KKR Financial Corp. Q3 2008 Earnings Call Transcript

| About: KKR (KKR)

KKR Financial Corp. (KFN) Q3 2008 Earnings Call November 11, 2008 5:00 PM ET


Laurie Poggi - Director of IR for KKR Fixed Income

Nino Fanlo - CEO

Dave Netjes - COO

Jeff Van Horn - CFO


Faye Elliott - Merrill Lynch

Jim Ballan - JPMorgan

Don Fandetti - Citigroup

John Hecht - JMP Securities

James Shanahan - Wachovia

Douglas Harter - Credit Suisse


Good afternoon, everyone, and welcome to the KKR Financial Holdings LLC conference call to discuss financial results for the third quarter 2008. Today's call is being recorded. Today's call includes a presentation by management followed by a question-and-answer session. (Operator Instructions).

Now, at this time for opening remarks and introductions, I would like to turn the conference over to Ms. Laurie Poggi. Please go ahead.

Laurie Poggi

Thank you. Good afternoon and welcome to KKR Financial Holdings third quarter conference call. I am Laurie Poggi, Director of Investor Relations for KKR Fixed Income. And with me today are Nino Fanlo, the company's Chief Executive Officer; Dave Netjes, the company's Chief Operating Officer; Jeff Van Horn, the company's Chief Financial Officer; Andrew Sossen, the company's General Counsel; and Michael McFerran, KKR Fixed Income's Chief Financial Officer.

Our earnings release for the quarter ended September 30, 2008, was issued today, and as with prior quarters, a supplemental information packet was posted on our website. Additionally, today we filed our Form 10-Q for the third quarter with the Securities and Exchange Commission. A replay of this call will be available on our website at www.KKR.com through November 17.

At this time, I would like to remind you that this conference call contains forward-looking statements that are based on the beliefs of the management team, regarding the operations and the results of the operations of the company, as well as general economic conditions.

These beliefs and the related forward-looking statements are subject to substantial risks and uncertainties, which are described in greater detail in the filings we have made with the Securities and Exchange Commission. These filings are available on the Securities and Exchange Commission's website at www.SEC.gov. Our actual results may vary materially from those described in these forward-looking statements.

And now, I will turn the call over to management. Nino, please go ahead.

Nino Fanlo

Thanks, Laurie. Good afternoon and thank you all for joining our call today. The headlines over the past three months speak for themselves. We are operating in extremely difficult times. The deleveraging of corporate and commercial America is creating a dislocation in the capital markets not witnessed since the Great Depression. Liquidity is scarce. Markets are extremely volatile. And the economy is increasingly facing once in a century challenges.

The crisis began in the summer of 2007, as so many of us recall. And while conditions have continued to deteriorate, I don't believe any of us could have predicted the events, and the severity of events, that have taken place over the past 10 weeks. We have witnessed the nationalization of Fannie Mae and Freddie Mac, a bailout of AIG which today increased dramatically, and the disappearance of three legendary Wall Street investment banks who survived the previous depression. We have also witnessed the failure of other commercial banks and a wave of consolidation take place in the financial services sector.

To list out all that has occurred would simply take too much time. However, the message is clear. The world has changed, and the landscape of financial services is fundamentally different than it was just one quarter ago.

During September, we witnessed a dramatic decline in leveraged loan prices, which was only exceeded by the sharp drop in loan prices in October. While we have positioned our balance sheet to be insulated for market value changes, we are not immune to them. As we have previously mentioned, we felt we were well positioned for a '90-'92 recession and that we would adjust adequately, if the recession was as difficult as '73-'75 or '80-'82. However, we need to reflect on our condition for today's environment, which may be closer to the 1930s.

For example, the average LCD flow name composite was a price of 88% on September 1 and as of November 6, it had dropped and it was 75%. To put this into context, because of their seniority in the capital structure, leveraged loans have historically traded near par, and loan prices declined only to the mid-90%s during the '01-'02 recession and not substantially below 90% in the '90-'92 recession.

Clearly today's prices are function of not only difficult credit fundamentals but extraordinary market technicals. The equity markets are priced at a level reflecting a recession. However, credit is priced at a level assuming a depression. Our view of the current and anticipated economic environment is best summarized as very difficult but manageable.

We do believe that the next few years will be challenging for the economy and a deep recession is a distinct possibility. The coordinated efforts of industrialized nations and central banks will significantly mitigate the severity of this downturn and positively assist the economy, but the actions taken most likely will not stave off a severe recession.

As we continue through the cycle, we expect that asset prices will eventually reflect fundamentals. And actually the last couple of weeks Dave and I are comforted by the fact that this is increasingly the case. Companies that experienced significant stress with expectations of default, however, will see that their prices remain near current levels, while the companies that do have the strong fundamentals will experience accretion in credit prices.

Liquidity in the global markets is terribly restricted and things may still get worse as the economy enters this deepening recession. Accordingly, KFN must be positioned as such. As we face these challenges, we know that our portfolio is well positioned with regard to senior term loan investment in companies that the KKR Group knows well.

As we've described in our past calls, we have made investments in companies that we believe based on scale and management are reasonably positioned to weather a downturn to the economy. Furthermore, the senior debt orientation of our portfolio helps to cushion any unexpected credit deterioration.

Defaults on senior loans do not necessarily translate into significant credit losses, and in certain cases, may not generate any losses. We believe we have a number of companies today whose price's trade at material discounts to par that reflect this instance where losses would be either minimal or none should a default arise.

Now with regard to our liabilities which we have spent considerable time over the past few years, over a 70% of our debt consists of long-term funding in the form of cash flow CLOs. With a weighted average spread to LIBOR of 48 basis points, these liabilities are valuable as they are both low cost and have a weighted average remaining term to maturity of over 10 years, which is nearly two times the average life of the assets they finance.

In the current market environment, certain of these structures will trap cash and deleverage modestly. And Dave will explain how this operates in a few minutes. However, they will continue to provide long-term value to KFN and its shareholders.

To bridge today's volatile market so that our assets may realize their full value, we are taking several important steps. We have made the difficult decision to not pay a dividend for the third quarter, to retain liquidity and to provide maximum flexibility with respect to uses of liquidity in the current extremely challenged environment.

We have also successfully completed the replacement of our revolving credit facility that was due to mature in the middle of 2009. This new facility provides us with increased flexibility, as it extends the maturity of our revolving credit financing and provides for less restricted financial covenants, that will enhance our flexibility to make appropriate portfolio management decisions on behalf of all of our shareholders.

We replaced the existing facility with two new facilities. Dave will provide you with more detail later in the call, and I will comment only briefly here. The two new facilities consisted of $300 million senior secured asset-based revolving credit facility provided by Bank of America and Citibank and we're grateful to them, and a $100 million unsecured standby credit line provided by our manager.

It is not clear we will need to utilize the capacity provided by the standby line, but it is there to provide additional flexibility in bridging the difference between the $368 million in borrowings outstanding under the credit facility, with the $300 million capacity of the new revolving credit facility.

We do not expect to borrow against the $100 million standby credit line initially, as we have sufficient liquidity to bridge the gap between our previous and new borrowing-based credit facilities. Rather we view the $100 million credit line from our manager as an akin to insurance policy for our business as we work our way through this environment over the coming months.

In today's environment obtaining any financing is actually a remarkable achievement, and we are very pleased we were able to execute these transactions albeit at a significantly higher cost than financing transactions we have been able to execute prior to the current financial crisis in the market.

Our condition and our challenges are no different than other borrowers face today and, therefore, we are grateful to our banks and our colleagues at KKR, who worked so diligently to get this done prior to today's release. We also as one would expect us to do are exploring various strategic alternatives including a change in corporate structure, a conversion to a bank, and the acquisition of a depository.

These are preliminary considerations only, and we expect that alternatives will evolve and develop as the economic landscape changes over time. However, it is important for us to recognize the considerable advantages today, that depository institutions enjoy as a result of the changing landscape.

I again want to emphasize the proactive steps taken are based on the strategy of providing us flexibility, and are prudent given our view of the current and anticipated market environment. The economic landscape is changing rapidly and we are committed to positioning KFN accordingly.

The foundation of our business is our people, our asset selection and our financing structures, all of which provide a sound base that will serve our shareholders well in the long term and we will get through these difficult times.

I will now ask Dave to walk you through the details of the financing transactions that we have entered into.

Dave Netjes

Thanks, Nino, and good afternoon, everyone. As Nino described, we have executed two new financing transactions. The rationale for doing so was straightforward. And as Nino said, we wanted to provide ourselves with flexibility in today's challenging environment. The covenants in our prior facility would have constrained our ability to make certain asset decisions, as they contain both a restrictive net worth covenant and a minimum net worth covenant.

The terms of our new credit facility provide us with the needed flexibility to manage our investment portfolio without excessive covenant constraints. The terms of our new credit facility are described in greater detail in our Form 10-Q that we filed with the SEC today.

The new facility is $300 million, which is a reduction of $200 million from our previous $500 million facility. Currently, as Nino mentioned, we have approximately $368 million of borrowings outstanding under our existing credit facility.

As part of entering into this new agreement, we are paying down the excess amount outstanding of approximately $68 million using existing cash. The $300 million facility size is reduced by the current lenders to $150 million on the one-year anniversary of this agreement. And if we can satisfy the $150 million commitment reduction by either paying down the facility, or syndicating the facility to other lenders prior to November 2009. The facility bears interest at a rate of LIBOR plus 3%.

Under the terms of this facility, we are restricted from making cash distributions to shareholders in excess of the amounts that we estimate to be necessary for our shareholders to satisfy federal and state tax liabilities with respect to their share of the company's taxable income until 2009, so long as we satisfy certain borrowing base conditions contained in the credit agreement.

As previously mentioned, we have entered into in an unsecured standby revolving credit facility with our manager. This agreement provides us with the ability to have an extra source of liquidity to utilize again, if needed, as we reduce the borrowings outstanding under our current credit facility. This agreement matures in December 2010, and bears interest at the rate of LIBOR plus 15% with the ability to pick up to 80% of the interest owned during any period by having it capitalized to the outstanding principal balance of the loan outstanding.

We have adequate liquidity today, but given the uncertainty of the financial markets, entering into an agreement for this facility provides us with added flexibility and comfort. This transaction was executed at market terms and was reviewed accordingly by both our outside counsel our Board of Directors and the affiliated transaction committee of our Board of Directors.

Next, I will spend a few minutes reviewing our CLOs and the Wayzata facility with you. As you are aware, we currently have five cash flow CLO transactions outstanding, consisting of CLO 2005-1, 2005-2, 2006-1, 2007-1 and 2007-A. In aggregate, these transactions totaled $8 billion. An affiliate of our manager owns 37% of CLO 2007-1 and 2007-A.

The indentures governing our CLO transactions include numerous compliance tests with respect to the collateral, the majority of which relate to the portfolio profile. In the event that a portfolio profile test is not met, the indenture places restrictions around our ability to reinvest available principal proceeds generated by the collateral in the CLOs until the specific tests have been cured.

In addition to the profile test, the indentures for the CLO transactions include other tests including overcollateralization tests and interest coverage tests. Overcollateralization tests or OC tests simply measure the ratio of the collateral value of the assets in the CLO to the debt for which the test is being measured. OC tests are stressed when assets are treated at market value rather than in par in the calculation.

In today's environment, it's apparent that the market value of assets is below par across the board, and as a result, we expect to experience periods of noncompliance with OC tests in certain of our CLO transactions.

Two things are happening in the market today that are making this likely. First, downgrades of investments to CCC increase the dollar amount of assets that are treated or carried at market value. And second, prices of all assets have been declining, which compounds this issue.

The details of the mechanics of our CLOs and the OC tests are described in further detail in the Sources of Funds section of the Management Discussion and Analysis in our Form 10-Q that we filed with the SEC today.

Next, I want to emphasize a few points. First, our portfolio is performing quite well, and the rating agency actions are expected response to a recessionary environment. Next, the historic decline in loan prices that we have all witnessed is the primary driver of pressure on our CLO OC tests.

To-date, none of our CLOs have actually failed an OC test on their payment date. If those tests were run based on our prices of as of last Friday, we would expect that we would be out of compliance with the tests for three of our CLOs.

Just a moment on what noncompliance means. First, and most importantly, we are not required to put up any cash. And equally, if not more important, we are not required to sell any of the assets. When an OC test is out of compliance, the quarterly cash payments due to us from the structure is simply use to reduce the senior debt that has been issued to and has been purchased by third-parties.

By doing so, if prices remain flat, the OC test is naturally brought back into compliance through deleveraging. And at that point in time, we would continue to get cash returned from this structure. This problem obviously accelerates when prices appreciate, or the OC test is obviously fixed one prices appreciate and significant price appreciation will actually cure the OC test.

In the interim, we expect that our free cash flow from CLO distributions will be reduced. The worst consequence of this is that we just will deleverage our debt until the failed OC tests are back in compliance.

Next, I want to spend just a moment on Wayzata, which is our market value CLO. This transaction is different from our cash flow CLOs in that under this facility when market values decline below a trigger, it does require us to post additional collateral. Wayzata allows for an approximate 5% decrease in market value before any collateral posting is required.

If market value declined by more than 5%, then the entire 5% cushion must be replenished. To-date, we have contributed approximately $150 million in additional cash to this transaction. And as of November 7, our current cushion under the test was approximately $80 million. This means we estimate the assets financed through Wayzata can drop in value an additional $80 million before we have to make a choice about adding additional collateral.

As you are aware, Wayzata is a non-recourse facility, and as such, if we choose not to add additional collateral, then the senior lender would foreclose on the assets held by the structure or held by the Wayzata facility.

Additionally, Wayzata requires that a current net asset value test be met in order to receive cash distributions. If the net asset value is below this amount, then cash is trapped until the NAV or net asset value is in compliance with this requirement.

Based on current asset prices, we would not receive cash distributions from Wayzata until this test is brought back into compliance. Similar to our cash flow CLOs, the assets held in Wayzata are performing very well.

The bottom line is that with loan prices in the mid-70s, certain of our securitization structures are going to cease being cash flow generative to us until they either deleverage or until prices appreciate or both occur.

Cash being trapped does not impact our available cash for operations, new investments and dividends. That said even if all of our CLOs and Wayzata cease generating cash for periods of time, we expect that we will have sufficient cash outside of these structures to service our debt and meet ongoing expenses.

With that, I'm going to ask Jeff Van Horn to walk us through our quarterly results.

Jeff Van Horn

Thanks, Dave, and good afternoon. Our GAAP net income for the quarter was $49 million, or $0.33 per diluted common share. Economic net income, which is GAAP net income adjusted to exclude share-based compensation expense, was $48.9 million, or $0.33 per diluted common share.

Similar to past quarters we have posted supplemental operating and financial information on our website today, which includes our economic income statement, per share valuation metrics, and information about our investment portfolio and financing.

Our results for the quarter include realized losses from sales of investments, totaling $12.4 million and impairments of two equity investments, totaling $10.5 million. Our results also include a gain of $3.1 million related to the repurchase and retirement of $5 million of trust preferred securities.

Our GAAP book value per share and economic book value per share as of quarter end were $11.47 and $12.05 respectively, as compared to $12.71 and $13 as of June 30, 2008. Our fair value per share as of quarter end, which reflects all of our financial assets and liabilities at fair value, was $13.85, as compared to $15.15 as of June 30, 2008.

As of quarter end, our current quarterly net income run rate was $0.44 per share. We define run rate income as net investment income from our current portfolio less estimated non-investment expenses.

Next, I'm going to hand the call back to Nino.

Nino Fanlo

Thank you, Jeff. Before we take any questions, I would like to close with a few remarks. We at KFN and KKR are committed to the long-term success of KFN. We think that the actions taken by KFN and KKR demonstrate our commitment to KFN during these challenging times.

As I mentioned, we will continue to evaluate all strategic options to ensure we have the optimal business strategy the appropriate structure. As Dave and Jeff have indicated, our balance sheet is sound and provides us with a strong base to create long-term value for our shareholders.

While the current environment is difficult, we will take the actions that are necessary to create long-term value. We will continue to strategically build on these actions, as we evolve during this difficult time to the new landscape of this challenging world.

The economy is likely entering its severest recession since at least the early 1980s and possibly the '30s. Calm, sensible, reasoned investment decisions will serve us well in these difficult times. A good friend recently reminded me that tough times do not last, but tough people do. We at KKR and KFN shall persevere and move the company forward.

With that, Laurie let's open it up to questions.

Laurie Poggi

Dustin, we are now ready for questions.

Question-and-Answer Session


(Operator Instructions). We will go first to Faye Elliott with Merrill Lynch.

Faye Elliott - Merrill Lynch

Thanks for taking my call. Can you give us a sense of the level of income we could see including the cash that is being trapped, if it were to actually be the case through the rest of the fourth quarter?

Nino Fanlo

Sure, Faye. As Jeff indicated, our run rate, which is a GAAP figure, reflects what the earnings are. As Dave indicated, the amount of cash flow available is a function of the change in rating agency actions and the price of securities at any point. I think what Dave indicated was we felt very comfortable that regardless of rating agency actions and price deterioration, the firm had adequate resources to meet all its financial liabilities and expenses.

And the amount of actual cash that would be available for distribution and further investment was a function of the price action.

Dave, would you like to expand on that?

Dave Netjes

Yes. Just the last item say is whether or not cash is trapped in a structure for GAAP that has no impact on our GAAP earnings because for GAAP purposes the CLOs are ignored. So the only thing that impacts our GAAP earnings are if assets go on non-accrual status or obviously if we have asset that we charge off. But trapping cash will not have any impact on our GAAP run rate earnings.


Our next question is from Jim Ballan with JPMorgan.

Jim Ballan - JPMorgan

Great. Thanks a lot. Can you talk a little bit about the pace at which capital is being returned to you, has that continued to slow? And, I mean, I guess for the assets that are in the CLOs that cash has either been reinvested or used to delever. But for the assets that are outside of the CLOs say that are in Wayzata, what are you using that liquidity for? Are you using it to pay downs Wayzata or holding onto that cash?

Nino Fanlo

I think we have to bracket the world into two worlds. Prior to the events of September 30, and the remarkable financial market performance of October, we were actively investing identifying new opportunities. And I would describe the world as it was as the way we had previously described, we were judiciously investing.

In September and October, I think events took more control of themselves, and cash was being diverted for reserves against further price declines. And of course events continue to transpire. NRG just a couple of weeks ago received a takeover bid. And we believe that there will likely be a monetization.

There has been considerable commentary about the FCC's approval of Verizon's acquisition of Alltel, which will generate cash. So the question you asked, Jim, about does cash continue to be created? The answer is of course it does continue to be created. But I would describe that the events of the past six weeks have certainly changed our normal operations.

Dave, would you like to add to that?

Dave Netjes

Yes. I think the last thing, Jim, the reason it was so important for us to get this new revolver in place was the covenants under it give us much more flexibility to take advantage of the current market environment. Previously because we had a relatively tight tangible net worth covenant, Nino, myself, Jeff, Mike, the entire team we would sit down and see extraordinary investment opportunities, but that would require selling something that for GAAP purposes would generate a loss, even though the payback through increased returns on the new investment could be as short as 6, 12, or 18 months.

And we were being hamstrung by the ability not to take advantage of that opportunity. That limitation became even more exacerbated as we went through the end of September and October, and we saw a bank loan sell off really precipitously. And we had to act on that so that we could take advantage of it. We've got $10 billion in CLOs. We shared with you what percentage the company owns.

That stuff is in place at an average price of LIBOR plus 50 for the next nine years. The most critical thing for me, Nino, and the entire management team to do is to take advantage of the opportunity set we see here today. That means selling some of the credits with higher prices and taking advantage of the dislocation in the marketplace. Getting those covenants fixed is the first step for us to be able to capitalize on that opportunity.

Jim Ballan - JPMorgan

Great. One other question if I may. So you're not paying the dividend here in the third quarter. If the fourth quarter looks for the most part like the third quarter, would you be able to pay [dividend] in the fourth quarter or would that also be third quarter from a dividend standpoint?

Nino Fanlo

Yes. I think you broke out a little bit there, Jim. I think I understood it. If the fourth quarter looked like the third quarter, would our dividend actions be the same? First, importantly, this discussion and this decision is not a management company decision, it's a Board decision. So I would not want to speak for the Board.

But I do believe that if you look at the effect of the markets and the deterioration of economic activity in October, I would not believe that the current environment is an improved environment that would lead to incremental risk taking. But again, I just want to be very clear that is a Board action and it is not up to management. I would not today on the facts that I had today recommend for any change in strategy from what you have just seen.

Jim Ballan - JPMorgan

Okay, great. Thanks a lot.


We'll go next to Don Fandetti with Citigroup.

Don Fandetti - Citigroup

Hi. Nino, your $100 million facility, I'm just trying to understand what is behind that. You say the manager and KKR Fixed Income. The part that is not KKR Fixed Income, I mean is there anything really behind that? I'm just trying to understand.

Nino Fanlo

I think you should look at the group that the world knows as KKR; the individuals, the partners, the organization that is what is providing the backstop facility. I apologize for the legal aspect of it. But it is the firm that people know as KKR to be the entity.

Dave Netjes

And Don, just so you are aware KKR Fixed Income is a subsidiary, a wholly-owned subsidiary of the GP. So it is the GP as everyone knows it.

Don Fandetti - Citigroup

Okay. And then you had mentioned the potential of looking at bank acquisitions. A, can you talk a little bit about the potential opportunities there? B, you probably need some capital to finance that. It looks like you are capital constrained. So I am not sure how you get to that potential opportunity.

Nino Fanlo

Let me answer in a couple of elements. First, the landscape obviously since our last earnings call, there used to be a securities industry. There is none. I think you could argue that there was a specialty finance industry that wasn't deeply constrained. If general Electric is forced to get government support, then I think we have really changed the level of dynamics.

So my remarks or our remarks I should say about the need to explore diligently, an institution that has access to regulated capital effectively is an essential element of our analysis and we will conduct it.

With regard to the equity capital to invest in it, I think it is fair to say that we have assets today and capital that would allow us to at least make modest acquisitions. And we believe we continue to have both investors as well as interested parties that would assist us in that if we needed to.


We will go next to John Hecht with JMP Securities.

John Hecht - JMP Securities

Good afternoon. Thanks for taking my questions. You guys once again provide us with a list of your top 50 investments. I'm wondering, can you maybe give us a sense for what you might call the hard watch lister or the components of this list that you're taking a very close look at from a credit prospective?

Nino Fanlo

Let me answer that in the following way, John. By the end of the quarter, the watch list which, in future disclosure we might be able to provide further color, our constraints on that are that it may restrict our ability to make portfolio decisions, if other potential investors knew which assets we were moving in and out of.

I can make the following remarks. Going into October, we did not believe there was any material change whatsoever in the condition of our watch list as it was at the end of the second quarter, and frankly, not materially different than it was at the end of the first quarter.

Now Dave and I as a result of the economic deterioration that is coming through in the numbers of October have committed to the Board that we will take a fresh look at how all the companies operate in what will be undoubtedly I think the worst recession since the early '80s. And it will require a more thorough scrubbing of what those assets.

We will in future [earnings releases] try to give a little broader color but we will always try to be careful to not restrict our ability to make portfolio changes by in effect telegraphing what assets we might be inclined to dispose of.

John Hecht - JMP Securities

Okay. In terms of the movement to the CLOs.

Nino Fanlo

I would like to make one more remark on that, John. We have previously described that the assets, or the impact that's has been felt to our balance sheet through P&L on SLOPs as well our OCI hits had been a fairly material hit. I continue to believe that through the third quarter, those figures were reflective of the risk that existed through the third quarter.

John Hecht - JMP Securities

Okay. And moving to the CLOs, can you give a sense of what is the overcollateralization requirements initially and where would it have to build to, and it sounds like it is a rating failure at this point in potentially three of your CLOs, and how long that might cash trap for assuming the assets don't prepay, just assuming normal course of business?

Dave Netjes

Sure. John, it depends on the CLOs, but for two of the CLOs, again it is not the payment date, but if we would apply the test on Friday, we are missing it by anywhere from $3 million or $4 million to $15 million or $20 million on two of them so we're relatively close.

On the third, it is a larger amount. On the larger CLO if you took the cash that that throws off over a three- or fourth-quarter period and use that to deleverage, and you have to hold two things constant assume prices don't go up or don't get worse as the case might be.

And you assume the relative level of ratings does not change materially that structured 2007-1 could be deleverage to the point where you are meeting the OC tests somewhere between quarters three or four. Again that is if you hold everything constant. If prices go up 3 or 4 or 5 points, it has a pretty material impact on the structure. And I would love for you to when you get time to stop by and we will walk you through that math.

Nino Fanlo

Yes. I would like to add it's the rating agency standards on this, there is a broad interpretation of what the terms are of a CCC. Those broad interpretations in conjunction with the extraordinary price declines, and it is really the price declines that have caused the challenges to this. So I just want to be very clear we had a horrible September, but really the damage in prices was really in October.

And that is what has created the primary challenges for the CLOs. I do not believe nor have I met anyone yet who believes that the price action of October is reflective of fundamentals. So I have some hope that even if time goes by and the natural deleveraging, it will be further assisted by rational price increases.

Dave Netjes

Yes. And just remember as you know John, we have a bias towards larger global businesses that are relatively large. As there was a tremendous amount of deleveraging by the hedge fund community and the mutual fund community at September 30, and then after, those are the names that from a price standpoint suffered the most. And we have actually seen that stabilize over the last couple of weeks and start to turnaround.

What we actually see happening now is the smaller less liquid names finally adjusting in prices. So we have reason to be mildly optimistic that the deleveraging that occurred at the end of the third quarter is behind us. That is not to mean that we don't expect to see a smaller wave here as we go through the end of the fourth quarter.

But we have also seen a number of nontraditional participants jump into this market. Distressed folks are buying it. We continue to see private equity shops buy it. The asset class is extremely cheap and is drawing in many new investors. I think that will bode well for us given the fact that we're in the very large flow names.

John Hecht - JMP Securities

Okay. And then the last question is Wayzata, Dave you mentioned there is an $80 million cushion and then there is that, is that a market value test you're talking about in terms of the cushion or is that an OC test?

Dave Netjes

You can think of that as if prices went down on the instruments or the loans that are in that structure, aggregate prices could go down $80 million to $85 million without the need to put in additional collateral. Notwithstanding that comment, I can assure you Nino, myself, and others are in very productive discussions with the financing source on that transaction about ways to curtail market value risk going forward.

We would love to turn it into a cash flow structure. We're having those discussions. We can't promise you that we will be successful. But we both have the same interests in line, I mean we have the right alignment of interest both us and the bank on the other side and that is in a very unprecedented market environment where prices are changing very rapidly, what's the best way to protect each other's interests. And those discussions are ongoing.

So, John, we're not going to sit back and just wait for market prices to go down. We have other options including deleveraging Wayzata if we chose to do that, now that we've got the new revolver in place. So it is priority number two tied only with managing credit risk in our business.

John Hecht - JMP Securities

Okay. Thanks very much.


Our next question comes from James Shanahan with Wachovia.

James Shanahan - Wachovia

Thank you. Most of my questions have been answered. And I found the information about the credit performance of the corporate loan portfolio in the Q, it is still quite impressive. But it would be nice if you continue to publish that information in the slides. Just a comment.

A follow-up, the $28.2 million in corporate loans that were changed to held for sale status, there was a charge there it looks like related to market value, why the switch? And is it your outlook for deterioration in that loan or maybe better execution today than in the future, is that the strategy?

Nino Fanlo

Mike, which are the 22 that you are talking about in held for sale?

James Shanahan - Wachovia

$28.2 million.

Jeff Van Horn

James, this is a small amount. It was a handful of loans we had traded just ordinary course of business, nothing unusual behind it.

James Shanahan - Wachovia

Thank you very much.


We have time for one final question. We will go to Douglas Harter with Credit Suisse.

Douglas Harter - Credit Suisse

Thanks. I was wondering to the extent that you are deleveraging Wayzata, how much of that $150 million that you have contributed could come out as you move it to the new facility or that all need to go to the new facility as well?

Nino Fanlo

I'm not sure I understood the question. What do you mean as we deleverage, pardon me?

Douglas Harter - Credit Suisse

You have said that as the prices have declined, you have had to put in $150 million of additional collateral into Wayzata. To the extent that you were to transition those loans over to the new facility, would you be able to free up any of that $150 million?

Nino Fanlo

Well, I think the Wayzata facility is still the most efficient way to finance those assets. I mean I think our borrowing base to be very clear will be substantially utilized today. So Wayzata remains the best place for those loans. And we have hoped that price appreciation will actually allow us to ultimately allow capital to be freed from that. Is that it?

Douglas Harter - Credit Suisse

Great. Thank you.

Nino Fanlo

Okay. Is there any other question, Laurie?

Laurie Poggi

That is it, Nino.

Nino Fanlo

Okay. I just want to make a couple of remarks. Financials have been so clearly in the spotlight over the past 60 days, and embedded in all the price action and the concern is an understandable fear about what the environment has been. A number of companies took actions they regret.

I will tell you today that KFN and what Dave and I and what our colleagues at KKR undertook was to employ a relatively conservative investment strategy with what we believed was a conservative financing strategy. We did not plan for the depths of challenges that a financial depression meant, but we will adjust to those.

People in organizations matter in business. It is critical to our investment decision. I want to reiterate that although the industry is facing unprecedented challenges, we are absolutely committed to see KFN through this difficult period of time, rebuild and as our Chairman Paul Hazen tells live to fight another day and see the other side of this recession. And be prepared to take those advantages that will result from these difficult, difficult times.

We thank you for your continued support. And we welcome at all times your interest in the company.


That does conclude today's conference call. We would like to again thank you for your participation. And you may disconnect at this time.

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