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Executives

Pam Testani - Investor Relations

Bill Sonneborn - Chief Executive Officer

Mike McFerran - Chief Operating Officer and Chief Financial Officer

Analysts

Lee Cooperman - Omega Advisors

Daniel Furtado - Jefferies

Gabe Poggi - FBR

Jason Stewart - Compass Point

Stephen Laws - Deutsche Bank

Jasper Burch – Macquarie

KKR Financial Holdings LLC (KFN) Q4 2012 Earnings Conference Call February 5, 2013 5:00 PM ET

Operator

Good day, ladies and gentlemen, and welcome to the KKR Financial Holdings LLC Fourth Quarter 2012 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time. (Operator Instructions) Today’s conference is being recorded.

I would now like to turn the call over to Pam Testani.

Pam Testani - Investor Relations

Thank you, Jamie, and welcome to our fourth quarter 2012 earnings call. I am joined by Bill Sonneborn, our CEO; and Mike McFerran, our COO and CFO.

We’d like to remind everyone that this call will contain forward-looking statements based on management’s beliefs, which do not guarantee future events or performance. These statements are subject to substantial risks that are described in greater detail both in our SEC filings and in the supplemental information presentation posted to our website. Actual results may vary materially from today’s statements. We’ll also refer to non-GAAP measures on this call, which are reconciled to GAAP figures in the supplements.

Before turning the call over to Mike and Bill to discuss our results, strategy performance, and the macro environment, let me start things off with some fourth quarter highlights. Today, we announced that our Board of Directors declared a regular quarterly cash distribution of $0.21 per common share, which is consistent with the distribution declared for the third quarter and a special distribution of $0.05 per common share. This brings cumulative distributions for the year to $0.86 per common share. The quarterly distribution is payable on February 28 to shareholders of record as of February 14 and the special distribution is payable on March 28 to shareholders of record as of March 14.

In addition, this afternoon we reported fourth quarter net income of $77 million, or $0.40 per diluted common share and fiscal year 2012 net income of $348 million or $1.87 per diluted common share. Fourth quarter and 2012 results reflect a 17% and 20% return on shareholders’ equity respectively. Our book value per share totaled $10.31 as of December 31st, which represents a 10% increase from the end of 2011.

I’ll now turn the call over to Mike.

Mike McFerran - Chief Operating Officer and Chief Financial Officer

Thanks, Pam, and good afternoon, everyone. Before beginning with our financial results, I wanted to highlight that we have changed our income statement presentation slightly to help you match up revenues and expenses for our segments, specifically natural resources. This change in presentation does not impact our net reported results, but it is useful in understanding the company’s revenue and expenses. Now, I’ll review our results for you then spend a little time discussing our liquidity and capital structure.

Today, we announced net income of $77 million or $0.40 per diluted common share for the fourth quarter. This is effectively flat with net income of $77 million or $0.43 per diluted common share for the fourth quarter of 2011. The decline on a per share basis year-over-year was related to our 7.5% convertible notes, specifically an increase in the conversion rate to account for distributions made in our common shares in 2012, and the change in our intended settlement method to all equity. Q4 net income consisted of $134 million of total revenues, $73 million of total investment costs, $37 million of other income, and $21 million of other expenses. Total revenues declined 2% from the fourth quarter of 2011.

Loan and securities interest income declined in aggregate by $12 million, which was predominantly offset by the increase in oil and gas revenue of $9 million. Overall, the change and composition of our revenue is consistent with our expectations for the following reasons. First, as we have migrated capital from our bank loan and high yield strategy to natural resources during 2011 and 2012. We are seeing a growing portion of our revenue come from natural resources. However, based on where we are in the lifecycle of this strategy. We believe that we are in the expansionary phase from a revenue perspective as our assets develop.

In addition we have seen securities income decline as expected due to divestures over the last six months of a significant portion of our high yield bond portfolio given the spread compression in the sector. From June 30th to December 31 we have reduced our bond holdings in our bank loan and high yield strategy by about 39% from $618 million par amount to $379 million par amount at year end. This was driven by the tight market spreads we saw in bonds in during the second half of 2012 and the relative value trade off between leverage loans which are generally senior in the capital structure and floating rates and high yields bonds which are generally supportive to loans and fixed rate.

The third factor that has had a modest impact on the income is the amortization on four of our CLOs that are no longer in their reinvestment periods. Accordingly principal repayments on CLOs 2051, 2052, 2061 and 2007A are used to reduce the principal amount of senior notes outstanding and are no longer reinvested in new assets in these structures.

Moving on to total investment costs, you will see that we have moved oil and gas expenses to this line item and we are now breaking out productions costs which are primarily cash expenses versus depletion, depreciation and amortization which are non-cash expenses. This should help you see trends in our national resources portfolio more clearly and give you the ability to calculate EBITDA for this strategy. Investment costs for the fourth quarter reflected a $22 million or 43% increase from the fourth quarter of 2011. This was primarily driven by the ramp up of our national resources strategy over the past year, which witnessed an $8 million increase in production expenses and a $5 million increase in DD&A.

Interest expense increased by $5 million year-over-year, which was almost exclusively driven by the aggregate $374 million of 30-year senior notes we issued in November of 2011 and March of 2012. In addition we wrote off $2 million of previously capitalized costs related to our prior revolving credit facility that was replaced during the fourth quarter. Going forward assuming that all of our convertible notes are retired, this will reduce annual interest expense by approximately $13 million per year with the last interest payment made in the first quarter of 2013.

I will come back to this topic in a bit when I discuss our decision to terminate the conversion feature of these notes, which is led to essentially all note holders surrendering them for conversion to shares. Other income which represents a realized and unrealized gains and losses on investments, derivatives, foreign exchange and fee income totaled $37 million for the fourth quarter. This represents a $24 million increase from the fourth quarter of 2011. The $37 million primarily consists of $23 million of realized gains including $8 million from the sale of our high-yield securities during the quarter.

Other income also benefited from a $4 million unrealized gain from our commodity price hedges and from $5 million of other income primarily related to fees we see during the quarter. As you have seen over the last several quarters other income experienced a significant fluctuations from quarter-to-quarter based on asset prices, repayments and gains or losses on divestitures. Other expenses totaled $21 million for the fourth quarter, which represents a modest 6% decline from the prior year period. Our reported earnings for the fourth quarter of 2012 represents a 17% return on equity and for the full year ended December 31, 2012 a 20% return on equity. Book value per common share totaled $10.31 as of year end as compared to $10.09 as of the end of the third quarter and $9.41 as of the end of 2011.

Looking at cash, on a normalized basis where we straight-lined the impact of our semi-annual convertible note interest payment, we generated a $0.26 of run-rate cash earnings per share or a 10% run-rate cash earnings return on equity and $0.36 of total net cash earnings per share which represents a 14% total cash return on equity. These amounts convert our normalized $0.29 of run rate and $0.21 of total net cash earnings per share for the third quarter of 2012.

Before handing this over to Bill, I will spend a little time on our capital structure and liquidity. With respect to the former, we have made a lot of progress on already strong capital structure since we last spoke. We have operated under a pretty simple principle over the past 14 months or so, which is with rates at historic lows, we can create meaningful long-term value for our shareholders by sourcing low-cost, long-term non-mark-to-market debt. Things won’t always be this way, I can sure assure you. With that mindset, we have attempted to be both thoughtful and creative. Now, we have evolved our capital structure.

Here is where we are today. We have $284 million of 30-year trust preferred securities that don’t start maturing until 2036. Of this amount, $155 million bear interest at a weighted average fixed rate of 7.7%. The remainder bear interest at a weighted average rate of LIBOR plus 238 basis points. But as we previously mentioned, we have entered into interest rate swaps through their maturity that lock in a weighted average fixed rate of 3.8%. We have completed two senior note transactions issuing a combined $374 million of 30-year fixed rate notes at a blended rate of 8.1%. And in January, we completed our first ever preferential preferred offering through which we issued $374 million of perpetual preferred shares with a cap 7.38% distribution rate.

Last, as we announced a few weeks ago, we exercised our ability to terminate the conversion feature on our 7.5% convertible notes, which had $172.5 million outstanding at year end. We have been asked by some of you why we decided to do this. The answer is pretty simple. The convert was expensive to our shareholders. In addition to receiving a 7.5% cash coupon, each quarter that we distributed more than $0.05 per share to our common shareholders, the number of shares that we would have to deliver upon conversion increased and not by an insignificant amount.

To give you a sense of the magnitude of these adjustments from December 31, 2011 to December 31, 2012, holders of these converts were entitled to 1.7 million more shares just because of that conversion rate adjustment, an increase of 7.3%. As a result, it was only getting more expensive to take these out. We are paying $12.9 million of annual interest expense. Given that background, we believe it was in the best interest of shareholders to terminate the conversion rights of noteholders as soon as we have the chance, which is exactly what we did. The only question was how to settle no conversions in the most attractive way for our shareholders through cash payment, issuing shares, or a combination thereof.

We had originally anticipated settlement conversions in the combination of cash and shares. While as our shares traded off after our announcement, that method became more dilutive. Relative to our initial plan, it was accretive to settle entirely in equity as the new shares were effectively issued at a premium to book value. For the 99.8% of conversions we have received so far, this is how we have proceeded with the settlement method that maximizes pro forma book value per share.

Assuming the rest of the notes are converted and we have settled those in equity as well, our total share count will be about, it would increase by about 26.1 million shares. The estimated impact of this and the increase in equity from retirement to convertible notes would result in a pro forma book value per share of $9.84 as of December 31. This amount does not include non-cash P&L charge we expect to recognize during the first quarter of 2013 from the write-off of capitalized debt issuance costs related to these converts and the access of the estimated fair value of the debt components at the time of conversion over their par value. We planned to disclose that estimated charge in the subsequent event footnote to our financial statements in our 10-K that we will file later this month.

Pro forma for the exclusion of our convertible notes and including our perpetual preferred equity issuance, our capital structure now consists of 1 billion face amount of long-term debt, perpetual preferred shares with a weighted average cost of just 7.1%. Across this capital, 64% has a remaining average maturity of 27 years and 36% is perpetual. This is a situation Bill and I sketched out as the ideal a few years ago. Long-term our perpetual low cost fixed rate capital that completely insulates us from mark to market volatility of asset prices that presents no refinancing risk.

Next I want to provide you with an updates on our revolving credit facility. On November 30th, we closed on a new three year revolver to replace our prior facility scheduled to mature in May of 2014. The new revolver has a $150 million of capacity with the ability to upsize it to $350 million and critically it’s not subject to any mark to market provisions since it’s not an asset based credit facility. It’s a noteworthy improvement as compared to our old facility, which had a borrowing base where changes in asset values could impact borrowings outstanding.

Additionally loans under the new facility bear interest at LIBOR plus 2.25%, which is 100 basis point reduction from our prior facility that bore interest at LIBOR plus 3.25%. And the new facility does not provided a cap on distributions to be paid of our common shareholders. It’s another noteworthy material improvement from our prior facility that had previously cap distributions at 65% of estimated taxable income. Based on the insulation from asset price movement that this facility provides, it gives us more flexibility, as an incremental source of capital are drawn even during severe market dislocations which will give us the comfort to deploy more capital in the future and to operate the plus cash on end. With respect to liquidity, we reported $238 million of cash as of year end and adjusted for the $362 million of net proceeds from our perpetual preferred offering. We have approximately $600 million of liquidity. About 20% to 30% of this is committed to our year earmarked for existing and identified opportunities through our national resources, special situations and commercial real estate strategy.

That said, combined with our un-drawn $150 million credit facility and the ability to source incremental low cost capital to divest additional rated CLO notes. We are at great position to be opportunistic.

With that I am going to hand this over to Bill.

Bill Sonneborn - Chief Executive Officer

Thank you, Mike. The sentiment in Q4 continued the year’s theme of a global risk on rally despite or maybe even encouraged by the fiscal cliff trauma, yields remained the favorite play of the day and record flows pushed prices even higher than the height they reached in Q3. $85 billion of monthly buying by the fed certainly has influenced investor behavior. The S&P/LSTA leverage loan index was up 1.4% for the quarter while the Merrill Lynch High Yield Master II index gained 3.2%. Between all these inflows and CLO issuance volumes over four times greater than 2011 issuers had been more active than ever.

This year’s leverage loan and high-yield issuance of $812 billion beat 2007’s previous record by our whopping 20%. The abundance of buyers in the market means yield is getting squeezed and reward for talking risk is on the decline. High-yield bond yields dipped to a record level of 5.7% during the first few weeks of 2013. When you think of this situation on a spread basis the 10-year treasure went from 1.63% at September 30th to about 2% at the end of January, so the rally experienced in the fourth quarter and so far this year is even more meaningful. Shareholders were asked why we sit today with over $600 million of cash and liquidity.

In our view we have entered the sixth inning of the credit cycle. We think that buoyant conditions will last for approximately around another 18 months. We have constantly stated that we will maintain discipline and focus on driving the best outcomes for our common shareholders. Even if that means maintaining excess liquidity to be in a position to drive shareholder returns when that cycle turns. With respect to our portfolio, we saw a consistent opportunity sets in our strategies in the fourth quarter.

As I go through each of them, I will be referencing pages 10 and 11 of our supplement provided on our website for returns on capital. In total our fourth quarter return on average net equity as Mike mentioned was 17% across all our strategies, which was down from 26% in Q3. On a run rate basis, which excludes other income such as gains, return on equity was 14%. Our bank loan and high-yield strategy remains our largest strategy by average net equity was just over two-thirds. We execute this strategy mostly through CLOs. You can now see the breakout between balance sheet and CLO investments on page 16.

During the fourth quarter, bank loans and high-yield generated a run-rate return on equity of 21% and a total return on equity of 28%. The fourth quarter’s continued spread tightening gave us an opportunity to take advantage of the CLO market. On December 21, we closed our first traditional syndicated CLO in five years, a $412 million structure at the four-year reinvestment period, non-call too with a weighted average liability spread of approximately LIBOR plus 209 basis points.

KFN holds 52% of the subordinated notes or about $23 million worth. Through January 31, we had ramped about 80% of the deal into assets yielding a weighted average of LIBOR plus 408 basis points or with a weighted average LIBOR floor of just over 1%. We believe that the push for yield is driven by the Fed will only drive spreads tighter in the near-term, in loans in particular. Investors are beginning to appreciate floating rate exposure and the massive volume of fresh CLO capital recently raised must be put to work.

We hope to use that tightening spread environment to print CLOs more regularly, however, we remained patient and disciplined. As we believe, liability spreads will keep tightening in the supply demand imbalance for loans today is resulting in a loan environment reminiscent of late 2006. In our second largest strategy by average net equity allocated, natural resources, we generated a 1% run-rate and a 11% total return on equity for the quarter. We continue to see strength in our royalty investments, which has been offset by slower ramp in our exploitation of proven producing properties.

During the fourth quarter, we deployed $4 million toward existing commitments to royalties. We also committed $40 million, $10 million of which funded in January to a new drilling partnership with a private E&P company. Drilling opportunities today are outpacing opportunities in other of our natural resources fleets, largely due to massive supply demand imbalance in funding capital intensive development projects in the North American shale plays. Thanks to KKR’s flexibility, is able to structure these deals in a way that’s quite attractive to KFN from a risk reward perspective. In mezzanine, we generated a 23% run rate and a 27% total return on equity for the fourth quarter. As you will now see on page 17 of the supplement, the portfolio was generating a 15% total coupon with incremental upside from capital appreciation through our equity exposure linked to those investments.

We didn’t deploy any incremental capital during the quarter as the backdrop has remained largely the same as in recent quarters. The strength in the U.S. credit markets means larger cap mezzanine lending in the U.S. is not as interesting for any, but the least creditworthy borrowers. The opportunities that remain somewhat brighter in Europe, with a pullback in bank lending, has enabled KFN to be a capital provider in a market that is effectively for a time acted as a capital vacuum. You saw evidence of this in our two most recent mezz transactions, which we mentioned in last quarter’s earnings call.

In special situations, we generated a 9% run rate and a 28% total return on equity. We have broken out the portfolio in more detail on page 18 of the supplement. As you know, these assets are up and distressed and subject to quarterly marks. So, we, as the management team, look at IRR condition to return on equity to fully understand and measure our performance. Through December 31, our approximately $370 million of cost basis in special situations investments has generated an IRR of 18% with an IRR of 38% on fully realized investments, and 13% on those that were still in.

Looking at the overall market for distressed, our highest levels of activity remain outside the U.S. We continue to see pockets of opportunities, but they are migrating away from the secondary market of distressed investments we have observed for the past several quarters and into more proprietary and private opportunities. This transition makes our KKR affiliation that much more valuable. The firm’s global reach across business idea generation and relationships have provided meaningful inroads to attractive situations.

Turning to fourth quarter, we deployed or committed to deploy about $32 million. Our largest single capital deployment in the quarter was about $18 million to acquire a portfolio of underperforming loans in Australia from a subsidiary of Lloyds Bank in the UK. We are able to acquire them in a highly attractive price of $0.40 on the $1 of particularly, largely because of KKR’s comfort in restructuring the non-performing companies and taking an active role in driving long-term value creation as a fresh and new equity program. The market rally and massive flows in the leverage loans and high yield bonds in the U.S. are definitely impacting the number of secondary distressed investing opportunities we see. So, we are actually benefiting from these trends in our existing positions, such as Oriental Trading, which we sold to Berkshire Hathaway in the fourth quarter.

Moving to real estate, we generated a 61% total return on equity for the fourth quarter. Given that our current investments aren’t contributing much run-rate income yet, we don’t know have the run-rate return on equity. We deployed $3 million in the quarter towards prior commitments and the team continues to see a quite robust pipeline of opportunities. Our previous investments continue to perform in line with or ahead of budget.

Finally, in private equity, we generated a 29% total return on equity for the fourth quarter. We also deployed an incremental $10 million to two private equity co-investments. The first was Alliant Insurance Services, which is the largest specialty insurance brokerage firm in the United States. The other was Acteon, which is a leading UK based service provider to the worldwide offshore oil and gas and renewable energy markets.

Taking a step back, we’ve spent 2012 delivering on the goals we have laid out over the last couple of years. First, we continued our diversification efforts deploying almost $400 million during the year to strategies besides our core allocation of bank loans and high yields, focusing on optimizing our ability to generate the best risk adjusted returns in capital for our shareholders. Second, we redoubled our focus on tangible shareholder value, raising our distribution for the third consecutive year, and creatively managing our capital structure to minimize dilution to our common shareholders.

Third, by deploying that capital in new investments that include naturally embedded free options or low-cost options, we have positioned ourselves to protect shareholder capital in a wide variety of macroeconomic environments. Fourth, we have taken advantage of our flexibility to pivot allocations in response to rapidly changing market conditions being prudent with our cash and de-risking as asset prices have run up. And finally, by continuing to improve our balance sheet and minimize its reliance on short-dated or mark-to-market funding, we have given ourselves even more flexibility to invest when markets dislocate in a longer runway to watch those investments play out over the long-term.

I note on this topic that we are able to issue over $350 million of what equates to our shareholders of tax deductible perpetual preferred equity during the quarter to the very rare type of issuance by any firm, but certainly a publicly traded partnership. Assuming an after tax cost of that perpetual preferred of approximately 4% to our common holders, such capital represents an enormous opportunity to create shareholder value. We sit here today with over $600 million of liquidity, which represents approximately 30% of our equity. If we achieve our objectives with this capital, that is to deploy it at our target return of treasuries plus 1000 basis points, maintain our discipline, and not comprise in the level of risk we are willing to take. We can drive significant additional earnings and distributions.

When you combine that with our options on substantially higher Fed funds raised, inflation, natural gas prices, equity sensitive assets, you have an opportunity to drive increased shareholder value in the years to come. Our position to continue to deliver that value we feel really proud of our team that has worked so hard to create attractive opportunities for KFN and its shareholders. While not all will work, I am confident the team is focused on the right things. I want to thank all of them, but I also want to thank all of you for your support and trust. Operator, we’ll now open it up for questions.

Question-and-Answer Session

Operator

(Operator Instructions)

Pam Testani

Should we start with Lee Cooperman at Omega?

Operator

Yes, the first question comes from Lee Cooperman from Omega Advisors.

Lee Cooperman - Omega Advisors

Thank you for very comprehensive rundown in the performance. I just want to make sure I am kind of relating to things properly. We have roughly what the 202 million fully diluted shares presently after the (call of the) risk that’s converters are higher than that?

Bill Sonneborn

That’s right, Lee.

Mike McFerran

That’s approximately correct.

Lee Cooperman - Omega Advisors

Alright, good. So, if your target lending rate is treasuries plus 1000 and then you have $237.6 million on unrestricted cash and I gather you have the credit line of $350 million which is close to $600 million you are talking about? I am assuming goal in if that cost might be 2%. So, would it be realistic to think in terms of you have unutilized lending capacity of close to $600 million that you could generate between 9 and 10 percentage point net of before loan loss provisioning and additional income. Is that a reasonable way of looking at it?

Mike McFerran

Yes, but the one thing I want to correct, Lee, is that 600 million is in cash, and in addition to that, we have $150 million untapped line of credit that we can increase to $350 million. So, if we increase that line of credit to $350 million that number will be $950 million.

Lee Cooperman - Omega Advisors

$950 million. So, theoretically let’s take 9%, 10%, that’s like $80 million or something like that on 202 or 203 million shares that if you had the lending opportunities, you could generate incremental earnings of?

Bill Sonneborn

And then above and beyond that, we have still remaining what we have been selling CLO mezz notes, which yielding kind of a cash cost of roughly 3% than we could sell in the market or redeploy. So, there is a lot of leverage there and separating to think we also have capacity for additional long-term debt raises for additional capital given the convert takeout which hurt us with the rating agencies when it was still there and the equity credit that the preferential preferred gives us?

Lee Cooperman - Omega Advisors

Okay. And then looking at the maturities of your debt, other than a minor amount of money, you have no consequential maturing debt for 23 years?

Bill Sonneborn

Really, no maturities for 23 years, well other than a small oil and gas credit facility down and so…

Lee Cooperman - Omega Advisors

Okay. Let me go on a few other, I am pleased that I understand everything so far. What do you think is the best measure of sustainable profitability that the Board would lever off to determine a dividend, in other words, the cash run-rate of $0.27 was 11% ROE, total net earnings normalized was $0.36 or 14% ROE, what do you think as you look at the structure of your business and how you allocate different amounts of capital to different activities? Is this a 14%, 15% ROE business over time or is it lower than that those earnings that would determine the distributable cash?

Mike McFerran

Our goal is to generate treasuries plus a 1000, which will flush away based upon what the interest rate environment, so treasuries plus 1000 a day is 12%.

Lee Cooperman - Omega Advisors

12% right, okay.

Mike McFerran

On a pro forma basis. We have parts of our portfolio that are earning quite high relative to that, but we are talking about incremental dollar in the ground just given the benefit of some of the legacy CLOs, but if that tenure goes up another 200 basis points, then you would be at that 14% return on equity.

Lee Cooperman - Omega Advisors

That’s good. And then a couple of years ago, I remember reading in the literature that you had a positive exposure rising interest rates that I think each one of your basis points would add about $10 million to EBITDA, what would that number be today?

Bill Sonneborn

So, in a supplement Lee on page 25, you will see the interest rate sensitivity of our credit portfolio. Now, it’s somewhat offset because we have lot of fixed rate debt in the holding company, but roughly you will see that the first kind of 100 basis points costs about $17 million and then we will start to creep that back. So, what we are hoping for in the context of a rate move is something more akin to 1994.

Lee Cooperman - Omega Advisors

Great, great, great.

Bill Sonneborn

That would be very good for KFN.

Lee Cooperman - Omega Advisors

That’s okay.

Bill Sonneborn

In some ways we are shaping up for that as a potential possibility.

Lee Cooperman - Omega Advisors

Alright, and then one last question, if 12% target ROE cash or earnings let’s say on our book value what kind of payout ratio would you guys be comfortable, you think the Board would be comfortable with. My understanding is that the cap has been removed on the new the credit facility, but I assume you’d like to retain some earnings and payout the bulk of them?

Bill Sonneborn

Yeah, I can’t speak for the Board, I’m just one member of that Board, so it will inappropriate for me to do that, but – and we have very fulsome discussions in the context of thinking about how much capital return to shareholders versus retained based upon opportunities we have, existing dry powder we have on the balance sheet and the like and so that all gets factored into the analysis of our distribution every quarter and every year.

Lee Cooperman - Omega Advisors

I guess one last observation or a question, you are set for rising inflation, rising interest rates, I guess the rest of the company would be if we go into a very deflationary environment.

Bill Sonneborn

Well, we tried to protect with that by having 30% of our common book value and cash, which is the best asset to have in deflation. So, we are trying to have a two-thirds of shareholders capital with an inflationary bet on, but we have one-third where we want to protect from our risk management if there is deflation and preserve shareholder capital, that’s one of the reason we’ve created the capital structure and yeah I’ll think of cash as an investment in certain times.

Lee Cooperman - Omega Advisors

Alright, last one, you would talk about euro CLO efforts, is there anything looking perspective there?

Bill Sonneborn

We are still trying to skin that cap, it’s a very complex equation given some of the rules and regulatory regimes that have gone on and continued to transpire in Europe, but it is still strategically a goal that we have.

Lee Cooperman - Omega Advisors

Alright, just congratulations to you and the whole team, you’ve done a terrific job and I appreciate it. Thank you.

Bill Sonneborn

Thank you, Lee.

Operator

The next question comes from Daniel Furtado from Jefferies.

Daniel Furtado - Jefferies

Thank you for the opportunity to ask you a question. The first one is assuming the forward outlooks for interest rate, how tight spreads are today. Is it safe to assume that for ‘13 the yield target a little bit more on the natural resources in terms of capital deployment or should we think about the deployment in ’12 as a way to model out ’13?

Mike McFerran

I mean, I think that’s a reasonable assumptions we set today, I mean if you just look at kind of what the market is saying in the contexts of the interest rate curve, it’s kind of saying very slow growth, low yield to the next five years, because if you look at kind of where the five year treasury is relatively to the 10-year treasury that implies that the buyers in the 10-year are expecting longer term inflation. But buyers that are in that kind of zero to five curve are not willing to admit that’s a possibility, and so natural resources and real estate are two reinvestments that provides cash yield (indiscernible) in different environments. So, we’ll have some capital deployment in this sector, but as we talked about that’s probably will more than a minority of our total capital. And if the CLO market which you’ve seen AAA spreads gone from like 145 to 140 now to 130, they have not tightened as fast as asset spreads have, but as they accelerate in the contexts of tightening, you could see more capital deployment and allocating more subordinated notes based upon the risk adjusted return in future CLO issuance.

Daniel Furtado - Jefferies

Understood. Thank you. And if I may with a follow-up one, when we think about the 2012-1 CLO issuance, is it safe to assume lifetime hurdle rates of treasuries plus 1000 or how do you think about the and I get it there is a lot of moving parts there, but when you get into the deal, you must have some baseline assumption and kind of what formula are you building that CLO to?

Bill Sonneborn

For that CLO, that is the bogie, we and clearly when we take on treasuries plus 1000 nicely about that CLO to the nature of it gives us that ability for the portfolio to adjust accordingly if rates go up.

Daniel Furtado - Jefferies

And will there be – can you give us some guidance on how to think about the slope of the ROE if we assume all-in hurdle return or all-in IR is in the T plus 1000 range and is that relatively straight lined of is there some slope because you have that reinvestment period on the front end?

Mike McFerran

There will be some slope in the first two quarters, but then after that where you will see potentially more opportunity – so then you will actually be in that treasuries plus 1000. After that it really depends on what the credit markets do. If you saw assets that really widen out following a wave of prepayments or something you saw really in 2007 for the first half of the year it seems tight and tight and tight and the second half of the year spreads widened out then you will have the opportunity to employee a lot more capital at wider spreads. If that repeats itself then we can do better than what we are targeting.

Daniel Furtado - Jefferies

Understood, thank you for that clarity, I appreciate it.

Bill Sonneborn

Thank you.

Operator

Your next question comes from Gabe Poggi from FBR.

Gabe Poggi - FBR

Hi, good afternoon guys my questions have been asked. Good job on the quarter.

Bill Sonneborn

Thanks Gabe.

Operator

Your next question comes from Jason Stewart from Compass Point.

Jason Stewart - Compass Point

Great, thank you. Can you give us an idea for what the average utilization on that warehouse line that was refinanced has been or maybe like the last year or so?

Mike McFerran

Absolutely, it was zero and the background on that is and as we mentioned in our remarks, A, we had liquidity where we didn’t need to use that revolving facility. And we haven’t used on for years and we frankly use that, we have that viewed that really as kind of a rainy day backup facility because the way it works it was a borrowing base where you pledge assets and declines in the fair value of assets would resolve then you have to pay it down or propose collateral. So, the benefit of the new facility we have in place is that we would actually expect to have much higher utilization because now we don’t have any negative precaution of asset price is falling. So, this gives us a lot more flexibility to use it opportunistically without the downside risk.

Jason Stewart - Compass Point

Okay and would there be a target level of cash that you would take that down to before utilizing this facility or…

Mike McFerran

We definitely would run we have – as we talked about pro forma $600 million of cash toady so we would have drawn that with a much a cash on the account. What it does change for us is Bill and I can operate the business with a different mindset of being able to run the business with a very small amount of cash knowing that we have that tech without any restriction.

Jason Stewart - Compass Point

Okay and then one last question. I think in one of your answers you said you may have sold some of the retained CLO notes I think 2007-1D was one and then the most recent, have you sold any of those subsequent to quarter end, it doesn’t look like was I missed it they were in the fourth quarter?

Mike McFerran

There was a small amount at the beginning of October that we talked about on our last call. There were none subsequent to quarter end and today we still hold and it’s in our supplement the number is about $85 million still of those Class D notes.

Jason Stewart - Compass Point

Got you. Okay, thank you for the questions.

Bill Sonneborn

Thank you.

Operator

Your next question comes from Stephen Laws from Deutsche Bank.

Stephen Laws - Deutsche Bank

Hi thanks for taking my questions and I appreciate all the data in the supplemental pack. To kind of follow up a little bit with what Daniel asked earlier kind of looking through the different business segments or targeted asset classes, it seems like you don’t find the mezzanine as attractive here and what you do see you prefer Europe over the U.S. And it looks like you did make some investments in special situations private equity and natural resources especially is that accurate. And then maybe can you comment on page 23 you kind of lay out a little bit of the commercial real estate strategy and maybe what type if any growth you guys think that occur there in 2013?

Bill Sonneborn

Sure good question. The U.S. mezz market and the reason that we just haven’t deployed there is we’ve tried to be pretty vocal of shareholders that we kind of have risk tolerance we will undertake and then we want to get that treasuries plus 1000 return with that risk tolerance. And because of the strength of the high-yield market the capital market here in the U.S. and the competition of lots of business development companies that focus exclusively or almost exclusively on the U.S. mezz market or second lien market, the return per unit of risk hasn’t met our threshold. So, where we found more opportunity is in Europe where there is fewer competitors. That being said a return of M&A volume which has also been slow in the U.S. could change that equation from the supply demand balance domestically. So, that’s the issue from a mezz perspective, how we thought about the asset class.

When it comes to thinking about real estate, we can provide that disclosure on page 23. My answer is we do expect to announce and you will see press releases potentially in the next few weeks or months of additional asset acquisitions targeting those things again they can protect shareholders’ capital given acquisition at well below replacement cost have an opportunity to provide yield and have upside depreciation particularly in an inflation area.

Stephen Laws - Deutsche Bank

Great and then I guess one kind of more housekeeping comment, on the share count obviously we had a higher diluted number given some of the – I guess balance sheet restructuring going on which seems like you guys have done a great job of that. Can you give us an idea of what we should look at is a fully diluted share count kind of going forward in our models?

Mike McFerran

Sure, so what you are seeing at December 31st, the reported share count number on the income statement is consistent with the assumption that we would settle all of the converts with the shares.

Stephen Laws - Deutsche Bank

Right and so that’s the number we should look at as far as go forward or will you settle some of those conversions?

Bill Sonneborn

(Not followed) I think today with cash so that would capture most of the converts than we have may go on top of it, but as we expressed the total increase would be 26.1 million shares.

Stephen Laws - Deutsche Bank

So, that’s what we should look at the increase from that the number that’s on the balance sheet.

Bill Sonneborn

Yes, that will be the increase in outstanding shares.

Stephen Laws - Deutsche Bank

Perfect. Again thanks for my questions and congratulations on very nice quarter.

Bill Sonneborn

Thank you.

Operator

The next question comes from Jasper Burch from Macquarie.

Jasper Burch - Macquarie

Hey, good afternoon guys. Bill I saw you said in the opening remarks that you expect buoyant conditions for at least another 18 months and it sounds like you are talking about in terms of spreads that are available on new investments does that sort of mean that we should expect relatively modest net investment unless we see some sort of disruption in asset pricing or credit spreads?

Bill Sonneborn

Well, I mean, especially there is lots of variables to that question, I did say we expect buoyant market conditions in the context of some in the credit markets to continue for at least 18 months and being the fixating of the credit cycle. And the reason being that may not impact capital deployment is talks about answer another question CLOs are very attractive asset class in periods of tightening credit spreads particularly when the liability side tightens at the same pace as the asset side. And you are starting to see liability spread they are tightened by 10 basis points just in the past six weeks they may tighten even further that moved down in the context of those structures locking in senior secured loans. And that treasuries plus 1000 and the optionality on that liability cost is extremely valuable for our shareholders. So, there is ways we can deploy substantial amounts of capital even in kind of those pretty strong credit market conditions that we’ve been experiencing over the past six months.

Jasper Burch - Macquarie

Thank you, that’s helpful. And then completely different direction we’re seeing some I guess not quite peers, but similar companies announced, are not similar companies, but peers guys like New Castle announced splits, splitting of their companies and it’s definitely given them some sort of valuation premium with the individual parts are being looked as more valuable than the whole. I know that the operational flexibility is sort of one of your trademarks that’s been really helpful to the shareholder returns through the downturn. And I was just wondering do you think that your share price that you have given a full credit for the various parts and sort of what sort of upside would we have to see in your mind to sort of evaluation in order to consider something like that?

Bill Sonneborn

Jasper, all good questions and I think we’ve talked in previous calls that we are very, very focused on shareholder value and so yes we have a REIT sub, yes, have an MLP sub and so to the extent that – as those scale over time, the only way we can unlock true shareholder value is through swaps or spin-offs, it’s always something we are opened to consider, that’s an embedded option and quite there is an example of an embedded option we carry in the structure that we can unlock if market condition suggest that’s the best way to drive value for our common holders.

Jasper Burch - Macquarie

Okay, well, thank you for taking my questions and nice job in the quarter.

Bill Sonneborn

Thank you.

Operator

(Operator Instructions)

Bill Sonneborn - Chief Executive Officer

Well, thank you all, I appreciate again your trust and confidence. We look forward to getting back to work and trying to hit the targets we set out for us. Thanks.

Operator

Ladies and gentlemen, that does conclude the conference for today. Again, thank you for your participation. You may all disconnect. Have a good day.

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