Item 2. Management’s
Discussion and Analysis of Financial Condition and Results of Operations
Unless
otherwise expressly stated or the context suggests otherwise, the terms “we,” “us”
and “our” refer, as of dates and for periods on and after May 4, 2007 to KKR
Financial Holdings LLC and its subsidiaries and, as of dates and for periods
prior to May 4, 2007, to our predecessor, KKR Financial Corp., and its
subsidiaries; “Manager” means KKR Financial Advisors LLC; “KKR” means Kohlberg Kravis
Roberts & Co. L.P. and its affiliated companies (excluding portfolio
companies that are minority or majority owned or managed by funds associated
with KKR); “Management Agreement” means the amended and restated management
agreement between KKR Financial Holdings LLC and the Manager. The following
management’s discussion and analysis (“MD&A”) is intended to assist the
reader in understanding our business. The MD&A is provided as a supplement
to, and should be read in conjunction with, our Condensed Consolidated
Financial Statements and accompanying notes included in this Quarterly Report
on Form 10-Q and our Consolidated Financial Statements and accompanying notes
included in our Annual Report on Form 10-K for the year ended December 31,
2006.
Forward
Looking Statements
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
and Section 21E of the Securities Exchange Act of 1934 that are based on
our current expectations, estimates and projections. Pursuant to those
sections, we may obtain a “safe harbor” for forward-looking statements by
identifying those and by accompanying those statements with cautionary
statements, which identify factors that could cause actual results to differ
from those expressed in the forward-looking statements. 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, changes in prepayment rates, general economic conditions, and other
factors not presently identified. Other factors that may impact our actual
results are discussed in our Annual Report on Form 10-K under the section
titled “Risk Factors.” 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.
Executive
Overview
We are a specialty finance company that uses leverage
with the objective of generating competitive risk-adjusted returns. We seek to
achieve our investment objective by investing in (i) corporate loans and debt
securities, (ii) marketable equity securities and (iii) non-marketable equity
securities. We also make opportunistic investments in other asset classes from
time to time. We invest in both cash and derivative instruments.
Our objective is to provide
competitive returns to our investors through a combination of distributions and
capital appreciation. As part of our investment strategy, we seek to invest
opportunistically in those asset classes that we believe can generate
competitive leveraged risk-adjusted returns, subject to maintaining our
exemption from regulation under the Investment Company Act of 1940, as amended
(the “Investment Company Act”).
Our income is generated
primarily from (i) net interest income and dividend income, (ii) realized
and unrealized gains and losses on our derivative instruments that are not
accounted for as hedges, (iii) realized gains and losses from the sales of
investments, (iv) realized and unrealized gains and losses on securities sold,
not yet purchased, and (v) fee income.
During the third quarter of
2007, there were material adverse changes in the mortgage industry and the
capital markets experienced significant disruptions which had a material
negative impact on our ability to finance our residential mortgage investments
on terms and conditions which met our return on equity requirements. Most
notably, the asset-backed commercial paper market was negatively impacted as
investors significantly reduced and to a certain extent no longer invested in
commercial paper backed by structured financial instruments, including
residential mortgage investments. The disruptions in the asset-backed
commercial paper market were exacerbated by the fact that commercial banks and
investment banks materially curtailed or discontinued providing their customers
with financing for residential mortgage investments. The secondary impact of
the lack of financing and liquidity for residential mortgage investments was
that market values of residential mortgage investments decreased materially
because traditional buyers were unable to obtain financing.
28
In response to the
aforementioned market disruptions that occurred during the quarter, we took
several steps to ensure that we had adequate liquidity to respond to the
current market environment. Specifically, we executed the following
transactions: (i) we sold $5.2 billion of residential mortgage loans and
mortgage-backed securities and recognized a loss of approximately $65.0
million, which was reduced by gains on the termination of related interest rate
hedges of approximately $28.6 million, and thereby recognized a net loss of
approximately $36.4 million; (ii) we received gross proceeds of $230.4 million
through the issuance of 16.0 million common shares at $14.40 to seven
unaffiliated institutional investors; (iii) we completed a share rights offering
which generated gross proceeds of $270.0 million ($56.6 million received in
October 2007 under a backstop agreement with certain principals of KKR through
which 3.9 million shares were issued) through the issuance of 18.75 million
shares at $14.40 per common share; (iv) we sold $139.6 million of our private
equity investments to unaffiliated third parties and recognized a net gain of
$51.6 million; and (v) we made the decision to dispose of our real estate
investment trust subsidiary, KKR Financial Corp. (“REIT Subsidiary”), and exit
the business of investing in residential mortgage investments. Accordingly, our
residential mortgage investment business and REIT Subsidiary are reported as a
discontinued operation for all periods presented and, for the three and nine
months ended September 30, 2007, we recorded charges totaling $243.7 million
relating thereto. Unless otherwise noted, information contained in our
Management Discussion and Analysis of this quarterly report relates to our
continuing operations.
We are externally managed and
advised by our Manager, an affiliate of KKR, pursuant to the Management
Agreement.
Cash Distributions to Shareholders
On
November 1, 2007, our Board of Directors declared a cash distribution for the
quarter ended September 30, 2007 on our common shares of $0.50 per common
share. The aggregate distribution amount of $57.6 million is payable on
November 29, 2007 to our common shareholders of record as of the close of
business on November 15, 2007.
Investment Portfolio
As of September 30, 2007 our investment portfolio
totaled $8.6 billion, representing an increase of 91.1% from $4.5 billion as of
December 31, 2006. As of September 30, 2007, our investment portfolio
primarily consisted of corporate loans and securities totaling $8.4 billion,
commercial real estate loans and securities totaling $145.1 million, and
marketable equity securities consisting of preferred and common stock totaling
$41.3 million. In addition, we held investments in non-marketable equity
securities totaling $20.1 million as of September 30, 2007.
Financing Transactions
On May 22, 2007, we closed KKR Financial CLO 2007-1,
Ltd. (“CLO 2007-1”), a $3.5 billion secured financing transaction. We issued
$2.4 billion of senior secured notes at par to unaffiliated investors with a
weighted-average coupon of three-month LIBOR plus 0.53% and issued $244.7
million of mezzanine notes and $186.6 million of subordinated notes to three
private investment funds (collectively, the “KKR Strategic Capital Funds”) that
are managed by an affiliate of our Manager.
During
June 2007, we issued $72.2 million of junior subordinated notes to KKR
Financial Capital Trust VI (“Trust VI”), an entity we formed for issuing
trust preferred securities and through which we received $70.0 million in gross
proceeds through Trust VI’s issuance of trust preferred securities to
unaffiliated investors. Interest is payable quarterly at a floating rate equal
to three-month LIBOR plus 2.50%.
On July 23, 2007, we issued an aggregate of $300.0
million of 7.000% convertible notes maturing on July 15, 2012 (the “Notes”) to
qualified institutional buyers. The Notes represent senior unsecured
obligations of us and bear interest at the rate of 7.000% per year. Interest is
payable semi-annually on January 15 and July 15 of each year, beginning January
15, 2008.
The Notes are convertible into our common shares,
initially at a conversion rate of 31.08 shares per $1,000 principal of Notes,
which is equivalent to an initial conversion price of $32.175 per common share.
The Notes are convertible prior to the maturity date at any time on or after
June 15, 2012 and also under the following circumstances: (i) a holder may
surrender any of its Notes for conversion during any calendar quarter beginning
after September 30, 2007 (and only during such calendar quarter) if, and only
if, the closing sale price of our common shares for at least 20 trading days
(whether or not consecutive) in the period of 30 consecutive trading days
ending on the last trading day of the preceding calendar quarter is greater
than 130% of the conversion price per common share in effect on the applicable
trading day; (ii) a holder may
29
surrender any of its Notes for conversion during the
five consecutive trading-day period following any five consecutive trading-day
period in which the trading price of the Notes was less than 98% of the product
of the closing sale price of our common shares multiplied by the applicable
conversion rate; (iii) a holder may surrender for conversion any of its Notes
if those Notes have been called for redemption, at any time prior to the
redemption date, even if the Notes are not otherwise convertible at such time;
and (iv) a holder may surrender any of its Notes for conversion if we engage in
certain specified transactions, as defined in the indenture covering the Notes.
In connection with the aforementioned common share
rights offering during the third quarter, we adjusted the conversion rate for
our Notes pursuant to the governing indenture for the Notes. The new conversion
price for the Notes is approximately $31.00 and was effective September 21,
2007. The new conversion rate for each $1,000 principal amount of Notes is
32.2581 of our common shares.
Critical Accounting Policies
Our consolidated financial statements are prepared by
management in conformity with accounting principles generally accepted in the
United States of America (“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.
Revenue
Recognition
We account for interest income on our investments
using the effective yield method. For investments purchased at par, the
effective yield is the contractual coupon rate on the investment. Unamortized
premiums and unaccreted discounts on non-residential mortgage-backed securities
are recognized in interest income over the contractual life, adjusted for
actual prepayments, of the securities using the effective interest method. For
securities representing beneficial interests in securitizations that are not
highly rated (i.e., subordinated tranches of residential mortgage-backed
securities, which are currently presented as discontinued operations for
financial statement purposes), unamortized premiums and unaccreted discounts
are recognized over the contractual life, adjusted for estimated prepayments and
estimated credit losses of the securities using the effective interest method.
Actual prepayment and credit loss experience is reviewed quarterly and
effective yields are recalculated when differences arise between prepayments
and credit losses originally anticipated compared to amounts actually received
plus anticipated future prepayments.
Interest income on loans includes interest at stated
coupon rates adjusted for accretion of purchase discounts and amortization of
purchase premiums. For corporate and commercial real estate loans, 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.
As of September 30, 2007, unamortized purchase
premiums and unaccreted purchase discounts on our investment portfolio totaled
$0.7 million and $82.8 million, respectively.
Upon adoption of SFAS No.
159,
The Fair Value Option for Financial Assets and
Financial Liabilities—Including an amendment of FASB Statement No. 115
(“SFAS No. 159”) as of January 1, 2007 as disclosed below under “Recent
Accounting Pronouncements”, we carry our investments in residential
mortgage-backed securities and residential mortgage loans, which are currently
presented as discontinued operations for financial statement purposes, at fair
value with changes in fair value recorded in loss (income) from discontinued
operations.
Share-Based
Compensation
We account for share-based compensation issued to
members of our Board of Directors and our Manager using the fair value based
methodology in accordance with SFAS No. 123(R),
Share-Based Payment
(“SFAS No. 123(R)”). 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
30
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 that the restricted common shares and/or common share options 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 shares and common share options that we granted to our
Manager using the graded vesting attribution method in accordance with SFAS No.
123(R).
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 and nine months ended
September 30, 2007, share-based compensation (benefit) expense totaled $(4.4)
million and $2.3 million, respectively. As of September 30, 2007, substantially
all of the non-vested common share options and restricted common shares issued
that are subject to SFAS No. 123(R) are subject to remeasurement. As
of September 30, 2007, a $1 increase in the price of our common shares
would have increased our future share-based compensation expense by approximately
$0.2 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 September 30, 2007, future
unamortized share-based compensation totaled $3.7 million, of which
$1.1 million, $2.4 million and $0.2 million will be recognized in 2007,
2008 and beyond, respectively.
Accounting for
Derivative Instruments and Hedging Activities
We recognize all derivatives on our condensed
consolidated balance sheet 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: (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 and, to the extent
that it is effective, changes in the fair value of the hedged asset or
liability attributable to the hedged risk, 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 (loss) income. We subsequently
reclassify these changes in estimated fair value to net income in the same
period(s) that the hedged transaction affects earnings in the same
financial statement category as the hedged item. For free-standing derivatives,
we report changes in the fair values in current period other 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, as required by SFAS No. 133,
Accounting for Derivative Instruments and Hedging
Activities
, as amended and interpreted (“SFAS No. 133”), we
also formally assesses whether the derivative we 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 immediately affect
periodic earnings, 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
September 30, 2007, the estimated fair value of our derivatives that are
accounted for as hedges totaled $(3.4) million.
Impairments
We evaluate our investment portfolio for impairment as
of each quarter end or more frequently if we become aware of any material
information that would lead us to believe that an investment may be impaired.
We evaluate whether the investment is considered impaired and whether the
impairment is other-than-temporary. If we make a determination that the
impairment is other-than-temporary, we recognize an impairment loss equal to
the difference between the amortized cost
31
basis and the estimated fair value of the investment.
We consider many factors in determining whether the impairment of an investment
is 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,
the amount of the loss, our intent and our financial ability to hold the
investment for a period of time sufficient for a recovery in its estimated fair
value, recent events specific to the issuer or industry, external credit
ratings and recent downgrades in such ratings.
Recent Accounting
Pronouncements
In February 2006, the FASB issued SFAS
No. 155,
Accounting for Certain Hybrid Financial
Instruments
(“SFAS No. 155”). Key provisions of SFAS
No. 155 include: (1) a broad fair value measurement option for
certain hybrid financial instruments that contain an embedded derivative that
would otherwise require bifurcation; (2) clarification that only the
simplest separations of interest payments and principal payments qualify for
the exception afforded to interest-only strips and principal-only strips from
derivative accounting under paragraph 14 of SFAS No. 133
,
thereby narrowing such exception; (3) a requirement
that beneficial interests in securitized financial assets be analyzed to
determine whether they are freestanding derivatives or whether they are hybrid
instruments that contain embedded derivatives requiring bifurcation;
(4) clarification that concentrations of credit risk in the form of
subordination are not embedded derivatives; and (5) elimination of the
prohibition on a QSPE holding passive derivative financial instruments that
pertain to beneficial interests that are or contain a derivative financial
instrument. In general, these changes will reduce the operational complexity
associated with bifurcating embedded derivatives, and increase the number of
beneficial interests in securitization transactions, including interest-only
strips and principal-only strips, required to be accounted for in accordance
with SFAS No. 133. We adopted SFAS No. 155 as of the beginning of 2007 and
the adoption of SFAS No. 155 did not have a material impact on our condensed
consolidated financial statements.
In June 2006, the FASB issued Interpretation
No. 48,
Accounting for Uncertainty in Income
Taxes—an interpretation of FASB Statement No. 109
(“FIN 48”).
FIN 48 clarifies the accounting for uncertainty in income taxes recognized in
an enterprise’s financial statements in accordance with FASB Statement
No. 109,
Accounting for Income Taxes
. FIN
48 prescribes a recognition threshold and measurement attribute for the
financial statement recognition and measurement of a tax position taken or
expected to be taken in a tax return. We adopted FIN 48 as of the beginning of
2007 and the adoption of FIN 48 did not have a material impact on our
condensed consolidated financial statements.
In June 2007, the
American Institute of Certified Public Accountants (AICPA) issued Statement of Position (SOP)
07-1,
Clarification of the Scope of the Audit and
Accounting Guide
Investment Companies
and
Accounting for Parent Companies and Equity Method Investors for Investments in
Investment Companies.
This SOP provides guidance for determining
whether an entity is within the scope of the AICPA Audit and Accounting Guide
Investment Companies
(the “Guide”). Entities that are within
the scope of the Guide are required, among other things, to carry their
investments at fair value, with changes in fair value included in earnings. In
October 2007, the effective date of SOP 07-1 was indefinitely deferred. The
Company is currently evaluating this new guidance and has not determined
whether it will be required to apply the provisions of the Guide in presenting
its financial statements.
On July 25, 2007, the
FASB authorized a proposed FASB Staff Position (the “proposed FSP”) that, if
approved for issuance by the FASB, will affect the accounting for the Notes.
The proposed FSP will require that the initial debt proceeds be allocated
between a liability component and an equity component. The resulting debt
discount would be amortized over the period the debt is expected to be
outstanding as additional interest expense. The proposed FSP is expected to be
effective for fiscal years beginning after December 15, 2007 and would require
retrospective application. We are currently evaluating the impact of adopting
proposed FSP.
In September 2006, the FASB issued SFAS
No. 157,
Fair Value Measurements
(“SFAS
No. 157”). This statement defines fair value, establishes a framework for
measuring fair value in GAAP and expands disclosures about fair value
measurements. SFAS No. 157 does not require any new fair value
measurements. We adopted SFAS No. 157 as of the beginning of 2007 and the
adoption of SFAS No. 157 did not have a material impact on the manner in
which the Company measures the fair value of its financial instruments, but did
result in certain additional disclosures.
In February 2007, FASB issued SFAS No. 159.
This statement permits entities to choose to measure many financial instruments
and certain other items at fair value (i.e., the fair value option). The
election to use the fair value option is available when an entity first
recognizes a financial asset or financial liability or upon entering into a
firm commitment. Subsequent changes in fair value must be recorded in earnings.
Additionally, SFAS No. 159 allows for a one-time election for existing
positions upon adoption, with the transition adjustment recorded to beginning
retained earnings.
We adopted SFAS No. 159 as of January 1, 2007 and
elected to apply the fair value option for our investments in residential
mortgage loans and residential mortgage-backed securities, which are currently
reflected as discontinued operations for financial statement purposes.
Additionally, we intend to consistently apply the election of the fair value
option to any future residential mortgage investments. We have elected the fair
value option for our residential mortgage investments for the purpose of
enhancing the transparency of our financial condition as fair value is
consistent with how we
32
manages the risks of our residential mortgage
investments. The transition adjustment to beginning accumulated deficit that
was recorded as of January 1, 2007 due to the adoption of SFAS No. 159 was a
loss of $55.7 million. The following table presents information about the
eligible instruments for which the Company elected the fair value option and
for which transition adjustments were recorded as of January 1, 2007 (amounts
in thousands):
|
|
|
Carrying Value at
January 1, 2007
|
|
Transition Adjustment to
Accumulated Deficit
Gain/(Loss)
|
|
Carrying Value at
January 1, 2007
(After Adoption of
SFAS No. 159)
|
|
|
Residential
mortgage loans
|
|
$
|
5,109,261
|
|
$
|
(35,653
|
)
|
$
|
5,073,608
|
|
|
Allowance for
loan losses
|
|
(1,500
|
)
|
1,500
|
|
—
|
|
|
Residential
mortgage-backed securities (1)
|
|
7,536,196
|
|
(21,575
|
)
|
7,536,196
|
|
|
Cumulative
effect of the adoption of the fair value option
|
|
|
|
$
|
(55,728
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(1)
Prior
to January 1, 2007, residential mortgage-backed securities were classified as
available-for-sale and carried at fair value. Accordingly, the election of the
fair value option for mortgage-backed securities did not change their carrying
value and resulted in a reclassification from accumulated other comprehensive
(loss) income to beginning accumulated deficit.
Results of Operations
Three
and nine months ended September 30, 2007 compared to three and nine months
ended September 30, 2006
Summary
Our net loss for the three and nine months ended
September 30, 2007 totaled $261.5 million (or $2.98 per diluted common share)
and $160.1 million (or $1.93 per diluted common share), respectively, as
compared to net income of $32.6 million (or $0.40 per diluted common share) and
$97.9 million (or $1.22 per diluted common share) for the three and nine months
ended September 30, 2006, respectively.
33
Net Investment Income
The following table presents the components of our net
investment income for the three and nine months ended September 30, 2007 and
2006:
Comparative
Net Investment Income Components
(Amounts in thousands)
|
|
|
For the three
months ended
September 30,
2007
|
|
For the three
months ended
September 30,
2006
|
|
For the nine
months ended
September 30,
2007
|
|
For the nine
months ended
September 30,
2006
|
|
|
Investment
Income:
|
|
|
|
|
|
|
|
|
|
|
Corporate loans
and securities interest income
|
|
$
|
160,922
|
|
$
|
80,298
|
|
$
|
348,587
|
|
$
|
192,223
|
|
|
Commercial real
estate loans and securities interest income
|
|
3,407
|
|
7,518
|
|
9,718
|
|
23,045
|
|
|
Other interest
income
|
|
11,850
|
|
2,638
|
|
20,101
|
|
5,928
|
|
|
Common and
preferred stock dividend income
|
|
782
|
|
945
|
|
2,722
|
|
2,740
|
|
|
Net discount
accretion
|
|
2,400
|
|
1,209
|
|
4,990
|
|
4,309
|
|
|
Total investment
income
|
|
179,361
|
|
92,608
|
|
386,118
|
|
228,245
|
|
|
Interest
Expense:
|
|
|
|
|
|
|
|
|
|
|
Repurchase
agreements
|
|
22,927
|
|
21,701
|
|
52,193
|
|
46,488
|
|
|
Collateralized
loan obligation senior secured notes
|
|
69,250
|
|
23,498
|
|
149,404
|
|
61,883
|
|
|
Secured
revolving credit facility
|
|
3,190
|
|
3,303
|
|
6,580
|
|
6,172
|
|
|
Secured demand
loan
|
|
513
|
|
615
|
|
1,728
|
|
1,692
|
|
|
Convertible
senior notes
|
|
4,183
|
|
—
|
|
4,183
|
|
—
|
|
|
Junior
subordinated notes
|
|
6,481
|
|
3,109
|
|
16,502
|
|
4,477
|
|
|
Other interest
expense
|
|
768
|
|
1,358
|
|
2,034
|
|
2,631
|
|
|
Interest rate
swap
|
|
(285
|
)
|
(26
|
)
|
(476
|
)
|
(25
|
)
|
|
Total interest
expense
|
|
107,027
|
|
53,558
|
|
232,148
|
|
123,318
|
|
|
Interest expense
to affiliates
|
|
21,148
|
|
—
|
|
29,404
|
|
—
|
|
|
Provision for
loan losses
|
|
25,000
|
|
—
|
|
25,000
|
|
—
|
|
|
Net investment
income
|
|
$
|
26,186
|
|
$
|
39,050
|
|
$
|
99,566
|
|
$
|
104,927
|
|
As presented in the table above, our net investment
income decreased by $12.9 million and $5.4 million for the three and nine
months ended September 30, 2007 compared to the three and nine months ended
September 30, 2006. Net investment income in the table above does not include
equity in income of unconsolidated affiliate of nil and $12.7 million for the
three and nine months ended September 30, 2007, respectively. Equity in income
of unconsolidated affiliate totaled $0.1 million for each of the three and nine
month periods ended September 30, 2006. Equity in income of unconsolidated
affiliate reflects our pro rata interest in the net income of a limited partnership
that was formed to hold the subordinated interests in three entities formed to
execute secured financing transactions in the form of collateralized loan
obligations (“CLOs”). On May 22, 2007, we closed CLO 2007-1 which includes the
three entities previously held by our unconsolidated affiliate. We hold the
majority of the economic returns of CLO 2007-1, and therefore consolidate this
entity under GAAP because we are the primary beneficiary. Additionally, we hold
the majority of the economic returns of KKR Financial CLO 2007-4, Ltd. (“CLO
2007-4”) and KKR Financial CLO 2008-1, Ltd. (“CLO 2008-1”), which are two
additional structured finance vehicles that were formed to execute CLO
transactions. As we are the primary beneficiary of these entities, we consolidate
them in accordance with GAAP. The minority economic interest in the returns of
CLO 2007-1, CLO 2007-4 and CLO 2008-1 are owned by KKR Strategic Capital Funds.
Interest expense to affiliates represents the net returns generated by CLO
2007-1, CLO 2007-4 and CLO 2008-1 that are attributable to the KKR Strategic
Capital Funds.
Included in net investment income for the three and
nine months ended September 30, 2007 is a provision for loan losses of $25.0
million related to our corporate loan portfolio. This provision is for losses
that we have estimated as being probable, but unrealized, in our corporate loan
portfolio as of September 30, 2007.
34
Other Income
The following table presents the components of our
other income for the three and nine months ended September 30, 2007 and
September 30, 2006:
Comparative
Other Income Components
(Amounts in thousands)
|
|
|
For the three
months ended
September 30,
2007
|
|
For the three
months ended
September 30,
2006
|
|
For the nine
months ended
September 30,
2007
|
|
For the nine
months ended
September 30,
2006
|
|
|
Net realized and
unrealized (loss) gain on derivatives and foreign exchange:
|
|
|
|
|
|
|
|
|
|
|
Interest rate
swaptions
|
|
$
|
15
|
|
$
|
(113
|
)
|
$
|
15
|
|
$
|
(55
|
)
|
|
Interest rate
swaps
|
|
(822
|
)
|
(152
|
)
|
(822
|
)
|
—
|
|
|
Credit default
swaps
|
|
1,424
|
|
(460
|
)
|
2,397
|
|
(384
|
)
|
|
Total rate of
return swaps
|
|
(16,834
|
)
|
1,222
|
|
(4,465
|
)
|
2,929
|
|
|
Common stock
warrants
|
|
145
|
|
—
|
|
432
|
|
—
|
|
|
Foreign exchange
translation
|
|
31
|
|
(140
|
)
|
21
|
|
1,176
|
|
|
Total realized
and unrealized (loss) gain on derivatives and foreign exchange
|
|
(16,041
|
)
|
357
|
|
(2,422
|
)
|
3,666
|
|
|
Net realized
gain on investments
|
|
53,400
|
|
2,781
|
|
87,164
|
|
4,922
|
|
|
Net realized and
unrealized gain on securities sold, not yet purchased
|
|
2,220
|
|
—
|
|
2,795
|
|
52
|
|
|
Other income
|
|
2,759
|
|
2,270
|
|
7,347
|
|
2,890
|
|
|
Total other
income
|
|
$
|
42,338
|
|
$
|
5,408
|
|
$
|
94,884
|
|
$
|
11,530
|
|
As presented in the table above, other income totaled
$42.3 million and $94.9 million for the three and nine months ended
September 30, 2007, respectively, as compared to $5.4 million and $11.5 million
for the three and nine months ended September 30, 2006, respectively. The
increase in total other income is primarily attributable to approximately $51.6
million of net realized gains on the sale of seven private equity investments,
partially offset by unrealized losses related to total rate of return swaps.
Non-Investment Expenses
The following table presents the components of our
non-investment expenses for the three and nine months ended September 30, 2007
and September 30, 2006:
Comparative
Non-Investment Expense Components
(Amounts in thousands)
|
|
|
For the three
months ended
September 30,
2007
|
|
For the three
months ended
September 30,
2006
|
|
For the nine
months ended
September 30,
2007
|
|
For the nine
months ended
September 30,
2006
|
|
|
Related party
management compensation:
|
|
|
|
|
|
|
|
|
|
|
Base management
fees
|
|
$
|
8,229
|
|
$
|
7,218
|
|
$
|
22,502
|
|
$
|
21,591
|
|
|
Incentive fee
|
|
—
|
|
2,498
|
|
12,620
|
|
4,766
|
|
|
Share-based
compensation
|
|
(4,581
|
)
|
10,043
|
|
1,897
|
|
21,620
|
|
|
CLO management fees
|
|
1,277
|
|
—
|
|
2,319
|
|
—
|
|
|
Related party
management compensation
|
|
4,925
|
|
19,759
|
|
39,338
|
|
47,977
|
|
|
General,
administrative and directors expenses
|
|
3,842
|
|
3,304
|
|
14,094
|
|
8,664
|
|
|
Professional
services
|
|
2,195
|
|
1,095
|
|
3,495
|
|
2,584
|
|
|
Total non-investment
expenses
|
|
$
|
10,962
|
|
$
|
24,158
|
|
$
|
56,927
|
|
$
|
59,225
|
|
As presented in the table above, our non-investment
expenses decreased by $13.2 million and $2.3 million for the three and nine
months ended September 30, 2007, respectively, compared to the three months and
nine months ended September 30, 2006. 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 management fees, CLO 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
35
Agreement. Our Manager is also entitled to an
incentive fee provided that our quarterly “net income,” as defined in the
Management Agreement, before the incentive fee exceeds a defined return hurdle.
General, administrative and directors expenses consist
of 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. The decrease in
non-investment expense is primarily due to a decrease in share-based
compensation related to the vesting of restricted common shares granted to our
Manager in the three and nine months ending September 30, 2007 compared to the
three and nine months ending September 30, 2006.
Income Tax Provision
We
are no longer treated as a
real-estate investment trust (“REIT”) for U.S. federal income tax purposes;
however, we intend to be treated as a partnership, and not as an association or
publicly traded partnership that is taxable as a corporation, for U.S. federal
income tax purposes. Therefore, we are not subject to U.S. federal income tax
at the entity-level, but are subject to limited state income taxes. Holders of
our shares will be 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.
The REIT Subsidiary, which is presented as a
discontinued operation for financial statement purposes, elected to be taxed as
a REIT and we believe that it has complied with the provisions of the Code with
respect thereto. Accordingly, the REIT subsidiary is not subject to federal
income tax to the extent that its distributions to us satisfy the REIT
requirements and certain asset, income and ownership tests, and recordkeeping
requirements are fulfilled.
KKR TRS Holdings Inc. (“TRS Inc.”), our domestic
taxable corporate subsidiary, is taxed as a regular subchapter C corporation
under the provisions of the Code. TRS Inc. was formed to make, from time to
time, certain investments that would not be REIT qualifying investments if made
directly by us, and to earn income that would not be REIT qualifying income if
earned directly by us. For the three and nine months ending September 30, 2007,
TRS Inc. had pre-tax net (loss) income of $(1.0) million and $1.1 million,
respectively, and for the three and nine months ending September 30, 2007, the
provision for income taxes totaled $(0.5) million and $0.4 million,
respectively. As of September 30, 2007, TRS Inc. had a net income tax
receivable of $1.2 million and a deferred tax liability of $0.2 million.
KKR Financial CLO 2005-1, Ltd., KKR Financial CLO
2005-2, Ltd., KKR Financial CLO 2006-1 Ltd., CLO 2007-1, CLO 2007-4, and CLO
2008-1 are foreign taxable corporate subsidiaries that were established to
facilitate securitization transactions, structured as secured financing
transactions, and KKR TRS Holdings, Ltd., is a foreign taxable corporate
subsidiary that was formed to make from time to time, certain foreign
investments. They are organized as exempted companies incorporated with limited
liability under the laws of the Cayman Islands, and are generally exempt from
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. Therefore, despite their status as taxable
corporate subsidiaries, they generally will not be subject to corporate income
tax in our financial statements on their earnings, and no provisions for income
taxes for the three and nine months ending September 30, 2007 were recorded;
however, we are generally required to include their current taxable income in
our calculation of taxable income allocable to shareholders.
Financial
Condition
Summary
The tables below summarize the carrying value,
amortized cost, and estimated fair value of our investment portfolio as of
September 30, 2007 and December 31, 2006, classified by interest rate type.
Carrying value is the value that investments are recorded at on our condensed
consolidated balance sheets and is estimated fair value for securities, amortized
cost for corporate and commercial real estate loans held for investment and the
lower of amortized cost or estimated fair value for loans held for sale.
Estimated fair values set forth in the tables below are based on dealer quotes
and/or nationally recognized pricing services.
36
The table below summarizes our investment portfolio as
of September 30, 2007 classified by interest rate type:
Investment
Portfolio
(Dollar amounts in thousands)
|
|
|
Carrying Value
|
|
Amortized Cost
|
|
Estimated
Fair Value
|
|
Portfolio Mix %
by Fair Value
|
|
|
Floating
Rate:
|
|
|
|
|
|
|
|
|
|
|
Corporate Loans
|
|
$
|
6,820,571
|
|
$
|
6,820,571
|
|
$
|
6,689,048
|
|
79.3
|
%
|
|
Corporate Debt
Securities
|
|
220,974
|
|
234,776
|
|
220,974
|
|
2.6
|
|
|
Commercial Real
Estate Loans
|
|
114,248
|
|
114,248
|
|
112,963
|
|
1.3
|
|
|
Total Floating Rate
|
|
7,155,793
|
|
7,169,595
|
|
7,022,985
|
|
83.2
|
|
|
Fixed
Rate:
|
|
|
|
|
|
|
|
|
|
|
Corporate Loans
|
|
164,912
|
|
164,912
|
|
163,548
|
|
1.9
|
|
|
Corporate Debt
Securities
|
|
1,160,391
|
|
1,210,314
|
|
1,160,391
|
|
13.8
|
|
|
Commercial Real
Estate Debt Securities
|
|
30,882
|
|
32,000
|
|
30,882
|
|
0.4
|
|
|
Total Fixed Rate
|
|
1,356,185
|
|
1,407,226
|
|
1,354,821
|
|
16.1
|
|
|
Marketable
and Non-Marketable Equity Securities:
|
|
|
|
|
|
|
|
|
|
|
Common and
Preferred Stock
|
|
41,315
|
|
45,821
|
|
41,315
|
|
0.5
|
|
|
Non-Marketable
Equity Securities
|
|
20,084
|
|
20,084
|
|
20,084
|
|
0.2
|
|
|
Total Marketable
and Non-Marketable Equity Securities
|
|
61,399
|
|
65,905
|
|
61,399
|
|
0.7
|
|
|
Total (1)
|
|
$
|
8,573,377
|
|
$
|
8,642,726
|
|
$
|
8,439,205
|
|
100.0
|
%
|
(1) Total carrying value excludes allowance
for loan losses of $25.0 million.
The schedule above excludes equity securities sold,
not yet purchased, with an amortized cost of $67.2 million as of September 30,
2007 and for which the Company had accumulated net unrealized losses of $2.5
million.
The table below summarizes our investment portfolio as
of December 31, 2006, classified by interest rate type:
Investment
Portfolio
(Dollar amounts in thousands)
|
|
|
Carrying Value
|
|
Amortized Cost
|
|
Estimated
Fair Value
|
|
Portfolio Mix %
by Fair Value
|
|
|
Floating
Rate:
|
|
|
|
|
|
|
|
|
|
|
Corporate Loans
|
|
$
|
3,200,567
|
|
$
|
3,200,567
|
|
$
|
3,221,334
|
|
71.8
|
%
|
|
Corporate Debt
Securities
|
|
357,696
|
|
344,650
|
|
357,696
|
|
8.0
|
|
|
Commercial Real
Estate Loans
|
|
108,693
|
|
108,693
|
|
109,192
|
|
2.4
|
|
|
Total Floating
Rate
|
|
3,666,956
|
|
3,653,910
|
|
3,688,222
|
|
82.2
|
|
|
Fixed
Rate:
|
|
|
|
|
|
|
|
|
|
|
Corporate Loans
|
|
25,000
|
|
25,000
|
|
25,000
|
|
0.6
|
|
|
Corporate Debt
Securities
|
|
505,753
|
|
486,321
|
|
505,753
|
|
11.3
|
|
|
Commercial Real
Estate Debt Securities
|
|
32,023
|
|
32,000
|
|
32,023
|
|
0.7
|
|
|
Total Fixed Rate
|
|
562,776
|
|
543,321
|
|
562,776
|
|
12.6
|
|
|
Marketable
and Non-Marketable Equity Securities:
|
|
|
|
|
|
|
|
|
|
|
Common and
Preferred Stock
|
|
68,968
|
|
68,113
|
|
68,968
|
|
1.5
|
|
|
Non-Marketable
Equity Securities
|
|
166,323
|
|
166,323
|
|
166,323
|
|
3.7
|
|
|
Total Marketable
and Non-Marketable Equity Securities
|
|
235,291
|
|
234,436
|
|
235,291
|
|
5.2
|
|
|
Total
|
|
$
|
4,465,023
|
|
$
|
4,431,667
|
|
$
|
4,486,289
|
|
100.0
|
%
|
37
Asset
Quality
Asset Quality Review
We evaluate and monitor the asset quality of our
investment portfolio by performing detailed credit reviews and by monitoring
key credit statistics and trends. We monitor the credit rating of our
investment portfolio through the use of both Moody’s Investor Services, Inc. (“Moody’s”)
and Standard & Poor’s Ratings Service (“Standard & Poor’s”)
ratings, and Moody’s weighted average rating factor, or WARF. WARF is the
quantitative equivalent of Moody’s traditional rating categories (e.g., Ba1,
Ba2, etc.) and is used by Moody’s in its credit enhancement calculations for
securitization transactions. By monitoring both Moody’s and Standard &
Poor’s ratings and Moody’s WARF we can monitor trends and changes in the credit
ratings of our investment portfolio.
Investment Securities
The following table summarizes the par value of our
debt investment securities portfolio by investment class stratified by Moody’s
and Standard & Poor’s ratings category as of September 30, 2007:
Investment
Securities
(Amounts in thousands)
|
Ratings Category
|
|
Corporate
Debt
Securities
|
|
Commercial
Real Estate Debt
Securities
|
|
Total
|
|
|
Aaa/AAA
|
|
$
|
—
|
|
$
|
—
|
|
$
|
—
|
|
|
Aa1/AA+ through
Aa3/AA-
|
|
—
|
|
—
|
|
—
|
|
|
A1/A+ through
A3/A-
|
|
—
|
|
—
|
|
—
|
|
|
Baa1/BBB+
through Baa3/BBB-
|
|
—
|
|
—
|
|
—
|
|
|
Ba1/BB+ through
Ba3/BB-
|
|
204,500
|
|
32,000
|
|
236,500
|
|
|
B1/B+ through
B3/B-
|
|
449,065
|
|
—
|
|
449,065
|
|
|
Caa1/CCC+ and
lower
|
|
778,500
|
|
—
|
|
778,500
|
|
|
Non-Rated
|
|
36,681
|
|
—
|
|
36,681
|
|
|
Total
|
|
$
|
1,468,746
|
|
$
|
32,000
|
|
$
|
1,500,746
|
|
The following table summarizes the par value of our
debt investment securities portfolio by investment class stratified by Moody’s
and Standard & Poor’s ratings category as of December 31, 2006:
Investment
Securities
(Amounts in thousands)
|
Ratings Category
|
|
Corporate
Debt
Securities
|
|
Commercial
Real Estate Debt
Securities
|
|
Total
|
|
|
Aaa/AAA
|
|
$
|
—
|
|
$
|
—
|
|
$
|
—
|
|
|
Aa1/AA+ through
Aa3/AA-
|
|
—
|
|
—
|
|
—
|
|
|
A1/A+ through A3/A-
|
|
—
|
|
—
|
|
—
|
|
|
Baa1/BBB+
through Baa3/BBB-
|
|
21,071
|
|
18,000
|
|
39,071
|
|
|
Ba1/BB+ through
Ba3/BB-
|
|
160,500
|
|
14,000
|
|
174,500
|
|
|
B1/B+ through
B3/B-
|
|
370,315
|
|
—
|
|
370,315
|
|
|
Caa1/CCC+ and
lower
|
|
208,505
|
|
—
|
|
208,505
|
|
|
Non-Rated
|
|
86,500
|
|
—
|
|
86,500
|
|
|
Total
|
|
$
|
846,891
|
|
$
|
32,000
|
|
$
|
878,891
|
|
Loans
Our corporate loan portfolio totaled $7.0 billion as
of September 30, 2007 and $3.2 billion as of December 31, 2006. Our
corporate loan portfolio consists of debt obligations of corporations,
partnerships and other entities in the form of first and second lien loans,
mezzanine loans and bridge loans.
We performed an allowance for loan losses analysis as
of September 30, 2007 and December 31, 2006, and we have made the
determination that an allowance for loan losses of $25.0 million and nil was
required for our corporate loan portfolio as of September 30, 2007 and
December 31, 2006, respectively.
38
The following table summarizes the par value of our
corporate loan portfolio stratified by Moody’s and Standard & Poor’s
ratings category as of September 30, 2007 and December 31, 2006:
Corporate
Loans
(Amounts in thousands)
|
Ratings Category
|
|
As of
September 30, 2007
|
|
As of
December 31, 2006
|
|
|
Aaa/AAA
|
|
$
|
—
|
|
$
|
—
|
|
|
Aa1/AA+ through
Aa3/AA-
|
|
—
|
|
—
|
|
|
A1/A+ through
A3/A-
|
|
—
|
|
—
|
|
|
Baa1/BBB+
through Baa3/BBB-
|
|
63,246
|
|
77,326
|
|
|
Ba1/BB+ through
Ba3/BB-
|
|
3,487,761
|
|
1,764,598
|
|
|
B1/B+ through
B3/B-
|
|
2,620,959
|
|
1,153,856
|
|
|
Caa1/CCC+ and
lower
|
|
373,284
|
|
93,340
|
|
|
Non-Rated
|
|
498,630
|
|
143,294
|
|
|
Total
|
|
$
|
7,043,880
|
|
$
|
3,232,414
|
|
Our commercial real estate loan portfolio totaled
$114.2 million and $108.7 million as of September 30, 2007 and
December 31, 2006, respectively.
We performed an allowance for loan losses analysis as
of September 30, 2007 and December 31, 2006, and we have made the
determination that no allowance for loan losses was required for our commercial
real estate loan portfolio as of September 30, 2007 and December 31, 2006.
The following table summarizes the par value of our
commercial real estate loan portfolio stratified by Moody’s and
Standard & Poor’s ratings category as of September 30, 2007 and
December 31, 2006:
Commercial Real
Estate Loans
(Amounts in thousands)
|
Ratings Category
|
|
As of
September 30, 2007
|
|
As of
December 31, 2006
|
|
|
Aaa/AAA
|
|
$
|
—
|
|
$
|
—
|
|
|
Aa1/AA+ through
Aa3/AA-
|
|
—
|
|
—
|
|
|
A1/A+ through
A3/A-
|
|
—
|
|
—
|
|
|
Baa1/BBB+
through Baa3/BBB-
|
|
—
|
|
—
|
|
|
Ba1/BB+ through
Ba3/BB-
|
|
15,000
|
|
2,908
|
|
|
B1/B+ through
B3/B-
|
|
99,341
|
|
90,882
|
|
|
Caa1/CCC+ and
lower
|
|
—
|
|
—
|
|
|
Non-Rated
|
|
—
|
|
15,000
|
|
|
Total
|
|
$
|
114,341
|
|
$
|
108,790
|
|
39
Asset
Repricing Characteristics
Summary
The table below summarizes the repricing
characteristics of our investment portfolio as of September 30, 2007 and
December 31, 2006, and is classified by interest rate type:
Investment
Portfolio
(Dollar amounts in thousands)
|
|
|
As of September 30, 2007
|
|
As of December 31, 2006
|
|
|
|
|
Amortized Cost
|
|
Portfolio Mix
|
|
Amortized Cost
|
|
Portfolio Mix
|
|
|
Floating
Rate:
|
|
|
|
|
|
|
|
|
|
|
Corporate Loans
|
|
$
|
6,820,571
|
|
79.5
|
%
|
$
|
3,200,567
|
|
76.3
|
%
|
|
Corporate Debt
Securities
|
|
234,776
|
|
2.7
|
|
344,650
|
|
8.2
|
|
|
Commercial Real
Estate Loans
|
|
114,248
|
|
1.4
|
|
108,693
|
|
2.6
|
|
|
Total Floating
Rate
|
|
7,169,595
|
|
83.6
|
|
3,653,910
|
|
87.1
|
|
|
Fixed
Rate:
|
|
|
|
|
|
|
|
|
|
|
Corporate Loans
|
|
164,912
|
|
1.9
|
|
25,000
|
|
0.6
|
|
|
Corporate Debt
Securities
|
|
1,210,314
|
|
14.1
|
|
486,321
|
|
11.6
|
|
|
Commercial Real
Estate Debt Securities
|
|
32,000
|
|
0.4
|
|
32,000
|
|
0.7
|
|
|
Total Fixed Rate
|
|
1,407,226
|
|
16.4
|
|
543,321
|
|
12.9
|
|
|
Total
|
|
$
|
8,576,821
|
|
100.0
|
%
|
$
|
4,197,231
|
|
100.0
|
%
|
The table above excludes marketable equity securities
with a fair value of $41.3 million and amortized cost of $45.8 million, and
non-marketable equity securities with a fair value of $20.1 million and
amortized cost of $20.1 million as of September 30, 2007. The table above also
excludes marketable equity securities with a fair value of $69.0 million and
amortized cost of $68.1 million, and non-marketable equity securities with a
fair value of $166.3 million and amortized cost of $166.3 million as of December 31,
2006.
Corporate Loans and Securities
All of our floating rate corporate loans and
securities have index reset frequencies of less than twelve months with the
majority of the loans resetting at least quarterly. The weighted-average coupon
on our floating rate corporate loans and securities was 7.79% and 8.00% as of
September 30, 2007 and December 31, 2006, respectively. As of September
30, 2007 and December 31, 2006, the weighted-average years to maturity of
our floating rate corporate loans and securities was 5.8 years and
6.0 years, respectively.
As of September 30, 2007, our fixed rate corporate
loans and debt securities had a weighted average coupon of 10.31% and a
weighted average years to maturity of 7.2 years, as compared to 9.75% and
6.3 years, respectively, as of December 31, 2006.
Commercial Real Estate Loans and
Securities
All of our floating rate commercial real estate loans
have index reset frequencies of less than twelve months. The weighted-average
coupon on our floating rate commercial real estate loans was 8.44% and 8.42% as
of September 30, 2007 and December 31, 2006, respectively. As of September
30, 2007 and December 31, 2006, the weighted-average years to maturity of
our floating rate commercial real estate loans was 1.7 years and
2.5 years, respectively.
As of September 30, 2007, our fixed rate commercial
real estate securities had a weighted average coupon of 7.12% and a weighted-average
years to maturity of 29.2 years, as compared to 7.12% and 29.9 years,
respectively, as of December 31, 2006. As of September 30, 2007 and December
31, 2006, we owned no fixed rate commercial real estate loans.
40
Portfolio
Purchases
We purchased $2.2 billion and $5.1 billion par
amount of investments during the three and nine months ended September 30,
2007, compared to $1.1 billion and $2.6 billion for the three and nine months
ended September 30, 2006, respectively.
The table below
summarizes our investment portfolio purchases for the periods indicated and
includes the par amount, or face amount, of the securities and loans that were
purchased:
Investment Portfolio Purchases
(Dollar amounts in thousands)
|
|
|
Three months ended
September 30, 2007
|
|
Three months ended
September 30, 2006
|
|
Nine months ended
September 30, 2007
|
|
Nine months ended
September 30, 2006
|
|
|
|
|
Par Amount
|
|
%
|
|
Par Amount
|
|
%
|
|
Par Amount
|
|
%
|
|
Par Amount
|
|
%
|
|
|
Securities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Corporate Debt Securities
|
|
$
|
184,500
|
|
8.4
|
%
|
$
|
167,500
|
|
15.8
|
%
|
$
|
942,500
|
|
18.4
|
%
|
$
|
507,516
|
|
19.6
|
%
|
|
Marketable Equity Securities
|
|
2,225
|
|
0.1
|
|
—
|
|
—
|
|
42,859
|
|
0.8
|
|
—
|
|
—
|
|
|
Non-Marketable Equity Securities
|
|
5,690
|
|
0.2
|
|
—
|
|
—
|
|
13,190
|
|
0.3
|
|
—
|
|
—
|
|
|
Total Securities Principal Balance
|
|
192,415
|
|
8.7
|
|
167,500
|
|
15.8
|
|
998,549
|
|
19.5
|
|
507,516
|
|
19.6
|
|
|
Loans:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Corporate Loans
|
|
2,013,571
|
|
91.3
|
|
877,356
|
|
82.6
|
|
4,115,402
|
|
80.5
|
|
2,063,858
|
|
79.7
|
|
|
Commercial Real Estate Loans
|
|
—
|
|
—
|
|
17,000
|
|
1.6
|
|
—
|
|
—
|
|
17,000
|
|
0.7
|
|
|
Total Loans Principal Balance
|
|
2,013,571
|
|
91.3
|
|
894,356
|
|
84.2
|
|
4,115,402
|
|
80.5
|
|
2,080,858
|
|
80.4
|
|
|
Grand Total Principal Balance
|
|
$
|
2,205,986
|
|
100.0
|
%
|
$
|
1,061,856
|
|
100.0
|
%
|
$
|
5,113,951
|
|
100.0
|
%
|
$
|
2,588,374
|
|
100.0
|
%
|
Discontinued
Operations
In August 2007, our Board of
Directors approved a plan to exit our residential mortgage investment
operations and sell our REIT Subsidiary. Accordingly, we have reported our
residential mortgage investment operations, including the REIT Subsidiary, as a
discontinued operation for all periods presented. The assets and liabilities of
our residential mortgage investment operations consist primarily of investments
in residential mortgage loans and securities, interest and principal receivable
from our residential mortgage loans and securities, cash and restricted cash
and equivalents balances, and debt and related interest payable consisting of
repurchase agreements and secured liquidity notes that are used to finance
investments in residential mortgage loans and securities. Investments in
residential mortgage loans and securities are accounted for at fair value as we
elected the fair value option of accounting for our investments in residential
mortgage loans and securities as of January 1, 2007. Changes in the fair value
of residential mortgage loans and securities are included in (losses) income
from discontinued operations on our condensed consolidated statements of
operations.
Our decision to exit the
residential mortgage investment operations business and sell our REIT
Subsidiary was based on various considerations including, but not limited to,
the following: (i) our restructuring from a REIT to a publicly traded LLC which
enabled us to execute our core business of investing in corporate loans and
debt securities without having to invest in residential mortgage assets to
qualify as a REIT; and (ii) the material adverse change in the mortgage
industry and associated liquidity crisis in the capital markets that arose
during the third quarter of 2007, which resulted in us being unable to finance
our residential mortgage investments on reasonable financial terms.
During the quarter ended
September 30, 2007, we sold approximately $5.2 billion of residential mortgage-backed
securities and recognized a loss of approximately $65.0 million. Included in
the $5.2 billion sale of residential mortgage-backed securities that were sold
were approximately $3.4 billion of residential mortgage backed securities rated
AAA/Aaa that were issued by securitization trusts where we own the subordinate
interests. We consolidate these securitization trusts as we are the primary
beneficiary under FIN 46R, and as a result, the sales were accounted for on a
consolidated basis as issuances of residential mortgage-backed securities. We
elected the fair value option under SFAS No. 159 for the residential
mortgage-backed securities issued by the securitization trusts and therefore
are carrying mortgage-backed securities issued by securitization trusts at fair
value with changes in fair value reflected in income (loss) from discontinued
operations.
As of September 30, 2007,
$0.6 billion of residential mortgage loans and $4.5 billion of residential
mortgage-backed securities were pledged as collateral for non-recourse secured
liquidity notes issued by two asset-backed secured liquidity note conduit
facilities (the “Facilities”) that are accounted for as subsidiaries of the
REIT Subsidiary as the REIT Subsidiary is the primary beneficiary of these entities
under FIN 46R. On October 18, 2007, we announced that the REIT Subsidiary had
consummated a restructuring of the Facilities. Pursuant to the terms of the
restructuring, the maturity date of the secured liquidity notes issued by the
Facilities was extended with approximately 50% of the principal balance due on
February 15, 2008 and the remaining principal balance due on March 13,
2008. Under the terms of the
restructuring, we continue to have the right, but not the obligation to
repurchase or refinance the collateral which collateralizes the Facilities and
pay off the Facilities prior to the scheduled maturity dates of the secured
liquidity notes.
41
During the quarter ended
September 30, 2007, we recorded a charge for discontinued operations of
approximately $243.7 million. The components of this charge consists of an
approximate $199.9 million investment in the Facilities, a reserve of $36.5
million for contingencies related to restructuring and anticipated future termination
of the Facilities, and an accrual for legal, accounting, and consulting fees of
approximately $7.3 million.
Summarized financial
information for discontinued operations is as follows (amounts in thousands):
|
|
|
As of
September 30, 2007
|
|
As of
December 31, 2006
|
|
|
Assets of discontinued
operations
|
|
$
|
8,770,814
|
|
$
|
12,743,069
|
|
|
Liabilities of
discontinued operations
|
|
$
|
8,651,267
|
|
$
|
12,090,678
|
|
(Loss) income from discontinued operations is as follows (amounts in
thousands):
|
|
|
Three months ended
|
|
Three months ended
|
|
Nine months ended
|
|
Nine months ended
|
|
|
|
|
September 30, 2007
|
|
September 30, 2006
|
|
September 30, 2007
|
|
September 30, 2006
|
|
|
(Loss) income
from discontinued operations
|
|
$
|
(318,683
|
)
|
$
|
11,855
|
|
$
|
(309,096
|
)
|
$
|
40,674
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Shareholders’ Equity
Our shareholders’ equity at each
of September 30, 2007 and December 31, 2006 totaled $1.7 billion. Included
in our shareholders’ equity as of September 30, 2007 and December 31, 2006
is accumulated other comprehensive (loss) income totaling $(72.8) million and
$70.5 million, respectively.
Our
average shareholders’ equity and return on average shareholders’ equity for the
three and nine months ended September 30, 2007 were $1.6 billion and
(64.7)%, and $1.7 billion and (12.8)%, respectively. Our average shareholders’
equity and return on average shareholders’ equity for the three and nine months
ended September 30, 2006 were $1.7 billion and 7.5%, and $1.7 billion and
7.7%, respectively. Return on average shareholders’ equity is defined as net
income (loss) divided by weighted-average shareholders’ equity.
Our book value per common share
as of September 30, 2007 and December 31, 2006 was $15.01 and $21.42,
respectively, and was computed based on 111,316,698 and 80,464,713 shares
issued and outstanding as September 30, 2007 and December 31, 2006,
respectively.
On August 21, 2007, we
consummated a common share offering of 16.0 million common shares to seven
unaffiliated institutional investors in separately negotiated public
transactions registered under the Securities Act of 1933, as amended (the “1933
Act”), at a price of $14.40 per share, which was the closing price of our
common shares on the New York Stock Exchange (“NYSE”) on August 17, 2007.
Proceeds from the transaction totaled $230.4 million and we will use the net proceeds
for general corporate purposes.
On the same date, we announced
a rights offering of our common shares of up to $270.0 million in which we
distributed non-transferable rights to subscribe for 18.75 million common
shares. Each holder of common shares received 0.19430 rights for each common
share held at the close of business on August 30, 2007, the record date for the
rights offering. The subscription price for the common shares offered in the
rights offering was $14.40 per common share, which was the closing price of our
common shares on August 17, 2007. In connection with this rights offering,
certain principals of KKR agreed to provide a backstop commitment to purchase
up to approximately $100.0 million of common shares at the price of $14.40 to
the extent the rights offering was not fully subscribed. The rights offering
expired on September 19, 2007 and generated gross proceeds totaling $213.4
million, which we will use for general corporate purposes. On October 2, 2007,
certain principals of KKR purchased 3.9 million common shares pursuant to the
backstop commitment for proceeds generating $56.6 million, which we will use
for general corporate purposes.
42
Liquidity and Capital Resources
We manage our liquidity with
the intention of maintaining the continuing ability to fund our operations and
fulfill our commitments on a timely and cost-effective basis. Based on changes
in our working capital, for any given period the cash flows provided by
operating activities may be less than the cumulative distributions paid on our
shares for such period and such shortfall, if any, may be funded through the
issuance of unsecured indebtedness or through the borrowing of additional
amounts through the pledging of certain of our assets. Our Board of Directors
considers available liquidity when declaring distributions to shareholders.
Significant disruptions in the
residential mortgage and asset-backed commercial paper markets during the third
quarter of 2007 had a material adverse impact on both the values and related
financings of our investments in residential mortgage loans and mortgage-backed
securities. In light of the adverse market conditions that occurred, we took
several steps as described in the “Executive Overview” above.
As a result of these steps, we
believe that our liquidity level and access to additional funding is in excess
of that necessary to enable us to meet our anticipated liquidity requirements
including, but not limited to, funding our purchases of investments, required
cash payments and additional collateral under our borrowings and our derivative
transactions, required periodic cash payments related to our derivative
transactions, payment of fees and expenses related to our Management Agreement,
payment of general corporate expenses and general corporate capital
expenditures and distributions to our shareholders. As of September 30, 2007,
we owed our Manager $5.0 million for the payment of management fees and
reimbursable expenses pursuant to the Management Agreement.
Any material event that impacts
capital markets participants may impair our ability to access additional
liquidity. If our cash resources are at any time insufficient to satisfy our
liquidity requirements, we may have to sell assets or issue debt or additional
equity securities.
Our ability to meet our
long-term liquidity and capital resource requirements may be subject to our
ability to obtain additional debt financing and equity capital. We may increase
our capital resources through offerings of equity securities (possibly including
common shares and one or more classes of preferred shares), medium-term notes,
securitization transactions structured as secured financings, and senior or
subordinated notes. If we are unable to renew, replace or expand our sources of
financing on acceptable terms, it may have an adverse effect on our business
and results of operations and our ability to make distributions to
shareholders. Upon liquidation, holders of our debt securities and lenders with
respect to other borrowings will receive, and any holders of preferred shares
that we may issue in the future may receive, a distribution of our available
assets prior to holders of our common shares. The decisions by investors and
lenders to enter into equity, and financing transactions with us will depend
upon a number of factors, including our historical and projected financial
performance, compliance with the terms of our current credit arrangements,
industry and market trends, the availability of capital and our investors’ and
lenders’ policies and rates applicable thereto, and the relative attractiveness
of alternative investment or lending opportunities.
Any material event that impacts
capital markets participants may also impair our ability to access additional
liquidity and we may therefore be required to sell some or all of our portfolio
investments in order to maintain sufficient liquidity. Such sales may be at
prices lower than the carrying value of our investments, which would result in
our recognition of such losses and reduced income.
We have entered into various
financing and derivative transactions in the normal course of business which
contain terms and conditions that include bilateral margin posting
requirements. During periods of increased adverse market volatility, we are
exposed to the risk that we may have to post additional margin collateral,
which may have a material adverse impact on our available liquidity. As a
result, our contingent liquidity reserves may not be sufficient in the event of
a material adverse change in the credit markets and related market price market
volatility.
For additional information, we
refer you to both the risk factors previously disclosed in the Company’s Form
10-K for the period ended December 31, 2006 and risk factors discussed under
the caption “Risk Factors” under Item 8.01 in the Current Report on Form 8-K
filed by the Company with the Securities and Exchange Commission on June 1,
2007.
We are no longer treated as a
REIT for U.S. federal income tax purposes and, as a result, will not be subject
to the REIT requirement to make distributions to our shareholders, although we
currently intend to distribute approximately 75% to 95% of our taxable income
to our shareholders. However, distributions by us must be approved by, and will
be subject to the sole discretion of, our Board of Directors and will be
subject to various considerations including, but not limited to, our financial
performance, liquidity requirements, distribution restrictions contained in our
current or future financing facilities, our distribution yield relative to our
peers and other relevant factors identified by our Board of Directors.
We do not believe that the sale
of the REIT Subsidiary or the exit of our residential mortgage investment
operations will have a negative recurring impact on our liquidity.
43
As described in the “Executive Overview” above, we recorded a charge
totaling $243.7 million related to the exit of our residential mortgage
investment operations and the sale of the REIT Subsidiary which has or will
reduce the Company’s liquidity by the amount of the charge.
Sources of
Funds
Securitization
Transactions
On May 22, 2007, we closed CLO 2007-1, a $3.5 billion secured financing
transaction. We issued $2.4 billion of senior secured notes at par to
unaffiliated investors with a weighted-average coupon of three-month LIBOR plus
0.53% and issued $244.7 million of mezzanine notes and $186.6 million of
subordinated notes to KKR Strategic Capital Funds.
Repurchase
Agreements
As
of September 30, 2007, we had $2.3 billion outstanding on repurchase
facilities with seven counterparties with a weighted average effective rate of
5.76% and a weighted average remaining term to maturity of 24 days. Due to the
fact that we borrow under repurchase agreements based on the estimated fair
value of our pledged investments and that changes in interest rates and credit
spreads can negatively impact the valuation of our pledged investments, our
ongoing ability to borrow under our repurchase facilities may be limited and
our lenders may initiate margin calls in the event interest rates change or the
value of our pledged securities declines as a result of adverse changes in
interest rates or credit spreads.
Secured
Credit Facility
During
June 2006 our $275.0 million secured revolving credit facility matured and
was replaced with a $375.0 million three year senior secured revolving credit
facility. During September 2006, the facility was amended to increase the
total commitment amount to $800.0 million with the option to further increase
the commitment amount to $900.0 million at any time so long as no default or
event of default on the facility has occurred and subject to addition of new
lenders, increases in the commitments of existing lenders, or a combination
thereof. The new senior secured revolving credit facility matures in
June 2009 and consists of two tranches. Outstanding borrowings under the
senior secured revolving credit facility bear interest at either (i) an
alternate base rate per annum equal to the greater of (a) the prime rate
in effect on such day, and (b) the federal funds rate in effect on such
day plus 0.50%, or (ii) an interest rate per annum equal to the LIBOR rate
for the applicable interest period plus 0.50% for borrowings under tranche A of
the facility and 0.75% for borrowings under tranche B of the facility. As of
September 30, 2007, we had $168.0 million in borrowings outstanding under
tranche B of this facility. In connection with our restructuring transaction,
the facility was further amended in May 2007 to add us and certain of our
wholly-owned subsidiaries as borrowers.
Junior
Subordinated Notes
During
June 2007, we formed Trust VI for the sole purpose of issuing trust preferred
securities. On June 29, 2007, Trust VI issued preferred securities to unaffiliated
investors for gross proceeds of $70.0 million and common securities to us for
$2.2 million. The combined proceeds were invested by Trust VI in $72.2 million
of junior subordinated notes issued by us. The junior subordinated notes are
the sole assets of Trust VI and mature on July 30, 2037, but are callable
on or after July 30, 2012. Interest is payable quarterly at a floating
rate equal to three-month LIBOR plus 2.50%.
Convertible Debt
On July 23, 2007, we issued an
aggregate of $300.0 million of 7.000% convertible notes maturing on July 15,
2012 to qualified institutional buyers. The Notes represent senior
unsecured obligations of us and bear interest at the rate of 7.000% per year.
Interest is payable semi-annually on January 15 and July 15 of each year,
beginning January 15, 2008.
The Notes are convertible into our common shares,
initially at a conversion rate of 31.08 shares per $1,000 principal of Notes,
which is equivalent to an initial conversion price of $32.175 per common share.
The Notes are convertible prior to the maturity date at any time on or after
June 15, 2012 and also under the following circumstances: (i) a holder may
surrender any of its Notes for conversion during any calendar quarter beginning
after September 30, 2007 (and only during such calendar quarter) if, and only
if, the closing sale price of our common shares for at least 20 trading days
(whether or not consecutive) in the period of 30 consecutive trading days
ending on the last trading day of the preceding calendar quarter is greater
than 130% of the conversion price per common share in effect on the applicable
trading day; (ii) a holder may surrender any of its Notes for conversion during
the five consecutive trading-day period following any five consecutive
trading-day period in which the trading price of the Notes was less than 98% of
the product of the closing sale price of our
44
common shares multiplied by the
applicable conversion rate; (iii) a holder may surrender for conversion any of
its Notes if those Notes have been called for redemption, at any time prior to
the redemption date, even if the Notes are not otherwise convertible at such
time; and (iv) a holder may surrender any of its Notes for conversion if we
engage in certain specified transactions, as defined in the indenture covering
the Notes.
In connection with our common
share rights offering during the third quarter, we adjusted the conversion rate
for our Notes pursuant to the governing indenture for the Notes. The new
conversion price for the Notes is approximately $31.00 and was effective
September 21, 2007. The new conversion rate for each $1,000 principal amount of
Notes is 32.2581 of our common shares.
Common Share Issuance
As discussed above in “Shareholders’
Equity”, on August 21, 2007, we consummated a common share offering with
proceeds from the transaction totaling $230.4 million. On the same date, we
announced a rights offering of common shares to our common shareholders of up
to $270.0 million. In connection with this rights offering, certain principals
of KKR agreed to provide a backstop commitment to purchase a certain amount of
common shares to the extent the rights offering was not fully subscribed. The
rights offering expired on September 19, 2007 with proceeds totaling $270.0
million, including $56.6 million of proceeds received from the backstop
commitment on October 2, 2007. The net proceeds received from the common share offering
and common share rights offering will be used for general corporate purposes.
Capital
Utilization and Leverage
As
of September 30, 2007 and December 31, 2006, we had shareholders’ equity
totaling $1.7 billion, and our leverage was 5.0 times and 2.1 times equity,
respectively.
Off-Balance
Sheet Commitments
The
Company participates in certain financing arrangements, including revolvers and
delayed draw facilities, whereby the Company is committed to provide funding at
the discretion of the borrower up to a specific predetermined amount. As of
September 30, 2007, the Company had unfunded financing commitments totaling
$164.3 million.
REIT Matters
As of September 30, 2007, we
believe that our REIT Subsidiary, presented as a discontinued operation,
qualified as a REIT under the provisions of the Internal Revenue Code of 1986,
as amended (the "Code"). The Code requires, among other things, that
at the end of each calendar quarter at least 75% of our REIT Subsidiary’s total
assets must be “real estate assets” as defined in the Code. The Code also
requires that each year at least 75% of our REIT Subsidiary’s gross income come
from real estate sources and 95% of our REIT Subsidiary’s gross income come
from real estate sources and certain other passive sources itemized in the
Code, such as dividends and interest. As of September 30, 2007, we believe that
our REIT Subsidiary was in compliance with such requirements. As of September
30, 2007, we also believe that our REIT Subsidiary met all of the REIT
requirements regarding the ownership of its common shares and the distribution
of its taxable income. However, the sections of the Code and the corresponding
U.S. Treasury Regulations that relate to qualification and taxation as a REIT
are highly technical and complex, and our REIT Subsidiary’s qualification and
taxation as a REIT depends upon its ability to meet various qualification tests
imposed under the Code (such as those described above), including through its
actual annual operating results, asset composition, distribution levels and
diversity of share ownership. Accordingly, no assurance can be given that our
REIT Subsidiary has been organized and has operated, or will continue to be
organized and operated, in a manner so as to qualify or remain qualified as a
REIT.
To maintain our REIT Subsidiary’s
status as a REIT for federal income tax purposes, our REIT Subsidiary is
required to distribute at least 90% of its REIT taxable income for each year.
In addition, for each taxable year, to avoid certain federal excise taxes, our
REIT Subsidiary is required to declare and pay dividends amounting to certain
designated percentages of our REIT Subsidiary’s taxable income by the end of
such taxable year. For the period covered by our calendar year 2006 federal tax
return, we believe that our REIT Subsidiary met all of the distribution
requirements of a REIT.
Exemption from Regulation under the Investment Company Act
We intend to conduct our
operations so that we are not required to register as an investment company
under the Investment Company Act. Our subsidiaries that issue collateralized
loan obligations (“CLOs”) generally will rely on Rule 3a-7, an exemption from
the Investment Company Act provided for certain structured financing vehicles. Accordingly,
each
45
of our CLO subsidiaries that
rely on Rule 3a-7 is subject to an indenture that contains specific guidelines
and restrictions, including a prohibition on the CLO issuers from acquiring and
disposing of assets primarily for the purposes of recognizing gains or
decreasing losses resulting from market value changes. Certain sales and
purchases of assets may be made so long as the CLOs do not violate the
guidelines contained in the indentures and are not based primarily on the
changes in market value. We can, however, continue to sell assets without
limitation if we believe the credit profile of the obligor will deteriorate. The
proceeds of permitted dispositions may be reinvested in collateral that is
consistent with the credit profile of the CLO under specific and predetermined
guidelines.
In addition, the combined value
of the investment securities issued by our subsidiaries that are excepted by
Section 3(c)(1) or 3(c)(7) of the Investment Company Act, together with any
other investment securities we may own, may not exceed 40% of our total assets
on an unconsolidated basis. This requirement limits the types of businesses in
which we may engage through these subsidiaries.
Quantitative and Qualitative Disclosures About Market Risk
Market Risks
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.
Inflation
Risks
Our investment portfolio
comprises the majority of our assets and our investments are financial in
nature. Changes in interest rates and credit spreads may have a material
adverse impact on our financial condition, results of operations and liquidity.
Changes in interest rates do not necessarily correlate with inflation rates or
changes in inflation rates.
Interest Rate
Risk
We believe that our primary
market risk is 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 imbedded 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.
We are exposed to basis risk
between our investments and our borrowings. Our floating rate investments and
our floating 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 floating 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 interest
rate risk and make interest rate risk decisions by evaluating our projected
earnings under selected interest rate scenarios. We also use static measures of
interest rate risk including duration. During periods of increasing interest
rates we are biased to purchase investments that are floating rate and we have
had that bias since our inception. We manage our interest rate risk using
various techniques ranging from the purchase of floating rate
46
investments to the use of interest rate derivatives. We generally fund
our floating rate investments with floating rate borrowings with similar
interest rate reset frequencies. We generally fund our fixed rate investments
with short-term floating rate borrowings and we may use interest rate
derivatives to hedge the variability of the cash flows associated with our
existing or forecasted floating rate borrowings. Hedging activities are complex
and accounting for interest rate derivatives as fair value or cash flow hedges
in accordance with SFAS No. 133 is difficult.
Prepayments will impact the
average lives of our fixed rate and hybrid investments and, as a result, we are
exposed to the risk that the amount of floating rate borrowings that we have
swapped from floating rate to fixed rate is materially different than we
expected because the average life of the fixed rate investment has either
extended or contracted. If the difference is material, we may have to adjust
the amount of our interest rate derivative position and such action could
generate a loss if we terminated any of the interest rate derivatives or it may
negatively impact our future earnings if we have to increase our interest rate
derivative positions because the average lives of our investments have
extended.
The following table summarizes
the estimated net fair value of our derivative instruments held at September
30, 2007 and December 31, 2006 (amounts in thousands):
Derivative
Fair Value
|
|
|
As of
September 30, 2007
|
|
As of
December 31, 2006
|
|
|
|
|
Notional
|
|
Fair Value
|
|
Notional
|
|
Fair Value
|
|
|
Cash Flow Hedges:
|
|
|
|
|
|
|
|
|
|
|
Interest rate swaps
|
|
$
|
383,333
|
|
$
|
(3,114
|
)
|
$
|
150,000
|
|
$
|
(1,711
|
)
|
|
Fair Value Hedges:
|
|
|
|
|
|
|
|
|
|
|
Interest rate swaps
|
|
32,000
|
|
(334
|
)
|
32,000
|
|
13
|
|
|
Free-Standing Derivatives:
|
|
|
|
|
|
|
|
|
|
|
Interest rate swaptions
|
|
—
|
|
—
|
|
31,000
|
|
75
|
|
|
Interest rate swaps
|
|
150,000
|
|
640
|
|
—
|
|
—
|
|
|
Credit default swaps—long
|
|
66,000
|
|
274
|
|
3,000
|
|
179
|
|
|
Credit default swaps—short
|
|
273,000
|
|
6,521
|
|
275,000
|
|
(797
|
)
|
|
Total rate of return swaps
|
|
445,811
|
|
(16,141
|
)
|
222,647
|
|
2,343
|
|
|
Common stock warrants
|
|
—
|
|
432
|
|
—
|
|
—
|
|
|
Net fair value
|
|
$
|
1,350,144
|
|
$
|
(11,722
|
)
|
$
|
713,647
|
|
$
|
102
|
|
Risk
Management
We seek to manage our interest
rate risk exposure to protect our investment portfolio and related borrowings
against the effects of major interest rate changes. We generally seek to manage
our interest rate risk by:
•
Changing the mix between our floating rate
investments and our fixed rate investments;
•
Monitoring and adjusting, if necessary, the
reset index and interest rates related to our investments and our borrowings;
•
Attempting to structure our borrowing agreements
to have a range of different maturities, terms, amortizations and interest rate
adjustment periods; and
•
Using interest rate derivatives to adjust the
interest rate sensitivity of our investment portfolio and our borrowings.
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 Management’s Discussion and Analysis
of Financial Condition and Results of Operations.
47
Item 4.
Controls and Procedures
The Company’s management
evaluated, with the participation of the Company’s principal executive and
principal financial officer, the effectiveness of the Company’s 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
September 30, 2007. Based on their evaluation, the Company’s principal
executive and principal financial officer concluded that the Company’s
disclosure controls and procedures as of September 30, 2007 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 SEC’s 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
Company’s internal control over financial reporting (as defined in Rules
13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the Company’s
three and nine months ending September 30, 2007, that has materially affected,
or is reasonably likely to materially affect, the Company’s internal control
over financial reporting.
PART II. OTHER INFORMATION
Item 1.
Legal Proceedings
None.
Item 1A.
Risk Factors
In addition to risk factors
disclosed in our Annual Report on Form 10-K for the fiscal year ended December
31, 2006 (see Part I, Item IA), set forth in this section is an additional risk
factor we currently believe would be applicable to our operation and business
strategy.
Periods of adverse market volatility
could adversely affect our liquidity.
During
periods of increased adverse market volatility, such as the recent disruption
in the residential mortgage and global asset-backed commercial paper market, we
are exposed to the risk that we may have to post additional margin collateral,
which may have a material adverse impact on our available liquidity. As a
result, our contingent liquidity reserves may not be sufficient in the event of
a material adverse change in the credit markets and related market price market
volatility.
Item 2
.
Unregistered Sales of Equity Securities and Use
of Proceeds
None.
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
|
31.1
|
|
Chief
Executive Officer Certification
|
|
31.2
|
|
Chief
Financial Officer Certification
|
|
32
|
|
Certification
Pursuant to 18 U.S.C. Section 1350
|
48
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/ SATURNINO S. FANLO
|
|
Chief
Executive Officer (Principal Executive Officer)
|
|
Saturnino S. Fanlo
|
|
|
|
|
|
|
|
/s/ JEFFREY B. VAN HORN
|
|
Chief
Financial Officer (Principal Financial and Accounting Officer)
|
|
Jeffrey B. Van Horn
|
|
|
|
|
|
|
|
Date:
November 7, 2007
|
|
|
49
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