Table of
Contents
UNITED STATES
SECURITIES
AND EXCHANGE COMMISSION
Washington,
D.C. 20549
FORM 10-Q
(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2010
or
o
TRANSITION REPORT
PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934
For the transition period from
to
Commission
file number: 001-33437
KKR
FINANCIAL HOLDINGS LLC
(Exact name of registrant as
specified in its charter)
Delaware
|
|
11-3801844
|
(State or other jurisdiction of
|
|
(I.R.S. Employer
|
incorporation or organization)
|
|
Identification No.)
|
555 California Street, 50
th
Floor
|
|
|
San Francisco, CA
|
|
94104
|
(Address of principal executive offices)
|
|
(Zip Code)
|
Registrants telephone
number, including area code:
(415) 315-3620
Indicate by check mark whether the registrant (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities
Exchange Act of 1934 during the preceding 12 months (or for such shorter
period that the registrant was required to file such reports), and (2) has
been subject to such filing requirements for the past 90 days.
x
Yes
o
No
Indicate by check mark whether the registrant has submitted
electronically and posted on its corporate Web site, if any, every Interactive
Data File required to be submitted and posted pursuant to Rule 405 of
Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or
for such shorter period that the registrant was required to submit and post
such files). Yes
o
No
o
Indicate by check mark whether the registrant is a large accelerated
filer, an accelerated filer, a non-accelerated filer, or a smaller reporting
company. See the definitions of large accelerated filer, accelerated filer
and smaller reporting company in Rule 12b-2 of the Exchange Act.
(Check one):
Large accelerated filer
o
|
|
Accelerated filer
x
|
|
|
|
Non-accelerated filer
o
|
|
Smaller reporting company
o
|
(Do not check if a smaller reporting company)
|
|
|
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Act).
o
Yes
x
No
The number of shares of the registrants common shares outstanding as
of October 28, 2010 was 158,412,565.
Table
of Contents
PART I. FINANCIAL
INFORMATION
Item 1.
Financial Statements
KKR Financial Holdings LLC and Subsidiaries
Condensed Consolidated Balance Sheets
(Unaudited)
(Amounts in thousands, except share information)
|
|
September 30,
2010
|
|
December 31,
2009
|
|
Assets
|
|
|
|
|
|
Cash and cash equivalents
|
|
$
|
96,991
|
|
$
|
97,086
|
|
Restricted cash and cash equivalents
|
|
365,220
|
|
342,706
|
|
Securities available-for-sale, $727,485 and
$740,949 pledged as collateral as of September 30, 2010 and
December 31, 2009, respectively
|
|
849,022
|
|
755,686
|
|
Corporate loans, net of allowance for loan losses
of $209,030 and $237,308 as of September 30, 2010 and December 31, 2009,
respectively
|
|
5,815,544
|
|
5,617,925
|
|
Corporate loans held for sale
|
|
667,196
|
|
925,718
|
|
Residential mortgage-backed securities, at estimated
fair value, $4,235 and $47,572 pledged as collateral as of September 30,
2010 and December 31, 2009, respectively
|
|
106,252
|
|
47,572
|
|
Residential mortgage loans, at estimated fair
value
|
|
|
|
2,097,699
|
|
Equity investments, at estimated fair value, $13,286
and $110,812 pledged as collateral as of September 30, 2010 and
December 31, 2009, respectively
|
|
84,307
|
|
120,269
|
|
Derivative assets
|
|
20,004
|
|
15,784
|
|
Interest and principal receivable
|
|
83,195
|
|
98,313
|
|
Reverse repurchase agreements
|
|
|
|
80,250
|
|
Other assets
|
|
72,325
|
|
100,997
|
|
Total assets
|
|
$
|
8,160,056
|
|
$
|
10,300,005
|
|
Liabilities
|
|
|
|
|
|
Collateralized loan obligation secured notes
|
|
$
|
5,630,141
|
|
$
|
5,667,716
|
|
Collateralized loan obligation junior secured
notes to affiliates
|
|
371,062
|
|
533,786
|
|
Senior secured credit facility
|
|
|
|
175,000
|
|
Convertible senior notes
|
|
343,863
|
|
275,800
|
|
Junior subordinated notes
|
|
283,517
|
|
283,517
|
|
Residential mortgage-backed securities issued, at
estimated fair value
|
|
|
|
2,034,772
|
|
Accounts payable, accrued expenses and other
liabilities
|
|
27,312
|
|
7,240
|
|
Accrued interest payable
|
|
17,538
|
|
25,297
|
|
Accrued interest payable to affiliates
|
|
3,846
|
|
2,911
|
|
Related party payable
|
|
12,431
|
|
3,367
|
|
Securities sold, not yet purchased
|
|
|
|
77,971
|
|
Derivative liabilities
|
|
108,697
|
|
45,970
|
|
Total liabilities
|
|
6,798,407
|
|
9,133,347
|
|
Shareholders Equity
|
|
|
|
|
|
Preferred shares, no par value, 50,000,000 shares
authorized and none issued and outstanding at September 30, 2010 and
December 31, 2009
|
|
|
|
|
|
Common shares, no par value, 500,000,000 shares
authorized, and 158,412,565 and 158,359,757 shares issued and outstanding at
September 30, 2010 and December 31, 2009, respectively
|
|
|
|
|
|
Paid-in-capital
|
|
2,578,945
|
|
2,563,634
|
|
Accumulated other comprehensive income
|
|
85,474
|
|
152,728
|
|
Accumulated deficit
|
|
(1,302,770
|
)
|
(1,549,704
|
)
|
Total shareholders equity
|
|
1,361,649
|
|
1,166,658
|
|
Total liabilities and
shareholders equity
|
|
$
|
8,160,056
|
|
$
|
10,300,005
|
|
See notes to condensed
consolidated financial statements.
3
Table
of Contents
KKR Financial Holdings LLC and Subsidiaries
Condensed Consolidated Statements of Operations
(Unaudited)
(Amounts in thousands, except per share information)
|
|
For the three
months ended
September 30,
2010
|
|
For the three
months ended
September 30,
2009
|
|
For the nine
months ended
September 30,
2010
|
|
For the nine
months ended
September 30,
2009
|
|
Net investment income:
|
|
|
|
|
|
|
|
|
|
Loan interest income
|
|
$
|
96,814
|
|
$
|
113,460
|
|
$
|
282,812
|
|
$
|
364,583
|
|
Securities interest income
|
|
25,406
|
|
21,701
|
|
79,067
|
|
73,805
|
|
Other interest income
|
|
29
|
|
75
|
|
2,086
|
|
824
|
|
Total investment income
|
|
122,249
|
|
135,236
|
|
363,965
|
|
439,212
|
|
Interest expense
|
|
30,051
|
|
57,340
|
|
100,402
|
|
219,625
|
|
Interest expense to affiliates
|
|
5,791
|
|
5,171
|
|
17,072
|
|
16,355
|
|
Provision for loan losses
|
|
8,087
|
|
|
|
8,087
|
|
39,795
|
|
Net investment income
|
|
78,320
|
|
72,725
|
|
238,404
|
|
163,437
|
|
Other income (loss):
|
|
|
|
|
|
|
|
|
|
Net realized and unrealized gain (loss) on
investments
|
|
19,441
|
|
21,181
|
|
83,803
|
|
(85,576
|
)
|
Net realized and unrealized gain (loss) on
derivatives and foreign exchange
|
|
3,831
|
|
19,930
|
|
(3,437
|
)
|
58,831
|
|
Net realized and unrealized gain (loss) on
residential mortgage-backed securities, residential mortgage loans, and
residential mortgage-backed securities issued, carried at estimated fair
value
|
|
1,492
|
|
(17,681
|
)
|
(7,764
|
)
|
(44,545
|
)
|
Net realized and unrealized (loss) gain on
securities sold, not yet purchased
|
|
|
|
(996
|
)
|
(756
|
)
|
2,920
|
|
Net (loss) gain on restructuring and
extinguishment of debt
|
|
|
|
(10,627
|
)
|
39,999
|
|
30,836
|
|
Other income
|
|
1,863
|
|
1,239
|
|
9,085
|
|
4,150
|
|
Total other income (loss):
|
|
26,627
|
|
13,046
|
|
120,930
|
|
(33,384
|
)
|
Non-investment expenses:
|
|
|
|
|
|
|
|
|
|
Related party management compensation
|
|
17,551
|
|
14,616
|
|
52,518
|
|
36,132
|
|
General, administrative and directors expenses
|
|
3,561
|
|
1,539
|
|
10,127
|
|
6,917
|
|
Professional services
|
|
1,041
|
|
441
|
|
3,335
|
|
5,916
|
|
Loan servicing
|
|
|
|
1,925
|
|
|
|
6,117
|
|
Total non-investment expenses
|
|
22,153
|
|
18,521
|
|
65,980
|
|
55,082
|
|
Income before income tax expense
|
|
82,794
|
|
67,250
|
|
293,354
|
|
74,971
|
|
Income tax expense
|
|
452
|
|
63
|
|
489
|
|
151
|
|
Net income
|
|
$
|
82,342
|
|
$
|
67,187
|
|
292,865
|
|
$
|
74,820
|
|
|
|
|
|
|
|
|
|
|
|
Net income per common share:
|
|
|
|
|
|
|
|
|
|
Basic
|
|
$
|
0.52
|
|
$
|
0.42
|
|
$
|
1.85
|
|
$
|
0.49
|
|
Diluted
|
|
$
|
0.52
|
|
$
|
0.42
|
|
$
|
1.85
|
|
$
|
0.49
|
|
|
|
|
|
|
|
|
|
|
|
Weighted-average number of common shares
outstanding:
|
|
|
|
|
|
|
|
|
|
Basic
|
|
157,057
|
|
156,997
|
|
157,018
|
|
152,664
|
|
Diluted
|
|
157,461
|
|
156,997
|
|
157,294
|
|
152,664
|
|
Distributions declared per common shares
|
|
$
|
0.12
|
|
|
|
$
|
0.29
|
|
|
|
See notes to condensed
consolidated financial statements.
4
Table
of Contents
KKR Financial Holdings LLC and Subsidiaries
Condensed Consolidated Statement of Changes in Shareholders Equity
(Unaudited)
(Amounts in thousands)
|
|
Common
Shares
|
|
Paid-In
Capital
|
|
Accumulated Other
Comprehensive
Income
|
|
Accumulated
Deficit
|
|
Comprehensive
Income
|
|
Total
Shareholders
Equity
|
|
Balance at January 1, 2010
|
|
158,360
|
|
$
|
2,563,634
|
|
$
|
152,728
|
|
$
|
(1,549,704
|
)
|
|
|
$
|
1,166,658
|
|
Net income
|
|
|
|
|
|
|
|
292,865
|
|
$
|
292,865
|
|
292,865
|
|
Net change in unrealized loss on cash flow
hedges
|
|
|
|
|
|
(44,432
|
)
|
|
|
(44,432
|
)
|
(44,432
|
)
|
Net change in unrealized gain on securities
available-for-sale
|
|
|
|
|
|
(22,822
|
)
|
|
|
(22,822
|
)
|
(22,822
|
)
|
Comprehensive income
|
|
|
|
|
|
|
|
|
|
$
|
225,611
|
|
|
|
Cash distributions on common shares
|
|
|
|
|
|
|
|
(45,931
|
)
|
|
|
(45,931
|
)
|
Issuance of common shares
|
|
53
|
|
|
|
|
|
|
|
|
|
|
|
Equity component of convertible notes issuance
|
|
|
|
9,973
|
|
|
|
|
|
|
|
9,973
|
|
Share-based compensation expense related to
restricted common shares
|
|
|
|
5,338
|
|
|
|
|
|
|
|
5,338
|
|
Balance at September 30,
2010
|
|
158,413
|
|
$
|
2,578,945
|
|
$
|
85,474
|
|
$
|
(1,302,770
|
)
|
|
|
$
|
1,361,649
|
|
See notes to condensed consolidated financial statements.
5
Table
of Contents
KKR Financial Holdings LLC and Subsidiaries
Condensed Consolidated Statements of Cash Flows
(Unaudited)
(Amounts in thousands)
|
|
For the nine
months ended
September 30, 2010
|
|
For the nine
months ended
September 30, 2009
|
|
Cash flows from operating
activities:
|
|
|
|
|
|
Net income
|
|
$
|
292,865
|
|
$
|
74,820
|
|
Adjustments to reconcile net income to net cash
provided by operating activities:
|
|
|
|
|
|
Net realized and unrealized loss (gain) on
derivatives, foreign exchange, and securities sold, not yet
purchased
|
|
4,695
|
|
(61,751
|
)
|
Net gain on restructuring and extinguishment of
debt
|
|
(39,999
|
)
|
(59,635
|
)
|
Write-off of debt issuance costs
|
|
8,160
|
|
4,611
|
|
Lower of cost or estimated fair value adjustment
on corporate loans held for sale
|
|
21,362
|
|
38,898
|
|
Provision for loan losses
|
|
8,087
|
|
39,795
|
|
Impairment on securities available-for-sale and
private equity at cost
|
|
9,979
|
|
40,013
|
|
Share-based compensation
|
|
5,338
|
|
2,605
|
|
Net realized and unrealized loss on residential
mortgage-backed securities, residential mortgage loans, and residential
mortgage-backed securities issued, carried at estimated fair value
|
|
7,764
|
|
44,545
|
|
Net realized and unrealized (gain) loss on
investments
|
|
(115,144
|
)
|
6,665
|
|
Deferred interest expense
|
|
4,427
|
|
|
|
Depreciation and net amortization
|
|
(65,653
|
)
|
(38,731
|
)
|
Changes in assets and liabilities:
|
|
|
|
|
|
Interest receivable
|
|
8,080
|
|
50,057
|
|
Other assets
|
|
(1,182
|
)
|
(11,911
|
)
|
Related party payable
|
|
9,064
|
|
10,017
|
|
Accounts payable, accrued expenses and other
liabilities
|
|
505
|
|
(47,847
|
)
|
Accrued interest payable
|
|
(7,759
|
)
|
(37,278
|
)
|
Accrued interest payable to affiliates
|
|
935
|
|
18,893
|
|
Net cash provided by operating activities
|
|
151,524
|
|
73,766
|
|
Cash flows from investing
activities:
|
|
|
|
|
|
Principal payments from investments
|
|
1,068,644
|
|
879,235
|
|
Proceeds from sale of investments
|
|
1,335,757
|
|
1,069,201
|
|
Purchases of investments
|
|
(2,304,444
|
)
|
(685,456
|
)
|
Net proceeds, purchases, and settlements of
derivatives
|
|
12,740
|
|
20,530
|
|
Net change in reverse repurchase agreements
|
|
80,250
|
|
7,908
|
|
Net change to restricted cash and cash equivalents
|
|
(22,514
|
)
|
1,045,434
|
|
Net cash provided by investing activities
|
|
170,433
|
|
2,336,852
|
|
Cash flows from financing
activities:
|
|
|
|
|
|
Repayment of senior secured credit facility
|
|
(227,805
|
)
|
(88,133
|
)
|
Proceeds from senior secured credit facility
|
|
50,319
|
|
|
|
Repayment of residential mortgage-backed
securities issued
|
|
|
|
(442,984
|
)
|
Retirement of collateralized loan obligation
secured notes
|
|
(104,510
|
)
|
(1,788,694
|
)
|
Retirement of collateralized loan obligation
junior secured notes to affiliates
|
|
(62,581
|
)
|
|
|
Net change in junior subordinated notes
|
|
|
|
(1,238
|
)
|
Proceeds from convertible senior notes
|
|
167,325
|
|
|
|
Repayment of convertible senior notes
|
|
(93,922
|
)
|
|
|
Distributions on common shares
|
|
(45,931
|
)
|
|
|
Other capitalized costs
|
|
(4,947
|
)
|
(5,137
|
)
|
Net cash used in financing activities
|
|
(322,052
|
)
|
(2,326,186
|
)
|
Net (decrease) increase in cash
and cash equivalents
|
|
(95
|
)
|
84,432
|
|
Cash and cash equivalents at
beginning of period
|
|
97,086
|
|
41,430
|
|
Cash and cash equivalents at
end of period
|
|
$
|
96,991
|
|
$
|
125,862
|
|
Supplemental cash flow
information:
|
|
|
|
|
|
Cash paid for interest
|
|
$
|
99,308
|
|
$
|
247,029
|
|
Cash paid for income taxes
|
|
$
|
580
|
|
$
|
373
|
|
Non-cash investing and
financing:
|
|
|
|
|
|
Deconsolidation of residential mortgage loans
|
|
$
|
2,034,772
|
|
$
|
|
|
Deconsolidation of residential mortgage-backed
securities issued
|
|
$
|
(2,034,772
|
)
|
$
|
|
|
Subordinate tranche of the residential mortgage
loan securitization trusts included in residential mortgage-backed securities
|
|
$
|
74,366
|
|
$
|
|
|
Equity component of the convertible senior notes
|
|
$
|
9,973
|
|
$
|
|
|
Net payable (receivable) for securities purchased
|
|
$
|
|
|
$
|
28,238
|
|
Conversion of corporate loan to private equity
investment
|
|
$
|
|
|
$
|
48,467
|
|
Exchange of convertible senior notes to equity
|
|
$
|
|
|
$
|
8,808
|
|
Exchange of CLO 2009-1 subordinated notes to
affiliate for its interest in CLO 2009-1 assets
|
|
$
|
|
|
$
|
90,429
|
|
See notes to condensed consolidated financial statements.
6
Table of
Contents
KKR Financial Holdings LLC and Subsidiaries
Notes to
Condensed Consolidated Financial Statements (Unaudited)
Note 1. Organization
KKR Financial Holdings LLC together with its subsidiaries (the Company
or KKR Financial) is a specialty finance company with expertise in a range of
asset classes. The Company primarily invests in financial assets including
below investment grade corporate debt, including senior secured and unsecured
loans, mezzanine loans, high yield corporate bonds, distressed and stressed
debt securities, marketable equity securities, and private equity.
Additionally, the Company has made or may make investments in other asset
classes including natural resources and real estate. The corporate loans the
Company invests in are generally referred to as syndicated bank loans, or
leveraged loans, and are purchased via assignment or participation in either
the primary or secondary market. The majority of the Companys corporate debt
investments are held in collateralized loan obligation (CLO) transactions
that the Company uses as long term financing for these investments. The Companys
CLO transactions are structured as on-balance sheet securitizations of
corporate loans and high yield debt securities. The senior secured notes issued
by the CLO transactions are generally owned by third party investors who are
unaffiliated with the Company and the Company owns the majority of the
subordinated notes in the CLO transactions. The Company executes its core
business strategy through majority-owned subsidiaries, including CLOs.
KKR Financial Advisors LLC (the Manager), a wholly owned
subsidiary of KKR Asset Management LLC (formerly known as Kohlberg Kravis Roberts & Co.
(Fixed Income) LLC), manages the Company pursuant to a management
agreement (the Management Agreement). KKR Asset Management LLC is a
wholly-owned subsidiary of Kohlberg Kravis Roberts & Co. L.P. (KKR).
Note 2. Summary of Significant Accounting
Policies
Basis of Presentation
The accompanying condensed consolidated financial statements have been
prepared in conformity with accounting principles generally accepted in the
United States of America (GAAP). The condensed consolidated financial
statements include the accounts of the Company and entities established to
complete secured financing transactions that are considered to be variable
interest entities and for which the Company is the primary beneficiary.
These condensed consolidated financial statements should be read in
conjunction with the consolidated financial statements and notes thereto
included in the Companys Annual Report on Form 10-K for the year ended
December 31, 2009. The Companys results for any interim period are not necessarily
indicative of results for a full year or any other interim period. In the
opinion of management, all normal recurring adjustments have been included for
a fair statement of this interim financial information.
Use of Estimates
The preparation of financial statements in conformity with GAAP
requires management to make estimates and assumptions that affect the amounts
reported in the Companys condensed consolidated financial statements and
accompanying notes. Actual results could differ from managements estimates.
Consolidation
Effective January 1, 2010, the Company adopted new guidance which
amended the accounting for the transfers of financial assets, eliminated the
concept of a qualified special purpose entity and significantly changed the criteria
by which an enterprise determines whether or not it must consolidate a variable
interest entity (VIE). Under the new guidance, consolidation of a VIE
requires both the power to direct the activities that most significantly impact
the VIEs economic performance and the obligation to absorb losses of the VIE
or the right to receive benefits of the VIE that could potentially be
significant to the VIE.
As a result of the adoption
of the new guidance regarding the amended consolidation model based on power
and economics, the Company determined that six residential mortgage loan
securitization trusts, which were previously consolidated by the Company as it
was deemed to be the primary beneficiary, were required to be deconsolidated.
The Company determined that it did not have the power to direct the activities
that most significantly impact the economic performance of the securitization
trusts or the performance of the securitization trusts underlying assets as
the Company was never the servicer of the trusts nor did it participate in any
servicing activities. Accordingly, the Company determined that it was no longer
the primary beneficiary of the six securitization trusts under the new guidance
and deconsolidated them as of January 1, 2010. This resulted in the
reduction of both assets and liabilities of approximately $2.0 billion. In
addition, loan interest income, interest expense, loan servicing expense, and
net unrealized and realized
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gain (loss) associated with
the residential mortgage loan securitization trusts will no longer be reported
on the Companys condensed consolidated financial statements. The deconsolidation
of the six residential mortgage loan securitization trusts had no net impact on
the Companys shareholders equity, results of operations and cash flows. Refer
to Note 6 to these condensed consolidated financial statements for further
discussion of the Companys residential mortgage-backed securities (RMBS) and
to Note 7 to these condensed consolidated financial statements for the impact
of the deconsolidation.
KKR Financial CLO 2005-1, Ltd. (CLO
2005-1), KKR Financial CLO 2005-2, Ltd. (CLO 2005-2), KKR
Financial CLO 2006-1, Ltd. (CLO 2006-1), KKR Financial
CLO 2007-1, Ltd.
(CLO 2007-1) and KKR Financial CLO
2007-A, Ltd. (CLO 2007-A) are entities established to complete secured
financing transactions. These entities are VIEs which the Company consolidates
as the Company has determined it has the power to direct the activities that
most significantly impact these entities economic performance and the Company
has both the obligation to absorb losses of these entities and the right to
receive benefits from these entities that could potentially be significant to
these entities.
These
five CLOs, through which the Company finances the majority of its corporate
debt investments, include $7.3 billion par amount, or $6.8 billion estimated
fair value, of corporate debt investments. The assets in each CLO can be used
only to settle the related entities debt which in aggregate total $5.6 billion
of senior and junior secured notes outstanding and $371.1 million of junior
notes outstanding that are held by an affiliate of the Manager. In CLO
transactions, subordinated notes have the first risk of loss and conversely,
the residual value upside of the transactions. As such, these CLOs are
considered non-recourse leverage.
In
addition, the Company continues to consolidate all non-VIEs in which it holds a
greater than 50 percent voting interest.
All inter-company balances and transactions have been eliminated in
consolidation.
Fair Value of Financial Instruments
Fair value is the price that would be received to sell an asset or paid
to transfer a liability in an orderly transaction between market participants
at the measurement date. Where available, fair value is based on observable
market prices or parameters, or derived from such prices or parameters. Where
observable prices or inputs are not available, valuation models are applied.
These valuation techniques involve some level of management estimation and
judgment, the degree of which is dependent on the price transparency for the
instruments or market and the instruments complexity for disclosure purposes.
Assets and liabilities recorded at fair value in the condensed consolidated
balance sheets are categorized based upon the level of judgment associated with
the inputs used to measure their value. Hierarchical levels, as defined under
GAAP, are directly related to the amount of subjectivity associated with the
inputs to fair valuations of these assets and liabilities, and are as follows:
Level 1: Inputs are unadjusted, quoted prices in active markets
for identical assets or liabilities at the measurement date.
The types of assets carried at level 1 fair value generally are
equity securities listed in active markets.
Level 2: Inputs, other than quoted prices included in
level 1, are observable for the asset or liability, either directly or
indirectly. Level 2 inputs include quoted prices for similar instruments
in active markets, and inputs other than quoted prices that are observable for
the asset or liability.
Fair value assets and liabilities that are generally included in this
category are certain corporate debt securities, certain corporate loans held
for sale, certain equity investments at estimated fair value, certain
securities sold, not yet purchased and certain financial instruments classified
as derivatives.
Level 3: Inputs are unobservable inputs for the asset or
liability, and include situations where there is little, if any, market
activity for the asset or liability. In certain cases, the inputs used to
measure fair value may fall into different levels of the fair value hierarchy.
In such cases, the level in the fair value hierarchy within which the fair
value measurement in its entirety falls has been determined based on the lowest
level input that is significant to the fair value measurement in its entirety.
The Companys assessment of the significance of a particular input to the fair
value measurement in its entirety requires judgment and consideration of
factors specific to the asset.
Assets and liabilities carried at fair value and included in this
category are certain corporate debt securities, certain corporate loans held
for sale, certain equity investments at estimated fair value, RMBS, residential
mortgage loans, residential mortgage-backed securities issued (RMBS Issued)
and certain derivatives.
A
significant decrease in the volume and level of activity for the asset or
liability is an indication that transactions or quoted prices may not be
representative of fair value because in such market conditions there may be
increased instances of transactions that are not orderly. In those
circumstances, further analysis of transactions or quoted prices is needed, and
a significant adjustment to the transactions or quoted prices may be necessary
to estimate fair value.
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The availability of observable inputs can vary depending on the
financial asset or liability and is affected by a wide variety of factors,
including, for example, the type of product, whether the product is new,
whether the product is traded on an active exchange or in the secondary market,
and the current market condition. To the extent that valuation is based on models
or inputs that are less observable or unobservable in the market, the
determination of fair value requires more judgment. Accordingly, the degree of
judgment exercised by the Company in determining fair value is greatest for
instruments categorized in level 3. In certain cases, the inputs used to
measure fair value may fall into different levels of the fair value hierarchy.
In such cases, for disclosure purposes, the level in the fair value hierarchy
within which the fair value measurement in its entirety falls is determined
based on the lowest level input that is significant to the fair value
measurement in its entirety. The variability of the observable inputs affected
by the factors described above may cause transfers between levels 1, 2, and/or
3, which the Company recognizes at the end of the reporting period.
Many financial assets and liabilities have bid and ask prices that can
be observed in the marketplace. Bid prices reflect the highest price that the
Company and others are willing to pay for an asset. Ask prices represent the
lowest price that the Company and others are willing to accept for an asset.
For financial assets and liabilities whose inputs are based on bid-ask prices,
the Company does not require that fair value always be a predetermined point in
the bid-ask range. The Companys policy is to allow for mid-market pricing and
adjusting to the point within the bid-ask range that meets the Companys best
estimate of fair value.
Depending on the relative liquidity in the markets for certain assets,
the Company may transfer assets to level 3 if it determines that
observable quoted prices, obtained directly or indirectly, are not available.
The valuation techniques used for the assets and liabilities that are valued
using level 3 of the fair value hierarchy are described below.
Residential Mortgage-Backed Securities, Residential
Mortgage Loans, and Residential Mortgage-Backed Securities Issued:
Residential mortgage-backed securities,
residential mortgage loans, and residential mortgage-backed securities issued
are initially valued at transaction price and are subsequently valued using
industry recognized models (including Intex and Bloomberg) and data for similar
instruments (e.g., nationally recognized pricing services or broker quotes).
The most significant inputs to the valuation of these instruments are default
and loss expectations and market credit spreads.
Corporate Debt Securities:
Corporate debt securities are initially
valued at transaction price and are subsequently valued using market data for
similar instruments (e.g., recent transactions or broker quotes),
comparisons to benchmark derivative indices or valuation models. Valuation
models are based on discounted cash flow techniques, for which the key inputs
are the amount and timing of expected future cash flows, market yields for such
instruments and recovery assumptions. Inputs are determined based on relative
value analyses, which incorporate similar instruments from similar issuers.
Over-the-counter (OTC) Derivative Contracts:
OTC derivative contracts include forward,
swap and option contracts related to interest rates, foreign currencies, credit
standing of reference entities, and equity prices. The fair value of OTC
derivative products can be modeled using a series of techniques, including
closed-form analytic formulae, such as the Black-Scholes option-pricing model,
and simulation models or a combination thereof. Many pricing models do not
entail material subjectivity because the methodologies employed do not
necessitate significant judgment, and the pricing inputs are observed from
actively quoted markets, as is the case for generic interest rate swap and
option contracts.
Cash and Cash Equivalents
Cash and cash equivalents include cash on hand, cash held in banks and
highly liquid investments with original maturities of three months or less.
Interest income earned on cash and cash equivalents is recorded in other
interest income.
Restricted Cash and Cash Equivalents
Restricted cash and cash equivalents represent amounts that are held by
third parties under certain of the Companys financing and derivative
transactions. Interest income earned on restricted cash and cash equivalents is
recorded in other interest income.
On the condensed consolidated statement of cash flows, net additions or
reductions to restricted cash and cash equivalents are classified as an
investing activity as restricted cash and cash equivalents reflect the receipts
from collections or sales of investments, as well as payments made to acquire
investments held by third parties.
Residential Mortgage-Backed Securities
The
Company carries its residential mortgage-backed securities at estimated fair
value with unrealized gains and losses reported in income. The Company elected
the fair value option for its residential mortgage investments for the purpose
of enhancing the transparency of its financial condition as fair value is
consistent with how the Company manages the risks of its residential mortgage
investments.
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Securities Available-for-Sale
The Company classifies its investments in securities as
available-for-sale as the Company may sell them prior to maturity and does not
hold them principally for the purpose of selling them in the near term. These
investments are carried at estimated fair value, with unrealized gains and
losses reported in accumulated other comprehensive income (loss). Estimated
fair values are based on quoted market prices, when available, on estimates
provided by independent pricing sources or dealers who make markets in such
securities, or internal valuation models when external sources of fair value
are not available. Upon the sale of a security, the realized net gain or loss
is computed on a weighted-average cost basis. Purchases and sales of securities
are recorded on the trade date.
The
Company monitors its available-for-sale securities portfolio for impairments. A
loss is recognized when it is determined that a decline in the estimated fair
value of a security below its amortized cost is other-than-temporary. The
Company considers many factors in determining whether the impairment of a
security is deemed to be other-than-temporary, including, but not limited to,
the length of time the security has had a decline in estimated fair value below
its amortized cost and the severity of the decline, the amount of the
unrealized loss, recent events specific to the issuer or industry, external
credit ratings and recent changes in such ratings. In addition, for debt
securities, the Company considers its intent to sell the debt security, the
Companys estimation of whether or not it expects to recover the debt securitys
entire amortized cost if it intends to hold the debt security, and whether it
is more likely than not that the Company will be required to sell the debt
security before its anticipated recovery. For equity securities, the Company
also considers its intent and ability to hold the equity security for a period
of time sufficient for a recovery in value.
The amount of the loss that is recognized when it is determined that a
decline in the estimated fair value of a security below its amortized cost is
other-than-temporary is dependent on certain factors. If the security is an
equity security or if the security is a debt security that the Company intends
to sell or estimates that it is more likely than not that the Company will be
required to sell before recovery of its amortized cost, then the impairment
amount recognized in earnings is the entire difference between the estimated
fair value of the security and its amortized cost. For debt securities that the
Company does not intend to sell or estimates that it is not more likely than not
to be required to sell before recovery, the impairment is separated into the
estimated amount relating to credit loss and the estimated amount relating to
all other factors. Only the estimated credit loss amount is recognized in
earnings, with the remainder of the loss amount recognized in other
comprehensive income (loss).
Unamortized premiums and unaccreted discounts on securities
available-for-sale are recognized in interest income over the contractual life,
adjusted for actual prepayments, of the securities using the effective interest
method.
Equity Investments, at Estimated Fair Value
The
Company has elected the fair value option of accounting for certain marketable
and private equity investments. The Company elects the fair value option of
accounting for private equity investments received through restructuring debt
transactions or issued by an entity in which the Company may have significant
influence. The Company elected the fair value option for certain equity
investments for the purpose of enhancing the transparency of its financial
condition as fair value is consistent with how the Company manages the risks of
these equity investments. Equity investments, at estimated fair value, are
managed based on overall value and potential returns. Investments carried at
fair value are presented separately on the condensed consolidated balance
sheets with unrealized gains and losses reported in net realized and unrealized
gains and losses on investments on the condensed consolidated statements of
operations.
Securities Sold, Not Yet Purchased
Securities sold, not yet purchased consist of equity and debt
securities that the Company has sold short. In order to facilitate a short
sale, the Company borrows the securities from another party and delivers the
securities to the buyer. The Company will be required to cover its short sale
in the future through the purchase of the security in the market at the
prevailing market price and deliver it to the counterparty from which it
borrowed. The Company is exposed to a loss to the extent that the security
price increases during the time from when the Company borrowed the security to
when the Company purchases it in the market to cover the short sale.
Corporate Loans
The Company purchases participations and assignments in corporate loans
in the primary and secondary market. Loans are held for investment and the
Company initially records loans at their purchase prices. The Company
subsequently accounts for loans based on their outstanding principal plus or
minus unaccreted purchase discounts and unamortized purchase premiums. Interest
income on loans includes interest at stated coupon rates adjusted for accretion
of purchase discounts and the amortization of purchase premiums. Unamortized
premiums and unaccreted discounts are recognized in interest income over the
contractual life, adjusted for actual prepayments, of the loans using the
effective interest method.
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A loan is typically placed on non-accrual status at such time as:
(i) management believes that scheduled debt service payments may not be
paid when contractually due; (ii) the loan becomes 90 days
delinquent; (iii) management determines the borrower is incapable of, or
has ceased efforts toward, curing the cause of the impairment; or (iv) the
net realizable value of the underlying collateral securing the loan decreases
below the Companys carrying value of such loan. As such, loans placed on
non-accrual status may or may not be contractually past due at the time of such
determination. While on non-accrual status, previously recognized accrued
interest is reversed if it is determined that such amounts are not collectible and
interest income is recognized using the cost-recovery method, cash-basis method
or some combination of the two methods. A loan is placed back on accrual status
when the ultimate collectability of the principal and interest is not in doubt.
Corporate Loans Held for Sale
Corporate loans held for sale consist of loans that the Company has
determined to no longer hold for investment. Corporate loans held for sale are
stated at lower of cost or estimated fair value.
Allowance for Loan Losses
The
Companys allowance for loan losses represents its estimate of probable credit
losses inherent in its corporate loan portfolio held for investment as of the
balance sheet date. Estimating the Companys allowance for loan losses involves
a high degree of management judgment and is based upon a comprehensive review
of the Companys loan portfolio that is performed on a quarterly basis. The
Companys allowance for loan losses consists of two components, an allocated
component and an unallocated component. The allocated component of the
allowance for loan losses pertains to specific loans that the Company has
determined are impaired. The Company determines a loan is impaired when
management estimates that it is probable that the Company will be unable to
collect all amounts due according to the contractual terms of the loan
agreement. On a quarterly basis, the Company performs a comprehensive review of
its entire loan portfolio and identifies certain loans that it has determined
are impaired. Once a loan is identified as being impaired, the Company places
the loan on non-accrual status, unless the loan is already on non-accrual
status, and records a reserve that reflects managements best estimate of the
loss that the Company expects to recognize from the loan. The expected loss is
estimated as being the difference between the Companys current cost basis of
the loan, including accrued interest receivable, and the loans estimated fair
value.
The
unallocated component of the Companys allowance for loan losses reflects its
estimate of probable losses inherent in the loan portfolio as of the balance
sheet date where the specific loan that the loan loss relates to is
indeterminable. The Company estimates the unallocated component of the
allowance for loan losses through a comprehensive review of its loan portfolio
and identifies certain loans that demonstrate possible indicators of
impairment. This assessment excludes all loans that are determined to be
impaired and as a result, an allocated reserve has been recorded. Such indicators
include, but are not limited to, the current and/or forecasted financial
performance and liquidity profile of the issuer, specific industry or economic
conditions that may impact the issuer, and the observable trading price of the
loan if available. Loans that demonstrate possible indicators of impairment are
aggregated on a watch list for monitoring and are sub-divided for
categorization based on the seniority of the loan in the issuers capital
structure, whether the loan is secured or unsecured, and the nature of the
collateral securing the loan, for purposes of applying possible default and
loss severity ranges based on the nature of the issuer and the specific loan.
The Company applies a range of default and loss severity estimates in order to estimate
a range of loss outcomes upon which to base its estimate of probable losses
that results in the determination of the unallocated component of the Companys
allowance for loan losses.
Leasehold Improvements and Equipment
Leasehold improvements and equipment are carried at cost less
depreciation and amortization and are reviewed for impairment whenever events
or changes in circumstances indicate that the carrying amount of the assets
might not be recoverable. Equipment is depreciated using the straight-line
method over the estimated useful lives of the respective assets of three years.
Leasehold improvements are amortized on a straight-line basis over the shorter
of their estimated useful lives or lease terms. Leasehold improvements and
equipment, net of accumulated depreciation and amortization, are included in
other assets.
Borrowings
The Company finances the acquisition of its investments, including
loans, residential mortgage-backed securities and securities
available-for-sale, primarily through the use of secured borrowings in the form
of securitization transactions structured as secured financings and other
secured and unsecured borrowings. The Company recognizes interest expense on
all borrowings on an accrual basis.
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Trust Preferred Securities
Trusts formed by the Company for the sole purpose of issuing trust
preferred securities are not consolidated by the Company as the Company has
determined that it is not the primary beneficiary of such trusts. The Companys
investment in the common securities of such trusts is included in other assets
on the Companys condensed consolidated financial statements.
Derivative Financial Instruments
The Company recognizes all derivatives on the condensed consolidated
balance sheet at estimated fair value. On the date the Company enters into a
derivative contract, the Company designates and documents each derivative contract
as one of the following at the time the contract is executed: (i) a hedge
of a recognized asset or liability (fair value hedge); (ii) a hedge of a
forecasted transaction or of the variability of cash flows to be received or
paid related to a recognized asset or liability (cash flow hedge);
(iii) a hedge of a net investment in a foreign operation; or (iv) a
derivative instrument not designated as a hedging instrument (free-standing
derivative). For a fair value hedge, the Company records changes in the
estimated fair value of the derivative instrument and, to the extent that it is
effective, changes in the fair value of the hedged asset or liability in the
current period earnings in the same financial statement category as the hedged
item. For a cash flow hedge, the Company records changes in the estimated fair
value of the derivative to the extent that it is effective in other
comprehensive (loss) income and subsequently reclassifies these changes in
estimated fair value to net income in the same period(s) that the hedged
transaction affects earnings. The effective portion of the cash flow hedges is
recorded in the same financial statement category as the hedged item. For
free-standing derivatives, the Company reports changes in the fair values in
other (loss) income.
The Company formally documents at inception its hedge relationships,
including identification of the hedging instruments and the hedged items, its
risk management objectives, strategy for undertaking the hedge transaction and
the Companys evaluation of effectiveness of its hedged transactions.
Periodically, the Company also formally assesses whether the derivative it
designated in each hedging relationship is expected to be and has been highly
effective in offsetting changes in estimated fair values or cash flows of the
hedged item using either the dollar offset or the regression analysis method.
If the Company determines that a derivative is not highly effective as a hedge,
it discontinues hedge accounting.
Foreign Currency
The Company makes investments in non-United States dollar denominated
securities and loans. As a result, the Company is subject to the risk of
fluctuation in the exchange rate between the United States dollar and the
foreign currency in which it makes an investment. In order to reduce the
currency risk, the Company may hedge the applicable foreign currency. All
investments denominated in a foreign currency are converted to the United
States dollar using prevailing exchange rates on the balance sheet date. Income,
expenses, gains and losses on investments denominated in a foreign currency are
converted to the United States dollar using the prevailing exchange rates on
the dates when they are recorded. Foreign exchange gains and losses are
recorded in the condensed consolidated statements of operations.
Manager Compensation
The Management Agreement provides for the payment of a base management
fee to the Manager, as well as an incentive fee if the Companys financial
performance exceeds certain benchmarks. Additionally, the Management Agreement
provides for the Manager to be reimbursed for certain expenses incurred on the
Companys behalf. See Note 13 to these condensed consolidated financial
statements for additional discussion on the payment of the base management fee
and incentive fee. The base management fee and the incentive fee are accrued
and expensed during the period for which they are earned by the Manager.
Share-Based Compensation
The Company accounts for share-based compensation issued to its
directors and to its Manager using the fair value based methodology in
accordance with accounting guidance. Compensation cost related to restricted
common shares issued to the Companys directors is measured at its estimated
fair value at the grant date, and is amortized and expensed over the vesting
period on a straight-line basis. Compensation cost related to restricted common
shares and common share options issued to the Manager is initially measured at
estimated fair value at the grant date, and is remeasured on subsequent dates
to the extent the awards are unvested. The Company has elected to use the
graded vesting attribution method to amortize compensation expense for the
restricted common shares and common share options granted to the Manager.
Income Taxes
The Company intends to continue to operate so as to qualify as a
partnership, and not as an association or publicly traded partnership that is
taxable as a corporation, for United States federal income tax purposes.
Therefore, the Company generally is not
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subject
to United States federal income tax at the entity level, but is subject to
limited state and foreign taxes. Holders of the Companys shares will be
required to take into account their allocable share of each item of the Companys
income, gain, loss, deduction, and credit for the taxable year of the Company
ending within or with their taxable year.
During 2010, the Company owned an equity interest in KKR Financial
Holdings II, LLC (KFH II) which elected to be taxed as a real estate
investment trust (a REIT) under the Internal Revenue Code of 1986, as amended
(the Code). KFH II holds certain real estate mortgage-backed securities. A
REIT generally 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.
The Company has wholly-owned
domestic and foreign subsidiaries that are taxable as corporations for United
States federal income tax purposes and thus are not consolidated with the
Company for United States federal income tax purposes. For financial reporting
purposes, current and deferred taxes are provided for on the portion of
earnings recognized by the Company with respect to its interest in 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. However, the Company
will be required to include their current taxable income in the Companys
calculation of its taxable income allocable to shareholders. CLO 2005-1, CLO
2005-2, CLO 2006-1, CLO 2007-1, CLO 2007-A and KKR Financial CLO 2009-1, Ltd.
(CLO 2009-1) are foreign subsidiaries of the Company that elected to be
treated as disregarded entities or partnerships for United States federal
income tax purposes. These subsidiaries were established to facilitate
securitization transactions, structured as secured financing transactions.
Earnings Per Share
The Company calculates earnings per share (EPS) using the two-class
method which is an earnings allocation formula that determines EPS for common
shares and participating securities. Unvested share-based payment awards that
contain non-forfeitable rights to dividends or dividend equivalents (whether
paid or unpaid) are participating securities and shall be included in the
computation of EPS using the two-class method. Accordingly, all earnings
(distributed and undistributed) are allocated to common shares and
participating securities based on their respective rights to receive dividends.
The Company presents both basic and diluted earnings (loss) per common
share in its condensed consolidated financial statements and footnotes thereto.
Basic earnings (loss) per common share (Basic EPS) excludes dilution and is computed
by dividing net income or loss by the weighted-average number of common shares,
including vested restricted common shares, outstanding for the period. Diluted
earnings (loss) per share (Diluted EPS) reflects the potential dilution of
common share options and unvested restricted common shares using the treasury
method, as well as the potential dilution of convertible senior notes using the
number of shares it would take to satisfy the excess conversion obligation
(average Company share price for the period in excess of the conversion price
related to the Companys convertible senior notes), if they are not
anti-dilutive. See Note 3 to these
condensed consolidated financial statements for earnings per common share
computations.
Recent Accounting Pronouncements
Consolidation
In February 2010, the
Financial Accounting Standards Board (FASB) issued new guidance deferring the
application of the amended consolidation requirements related to VIEs for a
reporting entitys interest in an entity that has all the attributes of an
investment company or for which it is applies measurement principles that are
consistent with those followed by investment companies. The guidance was
expected to most significantly affect reporting entities in the investment management
industry. Entities including, but not limited to, securitization entities or
entities with multiple levels of subordinated investors such as a CLO for which
the primary purpose of the capital structure of the entity is to provide credit
enhancement to senior interest holders, will not qualify for the deferral. The guidance was effective for interim and
annual reporting periods beginning after November 15, 2009. The adoption
of this new guidance did not have an effect on the Companys condensed consolidated
financial statements.
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Financing
Receivables and Allowance for Credit Losses
In July 2010, the FASB
issued new guidance to amend existing disclosure requirements to provide a
greater level of disaggregated information about the credit quality of
financing receivables and allowance for credit losses. The two levels of
disaggregation defined by the FASB are portfolio segment and class of financing
receivable. The amendments also require an entity to disclose credit quality
indicators, past due information, and modifications of financing receivables.
The guidance is effective for interim and annual reporting periods ending on or
after December 15, 2010. The Company will include the required disclosures
beginning with its consolidated financial statements for the year ending
December 31, 2010.
Note 3. Earnings per Share
The following table presents a reconciliation of basic and diluted net
income per common share, as well as the distributions declared per common share
for the three and nine months ended September 30, 2010 and 2009 (amounts
in thousands, except per share information):
|
|
Three months ended
September 30,
|
|
Nine months ended
September 30,
|
|
|
|
2010
|
|
2009
|
|
2010
|
|
2009
|
|
Net income
|
|
$
|
82,342
|
|
$
|
67,187
|
|
$
|
292,865
|
|
$
|
74,820
|
|
Less: Dividends and undistributed earnings
allocated to participating securities
|
|
687
|
|
574
|
|
2,482
|
|
657
|
|
Net income applicable to common shareholders
|
|
$
|
81,655
|
|
$
|
66,613
|
|
$
|
290,383
|
|
$
|
74,163
|
|
|
|
|
|
|
|
|
|
|
|
Basic:
|
|
|
|
|
|
|
|
|
|
Basic weighted-average shares outstanding
|
|
157,057
|
|
156,997
|
|
157,018
|
|
152,664
|
|
Net income per share
|
|
$
|
0.52
|
|
$
|
0.42
|
|
$
|
1.85
|
|
$
|
0.49
|
|
|
|
|
|
|
|
|
|
|
|
Diluted:
|
|
|
|
|
|
|
|
|
|
Diluted weighted-average shares outstanding (1)
|
|
157,461
|
|
156,997
|
|
157,294
|
|
152,664
|
|
Net income per share
|
|
$
|
0.52
|
|
$
|
0.42
|
|
$
|
1.85
|
|
$
|
0.49
|
|
|
|
|
|
|
|
|
|
|
|
Distributions declared per common share
|
|
$
|
0.12
|
|
$
|
|
|
$
|
0.29
|
|
$
|
|
|
(1)
An immaterial
conversion premium related to the convertible senior notes was included in the
diluted earnings per share for the three and nine months ended
September 30, 2010. Potential anti-dilutive common shares excluded from
diluted earnings per share related to common share options were 1,932,279 for
both the three and nine months ended September 30, 2010 and 2009.
Note 4. Securities Available-for-Sale
The
following table summarizes the Companys securities classified as
available-for-sale as of September 30, 2010 and December 31, 2009,
which are carried at estimated fair value (amounts in thousands):
|
|
September 30, 2010
|
|
December 31, 2009
|
|
|
|
Amortized
Cost
|
|
Gross
Unrealized
Gains
|
|
Gross
Unrealized
Losses
|
|
Estimated
Fair Value
|
|
Amortized
Cost
|
|
Gross
Unrealized
Gains
|
|
Gross
Unrealized
Losses
|
|
Estimated
Fair Value
|
|
Corporate debt securities
|
|
$
|
677,508
|
|
$
|
176,599
|
|
$
|
(5,085
|
)
|
$
|
849,022
|
|
$
|
560,637
|
|
$
|
198,242
|
|
$
|
(4,470
|
)
|
$
|
754,409
|
|
Common and preferred stock
|
|
|
|
|
|
|
|
|
|
713
|
|
564
|
|
|
|
1,277
|
|
Total
|
|
$
|
677,508
|
|
$
|
176,599
|
|
$
|
(5,085
|
)
|
$
|
849,022
|
|
$
|
561,350
|
|
$
|
198,806
|
|
$
|
(4,470
|
)
|
$
|
755,686
|
|
14
Table of Contents
The following table shows the gross unrealized losses and estimated
fair value of the Companys available-for-sale securities, aggregated by length
of time that the individual securities have been in a continuous unrealized
loss position, as of September 30, 2010 and December 31, 2009
(amounts in thousands):
|
|
Less Than 12 months
|
|
12 Months or More
|
|
Total
|
|
|
|
Estimated
Fair Value
|
|
Unrealized
Losses
|
|
Estimated
Fair Value
|
|
Unrealized
Losses
|
|
Estimated
Fair Value
|
|
Unrealized
Losses
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
September 30, 2010
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Corporate debt securities
|
|
$
|
73,364
|
|
$
|
(2,646
|
)
|
$
|
36,443
|
|
$
|
(2,439
|
)
|
$
|
109,807
|
|
$
|
(5,085
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
December 31, 2009
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Corporate debt securities
|
|
$
|
8,437
|
|
$
|
(113
|
)
|
$
|
70,967
|
|
$
|
(4,357
|
)
|
$
|
79,404
|
|
$
|
(4,470
|
)
|
The
unrealized losses in the table above are considered to be temporary impairments
due to market factors and are not reflective of credit deterioration. The
Company considers many factors when evaluating whether an impairment is
other-than-temporary. For corporate debt securities included in the table
above, the Company does not intend to sell them and does not believe that it is
more likely than not that the Company will be required to sell any of its
corporate debt securities prior to recovery. In addition, based on the analyses
performed by the Company on each of its corporate debt securities, the Company
believes that it should be able to recover the entire amortized cost amount of
the corporate debt securities included in the table above.
During the three and nine months ended September 30, 2010, the
Company recognized losses totaling $0.5 million and $1.7 million, respectively,
for corporate debt securities that it determined to be other-than-temporarily
impaired based on the criteria above. During the three and nine months ended
September 30, 2009, the Company recognized losses totaling nil and
$40.0 million, respectively, for corporate debt securities that it
determined to be other-than-temporarily impaired based on the criteria above.
The Company intends to sell these securities and as a result, the entire amount
is recorded through earnings in net realized and unrealized gain (loss) on
investments in the condensed consolidated statements of operations.
As of September 30, 2010 and December 31, 2009, the Company
had no corporate debt securities in default.
The following table shows the net realized gains (losses) on the sales
of securities (amounts in thousands):
|
|
For the three
months ended
September 30, 2010
|
|
For the three
months ended
September 30, 2009
|
|
For the nine
months ended
September 30, 2010
|
|
For the nine
months ended
September 30, 2009
|
|
Gross realized gains
|
|
$
|
17,598
|
|
$
|
22
|
|
$
|
60,398
|
|
$
|
9,975
|
|
Gross realized losses
|
|
|
|
(1,994
|
)
|
|
|
(9,350
|
)
|
Net realized gains (losses)
|
|
$
|
17,598
|
|
$
|
(1,972
|
)
|
$
|
60,398
|
|
$
|
625
|
|
Note 8 to these condensed consolidated financial statements describes
the Companys borrowings under which the Company has pledged securities
available-for-sale for borrowings. The following table summarizes the estimated
fair value of securities available-for-sale pledged as collateral as of
September 30, 2010 and December 31, 2009 (amounts in thousands):
|
|
As of
September 30, 2010
|
|
As of
December 31, 2009
|
|
Pledged as collateral for borrowings under senior
secured credit facility
|
|
$
|
|
|
$
|
107,845
|
|
Pledged as collateral for collateralized loan
obligation secured notes and junior secured notes to affiliates
|
|
727,485
|
|
633,104
|
|
Total
|
|
$
|
727,485
|
|
$
|
740,949
|
|
Note 5. Corporate Loans and Allowance for Loan Losses
The following table summarizes the Companys corporate loans as of
September 30, 2010 and December 31, 2009 (amounts in thousands):
|
|
September 30, 2010
|
|
December 31, 2009
|
|
|
|
Corporate
Loans
|
|
Corporate Loans
Held for Sale
|
|
Total Corporate
Loans
|
|
Corporate
Loans
|
|
Corporate Loans
Held for Sale
|
|
Total Corporate
Loans
|
|
Principal(1)
|
|
$
|
6,371,687
|
|
$
|
705,007
|
|
$
|
7,076,694
|
|
$
|
6,180,028
|
|
$
|
1,033,383
|
|
$
|
7,213,411
|
|
Unamortized discount
|
|
(347,113
|
)
|
(23,253
|
)
|
(370,366
|
)
|
(324,795
|
)
|
(76,028
|
)
|
(400,823
|
)
|
Total amortized cost
|
|
6,024,574
|
|
681,754
|
|
6,706,328
|
|
5,855,233
|
|
957,355
|
|
6,812,588
|
|
Lower of cost or fair value adjustment
|
|
|
|
(14,558
|
)
|
(14,558
|
)
|
|
|
(31,637
|
)
|
(31,637
|
)
|
Allowance for loan losses
|
|
(209,030
|
)
|
|
|
(209,030
|
)
|
(237,308
|
)
|
|
|
(237,308
|
)
|
Net carrying value
|
|
$
|
5,815,544
|
|
$
|
667,196
|
|
$
|
6,482,740
|
|
$
|
5,617,925
|
|
$
|
925,718
|
|
$
|
6,543,643
|
|
(1)
Principal
amount is net of charge-offs and other adjustments totaling $42.9 million and
$158.8 million as of September 30, 2010 and December 31, 2009,
respectively.
15
Table of Contents
The following table summarizes the changes in the allowance for loan
losses for the Companys corporate loan portfolio during the three and nine
months ended September 30, 2010 and 2009 (amounts in thousands):
|
|
For the three
months ended
September 30, 2010
|
|
For the three
months ended
September 30, 2009
|
|
For the nine
months ended
September 30, 2010
|
|
For the nine
months ended
September 30, 2009
|
|
Balance at beginning of period
|
|
$
|
210,218
|
|
$
|
473,202
|
|
$
|
237,308
|
|
$
|
480,775
|
|
Provision for loan losses
|
|
8,087
|
|
|
|
8,087
|
|
39,795
|
|
Charge-offs
|
|
(9,275
|
)
|
(2,978
|
)
|
(36,365
|
)
|
(50,346
|
)
|
Balance at end of period
|
|
$
|
209,030
|
|
$
|
470,224
|
|
$
|
209,030
|
|
$
|
470,224
|
|
As
of September 30, 2010 and December 31, 2009, the Company had an
allowance for loan losses of $209.0 million and $237.3 million, respectively.
As described in Note 2 to these condensed consolidated financial statements,
the allowance for loan losses represents the Companys estimate of probable
credit losses inherent in its loan portfolio as of the balance sheet date. The
Companys allowance for loan losses consists of two components, an allocated
component and an unallocated component. The allocated component of the
allowance for loan losses consists of individual loans that are impaired. The
unallocated component of the allowance for loan losses represents the Companys
estimate of losses inherent, but not identified, in its portfolio as of the
balance sheet date.
As
of September 30, 2010, the allocated component of the allowance for loan
losses totaled $53.0 million and relates to investments in certain loans issued
by six issuers with an aggregate par amount of $228.0 million and an aggregate
amortized cost amount of $151.0 million. In addition, certain impaired loans
from three of these issuers with an aggregate par amount of $85.1 million and
an aggregate amortized cost amount of $16.9 million had no associated allowance
for loan losses as the Companys amortized cost basis for these loans was below
the estimated fair value as of September 30, 2010. As of December 31,
2009, the allocated component of the allowance for loan losses totaled $81.7
million and relates to investments in loans issued by six issuers with an
aggregate par amount of $223.6 million and an aggregate amortized cost amount
of $121.2 million.
The
unallocated component of the allowance for loan losses totaled $156.0 million
and $155.6 million as of September 30, 2010 and December 31, 2009,
respectively. During the three and nine months ended September 30, 2010,
the Company recorded charge-offs totaling $9.3 million and $36.4 million,
respectively, comprised primarily of loans transferred to loans held for sale.
The Company recorded charge-offs totaling $3.0 million and $50.4 million for
the three and nine months ended September 30, 2009, respectively.
As of September 30, 2010, the Company had $667.2 million of loans
held for sale, a decrease of $258.5 million from December 31, 2009.
As of September 30, 2010 and December 31, 2009, the Company
had loans on non-accrual status with a total amortized cost of $167.1 million
and $439.9 million, respectively. The average investment in impaired loans
during the three and nine months ended September 30, 2010 was $178.4
million and $262.5 million, respectively, and during the three and nine months
ended September 30, 2009, average recorded investment in the impaired
loans was $717.3 million and $544.2 million, respectively. As of
September 30, 2010 and 2009, the allocated component of the allowance for
loan losses included all impaired loans for the respective periods. The amount
of interest income recognized using the cash-basis method during the time
within the period that the loans were impaired was $4.1 million and $11.1
million for the three and nine months ended September 30, 2010,
respectively, and $8.2 million and $15.0 million for the three and nine months
ended September 30, 2009, respectively.
As of September 30, 2010, the Company held corporate loans that
were in default with a total amortized cost of $19.7 million from two issuers.
As of December 31, 2009, the Company held loans that were in default with
a total amortized cost of $392.5 million from seven issuers. The majority of
corporate loans in default during 2010 and 2009 were included in the loans for
which the allocated component of the Companys allowance for losses was related
to, or for which the Company determined were loans held for sale as of
September 30, 2010 and December 31, 2009, respectively.
Note 8 to these condensed consolidated financial statements describes
the Companys borrowings under which the Company has pledged loans for
borrowings. The following table summarizes the amortized cost of total
corporate loans, including corporate loans held for sale, pledged as collateral
as of September 30, 2010 and December 31, 2009 (amounts in
thousands):
|
|
As of
September 30, 2010
|
|
As of
December 31, 2009
|
|
Pledged as collateral for borrowings under senior
secured credit facility
|
|
$
|
|
|
$
|
425,740
|
|
Pledged as collateral for collateralized loan
obligation secured notes and junior secured notes to affiliates
|
|
6,307,611
|
|
6,354,382
|
|
Total
|
|
$
|
6,307,611
|
|
$
|
6,780,122
|
|
16
Table of
Contents
Note 6. Residential Mortgage-Backed Securities
The
Company held RMBS with an estimated fair value of $106.3 million and $47.6
million as September 30, 2010 and December 31, 2009,
respectively. As of January 1,
2010, RMBS increased $74.4 million due to the deconsolidation of six
residential mortgage loan securitization trusts (see Consolidation under Note
2 to these condensed consolidated financial statements). The $74.4 million
represents the estimated fair value of the Companys RMBS which were issued by
these six residential mortgage securitization trusts.
Note 8 to these condensed consolidated financial statements describes
the Companys borrowings under which the Company has pledged RMBS. The
following table summarizes the estimated fair value of RMBS pledged as
collateral as of September 30, 2010 and December 31, 2009 (amounts in
thousands):
|
|
As of
September 30, 2010
|
|
As of
December 31, 2009
|
|
Pledged as collateral for borrowings under senior
secured credit facility
|
|
$
|
|
|
$
|
42,627
|
|
Pledged as collateral for collateralized loan
obligation secured notes and junior secured notes to affiliates
|
|
4,235
|
|
4,945
|
|
Total
|
|
$
|
4,235
|
|
$
|
47,572
|
|
Note 7. Deconsolidation of Residential Mortgage Loan
Securitization Trusts
On
January 1, 2010, the Company deconsolidated six residential mortgage
securitization trusts as a result of the Companys adoption of new guidance
regarding the consolidation model for variable interest entities. The Company
has no exposure to loss in excess of the estimated fair value of the $74.4
million RMBS which were issued by these six residential mortgage securitization
trusts (see Note 6 to these condensed consolidated financial statements).
The
following information represents the assets and liabilities removed from the
Companys condensed consolidated balance sheet as of January 1, 2010 as a
result of the deconsolidation of the six residential mortgage loan
securitization trusts (amounts in thousands):
|
|
As of
January 1, 2010
|
|
Assets
|
|
|
|
Residential mortgage loans, at estimated fair
value (1)
|
|
$
|
2,023,333
|
|
Real estate owned (recorded within other assets on
the condensed consolidated balance sheets)
|
|
11,439
|
|
Interest receivable
|
|
4,529
|
|
|
|
$
|
2,039,301
|
|
|
|
|
|
Liabilities
|
|
|
|
Residential mortgage-backed securities issued, at
estimated fair value
|
|
$
|
2,034,772
|
|
Accrued interest payable
|
|
4,529
|
|
|
|
$
|
2,039,301
|
|
(1)
Excludes $74.4
million which represents the estimated fair value of the Companys RMBS which
were issued by the six residential mortgage loan securitization trusts that
were deconsolidated under GAAP as of January 1, 2010.
As
a result of the deconsolidation of the six residential mortgage loan
securitization trusts, all references to residential mortgage loans interest
income, RMBS Issued interest expense, net realized and unrealized gain (loss)
on residential mortgage loans and RMBS Issued, and loan servicing expense
relate to prior period balances and activities.
Residential mortgage loans
The
Company carried its residential mortgage loans at estimated fair value with
unrealized gains and losses reported in income. The Company had elected the
fair value option for its residential mortgage loans for the purpose of
enhancing the transparency of its financial condition as fair value was
consistent with how the Company managed the risks of its residential mortgage
investments.
As of December 31, 2009, residential mortgage loans at estimated
fair value, totaled $2.1 billion, which excluded real estate owned (REO) as a
result of foreclosure on delinquent loans of $11.4 million as of
December 31, 2009. Loans were transferred to REO at the lower of cost or
fair value. REO was recorded within other assets on the Companys condensed
consolidated balance sheets.
17
Table of
Contents
The following table summarizes the estimated fair value of residential
mortgage loans pledged as collateral as of December 31, 2009 (amounts in
thousands):
|
|
As of
December 31, 2009
|
|
Pledged as collateral for borrowings under senior
secured credit facility
|
|
$
|
74,366
|
|
Pledged as collateral for residential
mortgage-backed securities issued
|
|
2,023,333
|
|
|
|
$
|
2,097,699
|
|
The following is a reconciliation of carrying amounts of residential
mortgage loans for the year ended December 31, 2009 (amounts in
thousands):
|
|
As of
December 31, 2009
|
|
Beginning balance
|
|
$
|
2,620,021
|
|
Principal payments
|
|
(585,429
|
)
|
Transfers in to REO
|
|
(646
|
)
|
Net change in unrealized and realized gain/loss
and premium/discount
|
|
63,753
|
|
Ending balance
|
|
$
|
2,097,699
|
|
The following table summarizes the delinquency statistics of the
residential mortgage loans, excluding REOs, as of December 31, 2009
(dollar amounts in thousands):
|
|
December 31, 2009
|
|
Delinquency Status
|
|
Number
of Loans
|
|
Principal
Amount
|
|
30 to 59 days
|
|
84
|
|
$
|
37,261
|
|
60 to 89 days
|
|
47
|
|
19,389
|
|
90 days or more
|
|
138
|
|
55,697
|
|
In foreclosure
|
|
139
|
|
57,497
|
|
Total
|
|
408
|
|
$
|
169,844
|
|
As of December 31, 2009, 26 of the residential mortgage loans
owned by the Company with an outstanding balance of $11.4 million were REOs as
a result of foreclosure on delinquent loans. As of December 31, 2009, the
Company had 277 loans that were either 90 days or greater past due or in
foreclosure and placed on non-accrual status.
As of December 31, 2009, the loss exposure or uncollected
principal amount related to the Companys delinquent residential mortgage loans
in the table above exceeded their fair value by $20.2 million.
Residential mortgage-backed
securities issued
RMBS Issued consisted of the senior tranches of six residential
mortgage loan securitization trusts that the Company previously consolidated
under GAAP and for which the Company reported the debt issued by these trusts
that it did not hold on its condensed consolidated balance sheets. The Company
carried RMBS Issued at estimated fair value with unrealized gains and losses
reported in income. The Company elected the fair value option for its RMBS
Issued for the purpose of enhancing the transparency of its financial condition
as fair value was consistent with how the Company managed the risks of its
residential mortgage portfolio.
As of December 31, 2009, RMBS Issued had an outstanding amount of
$2.6 billion and an estimated fair value of $2.0 billion. As of
December 31, 2009, the weighted average coupon of the RMBS Issued was 2.3%
and the weighted average years to maturity were 25.8 years.
18
Table of Contents
Note 8. Borrowings
Certain information with respect to the Companys borrowings as of
September 30, 2010 is summarized in the following table (dollar amounts in
thousands):
|
|
Outstanding
Borrowings
|
|
Weighted
Average
Borrowing
Rate
|
|
Weighted
Average
Remaining
Maturity
(in days)
|
|
Fair Value of
Collateral(1)
|
|
CLO 2005-1 senior secured notes
|
|
$
|
833,070
|
|
0.82
|
%
|
2,400
|
|
$
|
910,695
|
|
CLO 2005-2 senior secured notes
|
|
801,119
|
|
0.62
|
|
2,614
|
|
891,745
|
|
CLO 2006-1 senior secured notes
|
|
683,265
|
|
0.69
|
|
2,886
|
|
882,003
|
|
CLO 2007-1 senior secured notes
|
|
2,075,040
|
|
0.93
|
|
3,880
|
|
2,363,265
|
|
CLO 2007-1 junior secured notes to affiliates(2)
|
|
305,610
|
|
|
|
3,880
|
|
346,202
|
|
CLO 2007-1 junior secured notes(3)
|
|
61,727
|
|
|
|
3,880
|
|
70,301
|
|
CLO 2007-A senior secured notes
|
|
1,165,099
|
|
1.42
|
|
2,572
|
|
1,238,192
|
|
CLO 2007-A junior secured notes to affiliates(4)
|
|
65,452
|
|
|
|
2,572
|
|
69,558
|
|
CLO 2007-A junior secured notes(5)
|
|
10,821
|
|
|
|
2,572
|
|
11,500
|
|
Convertible senior notes
|
|
343,863
|
|
7.24
|
|
1,458
|
|
|
|
Junior subordinated notes
|
|
283,517
|
|
5.50
|
|
9,535
|
|
|
|
Total
|
|
$
|
6,628,583
|
|
|
|
|
|
$
|
6,783,461
|
|
(1)
Collateral for
borrowings consists of RMBS, securities available-for-sale, equity investments
at estimated fair value and corporate loans.
(2)
CLO 2007-1
junior secured notes to affiliates consist of (x) $175.3 million of
mezzanine notes with a weighted average borrowing rate of 5.4% and
(y) $130.3 million of subordinated notes that do not have a
contractual coupon rate, but instead receive a pro rata amount of the net
distributions from CLO 2007-1.
(3)
CLO 2007-1
junior secured notes consist of (x) $55.9 million of mezzanine notes
with a weighted average borrowing rate of 3.7% and (y) $5.8 million
of subordinated notes that do not have a contractual coupon rate, but instead
receive a pro rata amount of the net distributions from CLO 2007-1.
(4)
CLO 2007-A
junior secured notes to affiliates consist of (x) $55.0 million of mezzanine
notes with a weighted average borrowing rate of 6.7% and
(y) $10.5 million of subordinated notes that do not have a
contractual coupon rate, but instead receive a pro rata amount of the net
distributions from CLO 2007-A.
(5)
CLO 2007-A
junior secured notes consist of (x) $6.2 million of mezzanine notes
with a weighted average borrowing rate of 7.2% and (y) $4.6 million
of subordinated notes that do not have a contractual coupon rate, but instead
receive a pro rata amount of the net distributions from CLO 2007-A.
Certain information with respect to the Companys borrowings as of
December 31, 2009 is summarized in the following table (dollar amounts in
thousands):
|
|
Outstanding
Borrowings
|
|
Weighted
Average
Borrowing
Rate
|
|
Weighted
Average
Remaining
Maturity
(in days)
|
|
Fair Value of
Collateral(1)
|
|
Senior secured credit facility(2)
|
|
$
|
175,000
|
|
4.23
|
%
|
679
|
|
$
|
739,640
|
|
CLO 2005-1 senior secured notes
|
|
832,622
|
|
0.61
|
|
2,673
|
|
868,291
|
|
CLO 2005-2 senior secured notes
|
|
800,504
|
|
0.58
|
|
2,887
|
|
859,457
|
|
CLO 2006-1 senior secured notes
|
|
683,266
|
|
0.63
|
|
3,159
|
|
858,317
|
|
CLO 2007-1 senior secured notes
|
|
2,176,805
|
|
0.82
|
|
4,153
|
|
2,337,779
|
|
CLO 2007-1 junior secured notes to affiliates(3)
|
|
437,730
|
|
|
|
4,153
|
|
468,422
|
|
CLO 2007-1 junior secured notes(4)
|
|
14,185
|
|
|
|
4,153
|
|
15,237
|
|
CLO 2007-A senior secured notes
|
|
1,157,209
|
|
1.16
|
|
2,845
|
|
1,137,077
|
|
CLO 2007-A junior secured notes to affiliates(5)
|
|
96,056
|
|
|
|
2,845
|
|
94,505
|
|
CLO 2007-A junior secured notes(6)
|
|
3,125
|
|
|
|
2,845
|
|
3,074
|
|
Convertible senior notes
|
|
275,800
|
|
7.00
|
|
927
|
|
|
|
Junior subordinated notes
|
|
283,517
|
|
5.41
|
|
9,747
|
|
|
|
Total
|
|
$
|
6,935,819
|
|
|
|
|
|
$
|
7,381,799
|
|
(1)
Collateral for
borrowings consists of RMBS, securities available-for-sale, equity investments,
at estimated fair value, private equity investments, corporate and residential
mortgage loans and common stock warrants.
(2)
Calculated
weighted average remaining maturity based on the amended maturity date of
November 10, 2011.
19
Table of Contents
(3)
CLO 2007-1
junior secured notes to affiliates consist of (x) $256.9 million of
mezzanine notes with a weighted average borrowing rate of 5.2% and
(y) $180.8 million of subordinated notes that do not have a
contractual coupon rate, but instead receive a pro rata amount of the net
distributions from CLO 2007-1.
(4)
CLO 2007-1
junior secured notes consist of (x) $8.4 million of mezzanine notes
with a weighted average borrowing rate of 5.2% and (y) $5.8 million
of subordinated notes that do not have a contractual coupon rate, but instead
receive a pro rata amount of the net distributions from CLO 2007-1.
(5)
CLO 2007-A
junior secured notes to affiliates consist of (x) $81.5 million of mezzanine
notes with a weighted average borrowing rate of 6.5% and
(y) $14.6 million of subordinated notes that do not have a
contractual coupon rate, but instead receive a pro rata amount of the net
distributions from CLO 2007-A.
(6)
CLO 2007-A
junior secured notes consist of (x) $2.6 million of mezzanine notes
with a weighted average borrowing rate of 6.5% and (y) $0.5 million
of subordinated notes that do not have a contractual coupon rate, but instead
receive a pro rata amount of the net distributions from CLO 2007-A.
CLO
Notes
The indentures governing the Companys CLO transactions include
numerous compliance tests, the majority of which relate to the CLOs portfolio
profile. In the event that a portfolio profile test is not met, the indenture
places restrictions on the ability of the CLOs manager to reinvest available
principal proceeds generated by the collateral in the CLOs until the specific
test has been cured. In addition to the portfolio profile tests, the indentures
for the CLO transactions include over-collateralization tests (OC Tests)
which set the ratio of the collateral value of the assets in the CLO to the
tranches of debt for which the test is being measured, as well as interest
coverage tests. If a CLO is not in compliance with an OC Test or an interest
coverage test, cash flows normally payable to the holders of junior classes of
notes will be used by the CLO to amortize the most senior class of notes until
such point as the OC test is brought back into compliance. During the three and
nine months ended September 30, 2010, the Company paid down nil and $90.3
million of original CLO 2007-1 senior secured notes, respectively, due to the
failure of OC Tests. As of September 30, 2010, all of the Companys CLO
transactions were in compliance with their respective OC and interest coverage
tests.
During the three months ended March 31, 2010, in an open market
auction, the Company purchased $10.3 million of mezzanine notes issued by CLO
2007-A for $5.5 million and $72.7 million of mezzanine and subordinate notes
issued by CLO 2007-1 for $38.8 million, both of which were previously held by
an affiliate of the Companys manager. These transactions resulted in the
Company recording an aggregate gain on extinguishment of debt totaling $38.7
million for the three months ended March 31, 2010.
Senior Secured Credit Facility
On
May 3, 2010, the Company entered into a credit agreement for a four-year
$210.0 million asset-based revolving credit facility (the 2014 Facility),
maturing on May 3, 2014, that is subject to, among other things, the terms
of a borrowing base derived from the value of eligible specified financial
assets. The borrowing base is subject to certain caps and concentration
limits customary for financings of this type. The Company may obtain additional
commitments under the 2014 Facility so long as the aggregate amount of
commitments at any time does not exceed $600.0 million. On May 5, 2010,
the Company obtained additional commitments of $40.0 million, bringing the
total amount of commitments under the 2014 Facility to $250.0 million.
The
Company has the right to prepay loans under the 2014 Facility in whole or in
part at any time. Loans under the 2014 Facility bear interest at a rate equal
to the London interbank offered rate (LIBOR) plus 3.25% per annum. The 2014
Facility contains customary covenants applicable to the Company, including a
restriction from making distributions to holders of common shares in excess of
65% of the Companys estimated annual taxable income.
As
of September 30, 2010, the Company had no borrowings outstanding under the
2014 Facility.
As of September 30, 2010, the Company believes it was in
compliance with the 2014 Facility covenant requirements.
On May 26, 2010, the Company terminated its credit agreement,
dated as of November 10, 2008, maturing on November 10, 2011 (the 2011
Credit Agreement). The 2011 Credit Agreement was terminated in connection with
the Companys initial borrowing under its new credit facility entered into on
May 3, 2010 as described above. At the time of termination, there was
$150.0 million of borrowings outstanding under the 2011 Credit Agreement which
the Company prepaid. There were no early termination or prepayment fees
associated with the Companys termination and repayment of all outstanding
borrowings. The termination resulted in a $6.5 million write-off of unamortized
debt issuance costs.
20
Table
of Contents
Convertible
Debt
During January and February 2010, the Company repurchased
$95.2 million par amount of its 7.0% convertible senior notes maturing on
July 15, 2012 (the 7.0% Notes), reducing the amount outstanding from
$275.8 million as of December 31, 2009 to $180.6 million as of
September 30, 2010. These transactions resulted in the Company recording a
gain of $1.3 million, which was partially offset by a write-off of $0.6 million
of unamortized debt issuance costs.
On January 15, 2010, the Company issued $172.5 million of
7.5% Convertible Senior Notes due January 15, 2017 (7.5% Notes). The
7.5% Notes bear interest at a rate of 7.5% per annum on the principal amount,
accruing from January 15, 2010. Interest is payable semiannually in arrears
on January 15 and July 15 of each year, beginning on July 15,
2010. The 7.5% Notes will mature on January 15, 2017 unless previously
redeemed, repurchased or converted in accordance with their terms prior to such
date. Holders of the 7.5% Notes may convert their notes at the applicable
conversion rate at any time prior to the close of business on the business day
immediately preceding the stated maturity date subject to the Companys right
to terminate the conversion rights of the notes. The Company may satisfy its
obligation with respect to the 7.5% Notes tendered for conversion by delivering
to the holder either cash, common shares, no par value, issued by the Company
or a combination thereof. The initial conversion rate for each $1,000 principal
amount of 7.5% Notes is 122.2046 shares, which is equivalent to an initial
conversion price of approximately $8.18 per share. The conversion rate is
adjusted under certain circumstances, including the occurrence of certain
fundamental change transactions and the payment of a quarterly cash
distribution in excess of $0.05 per share, but will not be adjusted for accrued
and unpaid interest on the 7.5% Notes. As of September 30, 2010, the
conversation rate for each $1,000 principal amount of 7.5% Notes was 124.3675
shares. Net proceeds from the offering totaled $167.3 million, reflecting
$172.5 million from the issuance less $5.2 million for underwriting
fees.
In
accordance with accounting for convertible debt instruments that may settled in
cash upon conversion, the Company separately accounted for the liability and
equity components to reflect the nonconvertible debt borrowing rate. The
Company determined that the equity component of the 7.5% Notes totaled $10.0
million and is included in paid-in-capital on the Companys condensed
consolidated balance sheet as of September 30, 2010. The remaining
liability component of $163.3 million, included within convertible senior notes
on the Companys condensed consolidated balance sheet as of September 30,
2010, is comprised of the principal $172.5 million less the unamortized debt
discount of $9.2 million. The total debt discount amortization recognized for
the three and nine months ended September 30, 2010 was $0.3 million and
$0.8 million, respectively. The debt discount will continue to be amortized at
the effective interest rate of 8.6%. For the three and nine months ended
September 30, 2010, the total interest expense recognized on the 7.5%
Notes was $3.2 million and $9.2 million, respectively.
Note 9. Derivative Financial Instruments
The Company enters into derivative transactions in order to hedge its
interest rate risk exposure to the effects of interest rate changes.
Additionally, the Company enters into derivative transactions in the course of
its portfolio management activities. The counterparties to the Companys
derivative agreements are major financial institutions with which the Company
and its affiliates may also have other financial relationships. In the event of
nonperformance by the counterparties, the Company is potentially exposed to
losses. The counterparties to the Companys derivative agreements have
investment grade ratings and, as a result, the Company does not anticipate that
any of the counterparties will fail to fulfill their obligations.
Cash Flow Hedges
The Company uses interest rate derivatives consisting of swaps to hedge
a portion of the interest rate risk associated with its borrowings under CLO
senior secured notes as well as certain of its floating rate junior
subordinated notes. The Company designates these financial instruments as cash
flow hedges.
During
June 2010, the Company entered into a $100.0 million notional pay-fixed,
receive-variable interest rate swap. The swap has been designated as a cash
flow hedge, the objective of which is to eliminate the variability of cash
flows in the interest payments of the Companys floating rate junior
subordinated notes debt due to fluctuations in the indexed rate. Changes in
value of the interest rate swap are recorded through other comprehensive
income, with gains or losses representing hedge ineffectiveness, if any,
recognized in earnings during the reporting period. The hedged transaction
period is through October 2036, which is the stated maturity of the
floating rate debt.
Free-Standing Derivatives
Free-standing derivatives are derivatives that the Company has entered
into in conjunction with its investment and risk management activities, but for
which the Company has not designated the derivative contract as a hedging
instrument for accounting purposes. Such derivative contracts may include
credit default swaps (CDS), foreign exchange contracts, and interest rate
derivatives. Free-standing derivatives also include investment financing
arrangements (total rate of return swaps) whereby the
21
Table of Contents
Company
receives the sum of all interest, fees and any positive change in fair value
amounts from a reference asset with a specified notional amount and pays
interest on such notional amount plus any negative change in fair value amounts
from such reference asset.
The table below summarizes the aggregate notional amount and estimated
net fair value of the derivative instruments as of September 30, 2010 and
December 31, 2009 (amounts in thousands):
|
|
As of September 30, 2010
|
|
As of December 31, 2009
|
|
|
|
Notional
|
|
Estimated
Fair Value
|
|
Notional
|
|
Estimated
Fair Value
|
|
Cash Flow Hedges:
|
|
|
|
|
|
|
|
|
|
Interest rate swaps
|
|
$
|
483,333
|
|
$
|
(88,808
|
)
|
$
|
383,333
|
|
$
|
(43,800
|
)
|
Free-Standing Derivatives:
|
|
|
|
|
|
|
|
|
|
Interest rate swaps
|
|
307,112
|
|
1,272
|
|
89,246
|
|
(281
|
)
|
Credit default swapsprotection sold
|
|
13,500
|
|
362
|
|
51,000
|
|
(385
|
)
|
Total rate of return swaps
|
|
|
|
135
|
|
104,446
|
|
11,809
|
|
Foreign exchange forward contracts(1)
|
|
(145,282
|
)
|
(19,889
|
)
|
|
|
|
|
Foreign exchange options(1)
|
|
136,340
|
|
15,309
|
|
|
|
|
|
Common stock warrants
|
|
|
|
2,926
|
|
|
|
2,471
|
|
Total
|
|
$
|
795,003
|
|
$
|
(88,693
|
)
|
$
|
628,025
|
|
$
|
(30,186
|
)
|
(1)
Represents
forward contracts and options intended to offset the gains or losses resulting
from the settlement of the underlying foreign currency denominated asset.
Amounts presented were converted to U.S. dollars based on the exchange rates at
the end of each fiscal quarter.
A CDS is a contract in which
the contract buyer pays, in the case of a short position, or receives, in the
case of long position, a periodic premium until the contract expires or a
credit event occurs. In return for this premium, the contract seller receives a
payment from or makes a payment to the buyer if there is a credit default or
other specified credit event with respect to the issuer (also known as the
referenced entity) of the underlying credit instrument referenced in the CDS.
Typical credit events include bankruptcy, dissolution or insolvency of the
referenced entity, failure to pay and restructuring of the obligations of the
referenced entity.
As
of September 30, 2010 and December 31, 2009, the Comp
any had sold
protection with a notional amount of approximately $13.5 million and $51.0
million, respectively. The Company sells protection to replicate fixed income
securities and to complement the spot market when cash securities of the
referenced entity of a particular maturity are not available or when the
derivative alternative is less expensive compared to other purchasing
alternatives.
The following table shows the net realized gains on the Companys CDS
for the three and nine months ended September 30, 2010 and 2009 (amounts
in thousands):
|
|
For the three months
ended
September 30, 2010
|
|
For the three months
ended
September 30, 2009
|
|
For the nine months
ended
September 30, 2010
|
|
For the nine months
ended
September 30, 2009
|
|
Gross realized gains
|
|
$
|
|
|
$
|
|
|
$
|
|
|
$
|
58,967
|
|
Gross realized losses
|
|
|
|
|
|
|
|
(996
|
)
|
Net realized gains
|
|
$
|
|
|
$
|
|
|
$
|
|
|
$
|
57,971
|
|
For all hedges where hedge accounting is being applied, effectiveness
testing and other procedures to ensure the ongoing validity of the hedges are
performed at least quarterly. During the three and nine months ended
September 30, 2010 and 2009, the Company recognized an immaterial amount
of ineffectiveness in income on the condensed consolidated statements of
operations from its cash flow and fair value hedges.
Note 8 to these condensed consolidated financial statements
describes the Companys borrowings under which the Company has pledged warrants
for borrowings. The following table summarizes the estimated fair value of
warrants pledged as collateral as of September 30, 2010 and
December 31, 2009 (amounts in thousands):
|
|
As of
September 30,
2010
|
|
As of
December 31, 2009
|
|
Pledged as collateral for borrowings under senior
secured credit facility
|
|
$
|
|
|
$
|
1,078
|
|
Pledged as collateral for collateralized loan
obligation secured notes and junior secured notes to affiliates
|
|
|
|
1,393
|
|
Total
|
|
$
|
|
|
$
|
2,471
|
|
22
Table of Contents
Note 10. Accumulated Other Comprehensive Income (Loss)
The components of accumulated other comprehensive income were as
follows (amounts in thousands):
|
|
As of
September 30, 2010
|
|
As of
December 31, 2009
|
|
Net unrealized gains on available-for-sale
securities
|
|
$
|
171,514
|
|
$
|
194,336
|
|
Net unrealized losses on cash flow hedges
|
|
(86,040
|
)
|
(41,608
|
)
|
Accumulated other comprehensive income
|
|
$
|
85,474
|
|
$
|
152,728
|
|
The components of changes in other comprehensive income (loss) were as
follows (amounts in thousands):
|
|
Three months
ended
September 30, 2010
|
|
Three months
ended
September 30, 2009
|
|
Nine months
ended
September 30, 2010
|
|
Nine months
ended
September 30, 2009
|
|
Unrealized gains on securities available-for-sale:
|
|
|
|
|
|
|
|
|
|
Unrealized holding gains arising during period
|
|
$
|
51,787
|
|
$
|
146,406
|
|
$
|
41,676
|
|
$
|
336,599
|
|
Reclassification adjustments for (gains) losses
realized in net income(1)
|
|
(18,120
|
)
|
1,972
|
|
(64,498
|
)
|
(625
|
)
|
Unrealized gains (losses) on securities
available-for-sale
|
|
33,667
|
|
148,378
|
|
(22,822
|
)
|
335,974
|
|
Unrealized (losses) gains on cash flow hedges
|
|
(17,609
|
)
|
(7,422
|
)
|
(44,432
|
)
|
24,569
|
|
Other comprehensive income (loss)
|
|
$
|
16,058
|
|
$
|
140,956
|
|
$
|
(67,254
|
)
|
$
|
360,543
|
|
(1)
Excludes an
impairment charge of $0.5 million and $1.7 million for investments
which were determined to be other-than-temporary for the three and nine months
ended September 30, 2010, respectively, and nil and $40.0 million for the
three and nine months ended September 30, 2009, respectively.
Note 11. Commitments and Contingencies
Loan Commitments
As part of its strategy of investing in corporate loans, the Company
commits to purchase interests in primary market loan syndications, which
obligate the Company to acquire a predetermined interest in such loans at a
specified price on a to-be-determined settlement date. Consistent with standard
industry practices, once the Company has been informed of the amount of its
syndication allocation in a particular loan by the syndication agent, the
Company bears the risks and benefits of changes in the fair value of the
syndicated loan from that date forward. As of September 30, 2010 and
December 31, 2009, the Company had committed to purchase corporate loans
with aggregate commitments totaling $108.2 million par and $156.5 million
par, respectively. In addition, the Company participates in certain contingent
financing arrangements, whereby the Company is committed to provide funding of
up to a specific amount at the discretion of the borrower. As of
September 30, 2010 and December 31, 2009, the Company had unfunded
financing commitments totaling $31.9 million and $40.5 million,
respectively. The Company does not expect material losses related to those
corporate loans for which it committed to purchase and fund.
Contingencies
The Company has been named as a party in various legal actions which
include the matters described below. It is inherently difficult to predict the
ultimate outcome, particularly in cases in which claimants seek substantial or
unspecified damages, or where investigations or proceedings are at an early
stage and the Company cannot predict with certainty the loss or range of loss
that may be incurred. The Company has denied, or believes it has a meritorious
defense and will deny liability in the significant cases pending against the
Company discussed below. Based on current discussion and consultation with
counsel, management believes that the resolution of these matters will not have
a material impact on the Companys condensed consolidated financial statements.
On July 10, 2009, the Company surrendered for cancellation,
without consideration, approximately $64.0 million of mezzanine notes
issued to the Company by CLO 2005-2 (the 2005-2 Notes) and approximately
$222.4 million of mezzanine and junior notes issued to the Company by CLO
2006-1 (the 2006-1 Notes), as well as certain other notes issued to the
Company by another CLO. The surrendered notes were cancelled by the trustee
under the applicable indenture, and the obligations due under such surrendered
notes were deemed extinguished.
Holders constituting a majority of the controlling class of senior
notes of CLO 2005-2 (the 2005-2 Noteholders) notified the related trustee of
purported defaults under the indentures related to the surrender of the 2005-2
Notes. The Company announced on November 29, 2009 that it reached an
agreement on November 23, 2009 with the 2005-2 Noteholders pursuant to
which the 2005-2
23
Table of Contents
Noteholders
have agreed, subject to the terms and conditions of the agreement, not to
challenge the July 2009 surrender for cancellation transaction. In
exchange, the Company has agreed to certain arrangements, including, among
other things, to refrain from undertaking a comparable surrender for
cancellation, of any other mezzanine notes or junior notes issued to it by CLO
2005-2. In addition, the Company has agreed with the 2005-2 Noteholders that,
for so long as no legal action or similar challenge is brought to the Companys
prior surrender of notes in any of its CLO transactions, the Company will not
undertake a comparable surrender for cancellation, without consideration, of
any mezzanine notes or junior notes issued to it by CLO 2005-1, CLO 2006-1, CLO
2007-1 or CLO 2007-A.
In addition, during the first quarter of 2010, certain holders of the
senior notes of CLO 2006-1 (the 2006-1 Noteholders) notified the related
trustee of purported defaults under the indenture related to the surrender of
the 2006-1 Notes. The Company does not believe based on discussions with
counsel that an event of default has occurred and is engaged in discussions
with the 2006-1 Noteholders to resolve this matter. Accordingly, the Company
does not believe that this matter will have a material effect on its financial
condition.
The
parent company of the Manager has furnished information to the SEC in response
to a request from the SEC for information in connection with its examination of
certain investment advisors in order to review trading procedures and valuation
practices in the collateral pools of CLOs for which it acts as collateral
manager. The parent company of the Manager also provided information regarding
the surrender by the Company for cancellation, without consideration, of certain
notes that had been issued to the Company by collateral pools of CLOs. The
parent company of the Manager is fully cooperating with the SECs examination.
On August 7, 2008, the members of the Companys board of directors
and certain of its former executive officers and the Company were named in a
putative class action complaint filed by Charter Township of Clinton Police and
Fire Retirement System in the United States District Court for the Southern
District of New York, or the Charter Litigation. On March 13, 2009, the
lead plaintiff filed an amended complaint, which deleted as defendants the
members of the Companys board of directors and named as defendants only the
Companys former chief executive officer Saturnino S. Fanlo, the Companys
former chief operating officer David A. Netjes, the Companys former chief
financial officer Jeffrey B. Van Horn and the Company. The amended complaint
alleges that the Companys April 2, 2007 registration statement and
prospectus and the financial statements incorporated therein contained material
omissions in violation of Section 11 of the Securities Act, regarding the
risks and potential losses associated with the Companys real estate-related
assets, the Companys ability to finance its real estate-related assets and the
adequacy of the Companys loss reserves for its real estate-related assets. The
amended complaint further alleges that, pursuant to Section 15 of the
Securities Act, Messrs. Fanlo, Netjes and Van Horn each have legal
responsibility for the alleged Section 11 violation. On April 27,
2009, the defendants filed a motion to dismiss the amended complaint for
failure to state a claim under the Securities Act. Oral argument on the
defendants motion to dismiss took place on October 5, 2010, and the
parties are awaiting a decision from the Court.
On August 15, 2008, the members of the Companys board of
directors and its executive officers (collectively, the Kostecka Individual
Defendants) were named in a shareholder derivative action brought by Raymond W.
Kostecka, a purported shareholder, in the Superior Court of California, County
of San Francisco (the California Derivative Action). The Company was named as
a nominal defendant. The complaint in the California Derivative Action asserts
claims against the Kostecka Individual Defendants for breaches of fiduciary
duty, abuse of control, gross mismanagement, waste of corporate assets, and
unjust enrichment in connection with the conduct at issue in the Charter
Litigation, including the filing of the Companys April 2, 2007
registration statement with alleged material misstatements and omissions. By
order dated January 8, 2009, the Court approved the parties stipulation
to stay the proceedings in the California Derivative Action until the Charter
Litigation is dismissed on the pleadings or the Company files an answer to the
Charter Litigation.
On March 23, 2009, the members of the
Companys board of directors and certain of its executive officers
(collectively, the Haley Individual Defendants) were named in a shareholder
derivative action brought by Paul B. Haley, a purported shareholder, in the
United States District Court for the Southern District of New York (the New
York Derivative Action). The Company was named as a nominal defendant. The
complaint in the New York Derivative Action asserts claims against the Haley
Individual Defendants for breaches of fiduciary duty, breaches of the duty of
full disclosure, and for contribution in connection with the conduct at issue
in the Charter Litigation, including the filing of the Companys April 2,
2007 registration statement with alleged material misstatements and omissions.
By order dated June 18, 2009, the Court approved the parties stipulation
to stay the proceedings in the New York Derivative Action until the Charter
Litigation is dismissed on the pleadings or the Company files an answer to the
Charter Litigation.
Note 12. Share Options and Restricted Shares
On May 4, 2007, the Company adopted an amended and restated share
incentive plan (the 2007 Share Incentive Plan) that provides for the grant of
qualified incentive common share options that meet the requirements of
Section 422 of the Code, non-qualified common share options, share
appreciation rights, restricted common shares and other share-based awards. The
Compensation Committee of the board of directors administers the plan. Share
options and other share-based awards may be granted to the Manager, directors,
officers and any key employees of the Manager and to any other individual or
entity performing services for the Company.
24
Table of
Contents
The exercise price for any share option granted under the 2007 Share
Incentive Plan may not be less than 100% of the fair market value of the common
shares at the time the common share option is granted. Each option to acquire a
common share must terminate no more than ten years from the date it is granted.
As of September 30, 2010, the 2007 Share Incentive Plan authorizes a total
of 8,464,625 shares that may be used to satisfy awards under the 2007 Share
Incentive Plan.
The following table summarizes restricted common share transactions:
|
|
Manager
|
|
Directors
|
|
Total
|
|
Unvested shares as of
January 1, 2010
|
|
1,097,000
|
|
255,618
|
|
1,352,618
|
|
Issued
|
|
|
|
52,808
|
|
52,808
|
|
Vested
|
|
|
|
(95,822
|
)
|
(95,822
|
)
|
Cancelled
|
|
|
|
|
|
|
|
Forfeited
|
|
|
|
|
|
|
|
Unvested shares as of
September 30, 2010
|
|
1,097,000
|
|
212,604
|
|
1,309,604
|
|
The Company is required to value any unvested restricted common shares
granted to the Manager at the current market price. The Company valued the
unvested restricted common shares granted to the Manager at $8.78 and $4.62 per
share at September 30, 2010 and September 30, 2009, respectively.
There were $2.2 million and $3.1 million of total unrecognized
compensation costs related to unvested restricted common shares granted as of
September 30, 2010 and 2009, respectively. These costs are expected to be
recognized over three years from the date of grant.
The following table summarizes common share option transactions:
|
|
Number of
Options
|
|
Weighted-
Average
Exercise Price
|
|
Outstanding as of
January 1, 2010
|
|
1,932,279
|
|
$
|
20.00
|
|
Granted
|
|
|
|
|
|
Exercised
|
|
|
|
|
|
Forfeited
|
|
|
|
|
|
Outstanding as of
September 30, 2010
|
|
1,932,279
|
|
$
|
20.00
|
|
As of September 30, 2010 and December 31, 2009, 1,932,279
common share options were exercisable. As of September 30, 2010, the
common share options were fully vested and expire in August 2014. For the
three and nine months ended September 30, 2010 and 2009, the components of
share-based compensation expense are as follows (amounts in thousands):
|
|
For the three
months ended
September 30, 2010
|
|
For the three
months ended
September 30, 2009
|
|
For the nine
months ended
September 30, 2010
|
|
For the nine
months ended
September 30, 2009
|
|
Restricted shares granted to Manager
|
|
$
|
1,943
|
|
$
|
2,260
|
|
$
|
4,437
|
|
$
|
2,225
|
|
Restricted shares granted to certain directors
|
|
189
|
|
104
|
|
901
|
|
380
|
|
Total share-based compensation expense
|
|
$
|
2,132
|
|
$
|
2,364
|
|
$
|
5,338
|
|
$
|
2,605
|
|
Note 13. Management Agreement and Related Party
Transactions
The Manager manages the Companys day-to-day operations, subject to the
direction and oversight of the Companys board of directors. The Management
Agreement expires on December 31 of each year, but is automatically
renewed for a one-year term each December 31 unless terminated upon the
affirmative vote of at least two-thirds of the Companys independent directors,
or by a vote of the holders of a majority of the Companys outstanding common
shares, based upon (1) unsatisfactory performance by the Manager that is
materially detrimental to the Company or (2) a determination that the
management fee payable by the Manager is not fair, subject to the Managers
right to prevent such a termination under this clause (2) by
accepting a mutually acceptable reduction of management fees. The Manager must
be provided 180 days prior notice of any such termination and will be paid
a termination fee equal to four times the sum of the average annual base
management fee and the average annual incentive fee for the two 12-month
periods immediately preceding the date of termination, calculated as of the end
of the most recently completed fiscal quarter prior to the date of termination.
25
Table
of Contents
The Management Agreement contains certain provisions requiring the
Company to indemnify the Manager with respect to all losses or damages arising
from acts not constituting bad faith, willful misconduct, or gross negligence.
The Company has evaluated the impact of these guarantees on its condensed
consolidated financial statements and determined that they are not material.
For the three and nine months ended September 30, 2010, the
Company incurred $4.9 million and $13.7 million, respectively, in base
management fees. In addition, the Company recognized share-based compensation
expense related to restricted common shares granted to the Manager of $1.9
million and $4.4 million, respectively, for the three and nine months ended
September 30, 2010 (see Note 12 to these condensed consolidated financial
statements). For the three and nine months ended September 30, 2009, the
Company incurred $3.7 million and $11.0 million, respectively, in base
management fees. In addition, the Company recognized share-based compensation
expense related to restricted common shares granted to the Manager of $2.3 million
and $2.2 million, respectively, for the three and nine months ended
September 30, 2009 (see Note 12 to these condensed consolidated financial
statements).
Base management fees incurred and share-based compensation expense
relating to common share options and restricted common shares granted to the
Manager are included in related party management compensation on the condensed
consolidated statements of operations. Expenses incurred by the Manager and
reimbursed by the Company are reflected in the respective condensed
consolidated statements of operations, non-investment expense category based on
the nature of the expense.
The Manager is waiving base management fees related to the
$230.4 million common share offering and $270.0 million common share
rights offering that occurred during the third quarter of 2007 until such time
as the Companys common share closing price on the NYSE is $20.00 or more for
five consecutive trading days. Accordingly, the Manager permanently waived
approximately $2.2 million of base management fees during each of the three
months ended September 30, 2010 and 2009 and $6.6 million during each of
the nine months ended September 30, 2010 and 2009.
During
the three and nine months ended September 30, 2010, the Manager earned
$9.4 million and $30.3 million, respectively, of incentive fees. The $30.3
million of incentive fees earned for the nine months ended September 30,
2010 is net of a $9.7 million amount waived. During the three months ended
March 31, 2010, the Manager permanently waived payment of $9.7 million of
incentive fees that were related to the $38.7 million gain recorded by the
Company as a result of the repurchase of $83.0 million of mezzanine and
subordinate notes issued by CLO 2007-1 and CLO 2007-A. Incentive fees are included
in related party management compensation on the Companys condensed
consolidated statement of operations. For both the three and nine months ended September 30,
2009, the Manager earned $4.5 million of incentive fees.
An affiliate of the Manager has entered into separate management
agreements with the respective investment vehicles for CLO 2005-1,
CLO 2005-2, CLO 2006-1, CLO 2007-1, CLO 2007-A and CLO
2009-1 and is entitled to receive fees for the services performed as collateral
manager. Previously, the collateral
manager had waived the fees it earned for providing management services for the
Companys CLOs. Beginning April 15, 2007, the collateral manager ceased
waiving fees for CLO 2005-1 and beginning January 1, 2009, the
collateral manager ceased waiving fees for CLO 2005-2, CLO 2006-1,
CLO 2007-1, CLO 2007-A and Wayzata Funding LLC (restructured and
replaced with CLO 2009-1 on March 31, 2009). Beginning in July 2009,
the collateral manager reinstated waiving the CLO management fees for CLO 2005-2
and CLO 2006-1. In addition, due to CLO 2007-A and CLO 2007-1 regaining
compliance with their respective OC Tests during the first quarter of 2010, the
collateral manager also reinstated waiving the CLO management fees for CLO
2007-A and CLO 2007-1. For the three and nine months ended September 30,
2010, the collateral manager waived an aggregate of $8.7 million and $21.9
million, respectively, for CLO 2005-2, CLO 2006-1, CLO 2007-1 and CLO 2007-A.
For each of the three and nine months ended September 30, 2009, the
collateral manager waived $2.6 million for CLO 2005-2 and CLO 2006-1. In
addition, due to the deleveraging of CLO 2009-1 completed in July 2009
whereby all the senior notes were retired, the collateral manager is no longer
entitled to receive management fees from CLO 2009-1. The Company recorded an
expense for CLO management fees of $1.3 million and $4.1 million for
the three and nine months ended September 30, 2010, respectively. The
Company recorded an expense for CLO management fees of $4.2 million and $18.4
million for the three and nine months ended September 30, 2009,
respectively.
In addition, beginning January 1, 2009, the Manager permanently
waived reimbursable general and administrative expenses allocable to the
Company in an amount equal to the incremental CLO management fees received by
the Manager. Effective June 2010, all incremental CLO management fees
received by the Manager in 2009 had been fully applied to offset reimbursable
general and administrative expenses allocable to the Company. Accordingly,
reimbursable general and administrative expenses were charged and paid by the
Company beginning in June 2010. For
the three and nine months ended September 30, 2010, the Manager
permanently waived reimbursement of nil and $2.4 million in allocable general
and administrative expenses, respectively. For the three and nine months ended
September 30, 2009, the Manager permanently waived reimbursement of $2.4
million and $7.7 million, respectively, in allocable general and administrative
expenses.
The Company has invested in corporate loans, debt securities and other
investments of entities that are affiliates of KKR. As of September 30,
2010, the aggregate par amount of these affiliated investments totaled
$2.3 billion, or approximately 29% of the total investment portfolio, and
consisted of 24 issuers. The total $2.3 billion in affiliated investments
were comprised of $2.0 billion of corporate loans, $339.0 million of
corporate debt securities available-for-sale and $11.8 million of equity
investments, at estimated fair value. As of December 31, 2009, the
aggregate par amount of these affiliated investments totaled $2.8 billion,
or approximately 35% of the total investment portfolio, and consisted of 21
issuers. The total $2.8 billion in investments were comprised of
$2.3 billion of corporate loans, $466.0 million of corporate debt
securities available for sale, and $61.8 million notional amount of total
rate of return swaps referenced to corporate loans issued by affiliates of KKR
(included in derivative assets and liabilities on the condensed consolidated
balance sheet).
26
Table of
Contents
Note 14. Fair Value of Financial Instruments
Fair Value of Financial Instruments
The fair value of certain instruments including securities
available-for-sale, corporate loans, derivatives and loan commitments is based
on quoted market prices or estimates provided by independent pricing sources.
The fair value of cash and cash equivalents, interest receivable and interest
payable, approximates cost as of September 30, 2010 and December 31,
2009, due to the short-term nature of these instruments.
The table below discloses the carrying value and the estimated fair
value of the Companys financial instruments as of September 30, 2010 and
December 31, 2009 (amounts in thousands):
|
|
As of September 30, 2010
|
|
As of December 31, 2009
|
|
|
|
Carrying
Amount
|
|
Estimated Fair
Value
|
|
Carrying
Amount
|
|
Estimated Fair
Value
|
|
Financial Assets:
|
|
|
|
|
|
|
|
|
|
Cash, restricted cash, and cash equivalents
|
|
$
|
462,211
|
|
$
|
462,211
|
|
$
|
439,792
|
|
$
|
439,792
|
|
Securities available-for-sale
|
|
849,022
|
|
849,022
|
|
755,686
|
|
755,686
|
|
Corporate loans, net of allowance for loan losses
of $209,030 and $237,308 as of September 30, 2010 and December 31,
2009, respectively
|
|
5,815,544
|
|
5,806,905
|
|
5,617,925
|
|
5,459,273
|
|
Corporate loans held for sale
|
|
667,196
|
|
679,447
|
|
925,718
|
|
954,350
|
|
Residential mortgage-backed securities
|
|
106,252
|
|
106,252
|
|
47,572
|
|
47,572
|
|
Residential mortgage loans
|
|
|
|
|
|
2,097,699
|
|
2,097,699
|
|
Equity investments, at estimated fair value
|
|
84,307
|
|
84,307
|
|
120,269
|
|
120,269
|
|
Interest and principal receivable
|
|
83,195
|
|
83,195
|
|
98,313
|
|
98,313
|
|
Derivative assets
|
|
20,004
|
|
20,004
|
|
15,784
|
|
15,784
|
|
Reverse repurchase agreements
|
|
|
|
|
|
80,250
|
|
80,250
|
|
Private equity investments, at cost
|
|
6,771
|
|
6,741
|
|
17,505
|
|
24,658
|
|
|
|
|
|
|
|
|
|
|
|
Financial Liabilities:
|
|
|
|
|
|
|
|
|
|
Collateralized loan obligation secured notes
|
|
$
|
5,630,141
|
|
$
|
5,099,556
|
|
$
|
5,667,716
|
|
$
|
4,775,364
|
|
Collateralized loan obligation junior secured
notes to affiliates
|
|
371,062
|
|
251,136
|
|
533,786
|
|
221,755
|
|
Senior secured credit facility
|
|
|
|
|
|
175,000
|
|
175,000
|
|
Convertible senior notes
|
|
343,863
|
|
411,631
|
|
275,800
|
|
259,252
|
|
Junior subordinated notes
|
|
283,517
|
|
263,139
|
|
283,517
|
|
238,154
|
|
Residential mortgage-backed securities issued
|
|
|
|
|
|
2,034,772
|
|
2,034,772
|
|
Accounts payable, accrued expenses and other
liabilities
|
|
27,312
|
|
27,312
|
|
7,240
|
|
7,240
|
|
Accrued interest payable
|
|
17,538
|
|
17,538
|
|
25,297
|
|
25,297
|
|
Accrued interest payable to affiliates
|
|
3,846
|
|
3,846
|
|
2,911
|
|
2,911
|
|
Related party payable
|
|
12,431
|
|
12,431
|
|
3,367
|
|
3,367
|
|
Securities sold, not yet purchased
|
|
|
|
|
|
77,971
|
|
77,971
|
|
Derivative liabilities
|
|
108,697
|
|
108,697
|
|
45,970
|
|
45,970
|
|
27
Table of
Contents
Fair Value Measurements
The following table presents information about the Companys assets and
liabilities measured at fair value on a recurring basis as of
September 30, 2010, and indicates the fair value hierarchy of the
valuation techniques utilized by the Company to determine such fair value
(amounts in thousands):
|
|
Quoted Prices in
Active Markets
for Identical Assets
(Level 1)
|
|
Significant Other
Observable Inputs
(Level 2)
|
|
Significant
Unobservable
Inputs
(Level 3)
|
|
Balance as of
September 30, 2010
|
|
|
|
|
|
|
|
|
|
|
|
Assets:
|
|
|
|
|
|
|
|
|
|
Securities available-for-sale
|
|
$
|
|
|
$
|
736,188
|
|
$
|
112,834
|
|
$
|
849,022
|
|
Residential mortgage-backed securities
|
|
|
|
|
|
106,252
|
|
106,252
|
|
Equity investments, at estimated fair value
|
|
|
|
15,375
|
|
68,932
|
|
84,307
|
|
Free-standing derivatives interest rate swaps
|
|
|
|
|
|
1,272
|
|
1,272
|
|
Credit default swaps protection sold
|
|
|
|
362
|
|
|
|
362
|
|
Total rate of return swaps
|
|
|
|
|
|
135
|
|
135
|
|
Foreign exchange options
|
|
|
|
|
|
15,309
|
|
15,309
|
|
Common stock warrants
|
|
|
|
|
|
2,926
|
|
2,926
|
|
Total
|
|
$
|
|
|
$
|
751,925
|
|
$
|
307,660
|
|
$
|
1,059,585
|
|
|
|
|
|
|
|
|
|
|
|
Liabilities:
|
|
|
|
|
|
|
|
|
|
Cash flow interest rate swaps
|
|
$
|
|
|
$
|
(88,808
|
)
|
$
|
|
|
$
|
(88,808
|
)
|
Foreign exchange forward contracts
|
|
|
|
(19,889
|
)
|
|
|
(19,889
|
)
|
|
|
$
|
|
|
$
|
(108,697
|
)
|
$
|
|
|
$
|
(108,697
|
)
|
There were no transfers between levels 1 and 2 during the nine months
ended September 30, 2010.
The following table presents information about the Companys assets
measured at fair value on a non-recurring basis as of September 30, 2010,
and indicates the fair value hierarchy of the valuation techniques utilized by
the Company to determine such fair value (amounts in thousands). There were no
liabilities measured at fair value on a non-recurring basis:
|
|
Quoted Prices in
Active Markets
for Identical Assets
(Level 1)
|
|
Significant Other
Observable Inputs
(Level 2)
|
|
Significant
Unobservable Inputs
(Level 3)
|
|
Balance as of
September 30, 2010
|
|
Loans held for sale(1)
|
|
$
|
|
|
$
|
376,110
|
|
$
|
49,559
|
|
$
|
425,669
|
|
Private equity investments(2)
|
|
|
|
|
|
3,771
|
|
3,771
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(1)
As of September 30,
2010, total loans held for sale had a carrying value of $667.2 million of which
$425.7 million was carried at estimated fair value and the remaining
$241.5 million carried at amortized cost. Of the $425.7 million
carried at estimated fair value, $376.1 million was classified as level 2
given that the assets were valued using quoted prices and other observable
inputs in an active market. The remaining $49.6 million was classified as level
3 given that the Company applied unobservable inputs based on the best
available information to determine the estimated fair value.
(2)
Represents private equity
investments accounted for under the cost method that were classified as level 3
when the assets were impaired and measured at estimated fair value using
unobservable inputs.
28
Table
of Contents
The following table presents information about the Companys assets and
liabilities measured at fair value on a recurring basis as of December 31,
2009, and indicates the fair value hierarchy of the valuation techniques
utilized by the Company to determine such fair value (amounts in thousands):
|
|
Quoted Prices in
Active Markets
for Identical Assets
(Level 1)
|
|
Significant Other
Observable Inputs
(Level 2)
|
|
Significant
Unobservable Inputs
(Level 3)
|
|
Balance as of
December 31, 2009
|
|
Assets:
|
|
|
|
|
|
|
|
|
|
Securities available-for-sale
|
|
$
|
1,277
|
|
$
|
673,121
|
|
$
|
81,288
|
|
$
|
755,686
|
|
Residential mortgage-backed securities
|
|
|
|
|
|
47,572
|
|
47,572
|
|
Residential mortgage loans
|
|
|
|
|
|
2,097,699
|
|
2,097,699
|
|
Equity investments, at estimated fair value
|
|
26,483
|
|
75,497
|
|
18,289
|
|
120,269
|
|
Total rate of return swaps
|
|
|
|
|
|
11,809
|
|
11,809
|
|
Common stock warrants
|
|
|
|
|
|
2,471
|
|
2,471
|
|
Total
|
|
$
|
27,760
|
|
$
|
748,618
|
|
$
|
2,259,128
|
|
$
|
3,035,506
|
|
Liabilities:
|
|
|
|
|
|
|
|
|
|
Cash flow interest rate swaps
|
|
$
|
|
|
$
|
(43,800
|
)
|
$
|
|
|
$
|
(43,800
|
)
|
Free-standing derivatives interest rate swaps
|
|
|
|
|
|
(281
|
)
|
(281
|
)
|
Credit default swaps protection sold
|
|
|
|
(385
|
)
|
|
|
(385
|
)
|
Residential mortgage-backed securities issued
|
|
|
|
|
|
(2,034,772
|
)
|
(2,034,772
|
)
|
Securities sold, not yet purchased
|
|
|
|
(77,971
|
)
|
|
|
(77,971
|
)
|
Total
|
|
$
|
|
|
$
|
(122,156
|
)
|
$
|
(2,035,053
|
)
|
$
|
(2,157,209
|
)
|
The
following table presents information about the Companys assets measured at
fair value on a non-recurring basis as of December 31, 2009, and indicates
the fair value hierarchy of the valuation techniques utilized by the Company to
determine such fair value (amounts in thousands). There were no liabilities
measured at fair value on a non-recurring basis. There were no liabilities
measured at fair value on a non-recurring basis:
|
|
Quoted Prices in
Active Markets
for Identical Assets
(Level 1)
|
|
Significant Other
Observable Inputs
(Level 2)
|
|
Significant
Unobservable Inputs
(Level 3)
|
|
Balance as of
December 31, 2009
|
|
Loans held for sale(1)
|
|
$
|
|
|
$
|
533,308
|
|
$
|
|
|
$
|
533,308
|
|
REO
|
|
|
|
|
|
11,439
|
|
11,439
|
|
Total
|
|
$
|
|
|
$
|
533,308
|
|
$
|
11,439
|
|
$
|
544,747
|
|
(1)
As of
December 31, 2009, total loans held for sale had a carrying value of
$925.7 million of which $533.3 million was carried at estimated fair
value and the remaining $392.4 million carried at amortized cost. The
$533.3 million carried at estimated fair value was classified as
level 2 given that the assets were valued using quoted prices and other
observable inputs in an active market.
29
Table
of Contents
The following table presents additional information about assets,
including derivatives that are measured at fair value on a recurring basis for
which the Company has utilized level 3 inputs to determine fair value, for
the three months ended September 30, 2010 (amounts in thousands):
|
|
Securities
Available-
For-Sale
|
|
Residential
Mortgage-
Backed
Securities
|
|
Equity
Investments,
at Estimated
Fair Value
|
|
Total Rate of
Return
Swaps
|
|
Common
Stock
Warrants
|
|
Foreign
Exchange
Options
|
|
Free-Standing
Derivatives
Interest Rate
Swaps
|
|
Beginning
balance as of July 1, 2010
|
|
$
|
72,773
|
|
$
|
107,081
|
|
$
|
26,482
|
|
$
|
37
|
|
$
|
126
|
|
$
|
|
|
$
|
4,764
|
|
Total
gains or losses (realized and unrealized):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Included
in earnings(1)
|
|
649
|
|
2,208
|
|
(5,835
|
)
|
98
|
|
84
|
|
15,309
|
|
(3,482
|
)
|
Included
in other comprehensive income
|
|
5,279
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Transfers
in to level 3(2)
|
|
22,287
|
|
|
|
41,740
|
|
|
|
|
|
|
|
|
|
Purchases,
sales, other settlements and issuances, net
|
|
11,846
|
|
(3,037
|
)
|
6,545
|
|
|
|
2,716
|
|
|
|
(10
|
)
|
Ending
balance as of September 30, 2010
|
|
$
|
112,834
|
|
$
|
106,252
|
|
$
|
68,932
|
|
$
|
135
|
|
$
|
2,926
|
|
$
|
15,309
|
|
$
|
1,272
|
|
The
amount of total gains or losses for the period included in earnings
attributable to the change in unrealized gains or losses relating to assets
still held at the reporting date(1)
|
|
$
|
|
|
$
|
7,698
|
|
$
|
(5,835
|
)
|
$
|
|
|
$
|
84
|
|
$
|
15,309
|
|
$
|
(3,482
|
)
|
(1)
Amounts are included in net
realized and unrealized gain (loss) on investments, net realized and unrealized
gain (loss) on derivatives and foreign exchange or net realized and unrealized
gain (loss) on residential mortgage-backed securities, residential mortgage
loans, and residential mortgage-backed securities issued, carried at estimated
fair value in the condensed consolidated statements of operations.
(2)
Certain securities available-for-sale
and equity investments, at estimated fair value, were transferred in to level 3
reflecting reduced transparency of prices for these financial instruments as a
result of less trading activity.
The following table presents additional information about assets,
including derivatives that are measured at fair value on a recurring basis for
which the Company has utilized level 3 inputs to determine fair value, for
the nine months ended September 30, 2010 (amounts in thousands):
|
|
Securities
Available-
For-Sale
|
|
Residential
Mortgage-
Backed
Securities
|
|
Equity
Investments,
at Estimated
Fair Value
|
|
Total Rate of
Return
Swaps
|
|
Common
Stock
Warrants
|
|
Foreign
Exchange
Options
|
|
Free-Standing
Derivatives
Interest Rate
Swaps
|
|
Beginning
balance as of January 1, 2010
|
|
$
|
81,288
|
|
$
|
47,572
|
|
$
|
18,289
|
|
$
|
11,809
|
|
$
|
2,471
|
|
$
|
|
|
$
|
(281
|
)
|
Transfers
in from deconsolidation (1)
|
|
|
|
74,366
|
|
|
|
|
|
|
|
|
|
|
|
Total
gains or losses (realized and unrealized):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Included
in earnings(2)
|
|
4,927
|
|
(5,076
|
)
|
(8,732
|
)
|
1,801
|
|
135
|
|
15,309
|
|
1,348
|
|
Included
in other comprehensive income
|
|
6,957
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Transfers
in to level 3(3)
|
|
22,788
|
|
|
|
41,740
|
|
|
|
|
|
|
|
|
|
Purchases,
sales, other settlements and issuances, net
|
|
(3,126
|
)
|
(10,610
|
)
|
17,635
|
|
(13,475
|
)
|
320
|
|
|
|
205
|
|
Ending
balance as of September 30, 2010
|
|
$
|
112,834
|
|
$
|
106,252
|
|
$
|
68,932
|
|
$
|
135
|
|
$
|
2,926
|
|
$
|
15,309
|
|
$
|
1,272
|
|
The
amount of total gains or losses for the period included in earnings
attributable to the change in unrealized gains or losses relating to assets
still held at the reporting date(2)
|
|
$
|
|
|
$
|
5,383
|
|
$
|
(8,732
|
)
|
$
|
|
|
$
|
135
|
|
$
|
15,309
|
|
$
|
151
|
|
(1)
Represents the
subordinate tranches of the residential mortgage loan securitization trusts as
a result of the Companys deconsolidation as of January 1, 2010, computed
as $11.4 million of REO plus $62.9 million, which represents the difference
between the residential mortgage loans of $2.1 billion less RMBS Issued, at
estimated fair value, of $2.0 billion. See Note 2 for further discussion.
30
Table
of Contents
(2)
Amounts are
included in net realized and unrealized gain (loss) on investments, net
realized and unrealized gain (loss) on derivatives and foreign exchange or net
realized and unrealized gain (loss) on residential mortgage-backed securities,
residential mortgage loans, and residential mortgage-backed securities issued,
carried at estimated fair value in the condensed consolidated statements of
operations.
(3)
Certain
securities available-for-sale and equity investments, at estimated fair value,
were transferred in to level 3 reflecting reduced transparency of prices for these
financial instruments as a result of less trading activity.
The
following table presents additional information about assets, including
derivatives, that are measured at fair value on a recurring basis for which the
Company has utilized level 3 inputs to determine fair value, for the three
months ended September 30, 2009 (amounts in thousands):
|
|
Fair Value Measurements Using Significant Unobservable Inputs
(Level 3)
|
|
|
|
Securities
Available-
For-Sale
|
|
Residential
Mortgage-
Backed
Securities
|
|
Residential
Mortgage
Loans
|
|
Equity
Investments,
at Estimated
Fair Value
|
|
Derivatives,
net
|
|
Residential
Mortgage-
Backed
Securities
Issued
|
|
Beginning balance as of July 1, 2009
|
|
$
|
89,998
|
|
$
|
76,572
|
|
$
|
2,218,319
|
|
$
|
5,549
|
|
$
|
6,087
|
|
$
|
(2,080,592
|
)
|
Total gains or losses (realized and unrealized):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Included in earnings(1)
|
|
(520
|
)
|
597
|
|
239,114
|
|
(1,939
|
)
|
17,276
|
|
(258,576
|
)
|
Included in other comprehensive income
|
|
12,969
|
|
|
|
|
|
|
|
|
|
|
|
Transfers out of level 3
|
|
|
|
|
|
(2,988
|
)
|
|
|
|
|
|
|
Purchases, sales, other settlements and issuances,
net
|
|
(28,280
|
)
|
(6,913
|
)
|
(179,860
|
)
|
|
|
(2,649
|
)
|
173,745
|
|
Ending balance as of September 30, 2009
|
|
$
|
74,167
|
|
$
|
70,256
|
|
$
|
2,274,585
|
|
$
|
3,610
|
|
$
|
20,714
|
|
$
|
(2,165,423
|
)
|
The amount of total gains or losses for the period included
in earnings attributable to the change in unrealized gains or losses relating
to assets still held at the reporting date(1)
|
|
$
|
|
|
$
|
845
|
|
$
|
241,346
|
|
$
|
(1,939
|
)
|
$
|
11,221
|
|
$
|
(258,130
|
)
|
(1)
Amounts are included in net
realized and unrealized gain (loss) on investments, net realized and unrealized
(loss) gain on derivatives and foreign exchange or net realized and unrealized
loss on residential mortgage-backed securities, residential mortgage loans, and
residential mortgage-backed securities issued, carried at estimated fair value
in the condensed consolidated statements of operations.
31
Table
of Contents
The
following table presents additional information about assets, including
derivatives, that are measured at fair value on a recurring basis for which the
Company has utilized level 3 inputs to determine fair value, for the nine
months ended September 30, 2009 (amounts in thousands):
|
|
Fair Value Measurements Using Significant Unobservable Inputs
(Level 3)
|
|
|
|
Securities
Available-
For-Sale
|
|
Residential
Mortgage-
Backed
Securities
|
|
Residential
Mortgage
Loans
|
|
Equity
Investments,
at Estimated
Fair Value
|
|
Derivatives,
net
|
|
Residential
Mortgage-
Backed
Securities
Issued
|
|
Beginning balance as of January 1, 2009
|
|
$
|
89,109
|
|
$
|
102,814
|
|
$
|
2,620,021
|
|
$
|
5,287
|
|
$
|
(76,950
|
)
|
$
|
(2,462,882
|
)
|
Total gains or losses (realized and unrealized):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Included in earnings(1)
|
|
(6,676
|
)
|
(8,718
|
)
|
110,536
|
|
(1,677
|
)
|
42,556
|
|
(145,525
|
)
|
Included in other comprehensive income
|
|
28,798
|
|
|
|
|
|
|
|
|
|
|
|
Transfers out of level 3
|
|
|
|
|
|
(2,010
|
)
|
|
|
|
|
|
|
Purchases, sales, other settlements and issuances,
net
|
|
(37,064
|
)
|
(23,840
|
)
|
(453,962
|
)
|
|
|
55,108
|
|
442,984
|
|
Ending balance as of September 30, 2009
|
|
$
|
74,167
|
|
$
|
70,256
|
|
$
|
2,274,585
|
|
$
|
3,610
|
|
$
|
20,714
|
|
$
|
(2,165,423
|
)
|
The amount of total gains or losses for
the period included in earnings attributable to the change in
unrealized gains or losses relating to assets still held at the
reporting date(1)
|
|
$
|
|
|
$
|
(6,713
|
)
|
$
|
119,801
|
|
$
|
(1,677
|
)
|
$
|
55,106
|
|
$
|
(144,215
|
)
|
(1)
Amounts are included in net
realized and unrealized gain (loss) on investments, net realized and unrealized
(loss) gain on derivatives and foreign exchange or net realized and unrealized
loss on residential mortgage-backed securities, residential mortgage loans, and
residential mortgage-backed securities issued, carried at estimated fair value
in the condensed consolidated statements of operations.
Note 15. Subsequent Events
The
Company entered into two definitive agreements to acquire certain natural
resources investments, including existing producing natural gas wells and
infrastructure in Texas, for an aggregate purchase price of $37.4 million. One
transaction closed in October 2010 while the other is expected to close prior
to year-end 2010.
On November 3, 2010, the Companys board
of directors
declared a cash distribution for the quarter ended
September 30, 2010 on the Companys common shares of $0.14 per common
share. The distribution is payable on December 1, 2010 to common
shareholders of record as of the close of business on November 17, 2010.
32
Table of Contents
Item 2.
Managements Discussion and Analysis of Financial Condition and Results
of Operations
Except where otherwise expressly stated or the
context suggests otherwise, the terms we, us and our refer to KKR
Financial Holdings LLC and its subsidiaries.
The following discussion and analysis of our
financial condition and results of operations should be read in conjunction
with our condensed consolidated financial statements and related notes included
elsewhere in this Quarterly Report on Form 10-Q.
Certain
information contained in this Quarterly Report on Form 10-Q constitutes forward-looking
statements within the meaning of Section 27A of the Securities Act of
1933, as amended and Section 21E of the Securities Exchange Act of 1934,
as amended, that are based on our current expectations, estimates and
projections. Statements that are not historical facts, including statements
about our beliefs and expectations, are forward-looking statements. The words believe,
anticipate, intend, aim, expect, strive, plan, estimate, and project,
and similar words identify forward-looking statements. Such statements are not
guarantees of future performance, events or results and involve potential risks
and uncertainties. Accordingly, actual results and the timing of certain events
could differ materially from those addressed in forward-looking statements due
to a number of factors including, but not limited to, changes in interest rates
and market values, financing and capital availability, changes in prepayment
rates, general economic and political conditions and events, changes in market conditions,
particularly in the global fixed income, credit and equity markets, the impact
of current, pending and future legislation, regulation and legal actions, and
other factors not presently identified. Other factors that may impact our
actual results are discussed under Risk Factors in Item 1A of the
Companys Annual Report on Form 10-K filed with the Securities Exchange
Commission, or the SEC, on March 1, 2010, as further supplemented by the
disclosure under Risk Factors in Item 1A of this Quarterly Report on
Form 10-Q. We do not undertake, and specifically disclaim, any obligation
to publicly release the result of any revisions that may be made to any
forward-looking statements to reflect the occurrence of anticipated or
unanticipated events or circumstances after the date of such statements, except
for as required by federal securities laws.
Executive Overview
We are a specialty finance company with expertise in a range of asset
classes. Our core business strategy is to leverage the proprietary resources of
KKR Financial Advisors LLC (our Manager) with the objective of generating
both current income and capital appreciation. We primarily invest in financial
assets including below investment grade corporate debt, including senior secured
and unsecured loans, mezzanine loans, high yield corporate bonds, distressed
and stressed debt securities, marketable equity securities and private equity.
Additionally, we have made or may make investments in other asset classes
including natural resources and real estate. The corporate loans we invest in
are primarily referred to as syndicated bank loans, or leveraged loans, and are
purchased via assignment or participation in either the primary or secondary
market. The majority of our corporate debt investments are held in
collateralized loan obligation (CLO) transactions that are structured as
on-balance sheet securitizations and are used as long term financing for these
investments. The senior secured notes issued by the CLO transactions are primarily
owned by unaffiliated third party investors and we own the majority of the
subordinated notes in the CLO transactions. Our CLO transactions consist of
five cash flow CLO transactions, KKR Financial CLO 2005-1, Ltd.
(CLO 2005-1), KKR Financial CLO 2005-2, Ltd. (CLO
2005-2), KKR Financial CLO 2006-1, Ltd. (CLO 2006-1), KKR Financial CLO
2007-1, Ltd. (CLO 2007-1) and KKR Financial CLO 2007-A, Ltd.
(CLO 2007-A
and, together with CLO 2005-1, CLO 2005-2, CLO 2006-1, and CLO 2007-1, each a Cash
Flow CLO and, collectively, the Cash Flow CLOs). We execute our core
business strategy through majority-owned subsidiaries, including CLOs.
Summary of Results
Our
net income for the three and nine months ended September 30, 2010 totaled
$82.3 million (or $0.52 per diluted common share) and $292.9 million (or $1.85
per diluted common share), respectively, as compared to a net income of
$67.2 million (or $0.42 per diluted common share) and $74.8 million (or
$0.49 per diluted common share), for the three and nine months ended
September 30, 2009, respectively. The increase in net income of $15.2
million from the three months ended September 30, 2009 compared to the
same period in 2010 is attributable to an increase in net investment income of
$5.6 million and an increase in other income of $13.6 million primarily due to
realized gains on the sale of certain corporate debt securities and no loss on
the restructuring and extinguishment of debt, partially offset by an increase
in non-investment expenses of $3.6 million. The increase in net income of
$218.0 million from the nine months ended September 30, 2009 compared to
the same period in 2010 is attributable to an increase in net investment income
of $75.0 million and an increase in other income of $154.3 million primarily
due to realized gains on the sale of certain corporate debt securities,
partially offset by an increase in non-investment expenses of $10.9 million.
The components of these amounts for the three and nine month periods ended September 30,
2010 and 2009 are detailed this Managements Discussion and Analysis of
Financial Condition and Results of Operations.
Distributions to Shareholders
On November 3, 2010, our board of
directors
declared a cash distribution for the quarter ended September 30,
2010 on our common shares of $0.14 per share. The distribution is payable on December 1,
2010 to common shareholders of record as of the close of business on November 17,
2010.
33
Table
of Contents
The senior secured credit facility contains negative covenants that
restrict our ability, among other things, to pay dividends or make certain
other restricted payments, including a prohibition on distributions to our
shareholders in an amount in excess of 65% of our estimated annual taxable
income.
Consolidation
Effective January 1, 2010, we adopted new guidance that amended
the accounting for the transfers of financial assets, eliminated the concept of
a qualified special purpose entity (QSPE) and significantly changed the
criteria by which an enterprise determines whether or not it must consolidate a
variable interest entity (VIE). Under the new guidance, consolidation of a
VIE requires both the power to direct the activities that most significantly
impact the VIEs economic performance and the obligation to absorb losses of
the VIE or the right to receive benefits of the VIE that could potentially be
significant to the VIE.
As
a result of the adoption of the new guidance regarding the amended
consolidation model based on power and economics, we determined that six
residential mortgage loan securitization trusts, which were previously
consolidated by us as we were deemed to be the primary beneficiary, were
required to be deconsolidated. We determined that we did not have the power to
direct the activities that most significantly impacted the economic performance
of the securitization trusts or the performance of the securitization trusts
underlying asset and deconsolidated them as of January 1, 2010. This
resulted in the reduction of both assets and liabilities of approximately
$2.0 billion. In addition, loan interest income, interest expense, loan
servicing expense, and net unrealized and realized gain (loss) associated with
the residential mortgage loan securitization trusts will no longer be reported
on our condensed consolidated financial statements. Our deconsolidation of the
six residential mortgage loan securitization trusts had no net impact on
shareholders equity, results of operations and cash flows.
CLO 2005-1, CLO 2005-2, CLO 2006-1,
CLO 2007-1,
CLO 2007-A and KKR Financial CLO 2009-1, Ltd. (CLO 2009-1) are all
VIEs that we consolidate as we have determined we have the power to direct the
activities that most significantly impact these entities economic performance
and we have both the obligation to absorb losses of these entities and the
right to receive benefits from these entities that could potentially be
significant to these entities.
As our condensed consolidated financial statements in this Quarterly
Report on Form 10-Q are presented to reflect the consolidation of the CLOs
we hold investments in, the information contained in this Managements Discussion
and Analysis of Financial Condition and Results of Operations reflects the CLOs
on a consolidated basis which is consistent with the disclosures in our
condensed consolidated financial statements.
Investment Portfolio
Overview
As discussed above, the majority of our investments are held through
CLO transactions that are managed by an affiliate of our Manager and for which
we own the majority, and in some cases all, of the economic interests in the
transaction through the subordinated notes in the transaction. On an
unconsolidated basis, our investment portfolio primarily consists of the
following as of September 30, 2010: (i) mezzanine and subordinated
tranches of CLO transactions with an aggregate par amount of $1.1 billion;
(ii) corporate loans with an aggregate par amount of $571.4 million
and an estimated fair value of $447.9 million; (iii) corporate debt
securities with an aggregate par amount of $131.8 million and an estimated fair
value of $121.5 million; (iv) residential mortgage-backed securities (RMBS)
with a par amount of $240.5 million and estimated fair value of
$102.0 million; (v) equity investments and private equity investments
with an estimated fair value of $77.8 million. In addition, we hold other
investments including credit default swap transactions, foreign exchange hedges
and interest rate swaps.
Corporate
Debt Investments
Our investments in corporate debt primarily consist of investments in
below investment grade corporate loans, often referred to as syndicated bank
loans or leveraged loans, and corporate debt securities. Loans that are not
deemed to be held for sale are carried at amortized cost net of allowance for
loan losses on our condensed consolidated balance sheets. Loans that are
classified as held for sale are carried at the lower of net amortized cost or
estimated fair value on our condensed consolidated balance sheets. Debt
securities are carried at estimated fair value on our condensed consolidated
balance sheets.
These investments have an aggregate par balance of $8.0 billion,
an aggregate net amortized cost of $7.4 billion and an aggregate estimated fair
value of $7.3 billion as of September 30, 2010. Included in these
amounts is $7.3 billion par amount or $6.8 billion estimated fair value of
investments held in our five Cash Flow CLOs through which we finance the
majority of our corporate debt investments. These Cash Flow CLOs have aggregate
secured notes outstanding totaling $5.6 billion held by unaffiliated third
parties and an aggregate of $371.1 million of junior notes outstanding
that are held by an affiliate of our Manager. In CLO transactions, subordinated
notes effectively represent the equity in such transactions as they have the
first risk of loss and conversely,
34
Table of Contents
the
residual value upside of the transactions. We consolidate all five of our Cash
Flow CLOs and reflect all income and losses related to the assets in these CLOs
on our condensed consolidated statement of operations even though a minority
amount of the subordinated notes issued by two of our CLO transactions are not
held by us.
RMBS
Investments
Our residential mortgage investment portfolio consists of investments
in RMBS with an estimated fair value of $106.3 million as of
September 30, 2010.
Critical Accounting Policies
Our condensed consolidated financial statements are prepared by
management in conformity with accounting principles generally accepted in the
United States of America (GAAP). Our significant accounting policies are
fundamental to understanding our financial condition and results of operations
because some of these policies require that we make significant estimates and
assumptions that may affect the value of our assets or liabilities and
financial results. We believe that certain of our policies are critical because
they require us to make difficult, subjective, and complex judgments about
matters that are inherently uncertain. We have reviewed these critical
accounting policies with our board of directors and our audit committee.
Fair Value of Financial Instruments
Fair value is the price that would be received to sell an asset or paid
to transfer a liability in an orderly transaction between market participants
at the measurement date. Where available, fair value is based on observable
market prices or parameters or derived from such prices or parameters. Where
observable prices or inputs are not available, valuation models are applied.
These valuation techniques involve some level of management estimation and
judgment, the degree of which is dependent on the price transparency for the
instruments or market and the instruments complexity for disclosure purposes.
Assets and liabilities recorded at fair value in the condensed consolidated
balance sheets are categorized based upon the level of judgment associated with
the inputs used to measure their value. Hierarchical levels, as defined under
GAAP, are directly related to the amount of subjectivity associated with the
inputs to fair valuations of these assets and liabilities, and are as follows:
Level 1: Inputs are unadjusted, quoted prices in active markets
for identical assets or liabilities at the measurement date.
The types of assets carried at level 1 fair value are equity
securities listed in active markets.
Level 2: Inputs, other than quoted prices included in
level 1, are observable for the asset or liability, either directly or
indirectly. Level 2 inputs include quoted prices for similar instruments
in active markets, and inputs other than quoted prices that are observable for
the asset or liability.
Fair value assets and liabilities that are included in this category
are certain corporate debt securities, certain corporate loans held for sale,
certain equity investments at estimated fair value, certain securities sold,
not yet purchased and certain financial instruments classified as derivatives
where the fair value is based on observable market inputs.
Level 3: Inputs are unobservable inputs for the asset or
liability, and include situations where there is little, if any, market
activity for the asset or liability. In certain cases, the inputs used to
measure fair value may fall into different levels of the fair value hierarchy.
In such cases, the level in the fair value hierarchy within which the fair
value measurement in its entirety falls has been determined based on the lowest
level input that is significant to the fair value measurement in its entirety.
Our assessment of the significance of a particular input to the fair value
measurement in its entirety requires judgment and the consideration of factors
specific to the asset.
Assets and liabilities carried at fair value and included in this
category are certain corporate debt securities, certain corporate loans held
for sale, certain equity investments at estimated fair value, residential
mortgage-backed securities, residential mortgage loans, residential
mortgage-backed securities issued and certain derivatives.
A
significant decrease in the volume and level of activity for the asset or
liability is an indication that transactions or quoted prices may not be
representative of fair value because in such market conditions there may be
increased instances of transactions that are not orderly. In those
circumstances, further analysis of transactions or quoted prices is needed, and
a significant adjustment to the transactions or quoted prices may be necessary
to estimate fair value.
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The
availability of observable inputs can vary depending on the financial asset or
liability and is affected by a wide variety of factors, including, for example,
the type of product, whether the product is new, whether the product is traded
on an active exchange or in the secondary market, and the current market
condition. To the extent that valuation is based on models or inputs that are
less observable or unobservable in the market, the determination of fair value
requires more judgment. Accordingly, the degree of judgment exercised by us in
determining fair value is greatest for instruments categorized in level 3.
In certain cases, the inputs used to measure fair value may fall into different
levels of the fair value hierarchy. In such cases, for disclosure purposes, the
level in the fair value hierarchy within which the fair value measurement in
its entirety falls is determined based on the lowest level input that is
significant to the fair value measurement in its entirety.
Many financial assets and liabilities have bid and ask prices that can
be observed in the marketplace. Bid prices reflect the highest price that we
and others are willing to pay for an asset. Ask prices represent the lowest
price that we and others are willing to accept for an asset. For financial
assets and liabilities whose inputs are based on bid-ask prices, we do not
require that fair value always be a predetermined point in the bid-ask range.
Our policy is to allow for mid-market pricing and adjusting to the point within
the bid-ask range that meets our best estimate of fair value.
Depending on the relative liquidity in the markets for certain assets,
we may transfer assets to level 3 if we determine that observable quoted
prices, obtained directly or indirectly, are not available. The valuation
techniques used for the assets and liabilities that are valued using
level 3 of the fair value hierarchy are described below.
Residential Mortgage-Backed Securities, Residential
Mortgage Loans, and Residential Mortgage-Backed Securities Issued:
Residential mortgage-backed securities,
residential mortgage loans, and residential mortgage-backed securities issued
are initially valued at transaction price and are subsequently valued using
industry recognized models (including Intex and Bloomberg) and data for similar
instruments (e.g., nationally recognized pricing services or broker
quotes). The most significant inputs to the valuation of these instruments are
default and loss expectations and market credit spreads.
Corporate Debt Securities:
Corporate debt securities are initially
valued at transaction price and are subsequently valued using market data for
similar instruments (e.g., recent transactions or broker quotes),
comparisons to benchmark derivative indices or valuation models. Valuation
models are based on discounted cash flow techniques, for which the key inputs
are the amount and timing of expected future cash flows, market yields for such
instruments and recovery assumptions. Inputs are determined based on relative
value analyses, which incorporate similar instruments from similar issuers.
Over-the-counter (OTC) Derivative Contracts:
OTC derivative contracts include forward,
swap and option contracts related to interest rates, foreign currencies, credit
standing of reference entities, and equity prices. The fair value of OTC
derivative products can be modeled using a series of techniques, including
closed-form analytic formulae, such as the Black-Scholes option-pricing model,
and simulation models or a combination thereof. Many pricing models do not
entail material subjectivity because the methodologies employed do not
necessitate significant judgment, and the pricing inputs are observed from
actively quoted markets, as is the case for generic interest rate swap and
option contracts.
Share-Based Compensation
We account for share-based compensation issued to members of our board
of directors and our Manager using a fair value based methodology in accordance
with accounting guidance. We do not have any employees, although we believe
that members of our board of directors are deemed to be employees for purposes
of interpreting and applying accounting principles relating to share-based
compensation. We record as compensation costs the restricted common shares that
we issued to members of our board of directors at estimated fair value as of
the grant date and we amortize the cost into expense over the three-year
vesting period using the straight-line method. We record compensation costs for
restricted common shares and common share options that we issued to our Manager
at estimated fair value as of the grant date and we remeasure the amount on
subsequent reporting dates to the extent the awards have not vested. Unvested
restricted common shares are valued using observable secondary market prices.
Unvested common share options are valued using the Black-Scholes model and
assumptions based on observable market data for comparable companies. We
amortize compensation expense related to the restricted common share
and common share options that we granted to our Manager using the graded
vesting attribution method.
Because we remeasure the amount of compensation costs associated with
the unvested restricted common shares and unvested common share options that we
issued to our Manager as of each reporting period, our share-based compensation
expense reported in our condensed consolidated financial statements will change
based on the estimated fair value of our common shares and this may result in
earnings volatility. For the three months ended September 30, 2010,
share-based compensation was $2.1 million. As of September 30, 2010,
substantially all of the non-vested restricted common shares issued are subject
to remeasurement. As of September 30, 2010, a $1 increase in the price of our
common shares would have increased our future share-based compensation expense
by approximately $1.1 million and this future share-based compensation
expense would be recognized over the remaining vesting periods of our
outstanding restricted common shares and common share options. As of
September 30, 2010, the common share options were fully vested and expire
in August 2014. As of September 30, 2010, future unamortized
share-based compensation totaled $2.2 million, of which $1.0 million,
$1.0 million and $0.2 million will be recognized in 2010, 2011 and beyond,
respectively.
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Table of Contents
Accounting for Derivative Instruments and Hedging Activities
We recognize all derivatives on our condensed consolidated balance
sheets at estimated fair value. On the date we enter into a derivative
contract, we designate and document each derivative contract as one of the
following at the time the contract is executed: (i) a hedge of a
recognized asset or liability (fair value hedge); (ii) a hedge of a
forecasted transaction or of the variability of cash flows to be received or
paid related to a recognized asset or liability (cash flow hedge);
(iii) a hedge of a net investment in a foreign operation; or (iv) a
derivative instrument not designated as a hedging instrument (free-standing
derivative). For a fair value hedge, we record changes in the estimated fair
value of the derivative instrument and, to the extent that it is effective,
changes in the fair value of the hedged asset or liability in the current period
earnings in the same financial statement category as the hedged item. For a
cash flow hedge, we record changes in the estimated fair value of the
derivative to the extent that it is effective in other comprehensive income and
subsequently reclassify these changes in estimated fair value to net income in
the same period(s) that the hedged transaction affects earnings. The
effective portion of the cash flow hedge is recorded in the same financial
statement category as the hedged item. For free-standing derivatives, we report
changes in the fair values in other income (loss).
We formally document at inception our hedge relationships, including
identification of the hedging instruments and the hedged items, our risk
management objectives, strategy for undertaking the hedge transaction and our
evaluation of effectiveness of our hedged transactions. Periodically, we also
formally assess whether the derivative designated in each hedging relationship
is expected to be and has been highly effective in offsetting changes in
estimated fair values or cash flows of the hedged item using either the dollar
offset or the regression analysis method. If we determine that a derivative is
not highly effective as a hedge, we discontinue hedge accounting.
We are not required to account for our derivative contracts using hedge
accounting as described above. If we decide not to designate the derivative
contracts as hedges or if we fail to fulfill the criteria necessary to qualify
for hedge accounting, then the changes in the estimated fair values of our
derivative contracts would affect periodic earnings immediately potentially
resulting in the increased volatility of our earnings. The qualification
requirements for hedge accounting are complex and as a result, we must evaluate,
designate, and thoroughly document each hedge transaction at inception and
perform ineffectiveness analysis and prepare related documentation at inception
and on a recurring basis thereafter. As of September 30, 2010, the
estimated fair value of our net derivative liabilities totaled
$88.7 million.
Impairments
We
monitor our available-for-sale securities portfolio for impairments. A loss is
recognized when it is determined that a decline in the estimated fair value of
a security below its amortized cost is other-than-temporary. We consider many
factors in determining whether the impairment of a security is deemed to be
other-than-temporary, including, but not limited to, the length of time the
security has had a decline in estimated fair value below its amortized cost and
the severity of the decline, the amount of the unrealized loss, recent events
specific to the issuer or industry, external credit ratings and recent changes
in such ratings. In addition, for debt securities
we consider our intent to sell the debt security, our estimation of whether or
not we expect to recover the debt securitys entire amortized cost if we intend
to hold the debt security, and whether it is more likely than not that we will
be required to sell the debt security before its anticipated recovery. For
equity securities, we also consider our intent and ability to hold the equity
security for a period of time sufficient for a recovery in value.
The
amount of the loss that is recognized when it is determined that a decline in the
estimated fair value of a security below its amortized cost is
other-than-temporary is dependent on certain factors. If the security is an equity security or if
the security is a debt security that we intend to sell or estimate that it is
more likely than not that we will be required to sell before recovery of its
amortized cost, then the impairment amount recognized in earnings is the entire
difference between the estimated fair value of the security and its amortized
cost. For debt securities that we do not intend to sell or estimate that we are
not more likely than not to be required to sell before recovery, the impairment
is separated into the estimated amount relating to credit loss and the
estimated amount relating to all other factors. Only the estimated credit loss
amount is recognized in earnings, with the remainder of the loss amount
recognized in other comprehensive income.
This process involves a considerable amount of judgment by our
management. As of September 30, 2010, we had aggregate unrealized losses
on our securities classified as available-for-sale of approximately
$5.1 million, which if not recovered may result in the recognition of
future losses. During the three and nine months ended September 30, 2010,
we recorded charges for impairments of securities that we determined to be
other-than-temporary totaling $0.5 million and $1.7 million, respectively.
Allowance for Loan Losses
Our
allowance for loan losses represents our estimate of probable credit losses
inherent in our corporate loan portfolio held for investment as of the balance
sheet date. Estimating our allowance for
loan losses involves a high degree of management judgment and is based upon a
comprehensive review of our loan portfolio that is performed on a quarterly
basis. Our allowance for loan losses
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consists
of two components, an allocated component and an unallocated component. The
allocated component of our allowance for loan losses pertains to specific loans
that we have determined are impaired. We determine a loan is impaired when we
estimate that it is probable that we will be unable to collect all amounts due
according to the contractual terms of the loan agreement. On a quarterly basis
we perform a comprehensive review of our entire loan portfolio and identify
certain loans that we have determined are impaired. Once a loan is identified
as being impaired we place the loan on non-accrual status, unless the loan is
already on non-accrual status, and record a reserve that reflects our best
estimate of the loss that we expect to recognize from the loan. The expected
loss is estimated as being the difference between our current cost basis of the
loan, including accrued interest receivable, and the loans estimated fair
value.
The
unallocated component of our allowance for loan losses reflects our estimate of
probable losses inherent in our loan portfolio as of the balance sheet date
where the specific loan that the loan loss relates to is indeterminable. We
estimate the unallocated component of our allowance for loan losses through a
comprehensive review of our loan portfolio and identify certain loans that
demonstrate possible indicators of impairment. This assessment excludes all
loans that are determined to be impaired and as a result, an allocated reserve
has been recorded as described in the preceding paragraph. Such indicators
include, but are not limited to, the current and/or forecasted financial
performance and liquidity profile of the issuer, specific industry or economic
conditions that may impact the issuer, and the observable trading price of the
loan if available. Loans that demonstrate possible indicators of impairment are
aggregated on a watch list for monitoring and are sub-divided for
categorization based on the seniority of the loan in the issuers capital
structure, whether the loan is secured or unsecured, and the nature of the
collateral securing the loan, for purposes of applying possible default and
loss severity ranges based on the nature of the issuer and the specific loan.
We apply a range of default and loss severity estimates in order to estimate a
range of loss outcomes upon which to base our estimate of probable losses that
results in the determination of the unallocated component of our allowance for
loan losses. As of September 30, 2010, the range of outcomes used to
estimate the probability of default was between 1% and 20% and the range of loss
severity assumptions for loans that may default was between 5% and 85%. The
estimates and assumptions we use to estimate our allowance for loan losses are
based on our estimated range of outcomes that are determined from industry
information providing both historical and forecasted empirical performance of
the type of corporate loans that we invest in, as well as from our own
estimates based on the nature of our corporate loan portfolio. These estimates
and assumptions are susceptible to change due to our corporate loan portfolio
performance as well as industry performance of the corporate loan asset class
and general economic conditions. Changes in the assumptions and estimates used
to estimate our allowance for loan losses could have a material impact on our
financial condition and results of operations.
As of September 30, 2010, our allowance for loan losses totaled
$209.0 million.
Recent Accounting Pronouncements
Consolidation
In February 2010, the
Financial Accounting Standards Board (FASB) issued new guidance deferring the
application of the amended consolidation requirements related to VIEs for a
reporting entitys interest in an entity that has all the attributes of an
investment company or for which it is applies measurement principles that are
consistent with those followed by investment companies. The guidance was
expected to most significantly affect reporting entities in the investment
management industry. Entities including, but not limited to, securitization
entities or entities with multiple levels of subordinated investors such as a
CLO for which the primary purpose of the capital structure of the entity is to
provide credit enhancement to senior interest holders, will not qualify for the
deferral. The guidance was effective for interim and annual reporting periods
beginning after November 15, 2009. The adoption of this new guidance did
not have an effect on our condensed consolidated financial statements.
Financing
Receivables and Allowance for Credit Losses
In July 2010, the FASB
issued new guidance to amend existing disclosure requirements to provide a
greater level of disaggregated information about the credit quality of
financing receivables and allowance for credit losses. The two levels of
disaggregation defined by the FASB are portfolio segment and class of financing
receivable. The amendments also require an entity to disclose credit quality
indicators, past due information, and modifications of financing receivables.
The guidance is effective for interim and annual reporting periods ending on or
after December 15, 2010. We will include the required disclosures
beginning with our consolidated financial statements for the year ended
December 31, 2010.
Results of Operations
Summary
Our
net income for the three and nine months ended September 30, 2010 totaled
$82.3 million (or $0.52 per diluted common share) and $292.9 million (or $1.85
per diluted common share), respectively, as compared to a net income of
$67.2 million (or $0.42 per diluted common share) and $74.8 million (or
$0.49 per diluted common share), for the three and nine months ended
September 30, 2009, respectively.
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Table of Contents
The
increase in net income of $15.2 million for the three months ended September 30,
2010 from the three months ended September 30, 2009 is attributable to
several factors. Net investment income increased by $5.6 million resulting from
lower interest expense due to lower debt balances on our senior secured credit
facility and collateralized loan obligation secured notes. Other income
increased by $13.6 million due to net realized and unrealized gains on
investments, derivatives and foreign exchange totaling $23.3 million.
Other income for the three months ended September 30, 2009 consisted of
net realized and unrealized gains on investments, derivatives and foreign
exchange totaling $41.1 million that were offset by $28.3 million of net
realized and unrealized losses due to write-downs of our residential
mortgage-backed securities holdings and a loss from the restructuring and
extinguishment of debt. The increases in net investment income and other income
were partially offset by an increase in non-investment expenses of $3.6
million.
The
increase in net income of $218.0 million for the nine months ended September 30,
2010 from the nine months ended September 30, 2009 is also attributable to
various factors. Net investment income increased by $75.0 million resulting
from lower interest expense due to lower debt balances on our senior secured
credit facility and collateralized loan obligation secured notes. Other income
increased by $154.3 million due to net realized and unrealized gains on
investments, derivatives and foreign exchange totaling $80.4 million. Other
loss for the nine months ended September 30, 2009 primarily consisted of
net realized and unrealized losses on investments, derivatives and foreign
exchange totaling $26.7 million. The increases in net investment income and
other income were partially offset by an increase in non-investment expenses of
$10.9 million.
The following table presents the components of our net investment
income for the three and nine months ended September 30, 2010 and 2009:
Comparative
Net Investment Income Components
(Amounts in
thousands)
|
|
For the three
months ended
September 30, 2010
|
|
For the three
months ended
September 30, 2009
|
|
For the nine
months ended
September 30, 2010
|
|
For the nine
months ended
September 30, 2009
|
|
Investment Income:
|
|
|
|
|
|
|
|
|
|
Corporate loans and securities interest income
|
|
$
|
96,523
|
|
$
|
92,549
|
|
$
|
273,139
|
|
$
|
295,133
|
|
Residential mortgage loans and securities interest
income
|
|
5,518
|
|
25,369
|
|
19,169
|
|
96,213
|
|
Other interest income
|
|
27
|
|
49
|
|
140
|
|
511
|
|
Dividend income
|
|
2
|
|
26
|
|
1,946
|
|
313
|
|
Net discount accretion
|
|
20,179
|
|
17,243
|
|
69,571
|
|
47,042
|
|
Total investment income
|
|
122,249
|
|
135,236
|
|
363,965
|
|
439,212
|
|
Interest Expense:
|
|
|
|
|
|
|
|
|
|
Collateralized loan obligation secured notes
|
|
16,490
|
|
19,247
|
|
44,271
|
|
98,872
|
|
Senior secured credit facility
|
|
628
|
|
5,164
|
|
12,299
|
|
13,022
|
|
Convertible senior notes
|
|
6,966
|
|
4,969
|
|
21,193
|
|
15,474
|
|
Junior subordinated notes
|
|
3,930
|
|
4,092
|
|
11,698
|
|
12,709
|
|
Residential mortgage-backed securities issued
|
|
|
|
18,940
|
|
|
|
66,043
|
|
Interest rate swap
|
|
2,022
|
|
3,915
|
|
10,730
|
|
10,245
|
|
Other interest expense
|
|
15
|
|
1,013
|
|
211
|
|
3,260
|
|
Total interest expense
|
|
30,051
|
|
57,340
|
|
100,402
|
|
219,625
|
|
Interest expense to affiliates
|
|
5,791
|
|
5,171
|
|
17,072
|
|
16,355
|
|
Provision for loan losses
|
|
8,087
|
|
|
|
8,087
|
|
39,795
|
|
Net investment income
|
|
$
|
78,320
|
|
$
|
72,725
|
|
$
|
238,404
|
|
$
|
163,437
|
|
Due to our adoption of the new guidance related to consolidation of
variable interest entities (as described above under Executive Overview),
certain amounts for the three and nine months ended September 30, 2009,
which were related to the six residential mortgage loan securitization trusts
that we deconsolidated effective January 1, 2010, should be disregarded
for comparative purposes. For the three and nine months ended September 30,
2009, residential mortgage-backed securities issued (RMBS Issued) interest
expense totaled $18.9 million and $66.0 million, respectively, and residential
mortgage loans interest income totaled $20.9 million and $72.2 million, respectively,
related to the six residential mortgage loan securitization trusts which were
deconsolidated.
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Table of Contents
Net
investment income totaled $78.3 million and $238.4 million, respectively, for
the three and nine months ended September 30, 2010 as compared to $72.7
million and $163.4 million, respectively, for the three and nine months ended
September 30, 2009. Excluding the amounts discussed above related to RMBS
Issued and residential mortgage loans, the increase in net investment income
from the three months ended September 30, 2009 to the same period in 2010
was primarily attributable to (i) a modest increase in corporate loans and
securities interest income and (ii) a decline in interest expense due to
the paydown of the senior secured credit facility in July 2010 and a lower
collateralized loan obligations secured notes balance outstanding in 2010.
These benefits were slightly offset by the provision for loan losses recorded
in 2010.
Excluding
the amounts discussed above related to RMBS Issued and residential mortgage
loans, the increase in net investment income from the nine months ended
September 30, 2009 to the same period in 2010 was partly attributable to
lower provision for loan losses recorded in 2010. In addition, total interest
expense decreased due to a significant reduction in the collateralized loan
obligation secured notes balance outstanding from 2009 to 2010. The decline in
collateralized loan obligation secured notes was primarily due to paydowns as a
result of certain CLOs failing one or more of their respective
over-collateralization tests (OC Tests), as well as the replacement of
Wayzata Funding LLC (Wayzata) with CLO 2009-1 on March 31, 2009 and the
subsequent paydown of CLO 2009-1s outstanding senior notes totaling $560.8
million by July 2009.
Other
Income (Loss)
The following table presents the components of other income (loss) for
the three and nine months ended September 30, 2010 and 2009:
Comparative
Other Income (Loss) Components
(Amounts in
thousands)
|
|
For the three
months ended
September 30, 2010
|
|
For the three
months ended
September 30, 2009
|
|
For the nine
months ended
September 30, 2010
|
|
For the nine
months ended
September 30, 2009
|
|
Net realized and unrealized gain (loss) on
derivatives and foreign exchange:
|
|
|
|
|
|
|
|
|
|
Interest rate swaps
|
|
$
|
(3,482
|
)
|
$
|
(3,347
|
)
|
$
|
1,350
|
|
$
|
(2,780
|
)
|
Credit default swaps
|
|
448
|
|
3,928
|
|
1,703
|
|
16,836
|
|
Total rate of return swaps
|
|
98
|
|
18,061
|
|
1,801
|
|
42,774
|
|
Common stock warrants
|
|
84
|
|
|
|
135
|
|
|
|
Foreign exchange(1)
|
|
6,683
|
|
1,288
|
|
(8,426
|
)
|
2,001
|
|
Total net realized and unrealized gain (loss) on
derivatives and foreign exchange
|
|
3,831
|
|
19,930
|
|
(3,437
|
)
|
58,831
|
|
Net realized loss on residential mortgage-backed
securities and residential mortgage loans, carried at estimated fair
value
|
|
(6,206
|
)
|
(1,742
|
)
|
(13,147
|
)
|
(13,418
|
)
|
Net unrealized gain (loss) on residential
mortgage-backed securities, residential mortgage loans, and residential
mortgage-backed securities issued, carried at estimated fair value
|
|
7,698
|
|
(15,939
|
)
|
5,383
|
|
(31,127
|
)
|
Net realized and unrealized gain (loss) on
investments(2)
|
|
21,705
|
|
21,181
|
|
93,782
|
|
(45,563
|
)
|
Net realized and unrealized (loss) gain on
securities sold, not yet purchased
|
|
|
|
(996
|
)
|
(756
|
)
|
2,920
|
|
Impairment of securities available for sale and
private equity investments at cost
|
|
(2,264
|
)
|
|
|
(9,979
|
)
|
(40,013
|
)
|
Net (loss) gain on restructuring and
extinguishment of debt
|
|
|
|
(10,627
|
)
|
39,999
|
|
30,836
|
|
Other income
|
|
1,863
|
|
1,239
|
|
9,085
|
|
4,150
|
|
Total other income (loss)
|
|
$
|
26,627
|
|
$
|
13,046
|
|
$
|
120,930
|
|
$
|
(33,384
|
)
|
(1)
Includes
foreign exchange contracts and foreign exchange gain or loss.
(2)
Includes lower
of cost or estimated fair value adjustment to corporate loans held for sale and
unrealized gain (loss) on investments held at estimated fair value.
40
Table of Contents
For the three and nine months ended September 30, 2009, the
aggregate realized and unrealized gain (loss) on residential mortgage loans and
RMBS Issued related to the six residential mortgage loan securitization trusts
that we deconsolidated effective January 1, 2010. The deconsolidation had
no net impact on our results of operations for the three and nine months ended
September 30, 2010.
Total other income totaled
$26.6 million and $120.9 million, respectively, for the three and nine months
ended September 30, 2010 as compared to other income of $13.0 million and
other loss of $33.4 million, respectively, for the three and nine months ended
September 30, 2009. Total other income increased from the three months
ended September 30, 2009 to 2010 primarily due to net unrealized gain on
residential mortgage-backed securities, carried at estimated fair value
recognized in the third quarter of 2010 partially offset by net realized and
unrealized loss on derivatives and foreign exchange. In addition, in the third
quarter of 2009, there was a $10.6 million net loss on restructuring and
extinguishment of debt representing the payment of a $28.8 million placement
fee to the senior note holders of CLO 2009-1, partially offset by a $14.4
million net gain recognized from the retirement of the CLO 2009-1 subordinated
notes and a $3.8 million gain on the repurchase of $5.0 million of junior
subordinated notes in the third quarter of 2009. Total other income increased
from the nine months ended September 30, 2009 to 2010 primarily due to an
increase in bond and loan market values resulting in a reduction of impairment
write-downs and lower of cost or estimated fair value adjustments for corporate
loans held for sale. In addition, net unrealized gain on residential mortgage
backed securities carried at estimated fair value was recognized in the nine
months ended September 30, 2010. These gains were slightly offset by
foreign exchange losses and realized and unrealized losses on total rate of
returns, all of which we unwound during the first quarter of 2010. As of
September 30, 2010, approximately 3.6% of our total corporate debt
portfolio was foreign denominated, of which the majority was Euro based.
Net
gain (loss) on restructuring and extinguishment of debt totaled nil and $(10.6)
million for the three months ended September 30, 2010 and 2009,
respectively, and net gain on restructuring and extinguishment of debt totaled
$40.0 million and $30.8 million for the nine months ended September 30,
2010 and 2009, respectively. For the nine months ended September 30, 2010,
the $40.0 million primarily consisted of an aggregate gain on extinguishment of
debt totaling $38.7 million which resulted from a purchase of $83.0 million of
notes issued by CLO 2007-A and CLO 2007-1, both of which were previously held
by an affiliate of our Manager, during the first quarter of 2010. For the nine
months ended September 30, 2009, the $30.8 million primarily consisted of
a $34.6 million gain on debt restructuring reflecting the reduction of the
reported amount of debt held by an affiliate of our Manager upon the
replacement of Wayzata with CLO 2009-1 on March 31, 2009.
Non-Investment
Expenses
The following table presents the components of non-investment expenses
for the three and nine months ended September 30, 2010 and 2009:
Comparative
Non-Investment Expense Components
(Amounts in
thousands)
|
|
For the three
months ended
September 30, 2010
|
|
For the three
months ended
September 30, 2009
|
|
For the nine
months ended
September 30, 2010
|
|
For the nine
months ended
September 30, 2009
|
|
Related party management compensation:
|
|
|
|
|
|
|
|
|
|
Base management fees
|
|
$
|
4,870
|
|
$
|
3,720
|
|
$
|
13,708
|
|
$
|
10,998
|
|
Incentive fees
|
|
9,424
|
|
4,472
|
|
30,306
|
|
4,472
|
|
Share-based compensation
|
|
1,943
|
|
2,260
|
|
4,437
|
|
2,225
|
|
CLO management fees
|
|
1,314
|
|
4,164
|
|
4,067
|
|
18,437
|
|
Related party management compensation
|
|
17,551
|
|
14,616
|
|
52,518
|
|
36,132
|
|
Professional services
|
|
1,041
|
|
441
|
|
3,335
|
|
5,916
|
|
Loan servicing
|
|
|
|
1,925
|
|
|
|
6,117
|
|
Insurance
|
|
584
|
|
636
|
|
1,857
|
|
1,242
|
|
Directors expenses
|
|
654
|
|
710
|
|
2,159
|
|
1,402
|
|
General and administrative
|
|
2,323
|
|
193
|
|
6,111
|
|
4,273
|
|
Total non-investment expenses
|
|
$
|
22,153
|
|
$
|
18,521
|
|
$
|
65,980
|
|
$
|
55,082
|
|
For the three and nine months ended September 30, 2009, the entire
loan servicing expense of $1.9 million and $6.1 million, respectively, was
related to the six residential mortgage loan securitization trusts which we
deconsolidated effective January 1, 2010. As such, the $1.9 million and
$6.1 million balances should be disregarded for comparative purposes.
41
Table of Contents
As presented in the table above, our non-investment expenses increased
by approximately $3.6 million from the three months ended September 30,
2009 to 2010 and $10.9 million from the nine months ended September 30,
2009 to 2010. The significant components of non-investment expense are
described below.
Management compensation to related parties consists of base management
fees payable to our Manager pursuant to our management agreement (Management
Agreement), incentive fees, collateral management fees for our CLOs, and
share-based compensation related to restricted common shares and common share
options granted to our Manager.
The
base management fee payable was calculated in accordance with the Management
Agreement and is based on an annual rate of 1.75% times our equity as defined
in the Management Agreement. Base management fees increased by $1.2 million and
$2.7 million, from the three and nine months ended September 30, 2009 to
2010, respectively. Our Manager is also entitled to a quarterly incentive fee
provided that our quarterly net income, as defined in the Management
Agreement, before the incentive fee exceeds a defined return hurdle. During the
three and nine months ended September 30, 2010, our Manager earned $9.4
million and $30.3 million, respectively, of incentive fees. The $30.3 million
of incentive fees earned for the nine months ended September 30, 2010 is
net of a $9.7 million amount waived. During the three months ended
March 31, 2010, our Manager permanently waived payment of $9.7 million of
incentive fees that were related to the $38.7 million gain recorded by us
as a result of the repurchase of $83.0 million of mezzanine and subordinate
notes issued by CLO 2007-1 and CLO 2007-A. Incentive fees are included in
related party management compensation on our condensed consolidated statement
of operations. During both the three and nine months ended September 30,
2009, our Manager earned $4.5 million of incentive fees.
An affiliate of our Manager has entered into separate management
agreements with CLO 2005-1, CLO 2005-2, CLO 2006-1, CLO 2007-1, CLO 2007-A and
CLO 2009-1 and is entitled to receive fees for the services performed as
collateral manager. Previously, the collateral manager had waived the fees it
earned for providing management services for our CLOs. Beginning April 15,
2007, the collateral manager ceased waiving fees for CLO 2005-1 and
beginning January 1, 2009, the collateral manager ceased waiving fees for
CLO 2005-2, CLO 2006-1, CLO 2007-1, CLO 2007-A and Wayzata
(restructured and replaced with CLO 2009-1 on March 31, 2009). Beginning
in July 2009, the collateral manager reinstated waiving the CLO management
fees for CLO 2005-2 and CLO 2006-1. In addition, due to CLO 2007-A and CLO
2007-1 regaining compliance with their respective OC Tests during the first
quarter of 2010, the collateral manager also reinstated waiving the CLO
management fees for CLO 2007-A and CLO 2007-1. For the three and nine months
ended September 30, 2010, the collateral manager waived an aggregate of
$8.7 million and $21.9 million, respectively, for CLO 2005-2, CLO 2006-1, CLO
2007-1 and CLO 2007-A. In addition, due to the deleveraging of CLO 2009-1
completed in July 2009 whereby all the senior notes were retired, the
collateral manager is no longer entitled to receive fees for CLO 2009-1.
Accordingly, CLO management fees decreased $2.9 million from the three months
ended September 30, 2009 to 2010 and $14.4 million from the nine months
ended September 30, 2009 to 2010, to account for all six CLOs paying CLO
management fees during the first half of 2009.
In addition, beginning January 1, 2009, our Manager permanently
waived reimbursable general and administrative expenses allocable to us in an
amount equal to the incremental CLO management fees received by the Manager.
Effective June 2010, all incremental CLO management fees received by the
Manager in 2009 had been fully applied to offset reimbursable general and
administrative expenses allocable to us. Accordingly, reimbursable general and
administrative expenses were charged and paid by us beginning in June 2010.
For the three and nine months ended September 30, 2010, our Manager
permanently waived reimbursement of nil and $2.4 million, respectively, in
allocable general and administrative expenses. For the three and nine months
ended September 30, 2009, the Manager permanently waived reimbursement of
$2.4 million and $7.7 million, respectively, in allocable general and
administrative expenses.
General and administrative expenses include expenses incurred by our
Manager on our behalf that are reimbursable to our Manager pursuant to the
Management Agreement. General and administrative expenses increased $2.1
million and $1.8 million from the three and nine months ended September 30,
2009 to 2010, respectively, primarily due to the fact that there were no
remaining incremental CLO management fees to offset these expenses as described
above. Professional services expenses consist of legal, accounting and other
professional services. Professional fees increased $0.6 million from the three
months ended September 30, 2009 to 2010 and decreased $2.6 million from
the nine months ended September 30, 2009 to 2010. Directors expenses
represent share-based compensation, as well as expenses and reimbursables due
to the board of directors for their services.
Income Tax Provision
We intend to continue to operate so as to qualify as a partnership, and
not as an association or publicly traded partnership that is taxable as a
corporation, for United States federal income tax purposes. Therefore, we generally
are not subject to United States federal income tax at the entity level, but
are subject to limited state and foreign 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.
42
Table of Contents
During 2010, we owned an equity interest in KKR Financial Holdings
II, LLC (KFH II), which has elected to be taxed as a real estate
investment trust (a REIT) under the Internal Revenue Code of 1986, as amended
(the Code). KFH II holds certain real estate mortgage-backed securities. A
REIT generally 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 with us for
United States federal income tax purposes. For financial reporting purposes,
current and deferred taxes are provided for on the portion of earnings
recognized by us with respect to our interest in 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. No provisions for income
taxes for the quarter ended September 30, 2010 were recorded for the
foreign corporate subsidiaries; however, we are generally required to include
their current taxable income in our calculation of taxable income allocable to
shareholders. CLO 2005-1, CLO 2005-2, CLO 2006-1, CLO 2007-1, CLO 2007-A and
CLO 2009-1 are our foreign subsidiaries that elected to be treated as
disregarded entities or partnerships for United States federal income tax
purposes. These subsidiaries were established to facilitate securitization
transactions, structured as secured financing transactions.
Investment
Portfolio
Corporate Debt Investment Portfolio
Summary
Our corporate debt investment portfolio primarily consists of
investments in corporate loans and debt securities. Our corporate loans
primarily consist of senior secured, second lien and subordinated loans. The
corporate loans we invest in are primarily below investment grade and are
floating rate indexed to either one-month or three-month LIBOR. Our investments
in corporate debt securities primarily consist of investments in below
investment grade corporate bonds that are senior secured, senior unsecured and
subordinated. We evaluate and monitor the asset quality of our investment
portfolio by performing detailed credit reviews and by monitoring key credit
statistics and trends. The key credit statistics and trends we monitor to
evaluate the quality of our investments include credit ratings of both our
investments and the issuer, financial performance of the issuer including
earnings trends, free cash flows of the issuer, debt service coverage ratios of
the issuer, financial leverage of the issuer, and industry trends that have or
may impact the issuers current or future financial performance and debt
service ability.
Corporate
Loans
Our corporate loan portfolio had an aggregate par value of $7.1 billion
and $7.4 billion as of September 30, 2010 and December 31, 2009,
respectively. Our corporate loan portfolio consists of debt obligations of
corporations, partnerships and other entities in the form of senior secured
loans, second lien loans and subordinated loans.
The following table summarizes our corporate loans portfolio stratified
by type as of September 30, 2010 and December 31, 2009. Loans that
are not deemed to be held for sale are carried at amortized cost net of
allowance for loan losses on our condensed consolidated balance sheets. Loans
that are classified as held for sale are carried at the lower of net amortized
cost or estimated fair value on our condensed consolidated balance sheets.
43
Table of Contents
Corporate
Loans
(Amounts in
thousands)
|
|
September 30, 2010 (1)
|
|
December 31, 2009 (1)
|
|
|
|
Par
|
|
Carrying
Value
|
|
Amortized
Cost
|
|
Estimated
Fair Value
|
|
Par
|
|
Carrying
Value
|
|
Amortized
Cost
|
|
Estimated
Fair Value
|
|
Senior secured
|
|
$
|
6,253,440
|
|
$
|
5,967,363
|
|
$
|
5,967,363
|
|
$
|
5,794,733
|
|
$
|
6,538,799
|
|
$
|
6,093,463
|
|
$
|
6,093,463
|
|
$
|
5,774,248
|
|
Second lien
|
|
669,742
|
|
611,684
|
|
611,684
|
|
532,526
|
|
685,479
|
|
638,052
|
|
638,052
|
|
560,038
|
|
Subordinated
|
|
196,416
|
|
127,281
|
|
127,281
|
|
159,093
|
|
147,887
|
|
81,073
|
|
81,073
|
|
79,337
|
|
Subtotal
|
|
7,119,598
|
|
6,706,328
|
|
6,706,328
|
|
6,486,352
|
|
7,372,165
|
|
6,812,588
|
|
6,812,588
|
|
6,413,623
|
|
Lower of cost or fair value adjustment
|
|
|
|
(14,558
|
)
|
|
|
|
|
|
|
(31,637
|
)
|
|
|
|
|
Allowance for loan losses
|
|
|
|
(209,030
|
)
|
|
|
|
|
|
|
(237,308
|
)
|
|
|
|
|
Total
|
|
$
|
7,119,598
|
|
$
|
6,482,740
|
|
$
|
6,706,328
|
|
$
|
6,486,352
|
|
$
|
7,372,165
|
|
$
|
6,543,643
|
|
$
|
6,812,588
|
|
$
|
6,413,623
|
|
(1)
Includes loans
held for sale.
As of September 30, 2010, $7.1 billion, or 99.3%, of our
corporate loan portfolio was floating rate and $48.7 million, or 0.7%, was
fixed rate. In addition, as of September 30, 2010, $270.4 million par
amount, or 3.8%, of our corporate loan portfolio was denominated in foreign
currencies, of which 94.5% was denominated in Euro. As of December 31,
2009, $7.2 billion, or 98.3%, of our corporate loan portfolio was floating
rate and $0.1 billion, or 1.7%, was fixed rate. In addition, as of
December 31, 2009, $210.7 million par amount, or 2.9%, of our corporate
loan portfolio was denominated in foreign currencies, of which 100% was
denominated in Euro. Fixed and floating amounts and percentages are based on
par values.
All of our floating rate corporate loans have index reset frequencies
of less than twelve months with the majority resetting at least quarterly. The
weighted-average coupon of our floating rate corporate loans was 4.3% and 3.7%
as of September 30, 2010 and December 31, 2009, respectively, and the
weighted-average coupon spread to LIBOR of our floating rate corporate loan portfolio
was 3.6% and 3.1% as of September 30, 2010 and December 31, 2009,
respectively. The weighted-average years to maturity of our floating rate
corporate loans was 4.3 years as of both September 30, 2010 and
December 31, 2009. As of September 30, 2010 and December 31,
2009, $1.5 billion par amount, or 21.2%, and $0.6 billion par amount, or 8.8%,
respectively, of our floating rate corporate loan portfolio had interest rate
floors.
As of September 30, 2010, our fixed rate corporate loans had a
weighted-average coupon of 12.8% and weighted-average years to maturity of
4.3 years, as compared to 13.6% and 5.4 years, respectively, as of
December 31, 2009.
Loans placed on non-accrual status may or may not be contractually past
due at the time of such determination. When placed on non-accrual status,
previously recognized accrued interest is reversed and charged against current
income. While on non-accrual status, interest income is recognized using the
cost-recovery method, cash-basis method or some combination of the two methods.
A loan is placed back on accrual status when the ultimate collectability of the
principal and interest is not in doubt.
As of September 30, 2010 and December 31, 2009, we had loans
on non-accrual status with a total amortized cost of $167.1 million and $439.9
million, respectively. The average investment in impaired loans during the
three and nine months ended September 30, 2010 was $178.4 million and
$262.5 million, respectively, and during the three and nine months ended
September 30, 2009, the average recorded investment in impaired loans was
$717.3 million and $544.2 million, respectively. As of September 30, 2010
and 2009, the allocated component of the allowance for loan losses included all
impaired loans for the respective periods. The amount of interest income
recognized using the cash-basis method during the time within the period that
the loans were impaired was $4.1 million and $11.1 million for the three and
nine months ended September 30, 2010, respectively, and $8.2 million and
$15.0 million for the three and nine months ended September 30, 2009,
respectively.
As of September 30, 2010, we held corporate loans that were in
default with a total amortized cost of $19.7 million from two issuers. As of
December 31, 2009, we held corporate loans that were in default with a
total amortized cost of $392.5 million from seven issuers. The majority of
corporate loans in default during 2010 and 2009 were included in the loans for
which the allocated component of the allowance for losses was related to or in
those investments for which we determined were loans held for sale as of
September 30, 2010 and December 31, 2009, respectively.
44
Table of Contents
The following table summarizes the changes in the allowance for loan
losses for the three and nine months ended September 30, 2010 and 2009
(amounts in thousands):
|
|
For the three
months ended
September 30, 2010
|
|
For the three
months ended
September 30, 2009
|
|
For the nine
months ended
September 30, 2010
|
|
For the nine
months ended
September 30, 2009
|
|
Balance at beginning of period
|
|
$
|
210,218
|
|
$
|
473,202
|
|
$
|
237,308
|
|
$
|
480,775
|
|
Provision for loan losses
|
|
8,087
|
|
|
|
8,087
|
|
39,795
|
|
Charge-offs
|
|
(9,275
|
)
|
(2,978
|
)
|
(36,365
|
)
|
(50,346
|
)
|
Balance at end of period
|
|
$
|
209,030
|
|
$
|
470,224
|
|
$
|
209,030
|
|
$
|
470,224
|
|
As
of September 30, 2010 and December 31, 2009, we had an allowance for
loan losses of $209.0 million and $237.3 million, respectively. As
described under Critical Accounting Policies, our allowance for loan losses
represents our estimate of probable credit losses inherent in our corporate
loan portfolio held for investment as of the balance sheet date. Estimating our
allowance for loan losses involves a high degree of management judgment and is
based upon a comprehensive review of our loan portfolio that is performed on a
quarterly basis. Our allowance for loan losses consists of two components, an
allocated component and an unallocated component. The allocated component of
our allowance for loan losses pertains to specific loans that we have
determined are impaired. We determine a loan is impaired when we estimate that
it is probable that we will be unable to collect all amounts due according to
the contractual terms of the loan agreement. On a quarterly basis we perform a
comprehensive review of our entire loan portfolio and identify certain loans
that we have determined are impaired. Once a loan is identified as being
impaired we place the loan on non-accrual status, unless the loan is already on
non-accrual status, and record a reserve that reflects our best estimate of the
loss that we expect to recognize from the loan. The expected loss is estimated
as being the difference between our current cost basis of the loan, including
accrued interest receivable, and the loans estimated fair value.
The
unallocated component of our allowance for loan losses reflects our estimate of
probable losses inherent in our loan portfolio as of the balance sheet date
where the specific loan that the loan loss relates to is indeterminable. We
estimate the unallocated component of our allowance for loan losses through a
comprehensive review of our loan portfolio and identify certain loans that demonstrate
possible indicators of impairment. This assessment excludes all loans that are
determined to be impaired and as a result, an allocated reserve has been
recorded as described in the preceding paragraph. Such indicators include, but
are not limited to, the current and/or forecasted financial performance and
liquidity profile of the issuer, specific industry or economic conditions that
may impact the issuer, and the observable trading price of the loan if
available. Loans that demonstrate possible indicators of impairment are
aggregated on a watch list for monitoring and are sub-divided for
categorization based on the seniority of the loan in the issuers capital
structure, whether the loan is secured or unsecured, and the nature of the
collateral securing the loan, for purposes of applying possible default and
loss severity ranges based on the nature of the issuer and the specific loan.
We apply a range of default and loss severity estimates in order to estimate a
range of loss outcomes upon which to base our estimate of probable losses that
results in the determination of the unallocated component of our allowance for
loan losses.
As of September 30, 2010, the allocated component of the allowance
for loan losses totaled $53.0 million and relates to investments in certain
loans issued by six issuers with an aggregate par amount of $228.0 million and
an aggregate amortized cost amount of $151.0 million. In addition, certain
impaired loans from three of these issuers with an aggregate par amount of
$85.1 million and an aggregate amortized cost amount of $16.9 million had no
associated allowance for loan losses as our amortized cost basis for these
loans was below the estimated fair value as of September 30, 2010. As of
December 31, 2009, the allocated component of the allowance for loan
losses totaled $81.7 million and relates to investments in loans issued by six
issuers with an aggregate par amount of $223.6 million and an aggregate
amortized cost amount of $121.2 million.
The unallocated component of our allowance for loan losses totaled
$156.0 million and $155.6 million as of September 30, 2010 and
December 31, 2009, respectively. During the three and nine months ended
September 30, 2010, we recorded charge-offs totaling $9.3 million and
$36.4 million, respectively, comprised primarily of loans transferred to loans
held for sale. We recorded charge-offs totaling $3.0 million and $50.4 million
for the three and nine months ended September 30, 2009, respectively.
As of September 30, 2010, we had $667.2 million of loans held for
sale, a decrease of $258.5 million from December 31, 2009 due to the sale
of certain loans and the transfer of loans to held for investment for those we
determined we no longer had the intention of selling. We reduced the lower of
cost or estimated fair value allowance by $8.8 million for the three months
ended September 30, 2010 and recorded a net charge to earnings of $21.4
million for the nine months ended September 30, 2010 for certain loans
held for sale which had a carrying value of $667.2 million as of
September 30, 2010. We reduced the lower of cost or estimated fair value
allowance by $0.8 million for the three months ended September 30, 2009
and recorded a net charge to earnings of $38.9 million for the nine months
ended September 30, 2009 for certain loans held for sale which had a
carrying value of $504.1 million as of September 30, 2009.
45
Table of Contents
Corporate
Debt Securities
Our corporate debt securities portfolio had an aggregate par value of
$892.9 million and $834.1 million as of September 30, 2010 and
December 31, 2009, respectively. Our corporate debt securities portfolio
consists of debt obligations of corporations, partnerships and other entities
in the form of senior secured, senior unsecured and subordinated bonds.
The following table summarizes our corporate debt securities portfolio,
which is carried at estimated fair value, stratified by type as of
September 30, 2010 and December 31, 2009:
Corporate
Debt Securities
(Amounts in
thousands)
|
|
September 30, 2010
|
|
December 31, 2009
|
|
|
|
Par
|
|
Carrying
Value
|
|
Amortized
Cost
|
|
Estimated Fair
Value
|
|
Par
|
|
Carrying
Value
|
|
Amortized
Cost
|
|
Estimated Fair
Value
|
|
Senior secured
|
|
$
|
260,982
|
|
$
|
257,831
|
|
$
|
243,798
|
|
$
|
257,831
|
|
$
|
178,503
|
|
$
|
156,410
|
|
$
|
99,202
|
|
$
|
156,410
|
|
Senior unsecured
|
|
494,703
|
|
478,677
|
|
350,323
|
|
478,677
|
|
455,937
|
|
425,683
|
|
318,216
|
|
425,683
|
|
Subordinated
|
|
137,231
|
|
112,514
|
|
83,387
|
|
112,514
|
|
199,690
|
|
172,316
|
|
143,219
|
|
172,316
|
|
Total
|
|
$
|
892,916
|
|
$
|
849,022
|
|
$
|
677,508
|
|
$
|
849,022
|
|
$
|
834,130
|
|
$
|
754,409
|
|
$
|
560,637
|
|
$
|
754,409
|
|
As of September 30, 2010, $727.8 million, or 81.5%, of our
corporate debt securities portfolio was fixed rate and $165.1 million, or
18.5%, was floating rate. In addition, as of September 30, 2010, $15.8
million par amount, or 1.8%, of our corporate debt securities portfolio, was
denominated in foreign currencies, of which 56.7% was denominated in British pound
sterling. As of December 31, 2009, $647.4 million, or 77.6%, of our
corporate debt securities portfolio was fixed rate and $186.7 million, or
22.4%, was floating rate. In addition, as of December 31, 2009, we had no
corporate debt securities denominated in foreign currencies. Fixed and floating
amounts and percentages are based on par values.
As of September 30, 2010, our fixed rate corporate debt securities
had a weighted-average coupon of 9.2% and weighted-average years to maturity of
6.3 years, as compared to 10.0% and 6.2 years, respectively, as of
December 31, 2009. All of our floating rate corporate debt securities have
index reset frequencies of less than twelve months. The weighted-average coupon
on our floating rate corporate debt securities was 6.2% and 3.6% as of
September 30, 2010 and December 31, 2009, respectively, and the
weighted-average coupon spread to LIBOR of our floating rate corporate debt
securities was 5.4% and 3.4% as of September 30, 2010 and
December 31, 2009, respectively. The weighted-average years to maturity of
our floating rate corporate debt securities was 3.5 years and 4.1 years as
of September 30, 2010 and December 31, 2009, respectively. As of
September 30, 2010, $23.2 million par amount, or 14.0%, of our floating
rate corporate debt securities portfolio had interest rate floors and as of
December 31, 2009, none of our floating rate corporate debt securities had
interest rate floors.
During the three and nine months ended September 30, 2010, we
recorded impairment losses totaling $0.5 million and $1.7 million,
respectively, for corporate debt and equity securities that we determined to be
other-than-temporarily impaired. These securities were determined to be
other-than-temporarily impaired either due to our determination that recovery
in value is no longer likely or because we decided to sell the respective
security in response to specific credit concerns regarding the issuer. For the
three and nine months ended September 30, 2009, we recorded impairment
losses totaling nil and $40.0 million, respectively, for corporate debt and
equity securities that we determined to be other-than-temporarily impaired.
As of September 30, 2010 and December 31, 2009, we had no
corporate debt securities in default.
Residential Mortgage Investment Summary
Our residential mortgage investment portfolio consists of investments
in RMBS with an estimated fair value of $106.3 million as of
September 30, 2010.
As our condensed consolidated financial statements included in this
Quarterly Report on Form 10-Q are presented to reflect the deconsolidation
of the aforementioned six residential mortgage securitization trusts beginning
January 1, 2010, the information contained in this Managements Discussion
and Analysis of Financial Condition and Results of Operations reflects our
residential mortgage portfolio presented on a deconsolidated basis consistent
with the disclosures in our condensed consolidated financial statements. See Executive
Overview Consolidation for further discussion.
The table below summarizes the carrying value, amortized cost and
estimated fair value of our residential mortgage investment portfolio as of
September 30, 2010 and December 31, 2009. Carrying value is the value
that investments are recorded on our condensed consolidated balance sheets and
is estimated fair value for RMBS and residential mortgage loans. Estimated fair
values set forth in the tables below are based on dealer quotes, nationally
recognized pricing services and/or managements judgment when relevant
observable inputs do not exist.
46
Table of
Contents
Residential
Mortgage Investment Portfolio
(Amounts in
thousands)
|
|
September 30, 2010
|
|
December 31, 2009
|
|
|
|
Carrying
Value
|
|
Amortized
Cost
|
|
Estimated
Fair Value
|
|
Carrying
Value
|
|
Amortized
Cost
|
|
Estimated
Fair Value
|
|
Residential Mortgage Loans(1)
|
|
$
|
|
|
$
|
|
|
$
|
|
|
$
|
2,097,699
|
|
$
|
2,772,216
|
|
$
|
2,097,699
|
|
Residential Mortgage-Backed Securities
|
|
106,252
|
|
273,631
|
|
106,252
|
|
47,572
|
|
95,483
|
|
47,572
|
|
Total
|
|
$
|
106,252
|
|
$
|
273,631
|
|
$
|
106,252
|
|
$
|
2,145,271
|
|
$
|
2,867,699
|
|
$
|
2,145,271
|
|
(1)
Excludes real
estate owned (REO) as a result of foreclosure on delinquent loans of $11.4
million as of December 31, 2009.
As of December 31, 2009, 26 of our residential mortgage loans owned
by us with an outstanding balance of $11.4 million were REO as a result of
foreclosure on delinquent loans.
Portfolio Purchases
We purchased $0.5 billion and $2.3 billion par amount of corporate
debt investments during the three months and nine months ended
September 30, 2010, respectively, as compared to $0.3 billion and $0.9
billion for the three and nine months ended September 30, 2009,
respectively.
The table below summarizes our corporate debt investment portfolio
purchases for the three and nine months ended September 30, 2010 and 2009:
Investment
Portfolio Purchases
(Dollar
amounts in thousands)
|
|
Three months ended
September 30, 2010
|
|
Three months ended
September 30, 2009
|
|
Nine months ended
September 30, 2010
|
|
Nine months ended
September 30, 2009
|
|
|
|
Par Amount
|
|
%
|
|
Par Amount
|
|
%
|
|
Par Amount
|
|
%
|
|
Par Amount
|
|
%
|
|
Corporate Debt Securities
|
|
$
|
41,586
|
|
8.4
|
%
|
$
|
52,052
|
|
20.1
|
%
|
$
|
383,886
|
|
16.5
|
%
|
$
|
94,615
|
|
10.2
|
%
|
Corporate Loans
|
|
456,090
|
|
91.6
|
|
206,873
|
|
79.9
|
|
1,939,943
|
|
83.5
|
|
831,091
|
|
89.8
|
|
Total
|
|
$
|
497,676
|
|
100.0
|
%
|
$
|
258,925
|
|
100.0
|
%
|
$
|
2,323,829
|
|
100.0
|
%
|
$
|
925,706
|
|
100.0
|
%
|
The table above excludes purchases of equity investments, at estimated
fair value, of $7.3 million and $20.1 million for the three and nine months
ended September 30, 2010, respectively, and nil for the three and nine
months ended September 30, 2009.
The period immediately preceding 2009 was marked by historical asset
price declines, wider credit spreads and liquidity shortage. As such, during
the beginning of 2009, the market continued to feel the effects of the 2008
credit crisis. In contrast, due to greater access to liquidity and capital
appreciation during 2010, we had additional cash available for opportunistic
purchases. The majority of our purchases during the three and nine months ended
September 30, 2010 were through our Cash Flow CLOs.
Shareholders Equity
Our shareholders equity at September 30, 2010 and
December 31, 2009 totaled $1.4 billion and $1.2 billion, respectively.
Included in our shareholders equity as of September 30, 2010 and
December 31, 2009 is accumulated other comprehensive income totaling $85.5
million and $152.7 million, respectively.
Our average shareholders equity and return on average shareholders
equity for the three and nine months ended September 30, 2010 was
$1.3 billion and 24.7% and $1.3 billion and 30.4%, respectively. Our average shareholders equity and return
on average shareholders equity for the three and nine months ended
September 30, 2009 was $1.0 billion and 26.5%, and $841.8 million and
11.9%, respectively. Return on average shareholders equity is defined as net
income divided by weighted average shareholders equity.
Our book value per share as of September 30, 2010 and
December 31, 2009 was $8.60 and $7.37, respectively, and is computed based
on 158,412,565 and 158,359,757 shares issued and outstanding as of
September 30, 2010 and December 31, 2009, respectively.
On April 29, 2010, our board of directors declared a cash
distribution of $0.10 per share to shareholders of record on May 14, 2010.
The aggregate amount of the distribution of $15.8 million was paid on
May 28, 2010.
47
Table of Contents
On August 4, 2010, our board of
directors
declared a cash distribution of $0.12 per share to shareholders of
record on August 18, 2010. The aggregate amount of the distribution of
$19.0 million was paid on September 1, 2010.
On November 3, 2010, our board of
directors
declared a cash distribution for the quarter ended September 30,
2010 on our common shares of $0.14 per share. The distribution is payable on
December 1, 2010 to common shareholders of record as of the close of
business on November 17, 2010.
Liquidity and Capital Resources
We
actively manage our liquidity position with the objective of preserving our
ability to fund our operations and fulfill our commitments on a timely and
cost-effective basis. As of September 30, 2010, we had unrestricted cash
and cash equivalents totaling $97.0 million.
Although
we believe our current sources of liquidity are adequate to preserve our
ability to fund our operations and fulfill our commitments, we will continue to
evaluate opportunities to deploy incremental capital based on the terms of
capital available to us. This may include taking advantage of market timing to
issue equity or refinance or replace indebtedness, including the issuance of
new debt securities and retiring debt pursuant to privately negotiated
transactions, open market purchases or otherwise.
The majority of our investments are held in our Cash Flow CLOs.
Accordingly, the majority of our cash flows have historically been received
from our investments in the mezzanine and subordinated notes of our Cash Flow
CLOs. However, during the period in which a Cash Flow CLO is not in compliance
with an OC Test as outlined in its respective indenture, the cash flows we
would generally expect to receive from our Cash Flow CLO holdings are paid to the
senior note holders of the Cash Flow CLOs. During the quarter ended
September 30, 2010, all our Cash Flow CLOs were in compliance with certain
compliance tests (specifically, their respective OC Tests). As CLO 2007-A and
CLO 2007-1 came into compliance during the first quarter of 2010, both CLOs
resumed paying mezzanine and/or subordinate note holders, including us, during
2010.
Sources of Funds
Cash Flow
CLO Transactions
As of September 30, 2010, we had five Cash Flow CLOs outstanding.
An affiliate of our Manager owns an interest in the junior notes of both
CLO 2007-1 and CLO 2007-A. The aggregate carrying amount of the junior
notes in CLO 2007-1 and CLO 2007-A held by the affiliate of our Manager is
$371.1 million as of September 30, 2010 and is reflected as
collateralized loan obligation junior secured notes to affiliates on our
condensed consolidated balance sheets.
In accordance with GAAP, we consolidate each of these Cash Flow CLOs as
we have the power to direct the activities of these VIEs, as well as the
obligation to absorb losses of the VIEs and the right to receive benefits of
the VIEs that could potentially be significant to the VIEs. We utilize CLOs to
fund our investments in corporate loans and corporate debt securities. The
indentures governing our Cash Flow CLOs include numerous compliance tests, the
majority of which relate to the CLOs portfolio profile. In the event that a
portfolio profile test is not met, the indenture places restrictions on the
ability of the CLOs manager to reinvest available principal proceeds generated
by the collateral in the CLOs until the specific test has been cured. In
addition to the portfolio profile tests, the indentures for the Cash Flow CLOs
include OC Tests which set the ratio of the collateral value of the assets in
the CLO to the tranches of debt for which the test is being measured, as well
as interest coverage tests. For purposes of the calculation, collateral value
is the par value of the assets unless an asset is in default, is a discounted
obligation, or is a CCC-rated asset in excess of the percentage of CCC-rated
asset limit specified for each Cash Flow CLO.
If an asset is in default, the indenture for each Cash Flow CLO
transaction defines the value used to determine the collateral value, which
value is the lower of market value of the asset or the recovery value
proscribed for the asset based on its type and rating by Standard &
Poors or Moodys.
A discount obligation is an asset with a purchase price of less than a
particular percentage of par. The discount obligation amounts are specified in
each Cash Flow CLO and are generally set at a purchase price of less than 80%
of par for corporate loans and 75% of par for corporate debt securities.
The indenture for each Cash Flow CLO specifies a CCC-threshold for the
percentage of total assets in the CLO that can be rated CCC. All assets in
excess of the CCC threshold specified for the respective CLO are included in
the OC Tests at market value and not par.
48
Table of Contents
Defaults of assets in Cash Flow CLOs, ratings downgrade of assets in
Cash Flow CLOs to CCC, price declines of CCC assets in excess of the proscribed
CCC threshold amount, and price declines in assets classified as discount
obligations may reduce the over-collateralization ratio such that a Cash Flow
CLO is not in compliance. If a Cash Flow CLO is not in compliance with an OC
Test, cash flows normally payable to the holders of junior classes of notes
will be used by the CLO to amortize the most senior class of notes until such
point as the OC Test is brought back into compliance. As a result of the
historic declines in asset prices, particularly in the corporate loan and high
yield securities asset classes during the fourth quarter of 2008, one or more
of our Cash Flow CLOs were out of compliance with the OC Tests for periods of
time. While being out of compliance with an OC Test would not impact our investment
portfolio or results of operations, it would impact our unrestricted cash flows
available for operations, new investments and dividend distributions. As of
September 30, 2010, all of our Cash Flow CLOs were in compliance with
their respective OC Tests. The following table summarizes several of the
material tests and metrics for each of our Cash Flow CLOs. This information is
based on the September 2010 monthly reports which are prepared by the
independent third-party trustee for each Cash Flow CLO:
·
Investments:
The par value of the investments in each CLO plus principal cash in the CLO.
·
Senior interest
coverage (IC) ratio minimum: Minimum required ratio of interest income earned
on investments to interest expense on the senior debt issued by the CLO per the
respective CLOs indenture.
·
Actual senior
IC ratio: The ratio is interest income earned on the investments divided by
interest expense on the senior debt issued by the CLO.
·
CCC amount: The
par amount of assets rated CCC or below (excluding defaults, if any).
·
CCC threshold
percentage: Maximum amount of assets in portfolio that are rated CCC without
being subject to being valued at fair value for purposes of the OC Tests.
·
Senior OC Test
minimum: Minimum senior over-collateralization requirement per the respective
CLOs indenture.
·
Actual senior
OC Test: Actual senior over-collateralization amount as of the
September 2010 report date.
·
Actual cushion
/ (excess): Dollar amount that over-collateralization test is being passed,
cushion, or failed (excess).
·
Subordinated OC
Test minimum: Minimum subordinated over-collateralization requirement per the
respective CLOs indenture.
·
Actual
subordinated OC Test: Actual subordinated over-collateralization amount as of
September 2010 report date.
·
Subordinate
cushion / (excess): Dollar amount that the OC Test is being passed, cushion, or
failed (excess).
(dollar amounts in thousands)
|
|
CLO 2005-1
|
|
CLO 2005-2
|
|
CLO 2006-1
|
|
CLO 2007-1
|
|
CLO 2007-A
|
|
Investments
|
|
$
|
1,041,099
|
|
$
|
996,356
|
|
$
|
1,035,333
|
|
$
|
3,315,598
|
|
$
|
1,513,407
|
|
Senior IC ratio minimum
|
|
115.0
|
%
|
125.0
|
%
|
115.0
|
%
|
115.0
|
%
|
120.0
|
%
|
Actual senior IC ratio
|
|
468.1
|
%
|
843.8
|
%
|
501.2
|
%
|
667.0
|
%
|
441.9
|
%
|
CCC amount
|
|
$
|
41,264
|
|
$
|
39,377
|
|
$
|
157,253
|
|
$
|
536,695
|
|
$
|
219,458
|
|
CCC percentage of portfolio
|
|
4.0
|
%
|
4.0
|
%
|
15.2
|
%
|
16.2
|
%
|
14.5
|
%
|
CCC threshold percentage
|
|
5.0
|
%
|
7.5
|
%
|
7.5
|
%
|
7.5
|
%
|
7.5
|
%
|
Senior OC Test minimum
|
|
119.4
|
%
|
123.0
|
%
|
143.1
|
%
|
159.1
|
%
|
119.7
|
%
|
Actual senior OC Test
|
|
131.9
|
%
|
133.8
|
%
|
161.3
|
%
|
178.1
|
%
|
132.8
|
%
|
Cushion / (Excess)
|
|
$
|
96,443
|
|
$
|
80,134
|
|
$
|
110,728
|
|
$
|
336,847
|
|
$
|
144,495
|
|
Subordinated OC Test minimum
|
|
106.2
|
%
|
106.9
|
%
|
114.0
|
%
|
120.1
|
%
|
109.9
|
%
|
Actual subordinated OC Test
|
|
112.8
|
%
|
118.8
|
%
|
137.7
|
%
|
124.0
|
%
|
114.9
|
%
|
Cushion / (Excess)
|
|
$
|
59,357
|
|
$
|
99,268
|
|
$
|
168,749
|
|
$
|
100,131
|
|
$
|
63,288
|
|
On January 4, 2010, CLO 2007-A was brought into compliance with
its respective OC Tests. Also, on March 19, 2010, CLO 2007-1, our final
remaining Cash Flow CLO to be failing one or more of its respective OC Tests,
was brought into compliance with all of its respective OC Tests. Accordingly,
beginning in April 2010, CLO 2007-A resumed paying mezzanine and
subordinate note holders, including us. In addition, beginning in August 2010,
CLO 2007-1 resumed paying mezzanine note holders, including us. As reflected in
the table above, each of our Cash Flow CLOs was in compliance with its
respective IC ratio tests, senior OC Tests and subordinate OC Tests based on
the September 2010 monthly reports for the respective CLOs.
49
Table of Contents
During the three months ended March 31, 2010, in an open market
auction, we purchased $10.3 million of mezzanine notes issued by CLO 2007-A for
$5.5 million and $72.7 million of mezzanine and subordinate notes issued by CLO
2007-1 for $38.8 million, both of which were previously held by an affiliate of
our manager. These transactions resulted in us recording an aggregate gain on
extinguishment of debt totaling $38.7 million during the first quarter of 2010.
Senior
Secured Credit Facility
On
May 3, 2010, we entered into a credit agreement for a four-year $210.0
million asset-based revolving credit facility (the 2014 Facility), maturing
on May 3, 2014, that is subject to, among other things, the terms of a
borrowing base derived from the value of eligible specified financial
assets. The borrowing base is subject to certain caps and concentration
limits customary for financings of this type. We may obtain additional
commitments under the 2014 Facility so long as the aggregate amount of
commitments at any time does not exceed $600.0 million. On May 5, 2010, we
obtained additional commitments of $40.0 million, bringing the total amount of
commitments under the 2014 Facility to $250.0 million.
We
have the right to prepay loans under the 2014 Facility in whole or in part at
any time. Loans under the 2014 Facility bear interest at a rate equal to the
London interbank offered rate (LIBOR) plus 3.25% per annum. The 2014 Facility
contains customary covenants applicable to us, including a restriction from
making annual distributions to holders of common shares in excess of 65% of our
estimated annual taxable income.
On May 26, 2010, we terminated our credit agreement, dated as of
November 10, 2008 and maturing on November 10, 2011 (the 2011 Credit
Agreement). The 2011 Credit Agreement was terminated in connection with our
initial borrowing under our new credit facility entered into on May 3,
2010 as described above. At the time of termination, there was $150.0 million
of borrowings outstanding under the 2011 Credit Agreement which we repaid.
As of September 30, 2010, we had no borrowings outstanding under
the 2014 Facility.
As of September 30, 2010, we believe we were in compliance with
the 2014 Facility covenant requirements.
Convertible
Debt
On January 15, 2010, we issued $172.5 million of 7.5%
Convertible Senior Notes due January 15, 2017. The 7.5% Notes bear
interest at a rate of 7.5% per year on the principal amount, accruing from
January 15, 2010. Interest is payable semiannually in arrears on
January 15 and July 15 of each year, beginning on July 15, 2010.
The 7.5% Notes will mature on January 15, 2017 unless previously redeemed,
repurchased or converted in accordance with their terms prior to such date.
Holders of the 7.5% Notes may convert their notes at the applicable conversion
rate at any time prior to the close of business on the business day immediately
preceding the stated maturity date subject to our right to terminate the
conversion rights of the notes. We may satisfy our obligation with respect to
the 7.5% Notes tendered for conversion by delivering to the holder either cash,
common shares, no par value, issued by us or a combination thereof. The initial
conversion rate for each $1,000 principal amount of 7.5% Notes is 122.2046
shares, which is equivalent to an initial conversion price of approximately
$8.18 per share. The conversion rate is adjusted under certain circumstances,
including the occurrence of certain fundamental change transactions and the
payment of a quarterly cash distribution in excess of $0.05 per share, but will
not be adjusted for accrued and unpaid interest on the 7.5% Notes. As of September 30,
2010, the conversation rate for each $1,000 principal amount of 7.5% Notes was
124.3675 shares. Net proceeds from the offering totaled $167.3 million,
reflecting $172.5 million from the issuance less $5.2 million for
underwriting fees.
During the first quarter of 2010, we repurchased $95.2 million par
amount of our 7.0% convertible senior notes due 2012, reducing the amount
outstanding from $275.8 million as of December 31, 2009 to
$180.6 million as of September 30, 2010. These transactions resulted
in us recording a gain of $1.3 million, which was partially offset by a
write-off of $0.6 million of unamortized debt issuance costs during the first
quarter of 2010.
Off-Balance Sheet Commitments
As of September 30, 2010, we had committed to purchase corporate
loans with aggregate commitments totaling $108.2 million par. In addition,
we participate in certain financing arrangements, including revolvers and
delayed draw facilities, whereby we are committed to provide funding at the
discretion of the borrower up to a specific predetermined amount. As of
September 30, 2010, we had unfunded financing commitments totaling
$31.9 million. We do not expect material losses related to the corporate
loans for which we commit to purchase and fund.
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Table of Contents
Partnership Tax Matters
Non-Cash Phantom Taxable Income
We intend to continue to operate so that we qualify, for United States
federal income tax purposes, as a partnership and not as an association or a
publicly traded partnership taxable as a corporation. Holders of our shares are
subject to United States federal income taxation and generally other taxes,
such as state, local and foreign income taxes, on their allocable share of our
taxable income, regardless of whether or when they receive cash distributions.
In addition, certain of our investments, including investments in foreign
corporate subsidiaries, CLO issuers (including those treated as partnerships or
disregarded entities for United States federal income tax purposes), and debt
securities, may produce taxable income without corresponding distributions of
cash to us or may produce taxable income prior to or following the receipt of
cash relating to such income. Consequently, in some taxable years, holders of
our shares may recognize taxable income in excess of our cash distributions.
Furthermore, even if we did not pay cash distributions with respect to a
taxable year, holders of our shares may still have a tax liability attributable
to their allocation of taxable income from us during such year.
Qualifying Income Exception
We intend to continue to operate so that we qualify as a partnership,
and not as an association or a publicly traded partnership taxable as a
corporation, for United States federal income tax purposes. In general, if a
partnership is publicly traded (as defined in the Code), it will be treated
as a corporation for United States federal income purposes. A publicly traded
partnership will, however, be taxed as a partnership, and not as a corporation,
for United States federal income tax purposes, so long as it is not required to
register under the Investment Company Act and at least 90% of its gross income
for each taxable year constitutes qualifying income within the meaning of
Section 7704(d) of the Code. We refer to this exception as the qualifying
income exception. Qualifying income generally includes rents, dividends,
interest (to the extent such interest is neither derived from the conduct of a
financial or insurance business nor based, directly or indirectly, upon income
or profits of any person), income and gains derived from certain activities
related to minerals and natural resources, and capital gains from the sale or
other disposition of stocks, bonds and real property. Qualifying income also
includes other income derived from the business of investing in, among other
things, stocks and securities.
If we fail to satisfy the qualifying income exception described
above, items of income, gain, loss, deduction and credit would not pass through
to holders of our shares and such holders would be treated for United States
federal (and certain state and local) income tax purposes as shareholders in a
corporation. In such case, we would be required to pay income tax at regular
corporate rates on all of our income. In addition, we would likely be liable
for state and local income and/or franchise taxes on all of our income.
Distributions to holders of our shares would constitute ordinary dividend
income taxable to such holders to the extent of our earnings and profits, and
these distributions would not be deductible by us. If we were taxable as a
corporation, it could result in a material reduction in cash flow and after-tax
return for holders of our shares and thus could result in a substantial
reduction in the value of our shares and any other securities we may issue.
Tax Consequences of Investments
in Natural Resources
As
referenced above, we have made certain investments in natural resources. It is
likely that the income from such 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 income with the conduct
of a United States trade or business. To
the extent our income is treated as effectively connected income, a holder who
is a non-United States person generally would be required to (i) file a
United States federal income tax return for such year reporting its allocable
share, if any, of our income or loss effectively connected with such trade or
business and (ii) pay United States federal income tax at regular United
States tax rates on any such income. Moreover, if such a holder is a corporation,
it might be subject to a United States branch profits tax on its allocable
share of our effectively connected income. In addition, distributions to such a
holder would be subject to withholding at the highest applicable tax rate to
the extent of the holders allocable share of our effectively connected income.
Any amount so withheld would be creditable against such holders United States
federal income tax liability, and such holder could claim a refund to the
extent that the amount withheld exceeded such persons United States federal
income tax liability for the taxable year. Finally, if we are engaged in a
United States trade or business, a portion of any gain recognized by an
investor who is a non-United States person on the sale or exchange of its
shares may be treated for United States federal income tax purposes as
effectively connected income, and hence such holder may be subject to United
States federal income tax on the sale or exchange.
In
addition, for all of our holders, investments in natural resources likely
constitute doing business in the jurisdictions in which such assets are
located. As a result, holders of our
shares will likely be required to file foreign, state and local income tax returns
and pay foreign, state and local income taxes in some or all of these various
jurisdictions. Further, holders may be
subject to penalties for failure to comply with those requirements.
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Our Investment Company Act Status
Section 3(a)(1)(A) of the Investment Company Act defines an
investment company as any issuer that is, holds itself out as being, or
proposes to be, primarily engaged in the business of investing, reinvesting or
trading in securities and Section 3(a)(1)(C) of the Investment
Company Act defines an investment company as any issuer that is engaged or
proposes to engage in the business of investing, reinvesting, owning, holding
or trading in securities and owns or proposes to acquire investment securities
(within the meaning of the Investment Company Act) having a value exceeding 40%
of the value of the issuers total assets (exclusive of U.S. government
securities and cash items) on an unconsolidated basis (the 40% test).
Excluded from the term investment securities are, among others, securities
issued by majority-owned subsidiaries unless the subsidiary is an investment
company or relies on the exceptions from the definition of an investment
company provided by Section 3(c)(1) or Section 3(c)(7) of
the Investment Company Act (a fund). The Investment Company Act defines a majority-owned
subsidiary of a person as any company 50% or more of the outstanding voting
securities (i.e., those securities presently entitling the holder thereof
to vote for the election of directors of the company) of which are owned by
that person, or by another company that is, itself, a majority owned subsidiary
of that person.
We are organized as a holding company. We conduct our operations
primarily through our majority owned subsidiaries. Each of our subsidiaries is
either outside of the definition of an investment company in Sections
3(a)(1)(A) and 3(a)(1)(C), described above, or excepted from the definition
of an investment company under the Investment Company Act. We believe that we
are not, and that we do not propose to be, primarily engaged in the business of
investing, reinvesting or trading in securities and we do not believe that we
have held ourselves out as such. We intend to continue to conduct our
operations so that we are not required to register as an investment company
under the Investment Company Act.
We monitor our holdings regularly to confirm our continued compliance
with the 40% test. In calculating our position under the 40% test, we are
responsible for determining whether any of our subsidiaries is majority-owned.
We treat subsidiaries in which we own at least 50% of the outstanding voting
securities, including those that issue CLOs, as majority-owned for purposes of
the 40% test. Some of our subsidiaries may rely solely on
Section 3(c)(1) or Section 3(c)(7) of the Investment
Company Act. In order for us to satisfy the 40% test, our ownership interests
in those subsidiaries or any of our subsidiaries that are not majority-owned,
together with any other investment securities that we may own, may not have a
combined value in excess of 40% of the value of our total assets on an
unconsolidated basis and exclusive of U.S. government securities and cash
items. However, most of our subsidiaries either fall outside of the general
definitions of an investment company or rely on exceptions provided by
provisions of, and rules and regulations promulgated under, the Investment
Company Act (other than Section 3(c)(1) or
Section 3(c)(7) of the Investment Company Act) and, therefore, are
not defined or regulated as investment companies. In order to conform to these
exceptions, these subsidiaries are limited with respect to the assets in which
each of them can invest and/or the types of securities each of them may issue.
We must, therefore, monitor each subsidiarys compliance with its applicable
exception and our freedom of action, and that of our subsidiaries, may be
limited as a result. For example, our subsidiaries that issue CLOs generally
rely on Rule 3a-7 under Investment Company Act, while KKR Financial
Holdings II, LLC, or KFH II, our subsidiary that is taxed as a REIT for
U.S. federal income tax purposes, generally relies on Section 3(c)(5)(C) of
the Investment Company Act. Each of these exceptions requires, among other
things that the subsidiary (i) not issue redeemable securities and
(ii) engage in the business of holding certain types of assets, consistent
with the terms of the exception. Similarly, any subsidiaries engaged in the
ownership of oil and gas assets may, depending on the nature of the assets, be
outside the definition of an investment company or rely on exceptions provided
by Section 3(c)(5)(C) or Section 3(c)(9) of the Investment
Company Act. While
Section 3(c)(9) of the Investment Company Act does not limit the
nature of the securities issued, it does impose business engagement
requirements that limit the types of assets that may be held.
We do not treat our interests in majority-owned subsidiaries that are
outside of the general definition of an investment company or that rely on
Section 3(c)(5)(C) or Section 3(c)(9) of, or Rule 3a-7
under, the Investment Company Act as investment securities when calculating our
40% test.
We sometimes refer to our subsidiaries that rely on Rule 3a-7
under the Investment Company Act as CLO subsidiaries. Rule 3a-7 under
the Investment Company Act is available to certain structured financing
vehicles that are engaged in the business of holding financial assets that, by
their terms, convert into cash within a finite time period and that issue fixed
income securities entitling holders to receive payments that depend primarily
on the cash flows from these assets, provided that, among other things, the
structured finance vehicle does not engage in certain portfolio management
practices resembling those employed by mutual funds. Accordingly, each of these
CLO subsidiaries is subject to an indenture (or similar transaction documents)
that contains specific guidelines and restrictions limiting the discretion of
the CLO subsidiary and its collateral manager. In particular, these guidelines
and restrictions prohibit the CLO subsidiary from acquiring and disposing of
assets primarily for the purpose of recognizing gains or decreasing losses
resulting from market value changes. Thus, a CLO subsidiary cannot acquire or
dispose of assets primarily to enhance returns to the owner of the equity in
the CLO subsidiary; however, subject to this limitation, sales and purchases of
assets may be made so long as doing so does not violate guidelines contained in
the CLO subsidiarys relevant transaction documents. A CLO subsidiary generally
can, for example, sell an asset if the collateral manager believes that its
credit quality has declined since its acquisition or that the credit profile of
the obligor will deteriorate and the proceeds of permitted dispositions may be
reinvested in
52
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additional
collateral, subject to fulfilling the requirements set forth in Rule 3a-7
under the Investment Company Act and the CLO subsidiarys relevant transaction
documents. As a result of these restrictions, our CLO subsidiaries may suffer
losses on their assets and we may suffer losses on our investments in those CLO
subsidiaries.
We sometimes refer to KFH II, our subsidiary that relies on
Section 3(c)(5)(C) of the Investment Company Act, as our REIT
subsidiary. Section 3(c)(5)(C) of the Investment Company Act is
available to companies that are primarily engaged in the business of purchasing
or otherwise acquiring mortgages and other liens on and interests in real
estate. While the SEC has not promulgated rules to address precisely what
is required for a company to be considered to be primarily engaged in the
business of purchasing or otherwise acquiring mortgages and other liens on and
interests in real estate, the SECs Division of Investment Management, or the Division,
has taken the position, through a series of no-action and interpretive letters,
that a company may rely on Section 3(c)(5)(C) of the Investment
Company Act if, among other things, at least 55% of the companys assets consist
of mortgage loans, other assets that are considered the functional equivalent
of mortgage loans and certain other interests in real property (collectively, qualifying
real estate assets), and at least 25% of the companys assets consist of real
estate-related assets (reduced by the excess of the companys qualifying real
estate assets over the required 55%), leaving no more than 20% of the companys
assets to be invested in miscellaneous assets. The Division has also provided
guidance as to the types of assets that can be considered qualifying real
estate assets. Because the Divisions interpretive letters are not binding
except as they relate to the companies to whom they are addressed, if the
Division were to change its position as to, among other things, what assets
might constitute qualifying real estate assets our REIT subsidiary might be
required to change its investment strategy to comply with the changed position.
We cannot predict whether such a change would be adverse.
Based on current guidance, our REIT subsidiary classifies investments
in mortgage loans as qualifying real estate assets, as long as the loans are fully
secured by an interest in real estate on which we retain the right to
foreclose. That is, if the loan-to-value ratio of the loan is equal to or less
than 100%, then the mortgage loan is considered to be a qualifying real estate
asset. Mortgage loans with loan-to-value ratios in excess of 100% are
considered to be only real estate-related assets. Our REIT subsidiary considers
agency whole pool certificates to be qualifying real estate assets. Examples of
agencies that issue whole pool certificates are the Federal National Mortgage
Association, the Federal Home Loan Mortgage Corporation and the Government
National Mortgage Association. An agency whole pool certificate is a
certificate issued or guaranteed as to principal and interest by the U.S.
government or by a federally chartered entity, which represents the entire
beneficial interest in the underlying pool of mortgage loans. By contrast, an
agency certificate that represents less than the entire beneficial interest in
the underlying mortgage loans is not considered to be a qualifying real estate
asset, but is considered to be a real estate-related asset.
Most non-agency mortgage-backed securities do not constitute qualifying
real estate assets because they represent less than the entire beneficial
interest in the related pool of mortgage loans; however, based on Division
guidance, where our REIT subsidiarys investment in non-agency mortgage- backed
securities is the functional equivalent of owning the underlying mortgage
loans, our REIT subsidiary may treat those securities as qualifying real estate
assets. Moreover, investments in mortgage-backed securities that do not constitute
qualifying real estate assets will be classified as real estate- related
assets. Therefore, based upon the specific terms and circumstances related to
each non-agency mortgage-backed security that our REIT subsidiary owns, our
REIT subsidiary will make a determination of whether that security should be
classified as a qualifying real estate asset or as a real estate- related
asset; and there may be instances where a security is recharacterized from
being a qualifying real estate asset to a real estate-related asset, or
conversely, from being a real estate-related asset to being a qualifying real
estate asset based upon the acquisition or disposition or redemption of related
classes of securities from the same securitization trust. If our REIT subsidiary
acquires securities that, collectively, receive all of the principal and
interest paid on the related pool of underlying mortgage loans (less fees, such
as servicing and trustee fees, and expenses of the securitization), and that
subsidiary has foreclosure rights with respect to those mortgage loans, then
our REIT subsidiary will consider those securities, collectively, to be
qualifying real estate assets. If another entity acquires any of the securities
that are expected to receive cash flow from the underlying mortgage loans, then
our REIT subsidiary will consider whether it has appropriate foreclosure rights
with respect to the underlying loans and whether its investment is a first loss
position in deciding whether these securities should be classified as
qualifying real estate assets. If our REIT subsidiary owns more than one
subordinate class, then, to determine the classification of subordinate classes
other than the first loss class, our REIT subsidiary will consider whether such
classes are contiguous with the first loss class (with no other classes
absorbing losses after the first loss class and before any other subordinate
classes that our REIT subsidiary owns), whether our REIT subsidiary owns the
entire amount of each such class and whether our REIT subsidiary would continue
to have appropriate foreclosure rights in connection with each such class if
the more subordinate classes were no longer outstanding. If the answers to any
of these questions is no, then our REIT subsidiary would expect not to classify
that particular class, or classes senior to that class, as qualifying real
estate assets.
We have made or may make oil and gas 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
53
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Subsidiary
holds a sufficient amount of oil and gas assets constituting real estate
interests together with other assets that are not investment securities such as
equipment. Oil and Gas Subsidiaries that
hold oil and gas assets that constitute real property interests, but are unable
to pass the 40% test, may rely on Section 3(c)(5)(C), subject to the
requirements and restrictions described above.
Alternately, an Oil and Gas Subsidiary may rely on Section 3(c)(9) of
the Investment Company Act if substantially all of its business consists of
owning or holding oil, gas or other mineral royalties or leases, certain
fractional interests, or certificates of interest or participations in or
investment contracts relating to such royalties, leases or fractional interests. These various restrictions imposed on our Oil
and Gas Subsidiaries by the Investment Company Act may have the effect of
limiting our freedom of action with respect to oil and gas assets (or other
assets) that may be held or acquired by such subsidiary or the manner in which
we may deal in such assets.
As noted above, if the combined values of the investment securities
issued by our subsidiaries that must rely on Section 3(c)(1) or
Section 3(c)(7) of the Investment Company Act, together with any
other investment securities we may own, exceeds 40% of the value of our total
assets (exclusive of U.S. government securities and cash items) on an
unconsolidated basis, we may be deemed to be an investment company. If we fail
to maintain an exception, exemption or other exclusion from the Investment
Company Act, we could, among other things, be required either (i) to
change substantially the manner in which we conduct our operations to avoid
being subject to the Investment Company Act or (ii) to register as an
investment company. Either of these would likely have a material adverse effect
on us, our ability to service our indebtedness and to make distributions on our
shares, and on the market price of our shares and any other securities we may
issue. If we were required to register as an investment company under the
Investment Company Act, we would become subject to substantial regulation with
respect to our capital structure (including our ability to use leverage),
management, operations, transactions with certain affiliated persons (within
the meaning of the Investment Company Act), portfolio composition (including
restrictions with respect to diversification and industry concentration) and
other matters. Additionally, our Manager would have the right to terminate our
management agreement. Moreover, if we were required to register as an
investment company, we would no longer be eligible to be treated as a
partnership for United States federal income tax purposes. Instead, we would be
classified as a corporation for tax purposes and would be able to avoid
corporate taxation only to the extent that we were able to elect and qualify as
a regulated investment company (RIC) under applicable tax rules. Because our
eligibility for RIC status would depend on our assets and sources of income at
the time that we were required to register as an investment company, there can
be no assurance that we would be able to qualify as a RIC. If we were to lose
partnership status and fail to qualify as a RIC, we would be taxed as a regular
corporation. See Partnership Tax Matters
Qualifying
Income Exception
.
We have not requested approval or guidance from the SEC or its staff
with respect to our Investment Company Act determinations, including, in
particular: our treatment of any subsidiary as majority-owned; the compliance
of any subsidiary with Section 3(c)(5)(C) or
Section 3(c)(9) of, or Rule 3a-7 under, the Investment Company
Act, including any subsidiarys determinations with respect to the consistency
of its assets or operations with the requirements thereof; or whether our
interests in one or more subsidiaries constitute investment securities for
purposes of the 40% test. If the SEC were to disagree with our treatment of one
or more subsidiaries as being excepted from the Investment Company Act pursuant
to Rule 3a-7, Section 3(c)(5)(C) or Section 3(c)(9), with
our determination that one or more of our other holdings do not constitute
investment securities for purposes of the 40% test, or with our determinations
as to the nature of the business in which we engage or the manner in which we
hold ourselves out, we and/or one or more of our subsidiaries would need to
adjust our operating strategies or assets in order for us to continue to pass
the 40% test or register as an investment company, either of which could have a
material adverse effect on us. Moreover, we may be required to adjust our
operating strategy and holdings, or to effect sales of our assets in a manner
that, or at a time or price at which, we would not otherwise choose, if there
are changes in the laws or rules governing our Investment Company Act
status or that of our subsidiaries, or if the SEC or its staff provides more
specific or different guidance regarding the application of relevant provisions
of, and rules under, the Investment Company Act. Such guidance could
provide additional flexibility, or it could further inhibit our ability, or the
ability of a subsidiary, to pursue a chosen operating strategy, which could
have a material adverse effect on us.
If the SEC or a court of competent jurisdiction were to find that we
were required, but failed, to register as an investment company in violation of
the Investment Company Act, we would have to cease business activities, we
would breach representations and warranties and/or be in default as to certain
of our contracts and obligations, civil or criminal actions could be brought
against us, our contracts would be unenforceable unless a court were to require
enforcement and a court could appoint a receiver to take control of us and
liquidate our business, any or all of which would have a material adverse
effect on our business.
Quantitative and Qualitative Disclosures About Market
Risk
Foreign
Currency Risks
From time to time, we may make investments that are denominated in a
foreign currency through which we may be subject to foreign currency exchange
risk. As of September 30, 2010, $286.1 million par amount, or 3.6%, of our
corporate debt portfolio was denominated in foreign currencies, of which 91.7% was
denominated in Euro.
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Table of Contents
Credit
Spread Exposure
Our investments are subject to spread risk. Our investments in floating
rate loans and securities are valued based on a market credit spread over LIBOR
and for which the value is affected by changes in the market credit spreads
over LIBOR. Our investments in fixed rate loans and securities are valued based
on a market credit spread over the rate payable on fixed rate United States
Treasuries of like maturity. Increased credit spreads, or credit spread
widening, will have an adverse impact on the value of our investments while
decreased credit spreads, or credit spread tightening, will have a positive
impact on the value of our investments.
Interest Rate Risk
Interest rate risk is defined as the sensitivity of our current and
future earnings to interest rate volatility, variability of spread
relationships, the difference in repricing intervals between our assets and
liabilities and the effect that interest rates may have on our cash flows and
the prepayment rates experienced on our investments that have embedded borrower
optionality. The objective of interest rate risk management is to achieve
earnings, preserve capital and achieve liquidity by minimizing the negative
impacts of changing interest rates, asset and liability mix, and prepayment
activity.
We are exposed to basis risk between our investments and our
borrowings. Interest rates on our floating rate investments and our variable
rate borrowings do not reset on the same day or with the same frequency and, as
a result, we are exposed to basis risk with respect to index reset frequency.
Our floating rate investments may reprice on indices that are different than
the indices that are used to price our variable rate borrowings and, as a
result, we are exposed to basis risk with respect to repricing index. The basis
risks noted above, in addition to other forms of basis risk that exist between
our investments and borrowings, may be material and could negatively impact
future net interest margins.
Interest rate risk impacts our interest income, interest expense,
prepayments, and the fair value of our investments, interest rate derivatives,
and liabilities. We manage our interest rate risk using various techniques
ranging from the purchase of floating rate investments to the use of interest
rate derivatives. The use of interest rate derivatives is a component of our
interest risk management strategy. The contractual notional balance of our
interest rate swaps was $483.3 million as of September 30, 2010.
Derivative
Risk
Derivative transactions, including engaging in swaps and foreign
currency transactions, are subject to certain risks. There is no guarantee that
a company can eliminate its exposure under an outstanding swap agreement by
entering into an offsetting swap agreement with the same or another party.
Also, there is a possibility of default of the other party to the transaction
or illiquidity of the derivative instrument. Furthermore, the ability to
successfully use derivative transactions depends on the ability to predict
market movements which cannot be guaranteed. As such, participation in
derivative instruments may result in greater losses as we would have to sell or
purchase an investment at inopportune times for prices other than current
market prices or may force us to hold an asset we might otherwise have sold. In
addition, as certain derivative instruments are unregulated, they are difficult
to value and are therefore susceptible to liquidity and credit risks.
Collateral posting requirements are individually negotiated between
counterparties and there is no regulatory requirement concerning the amount of
collateral that a counterparty must post to secure its obligations under
certain derivative instruments. Because they are unregulated, there is no
requirement that parties to a contract be informed in advance when a credit
default swap is sold. As a result, investors may have difficulty identifying
the party responsible for payment of their claims. If a counterpartys credit
becomes significantly impaired, multiple requests for collateral posting in a
short period of time could increase the risk that we may not receive adequate
collateral. Amounts paid by us as premiums and cash or other assets held in
margin accounts with respect to derivative instruments are not available for
investment purposes.
The following table summarizes the estimated net fair value of our
derivative instruments held as of September 30, 2010 and December 31,
2009 (amounts in thousands):
|
|
As of September 30,
2010
|
|
As of December 31,
2009
|
|
|
|
Notional
|
|
Estimated
Fair Value
|
|
Notional
|
|
Estimated
Fair Value
|
|
Cash Flow Hedges:
|
|
|
|
|
|
|
|
|
|
Interest rate swaps
|
|
$
|
483,333
|
|
$
|
(88,808
|
)
|
$
|
383,333
|
|
$
|
(43,800
|
)
|
Free-Standing Derivatives:
|
|
|
|
|
|
|
|
|
|
Interest rate swaps
|
|
307,112
|
|
1,272
|
|
89,246
|
|
(281
|
)
|
Credit default swapsprotection sold
|
|
13,500
|
|
362
|
|
51,000
|
|
(385
|
)
|
Total rate of return swaps
|
|
|
|
135
|
|
104,446
|
|
11,809
|
|
Foreign exchange forward contracts
|
|
(145,282
|
)
|
(19,889
|
)
|
|
|
|
|
Foreign exchange options
|
|
136,340
|
|
15,309
|
|
|
|
|
|
Common stock warrants
|
|
|
|
2,926
|
|
|
|
2,471
|
|
Total
|
|
$
|
795,003
|
|
$
|
(88,693
|
)
|
$
|
628,025
|
|
$
|
(30,186
|
)
|
55
Table of Contents
For our derivatives, our credit exposure is directly with our
counterparties and continues until the maturity or termination of such contracts.
The following table sets forth the fair values of our primary derivative
investments by remaining contractual maturity as of September 30, 2010
(amounts in thousands):
|
|
Less than
1 year
|
|
1-3 years
|
|
3-5 Years
|
|
More than
5 years
|
|
Total
|
|
Cash Flow Hedges:
|
|
|
|
|
|
|
|
|
|
|
|
Interest rate swaps
|
|
$
|
|
|
$
|
|
|
$
|
|
|
$
|
(88,808
|
)
|
$
|
(88,808
|
)
|
Free-Standing Derivatives:
|
|
|
|
|
|
|
|
|
|
|
|
Interest rate swaps
|
|
1,272
|
|
|
|
|
|
|
|
1,272
|
|
Credit default swapsprotection sold
|
|
|
|
362
|
|
|
|
|
|
362
|
|
Total rate of return swaps
|
|
135
|
|
|
|
|
|
|
|
135
|
|
Foreign exchange forward contracts
|
|
|
|
(54
|
)
|
(19,835
|
)
|
|
|
(19,889
|
)
|
Foreign exchange options
|
|
|
|
|
|
15,309
|
|
|
|
15,309
|
|
Total
|
|
$
|
1,407
|
|
$
|
308
|
|
$
|
(4,526
|
)
|
$
|
(88,808
|
)
|
$
|
(91,619
|
)
|
Management Estimates
The preparation of our financial statements requires management to make
estimates and assumptions that affect the amounts reported in our condensed
consolidated financial statements and accompanying notes. Significant
estimates, assumptions and judgments are applied in situations including the determination
of our allowance for loan losses and the valuation of certain investments. We
revise our estimates when appropriate. However, actual results could materially
differ from managements estimates.
Item 3. Quantitative and Qualitative Disclosures
about Market Risk
See
discussion of quantitative and qualitative disclosures about market risk in Quantitative
and Qualitative Disclosures About Market Risk section of Managements
Discussion and Analysis of Financial Condition and Results of Operations.
Item 4. Controls and Procedures
The
Companys management evaluated, with the participation of the Companys
principal executive and principal financial officer, the effectiveness of the
Companys disclosure controls and procedures (as defined in Rules 13a-15(e) and
15d-15(e) under the Securities Exchange Act of 1934, as amended (the Exchange
Act)) as of September 30, 2010. Based on their evaluation, the Companys
principal executive and principal financial officer concluded that the Companys
disclosure controls and procedures as of September 30, 2010 were designed
and were functioning effectively to provide reasonable assurance that the
information required to be disclosed by the Company in reports filed under the
Exchange Act is (i) recorded, processed, summarized, and reported within
the time periods specified in the SECs rules and forms, and
(ii) accumulated and communicated to management, including the principal
executive and principal financial officers, as appropriate, to allow timely
decisions regarding disclosure.
There
has been no change in the Companys internal control over financial reporting
(as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange
Act) that occurred during the three months ending September 30, 2010, that
has materially affected, or is reasonably likely to materially affect, the
Companys internal control over financial reporting.
PART II.
OTHER INFORMATION
Item 1. Legal
Proceedings
We have been named as a party in various legal actions which include
the matters described below. We have denied, or believe we have a meritorious
defense and will deny liability in the significant cases pending against us
discussed below. Based on current discussion and consultation with counsel, we
believe that the resolution of these matters will not have a material impact on
our financial condition or cash flow.
On August 7, 2008, the members of our board of directors and
certain of our former executive officers and we were named in a putative class
action complaint filed by Charter Township of Clinton Police and Fire
Retirement System in the United States District Court for the Southern District
of New York, or the Charter Litigation. On March 13, 2009, the lead
plaintiff filed an amended complaint, which deleted as defendants the members
of our board of directors and named as defendants only our former chief
executive officer Saturnino S. Fanlo, our former chief operating officer David
A. Netjes, our former chief financial officer Jeffrey B. Van Horn and us. The
amended complaint alleges that our April 2, 2007 registration statement
and prospectus and the financial
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Contents
statements
incorporated therein contained material omissions in violation of
Section 11 of the Securities Act, regarding the risks and potential losses
associated with our real estate-related assets, our ability to finance our real
estate-related assets and the adequacy of our loss reserves for our real
estate-related assets. The amended complaint further alleges that, pursuant to
Section 15 of the Securities Act, Messrs. Fanlo, Netjes and Van Horn
each have legal responsibility for the alleged Section 11 violation. On
April 27, 2009, the defendants filed a motion to dismiss the amended
complaint for failure to state a claim under the Securities Act. Oral argument
on the defendants motion to dismiss took place on October 5, 2010, and
the parties are awaiting a decision from the Court.
On August 15, 2008, the members of our board of directors and our
executive officers (collectively, the Kostecka Individual Defendants) were
named in a shareholder derivative action brought by Raymond W. Kostecka, a
purported shareholder, in the Superior Court of California, County of San
Francisco (the California Derivative Action). We are named as a nominal
defendant. The complaint in the California Derivative Action asserts claims
against the Kostecka Individual Defendants for breaches of fiduciary duty,
abuse of control, gross mismanagement, waste of corporate assets, and unjust
enrichment in connection with the conduct at issue in the Charter Litigation,
including the filing of our April 2, 2007 registration statement with
alleged material misstatements and omissions. By order dated January 8,
2009, the Court approved the parties stipulation to stay the proceedings in
the California Derivative Action until the Charter Litigation is dismissed on
the pleadings or we file an answer to the Charter Litigation.
On March 23, 2009, the members of our
board of directors and certain of our executive officers (collectively, the Haley
Individual Defendants) were named in a shareholder derivative action brought
by Paul B. Haley, a purported shareholder, in the United States District Court
for the Southern District of New York (the New York Derivative Action). We
are named as a nominal defendant. The complaint in the New York Derivative
Action asserts claims against the Haley Individual Defendants for breaches of
fiduciary duty, breaches of the duty of full disclosure, and for contribution
in connection with the conduct at issue in the Charter Litigation, including
the filing of our April 2, 2007 registration statement with alleged
material misstatements and omissions. By order dated June 18, 2009, the
Court approved the parties stipulation to stay the proceedings in the New York
Derivative Action until the Charter Litigation is dismissed on the pleadings or
we file an answer to the Charter Litigation.
Item 1A. Risk Factors
Other
than the risk factors set forth below, there have been no material changes in
our risk factors from those disclosed in our Annual Report on Form 10-K
for the year ended December 31, 2009.
We leverage our portfolio
investments, which may adversely affect our return on our investments and may
reduce cash available for distribution.
We leverage our portfolio investments through
borrowings, generally through the use of bank credit facilities, total rate of
return swaps, securitizations, including the issuance of CLOs, and other
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. At the current time, the
only contractual limitation on our ability to leverage our portfolio is a
covenant contained in our senior secured credit facility that our leverage
ratio cannot exceed 2.0 to 1.0, computed on a basis that generally excludes the
debt of variable interest entities that we consolidate under GAAP. Our return
on our investments and cash available for distribution to holders of our shares
may 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. Our debt service payments reduce cash flow
available for distributions to holders of our shares.
Maintenance of our Investment Company Act exemption
imposes limits on our operations, which may adversely affect our results of
operations.
Section 3(a)(1)(A) of
the Investment Company Act defines an investment company as any issuer that is,
holds itself out as being, or proposes to be, primarily engaged in the business
of investing, reinvesting or trading in securities and
Section 3(a)(1)(C) of the Investment Company Act defines an
investment company as any issuer that is engaged or proposes to engage in the
business of investing, reinvesting, owning, holding or trading in securities
and owns or proposes to acquire investment securities (within the meaning of
the Investment Company Act) having a value exceeding 40% of the value of the
issuers total assets (exclusive of U.S. government securities and cash items)
on an unconsolidated basis (the 40% test). Excluded from the term investment
securities are, among others, securities issued by majority-owned subsidiaries
unless the subsidiary is an investment company or relies on the exceptions from
the definition of an investment company provided by
Section 3(c)(1) or Section 3(c)(7) of the Investment
Company Act (a fund). The Investment Company Act defines a majority-owned
subsidiary of a person as any company 50% or more of the outstanding voting
securities (i.e., those securities presently entitling the holder thereof
to vote for the election of directors of the company) of which are owned by
that person, or by another company that is, itself, a majority owned subsidiary
of that person.
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We are organized as a holding company. We conduct our operations
primarily through our majority-owned subsidiaries. Each of our subsidiaries is
either outside of the definition of an investment company in Sections
3(a)(1)(A) and 3(a)(1)(C), described above, or excepted from the definition
of an investment company under the Investment Company Act. We believe that we
are not, and that we do not propose to be, primarily engaged in the business of
investing, reinvesting or trading in securities and we do not believe that we
have held ourselves out as such. We intend to continue to conduct our
operations so that we are not required to register as an investment company
under the Investment Company Act.
We monitor our holdings regularly to confirm our continued compliance
with the 40% test. In calculating our position under the 40% test, we are
responsible for determining whether any of our subsidiaries is majority-owned.
We treat subsidiaries in which we own at least 50% of the outstanding voting
securities, including those that issue CLOs, as majority-owned for purposes of
the 40% test. Some of our subsidiaries may rely solely on
Section 3(c)(1) or Section 3(c)(7) of the Investment
Company Act. In order for us to satisfy the 40% test, our ownership interests
in those subsidiaries or any of our subsidiaries that are not majority-owned,
together with any other investment securities that we may own, may not have a
combined value in excess of 40% of the value of our total assets on an
unconsolidated basis and exclusive of U.S. government securities and cash
items. However, most of our subsidiaries either fall outside of the general
definitions of an investment company or rely on exceptions provided by
provisions of, and rules and regulations promulgated under, the Investment
Company Act (other than Section 3(c)(1) or
Section 3(c)(7) of the Investment Company Act) and, therefore, are
not defined or regulated as investment companies. In order to conform to these
exceptions, these subsidiaries are limited with respect to the assets in which
each of them can invest and/or the types of securities each of them may issue.
We must, therefore, monitor each subsidiarys compliance with its applicable
exception and our freedom of action, and that of our subsidiaries, may be
limited as a result. For example, our subsidiaries that issue CLOs generally
rely on Rule 3a-7 under Investment Company Act, while KKR Financial
Holdings II, LLC, or KFH II, our subsidiary that is taxed as a REIT for
U.S. federal income tax purposes, generally relies on Section 3(c)(5)(C) of
the Investment Company Act. Each of these exceptions requires, among other
things that the subsidiary (i) not issue redeemable securities and
(ii) engage in the business of holding certain types of assets, consistent
with the terms of the exception. Similarly, any subsidiaries engaged in the
ownership of oil and gas assets may, depending on the nature of the assets, be
outside the definition of an investment company or rely on exceptions provided
by Section 3(c)(5)(C) or Section 3(c)(9) of the Investment
Company Act. While
Section 3(c)(9) of the Investment Company Act does not limit the
nature of the securities issued, it does impose business engagement
requirements that limit the types of assets that may be held.
We do not treat our interests in majority-owned subsidiaries that are
outside of the general definition of an investment company or that rely on
Section 3(c)(5)(C) or Section 3(c)(9) of, or Rule 3a-7
under, the Investment Company Act as investment securities when calculating our
40% test.
We sometimes refer to our subsidiaries that rely on Rule 3a-7
under the Investment Company Act as CLO subsidiaries. Rule 3a-7 under
the Investment Company Act is available to certain structured financing
vehicles that are engaged in the business of holding financial assets that, by
their terms, convert into cash within a finite time period and that issue fixed
income securities entitling holders to receive payments that depend primarily
on the cash flows from these assets, provided that, among other things, the
structured finance vehicle does not engage in certain portfolio management
practices resembling those employed by mutual funds. Accordingly, each of these
CLO subsidiaries is subject to an indenture (or similar transaction documents)
that contains specific guidelines and restrictions limiting the discretion of
the CLO subsidiary and its collateral manager. In particular, these guidelines
and restrictions prohibit the CLO subsidiary from acquiring and disposing of
assets primarily for the purpose of recognizing gains or decreasing losses
resulting from market value changes. Thus, a CLO subsidiary cannot acquire or
dispose of assets primarily to enhance returns to the owner of the equity in
the CLO subsidiary; however, subject to this limitation, sales and purchases of
assets may be made so long as doing so does not violate guidelines contained in
the CLO subsidiarys relevant transaction documents. A CLO subsidiary generally
can, for example, sell an asset if the collateral manager believes that its credit
quality has declined since its acquisition or that the credit profile of the
obligor will deteriorate and the proceeds of permitted dispositions may be
reinvested in additional collateral, subject to fulfilling the requirements set
forth in Rule 3a-7 under the Investment Company Act and the CLO subsidiarys
relevant transaction documents. As a result of these restrictions, our CLO
subsidiaries may suffer losses on their assets and we may suffer losses on our
investments in those CLO subsidiaries.
We sometimes refer to KFH II, our subsidiary that relies on
Section 3(c)(5)(C) of the Investment Company Act, as our REIT
subsidiary. Section 3(c)(5)(C) of the Investment Company Act is
available to companies that are primarily engaged in the business of purchasing
or otherwise acquiring mortgages and other liens on and interests in real
estate. While the SEC has not promulgated rules to address precisely what
is required for a company to be considered to be primarily engaged in the
business of purchasing or otherwise acquiring mortgages and other liens on and
interests in real estate, the SECs Division of Investment Management, or the Division,
has taken the position, through a series of no-action and interpretive letters,
that a company may rely on Section 3(c)(5)(C) of the Investment
Company Act if, among other things, at least 55% of the companys assets
consist of mortgage loans, other assets that are considered the functional
equivalent of mortgage loans and certain other interests in real property (collectively,
qualifying real estate assets), and at least 25% of the companys assets
consist of real estate-related assets (reduced by the excess of the companys
qualifying real estate assets over the required 55%), leaving no more than 20%
of the companys assets to
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be
invested in miscellaneous assets. The Division has also provided guidance as to
the types of assets that can be considered qualifying real estate assets.
Because the Divisions interpretive letters are not binding except as they
relate to the companies to whom they are addressed, if the Division were to
change its position as to, among other things, what assets might constitute
qualifying real estate assets our REIT subsidiary might be required to change
its investment strategy to comply with the changed position. We cannot predict
whether such a change would be adverse.
Based on current guidance, our REIT subsidiary classifies investments
in mortgage loans as qualifying real estate assets, as long as the loans are fully
secured by an interest in real estate on which we retain the right to
foreclose. That is, if the loan-to-value ratio of the loan is equal to or less
than 100%, then the mortgage loan is considered to be a qualifying real estate
asset. Mortgage loans with loan-to-value ratios in excess of 100% are
considered to be only real estate-related assets. Our REIT subsidiary considers
agency whole pool certificates to be qualifying real estate assets. Examples of
agencies that issue whole pool certificates are the Federal National Mortgage
Association, the Federal Home Loan Mortgage Corporation and the Government
National Mortgage Association. An agency whole pool certificate is a
certificate issued or guaranteed as to principal and interest by the U.S.
government or by a federally chartered entity, which represents the entire
beneficial interest in the underlying pool of mortgage loans. By contrast, an
agency certificate that represents less than the entire beneficial interest in
the underlying mortgage loans is not considered to be a qualifying real estate
asset, but is considered to be a real estate-related asset.
Most non-agency mortgage-backed securities do not constitute qualifying
real estate assets because they represent less than the entire beneficial
interest in the related pool of mortgage loans; however, based on Division
guidance, where our REIT subsidiarys investment in non-agency mortgage- backed
securities is the functional equivalent of owning the underlying mortgage
loans, our REIT subsidiary may treat those securities as qualifying real estate
assets. Moreover, investments in mortgage-backed securities that do not constitute
qualifying real estate assets will be classified as real estate- related
assets. Therefore, based upon the specific terms and circumstances related to
each non-agency mortgage-backed security that our REIT subsidiary owns, our
REIT subsidiary will make a determination of whether that security should be
classified as a qualifying real estate asset or as a real estate- related
asset; and there may be instances where a security is recharacterized from
being a qualifying real estate asset to a real estate-related asset, or
conversely, from being a real estate-related asset to being a qualifying real
estate asset based upon the acquisition or disposition or redemption of related
classes of securities from the same securitization trust. If our REIT subsidiary
acquires securities that, collectively, receive all of the principal and
interest paid on the related pool of underlying mortgage loans (less fees, such
as servicing and trustee fees, and expenses of the securitization), and that
subsidiary has foreclosure rights with respect to those mortgage loans, then
our REIT subsidiary will consider those securities, collectively, to be
qualifying real estate assets. If another entity acquires any of the securities
that are expected to receive cash flow from the underlying mortgage loans, then
our REIT subsidiary will consider whether it has appropriate foreclosure rights
with respect to the underlying loans and whether its investment is a first loss
position in deciding whether these securities should be classified as
qualifying real estate assets. If our REIT subsidiary owns more than one
subordinate class, then, to determine the classification of subordinate classes
other than the first loss class, our REIT subsidiary will consider whether such
classes are contiguous with the first loss class (with no other classes
absorbing losses after the first loss class and before any other subordinate
classes that our REIT subsidiary owns), whether our REIT subsidiary owns the
entire amount of each such class and whether our REIT subsidiary would continue
to have appropriate foreclosure rights in connection with each such class if
the more subordinate classes were no longer outstanding. If the answers to any
of these questions is no, then our REIT subsidiary would expect not to classify
that particular class, or classes senior to that class, as qualifying real
estate assets.
We have made or may make oil and gas 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 gas assets (or other assets) that may be held or acquired by such
subsidiary or the manner in which we may deal in such assets.
As noted above, if the combined values of the investment securities
issued by our subsidiaries that must rely on Section 3(c)(1) or
Section 3(c)(7) of the Investment Company Act, together with any
other investment securities we may own, exceeds 40% of the value of our total
assets (exclusive of U.S. government securities and cash items) on an
unconsolidated basis, we may be deemed to be an investment company. If we fail
to maintain an exception, exemption or other exclusion from the Investment
Company Act, we could, among other things, be required either (i) to
change substantially the manner in which we conduct our
59
Table of Contents
operations
to avoid being subject to the Investment Company Act or (ii) to register
as an investment company. Either of these would likely have a material adverse
effect on us, our ability to service our indebtedness and to make distributions
on our shares, and on the market price of our shares and any other securities
we may issue. If we were required to register as an investment company under
the Investment Company Act, we would become subject to substantial regulation
with respect to our capital structure (including our ability to use leverage),
management, operations, transactions with certain affiliated persons (within
the meaning of the Investment Company Act), portfolio composition (including
restrictions with respect to diversification and industry concentration) and
other matters. Additionally, our Manager would have the right to terminate our
management agreement. Moreover, if we were required to register as an
investment company, we would no longer be eligible to be treated as a
partnership for United States federal income tax purposes. Instead, we would be
classified as a corporation for tax purposes and would be able to avoid
corporate taxation only to the extent that we were able to elect and qualify as
a regulated investment company (RIC) under applicable tax rules. Because our
eligibility for RIC status would depend on our assets and sources of income at
the time that we were required to register as an investment company, there can
be no assurance that we would be able to qualify as a RIC. If we were to lose
partnership status and fail to qualify as a RIC, we would be taxed as a regular
corporation. See Partnership Tax Matters
Qualifying
Income Exception
.
We have not requested approval or guidance from the SEC or its staff
with respect to our Investment Company Act determinations, including, in
particular: our treatment of any subsidiary as majority-owned; the compliance
of any subsidiary with Section 3(c)(5)(C) or
Section 3(c)(9) of, or Rule 3a-7 under, the Investment Company
Act, including any subsidiarys determinations with respect to the consistency
of its assets or operations with the requirements thereof; or whether our
interests in one or more subsidiaries constitute investment securities for
purposes of the 40% test. If the SEC were to disagree with our treatment of one
or more subsidiaries as being excepted from the Investment Company Act pursuant
to Rule 3a-7, Section 3(c)(5)(C) or Section 3(c)(9), with
our determination that one or more of our other holdings do not constitute
investment securities for purposes of the 40% test, or with our determinations
as to the nature of the business in which we engage or the manner in which we
hold ourselves out, we and/or one or more of our subsidiaries would need to
adjust our operating strategies or assets in order for us to continue to pass
the 40% test or register as an investment company, either of which could have a
material adverse effect on us. Moreover, we may be required to adjust our
operating strategy and holdings, or to effect sales of our assets in a manner
that, or at a time or price at which, we would not otherwise choose, if there
are changes in the laws or rules governing our Investment Company Act
status or that of our subsidiaries, or if the SEC or its staff provides more
specific or different guidance regarding the application of relevant provisions
of, and rules under, the Investment Company Act. Such guidance could
provide additional flexibility, or it could further inhibit our ability, or the
ability of a subsidiary, to pursue a chosen operating strategy, which could
have a material adverse effect on us.
If the SEC or a court of competent jurisdiction were to find that we
were required, but failed, to register as an investment company in violation of
the Investment Company Act, we would have to cease business activities, we
would breach representations and warranties and/or be in default as to certain
of our contracts and obligations, civil or criminal actions could be brought
against us, our contracts would be unenforceable unless a court were to require
enforcement and a court could appoint a receiver to take control of us and
liquidate our business, any or all of which would have a material adverse
effect on our business.
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, 2009, our Manager
and its affiliates collectively owned approximately 8.5% of our outstanding
common shares on a fully diluted basis. In addition, as of December 31,
2009 our chairman, Paul M. Hazen, who serves as a member of our Managers
investment committee beneficially owned approximately 0.8% of our outstanding
common shares on a fully diluted basis, and two of our directors, Scott C.
Nuttall, who is an executive at KKR and until February 2009 served as a
member of our Managers investment committee and William C. Sonneborn, who is
an executive at KKR and serves as a member of our Managers investment
committee, beneficially owned approximately 0.8% and 0.7% of our outstanding
common shares on a fully diluted basis, respectively. For purposes of computing
the percentage of shares of our outstanding common shares beneficially owned as
of December 31, 2009 by any person or persons on a fully diluted basis, we
define beneficial ownership to include securities actually owned by a person or
persons and securities over which that person or persons have or share voting
or dispositive control, and we have based that calculation on our common shares
and options to purchase our common shares outstanding as of December 31,
2009 and have assumed the exercise of all options to purchase our common shares
beneficially owned by such person or persons, as the case may be. 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 action of our board of directors in following or declining to follow its
advice or recommendations. The management agreement provides that our Manager,
its members, managers, officers and employees will not be liable to us, any
subsidiary of ours, our directors, holders of our shares or any subsidiarys
shareholders for acts or omissions pursuant to or 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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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 Manager has implemented policies and procedures to mitigate
conflicts of interest in such transactions.
The parent company of our Manager has furnished
information to the SEC in response to a request from the SEC for information in
connection with its examination of certain investment advisors in order to
review trading procedures and valuation practices in the collateral pools of
structured credit products. The parent company of our Manager also provided
information regarding the surrender by us for cancellation, without consideration,
of certain notes that had been issued to us by collateral pools of CLOs. The
parent company of our Manager is fully cooperating with the SECs examination.
We have made and may make investments, such as
investments in natural resources, that would generate income that is treated as
effectively connected with respect to holders of our common shares that are not
United States persons.
We have made and may make investments, such as
investments in natural resources, the income from which likely would be treated
as effectively connected with the conduct of a United States trade or business
with respect to holders of our shares that are not United States persons
within the meaning of Section 7701(a)(30) of the Code. Furthermore, any notional principal contracts
that we enter into, if any, in connection with investments in natural resources
likely would generate income that would be treated as effectively connected
income with the conduct of a United States trade or business. To the extent our income is treated as
effectively connected income, a holder who is a non-United States person
generally would be required to (i) file a United States federal
income tax return for such year reporting its allocable share, if any, of our
income or loss effectively connected with such trade or business and
(ii) pay United States federal income tax at regular United States tax
rates on any such income. Moreover, if such a holder is a corporation, it might
be subject to a United States branch profits tax on its allocable share of our
effectively connected income. In addition, distributions to such a holder would
be subject to withholding at the highest applicable tax rate to the extent of
the holders allocable share of our effectively connected income. Any amount so
withheld would be creditable against such holders United States federal income
tax liability, and such holder could claim a refund to the extent that the
amount withheld exceeded such persons United States federal income tax
liability for the taxable year. Finally, if we are engaged in a United States
trade or business, a portion of any gain recognized by an investor who is a
non-United States person on the sale or exchange of its shares may be treated
for United States federal income tax purposes as effectively connected income,
and hence such holder may be subject to United States federal income tax on the
sale or exchange.
Holders of our shares may be
subject to foreign, state and local taxes and return filing requirements as a
result of investing in our shares.
In addition to United States federal income taxes, holders of our
common shares will likely be subject to other taxes, including foreign, state
and local taxes, unincorporated business taxes and estate, inheritance or
intangible taxes that are imposed by the various jurisdictions in which we
conduct business or own property. For
example, we will likely be treated as doing business in any foreign, state or
local jurisdiction in which our natural resources investments are located. As a result, our holders will likely be
required to file foreign, state and local income tax returns and pay foreign,
state and local income taxes in some or all of these various
jurisdictions. Further, holders may be
subject to penalties for failure to comply with those requirements.
Item 2
.
Unregistered Sales of Equity Securities and
Use of Proceeds
On July 15, 2010, our
non-employee directors deferred an immaterial amount of cash compensation in
exchange for 4,908 phantom shares pursuant to the KKR Financial Holdings LLC
Non-Employee Directors Deferred Compensation and Share Award Plan. In
addition, on August 9, 2010, our non-employee directors received a total
of 26,965 phantom shares in lieu of restricted shares pursuant to the KKR
Financial Holdings LLC Non-Employee Directors Deferred Compensation and Share
Award Plan. Each phantom share is the economic equivalent of one of our common
shares. The phantom shares become payable, in cash or common shares, at the
election of the Company, upon the earlier of (i) the first day of January following
the applicable non-employee directors termination of service as a director or (ii) an
election date pre-selected by the applicable non-employee director, and in any
event in cash or common shares, at the election of the applicable non-employee
director, upon the occurrence of a change in control of the Company. The grants
made to our non-employee directors were exempt from the registration
requirements of the Securities Act pursuant to Section 4(2) thereof.
61
Table of Contents
On
August 9, 2010, the Compensation Committee of our board of directors
granted to our non-employee directors an aggregate of 52,808 restricted common
shares pursuant to our 2007 Share Incentive Plan. Each of these grants vests in
one-third increments on the first three anniversaries of the date of grant. The
grants made to our non-employee directors were exempt from the registration
requirements of the Securities Act pursuant to Section 4(2) thereof.
For further discussion of the 2007 Share Incentive Plan, see Item 1. Financial
StatementsNote 12. Share Options and Restricted Shares of this Quarterly
Report on Form 10-Q.
Item 3. Defaults
Upon Senior Securities
None.
Item 4. Submission
of Matters to a Vote of Security Holders
None.
Item 5. Other
Information
On
November 3, 2010, our board of directors
appointed Chief Operating
Officer Michael R. McFerran to the additional post of Chief Financial Officer.
Mr. McFerran will succeed Jeffrey B. Van Horn, who has been named Kohlberg
Kravis Roberts & Co. L.P.s Global Director of Tax as well as our
Executive Vice President, Director of Tax. The board of directors also
appointed Nicole J. Macarchuk as our General Counsel. All appointments were
effective on November 3, 2010.
Mr. McFerran has been
our Chief Operating Officer since December 2008. Mr. McFerran has
been employed by our Manager since June 2005 and is our Managers Chief
Financial Officer. Prior to joining our Manager, Mr. McFerran spent the
majority of his career at Ernst & Young in their financial services
practice, where he specialized in providing assurance and consulting services
to a diverse mix of financial services firms. Additionally, prior to joining
KKR, Mr. McFerran held Vice President positions at both XL Capital Ltd.
and American Express. Mr. McFerran holds an M.B.A. from the Haas School of
Business at U.C. Berkeley and is a Certified Public Accountant.
We expect that in February 2011,
certain restricted common shares held by Mr. McFerran and certain other
executive officers of the Company will vest in accordance with their terms,
resulting in federal and state tax withholding obligations. The Company may engage in transactions with
Mr. McFerran and such other executive officers in order to facilitate the
payment of such withholding obligations, including purchasing, at the
then-current market price, a number of such restricted common shares sufficient
to satisfy the withholding obligations of such individuals.
Ms. Macarchuk joins our
Manager as a Director and is our Managers General Counsel. Prior to joining,
Ms. Macarchuk served as General Counsel and Managing Director at Och-Ziff
Capital Management Group. She holds a
J.D. from Fordham University Law School and a B.A. from Fordham University.
Item 6. Exhibits
Exhibit
Number
|
|
Description
|
|
|
|
31.1
|
|
Chief
Executive Officer Certification
|
31.2
|
|
Chief
Financial Officer Certification
|
32
|
|
Certification
Pursuant to 18 U.S.C. Section 1350
|
62
Table of Contents
SIGNATURES
Pursuant
to the requirements of the Securities Exchange Act of 1934, KKR Financial
Holdings LLC has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
|
|
KKR Financial Holdings LLC
|
|
|
|
Signature
|
|
Title
|
|
|
|
|
|
|
/s/
WILLIAM C. SONNEBORN
|
|
Chief
Executive Officer (Principal Executive Officer)
|
William C. Sonneborn
|
|
|
|
|
|
|
|
|
/s/
MICHAEL R. MCFERRAN
|
|
Chief
Financial Officer (Principal Financial and Accounting Officer)
|
Michael R. McFerran
|
|
|
|
|
Date:
November 4, 2010
|
|
|
63
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