or Rule 3a-7 under, the Investment Company Act as
investment securities when calculating our 40% test.
We sometimes refer to our subsidiaries that rely on Rule 3a-7
under the Investment Company Act as CLO subsidiaries. Rule 3a-7 under
the Investment Company Act is available to certain structured financing
vehicles that are engaged in the business of holding financial assets that, by
their terms, convert into cash within a finite time period and that issue fixed
income securities entitling holders to receive payments that depend primarily
on the cash flows from these assets, provided that, among other things, the
structured finance vehicle does not engage in certain portfolio management
practices resembling those employed by mutual funds. Accordingly, each of these
CLO subsidiaries is subject to an indenture (or similar transaction documents)
that contains specific guidelines and restrictions limiting the discretion of
the CLO subsidiary and its collateral manager. In particular, these guidelines
and restrictions prohibit the CLO subsidiary from acquiring and disposing of
assets primarily for the purpose of recognizing gains or decreasing losses resulting
from market value changes. Thus, a CLO subsidiary cannot acquire or dispose of
assets primarily to enhance returns to the owner of the equity in the CLO
subsidiary; however, subject to this limitation, sales and purchases of assets
may be made so long as doing so does not violate guidelines contained in the
CLO subsidiarys relevant transaction documents. A CLO subsidiary generally
can, for example, sell an asset if the collateral manager believes that its
credit quality has declined since its acquisition or that the credit profile of
the obligor will deteriorate and the proceeds of permitted dispositions may be
reinvested in additional collateral, subject to fulfilling the requirements set
forth in Rule 3a-7 under the Investment Company Act and the CLO subsidiarys
relevant transaction documents. As a result of these restrictions, our CLO
subsidiaries may suffer losses on their assets and we may suffer losses on our
investments in those CLO subsidiaries.
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Table of Contents
We sometimes refer to KFH II, our subsidiary that relies on Section 3(c)(5)(C) of
the Investment Company Act, as our REIT subsidiary. Section 3(c)(5)(C) of
the Investment Company Act is available to companies that are primarily engaged
in the business of purchasing or otherwise acquiring mortgages and other liens
on and interests in real estate. While the SEC has not promulgated rules to
address precisely what is required for a company to be considered to be primarily
engaged in the business of purchasing or otherwise acquiring mortgages and
other liens on and interests in real estate, the SECs Division of Investment
Management, or the Division, has taken the position, through a series of
no-action and interpretive letters, that a company may rely on Section 3(c)(5)(C)
of the Investment Company Act if, among other things, at least 55% of the
companys assets consist of mortgage loans, other assets that are considered
the functional equivalent of mortgage loans and certain other interests in real
property (collectively, qualifying real estate assets), and at least 25% of
the companys assets consist of real estate-related assets (reduced by the excess
of the companys qualifying real estate assets over the required 55%), leaving
no more than 20% of the companys assets to be invested in miscellaneous
assets. The Division has also provided guidance as to the types of assets that
can be considered qualifying real estate assets. Because the Divisions
interpretive letters are not binding except as they relate to the companies to
whom they are addressed, if the Division were to change its position as to,
among other things, what assets might constitute qualifying real estate assets
our REIT subsidiary might be required to change its investment strategy to
comply with the changed position. We cannot predict whether such a change would
be adverse.
Based on current guidance, our REIT subsidiary classifies investments
in mortgage loans as qualifying real estate assets, as long as the loans are fully
secured by an interest in real estate on which we retain the right to
foreclose. That is, if the loan-to-value ratio of the loan is equal to or less
than 100%, then the mortgage loan is considered to be a qualifying real estate
asset. Mortgage loans with loan-to-value ratios in excess of 100% are
considered to be only real estate-related assets. Our REIT subsidiary considers
agency whole pool certificates to be qualifying real estate assets. Examples of
agencies that issue whole pool certificates are the Federal National Mortgage
Association, the Federal Home Loan Mortgage Corporation and the Government
National Mortgage Association. An agency whole pool certificate is a
certificate issued or guaranteed as to principal and interest by the U.S.
government or by a federally chartered entity, which represents the entire
beneficial interest in the underlying pool of mortgage loans. By contrast, an
agency certificate that represents less than the entire beneficial interest in
the underlying mortgage loans is not considered to be a qualifying real estate
asset, but is considered to be a real estate-related asset.
Most non-agency mortgage-backed securities do not constitute qualifying
real estate assets because they represent less than the entire beneficial
interest in the related pool of mortgage loans; however, based on Division
guidance, where our REIT subsidiarys investment in non-agency mortgage- backed
securities is the functional equivalent of owning the underlying mortgage
loans, our REIT subsidiary may treat those securities as qualifying real estate
assets. Moreover, investments in mortgage-backed securities that do not
constitute qualifying real estate assets will be classified as real estate-
related assets. Therefore, based upon the specific terms and circumstances
related to each non-agency mortgage-backed security that our REIT subsidiary
owns, our REIT subsidiary will make a determination of whether that security
should be classified as a qualifying real estate asset or as a real estate-
related asset; and there may be instances where a security is recharacterized
from being a qualifying real estate asset to a real estate-related asset, or
conversely, from being a real estate-related asset to being a qualifying real
estate asset based upon the acquisition or disposition or redemption of related
classes of securities from the same securitization trust. If our REIT
subsidiary acquires securities that, collectively, receive all of the principal
and interest paid on the related pool of underlying mortgage loans (less fees,
such as servicing and trustee fees, and expenses of the securitization), and
that subsidiary has foreclosure rights with respect to those mortgage loans,
then our REIT subsidiary will consider those securities, collectively, to be
qualifying real estate assets. If another entity acquires any of the securities
that are expected to receive cash flow from the underlying mortgage loans, then
our REIT subsidiary will consider whether it has appropriate foreclosure rights
with respect to the underlying loans and whether its investment is a first loss
position in deciding whether these securities should be classified as
qualifying real estate assets. If our REIT subsidiary owns more than one
subordinate class, then, to determine the classification of subordinate classes
other than the first loss class, our REIT subsidiary will consider whether such
classes are contiguous with the first loss class (with no other classes
absorbing losses after the first loss class and before any other subordinate
classes that our REIT subsidiary owns), whether our REIT subsidiary owns the
entire amount of each such class and whether our REIT subsidiary would continue
to have appropriate foreclosure rights in connection with each such class if
the more subordinate classes were no longer outstanding. If the answers to any
of these questions is no, then our REIT subsidiary would expect not to classify
that particular class, or classes senior to that class, as qualifying real
estate assets.
We may hold oil and gas assets through one or more subsidiaries and
would refer to those subsidiaries as our Oil and Gas Subsidiaries. Depending upon the nature of the oil and gas
assets held by an Oil and Gas Subsidiary, such Oil and Gas Subsidiary may rely
on Section 3(c)(5)(C) or Section 3(c)(9) of the Investment Company Act or may
fall outside of the general definition of an investment company. An Oil and Gas Subsidiary that does not engage
primarily, propose to engage primarily or hold itself out as engaging primarily
in the business of investing, reinvesting or trading in securities will be
outside of the general definition of an investment company provided that it
passes the 40% test. This may be the
case where an Oil and Gas Subsidiary holds a sufficient amount of oil and gas
assets constituting real estate interests together with other assets that are
not investment securities such as equipment.
Oil and Gas Subsidiaries that hold oil and gas assets that constitute
real property interests, but are unable to pass the 40% test, may rely on
Section 3(c)(5)(C), subject to the requirements and restrictions described
above. Alternately, an Oil and Gas
Subsidiary may rely on Section 3(c)(9) of the Investment Company Act if
substantially all of its business consists of owning or holding oil, gas or
other mineral royalties or leases, certain fractional interests, or
certificates of interest or participations in or investment contracts relating
to such royalties, leases or fractional interests. These various restrictions imposed on our Oil
and Gas Subsidiaries by the Investment Company Act may have the effect of
limiting our freedom of action with respect to oil and gas assets (or other
assets) that may be held or acquired by such subsidiary or the manner in which
we may deal in such assets.
As noted above, if the combined values of the investment securities
issued by our subsidiaries that must rely on Section 3(c)(1) or Section 3(c)(7) of
the Investment Company Act, together with any other investment securities we
may own, exceeds 40% of the value of our total assets (exclusive of U.S.
government securities and cash items) on an unconsolidated basis, we may be
deemed to be an investment company. If we fail to maintain an exception,
exemption or other exclusion from the Investment Company Act, we could, among
other things, be required either (i) to change substantially the manner in
which we conduct our operations to avoid being subject to the Investment
Company Act or (ii) to register as an investment company. Either of these
would likely have a material adverse effect on us, our ability to service our
indebtedness and to make distributions on our shares, and on the market price
of our shares and any other securities we may issue. If we were required to
register as an investment company under the Investment Company Act, we would
become subject to substantial regulation with respect to our capital structure
(including our ability to use leverage), management, operations, transactions
with certain affiliated persons (within the meaning of the Investment Company
Act), portfolio composition (including restrictions with respect to
diversification and industry concentration) and other matters. Additionally,
our Manager would have the right to
50
Table of Contents
terminate
our management agreement. Moreover, if we were required to register as an
investment company, we would no longer be eligible to be treated as a
partnership for United States federal income tax purposes. Instead, we would be
classified as a corporation for tax purposes and would be able to avoid
corporate taxation only to the extent that we were able to elect and qualify as
a regulated investment company (RIC) under applicable tax rules. Because our
eligibility for RIC status would depend on our assets and sources of income at
the time that we were required to register as an investment company, there can
be no assurance that we would be able to qualify as a RIC. If we were to lose
partnership status and fail to qualify as a RIC, we would be taxed as a regular
corporation. See Partnership Tax Matters
Qualifying
Income Exception
.
We have not requested approval or guidance from the SEC or its staff
with respect to our Investment Company Act determinations, including, in
particular: our treatment of any subsidiary as majority-owned; the compliance
of any subsidiary with Section 3(c)(5)(C) or Section 3(c)(9) of, or Rule 3a-7
under, the Investment Company Act, including any subsidiarys determinations
with respect to the consistency of its assets or operations with the
requirements thereof; or whether our interests in one or more subsidiaries
constitute investment securities for purposes of the 40% test. If the SEC were
to disagree with our treatment of one or more subsidiaries as being excepted
from the Investment Company Act pursuant to Rule 3a-7, Section 3(c)(5)(C)
or Section 3(c)(9), with our determination that one or more of our other
holdings do not constitute investment securities for purposes of the 40% test,
or with our determinations as to the nature of the business in which we engage
or the manner in which we hold ourselves out, we and/or one or more of our
subsidiaries would need to adjust our operating strategies or assets in order
for us to continue to pass the 40% test or register as an investment company,
either of which could have a material adverse effect on us. Moreover, we may be
required to adjust our operating strategy and holdings, or to effect sales of
our assets in a manner that, or at a time or price at which, we would not
otherwise choose, if there are changes in the laws or rules governing our
Investment Company Act status or that of our subsidiaries, or if the SEC or its
staff provides more specific or different guidance regarding the application of
relevant provisions of, and rules under, the Investment Company Act. Such
guidance could provide additional flexibility, or it could further inhibit our
ability, or the ability of a subsidiary, to pursue a chosen operating strategy,
which could have a material adverse effect on us.
If the SEC or a court of competent jurisdiction were to find that we
were required, but failed, to register as an investment company in violation of
the Investment Company Act, we would have to cease business activities, we
would breach representations and warranties and/or be in default as to certain
of our contracts and obligations, civil or criminal actions could be brought
against us, our contracts would be unenforceable unless a court were to require
enforcement and a court could appoint a receiver to take control of us and
liquidate our business, any or all of which would have a material adverse
effect on our business.
Quantitative and Qualitative Disclosures About Market
Risk
Foreign
Currency Risks
From time to time, we may make investments that are denominated in a
foreign currency through which we may be subject to foreign currency exchange
risk.
Credit
Spread Exposure
Our investments are subject to spread risk. Our investments in floating
rate loans and securities are valued based on a market credit spread over LIBOR
and for which the value is affected by changes in the market credit spreads over
LIBOR. Our investments in fixed rate loans and securities are valued based on a
market credit spread over the rate payable on fixed rate United States
Treasuries of like maturity. Increased credit spreads, or credit spread
widening, will have an adverse impact on the value of our investments while
decreased credit spreads, or credit spread tightening, will have a positive
impact on the value of our investments.
Interest Rate Risk
Interest rate risk is defined as the sensitivity of our current and
future earnings to interest rate volatility, variability of spread
relationships, the difference in repricing intervals between our assets and
liabilities and the effect that interest rates may have on our cash flows and
the prepayment rates experienced on our investments that have embedded borrower
optionality. The objective of interest rate risk management is to achieve
earnings, preserve capital and achieve liquidity by minimizing the negative
impacts of changing interest rates, asset and liability mix, and prepayment
activity.
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Table of Contents
We are exposed to basis risk between our investments and our
borrowings. Interest rates on our floating rate investments and our variable
rate borrowings do not reset on the same day or with the same frequency and, as
a result, we are exposed to basis risk with respect to index reset frequency.
Our floating rate investments may reprice on indices that are different than
the indices that are used to price our variable rate borrowings and, as a
result, we are exposed to basis risk with respect to repricing index. The basis
risks noted above, in addition to other forms of basis risk that exist between
our investments and borrowings, may be material and could negatively impact
future net interest margins.
Interest rate risk impacts our interest income, interest expense,
prepayments, and the fair value of our investments, interest rate derivatives, and
liabilities. We manage our interest rate risk using various techniques ranging
from the purchase of floating rate investments to the use of interest rate
derivatives. The use of interest rate derivatives is a component of our
interest risk management strategy. The contractual notional balance of our
amortizing interest rate swaps was $383.3 million as of both March 31,
2010 and December 31, 2009.
Derivative
Risk
Derivative transactions, including engaging in swaps and foreign
currency transactions, are subject to certain risks. There is no guarantee that
a company can eliminate its exposure under an outstanding swap agreement by
entering into an offsetting swap agreement with the same or another party.
Also, there is a possibility of default of the other party to the transaction
or illiquidity of the derivative instrument. Furthermore, the ability to
successfully use derivative transactions depends on the ability to predict
market movements which cannot be guaranteed. As such, participation in derivative
instruments may result in greater losses as we would have to sell or purchase
an investment at inopportune times for prices other than current market prices
or may force us to hold an asset we might otherwise have sold. In addition, as
certain derivative instruments are unregulated, they are difficult to value and
are therefore susceptible to liquidity and credit risks.
Collateral posting requirements are individually negotiated between
counterparties and there is no regulatory requirement concerning the amount of
collateral that a counterparty must post to secure its obligations under
certain derivative instruments. Because they are unregulated, there is no
requirement that parties to a contract be informed in advance when a credit
default swap is sold. As a result, investors may have difficulty identifying
the party responsible for payment of their claims. If a counterpartys credit
becomes significantly impaired, multiple requests for collateral posting in a
short period of time could increase the risk that we may not receive adequate
collateral. Amounts paid by us as premiums and cash or other assets held in
margin accounts with respect to derivative instruments are not available for
investment purposes.
The following table summarizes the estimated net fair value of our
derivative instruments held at March 31, 2010 and December 31, 2009
(amounts in thousands):
|
|
As of March 31,
2010
|
|
As of December 31,
2009
|
|
|
|
Notional
|
|
Estimated
Fair Value
|
|
Notional
|
|
Estimated
Fair Value
|
|
Cash Flow Hedges:
|
|
|
|
|
|
|
|
|
|
Interest rate swaps
|
|
$
|
383,333
|
|
$
|
(48,705
|
)
|
$
|
383,333
|
|
$
|
(43,800
|
)
|
Free-Standing Derivatives:
|
|
|
|
|
|
|
|
|
|
Interest rate swaps
|
|
83,965
|
|
(641
|
)
|
89,246
|
|
(281
|
)
|
Credit default swapsprotection sold
|
|
51,000
|
|
225
|
|
51,000
|
|
(385
|
)
|
Total rate of return swaps
|
|
|
|
228
|
|
104,446
|
|
11,809
|
|
Common stock warrants
|
|
|
|
198
|
|
|
|
2,471
|
|
Total
|
|
$
|
518,298
|
|
$
|
(48,695
|
)
|
$
|
628,025
|
|
$
|
(30,186
|
)
|
For our derivatives, our credit exposure is directly with our
counterparties and continues until the maturity or termination of such contracts.
The following table sets forth the fair values of our primary derivative
investments by remaining contractual maturity as of March 31, 2010
(amounts in thousands):
|
|
Less than
1 year
|
|
1-3 years
|
|
3-5 Years
|
|
More than
5 years
|
|
Total
|
|
Cash Flow Hedges:
|
|
|
|
|
|
|
|
|
|
|
|
Interest rate swaps
|
|
$
|
|
|
$
|
|
|
$
|
|
|
$
|
(48,705
|
)
|
$
|
(48,705
|
)
|
Free-Standing Derivatives:
|
|
|
|
|
|
|
|
|
|
|
|
Interest rate swaps
|
|
(641
|
)
|
|
|
|
|
|
|
(641
|
)
|
Credit default swapsprotection sold
|
|
(69
|
)
|
294
|
|
|
|
|
|
225
|
|
Total rate of return swaps
|
|
228
|
|
|
|
|
|
|
|
228
|
|
Total
|
|
$
|
(482
|
)
|
$
|
294
|
|
$
|
|
|
$
|
(48,705
|
)
|
$
|
(48,893
|
)
|
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Table of Contents
Management Estimates
The preparation of our financial statements requires management to make
estimates and assumptions that affect the amounts reported in our consolidated
financial statements and accompanying notes. Significant estimates, assumptions
and judgments are applied in situations including the determination of our
allowance for loan losses and the valuation of certain investments. We revise
our estimates when appropriate. However, actual results could materially differ
from managements estimates.
Item 3.
Quantitative and
Qualitative Disclosures about Market Risk
See
discussion of quantitative and qualitative disclosures about market risk in Quantitative
and Qualitative Disclosures About Market Risk section of Managements Discussion
and Analysis of Financial Condition and Results of Operations.
Item 4.
Controls and Procedures
The
Companys management evaluated, with the participation of the Companys
principal executive and principal financial officer, the effectiveness of the
Companys disclosure controls and procedures (as defined in Rules 13a-15(e) and
15d-15(e) under the Securities Exchange Act of 1934, as amended (the Exchange
Act)) as of March 31, 2010. Based on their evaluation, the Companys principal
executive and principal financial officer concluded that the Companys
disclosure controls and procedures as of March 31, 2010 were designed and
were functioning effectively to provide reasonable assurance that the
information required to be disclosed by the Company in reports filed under the
Exchange Act is (i) recorded, processed, summarized, and reported within
the time periods specified in the SECs rules and forms, and (ii) accumulated
and communicated to management, including the principal executive and principal
financial officers, as appropriate, to allow timely decisions regarding
disclosure.
There
has been no change in the Companys internal control over financial reporting
(as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act)
that occurred during the three ending March 31, 2010, that has materially
affected, or is reasonably likely to materially affect, the Companys internal
control over financial reporting.
PART II.
OTHER INFORMATION
Item 1. Legal
Proceedings
We have been named as a party in various legal actions which include
the matters described below. We have denied, or believe we have a meritorious
defense and will deny liability in the significant cases pending against us
discussed below. Based on current discussion and consultation with counsel, we
believe that the resolution of these matters will not have a material impact on
our financial condition or cash flow.
On August 7, 2008, the members of our board of directors and
certain of our current and former executive officers and we were named in a
putative class action complaint filed by Charter Township of Clinton Police and
Fire Retirement System in the United States District Court for the Southern
District of New York, or the Charter Litigation. On March 13, 2009, the
lead plaintiff filed an amended complaint, which deleted as defendants the
members of our board of directors and named as defendants only our former chief
executive officer Saturnino S. Fanlo, our former chief operating officer David
A. Netjes, our current chief financial officer Jeffrey B. Van Horn and us. The
amended complaint alleges that our April 2, 2007 registration statement
and prospectus and the financial statements incorporated therein contained
material omissions in violation of Section 11 of the Securities Act,
regarding the risks and potential losses associated with our real
estate-related assets, our ability to finance our real estate-related assets
and the adequacy of our loss reserves for our real estate-related assets. The
amended complaint further alleges that, pursuant to Section 15 of the
Securities Act, Messrs. Fanlo, Netjes and Van Horn each have legal
responsibility for the alleged Section 11 violation. On April 27,
2009, the defendants filed a motion to dismiss the amended complaint for
failure to state a claim under the Securities Act.
On August 15, 2008, the members of our board of directors and our
executive officers (collectively, the Kostecka Individual Defendants) were
named in a shareholder derivative action brought by Raymond W. Kostecka, a
purported shareholder, in the Superior Court of California, County of San
Francisco (the California Derivative Action). We are named as a nominal
defendant. The complaint in the California Derivative Action asserts claims
against the Kostecka Individual Defendants for breaches of fiduciary duty,
abuse of control, gross mismanagement, waste of corporate assets, and unjust
enrichment in connection with the conduct at issue in the Charter Litigation,
including the filing of our April 2, 2007 registration statement with
alleged material misstatements and omissions. By order dated January 8,
2009, the Court approved the parties stipulation to stay the proceedings in
the California Derivative Action until the Charter Litigation is dismissed on
the pleadings or we file an answer to the Charter Litigation.
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On March 23, 2009, the members of our board
of directors and certain of our executive officers (collectively, the Haley
Individual Defendants) were named in a shareholder derivative action brought
by Paul B. Haley, a purported shareholder, in the United States District Court
for the Southern District of New York (the New York Derivative Action). We
are named as a nominal defendant. The complaint in the New York Derivative
Action asserts claims against the Haley Individual Defendants for breaches of
fiduciary duty, breaches of the duty of full disclosure, and for contribution
in connection with the conduct at issue in the Charter Litigation, including
the filing of our April 2, 2007 registration statement with alleged
material misstatements and omissions. By order dated June 18, 2009, the
Court approved the parties stipulation to stay the proceedings in the New York
Derivative Action until the Charter Litigation is dismissed on the pleadings or
we file an answer to the Charter Litigation.
Item 1A. Risk Factors
Other
than the risk factors set forth below, there have been no material changes in
our risk factors from those disclosed in our Annual Report on Form 10-K
for the year ended December 31, 2009.
Maintenance of our Investment Company Act exemption imposes
limits on our operations, which may adversely affect our results of operations.
Section 3(a)(1)(A) of
the Investment Company Act defines an investment company as any issuer that is,
holds itself out as being, or proposes to be, primarily engaged in the business
of investing, reinvesting or trading in securities and Section 3(a)(1)(C) of
the Investment Company Act defines an investment company as any issuer that is
engaged or proposes to engage in the business of investing, reinvesting,
owning, holding or trading in securities and owns or proposes to acquire
investment securities (within the meaning of the Investment Company Act)
having a value exceeding 40% of the value of the issuers total assets
(exclusive of U.S. government securities and cash items) on an unconsolidated
basis (the 40% test). Excluded from the term investment securities are,
among others, securities issued by majority-owned subsidiaries unless the
subsidiary is an investment company or relies on the exceptions from the
definition of an investment company provided by Section 3(c)(1) or Section 3(c)(7) of
the Investment Company Act (a fund). The Investment Company Act defines a
majority-owned subsidiary of a person as any company 50% or more of the
outstanding voting securities (i.e., those securities presently entitling
the holder thereof to vote for the election of directors of the company) of
which are owned by that person, or by another company that is, itself, a
majority owned subsidiary of that person.
We are organized as a holding company. We conduct our operations
primarily through our majority-owned subsidiaries. Each of our subsidiaries is
either outside of the definition of an investment company in Sections 3(a)(1)(A) and
3(a)(1)(C), described above, or excepted from the definition of an investment
company under the Investment Company Act. We believe that we are not, and that
we do not propose to be, primarily engaged in the business of investing,
reinvesting or trading in securities and we do not believe that we have held
ourselves out as such. We intend to continue to conduct our operations so that
we are not required to register as an investment company under the Investment
Company Act.
We monitor our holdings regularly to confirm our continued compliance
with the 40% test. In calculating our position under the 40% test, we are
responsible for determining whether any of our subsidiaries is majority-owned.
We treat subsidiaries in which we own at least 50% of the outstanding voting
securities, including those that issue CLOs, as majority-owned for purposes of
the 40% test. Some of our subsidiaries may rely solely on Section 3(c)(1) or
Section 3(c)(7) of the Investment Company Act. In order for us to
satisfy the 40% test, our ownership interests in those subsidiaries or any of
our subsidiaries that are not majority-owned, together with any other
investment securities that we may own, may not have a combined value in
excess of 40% of the value of our total assets on an unconsolidated basis and
exclusive of U.S. government securities and cash items. However, most of our
subsidiaries either fall outside of the general definitions of an investment
company or rely on exceptions provided by provisions of, and rules and
regulations promulgated under, the Investment Company Act (other than Section 3(c)(1) or
Section 3(c)(7) of the Investment Company Act) and, therefore, are
not defined or regulated as investment companies. In order to conform to these
exceptions, these subsidiaries are limited with respect to the assets in which
each of them can invest and/or the types of securities each of them may issue.
We must, therefore, monitor each subsidiarys compliance with its applicable
exception and our freedom of action, and that of our subsidiaries, may be
limited as a result. For example, our subsidiaries that issue CLOs generally
rely on Rule 3a-7 under Investment Company Act, while KKR Financial
Holdings II, LLC, or KFH II, our subsidiary that is taxed as a REIT for
U.S. federal income tax purposes, generally relies on Section 3(c)(5)(C) of
the Investment Company Act. Each of these exceptions requires, among other
things that the subsidiary (i) not issue redeemable securities and (ii) engage
in the business of holding certain types of assets, consistent with the terms
of the exception. Similarly, any subsidiaries engaged in the ownership of oil
and gas assets may, depending on the nature of the assets, be outside
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the
definition of an investment company or rely on exceptions provided by Section 3(c)(5)(C) or
Section 3(c)(9) of the Investment Company Act. While Section 3(c)(9) of the
Investment Company Act does not limit the nature of the securities issued, it
does impose business engagement requirements that limit the types of assets
that may be held.
We do not treat our interests in majority-owned subsidiaries that are
outside of the general definition of an investment company or that rely on Section 3(c)(5)(C) or
Section 3(c)(9) of, or Rule 3a-7 under, the Investment Company
Act as investment securities when calculating our 40% test.
We sometimes refer to our subsidiaries that rely on Rule 3a-7
under the Investment Company Act as CLO subsidiaries. Rule 3a-7 under
the Investment Company Act is available to certain structured financing
vehicles that are engaged in the business of holding financial assets that, by
their terms, convert into cash within a finite time period and that issue fixed
income securities entitling holders to receive payments that depend primarily
on the cash flows from these assets, provided that, among other things, the
structured finance vehicle does not engage in certain portfolio management
practices resembling those employed by mutual funds. Accordingly, each of these
CLO subsidiaries is subject to an indenture (or similar transaction documents)
that contains specific guidelines and restrictions limiting the discretion of
the CLO subsidiary and its collateral manager. In particular, these guidelines
and restrictions prohibit the CLO subsidiary from acquiring and disposing of
assets primarily for the purpose of recognizing gains or decreasing losses
resulting from market value changes. Thus, a CLO subsidiary cannot acquire or
dispose of assets primarily to enhance returns to the owner of the equity in
the CLO subsidiary; however, subject to this limitation, sales and purchases of
assets may be made so long as doing so does not violate guidelines contained in
the CLO subsidiarys relevant transaction documents. A CLO subsidiary generally
can, for example, sell an asset if the collateral manager believes that its
credit quality has declined since its acquisition or that the credit profile of
the obligor will deteriorate and the proceeds of permitted dispositions may be
reinvested in additional collateral, subject to fulfilling the requirements set
forth in Rule 3a-7 under the Investment Company Act and the CLO
subsidiarys relevant transaction documents. As a result of these restrictions,
our CLO subsidiaries may suffer losses on their assets and we may suffer losses
on our investments in those CLO subsidiaries.
We sometimes refer to KFH II, our subsidiary that relies on Section 3(c)(5)(C) of
the Investment Company Act, as our REIT subsidiary. Section 3(c)(5)(C) of
the Investment Company Act is available to companies that are primarily engaged
in the business of purchasing or otherwise acquiring mortgages and other liens
on and interests in real estate. While the SEC has not promulgated rules to
address precisely what is required for a company to be considered to be
primarily engaged in the business of purchasing or otherwise acquiring
mortgages and other liens on and interests in real estate, the SECs Division
of Investment Management, or the Division, has taken the position, through a
series of no-action and interpretive letters, that a company may rely on Section 3(c)(5)(C) of
the Investment Company Act if, among other things, at least 55% of the
companys assets consist of mortgage loans, other assets that are considered
the functional equivalent of mortgage loans and certain other interests in real
property
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(collectively,
qualifying real estate assets), and at least 25% of the companys assets
consist of real estate-related assets (reduced by the excess of the companys
qualifying real estate assets over the required 55%), leaving no more than 20%
of the companys assets to be invested in miscellaneous assets. The Division
has also provided guidance as to the types of assets that can be considered
qualifying real estate assets. Because the Divisions interpretive letters are
not binding except as they relate to the companies to whom they are addressed,
if the Division were to change its position as to, among other things, what
assets might constitute qualifying real estate assets our REIT subsidiary might
be required to change its investment strategy to comply with the changed
position. We cannot predict whether such a change would be adverse.
Based on current guidance, our REIT subsidiary classifies investments
in mortgage loans as qualifying real estate assets, as long as the loans are
fully secured by an interest in real estate on which we retain the right to
foreclose. That is, if the loan-to-value ratio of the loan is equal to or less
than 100%, then the mortgage loan is considered to be a qualifying real estate
asset. Mortgage loans with loan-to-value ratios in excess of 100% are
considered to be only real estate-related assets. Our REIT subsidiary considers
agency whole pool certificates to be qualifying real estate assets. Examples of
agencies that issue whole pool certificates are the Federal National Mortgage
Association, the Federal Home Loan Mortgage Corporation and the Government
National Mortgage Association. An agency whole pool certificate is a
certificate issued or guaranteed as to principal and interest by the U.S.
government or by a federally chartered entity, which represents the entire
beneficial interest in the underlying pool of mortgage loans. By contrast, an
agency certificate that represents less than the entire beneficial interest in
the underlying mortgage loans is not considered to be a qualifying real estate
asset, but is considered to be a real estate-related asset.
Most non-agency mortgage-backed securities do not constitute qualifying
real estate assets because they represent less than the entire beneficial
interest in the related pool of mortgage loans; however, based on Division
guidance, where our REIT subsidiarys investment in non-agency mortgage- backed
securities is the functional equivalent of owning the underlying mortgage
loans, our REIT subsidiary may treat those securities as qualifying real estate
assets. Moreover, investments in mortgage-backed securities that do not
constitute qualifying real estate assets will be classified as real estate-
related assets. Therefore, based upon the specific terms and circumstances
related to each non-agency mortgage-backed security that our REIT subsidiary
owns, our REIT subsidiary will make a determination of whether that security
should be classified as a qualifying real estate asset or as a real estate-
related asset; and there may be instances where a security is recharacterized
from being a qualifying real estate asset to a real estate-related asset, or
conversely, from being a real estate-related asset to being a qualifying real
estate asset based upon the acquisition or disposition or redemption of related
classes of securities from the same securitization trust. If our REIT
subsidiary acquires securities that, collectively, receive all of the principal
and interest paid on the related pool of underlying mortgage loans (less fees,
such as servicing and trustee fees, and expenses of the securitization), and
that subsidiary has foreclosure rights with respect to those mortgage loans,
then our REIT subsidiary will consider those securities, collectively, to be
qualifying real estate assets. If another entity acquires any of
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the
securities that are expected to receive cash flow from the underlying mortgage
loans, then our REIT subsidiary will consider whether it has appropriate
foreclosure rights with respect to the underlying loans and whether its
investment is a first loss position in deciding whether these securities should
be classified as qualifying real estate assets. If our REIT subsidiary owns
more than one subordinate class, then, to determine the classification of
subordinate classes other than the first loss class, our REIT subsidiary will
consider whether such classes are contiguous with the first loss class (with no
other classes absorbing losses after the first loss class and before any other
subordinate classes that our REIT subsidiary owns), whether our REIT subsidiary
owns the entire amount of each such class and whether our REIT subsidiary would
continue to have appropriate foreclosure rights in connection with each such
class if the more subordinate classes were no longer outstanding. If the
answers to any of these questions is no, then our REIT subsidiary would expect
not to classify that particular class, or classes senior to that class, as
qualifying real estate assets.
We may hold oil and gas assets through one or more subsidiaries and
would refer to those subsidiaries as our Oil and Gas Subsidiaries. Depending upon the nature of the oil and gas
assets held by an Oil and Gas Subsidiary, such Oil and Gas Subsidiary may rely
on Section 3(c)(5)(C) or Section 3(c)(9) of the Investment
Company Act or may fall outside of the general definition of an investment company. An Oil and Gas Subsidiary that does not
engage primarily, propose to engage primarily or hold itself out as engaging
primarily in the business of investing, reinvesting or trading in securities
will be outside of the general definition of an investment company provided
that it passes the 40% test. This may be
the case where an Oil and Gas Subsidiary holds a sufficient amount of oil and
gas assets constituting real estate interests together with other assets that
are not investment securities such as equipment. Oil and Gas Subsidiaries that hold oil and
gas assets that constitute real property interests, but are unable to pass the
40% test, may rely on Section 3(c)(5)(C), subject to the requirements and
restrictions described above.
Alternately, an Oil and Gas Subsidiary may rely on Section 3(c)(9) of
the Investment Company Act if substantially all of its business consists of
owning or holding oil, gas or other mineral royalties or leases, certain
fractional interests, or certificates of interest or participations in or
investment contracts relating to such royalties, leases or fractional
interests. These various restrictions
imposed on our Oil and Gas Subsidiaries by the Investment Company Act may have
the effect of limiting our freedom of action with respect to oil and gas assets
(or other assets) that may be held or acquired by such subsidiary or the manner
in which we may deal in such assets.
As noted above, if the combined values of the investment securities
issued by our subsidiaries that must rely on Section 3(c)(1) or Section 3(c)(7) of
the Investment Company Act, together with any other investment securities we
may own, exceeds 40% of the value of our total assets (exclusive of U.S.
government securities and cash items) on an unconsolidated basis, we may be
deemed to be an investment company. If we fail to maintain an exception,
exemption or other exclusion from the Investment Company Act, we could, among
other things, be required either (i) to change substantially the manner in
which we conduct our operations to avoid being subject to the Investment
Company Act or (ii) to register as an investment company. Either of these
would likely have a material adverse effect on us, our ability to service our
indebtedness and to make
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distributions
on our shares, and on the market price of our shares and any other securities
we may issue. If we were required to register as an investment company under
the Investment Company Act, we would become subject to substantial regulation
with respect to our capital structure (including our ability to use leverage),
management, operations, transactions with certain affiliated persons (within
the meaning of the Investment Company Act), portfolio composition (including
restrictions with respect to diversification and industry concentration) and
other matters. Additionally, our Manager would have the right to terminate our
management agreement. Moreover, if we were required to register as an
investment company, we would no longer be eligible to be treated as a
partnership for United States federal income tax purposes. Instead, we would be
classified as a corporation for tax purposes and would be able to avoid
corporate taxation only to the extent that we were able to elect and qualify as
a regulated investment company (RIC) under applicable tax rules. Because our
eligibility for RIC status would depend on our assets and sources of income at
the time that we were required to register as an investment company, there can
be no assurance that we would be able to qualify as a RIC. If we were to lose
partnership status and fail to qualify as a RIC, we would be taxed as a regular
corporation. See Partnership Tax Matters
Qualifying
Income Exception
.
We have not requested approval or guidance from the SEC or its staff
with respect to our Investment Company Act determinations, including, in
particular: our treatment of any subsidiary as majority-owned; the compliance
of any subsidiary with Section 3(c)(5)(C) or Section 3(c)(9) of,
or Rule 3a-7 under, the Investment Company Act, including any subsidiarys
determinations with respect to the consistency of its assets or operations with
the requirements thereof; or whether our interests in one or more subsidiaries
constitute investment securities for purposes of the 40% test. If the SEC were
to disagree with our treatment of one or more subsidiaries as being excepted
from the Investment Company Act pursuant to Rule 3a-7, Section 3(c)(5)(C) or
Section 3(c)(9), with our determination that one or more of our other
holdings do not constitute investment securities for purposes of the 40% test,
or with our determinations as to the nature of the business in which we engage
or the manner in which we hold ourselves out, we and/or one or more of our
subsidiaries would need to adjust our operating strategies or assets in order
for us to continue to pass the 40% test or register as an investment company, either
of which could have a material adverse effect on us. Moreover, we may be
required to adjust our operating strategy and holdings, or to effect sales of
our assets in a manner that, or at a time or price at which, we would not
otherwise choose, if there are changes in the laws or rules governing our
Investment Company Act status or that of our subsidiaries, or if the SEC or its
staff provides more specific or different guidance regarding the application of
relevant provisions of, and rules under, the Investment Company Act. Such
guidance could provide additional flexibility, or it could further inhibit our
ability, or the ability of a subsidiary, to pursue a chosen operating strategy,
which could have a material adverse effect on us.
If the SEC or a court of competent jurisdiction were to find that we
were required, but failed, to register as an investment company in violation of
the Investment Company Act, we would have to cease business activities, we
would breach representations and warranties and/or be in default as to certain
of our contracts and obligations, civil or criminal actions could be brought
against us, our contracts would be unenforceable unless a court were to require
enforcement and a court could appoint a receiver to take control of us and
liquidate our business, any or all of which would have a material adverse
effect on our business.
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We may make investments, such as investments in natural
resources, that would generate income
that is treated as effectively connected with respect to holders of our common
shares that are not United States persons.
We
may make investments, such as investments in natural resources, the income from
which likely would be treated as effectively connected with the conduct of a
United States trade or business with respect to holders of our shares that are
not United States persons within the meaning of Section 7701(a)(30) of
the Code. Furthermore, any notional
principal contracts that we enter into, if any, in connection with investments
in natural resources likely would generate income that would be treated as
effectively connected income with the conduct of a United States trade or
business. To the extent our income is
treated as effectively connected income, a holder who is a non-United States
person generally would be required to (i) file a United States
federal income tax return for such year reporting its allocable share, if any,
of our income or loss effectively connected with such trade or business and (ii) pay
United States federal income tax at regular United States tax rates on any such
income. Moreover, if such a holder is a corporation, it might be subject to a
United States branch profits tax on its allocable share of our effectively
connected income. In addition, distributions to such a holder would be subject
to withholding at the highest applicable tax rate to the extent of the holders
allocable share of our effectively connected income. Any amount so withheld
would be creditable against such holders United States federal income tax
liability, and such holder could claim a refund to the extent that the amount
withheld exceeded such persons United States federal income tax liability for
the taxable year. Finally, if we are engaged in a United States trade or
business, a portion of any gain recognized by an investor who is a non-United States
person on the sale or exchange of its shares may be treated for United States
federal income tax purposes as effectively connected income, and hence such
holder may be subject to United States federal income tax on the sale or
exchange.
Holders of our shares may be subject to foreign, state and local taxes
and return filing requirements as a result of investing in our shares.
In addition to United States federal income taxes, holders of our
common shares will likely be subject to other taxes, including foreign, state
and local taxes, unincorporated business taxes and estate, inheritance or
intangible taxes that are imposed by the various jurisdictions in which we
conduct business or own property. For
example, we will likely be treated as doing business in any foreign, state or
local jurisdiction in which any natural resources in which we invest are
located. As a result, our holders will
likely be required to file foreign, state and local income tax returns and pay
foreign, state and local income taxes in some or all of these various
jurisdictions. Further, holders may be
subject to penalties for failure to comply with those requirements.
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Item 2
.
Unregistered Sales of Equity Securities and
Use of Proceeds
On
January 15, 2010, our non-employee directors deferred a total of $0.1 million
in cash compensation in exchange for 9,728 shares of phantom shares pursuant to
the KKR Financial Holdings LLC Non-Employee Directors Deferred Compensation
and Share Award Plan. Each phantom share
is the economic equivalent of one of our common shares. The phantom shares
become payable, in cash or common shares, at the election of the Company, upon
the earlier of (i) the first day of January following the applicable
non-employee directors termination of service as a director or (ii) an
election date pre-selected by the applicable non-employee director, and in any
event in cash or common shares, at the election of the applicable non-employee
director, upon the occurrence of a change in control of the Company. The grants made to our non-employee directors
were exempt from the registration requirements of the Securities Act pursuant
to Section 4(2) thereof.
Item 3. Defaults
Upon Senior Securities
None.
Item 4. Submission
of Matters to a Vote of Security Holders
None.
Item 5. Other
Information
None.
Item 6. Exhibits
Exhibit
Number
|
|
Description
|
|
|
|
31.1
|
|
Chief Executive Officer
Certification
|
31.2
|
|
Chief Financial Officer
Certification
|
32
|
|
Certification Pursuant
to 18 U.S.C. Section 1350
|
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SIGNATURES
Pursuant
to the requirements of the Securities Exchange Act of 1934, KKR Financial
Holdings LLC has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
|
|
KKR Financial Holdings LLC
|
|
|
|
Signature
|
|
Title
|
|
|
|
|
|
|
/s/ WILLIAM C.
SONNEBORN
|
|
Chief Executive Officer
(Principal Executive Officer)
|
William
C. Sonneborn
|
|
|
|
|
|
|
|
|
/s/ JEFFREY B. VAN HORN
|
|
Chief Financial Officer
(Principal Financial and Accounting Officer)
|
Jeffrey
B. Van Horn
|
|
|
Date:
April 29,
2010
61
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