ITEM 1. BUSINESS
OUR COMPANY
We are a specialty finance company with expertise in a range of asset classes. Our core business strategy is to leverage the
proprietary resources of our manager with the objective of generating both current income and capital appreciation by deploying capital to our strategies, which include bank loans and high yield
securities, natural resources, special situations, mezzanine, commercial real estate and private equity. Our holdings across these strategies primarily consist of below investment grade syndicated
corporate loans, also known as leveraged loans, high yield debt securities, private equity, interests in joint ventures and partnerships, and working and royalty interests in oil and gas properties.
The corporate loans that we hold are typically purchased via assignment or participation in the primary or secondary market.
The
majority of our holdings consist of corporate loans and high yield debt securities held in collateralized loan obligation ("CLO") transactions that are structured as
on-balance sheet securitizations and are used as long term financing for our investments in corporate debt. The senior secured debt issued by the CLO transactions is primarily owned by
unaffiliated third party investors and we own the majority of the subordinated notes in the CLO transactions. Our CLO transactions consist of seven CLO transactions, KKR Financial CLO
2005-1, Ltd. ("CLO 2005-1"), KKR Financial CLO 2005-2, Ltd. ("CLO 2005-2"), KKR Financial CLO 2006-1, Ltd. ("CLO
2006-1"), KKR Financial CLO 2007-1, Ltd. ("CLO 2007-1"), KKR Financial CLO 2007-A, Ltd. ("CLO 2007-A"), KKR Financial CLO
2011-1, Ltd. ("CLO 2011-1") and KKR Financial CLO 2012-1, Ltd. ("CLO 2012-1") (collectively the "Cash Flow CLOs"). We execute our core
business strategy through our majority-owned subsidiaries, including CLOs.
We
are a Delaware limited liability company and were organized on January 17, 2007. We are the successor to KKR Financial Corp., a Maryland corporation. Our common shares are
publicly traded on the New York Stock Exchange ("NYSE") under the symbol "KFN". We intend to continue to operate so that we qualify, for United States federal income tax purposes, as a partnership and
not as an association or publicly traded partnership taxable as a corporation.
OUR MANAGER
We are externally managed and advised by KKR Financial Advisors LLC (our "Manager"), a wholly-owned subsidiary of KKR Asset
Management LLC ("KAM" or "the parent of our Manager"), pursuant to a management agreement (the "Management Agreement"). KAM is a wholly-owned subsidiary of Kohlberg Kravis
Roberts & Co. L.P. ("KKR").
Our
Manager is responsible for our operations and performs all services and activities relating to the management of our assets, liabilities and operations. Pursuant to the terms of the
Management Agreement, our Manager provides us with our management team, along with appropriate support personnel. All of our executive officers are employees or members of KKR or one or more of its
affiliates. Our Manager is under the direction of our board of directors and is required to manage our business affairs in conformity with the investment guidelines that are approved by a majority of
our independent directors.
The
executive offices of our Manager are located at 555 California Street, 50
th
Floor, San Francisco, California 94104 and the telephone number of our Manager's
executive offices is (415) 315-3620.
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OUR STRATEGY
Our objective is to provide long-term value for our shareholders by generating an attractive total return through cash
distributions and increased enterprise value. We seek to achieve our objective by deploying capital opportunistically across capital structures and asset classes, including bank loans and high yield
securities, natural resources, special situations, mezzanine, commercial real estate and private equity. As part of our strategy, we seek opportunities in those asset classes that can generate
competitive leveraged risk-adjusted returns, subject to maintaining our exemption from registration under the Investment Company Act of 1940, as amended (the "Investment Company Act").
Our
Manager utilizes its access to the global resources and professionals of KKR, along with the same philosophy of value creation that KKR employs, in order to create a portfolio that
is constructed to generate recurring cash flows, long-term capital appreciation and overall competitive returns to investors. We make asset class allocation decisions based on various
factors including: relative value, leveraged risk-adjusted returns, current and projected credit fundamentals, current and projected supply and demand, credit risk concentration
considerations, current and projected macroeconomic considerations, liquidity, all-in cost of financing and financing availability, and maintaining our exemption from the Investment
Company Act.
As
of December 31, 2012, we determined that we operate our business through multiple reportable business segments, which are differentiated primarily by their investment focuses.
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Credit ("Credit"): The Credit segment includes primarily below investment grade corporate debt comprised of senior secured
and unsecured loans, mezzanine loans, private and public equity investments, high yield bonds, and distressed and stressed debt securities.
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Natural resources ("Natural Resources"): The Natural Resources segment, which was previously included within the other
segment ("Other"), consists of non-operated working and overriding royalty interests in oil and natural gas properties. For segment reporting purposes, the Natural Resources segment excludes private
equity focused on the oil and gas sector.
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Other: The Other segment includes all other portfolio holdings, including commercial real estate.
The
segments currently reported are consistent with the way decisions regarding the allocation of resources are made, as well as how operating results are reviewed by us. For further
financial information related to our segments, refer to "Item 8. Financial Statements and Supplementary DataNote 15. Segment Reporting."
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
(which are treated as partnerships, disregarded entities or foreign corporations for United States federal income tax purposes), partnerships generally and debt securities, may produce taxable income
without corresponding distributions of cash to us or may produce taxable income prior to or following the receipt of cash relating to such income. In addition, we have recognized and may recognize in
the future cancellation of indebtedness income upon the retirement of our debt at a discount. We generally allocate our taxable income and loss using a monthly convention, which means that we
determine our
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taxable
income and losses for the taxable year to be allocated to our shares and then prorate that amount on a monthly basis. Consequently, in some taxable years, holders of our shares may recognize
taxable income in excess of our cash distributions. Furthermore, even if we did not pay cash distributions with respect to a taxable year, holders of our shares may still have a tax liability
attributable to their allocation of taxable income from us during such year.
Qualifying Income Exception
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. In general, if a partnership is "publicly traded" (as defined in the Internal Revenue Code of 1986, as amended (the "Code")), it
will be treated as a corporation for United States federal income tax purposes. A publicly traded partnership will be taxed as a partnership, however, 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 of 1940 (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 and Real Estate
As referenced above, we have made and may make certain investments in natural resources and real estate. It is likely that the income
from natural resources investments will 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 with the conduct of a United States trade or business. In addition, if any REIT subsidiary in which we own an interest
recognizes gain on the disposition of a United States real property interest, or if we recognize gain on the disposition of a United States real property interest that we hold through a
pass-through entity (including gain from the sale of stock in a REIT subsidiary that invests primarily in real estate), such gain will be treated as effectively connected with the conduct
of a United States trade or business. Further, our investments in real estate through pass-through entities may generate operating income that is treated as effectively connected with the
conduct of a United States trade or business.
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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 holder's allocable share of our
effectively connected income. Any amount so withheld would be creditable against such holder's United States federal income tax liability, and such holder could claim a refund to the extent that the
amount withheld exceeded such holder's United States federal income tax liability for the taxable year.
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 gain from the sale
or exchange. Moreover, if the fair market value of our investments in "United States real property interests," which include our investments in natural resources, real estate and certain REIT
subsidiaries that invest primarily in real estate, represent more than 10% of the total fair market value of our assets, our shares could be treated as "United States real property interests". In such
case, gain recognized by an investor who is a non-United States person on the sale or exchange of its shares would be treated for United States federal income tax purposes as effectively
connected income (unless the gain is attributable to a class of our shares that is regularly traded on a securities market and the non-United States person owns 5% or less of the shares of
that class). We do not believe that the fair market value of our investments in United States real property interests represents more than 10% of the total fair market value of our assets at this
time. No assurance can be provided that our future investments in United States real property interests will not cause us to exceed the 10% threshold described above. If gain from the sale of our
shares is treated as effectively connected income, the holder may be subject to United States federal income and/or withholding tax on the sale or exchange.
In
addition, all holders of our shares will likely have state tax filing obligations in jurisdictions in which we have made investments in natural resources or real estate (other than
through a REIT subsidiary). 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 if they fail to comply with those requirements. Our current investments may cause our holders to have state tax filing
obligations in the following states: Kansas, Louisiana, Mississippi, North Dakota, Ohio, Oklahoma, Pennsylvania and Texas. We may make investments in other states in the future.
For
holders of our shares that are regulated investment companies, to the extent that our income from our investments in natural resources and real estate exceeds 10% of our gross
income, then we will likely be treated as a "qualified publicly traded partnership" for purposes of the income and asset diversification tests that apply to regulated investment companies. Because
such qualification will depend on the nature of our future investments, no assurance can be provided that we will or will not be treated as a "qualified publicly traded partnership" in any particular
year.
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
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securities"
(within the meaning of the Investment Company Act) having a value exceeding 40% of the value of the issuer's total assets (exclusive of United States 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").
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 as majority-owned subsidiaries for purposes of the 40% test entities, including those that issue CLOs, in which we own at least 50% of the outstanding
voting securities or that are otherwise structured consistent with applicable SEC staff guidance. Some of our majority-owned subsidiaries may rely solely on the exceptions from the definition of
"investment company" found in 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 for purposes of the Investment Company Act, 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 United States government securities and cash items. However, many of our majority-owned 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, the securities of those subsidiaries that we own and hold are not investment securities for purposes of
the Investment Company Act. 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 subsidiary's compliance with its applicable exception and our freedom of action relating to such a subsidiary, and that of the subsidiary itself, may
be limited as a result. For example, our subsidiaries that issue CLOs generally rely on the exception provided by Rule 3a-7 under the Investment Company Act, while our real estate
subsidiaries, including those that are taxed as REITs for United States federal income tax purposes, generally rely on the exception provided by 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
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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 management investment companies (e.g., 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 subsidiary's 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 subsidiary's 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 our subsidiaries that rely on Section 3(c)(5)(C) of the Investment Company Act, as our "real estate subsidiaries." 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 SEC's 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 company's 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 company's assets consist of real estate-related assets (reduced by the excess of the company's qualifying real estate assets over the required 55%), leaving no more than 20% of the
company's 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 Division's
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 subsidiaries 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 real estate subsidiaries classify 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 unilateral 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 real
estate subsidiaries consider 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
United States 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
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be
a qualifying real estate asset, but is considered by our real estate subsidiaries 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 real estate subsidiaries' investment in non-agency mortgage-backed securities is the "functional equivalent" of owning the
underlying mortgage loans, our real estate subsidiaries may treat those securities as qualifying real estate assets. Moreover, investments in mortgage-backed securities that do not constitute
qualifying real estate assets are classified by our real estate subsidiaries as real estate-related assets. Therefore, based upon the specific terms and circumstances related to each
non-agency mortgage-backed security that our real estate subsidiaries own, our real estate subsidiaries 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 real estate subsidiaries acquire 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 unilateral foreclosure rights with respect to those mortgage
loans, then our real estate subsidiaries 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 real estate subsidiaries 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 real estate subsidiaries own more than one subordinate class,
then, to determine the classification of subordinate classes other than the first loss class, our real estate subsidiaries 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 real estate subsidiaries own), whether our real estate subsidiaries own the entire
amount of each such class and whether our real estate subsidiaries 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 real estate subsidiaries would expect not to classify that particular class, or classes senior to that class, as qualifying
real estate assets.
We
have made or may make oil and gas and other mineral investments that are held 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
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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 securities issued to us by any non-majority-owned subsidiaries and 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, exceed 40% of the value of our total assets (exclusive of United States 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, the type of investments we make, 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 terminate our Management Agreement effective the date immediately prior to our becoming an investment company. 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 MattersQualifying 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
subsidiary's 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), Section 3(c)(9) or any other exception, 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. The SEC published on August 31, 2011 an advance notice of proposed rulemaking to
potentially amend the conditions for reliance on Rule 3a-7 and the treatment of asset-backed issuers that rely on Rule 3a-7 under the Investment Company Act (the
"3a-7 Release"). The SEC, in the 3a-7 Release, requested public comment on the nature and operation of issuers that rely on Rule 3a-7 and indicated various
steps it may consider taking in connection with Rule 3a-7, although it did not formally propose any changes to
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the
rule. Among the issues for which the SEC has requested comment in the 3a-7 Release is whether Rule 3a-7 should be modified so that parent companies of subsidiaries
that rely on Rule 3a-7 should treat their interests in such subsidiaries as investment securities for purposes of the 40% test. The SEC also published on August 31, 2011 a
concept release seeking information about the nature of entities that invest in mortgages and mortgage-related pools and public comment on how the SEC staff's interpretive positions in connection with
Section 3(c)(5)(C) affect these entities, although it did not propose any new interpretive positions or changes to existing interpretive positions in connection with Section 3(c)(5)(C).
Any guidance or action from the SEC or its staff, including changes that the SEC may ultimately propose and adopt to the way Rule 3a-7 applies to entities or new or modified
interpretive positions related to Section 3(c)(5)(C), could further inhibit our ability, or the ability of a subsidiary, to pursue our current or future operating strategies, 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 may
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.
MANAGEMENT AGREEMENT
We are party to a Management Agreement with our Manager, pursuant to which our Manager will provide for the
day-to-day management of our operations.
The
Management Agreement requires our Manager to manage our business affairs in conformity with the Investment Guidelines that are approved by a majority of our independent directors.
Our Manager is under the direction of our board of directors. Our Manager is responsible for (i) the selection, purchase and sale of our investments, (ii) our financing and risk
management activities, and (iii) providing us with investment advisory services.
The
Management Agreement expires on December 31, 2013 and is automatically renewed for a one-year term on such date and each anniversary date thereafter, unless
terminated. Our
independent directors review our Manager's performance annually and the Management Agreement may be terminated annually (upon 180 day prior written notice) upon the affirmative vote of at least
two-thirds of our independent directors, or by a vote of the holders of a majority of our outstanding common shares, based upon (1) unsatisfactory performance by the Manager that is
materially detrimental to us or (2) a determination that the management fees payable to our Manager are not fair, subject to our Manager's right to prevent such a termination under this
clause (2) by accepting a mutually acceptable reduction of management fees. We must provide a 180 day prior written notice of any such termination and our Manager 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 preceding the date of termination,
calculated as of the end of the most recently completed fiscal quarter prior to the date of termination.
We
may also terminate the Management Agreement without payment of the termination fee with a 30 day prior written notice for cause, which is defined as (i) our Manager's
continued material breach of any provision of the Management Agreement following a period of 30 days after written notice thereof, (ii) our Manager's fraud, misappropriation of funds, or
embezzlement against us, (iii) our Manager's gross negligence in the performance of its duties under the Management Agreement, (iv) the commencement of any proceeding relating to our
Manager's bankruptcy or insolvency, (v) the dissolution of our Manager, or (vi) a change of control of our Manager. Cause does not include
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unsatisfactory
performance, even if that performance is materially detrimental to our business. Our Manager may terminate the Management Agreement, without payment of the termination fee, in the event
we become regulated as an investment company under the Investment Company Act. Furthermore, our Manager may decline to renew the Management Agreement by providing us with a 180 day prior
written notice. Our Manager may also terminate the Management Agreement upon 60 days prior written notice if we default in the performance of any material term of the Management Agreement and
the default continues for a period of 30 days after written notice to us, whereupon we would be required to pay our Manager the termination fee described above.
We
do not employ personnel and therefore rely on the resources and personnel of our Manager to conduct our operations. For performing these services under the Management Agreement, our
Manager receives a base management fee and incentive compensation based on our performance. Our Manager also receives reimbursements for certain expenses, which are made on the first business day of
each calendar month.
Base Management Fee.
We pay our Manager a base management fee monthly in arrears in an amount equal to
1
/
12
of our equity, as defined
in the Management Agreement, multiplied by 1.75%. We believe that the base management fee that our Manager is entitled to receive is generally comparable to the
base management fee received by the managers of comparable externally managed specialty finance companies. Our Manager uses the proceeds from its management fee in part to pay compensation to its
officers and employees who, notwithstanding that certain of them also are officers of us, receive no compensation directly from us.
For
purposes of calculating the base management fee, our equity means, for any month, the sum of (i) the net proceeds from any issuance of our common shares, after deducting any
underwriting discount and commissions and other expenses and costs relating to the issuance, (ii) the net proceeds of any issuances of preferred shares or trust preferred stock (iii) the
net proceeds of any issuances of convertible debt or other securities determined to be "equity" by our board of directors, provided that such issuances are approved by our board of directors, and
(iv) our retained earnings at the end of such month (without taking into account any non-cash equity compensation expense incurred in current or prior periods), which amount shall
be reduced by any amount that we pay for the repurchases of our common shares. The foregoing calculation of the base management fee is adjusted to exclude special one-time events pursuant
to changes in accounting principles generally accepted in the United States of America ("GAAP"), as well as non-cash charges, after discussion between our Manager and our independent
directors and approval by a majority of our independent directors in the case of non-cash charges.
Our
Manager is required to calculate the base management fee within fifteen business days after the end of each month and deliver that calculation to us promptly. We are obligated to pay
the base management fee within twenty business days after the end of each month. We may elect to have our Manager allocate the base management fee among us and our subsidiaries, in which case the fee
would be paid directly by each entity that received an allocation.
Our
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 our common share closing price on the NYSE is $20.00 or more for five consecutive trading days. Accordingly, our Manager permanently waived approximately
$8.8 million of base management fees during each of the years ended December 31, 2012, 2011 and 2010. For the year ended December 31, 2012, $28.2 million of base management
fees were earned by our Manager.
Reimbursement of Expenses.
Because our Manager's employees perform certain legal, accounting, due diligence tasks and other
services that outside
professionals or outside consultants otherwise would perform, our Manager is paid or reimbursed for the documented cost of performing such tasks,
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provided
that such costs and reimbursements are no greater than those which would be paid to outside professionals or consultants on an arm's-length basis.
We
also pay all operating expenses, except those specifically required to be borne by our Manager under the Management Agreement. The expenses required to be paid by us include, but are
not limited to, rent, issuance and transaction costs incident to the acquisition, disposition and financing of our investments, legal, tax, accounting, consulting and auditing fees and expenses, the
compensation and expenses of our directors, the cost of directors' and officers' liability insurance, the costs associated with the establishment and maintenance of any credit facilities and other
indebtedness of ours (including commitment fees, accounting fees, legal fees and closing costs), expenses associated with other securities offerings of ours, expenses relating to making distributions
to our shareholders, the costs of printing and mailing proxies and reports to our shareholders, costs associated with any computer software or hardware, electronic equipment, or purchased information
technology services from third party vendors, costs incurred by employees of our Manager for travel on our behalf, the costs and expenses incurred with respect to market information systems and
publications, research publications and materials, and settlement, clearing, and custodial fees and expenses, expenses of our transfer agent, the costs of maintaining compliance with all federal,
state and local rules and regulations or any other regulatory agency, all taxes and license fees and all insurance costs incurred by us or on our behalf. In addition, we will be required to pay our
pro rata portion of rent, telephone, utilities, office furniture, equipment, machinery and other office, internal and overhead expenses of our Manager and its affiliates required for our operations.
Except as noted above, our Manager is responsible for all costs incident to the performance of its duties under the Management Agreement, including compensation of our Manager's employees and other
related expenses, except that we may elect to have our Manager allocate expenses among us and our subsidiaries, in which case expenses would be paid directly by each entity that received an
allocation. For the year ended December 31, 2012, we incurred reimbursable expenses to our Manager of $10.2 million.
Incentive Compensation.
In addition to the base management fee, our Manager receives quarterly incentive compensation in an
amount equal to the
product of: (i) 25% of the dollar amount by which: (a) our Net Income, before incentive compensation, per weighted average share of our common shares for such quarter, exceeds
(b) an amount equal to (A) the weighted average of the price per share of the common stock of KKR Financial Corp. in its August 2004 private placement and the prices per share of the
common stock of KKR Financial Corp. in its initial public offering and any subsequent offerings by KKR Financial Holdings LLC multiplied by (B) the greater of (1) 2.00% and
(2) 0.50% plus one-fourth of the Ten Year Treasury Rate for such quarter, multiplied by (ii) the weighted average number of our common shares outstanding in such quarter. The
foregoing calculation of incentive compensation will be adjusted to exclude special one-time events pursuant to changes in GAAP, as well as non-cash charges, after discussion
between our Manager and our independent directors and approval by a majority of our independent directors in the case of non-cash charges. In addition, any shares that by their terms are
entitled to a specified periodic distribution, including the Company's 7.375% Series A LLC Preferred Shares, will not be treated as shares, nor included as shares offered or outstanding, for the
purpose of calculating incentive compensation, and instead the aggregate distribution amount that accrues to these shares during the
fiscal quarter of such calculation will be subtracted from our Net Income, before incentive compensation for purposes of clause (i)(A). The incentive compensation calculation and payment shall
be made quarterly in arrears. For purposes of the foregoing: "Net Income" will be determined by calculating the net income available to shareholders before non-cash equity compensation
expense, in accordance with GAAP; and "Ten Year Treasury Rate" means the average of weekly average yield to maturity for United States Treasury securities (adjusted to a constant maturity of ten
years) as published weekly by the Federal Reserve Board in publication H.15 or any successor publication during a fiscal quarter.
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Our ability to achieve returns in excess of the thresholds noted above in order for our Manager to earn the incentive compensation described in the preceding
paragraph is dependent upon various factors, many of which are not within our control.
Our
Manager is required to compute the quarterly incentive compensation within 30 days after the end of each fiscal quarter, and we are required to pay the quarterly incentive
compensation with respect to each fiscal quarter within five business days following the delivery to us of our Manager's written statement setting forth the computation of the incentive fee for such
quarter. We may elect to have our Manager allocate the incentive fee among us and our subsidiaries, in which case the fee would be paid directly by each entity that received an allocation.
For
the year ended December 31, 2012, $37.6 million of incentive fees were earned by our Manager.
The Collateral Management Agreements
As of December 31, 2012, the CLO management fees for all CLOs, except for CLO 2005-1 and CLO 2012-1, are
being waived or are not entitled to be received. For the year ended December 31, 2012, the collateral manager waived aggregate CLO management fees of $32.2 million and we recorded an
expense for CLO management fees totaling $4.2 million.
COMPETITION
Our net income depends, in large part, on our ability to acquire assets at favorable spreads over our borrowing costs. A number of
entities compete with us to make the types of investments that we make. We compete with financial companies, oil and natural gas companies, public and private funds, commercial and investment banks
and commercial finance companies. Some of the competitors are large and may have greater financial and technical resources and greater access to deal flow than are available to us. In addition, some
competitors may have a lower cost of funds than us and access to financing sources that are not available to us. Finally, some of our competitors may have higher risk tolerances or different risk
assessments, which could allow them to consider a wider variety of investments and establish more relationships than us.
We
cannot assure our shareholders that the competitive pressures we face will not have a material adverse effect on our business, financial condition and results of operations. Also, as
a result of this competition, we may not be able to take advantage of attractive investment opportunities from time to time, and we do not offer any assurance that we will be able to identify and make
investments that are consistent with our investment objectives.
STAFFING
We do not have any employees. We are managed by KKR Financial Advisors LLC, our Manager, pursuant to the Management Agreement.
Our Manager is a wholly-owned subsidiary of KAM and all of our executive officers are members or employees of KKR or one or more of its affiliates.
INCOME TAXES
We intend to continue to operate so that we qualify, for United States federal income tax purposes, as a partnership and not as an
association or publicly traded partnership taxable as a corporation. Therefore, we generally are not subject to United States federal income tax at the entity level, but are subject to limited state
and foreign 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 ending within
or with their taxable year.
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We
own equity interests in entities that have elected or intend to elect to be taxed as a real estate investment trust (a "REIT") under the Code. 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.
We
have wholly-owned domestic and foreign subsidiaries that are taxable as corporations for United States federal income tax purposes and thus are not consolidated by 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 the
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. The foreign corporate subsidiaries were
formed to make certain foreign and domestic investments from time to time. The foreign corporate subsidiaries 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. 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 year ended December 31, 2012 were recorded; however, we will be required to include their current taxable income in our calculation of our taxable income allocable to shareholders.
REIT MATTERS
We own equity interests in entities that have elected or intend to elect to be taxed as REITs. The Code requires, among other things,
that at the end of each calendar quarter at least 75% of a REIT's total assets must be "real estate assets" as defined in the Code. The Code also requires that each year at least 75% of a REIT's gross
income come from real estate sources and at least 95% of a REIT's gross income come from real estate sources and certain other passive sources itemized in the Code, such as dividends and interest. As
of December 31, 2012, we believe our REITs were in compliance with all requirements necessary to be taxed as a REIT. However, the sections of the Code and the corresponding United States
Treasury Regulations that relate to qualification and taxation as a REIT are highly technical and complex, and qualification and taxation as a REIT depends upon the ability to meet various
qualification tests imposed under the Code (such as those described above), including through actual annual operating results, asset composition, distribution levels and diversity of share ownership.
Accordingly, no assurance can be given that any REIT in which we own an equity interest will be deemed to have been organized and to have operated, or to continue to be organized and operated, in a
manner so as to qualify or remain qualified as a REIT.
RESTRICTIONS ON OWNERSHIP OF OUR SHARES
Due to limitations on the concentration of ownership of a REIT imposed by the Code, our amended and restated operating agreement, among
other limitations, generally prohibits any shareholder from beneficially or constructively owning more than 9.8% in value or in number of shares, whichever is more restrictive, of any class or series
of the outstanding shares of our company, including common shares or preferred shares. Our board of directors has discretion to grant exemptions from the ownership limit, subject to terms and
conditions as it deems appropriate.
REGULATION OF THE OIL AND NATURAL GAS INDUSTRY
We have made and may continue to make investments in the oil and natural gas industry. The operations underlying these investments are
substantially affected by federal, state and local laws and
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regulations.
In particular, oil and natural gas production and related operations are, or have been, subject to price controls, taxes and numerous other laws and regulations, including those relating
to the transportation of oil and natural gas. All of the jurisdictions in which we own or operate properties for oil and natural gas production have statutory provisions regulating the exploration for
and production of oil and natural gas, including provisions related to permits for the drilling of wells, bonding requirements to drill or operate wells, the location of wells, the method of drilling
and casing wells, the surface use and restoration of properties upon which wells are drilled, sourcing and disposal of water used in the drilling and completion process and the abandonment of wells.
The operations underlying our investments are also subject to various conservation laws and regulations. These include regulation of the size of drilling and spacing units or proration units, the
number of wells which may be drilled in an area, and the unitization or pooling of oil and natural gas wells, as well as regulations that generally prohibit the venting or flaring of natural gas and
impose certain requirements regarding the ratability or fair apportionment of production from fields and individual wells.
The
exploration, development and production operations underlying our investments in oil and gas are also subject to stringent federal, regional, state and local laws and regulations
governing occupational health and safety, the discharge of materials into the environment or otherwise relating to environmental protection. These laws and regulations may, among other things, require
the acquisition of permits to conduct exploration, drilling and production operations; govern the amounts and types of substances that may be released into the environment; limit or prohibit
construction or drilling activities in sensitive areas such as wetlands, wilderness areas or areas inhabited by endangered species; require investigatory and remedial actions to mitigate pollution
conditions; impose obligations to reclaim and abandon well sites and pits; and impose specific criteria addressing worker protection. Failure to comply with these laws and regulations may result in
the assessment of administrative, civil and criminal penalties, the imposition of remedial obligations and the issuance of orders enjoining some or all of our operations in affected areas. These laws
and regulations may also restrict the rate of oil and natural gas production below the rate that would otherwise be possible. The regulatory burden on the oil and gas industry increases the cost of
doing business in the industry and consequently affects profitability.
The
trend in environmental regulation is to place more restrictions and limitations on activities that may affect the environment, and thus, any changes in federal or state environmental
laws and regulations or re-interpretation of applicable enforcement policies that result in more stringent and costly well construction, drilling, water management or completion
activities, or waste handling, storage, transport, disposal or remediation requirements could have a material adverse effect on our financial position. The operators of the oil and gas properties in
which we invest may be unable to pass on such increased compliance costs to their customers. Moreover, accidental releases or spills may occur in the course of those operations, and we cannot assure
you that we will not incur significant costs and liabilities as a result of such releases or spills, including any third party claims for damage to property, natural resources or persons. Failure to
comply with applicable laws and regulations can result in substantial penalties.
Although
we believe that the operations underlying our oil and gas investments are in substantial compliance with all applicable laws and regulations, and that continued substantial
compliance with existing requirements will not have a material adverse effect on the value of our natural resources investments, our ability to use these investments as collateral, or our results of
operations, such laws and regulations are frequently amended or reinterpreted. Additionally, currently unforeseen environmental incidents may occur or past non-compliance with
environmental laws or regulations may be discovered. Therefore, we are unable to predict the future costs or impact of compliance. Additional proposals and proceedings that affect the oil and natural
gas industry are regularly considered by Congress, the states, the Federal Energy Regulatory Commission and the courts. We cannot predict when or whether any such proposals may become effective.
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IRAN SANCTIONS RELATED DISCLOSURE
Under the Iran Threat Reduction and Syrian Human Rights Act of 2012, which added Section 13(r) of the Exchange Act, we are
required to include certain disclosures in our periodic reports if we or any of our "affiliates" knowingly engaged in certain specified activities during the period covered by the report. We are not
presently aware that we and our consolidated subsidiaries have knowingly engaged in any transaction or dealing reportable under Section 13(r) of the Exchange Act during the year ended
December 31, 2012. We note, however, that KKR & Co. L.P., an affiliate of our Manager, has informed us that it has included the disclosure reproduced below (relating to two
companies in which its private equity funds have invested) in Exhibit 99.1 to its annual report on Form 10-K as filed with the SEC on February 22, 2013 as required by
Section 13(r) of the Exchange Act (the "KKR Disclosure").
"During the year ended December 31, 2012, a European company in which our private equity funds have invested sold television
content to the Islamic Republic of Iran Broadcasting ("IRIB") for less than €45,000. We have been advised by the company that it does not intend to sell any further content to the
IRIB.
A
European subsidiary of a company in which our private equity funds have invested shipped a cancer drug to Medical Equipment and Pharmaceutical Holding Co. in June 2012. The
company has informed
us that anticipated gross revenue from such shipment was approximately €92,000."
ITEM 1A. RISK FACTORS
Our shareholders should carefully consider the risks described below and the information contained in this Annual Report on
Form 10-K and other filings that we make from time to time, including our consolidated financial statements and accompanying notes. Any of the following risks could materially
adversely affect our business, financial condition or results of operations. The risks described below are not the only risks we face. We have only described the risks we consider to be material.
However, we may face additional risks that are viewed by us as not material or are not presently known to us.
RISKS RELATED TO OUR OPERATIONS, BUSINESS STRATEGY AND INVESTMENTS
Our business and the businesses in which we invest are materially affected by conditions in the global financial markets and economic conditions generally.
Our business and the businesses of the companies in which we invest are materially affected by conditions in the global financial
markets and economic conditions generally, such as interest rates, availability and cost of capital, inflation rates, economic uncertainty, default rates, commodity prices, currency exchange rates,
changes in laws (including laws relating to taxation), possible further downgrades in the credit ratings of the U.S. or other developed nations] and other national and international
political circumstances. While the adverse effects of the unprecedented turmoil in the global credit and securities markets in late 2007 through early 2009 have abated, ongoing developments in the
U.S. and global financial markets following that period, market volatility, slow economic growth and regulatory developments continue to illustrate that the current environment is still one of
uncertainty.
These
economic conditions resulted in, and may in future again result in, significant declines in the values of nearly all asset classes. a serious lack of liquidity in the credit
markets, increases in margin
calls for investors, requirements that derivatives counterparties post additional collateral, redemptions by mutual and hedge fund investors and outflows of client funds across the financial services
industry.
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Although
the global financial markets continued to recover in 2012, there can be no assurance that these markets will continue to improve and persistently high unemployment rates in the United States,
slow recovery in many real estate markets, recessions in a number of European nations and slowing growth in developing countries all highlight the fact that economic conditions are still unstable and
unpredictable. If the overall business environment worsens, our results of operations may be adversely affected.
In
addition, low interest rates related to monetary stimulus and economic stagnation may negatively impact expected returns on all types of investments as the demand for relatively
higher return assets increases and the supply decreases.
Dislocations in the corporate credit sector could adversely affect us and one or more of our lenders, which could result in increases in our borrowing costs, reductions in
our liquidity and reductions in the value of the investments in our portfolio.
Dislocations in the corporate credit sector, such as those experienced beginning in the third quarter of 2007 through the beginning of
2011, could adversely affect one or more of the counterparties providing funding for our investments and could cause those counterparties to be unwilling or unable to provide us with additional
financing which may adversely affect our liquidity and financial condition. This could potentially limit our ability to finance our investments and operations, increase our financing costs and reduce
our liquidity. If one or more major market participants were to fail or withdraw from the market, it could negatively impact the marketability of all fixed income securities and this could reduce the
value of the securities in our portfolio, thus reducing our net book value. Furthermore, if one or more of our counterparties were unwilling or unable to provide us with ongoing financing, we could be
forced to sell our investments at a time when prices are depressed.
Liquidity is essential to our businesses and we rely on external sources to finance a significant portion of our operations. If we are unable to raise funding from these
external sources, we may be forced to liquidate certain of our assets and our results of operations may be adversely affected.
Liquidity is essential to our business. Our liquidity could be substantially adversely affected by an inability to raise funding in the
long-term or short-term debt capital markets or the equity capital markets or an inability to access the secured lending markets. Factors that we cannot control, such as
disruptions in the financial markets, the ongoing economic difficulties in Europe, the failure of the United States to reduce its deficit in amounts deemed to be sufficient, possible downgrades in the
credit ratings of U.S. debt, changes to tax laws, contractions or limited growth in the economy or negative views about corporate credit investing and the specialty finance industry generally, could
impair our ability to raise funding. In addition, our ability to raise funding could be impaired if lenders develop a negative perception of our long-term or short-term
financial prospects. Such negative perceptions could develop if we incur large trading losses, or we suffer a decline in the level of our business activity, among other reasons. If we are unable to
raise funding using the methods described above, we would likely need to liquidate unencumbered assets, such as our investment and trading portfolios, to meet maturing liabilities. We may be unable to
sell some of our assets, or we may have to sell assets at a discount from market value, either of which could adversely affect our results of operations and may have a negative impact on the market
price of our common shares and any other securities we may issue.
We may not realize gains or income from our investments.
We seek to generate both current income and capital appreciation. The assets in which we invest may not appreciate in value, however,
and, in fact, may decline in value, and the debt securities in which we invest may default on interest and/or principal payments. Accordingly, we may not be able to
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realize
gains or income from our investments. Additionally, any gains that we do realize may not be sufficient to offset any other losses we experience or offset our expenses.
We leverage a portion of our portfolio investments, which may adversely affect our return on our investments and may reduce cash available for distribution.
We leverage a portion of our portfolio investments through borrowings, generally through the use of bank credit facilities and
securitizations, including the issuance of CLOs, and other secured and unsecured borrowings. The percentage of leverage varies depending on our ability to obtain credit facilities and the lenders' and
rating agencies' estimate of the stability of the portfolio investments' cash flow. As of December 31, 2012, the only contractual limitation on our ability to leverage our portfolio is a
covenant contained in our revolving credit facility that our leverage ratio cannot exceed 1.5 to 1.0, computed on a basis that generally excludes the debt of variable interest entities that we
consolidate under GAAP such as our CLO subsidiaries. Our ability to generate returns on our investments and make cash available for distribution to holders of our common shares would be reduced to the
extent that changes in market conditions cause the cost of our financing to increase relative to the income that can be derived from the assets acquired and financed.
We make non-United States dollar denominated investments, which subject us to currency rate exposure and the uncertainty of foreign laws and markets.
From time to time, we make investments that are denominated in foreign currencies. For example, as of December 31, 2012,
$350.4 million par amount, or 5.0%, of our corporate debt portfolio was denominated in foreign currencies, of which 69.6% was denominated in Euros, and $147.5 million par amount, or
42.6%, of other assets, which includes equity investments at estimated fair value and interests in joint ventures and partnerships, was denominated in foreign currencies, of which 43.7% was
denominated in Euros and 21.7% was denominated in Canadian dollars. A change in foreign currency exchange rates, in particular that of the euro relative to the dollar, may have an adverse impact on
returns on any of these non-dollar denominated investments. For example, our returns on these investments may be adversely affected by events in Eurozone countries that could cause the
euro to fall versus the dollar such as defaults on sovereign debt, rating downgrades, continued economic contraction, the need for further financial relief of impacted countries, successions from the
Eurozone or the perception that any such event may occur. See "Quantitative and Qualitative Disclosures About Market RiskForeign Currency Risks" in Item 7 of this Annual Report for
further information about our currency rate exposure.
Although
we may choose to hedge our foreign currency risk, we may not be able to do so successfully and may incur losses on these investments as a result of exchange rate fluctuations.
Investments in foreign countries also subject us to certain additional risks, including risks relating to the potential imposition of non-United States taxes, compliance with multiple and
potentially conflicting regulatory schemes and political and economic instability abroad, any of which could adversely affect our returns on these investments.
The majority of our assets consist of high-yield, below investment grade or unrated debt, which generally has a greater risk of loss than investment grade rated
debt and, if those losses are realized, it could adversely affect our results of operations, our ability to service our indebtedness and our cash available for distribution to holders of our common
shares.
Our assets include below investment grade or unrated debt, including loans and bonds, each of which generally involves a higher degree
of risk than investment grade rated debt. Issuers of high yield or unrated debt may be highly leveraged, and their relatively high debt-to-equity ratios create increased risks
that their operations might not generate sufficient cash flow to service their debt obligations. As a result, high yield or unrated debt is often less liquid than investment grade rated debt.
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In
addition to the above, numerous other factors may affect a company's ability to repay its debt, including the failure to meet its business plan, a downturn in its industry or negative
economic conditions. Deterioration in a company's financial condition and prospects may be accompanied by deterioration in the collateral for the high yield debt. Losses on our high yield debt
holdings could adversely affect our results of operations, which could adversely affect our ability to service our indebtedness and cash available for distribution to holders of our common shares.
Our investment portfolio is and may continue to be concentrated in a limited number of companies and industries, which will subject us to a risk of significant loss if any
of these companies defaults on its obligations to us or if there is a downturn in a particular industry.
Our investment portfolio is and may continue to be concentrated in a limited number of companies and industries. This lack of
diversification may subject our investment portfolio to more rapid changes in value than would be the case if our assets were more widely diversified. For example, as of December 31, 2012, the
20 largest issuers which we have invested in represented approximately 42% of our total debt investment portfolio on an estimated fair value basis. As a result, our results of operations, financial
condition and ability to pay distributions to our shareholders may be adversely affected if a small number of borrowers default in their obligations to us or if we need to write down the value of any
one investment. If such impairments exceed our recorded allowance for loan losses our net income will be adversely affected. Moreover, securities issued by some of our largest issuers are recorded at
estimated fair value and our net income may be adversely affected if these fair value determinations are materially higher than the values that we ultimately realize upon disposal of such securities.
Additionally, a downturn in any particular industry in which we are invested could also negatively impact our results of operations and our ability to pay distributions. For example, as of
December 31, 2012, we had approximately 22% of our total debt investment
portfolio on an estimated fair value basis in two industriesHealthcare, Education and Childcare and Diversified/Conglomerate Services.
If we are unable to continue to utilize CLOs or other similar financing vehicles successfully, we may be unable to grow or fully execute our business strategy and our
results of operations may be adversely affected.
We have historically financed a substantial portion of our investments through, and derived a substantial portion of our revenue from,
our CLO subsidiaries. These CLOs have served as long-term, non-recourse financing for debt investments and as a way to minimize refinancing risk, minimize maturity risk and
secure a fixed cost of funds over an underlying market interest rate. An inability to continue to utilize CLOs or other similar financing vehicles successfully could limit our ability to fund future
investments, grow our business or fully execute our business strategy and our results of operations may be adversely affected.
A number of our CLOs are outside of reinvestment periods, which may adversely affect our returns on investment and ability to maintain compliance with certain
overcollateralization and interest coverage tests.
Our CLOs generally have periods during which, subject to certain restrictions, their managers can sell or buy assets at their
discretion and can reinvest principal proceeds into new assets, commonly referred to as a "reinvestment period". Outside of a reinvestment period, the principal proceeds from the assets held in the
CLO must generally be used to pay down the related CLO's debt, which causes the leverage on the CLO to decrease. Such leverage decreases may cause our return on investment to decline. In addition, in
the past the ability to reinvest has been important in maintaining compliance with the overcollateralization and interest coverage tests for certain of our CLOs. Outside of a reinvestment period, our
ability to maintain compliance with such tests for that CLO may be negatively impacted. The reinvestment periods for CLO 2005-1, CLO 2005-2, CLO 2006-1 and CLO
2007-A have
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ended
and the reinvestment period for CLO 2007-1 will end in May 2014. In addition, CLO 2011-1 has no reinvestment period and is an amortizing static pool CLO transaction.
Downturns in the global credit markets may affect the collateral in our CLO investments, which may adversely affect our cash flows from CLO investments.
Among the sectors particularly challenged by adverse economic conditions, including those experienced during the credit crisis, are the
CLO and leveraged finance markets. We have significant exposure to these markets through our investments in CLO 2005-1, CLO 2005-2, CLO 2006-1,
CLO 2007-1, CLO 2007-A, CLO 2011-1 and CLO 2012-1, each of which is a Cayman Islands incorporated special purpose company that issued to us and
other investors notes secured by a pool of collateral consisting primarily of corporate leveraged loans. In most cases, our Cash Flow CLO investments are in deeply subordinated securities issued by
the CLO issuers, representing highly leveraged investments in the underlying collateral, which increases both the opportunity for higher returns as well as the magnitude of losses when compared to
other investors in these CLO structures that rank more senior to us in right of payment. As a result of our subordinated position in these CLO structures, we and our investors are at greater risk of
suffering losses on our cash flow CLO investments during periods of adverse economic conditions.
During
an economic downturn, the CLOs in which we invest may experience increases in downgrades, depreciations in market value and defaults in respect of their collateral. The CLOs'
portfolio profile tests set limits on the amount of discounted obligations a CLO can hold. During any time that a CLO issuer exceeds such a limit, the ability of the CLO's manager to sell assets and
reinvest available principal proceeds into substitute assets is restricted. In addition, discounted assets and assets rated "CCC" or lower in excess of applicable limits in the CLO issuers' investment
criteria are not given full par credit for purposes of calculation of the CLO issuers' over-collateralization tests. As a result, these CLOs may fail one or more of their
over-collateralization tests, which would cause diversions of cash flows away from us as holders of the more junior CLO securities in favor of investors more senior than us in right of
repayment, until the relevant over-collateralization tests are satisfied. This diversion of cash flows may have a material adverse impact on our business and our ability to make
distributions to shareholders. In addition, it is possible that our cash flow CLOs' collateral could be depleted before we realize a return on our cash flow CLO investments.
At
various times during the credit crisis, a number of our CLOs were out of compliance with the compliance tests outlined in their respective indentures. Although all of our CLOs were in
compliance as of December 31, 2012, there can be no assurance that all of our CLOs will remain in compliance with their respective compliance tests during 2013 and that we will not, as a
result, be required to pay cash flows to the senior note holders of the CLOs that were out of compliance that we would otherwise have expected to receive from our CLOs.
The
ability of the CLOs to make interest payments to the holders of the senior notes of those structures is highly dependent upon the performance of the CLO collateral. If the collateral
in those structures were to experience a significant decrease in cash flow due to an increased default level, the issuer may be unable to pay interest to the holders of the senior notes, which would
allow such holders to declare an event of default under the indenture governing the transaction and accelerate all principal and interest outstanding on the senior notes. In addition, our CLO
structures also contain
certain events of default tied to the value of the CLO collateral, which events of default could also cause an acceleration of the senior notes. If the value of the CLO collateral within a CLO were to
be less than the amount of senior notes issued and outstanding, the senior note holders would have the ability to declare an event of default.
There
can be no assurance that market conditions giving rise to these types of consequences will not occur, subsist or become more acute in the future. Because our CLO structures involve
complex
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collateral
and other arrangements, the documentation for such structures is complex, is subject to differing interpretations and involves legal risk.
We may enter into derivative contracts that could expose us to contingent liabilities in the future.
Part of our investment strategy involves entering into derivative contracts that could require us to fund cash payments in the future
under certain circumstances, including an event of default or other early termination event, or the decision by a counterparty to request margin securities under the terms of the derivative contract.
The amounts due with respect to swaps would generally be equal to the unrealized loss of the open swap positions with the respective counterparty and could also include other fees and charges. These
payments are contingent liabilities and therefore may not appear on our balance sheet. Our ability to fund these contingent liabilities will depend on the liquidity of our assets and access to capital
at the time, and the need to fund these contingent liabilities could adversely impact our financial condition.
The derivatives that we use to hedge against interest rate, foreign currency and commodity exposure are volatile and may adversely affect our results of operations, which
could adversely affect our ability to make payments due on our indebtedness and cash available for distribution to holders of our common shares.
From time to time, we enter into various hedging instruments such as swaps, options, forwards and futures as part of our strategy to
manage our risk related to interest rates, holdings denominated in foreign currencies and energy prices in connection with our natural resources investments. In the future we may enter into additional
hedging instruments as part of these or other risk management strategies. Our hedging activity varies in scope based on the level of interest rates, the
type of portfolio investments held, market prices for natural resources, and other changing market conditions. These hedging instruments may fail to protect us from interest rate, foreign currency or
commodity price volatility or could adversely affect us because, among other things:
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hedging instruments can be expensive, particularly during periods of volatility in interest rates, foreign currency and
commodity prices;
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available hedging instruments may not correspond directly with the risk for which protection is sought;
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the duration of the hedge may be significantly different than the duration of the related liability or asset;
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the credit quality of the party owing money on the hedge may be downgraded to such an extent that it impairs or makes
economically unattractive our ability to sell or assign our side of the hedging transaction; and
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the party owing money in the hedging transaction may default on its obligation to pay.
The
cost of using hedging instruments increases as the period covered by the instrument increases and, with respect to interest rate hedges, during periods of rising and volatile
interest rates, with respect to foreign currency hedges, during periods of volatile foreign currencies or, with respect to commodity hedges, during periods of falling and volatile commodity prices. We
may increase our hedging activity and thus increase our hedging costs during such periods when hedging costs have increased.
Any
hedging activity we engage in may adversely affect our results of operations, which could adversely affect our ability to make payments due on our indebtedness and cash available for
distribution to holders of our common shares. Therefore, while we may enter into such transactions to seek to reduce interest rate, foreign currency and commodity risks related to our natural
resources investments, unanticipated changes in interest rates, foreign currency and commodity prices may result
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in
poorer overall investment performance than if we had not engaged in any such hedging transactions. In addition, the degree of correlation between price movements of the instruments used in a
hedging strategy and price movements in the portfolio positions or liabilities being hedged may vary materially. Moreover, for a variety of reasons, we may not seek to establish a perfect correlation
between such hedging instruments and the portfolio holdings or liabilities being hedged. Any such imperfect correlation may expose us to risk of loss.
Hedging instruments often involve counterparty risks and costs.
The business failure of a hedging counterparty with whom we enter into a hedging transaction will most likely result in a default.
Default by a party with whom we enter into a hedging transaction may result in the loss of unrealized profits, leave us with unsecured exposure and force us to cover our resale commitments, if any, at
the then current market price. It may not always be possible to dispose of or close out a hedging position without the consent of the hedging counterparty, and we may not be able to enter into an
offsetting contract in order to cover our risk. We cannot assure our shareholders that a liquid secondary market will exist for hedging instruments purchased or sold, and we may be required to
maintain a position until exercise or expiration, which could result in losses.
Hedging instruments involve risks and costs.
The enforceability of agreements underlying hedging transactions may depend on compliance with applicable statutory and other
regulatory requirements and, depending on the identity of the counterparty, applicable international requirements. The business failure of a hedging counterparty with whom we enter into a hedging
transaction will most likely result in a default. Default by a party with whom we enter into a hedging transaction may result in the loss of unrealized profits, leave us with unsecured exposure and
force us to cover our resale commitments, if any, at the then current market price. It may not always be possible to dispose of or close out a hedging position without the consent of the hedging
counterparty, and we may not be able to enter into an offsetting contract in order to cover our risk. We cannot assure our shareholders that a liquid secondary market will exist for hedging
instruments purchased or sold, and we may be required to maintain a position until exercise or expiration, which could result in losses.
The full impact of regulatory changes, including the Dodd-Frank Act, on our business is uncertain.
On July 21, 2010, the United States enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act (the
"Dodd-Frank Act"). The Dodd-Frank Act affects almost every aspect of the United States financial services industry, including certain aspects of the markets in which we
operate. For example, the Dodd-Frank Act imposes additional disclosure requirements for public companies and generally requires issuers or originators of asset-backed securities to retain
at least five percent of the credit risk associated with the securitized assets. In addition, the Dodd-Frank Act:
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establishes the Financial Stability Oversight Council (the "FSOC"), a federal agency acting as the financial system's
systemic risk regulator with the authority to review the activities of non-bank financial firms, to make recommendations and impose standards regarding capital, leverage, liquidity, risk
management and other requirements for financial firms and to impose regulatory standards on certain financial firms deemed to pose a systemic risk to the financial stability of the United States;
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imposes certain regulatory requirements on the trading of "swaps" and "security-based swaps" (as such terms are defined in
the Dodd-Frank Act and final rules from the Commodity Futures Trading Commission (the "CFTC") and the SEC), including requirements that certain swaps and security-based swaps be executed
on an exchange or "swap execution facility" and cleared through a clearing house, and requirements that entities acting as dealers or major participants
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register
in the appropriate category and comply with capital, margin, record keeping and reporting and business conduct rules which could increase the cost of trading in the derivative markets or
reduce trading levels in the derivative markets;
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substantially restricts the ability of banking organizations to sponsor or invest in private equity and hedge funds or
engage in proprietary trading; and
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grants the United States government resolution authority to liquidate or take emergency measures with regard to troubled
financial institutions (including nonbank financial institutions) that fall outside the resolution authority of the Federal Deposit Insurance Corporation.
In
addition, the Dodd-Frank Act could affect our Investment Company Act status. See the risk factor entitled "If the SEC were to disagree with our Investment Company Act
determinations, our business could be adversely affected."
Many
of the Dodd-Frank Act's provisions are subject to final rulemaking by the U.S. financial regulatory agencies, and the implications of the Dodd-Frank Act for
our business will depend to a large extent on how such rules are adopted and implemented by various U.S. financial regulatory agencies, such as the FSOC, CFTC and SEC. For example, if the FSOC were to
determine that we are a systemically important nonbank financial company, we would be subject to a heightened degree of regulation and supervision. In addition, the CFTC and SEC have proposed or
adopted rules to establish a new regulatory framework for commodity swaps and security-based swaps which could limit our positions or trading in such instruments. We continue to analyze the impact of
rules adopted under the Dodd-Frank Act. However, the full impact will not be known until the rules, and other regulatory initiatives that overlap with the rules, are finalized and their
combined impacts can be understood.
In
addition, in November 2012, the Financial Stability Board, an international body of which the United States is a member, issued an initial set of policy recommendations to strengthen
oversight and regulation of the so-called "shadow banking system", broadly described as credit intermediation involving entities and activities outside the regular banking system, such as
private equity funds and hedge funds. The policy recommendations outlined initial steps to define the scope of the shadow banking system and proposed general governing principles for a monitoring and
regulatory framework. The Financial Stability Board is expected to finalize policy recommendations concerning the shadow banking sector before the G-20 meets in Russia in early September
2013. While at this stage it is difficult to predict the scope of any new regulations, if such regulations were to extend the regulatory and supervisory requirements currently applicable to banks,
such as capital and liquidity standards, to our business, or were to otherwise classify all or a portion of our business as "shadow banking," our regulatory and operating costs, as well as the public
scrutiny we face, would increase, which may have a material adverse effect on our business.
Legal, tax and regulatory changes could occur and may adversely affect our ability to pursue our hedging strategies and/or increase the costs of implementing such
strategies.
The enforceability of agreements underlying hedging transactions may depend on compliance with applicable statutory and other
regulatory requirements and, depending on the identity of the counterparty, applicable international requirements. New or amended regulations may be imposed by the CFTC, the SEC, the U.S. Federal
Reserve or other financial regulators, other governmental regulatory authorities or self-regulatory organizations that supervise the financial markets that could adversely affect us. In
particular, these agencies are empowered to promulgate a variety of new rules pursuant to recently enacted financial reform legislation in the United States. We also may be adversely affected by
changes in the enforcement or interpretation of existing statutes and rules by these governmental regulatory authorities or self-regulatory organizations.
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In addition, the securities and futures markets are subject to comprehensive statutes, regulations and margin requirements. For example, the Dodd-Frank Act
provides for new regulation of the derivatives market, including clearing, margin, reporting, recordkeeping, and registration requirements. Although the CFTC has released final rules relating to
clearing, reporting, recordkeeping and registration requirements under the Dodd-Frank Act, many of the provisions are subject to further final rulemaking, and thus the Dodd-Frank Act's ultimate impact
remains unclear. New regulations could, among other things, restrict our ability to engage in derivatives transactions (for example, by making certain types of derivatives transactions no longer
available to us) and/or increase the costs of such derivatives transactions (for example, by increasing margin or capital requirements), and we may be unable to execute our hedging strategies as a
result. It is unclear how the regulatory changes will affect counterparty risk.
We may make investments or obtain credit that may require us to post additional collateral in periods of adverse market volatility, which could adversely affect our
financial condition and liquidity.
We may make investments or have credit sources in the future that, during periods of adverse market volatility, such as the periods we
observed during the global credit crisis, could require us to post additional margin collateral, which may have a material adverse impact on our liquidity. For example, in the past, certain of our
financing facilities allowed the counterparties
to determine a new market value of the collateral to reflect current market conditions. In such cases, if a counterparty had determined that the value of the collateral had decreased, it could have
initiated a margin call and required us to either post additional collateral or repay a portion of the outstanding borrowing, on minimal notice. If we make investments or obtain credit on similar
terms in the future, periods of adverse market volatility could result in a significant increase in margin calls and our liquidity, results of operations, financial condition, and business prospects
could suffer. In such a case, it is possible that in order to obtain cash to satisfy a margin call, we would be required to liquidate assets or raise capital at a disadvantageous time, which could
cause us to incur further losses or otherwise adversely affect our results of operations and financial condition, could impair our ability to pay distributions to our shareholders and could have a
negative impact on the market price of our shares and any other securities we may issue. In the event we are required to post additional collateral on investments, our contingent liquidity reserves
may not be sufficient at such time in the event of a material adverse change in the credit markets and related market price market volatility.
We are subject to risks in using prime brokers, custodians, administrators and other agents.
We depend on the services of prime brokers, custodians, administrators and other agents to carry out certain of our securities
transactions. In the event of the insolvency of a prime broker and/or custodian, we may not be able to recover equivalent assets in full as we will rank among the prime broker's and custodian's
unsecured creditors in relation to assets which the prime broker or custodian borrows, lends or otherwise uses. In addition, our cash held with a prime broker or custodian may not be segregated from
the prime broker's or custodian's own cash, and we therefore may rank as unsecured creditors in relation thereto. The inability to recover assets from the prime broker or custodian could have a
material impact on the performance of our business, financial condition and results of operations.
We may not be able to generate sufficient cash to service or make required repayments of our indebtedness and we may be forced to take other actions to satisfy our
obligations under our indebtedness, which may not be successful.
As of December 31, 2012, we had approximately $829.8 million of total recourse debt outstanding.
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Our
debt level and related debt service obligations:
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may limit our ability to obtain additional financing in excess of our current borrowing capacity on satisfactory terms to
fund working capital requirements, capital expenditures, acquisitions, investments, debt service requirements, capital stock and debt repurchases, distributions and other general corporate
requirements or to refinance existing indebtedness;
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require us to dedicate a substantial portion of our cash flows to the payment of principal and interest on our debt which
will reduce the funds we have available for other purposes;
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limit our liquidity and operational flexibility and our ability to respond to the challenging economic and business
conditions that currently exist or that we may face in the future;
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may require us in the future to reduce discretionary spending, dispose of assets or forgo investments, acquisitions or
other strategic opportunities;
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impose on us additional financial and operational restrictions;
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expose us to increased interest rate risk because a substantial portion of our debt obligations are at variable interest
rates; and
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subject us to market and industry speculation as to our financial condition and the effect of our debt level and debt
service obligations on our operations, which speculation could be disruptive to our relationships with customers, suppliers, employees, creditors and other third parties.
A
breach of any of the covenants in certain of our debt agreements could result in a default under our revolving credit facility, maturing on November 30, 2015 (the "2015
Facility"), 7.5% convertible senior notes due January 15, 2017 ("7.5% Notes"), 8.375% senior notes due November 15, 2041 ("8.375% Notes") and 7.500% senior notes due March 20,
2042. In addition, any distributions on our 7.375% Series A LLC Preferred Shares (the "Series A LLC Preferred Shares"), which were issued on January 17, 2013, could be negatively
impacted. If a default occurs under any of these obligations and we are not able to obtain a waiver from the requisite debt holders, then, among other things, our debt holders could declare all
outstanding principal and interest to be immediately due and payable. If our outstanding indebtedness were to be accelerated, we cannot assure you that our assets would be sufficient to repay in full
that debt and any potential future indebtedness, which would cause the market price of our common shares to decline significantly. We could also be forced into bankruptcy or liquidation.
The terms of our indebtedness and preferred shares may restrict our ability to make future distributions, make cash payments in respect of any conversion or repurchases of
indebtedness and impose limitations on our current and future operations.
The agreement governing the 2015 Facility contains, and any future indebtedness may also contain, a number of restrictive covenants
that impose operating and other restrictions on us, including restrictions on our ability to engage in our current and future operations or to make distributions to holders of our shares. The 2015
Facility credit agreement includes covenants restricting our ability to:
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make distributions on, or to make cash payments in respect of any conversion or repurchases of our indebtedness if an
event of default, or certain events that with notice or passage of time or both would constitute an event of default, under the 2015 Facility occur at a time when we have any amounts outstanding under
the 2015 Facility.
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incur or guarantee additional debt, other than debt incurred in the course of our business consistent with current
operations;
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create or incur liens, other than liens relating to secured debt permitted to be incurred and other limited exceptions;
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engage in mergers and sales of substantially all of our assets;
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make loans, acquisitions or investments, other than investments made in the course of our business consistent with current
operations;
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materially alter our current investment and valuation policies; and
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engage in transactions with affiliates.
In
addition, the 2015 Facility credit agreement also includes financial covenants, including requirements that we:
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maintain adjusted consolidated tangible net worth (as defined in the 2015 Facility credit agreement) of at least
$1 billion plus 25% of the net proceeds of any issuance of equity interests in us;
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not exceed a leverage ratio (as defined in the 2015 Facility credit agreement) of 1.50 to 1.00 computed on a basis that
generally excludes the debt of variable interest entities that we consolidate under GAAP; and
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maintain a ratio of adjusted consolidated total assets (as defined in the 2015 Facility Agreement credit agreement) to
recourse indebtedness (as defined in the 2015 Facility credit agreement) of at least of 8.00 to 1.00.
As
a result of these covenants, we are limited in the manner in which we conduct our business and we may be unable to engage in favorable business activities or finance future operations
or capital needs. Our ability to comply with the covenants and restrictions contained in the agreements governing our indebtedness may be affected by economic, financial and industry conditions beyond
our control. A breach of any of these covenants could result in a default under the 2015 Facility credit agreement. Upon the occurrence of an event of default under the 2015 Facility credit agreement,
the lenders are not required to lend any additional amounts to us and could elect to declare all borrowings outstanding thereunder, together with accrued and unpaid interest and fees, to be due and
payable, which could also result in an event of default under our other agreements relating to our borrowings. If we were unable to refinance these borrowings on favorable terms, our results of
operations and financial condition could be adversely impacted by increased costs and less favorable terms, including higher interest rates and more restrictive covenants. The instruments governing
the terms of any future refinancing of any borrowings are likely to contain similar or more restrictive covenants.
In
addition, the terms of our Series A LLC Preferred Shares restrict our ability make distributions on our common shares under certain circumstances and future issuances of
preferred shares may contain similar or more restrictive terms. For more information about the restrictions imposed by our Series A LLC Preferred Shares see the risk described in this report
under the caption "
The terms of our preferred shares restrict our ability to make future distributions on our common shares and may adversely affect the rights of the holders
of our common shares.
"
There can be no assurances that our operations will generate sufficient cash flows or that credit facilities will be available to us in an amount sufficient to enable us to
pay our indebtedness or to fund other liquidity needs.
Our ability to make scheduled payments or prepayments on our debt and other financial obligations will depend on our future financial
and operating performance and the value of our investments. There can be no assurances that our operations will generate sufficient cash flows or that new sources of credit will be available to us in
an amount sufficient to enable us to pay our indebtedness or to fund our other liquidity needs. Our financial and operating performance is subject to prevailing economic and industry conditions and to
financial, business and other factors, some of which are beyond our control. Our substantial leverage exposes us to significant risk during periods of economic downturn such as the one we recently
experienced, as our cash flows may decrease, but our
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required
principal payments in respect of indebtedness do not change and our interest expense obligations could increase due to increases in interest rates.
If
our cash flows and capital resources are insufficient to fund our debt service obligations, we will likely face increased pressure to dispose of assets, seek additional capital or
restructure or refinance our indebtedness. These actions could have a material adverse effect on our business, financial condition and results of operations. In addition, we cannot assure that we
would be able to take any of these actions, that these actions would be successful and permit us to meet our scheduled debt service obligations or that these actions would be permitted under the terms
of our existing or future debt agreements, including our 2015 Facility credit agreement. For example, we may need to refinance all or a portion of our indebtedness on or before maturity. There can be
no assurance that we will be able to refinance any of our indebtedness on commercially reasonable terms or at all. In the absence of improved operating results and access to capital resources, we
could face substantial liquidity problems and might be required to dispose of material assets or operations to meet our debt service and other obligations. The 2015 Facility credit agreement restricts
our ability to dispose of assets and use the proceeds from such dispositions. We may not be able to consummate those dispositions or to obtain the proceeds realized. Additionally, these proceeds may
not be adequate to meet our debt service obligations then due.
If
we cannot make scheduled payments or prepayments on our debt, we will be in default and, as a result, among other things, our debt holders could declare all outstanding principal and
interest to be due and payable and we could be forced into bankruptcy or liquidation or required to substantially restructure or alter our business operations or debt obligations.
Variable rate indebtedness subjects us to interest rate risk, which could cause our debt service obligations to increase significantly.
As of December 31, 2012, approximately $128.9 million of our recourse borrowings, consisting of our junior subordinated
notes issued in connection with our trust preferred securities, were at variable rates of interest and expose us to interest rate risk. If interest rates increase, our debt service obligations on the
variable rate indebtedness would increase even though the amount borrowed remained the same. We may use interest rate derivatives such as interest rate swap agreements to hedge the variability of the
cash flows associated with our existing or forecasted variable rate borrowings. Although we may enter into additional interest rate swaps, involving the exchange of floating for fixed rate interest
payments, to reduce interest rate volatility, such hedging may increase our costs of funding. We cannot provide assurances that we will be able to enter into interest rate hedges that effectively
mitigate our exposure to interest rate risk.
If credit spreads on our borrowings increase and the credit spreads on our investments do not also increase, we are unlikely to achieve our projected leveraged
risk-adjusted returns. Also, if credit spreads on investments increase in the future, our existing investments will likely experience a material reduction in value.
We make investment decisions based upon projected leveraged risk-adjusted returns. When making such projections we make
assumptions regarding the long-term cost of financing such investments, particularly the credit spreads associated with our long-term financings. We define credit spread as the
risk premium for taking credit risk which is the difference between the risk free rate and the interest rate paid on the applicable investment or loan, as the case may be. If credit spreads on our
long-term financings increase and the credit spreads on our investments are not increased accordingly, we will likely not achieve our targeted leveraged risk-adjusted returns
and we will likely experience a material adverse reduction in the value of our investments.
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Ratings agencies may downgrade our credit ratings, which could make it more difficult for us to raise capital and could increase our financing costs.
We are currently rated by two nationally recognized statistical rating organizations. These rating agencies regularly evaluate us based
on a number of factors, including our financial strength and leverage as well as factors not within our control, including conditions affecting our industry generally and the wider state of the
economy. A negative change in our ratings outlook or any downgrade in our current investment-grade credit ratings by our rating agencies, particularly below investment grade, could, among other
things, adversely affect our access to sources of liquidity and capital, cost of borrowing and may result in more stringent covenants under the terms of any new debt.
Declines in the fair values of our investments may adversely affect our results of operations and credit availability, which may adversely affect, in turn, our ability to
make payments due on our indebtedness and our cash available for distribution to holders of our common shares.
Certain of our assets are required to be carried at (i) estimated fair value, including our securities
available-for-sale, residential mortgage-backed securities, and corporate debt and equity for which we elected to carry at estimated fair value, (ii) lower
of cost of estimated fair value for our corporate loans held for sale, or (iii) amortized cost with a related allowance for credit losses for our corporate loans.
Changes
in the fair values of certain assets will directly affect our results of operations as unrealized gains or losses, or be charged or credited to our shareholders' equity in each
period even if no sale is made. As a result, a decline in values would reduce our book value per share. Moreover, if the decline in value of an available-for-sale security is
considered by our management to be other-than-temporary, such decline will be recorded as a charge which will adversely affect our results of operations.
A
decline in the market value of our assets may adversely affect our results of operations, particularly in instances where we have borrowed money based on the market value of those
assets. If the market value of those assets declines, the lender may require us to post additional collateral to support the loan. If we were unable to post the additional collateral, we would have to
sell the assets at a time when we might not otherwise choose to do so. A reduction in credit available may adversely affect our results of operations, our ability to make payments due on our
indebtedness and cash available for distribution to holders of our shares.
Further,
financing counterparties may require us to maintain a certain amount of cash or to set aside unlevered assets sufficient to maintain a specified liquidity position intended to
allow us to satisfy our collateral obligations. As a result, we may not be able to leverage our assets as fully as we would choose, which may reduce our return on equity. In the event that we are
unable to meet these contractual obligations, our financial condition could deteriorate rapidly because we may be required to sell our investments at distressed prices in order to meet such margin or
liquidity requirements.
Market
values of our investments may decline for a number of reasons, such as causes related to changes in prevailing market rates, increases in defaults, increases in voluntary
prepayments for those investments that we have that are subject to prepayment risk, and widening of credit spreads.
Certain of our investments are illiquid and we may not be able to vary our portfolio in response to changes in economic and other conditions.
Certain of our investments may not be readily convertible to cash due to their illiquidity. For example, we are party to certain
private, unregistered debt transactions in which the securities issued to us are not widely held and trade only in secondary, less established markets. As a result, our ability to vary our portfolio
in response to changes in economic and other conditions may be limited relative to our investment in securities that trade in more liquid markets. In addition, if we are required to liquidate all or a
portion of our portfolio quickly, we may realize significantly less than the value at
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which
we have previously recorded our investments. Furthermore, our Manager conducts diligence on our investments and employees of our Manager may serve on the boards of directors of business entities
in which we invest. These activities may provide our Manager with material non-public information with respect to business entities in which we invest. As a result, we may face additional
restrictions on our ability to liquidate an investment in such business entities to the extent that we or our Manager has, or could be attributed with, material non-public information. See
the risk factor entitled "Our access to confidential information may restrict our ability to take action with respect to some investments, which, in turn, may negatively affect our results of
operations."
Some of our portfolio investments are recorded at fair value as determined by our Manager and, as a result, there is uncertainty as to the value of these investments.
Some of our portfolio investments are, and we believe are likely to continue to be, in the form of loans, securities and partnership
interests that have limited liquidity or are not publicly traded. The fair value of investments that have limited liquidity or are not publicly traded may not be readily determinable. We generally
value these investments quarterly at fair value as determined by our Manager pursuant to applicable United States GAAP accounting guidance. Because such valuations are inherently uncertain and may
fluctuate over short periods of time and be based on estimates, our determinations of fair value may differ materially from the values that would have been used if a ready market for these investments
existed. The market value of our shares and any other securities we may issue could be adversely affected if our determinations regarding the fair value of these investments are materially higher than
the values that we ultimately realize upon their disposal.
Our rights under our indirect investments in corporate leveraged loans may be more restricted than direct investments in such loans.
We hold interests in corporate leveraged loans originated by banks and other financial institutions. We acquire interests in corporate
leveraged loans either directly by a direct purchase or an assignment, or indirectly through a participation. The purchaser of an assignment typically succeeds to all the rights and obligations of the
assigning institution and becomes a lender under the credit agreement with respect to the debt obligation. In contrast, participation interests in a portion of a debt obligation typically result in a
contractual relationship only with the institution participating out the interest, not with the borrower. Thus, in purchasing participations, we generally will have no right to enforce compliance by
the borrower with the terms of the credit agreement, nor any rights of offset against the borrower, and we may not directly benefit from the collateral supporting
the debt obligation in which we have purchased the participation. As a result, we will assume the credit risk of both the borrower and the institution selling the participation.
The mortgage loans underlying the mortgage-backed securities we invest in are subject to delinquency, foreclosure and loss, which could result in losses to us.
As of December 31, 2012, we held residential mortgage-backed securities with an aggregate estimated fair value of
$83.8 million. Residential mortgage-backed securities evidence interests in or are secured by pools of residential mortgage loans. Accordingly, the mortgage-backed securities we invest in are
subject to all of the risks of the underlying mortgage loans. Residential mortgage loans are secured by single-family residential property and are subject to risks of delinquency, foreclosure and risk
of loss. The ability of a borrower to repay a loan secured by a residential property is dependent upon the income or assets of the borrower. A number of factors, including a general economic downturn,
acts of God, terrorism, social unrest and civil disturbances, may impair borrowers' abilities to repay their loans. Foreclosure of a mortgage loan can be an expensive and lengthy process that could
have a substantial negative effect on our anticipated return on the foreclosed mortgage loan.
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Credit default swaps are subject to risks related to changes in credit spreads, credit quality and expected recovery rates of the underlying credit instrument.
We may enter into credit default swaps ("CDS") as investments or hedges. CDS involve greater risks than investing in the reference
obligation directly. In addition to general market risks, CDS are subject to risks related to changes in interest rates, credit spreads, credit quality and expected recovery rates of the underlying
credit instrument. A CDS is a contract in which the contract buyer pays, in the case of a short position, or receives, in the case of a 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, in the case of a short position, or makes a payment to, in the case of a long position, the buyer if
there is a credit default or other specified credit event with respect to the issuer of the underlying credit instrument referenced in the CDS. The contract buyer will lose its investment and recover
nothing should no event of default occur. If an event of default were to occur, the value of the reference obligation received by the contract seller (if any), coupled with the periodic payments
previously received, may be less than the full notional value it pays to the buyer, resulting in a loss of value to the seller. If we act as the contract seller of a CDS, we would be exposed to many
of the same risks of leverage described herein since if an event of default occurs the seller must pay the buyer the full notional value of the reference obligation.
We may change our investment strategy without shareholder consent, which may result in our making investments that entail more risk than our current investments.
Our investment strategy may evolve, in light of existing market conditions and investment opportunities, and this evolution may involve
additional risks. Investment opportunities that present unattractive risk-return profiles relative to other available investment opportunities under particular market conditions may become
relatively attractive under changed market conditions and changes in market conditions may therefore result in changes in the investments we target. Decisions to make investments in new asset
categories present risks that may be difficult for us to adequately assess and could therefore reduce the stability of our distributions or have adverse effects on our financial condition. A change in
our investment strategy may also increase our exposure to interest rate, commodity, foreign currency or credit market fluctuations. Our failure to accurately assess the risks inherent in new asset
categories or the financing risks associated with such assets could adversely affect our results of operations and our financial condition.
Our dependence on the management of other entities may adversely affect our business.
We do not control the management, investment decisions or operations of the business entities in which we invest. Management of those
enterprises may decide to change the nature of their assets, or management may otherwise change in a manner that is not satisfactory to us or value enhancing for the investment we have made in such
entities. We typically have no ability to affect these management decisions and we may have only limited ability to dispose of our investments.
Due diligence conducted by our Manager may not reveal all of the risks of the businesses in which we invest.
Before making an investment in a business entity, our Manager typically assesses the strength and skills of the entity's management and
other factors that it believes will determine the success of the investment. In making the assessment and otherwise conducting due diligence, our Manager relies on the resources available to it and,
in some cases, an investigation by third parties. This process is particularly important and subjective with respect to newly organized entities because there may be little or no information publicly
available about the entities. Accordingly, there can be no assurance that this due diligence process will uncover all relevant facts or that any investment will be successful. In addition, we and KKR
have established certain procedures relating to conflicts of interests that may restrict us from accessing certain confidential information in the possession of KKR or one of its affiliates. As a
result, we may pursue investments without obtaining access to such confidential
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information,
which information, if reviewed, might otherwise impact our judgment with respect to such investments.
We operate in a highly competitive market for investment opportunities.
We compete for investments with various other investors, such as other public and private funds, commercial and investment banks and
other companies, including funds and companies affiliated with our Manager. Some of our competitors have greater resources than we possess or have greater access to capital or various types of
financing structures than are available to us and may have investment objectives that overlap with ours, which may create competition for investment opportunities with limited supply. The competitive
pressures we face could impair our business, financial condition and results of operations. As a result of this competition, we may not be able to take advantage of attractive investment opportunities
from time to time. Furthermore, competition for investments may lead to a decrease in returns available from such investments, which may further limit our ability to generate our desired returns.
There is an inherent risk that we may incur environmental costs and liabilities as a result of our natural resources and real estate investments.
We have made and may continue to make certain investments in real estate and oil and gas industries, which present inherent
environmental and safety risks. The oil and gas industries, in particular, are subject to stringent and complex foreign, federal, state and local environmental laws, ordinances and regulations. Under
these laws, ordinances and regulations, regardless of fault, owners and operators of oil and gas properties and facilities can be held jointly and severally liable for the cost of remediating
contamination and providing compensation for damages to natural resources. Our investments in oil and gas and real estate also present inherent risk of personal and property injury. We are not insured
against all losses or liabilities that could arise from these investments. On-going compliance with environmental laws, ordinances and regulations applicable to these investments may
entail significant expense. Environmental and safety obligations and liabilities can be substantial and could adversely impact the value of our natural resources investments, our ability to use these
investments as collateral and may otherwise have a material adverse effect on our results of operations.
In
addition, the trend in environmental regulation is to place more restrictions and limitations on activities that may affect the environment, and thus, any changes in federal or state
environmental laws
and regulations or re-interpretation of applicable enforcement policies that result in more stringent and costly well construction, drilling, water management or completion activities, or
waste handling, storage, transport, disposal or remediation requirements could have a material adverse effect on our financial position. The operators of the oil and gas properties in which we invest
may be unable to pass on such increased compliance costs to their customers.
Our estimated oil, natural gas, and natural gas liquids reserve quantities and future production rates are based on many assumptions that may prove to be inaccurate. Any
material inaccuracies in these reserve estimates or the underlying assumptions will materially affect the quantities and value of our reserves.
Numerous uncertainties are inherent in estimating quantities of oil, natural gas, and natural gas liquids reserves. The process of
estimating oil, natural gas, and natural gas liquids reserves is complex, requiring significant decisions and assumptions in the evaluation of available geological, engineering and economic data for
each reservoir, and reserve estimates also rely upon various assumptions, including assumptions regarding future oil, natural gas, and natural gas liquids prices, production levels, and operating and
development costs. As a result, estimated quantities of proved reserves and projections of future production rates and the timing of development expenditures may prove to be inaccurate. Over time, we
may make material changes to reserve estimates taking into account the results of actual drilling and production. Any significant variance in our assumptions and actual results could greatly affect
our estimates of reserves, the economically recoverable quantities of oil, natural gas, and natural gas liquids attributable to any particular group of properties, the classifications of reserves
based on risk of recovery, and estimates of the future net cash flows.
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Our natural resources investments are subject to complex federal, state, local and other laws and regulations that could adversely affect the value of our natural resources
investments.
The natural resources operations in which we invest are subject to complex federal, state and local laws and regulations as interpreted
and enforced by governmental authorities possessing jurisdiction over various aspects of the exploration, production and transportation of natural resources. These operations must obtain and maintain
numerous permits, approvals and certificates from various governmental authorities that may entail significant expense, impose onerous conditions on operations or place limitations on production
methods or quantity. While compliance with such processes has not yet had a material impact on the value of our natural resources investments, new regulations, laws or enforcement policies could be
more stringent and significantly increase compliance costs or otherwise materially decrease the value of our natural resources properties. For example, some states have adopted, and other states and
the federal government are considering adopting, regulations that place restrictions of the use of an extraction process called hydraulic fracturing, used by the oil and gas operations in which we
invest. This or other added regulation could lead to operational delays, increased operating costs, increased liability risks and reduced production of oil and gas, which could adversely impact the
value of our natural resources investments, our ability to use these investments as collateral and may otherwise have a material adverse effect on our results of operations.
If commodity prices decline and remain depressed for a prolonged period, a significant portion of our development projects may become uneconomic and cause write downs of the
value of our oil and natural gas properties, which may reduce the value of our natural resources investments, have a negative impact on our ability to use these investments as collateral or otherwise
have a material adverse effect on our results of operations.
Oil and natural gas are commodities and, therefore, their prices are subject to wide fluctuations in response to relatively minor
changes in supply and demand. Historically, the markets for oil and natural gas have been volatile. For example, for the five years ended December 31, 2012, the WTI oil spot price ranged from a
high of $145.31 per Bbl to a low of $30.28 per Bbl, while the Henry Hub natural gas spot price ranged from a high of $13.32 per MMBtu to a low of $1.83 per MMBtu. These markets will likely continue to
be volatile in the future. The prices we receive for our production, and the levels of our production, depend on numerous factors beyond our control,
including:
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worldwide and regional economic conditions impacting the global supply and demand for oil and natural gas;
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the amount of added production from development of unconventional natural gas reserves;
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the price and quantity of imports of foreign oil and natural gas;
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political conditions in or affecting other oil-producing and natural gas-producing countries,
including the current conflicts in the Middle East and conditions in South America, China, India and Russia;
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the level of global oil and natural gas exploration and production;
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the level of global oil and natural gas inventories;
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localized supply and demand fundamentals and regional, domestic and international transportation availability;
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weather conditions and natural disasters;
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domestic and foreign governmental regulations;
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speculation as to the future price of oil and the speculative trading of oil and natural gas futures contracts;
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price and availability of competitors' supplies of oil and natural gas;
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technological advances affecting energy consumption; and
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the price and availability of alternative fuels.
Significantly
and sustained lower natural gas prices, and to a lesser extent significantly lower crude oil prices, could render many of our development and production projects
uneconomical and result in a downward adjustment of our reserve estimates. Further, deteriorating commodity prices may cause us to recognize impairments in the value of our oil and natural gas
properties. In addition, if our estimates of development costs increase, production data factors change or drilling results deteriorate, accounting rules may require us to write down, as a
non-cash charge to earnings, the carrying value of our oil and natural gas properties for impairments. This could reduce the value of our natural resources investments, have a negative
impact on our ability to use these investments as collateral or otherwise have a material adverse effect on our results of operations.
The performance of our natural resources investments depend on the skill, ability and decisions of third party operators.
The success of the drilling, development and production of the oil and natural gas properties in which we have working interests is
substantially dependent upon the decisions of third-party operators and their diligence to comply with various laws, rules and regulations affecting such properties. The failure of any third-party
operator to make decisions, perform their services, discharge their obligations, deal with regulatory agencies, and comply with laws, rules and regulations, including environmental laws and
regulations in a proper manner with respect to properties in which we have an interest could result in material adverse consequences to our interest in such properties. Such adverse consequences could
result in liabilities to us, reduce the value of our working interests and adversely affect our cash flows from such investments and our results of operations. In addition, our royalty interests in
oil and natural gas properties are predicated on the overall operating performance of third party operators, which could result in a reduction in value of our royalty interests and adversely affect
our cash flows from such investments.
RISKS RELATED TO OUR ORGANIZATION AND STRUCTURE
Maintenance of our Investment Company Act exemption imposes limits on our operations, which may adversely affect our results of operations.
As described above in "Item 1. BusinessOur Investment Company Act Status" we conduct our operations through our
subsidiaries. In order for us to exclude from "investment securities" our subsidiaries' securities that we hold, each such subsidiary must be structured to both meet the definition of "majority-owned
subsidiary" in the Investment Company Act, and to not fall within the definition of investment company in the Investment Company Act or meet an
applicable exception from that definition. As a result of this structuring, our 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, and we could suffer losses on our investments in our subsidiaries or be unable to take full advantage of all available investment opportunities. For example, our CLO subsidiaries
cannot acquire or dispose of assets primarily to enhance returns to the owner of the equity in the CLO subsidiary, and, as a result, may suffer losses on their assets and we may suffer losses on our
investments in those CLO subsidiaries. And our REIT subsidiary and oil and gas subsidiaries are each limited in the type of assets they can acquire and must ensure that a large portion of their total
assets relate to those assets, which may have the effect of limiting our freedom of action with respect to real estate and oil and gas assets that may be held or acquired by such subsidiaries or the
manner in which we may deal in such assets.
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If the SEC were to disagree with our Investment Company Act determinations, our business could be adversely affected.
We have not requested approval or guidance from the SEC 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 subsidiary's 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), Section 3(c)(9) or any other exception, 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. The SEC published on August 31, 2011 an advance notice of proposed rulemaking to
potentially amend the conditions for reliance on Rule 3a-7 and the treatment of asset-backed issuers that rely on Rule 3a-7 under the Investment Company Act (the
"3a-7 Release"). The SEC, in the 3a-7 Release, requested public comment on the nature and operation of issuers that rely on Rule 3a-7 and indicated various
steps it may consider taking in connection with Rule 3a-7, although it did not formally propose any changes to the rule. Among the issues for which the SEC has requested comment in
the 3a-7 Release is whether Rule 3a-7 should be modified so that parent companies of subsidiaries that rely on Rule 3a-7 should treat their interests
in such subsidiaries as investment securities for purposes of the 40% test. The SEC also published on August 31, 2011 a concept release seeking
information about the nature of entities that invest in mortgages and mortgage-related pools and public comment on how the SEC staff's interpretive positions in connection with
Section 3(c)(5)(C) affect these entities, although it did not propose any new interpretive positions or changes to existing interpretive positions in connection with Section 3(c)(5)(C).
Any guidance or action from the SEC or its staff, including changes that the SEC may ultimately propose and adopt to the way Rule 3a-7 applies to entities or new or modified
interpretive positions related to Section 3(c)(5)(C), could further inhibit our ability, or the ability of a subsidiary, to pursue our current or future operating strategies, 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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RISKS RELATED TO OWNERSHIP OF OUR COMMON SHARES
Certain provisions of our operating agreement will make it difficult for third parties to acquire control of us and could deprive holders of our common shares of the
opportunity to obtain a takeover premium for their common shares.
Our operating agreement contains a number of provisions that could make it more difficult for a third party to acquire, or may
discourage a third party from acquiring, control of us. These provisions include, among others:
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restrictions on our ability to enter into certain transactions with major holders of our shares or their affiliates or
associates modeled on certain limitations contained in Section 203 of the General Corporation Law of the State of Delaware;
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generally allowing only our board of directors to fill newly created directorships;
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requiring that directors may be removed only for cause (as defined in the operating agreement) and then only by a vote of
at least two-thirds of the votes entitled to be cast in the election of such director;
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requiring advance notice for holders of our common shares to nominate candidates for election to our board of directors or
to propose matters to be considered by holders of our common shares at a meeting of holders of our common shares;
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our ability to issue additional securities, including, but not limited to, preferred shares, without approval by holders
of our common shares;
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a prohibition, subject to any exemptions granted by our board of directors, on any person beneficially or constructively
owning in excess of 9.8% in value or in number of any class or series of our outstanding shares, whichever is more restrictive, excluding shares not treated as outstanding for United States federal
income tax purposes;
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the ability of our board of directors to amend the operating agreement without approval of the holders of our shares
except under certain specified circumstances; and
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limitations on the ability of holders of our shares to call special meetings of holders of our shares or to act by written
consent.
These
provisions, as well as other provisions in the operating agreement, may delay, defer or prevent a transaction or a change in control that might otherwise result in holders of our
common shares obtaining a takeover premium for their common shares.
Certain
provisions of the Management Agreement also could make it more difficult for third parties to acquire control of us by various means, including limitations on our right to
terminate the Management Agreement and a requirement that, under certain circumstances, we make a substantial payment to the Manager in the event of a termination. In addition, provisions in
agreements governing our current or future indebtedness may affect the likelihood of a change in control by requiring us to offer to redeem, repurchase or repay outstanding indebtedness and/or
increasing the costs of such indebtedness.
The terms of our preferred shares restrict our ability to make future distributions on our common shares and may adversely affect the rights of the holders of our common
shares.
As of January 17, 2013, we had 14.95 million Series A LLC Preferred Shares outstanding and our operating
agreement permits our Board of Directors to authorize, without shareholder approval, the issuance of up to an additional approximate 35 million preferred shares with distribution, liquidation,
conversion, voting and other rights which could adversely affect the rights of holders of our common
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shares.
Our Series A LLC Preferred Shares rank senior to the common shares with respect to payment of distributions and distribution of our assets upon our dissolution and any future
preferred shares that we issue may do so as well. Distributions on the Series A LLC Preferred Shares are cumulative and are paid quarterly when, as, and if declared by our Board of
Directors. We may not declare or pay distributions on our common shares unless all accrued distributions have been declared and paid, or set aside for payment, on the Series A LLC
Preferred Shares. The Series A LLC Preferred Shares have limited voting rights, however, in the event that we miss six quarterly distributions (whether or not consecutive) on the
Series A LLC Preferred Shares, the holders of such shares will be entitled to appoint two directors to our Board until such time as all accrued distributions on the
Series A LLC Preferred Shares have been declared and paid or set aside for payment. Any preferred shares that we issue in the future may contain restrictions on our ability to make
distributions on our common shares and have rights and preferences that have a similar or more adverse affect on the rights of holders of our common shares.
We may issue additional debt and equity securities which are senior to our common shares as to distributions and upon our dissolution, which could materially adversely
affect the market price of our common shares.
In the future, we may attempt to increase our capital resources by entering into additional debt or debt-like financings
that are secured by all or some of our assets, or issuing debt or additional equity securities, which could include issuances of secured liquidity notes, medium-term notes, senior notes,
subordinated notes or additional preferred and common shares. In the event of our dissolution, liabilities of our creditors, including our lenders and holders of our debt securities, would be
satisfied from our available assets in priority to distributions to holders of our common or preferred shares. Because our decision to incur debt and issue shares in any future offerings will depend
on the terms of our operating agreements, market conditions and other factors beyond our control, we cannot predict or estimate the amount, timing or nature of our future offerings or our future debt
and equity financings. Further, market conditions could require us to accept less favorable terms for the issuance of our securities in the future, including, but not limited to, issuing common shares
at a discount to market value. Accordingly, holders of our common shares and of any securities we may issue whose value is linked to the value of our common shares will bear the risk of our future
offerings reducing the value of their common shares or any such other securities and diluting their interest in us. In addition, we can change our leverage strategy and investment policies from time
to time without approval of holders of any of our shares, which could adversely affect the market price of our common shares.
Our board of directors has broad authority to change many of the terms of our common shares and may change our distribution policy without the approval of holders of our
common shares.
Our operating agreement gives our board of directors broad authority to effect amendments to the provisions of our operating agreement
that could change many of the terms of our common shares without the consent of holders of our common shares. Distributions on our common shares and our distribution policy are made at the sole
discretion of our board of directors. As a result, our board of directors may, without the approval of holders of our common shares, make changes to our distribution policy or make changes to many of
the terms of our common shares that are adverse to the holders of our common shares.
Our board of directors has full authority and discretion over distributions on our shares and it may decide to reduce or eliminate distributions at any time, which may
adversely affect the market price for our common shares and any other securities we may issue.
Our board of directors has full authority and sole discretion to determine whether or not a distribution will be declared and paid, and
the amount and timing of any distribution
that may be paid, to holders of our shares and (unless otherwise provided by our board of directors if and when it
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establishes
the terms of any new class or series of our shares) any other class or series of shares we may issue in the future. Our board of directors may, in its sole discretion, determine to reduce
or eliminate distributions on our common shares and (unless otherwise so provided by our board of directors) any other class or series of shares we may issue in the future, which may have a material
adverse effect on the market price of our common shares, any such other shares and any other securities we may issue. In addition, in computing United States federal income tax liability for a taxable
year, each holder of our common shares will be required to take into account its allocable share of items of our income, gain, loss, deduction and credit for our taxable year ending within or with
such holder's taxable year, regardless of whether such holder has received any distributions. Each holder's tax liability will depend on its unique circumstances. As a result, it is possible that a
holder's United States federal income tax liability with respect to its allocable share of these items in a particular taxable year could exceed the cash distributions received by such holder.
Accordingly, each holder should ensure that it has sufficient cash flow from other sources to pay all tax liabilities attributable to its investment in our shares.
In
addition, as discussed above under "Risks Related to our Organization and StructureThe terms of our indebtedness may restrict our ability to make future distributions and
impose limitations on our current and future operations," the 2015 Facility includes covenants that restricts our ability to make distributions on, and to redeem or repurchase, our shares, if an event
of default, or certain events that with notice or passage of time or both would constitute an event of default, under the 2015 Facility occur at a time when we have any amounts outstanding under the
2015 Facility.
We intend to pay quarterly distributions to holders of our common shares, but our ability to do so may be limited, which could cause the market price of our common shares to
decline significantly.
We resumed paying quarterly dividends beginning in the fourth quarter of 2009 and we currently intend to continue paying cash
distributions to holders of our common shares on a quarterly basis. For all quarters and year ended December 31, 2012, we have declared cumulative cash distributions on our common shares of
$0.86 per common share.
Our
ability to pay quarterly distributions on our common shares will be subject to, among other things, general business conditions, our financial results, the impact of paying
distributions on our credit
ratings, the amount of ordinary taxable income or loss earned by us, gains or losses recognized by us on the disposition of assets, our liquidity needs and legal and contractual restrictions on the
payment of distributions under our borrowing agreements and the terms of our preferred shares and any other equity securities that we may issue that are senior to the common shares with respect to
distributions. Any reduction or discontinuation of quarterly distributions could cause the market price of our common shares to decline significantly. Moreover, in the event our payment of quarterly
distributions is reduced or discontinued, our failure or inability to resume paying distributions could result in a persistently low market valuation of our common shares.
RISKS RELATED TO OUR MANAGEMENT AND OUR RELATIONSHIP WITH OUR MANAGER
We are highly dependent on our Manager and may not find a suitable replacement if our Manager terminates the Management Agreement.
We have no employees. Our Manager, and its officers and employees, allocate a portion of their time to businesses and activities that
are not related to, or affiliated with, us and, accordingly, its officers and employees do not spend all of their time managing our activities and our investment portfolio. We expect that the portion
of our Manager's time that is allocated to other businesses and activities will increase in the future as our Manager and KKR expand their investment focus to include additional investment vehicles,
including vehicles that compete more directly with us, which time allocations may be material. We have no separate facilities and are completely reliant on our Manager,
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which
has significant discretion as to the implementation and execution of our business and investment strategies and our risk management practices. We are also subject to the risk that our Manager
will terminate the Management Agreement and that no suitable replacement will be found. We believe that our success depends to a significant extent upon the experience of our Manager's executive
officers, whose continued service is not guaranteed.
The departure of any of the senior management and investment professionals of our Manager or the loss of our access to KKR's senior management and investment professionals
may adversely affect our ability to achieve our investment objectives.
We depend on the diligence, skill and network of business contacts of the senior management and investment professionals of our
Manager. We also depend on our Manager's access to the investment professionals and senior management of KKR and the information and deal flow generated by the KKR investment professionals and senior
management during the normal course of their investment and portfolio management activities. The senior management and the investment professionals of our Manager evaluate, negotiate, structure, close
and monitor our investments. Our future success will depend on the continued service of the senior management team and investment professionals of our Manager. The departure of any of the senior
management or investment professionals of our Manager, or of a significant number of the investment professionals or senior management of KKR, could have a material adverse effect on our ability to
achieve our investment objectives. In addition, we can offer no assurance that our Manager will remain our Manager or that we will continue to have access to KKR's investment professionals or senior
management or KKR's information and deal flow.
If our Manager ceases to be our manager pursuant to the Management Agreement, financial institutions providing our credit facilities may not provide future financing to us.
The financial institutions that finance our investments may require that our Manager continue to manage our operations pursuant to the
Management Agreement as a condition to making continued advances to us under these credit facilities. Additionally, if our Manager ceases to be our manager, each of these financial institutions under
these credit facilities may terminate their facility and their obligation to advance funds to us in order to finance our current and future investments. If our Manager ceases to be our manager for any
reason and we are not able to continue to obtain financing under these or suitable replacement credit facilities, our growth may be limited or we may be forced to sell our investments at a loss.
Our board of directors has approved very broad investment policies for our Manager and does not approve individual investment decisions made by our Manager except in limited
circumstances.
Our Manager is authorized to follow very broad investment policies (our "Investment Policies") and, in connection with the conversion
transaction, these Investment Policies were revised to provide even greater latitude to our Manager with respect to certain matters relating to transactions with our affiliates. Our directors
periodically review and approve our Investment Policies. Our board of directors generally does not approve any individual investments, other than approving a limited set of transactions with
affiliates that require the prior approval of the Affiliated Transactions Committee of our board of directors. Furthermore, transactions entered into by our Manager may be
difficult or impossible to terminate or unwind. Our Manager has significant latitude within the broad parameters of the Investment Policies in determining the types of assets it may decide are proper
investments for us.
Certain of our investments may create a conflict of interest with KKR and other affiliates and may expose us to additional legal risks.
Subject to complying with our Investment Policies and the charter of the Affiliated Transactions Committee of our board of directors, a
core element of our business strategy is that our Manager will
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at
times cause us to invest in corporate leveraged loans, high yield securities and equity securities of companies affiliated with KKR, provided that such investments meet our requirements.
To
the extent KKR is the owner of a majority of the outstanding equity securities of such companies, KKR may have the ability to elect all of the members of the board of directors of a
company we invest in and thereby control its policies and operations, including the appointment of management, future issuances of shares or other securities, the payments of dividends, if any, on its
shares, the incurrence of debt by it, amendments to its certificate of incorporation and bylaws and entering into extraordinary transactions, and KKR's interests may not in all cases be aligned with
the interests of the holders of the securities we own. In addition, with respect to companies in which we have an equity investment, to the extent that KKR is the controlling shareholder it may be
able to determine the outcome of all matters requiring shareholder approval and will generally be able to cause or prevent a change of control of a company we invest in or a change in the composition
of its board of directors and could preclude any unsolicited acquisition of that company regardless as to whether we agree with such determination. So long as KKR continues to own a significant amount
of the voting power of a company we invest in, even if such amount is less than 50%, it will continue to influence strongly, or effectively control, that company's decisions. Our interests with
respect to the management, investment decisions, or operations of those companies may at times be in conflict with those of KKR. In addition, to the extent that affiliates of our Manager or KKR invest
in companies in which we have an investment, similar conflicts between our interests and theirs may arise. In addition, our Manager has implemented policies and procedures to mitigate potential
conflicts of interest, which policies impose limitations on our ability to make certain investments in companies affiliated with KKR.
In
addition, interests and those of KKR may at times be in conflict because the CLO issuers in which we invest hold corporate leveraged loans the obligors on which are
KKR-affiliated companies. KKR may have an interest in causing such companies to pursue acquisitions, divestitures,
exchange offers, debt restructurings and other transactions that, in KKR's judgment, could enhance its equity investment, even though such transactions might involve risks to holders of indebtedness,
which include our CLO issuers. For example, KKR could cause a company that is the obligor on a loan held by one of our CLO issuers to make acquisitions that increase its indebtedness or to sell
revenue generating assets, thereby potentially decreasing the ability of the company to repay its debt. In cases where a company's debt undergoes a restructuring, the interests of KKR as an equity
investor and our CLO issuers as debt investors may diverge, and KKR may have an interest in pursuing a restructuring strategy that benefits the equity holders to the detriment of the lenders, such as
our CLO issuers. This risk may be exacerbated in the current economic environment given reduced liquidity available for debt refinancing, among other factors.
If
a KKR-affiliated company were to file for bankruptcy or similar action, we face the risk that a court may subordinate our debt investment in such company to the claims of
more junior debt holders or may recharacterize our investment as an equity investment. Any such action by a court would have a material adverse impact on the value of these investments.
There are various potential conflicts of interest in our relationship with our Manager and its affiliates, including KKR, which could result in decisions that are not in the
best interests of holders of our shares.
We are subject to potential conflicts of interest arising out of our relationship with our Manager and its affiliates. As of
December 31, 2012, our Manager and its affiliates collectively owned approximately 5.8% of our outstanding common shares on a fully diluted basis.
Our
Management Agreement with our Manager was negotiated between related parties, and its terms, including fees payable, may not be as favorable to us as if it had been negotiated with
an unaffiliated third party. Pursuant to the Management Agreement, our Manager will not assume any responsibility other than to render the services called for thereunder and will not be responsible
for any
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action
of our board of directors in following or declining to follow its advice or recommendations. See the risk factor entitled "Our Manager's liability is limited under the Management Agreement, and
we have agreed to indemnify our Manager against certain liabilities."
As
noted above, our Manager will at times cause us to invest in loans and securities of companies affiliated with KKR, provided that such investments meet our requirements, and the terms
of which
such investments are made may not be as favorable as if they were negotiated with unaffiliated third parties. In addition, from time to time, the Manager may cause us to buy loans or securities from,
or to sell loans or securities to, other clients of KKR or its affiliates.
The incentive fee provided for under the Management Agreement may induce our Manager to make certain investments, including speculative investments.
The management compensation structure to which we have agreed with our Manager may cause our Manager to invest in high risk investments
or take other risks, which, if they result in a loss, could harm our financial results. In addition to its base management fee, our Manager is entitled to receive incentive compensation based in part
upon our achievement of specified levels of net income. See "Item 1. BusinessManagement Agreement" for further information regarding our management compensation structure. In
evaluating investments and other management strategies, the opportunity to earn incentive compensation based on net income may lead our Manager to place undue emphasis on the maximization of net
income at the expense of other criteria, such as preservation of capital, maintaining sufficient liquidity, and/or management of credit risk or market risk, in order to achieve higher incentive
compensation. Investments with higher yield potential are generally riskier or more speculative. In addition, our Manager's compensation is partly based on GAAP results, which may not always correlate
to economic results that increase the market price of our shares. As a result, our Manager may still receive management fees and incentive compensation even in times of poor economic financial results
that precipitate a decline in the market price of our shares. If there is a disconnect between our GAAP results and the market value of our shares, the incentive fees paid to our Manager may be higher
than our share price would suggest is warranted. Furthermore, the Compensation Committee of our board of directors may make grants of options and restricted shares to our Manager in the future and the
factors considered by the Compensation Committee in making these grants may include performance related factors which may also induce our Manager to make investments that are riskier or more
speculative. This could result in increased risk to the value of our investment portfolio.
Conflicts may arise in connection with the allocation of investment opportunities by affiliates of our Manager.
Our Management Agreement with our Manager does not prevent our Manager and its affiliates from engaging in additional management or
investment opportunities. The Management Agreement does not restrict our Manager and its affiliates from raising, sponsoring or advising any new investment fund, company or other entity, including a
REIT, or holding proprietary investment accounts, unless such fund, account, company or other entity invests primarily in domestic mortgage-backed securities. This restriction is of significantly less
relevance since the May 4, 2007 restructuring pursuant to which we succeeded KKR Financial Corp., because since then our investments in domestic mortgage-backed securities have significantly
decreased and as of December 31, 2012 comprised $83.8 million of our investment portfolio. As a result, our Manager and its affiliates, including KKR, currently are engaged in and may in
the future engage in management or investment opportunities on behalf of others or themselves that would have been suitable for us and we may have fewer attractive investment opportunities.
In
addition, affiliates of our Manager currently manage separate investment funds and separately managed accounts ("KKR Funds and Accounts"), including proprietary investment accounts
that invest in the same non-mortgage-backed securities investments that we invest in, including other fixed income,
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natural
resources and real estate investments. With respect to these other KKR Funds and Accounts and any other funds or accounts that may be established in the future, our Manager and its affiliates
will face conflicts in the allocation of investment opportunities. Such allocation is at the discretion of our Manager and its affiliates in accordance with their respective allocation policies and
procedures. These policies take into account a number of factors, including mandatory minimum investment rights, investment objectives, available capital, concentration limits, risk profiles and other
investment restrictions applicable to us and these competing KKR Funds and Accounts. Our Manager and its affiliates have broad discretion in administering these policies and there is no guarantee that
in making allocations our Manager and its affiliates will act in the best interests of holders of our shares or any other securities we may issue. In addition, certain of such other KKR Funds and
Accounts may participate in investment opportunities on more favorable terms than us.
Conflicts may arise between our investments and investments held by other funds and accounts managed by our Manager and its affiliates.
We may invest in the same issuers as other KKR Funds and Accounts, although their investments may include different obligations of such
issuer. For example, we might invest in senior loans issued by a borrower and one or more KKR Funds and Accounts might invest in the borrower's junior debt and/or equity. Conflicts of interest may
arise where we and other KKR Funds and Accounts simultaneously hold securities representing different parts of the capital structure of a stressed or distressed issuer. In such circumstances,
decisions made with respect to the securities held by one KKR Fund or Account may cause (or have the potential to cause) harm to the different class of securities of the issuer held by us or other KKR
Funds and Accounts. For example, if such an issuer goes into bankruptcy or reorganization, becomes insolvent or otherwise experiences financial distress or is unable to meet its payment obligations or
comply with covenants relating to credit obligations held by us or by the other KKR Funds and Accounts, such other KKR Funds and Accounts may have an interest that conflicts with our interests. If
additional financing for such an issuer is necessary as a result of financial or other difficulties, it may not be in our best interests to provide such additional financing, but such additional
financing could be seen to benefit investments held by other KKR Funds and Accounts. In addition, other KKR Funds and Accounts may engage in short sales of (or otherwise take short positions in)
securities or other instruments of issuers in which we invest, which could be seen as harming our performance for the benefit of the accounts taking short positions if such short positions cause the
market value of our investments to fall. In conflict situations such as the ones discussed in this paragraph,
the Manager and its affiliates will seek to resolve any such conflicts in accordance with its compliance procedures.
We compete with other investment entities affiliated with KKR for access to KKR's investment professionals.
KKR and its affiliates, including the parent of our manager, manage several private equity funds, other funds and separately managed
accounts, and we believe that KKR and its affiliates, including the parent of our manager, will establish and manage other investment entities in the future. Certain of these investment entities have,
and any newly created entities may have, an investment focus similar to our focus. In addition, if our investment strategy evolves, our investment objectives may overlap with an increasing number of
such entities. As a result we compete with these entities and may compete with an increasing number of such entities for access to the benefits that our relationship with KKR provides to us. Our
ability to continue to engage in these types of opportunities in the future depends, to a significant extent, on competing demands for these investment opportunities by other investment entities
established by KKR and its affiliates. To the extent that we and other KKR affiliated entities or related parties compete for investment opportunities, there can be no assurances that we will get the
best of those opportunities or that the performance of the investments allocated to us, even within the same asset classes, will perform as favorably as those allocated to others.
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Termination of the Management Agreement with our Manager by us is difficult and costly.
The Management Agreement expires on December 31 of each year, but is automatically renewed for a one-year term on
each December 31 unless terminated upon the affirmative vote of at least two-thirds of our independent directors, or by a vote of the holders of a majority of our outstanding common
shares, based upon (i) unsatisfactory performance by our Manager that is materially detrimental to us or (ii) a determination that the management fee payable to our Manager is not fair,
subject to our Manager's right to prevent such a termination under this clause (ii) by accepting a mutually acceptable reduction of management fees. Our Manager must be provided with
180 days' prior written 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.
These provisions would result in substantial cost to us if we terminate the Management Agreement, thereby adversely affecting our ability to terminate our Manager.
Our access to confidential information may restrict our ability to take action with respect to some investments, which, in turn, may negatively affect our results of
operations.
We, directly or through our Manager, may obtain confidential information about the companies in which we have invested or may invest.
If we do possess confidential information about such companies, there may be restrictions on our ability to make, dispose of, increase the amount of, or otherwise take action with respect to, an
investment in those companies. Our relationship with KKR could create a conflict of interest to the extent our Manager becomes aware of inside information concerning investments or potential
investment targets. We have implemented compliance procedures and practices designed to ensure that inside information is not used for making investment decisions on our behalf. We cannot assure our
shareholders, however, that these procedures and practices will be effective. In addition, this conflict and these procedures and practices may limit the freedom of our Manager to make potentially
profitable investments which could have an adverse effect on our results of operations. Conversely, we may pursue investments without obtaining access to confidential information otherwise in the
possession of KKR or one of its affiliates, which information, if reviewed, might otherwise impact our judgment with respect to such investments.
Our Manager's liability is limited under the Management Agreement, and we have agreed to indemnify our Manager against certain liabilities.
Pursuant to the Management Agreement, our Manager will not assume any responsibility other than to render the services called for
thereunder in good faith and will not be responsible for any action of our board of directors in following or declining to follow its advice or recommendations. Our Manager and its members, managers,
officers and employees will not be liable to us, any subsidiary of ours, our directors, our shareholders or any subsidiary's shareholders for acts or omissions pursuant to or performed in accordance
with the Management Agreement, except by reason of acts constituting bad faith, willful misconduct, gross negligence, or reckless disregard of their duties under the Management Agreement. Pursuant to
the Management Agreement, we have agreed to indemnify our Manager and its members, managers, officers and employees and each person controlling our Manager with respect to all expenses, losses,
damages, liabilities, demands, charges and claims arising from acts or omissions of such indemnified party not constituting bad faith, willful misconduct, gross negligence, or reckless disregard of
duties, performed in good faith in accordance with and pursuant to the Management Agreement.
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TAX RISKS
Holders of our shares will be subject to United States federal income tax and generally other taxes, such as state, local and foreign income tax, on their share of our
taxable income, regardless of whether or when they receive any cash distributions from us, and may recognize income or have tax liability in excess of our cash distributions.
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 items of income, gain, deduction, and credit for each of our taxable years ending with or within the holder's taxable year, regardless of whether
or when they receive cash distributions. In addition, certain of our investments, including investments in certain foreign corporate subsidiaries, CLO issuers (which are treated as partnerships,
disregarded entities or foreign corporations for United States federal
income tax purposes), partnerships generally and debt securities, may produce taxable income without corresponding distributions of cash to us or may produce taxable income prior to or following the
receipt of cash relating to such income. Those investments typically produce ordinary income on a current basis, but any losses we would recognize from those investments would typically be treated as
capital losses. In addition, we have recognized and may recognize in the future cancellation of indebtedness income upon the retirement of our debt at a discount. Because of our methods of allocating
income and gain among holders of our shares, you may be taxed on amounts that accrued economically before you became a shareholder. Consequently, in some taxable years, holders of our shares may
recognize taxable income in excess of our cash distributions, and holders may be allocated capital losses either in the same or future years that cannot be used to offset such taxable income.
Furthermore, even if we did not pay cash distributions with respect to a taxable year, holders of our shares may still have a tax liability attributable to their allocation of our taxable income.
Accordingly, each shareholder should ensure that it has sufficient cash flow from other sources to pay all tax liabilities.
If we were treated as a corporation for United States federal income tax purposes, all of our income will be subject to an entity-level tax, which 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.
The value of your investment in us depends in part on our being treated as a partnership for United States federal income tax purposes.
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. 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 tax 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
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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 be taxable as ordinary dividend income 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.
Complying with certain tax-related requirements may cause us to forego otherwise attractive business or investment opportunities.
To be treated as a partnership for United States federal income tax purposes, and not as an association or publicly traded partnership
taxable as a corporation, we must satisfy the qualifying income exception, which requires that at least 90% of our gross income each taxable year consist of interest, dividends, capital gains and
other types of "qualifying income." Interest income will not be qualifying income for the qualifying income exception if it is derived from "the conduct of a financial or insurance business." This
requirement limits our ability to originate loans or acquire loans originated by our Manager and its affiliates. In order to comply with this requirement, we (or our subsidiaries) may be required to
invest through foreign or domestic corporations that are subject to corporate income tax or forego attractive business or investment opportunities. Thus, compliance with this requirement may adversely
affect our return on our investments and results of operations.
We cannot predict the tax liability attributable to our shares for any particular holder of our shares.
Each holder of our shares will determine its tax liability attributable to its ownership of our shares based on its own unique
circumstances. Holders of our shares may have different tax liabilities attributable to our shares for many reasons unique to the holders, including among other things, limitations on miscellaneous
itemized deductions, alternative minimum tax liabilities, differing tax bases in our assets or the holder's status as a non-United States person or tax-exempt entity. As a
result, we cannot predict the tax liability attributable to our shares for any particular holder and such tax liability may exceed the amount of cash actually distributed to such holder for the year.
The ability of holders of our common shares to deduct certain expenses incurred by us may be limited.
In general, expenses incurred by us that are considered "miscellaneous itemized deductions" may be deducted by a holder of our common
shares that is an individual, estate or trust only to the extent that such holder's allocable share of those expenses, along with the holder's other miscellaneous itemized deductions, exceed, in the
aggregate, 2% of such holder's adjusted gross income. In addition, these expenses are also not deductible in determining the alternative minimum tax liability of a holder. We treat the management fees
that we pay to our Manager and certain other expenses incurred by us as miscellaneous itemized deductions. A holder's inability to deduct all or a portion of such expenses could result in an amount of
taxable income to such holder with respect to us that exceeds the amount of cash actually distributed to such holder for the year.
Common shareholders that are individuals, trusts, or estates may have a higher tax liability if the Internal Revenue Service (the "IRS") successfully challenges our
treatment of distributions paid on our Series A LLC Preferred Shares.
The treatment of interests in a partnership, such as our Series A LLC Preferred Shares, and the payments received in
respect of such interests is uncertain. Our Series A LLC Preferred Shares will accrue distributions at an annual rate of 7.375%. In general, we will specially allocate to our
Series A LLC Preferred Shares items of our gross income (excluding any gross income from the sale or exchange of capital assets) (our "gross ordinary income") in an amount equal to the
distributions paid in respect of our Series A LLC Preferred Shares during the taxable year. The amount of gross ordinary
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income
that we allocate to our Series A LLC Preferred Shares will reduce the amount of income that is allocable to our common shares.
We
intend to treat our Series A LLC Preferred Shares as partnership interests in us and the amounts paid to our Series A LLC Preferred Shares as distributions
related to allocations of our items of income. The IRS, however, may contend that payments on our Series A LLC Preferred Shares represent "guaranteed payments." In that case, no portion
of our income would be allocated to our Series A LLC Preferred Shares, but our common shareholders would be entitled to a deduction for their allocable share of the distributions treated
as "guaranteed payments." Although not entirely free from doubt, deductions attributable to "guaranteed payments" should generally be treated as "miscellaneous itemized deductions." In general,
"miscellaneous itemized deductions" may be deducted by a common
shareholder that is an individual, estate or trust only to the extent that such holder's allocable share of those expenses, along with the holder's other miscellaneous itemized deductions, exceed, in
the aggregate, 2% of such holder's adjusted gross income. In addition, these expenses are also not deductible in determining the alternative minimum tax liability of a holder. As a result of those
restrictions, common shareholders may not be able to deduct all or a portion of their allocable share of deductions attributable to any "guaranteed payments," and, therefore, common shareholders that
are individuals, trusts, or estates may have a higher tax liability if the IRS successfully challenges our treatment of distributions paid on our Series A LLC Preferred Shares.
Holders of our shares may recognize gain for United States federal income tax purposes when we sell assets that cause us to recognize a loss for financial reporting
purposes.
We have elected under Section 754 of the Code to adjust the tax basis in all or a portion of our assets upon certain events,
including the sale of our shares. However, we generally do not intend to adjust the tax basis of our assets with respect to purchasers of our Series A LLC Preferred Shares, except in
extraordinary circumstances. We believe that treatment is appropriate under the applicable Treasury regulations because the holders of the Series A LLC Preferred Shares do not
participate in the income or gain from the sale of our assets and are entitled only to fixed distributions, but the IRS may successfully challenge that position. Because our holders are treated as
having differing tax bases in our assets, a sale of an asset by us may cause holders to recognize different amounts of gain or loss or may cause some holders to recognize a gain and others to
recognize a loss. Depending on the purchase price the shareholder paid for our shares, our holders may recognize gain for United States federal income tax purposes from the sale of certain of our
assets even though the sale would cause us to recognize a loss for financial accounting purposes.
We have made and may make investments, such as investments in natural resources and real estate, that generate income that is treated as "effectively connected" with a
United States trade or business with respect to holders of our shares that are not "United States persons."
We have made and may make investments, such as investments in natural resources and real estate that generate income that is treated as
"effectively connected" with a United States trade or business with respect to holders that are not "United States persons" within the meaning of section 7701(a)(30) of the Code. It is likely
that income from our natural resources investments will be treated as effectively connected income. 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 with a United States trade or business. Our investments in real estate may also generate
income that would be treated as effectively connected income. 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 (and possibly state income tax returns) for such year reporting its allocable share, if any, of our income
effectively connected with such trade or business and (ii) pay United States federal income tax (and possibly state 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
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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
federal income tax rate to the extent of the holder's allocable share of our effectively connected income. Any amount so withheld would be creditable against such holder's United States federal income
tax liability, and such holder could claim a refund to the extent that the amount withheld exceeded such person's United States federal income tax liability for the taxable year.
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 gain from the sale
or exchange. Moreover, if the fair market value of our investments in "United States real property interests," which include our investments in natural resources, real estate and certain REIT
subsidiaries that invest primarily in real estate, represent more than 10% of the total fair market value of our assets, our shares could be treated as "United States real property interests." In such
case, gain recognized by an investor who is a non-United States person on the sale or exchange of its shares would be treated for United States federal income tax purposes as effectively
connected income (unless the gain is attributable to a class of our shares that is regularly traded on a securities market and the non-United States person owns 5% or less of the shares of
that class). If gain from the sale of our shares is treated as effectively connected income, the 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 shares may be subject to other taxes, including foreign, state and
local taxes, unincorporated business taxes and estate, inheritance or intangible property taxes that are imposed by the various jurisdictions in which we conduct business or own property, even if the
holders of our shares do not reside in any of those jurisdictions. For example, our holders may have state filing obligations in jurisdictions in which we have made investments in natural resources or
real estate (other than through a REIT subsidiary). As a result, our holders may 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. It is the responsibility of each holder to file all United States
federal, state and local tax returns that may be required of such holder.
Holders of our shares may be subject to California income taxes or withholding on their allocable share of our income and gains.
Our Manager has offices in California, and thus we could be deemed to have California source income. Based on our current and
anticipated investment activities, we believe that holders of our shares who are not residents of California and corporate holders of our shares who do not have other income derived from California
should not be subject to California income taxes on their share of our income or gains. However, no assurance can be provided that our future activities will not cause holders of our shares who are
not residents of California and such corporate holders of our shares to be subject to California income tax on all or a portion of their share of our income or gains, and no assurance can be provided
that the California Franchise Tax Board will not successfully challenge our current position that such holders are not subject to California income tax on their share of our income and gains. If it
were determined that we had California source income, we would be required to withhold at a rate of 7% of the distributions of California source income to domestic (non-foreign)
nonresident holders of our shares and at the highest rate of tax imposed on individuals and corporations, respectively, of the allocated share of California source income for foreign
(non-U.S.) holders of our shares.
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Holders of our shares may recognize a greater taxable gain (or a smaller tax loss) on a disposition of our shares than expected because of the treatment of debt under the
partnership tax accounting rules.
We will incur debt for a variety of reasons, including for acquisitions as well as other purposes. Under partnership tax accounting
principles (which apply to us), our debt is generally allocable to holders of our shares, who will realize the benefit of including their allocable share of the debt in the tax basis of their shares.
The tax basis in our shares will be adjusted for, among other things, distributions of cash and allocations of our losses, if any. At the time a holder of our shares later sells its shares, the
holder's amount realized on the sale will include not only the sales price of the shares but also will include such holder's portion of debt allocable to those shares (which is treated as proceeds
from the sale of those shares). Depending on the nature of our activities after having incurred the debt, and the utilization of the borrowed funds, a later sale of our shares could result in a larger
taxable gain (or a smaller tax loss) than anticipated.
If we have a termination for United States federal income tax purposes, holders of our shares may be required to include more than 12 months of our taxable income in
their taxable income for the year of the termination.
We will be considered to have been terminated for United States federal income tax purposes if there is a sale or exchange of 50% or
more of the total interests in our capital and profits within a 12-month period. A termination of our partnership would, among other things, result in the closing of our taxable year for
all holders. In the case of a holder reporting on a taxable year other than a fiscal year ending on our year end, which is expected to continue to be the calendar year, the closing of our taxable year
may result in more than 12 months of our taxable income or loss being includable in the holder's taxable income for the year of termination. We would be required to satisfy the 90% "qualifying
income" test for each tax period and to make new tax elections after a termination, including a new tax election under Section 754 of the Code. A termination could also result in penalties if
we were unable to determine that the termination had occurred. In the event that we become aware of a termination, we will use commercially reasonable efforts to minimize any such penalties. Moreover,
a termination might either accelerate the application of, or subject us to, any tax legislation enacted before the termination. We have experienced terminations in the past, and it is likely that we
will experience terminations in the future. The IRS has announced a publicly traded partnership technical termination relief program whereby, if the taxpayer requests relief and such relief is granted
by the IRS, among other things, the partnership would only have to provide one Schedule K-1 to most holders of shares for the year notwithstanding two or more partnership tax years.
We could incur a significant tax liability if the IRS successfully asserts that the "anti-stapling" rules apply to certain of our subsidiaries, which could
result in a reduction in cash flow and after-tax return for holders of shares and thus could result in a reduction of the value of those shares.
If we were subject to the "anti-stapling" rules of Section 269B of the Code, we would incur a significant tax
liability as a result of owning (i) more than 50% of the value of both a domestic corporate subsidiary and a foreign corporate subsidiary, or (ii) more than 50% of both a REIT and a
domestic or foreign corporate subsidiary. If the "anti-stapling" rules applied, our foreign corporate subsidiaries would be treated as domestic corporations, which would cause those
entities to be subject to United States federal corporate income taxation, and any REIT subsidiary would be treated as a single entity with our domestic and foreign corporate subsidiaries for purposes
of the REIT qualification requirements, which could result in the REIT subsidiary failing to qualify as a REIT and being subject to United States federal corporate income taxation. Currently, we have
several subsidiaries that could be affected if we were subject to the "anti-stapling" rules, including one subsidiary taxed as a REIT and several foreign and domestic corporate
subsidiaries. Because we own, or are treated as owning, a substantial proportion of our assets directly for United States federal income tax purposes, we do not believe that the
"anti-stapling" rules have applied or will apply. However, there can be no assurance that the IRS would not successfully assert a contrary position,
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which
could result in a reduction in cash flow and after-tax return for holders of shares and thus could result in a reduction of the value of those shares.
Tax-exempt holders of our shares will likely recognize significant amounts of "unrelated business taxable income."
An organization that is otherwise exempt from United States federal income tax is nonetheless subject to taxation with respect to its
"unrelated business taxable income" ("UBTI"). Generally, a tax-exempt partner of a partnership would be treated as earning UBTI if the partnership regularly engages in a trade or business
that is unrelated to the exempt function of the tax-exempt partner, if the partnership derives income from debt-financed property or if the partner interest itself is
debt-financed. Because we have incurred "acquisition indebtedness" with respect to certain equity and debt securities we hold (either directly or indirectly through subsidiaries that are
treated as partnerships or disregarded entities for United States federal income tax purposes), a proportionate share of a holder's income from us with respect to such securities will be treated as
UBTI. In addition, we have made and may make investments, such as investments in natural resources and real estate, that likely will generate income treated as effectively connected with a United
States trade or business. Accordingly, tax-exempt holders of our shares will likely recognize significant amounts of UBTI. Tax-exempt holders of our shares are strongly urged
to consult their tax advisors regarding the tax consequences of owning our shares.
Although we anticipate that our foreign corporate subsidiaries will not be subject to United States federal income tax on a net basis, no assurance can be given that such
subsidiaries will not be subject to United States federal income tax on a net basis in any given taxable year.
We anticipate that our foreign corporate subsidiaries will generally continue to conduct their activities in such a way as not to be
deemed to be engaged in a United States trade or business and not to be subject to United States federal income tax. There can be no assurance, however, that our foreign corporate subsidiaries will
not pursue investments or engage in activities that may cause them to be engaged in a United States trade or business. Moreover, there can be no assurance that as a result of any change in applicable
law, treaty, rule or regulation or interpretation thereof, the activities of any of our foreign corporate subsidiaries would not become subject to United States federal income tax. Further, there can
be no assurance that unanticipated activities of our foreign subsidiaries would not cause such subsidiaries to become subject to United States federal income tax. If any of our foreign corporate
subsidiaries became subject to United States federal income tax (including the United States branch profits tax), it would significantly reduce the amount of cash available for distribution to us,
which in turn could have an adverse impact on the value of our shares and any other securities we may issue. Our foreign corporate subsidiaries are generally not expected to
be subject to United States federal income tax on a net basis, and such subsidiaries may receive income that is subject to withholding taxes imposed by the United States or other countries. Any such
withholding taxes would further reduce the amount of cash available for distribution to us.
Certain of our investments may subject us to United States federal income tax and could have negative tax consequences for our shareholders.
A portion of our distributions likely will constitute "excess inclusion income." Excess inclusion income is generated by residual
interests in real estate mortgage investment conduits ("REMICs") and taxable mortgage pool arrangements owned by REITs. We own through a disregarded entity a small number of REMIC residual interests.
In addition, one of our REIT subsidiaries has entered into financing arrangements that are treated as taxable mortgage pools. We will be taxable at the highest corporate income tax rate on any excess
inclusion income from a REMIC residual interest that is allocable to the percentage of our shares held in record name by disqualified organizations. Although the law is not clear, we may also be
subject to that tax if the excess inclusion income arises from a
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mortgage pool arrangement owned by a REIT in which we invest. Disqualified organizations are generally certain cooperatives, governmental entities and tax-exempt organizations that
are exempt from unrelated business tax (including certain state pension plans and charitable remainder trusts). They are permitted to own our shares. Because this tax would be imposed on us, all of
the holders of our shares, including holders that are not disqualified organizations, would bear a portion of the tax cost associated with our ownership of REMIC residual interests and with the
classification of any of our REIT subsidiaries or a portion of the assets of any of our REIT subsidiaries as a taxable mortgage pool. A regulated investment company or other pass-through
entity owning our shares may also be subject to tax at the highest corporate rate on any excess inclusion income allocated to their record name owners that are disqualified organizations. Nominees who
hold our shares on behalf of disqualified organizations also potentially may be subject to this tax.
Excess
inclusion income cannot be offset by losses of our shareholders. If the shareholder is a tax-exempt entity and not a disqualified organization, then this income would
be fully taxable as UBTI under Section 512 of the Code. If the shareholder is a foreign person, it would be subject to United States federal income tax withholding on this income without
reduction or exemption pursuant to any otherwise applicable income tax treaty.
Dividends paid by, and certain income inclusions derived with respect to our ownership of, our REIT subsidiaries and foreign corporate subsidiaries will not qualify for the
reduced tax rates generally applicable to corporate dividends paid to taxpayers taxed at individual rates.
The maximum tax rate applicable to "qualified dividend income" payable to domestic shareholders taxed at individual rates is 20%.
Dividends paid by, and certain income inclusions derived with respect to the ownership of, REITs, passive foreign investment companies ("PFICs") and certain controlled foreign corporations ("CFCs"),
however, generally are not eligible for the reduced rates on qualified dividend income. We have treated and intend to continue to treat our foreign corporate subsidiaries as the type of CFCs whose
income inclusions are not eligible for lower tax rates on dividend income. The more favorable rates applicable to regular corporate qualified dividends could cause investors who are taxed at
individual rates to perceive investments in companies such as us whose holdings include foreign corporations and REITs to be relatively less attractive than investments in the stocks of domestic
non-REIT corporations that pay dividends treated as qualified dividend income, which could adversely affect the value of our shares and any other securities we may issue.
Under the Foreign Account Tax Compliance Act ("FATCA"), withholding tax may apply to the portion of our distributions that constitute "withholdable payments" other than
gross proceeds after December 31, 2013 and to distributions of gross proceeds of certain asset sales by us and proceeds of sales in respect of our shares after December 31, 2016.
Under current law, holders of our shares that are not United States persons are generally subject to United States federal withholding
tax at the rate of 30% (or such lower rate provided by an applicable tax treaty) on their share of our gross income from dividends, interest (other than interest that constitutes "portfolio interest"
within the meaning of the Code) and certain other income that is not treated as effectively connected with a United States trade or business. For payments made after December 31, 2013, in
addition to this withholding tax that currently applies, FATCA will impose, without duplication, a United States federal withholding tax at a 30% rate on "withholdable payments" made to foreign
financial institutions (and their more than 50% affiliates) unless the payee foreign financial institution agrees, among other things, to disclose the identity of certain United States persons and
United States owned foreign entities with accounts at the institution (or the institution's affiliates) and to annually report certain information about such accounts. "Withholdable payments" include
payments of interest (including original issue discount), dividends, and other items of fixed or determinable annual or periodical gains, profits, and income, in each case, from sources within the
United States, as well as gross proceeds from the sale of any property of a type which can produce
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interest
or dividends from sources within the United States. FATCA will also require withholding on the gross proceeds of such sales for payments made after December 31, 2016. The FATCA
withholding tax will also apply to withholdable payments to certain foreign entities that do not disclose the name, address, and taxpayer identification number of any substantial United States owners
(or certify that they do not have any substantial United States owners). We expect that some or all of our distributions will constitute "withholdable payments." Thus, if a holder holds our shares
through a foreign financial institution or foreign corporation or trust, a portion of payments to such holder made after December 31, 2013 may be subject to 30% withholding under FATCA.
If
we are required to withhold any United States federal withholding tax on distributions made to any holder of our shares, we will pay such withheld amount to the IRS. That payment, if
made, will be treated as a distribution of cash to the holder of the shares with respect to whom the payment was made and will reduce the amount of cash to which such holder would otherwise be
entitled.
Ownership limitations in the operating agreement that apply so long as we own an interest in a REIT may restrict a change of control in which our holders might receive a
premium for their shares.
In order for each of our REIT subsidiaries to continue to qualify as REITs, no more than 50% in value of its outstanding capital stock
may be owned, directly or indirectly, by five or fewer individuals during the last half of any calendar year and its shares must be beneficially owned by 100 or more persons during at least
335 days of a taxable year of 12 months or during a proportionate part of a shorter taxable year. "Individuals" for this purpose include natural persons, private foundations, some
employee benefit plans and trusts, and some charitable trusts. We intend for each of our REIT subsidiaries to be owned, directly or indirectly, by us and by holders of the preferred shares issued by
such REIT subsidiary. In order to preserve our current REIT subsidiaries and any future REIT subsidiary, the operating agreement generally prohibits, subject to exceptions, any person from
beneficially owning or constructively owning shares in excess of 9.8% in value or in number of any class or series of our outstanding shares, whichever is more restrictive, excluding shares not
treated as outstanding for United States federal income tax purposes. This restriction may be terminated by our board of directors if it determines that it is no longer in our best interests for our
REIT subsidiaries to continue to qualify as REITs under the Code or that compliance with those restrictions is no longer required to qualify as a REIT, and our board of directors may also, in its sole
discretion, exempt a person from this restriction.
The
ownership limitation could have the effect of discouraging a takeover or other transaction in which holders of our shares might receive a premium for their shares over the then
prevailing market price or which holders might believe to be otherwise in their best interests.
The failure of any REIT subsidiary to qualify as a REIT would generally cause it to be subject to United States federal income tax on its taxable income, which could result
in a reduction in cash flow and after-tax return for holders of our shares and thus could result in a reduction of the value of those shares and any other securities we may issue.
We intend that each of our current and any future REIT subsidiaries will operate and continue to operate in a manner so as to qualify
to be taxed as a REIT for United States federal income tax purposes. No ruling from the IRS, however, has been or will be sought with regard to the treatment of any REIT subsidiary as a REIT for
United States federal income tax purposes, and the ability to qualify as a REIT depends on the satisfaction of certain asset, income, organizational, distribution, shareholder ownership and other
requirements on a continuing basis. Accordingly, no assurance can be given that any REIT subsidiary will satisfy such requirements for any particular taxable year. If any REIT subsidiary were to fail
to qualify as a REIT in any taxable year, it would be subject to United States federal income tax, including any applicable alternative minimum tax, on its net taxable income at regular corporate
rates, and distributions would not be deductible by it in computing its taxable income. Any such corporate tax liability could be substantial and could reduce the amount of cash
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available
for distribution to us, which in turn would reduce the amount of cash available for distribution to holders of our shares and could have an adverse impact on the value of those shares and
any other securities we may issue. Unless entitled to relief under certain Code provisions, such REIT subsidiary also would be disqualified from taxation as a REIT for the four taxable years following
the year during which it ceased to qualify as a REIT.
A holder whose shares are loaned to a "short seller" to cover a short sale of shares may be considered as having disposed of those shares. If so, the holder would no longer
be treated for tax purposes as a partner with respect to those shares during the period of the loan and may recognize gain or loss from the disposition.
Because a holder whose shares are loaned to a "short seller" to cover a short sale of shares may be considered as having disposed of
the loaned shares, the holder may no longer be treated for tax purposes as a partner with respect to those shares during the period of the loan to the short seller and the holder may recognize gain or
loss from such disposition. Moreover, during the period of the loan to the short seller, any of our income, gain, loss, or deduction with respect to those shares may not be reportable by the holder
and any cash distributions received by the holder as to those shares could be fully taxable as ordinary income. Holders desiring to assure their status as partners and avoid the risk of gain
recognition from a loan to a short seller are urged to
modify any applicable brokerage account agreements to prohibit their brokers from borrowing their shares.
The IRS Schedules K-1 we will provide will be significantly more complicated than the IRS Forms 1099 provided by REITs and regular corporations,
and holders of our shares may be required to request an extension of the time to file their tax returns.
Holders of our shares are required to take into account their allocable share of items of our income, gain, loss, deduction and credit
for our taxable year ending within or with their taxable year. We will use reasonable efforts to furnish holders of our shares with tax information (including IRS Schedule K-1),
which describes their allocable share of such items for our preceding taxable year, as promptly as possible. However, we may not be able to provide holders of our shares with tax information on a
timely basis. Because holders of our shares will be required to report their allocable share of each item of our income, gain, loss, deduction, and credit on their tax returns, tax reporting for
holders of our shares will be significantly more complicated than for shareholders in a REIT or a regular corporation. In addition, delivery of this information to holders of our shares will be
subject to delay in the event of, among other reasons, the late receipt of any necessary tax information from an investment in which we hold an interest. It is therefore possible that, in any taxable
year, holders of our shares will need to apply for extensions of time to file their tax returns.
Our structure involves complex provisions of United States federal income tax law for which no clear precedent or authority may be available, and which is subject to
potential change, possibly on a retroactive basis. Any such change could result in adverse consequences to the holders of our shares and any other securities we may issue.
The United States federal income tax treatment of holders of our shares depends in some instances on determinations of fact and
interpretations of complex provisions of United States federal income tax law for which no clear precedent or authority may be available. The United States federal income tax rules are constantly
under review by the IRS, resulting in revised interpretations of established concepts. The IRS pays close attention to the proper application of tax laws to partnerships and investments in foreign
entities. The present United States federal income tax treatment of an investment in our shares may be modified by administrative, legislative or judicial interpretation at any time, and any such
action may affect investments and commitments previously made. We and holders of our shares could be adversely affected by any such change in, or any new tax law, regulation or interpretation. Our
operating agreement permits our board of directors to modify (subject to certain exceptions) the operating agreement from time to time, without the consent of the holders of our
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shares.
These modifications may address, among other things, certain changes in United States federal income tax regulations, legislation or interpretation. In some circumstances, such revisions could
have an adverse impact on some or all of the holders of our shares and of any other securities we may issue. Moreover, we intend to apply certain assumptions and conventions in an attempt to comply
with applicable rules and to report income, gain, deduction, loss and credit to holders of our shares in a manner that reflects their distributive share of our items, but these assumptions and
conventions may not be in compliance with all aspects of applicable tax requirements. It is possible that the IRS will assert successfully that the conventions and assumptions we use do not satisfy
the technical requirements of the Code and/or United States Treasury Regulations and could require that items of income, gain, deduction, loss or credit be adjusted or reallocated in a manner that
adversely affects holders of our shares and of any other securities we may issue.
We may be subject to adverse legislative or regulatory tax changes that could reduce the market price of our shares.
At any time, the federal income tax laws or regulations governing publicly traded partnerships or the administrative interpretations of
those laws or regulations may be amended. We cannot predict when or if any new federal income tax law, regulation or administrative interpretation, or any amendment to any existing federal income tax
law, regulation or administrative interpretation, will be adopted or promulgated or will become effective and any such law, regulation or interpretation may take effect retroactively. We and our
holders could be adversely affected by any change in, or any new, federal income tax law, regulation or administrative interpretation. Additionally, revisions in federal tax laws and interpretations
thereof could cause us to change our investments and commitments and affect the tax considerations of an investment in us.