KKR Financial Holdings LLC Q4 2008 Earnings Call Transcript

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 |  About: KKR (KKR)
by: SA Transcripts

KKR Financial Holdings LLC (KFN) Q4 2008 Earnings Call Transcript March 2, 2009 8:00 AM ET

Executives

Laurie Poggi – Director, IR

Bill Sonneborn – CEO

Michael McFerran – Interim COO

Jeff Van Horn – CFO

Analysts

John Hecht – JMP Securities

Louis Margolis – Select Advisors

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the KKR Financial Holdings LLC fourth quarter 2008 conference call. During today's presentation, all parties will be in a listen-only mode. Following the presentation, the conference will be open for questions. (Operator instructions)

I would like to turn the conference over to Laurie Poggi, Investor Relations for KKR Asset Management. Please go ahead.

Laurie Poggi

Good morning everyone, and welcome to KFN’s fourth quarter 2008 conference call. I am Laurie Poggi, Director of Investor Relations for KKR Asset Management. And with me today are Bill Sonneborn, the company's Chief Executive Officer; Michael McFerran, the company’s interim Chief Operating Officer; Jeff Van Horn, the company's Chief Financial Officer; and Andrew Sossen, the company's General Counsel.

Our financial results release for the fourth quarter and year ended December 31, 2008, was issued today, and as with prior quarters, a supplemental information packet was posted on our website. Additionally, today we filed our annual report on Form 10-K for the year ended December 31 with the Securities and Exchange Commission. A replay of this call will be available on the company’s website through Monday, March 9, 2009.

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. Bill, please go ahead.

Bill Sonneborn

Thanks, Laurie. Good morning and thank you for joining our call today to review the company's results for the past quarter. During our call in December, I discussed both the challenges facing KFN, and the need to undertake a review of the company, its capital structure, business model and strategic plan.

Specifically, we discussed coming to our shareholders with management's views and recommended actions to aggressively address near term liquidity issues, develop our business model and prudent capital structure, continue to invest in our managers platform and team, and proactively manage our credit portfolio.

During today's call, I will provide you with an update on both the company and the steps we have taken over the past few months to address a number of these challenges. Currently, almost all leverage financial companies are facing real challenges and must adjust and rethink their business models.

As a specialty financial company, KFN is no exception. As discussed in our December call, over the course of the fourth quarter KFN was materially impacted by the dramatic decline in leverage loan prices. The greatest stress to the company during this price decline was the impact on Wayzata, our market value CLO transaction.

I will discuss Wayzata in greater detail later in the call, but I do want to briefly mention that we have successfully negotiated an agreement with the senior note holder to remove the market value margin posting provisions contained in this facility. We believe that our equity in this structure represents real value to our shareholders, even when valuing the underlying loan collateral on a liquidation basis.

We believe that these changes will allow KFN to both preserve the substantial equity value of the structure, and allow the assets to realize their true long-term value. Before going any further, I will spend a few minutes putting into context how leverage loan prices performed during the fourth quarter of 2008, and provide some perspective of how they have performed so far this year.

As shown on page 7 of the presentation we posted to our website this morning, approximately 84% of our investments are in leverage loans, of which 88%, nearly 90%, are senior secured. A senior secured loan is at the top of an issuer’s capital structure, and generally has between 30% to 50% of the capital structure beneath it. A senior secured loan represents a secured contractual claim on the issuer's assets, and for this reason senior secured leverage loans historically have lower price volatility and higher recovery rates when defaults have occurred, since defaults don't translate into dollar per dollar losses.

Similar to most fixed-income assets, leverage loan prices during the fourth quarter were impacted by weak market technicals, very soft macroeconomic conditions, overleveraged business models, and refinancing issues. During the trough of October 2008, which was revisited in mid-December, the average bid price for leverage loans was in the low 60s. Two items to note here, first for the period from January 97, the inception of the S&P/LFTA Index for performing leverage loans through the beginning of 2008, the index had never dropped below 90.

Second, historically the long-term performance of leverage loans has had a very low correlation to equities. However, during the fourth quarter of 2008 the S&P/LFTA Index produced returns that were very highly correlated with the S&P 500. The months with the worst returns in 2008 for the S&P LSTA index were September, October, and November when the returns were negative 8.3%, negative 16.3%, and negative 8.4% respectively.

In comparison, the S&P 500 had returns of almost the same negative 9.1%, negative 16.9%, and negative 7.5% respectively over the same three-month period. Since mid-December when prices did touch those October lows, corporate credit prices have rebounded, average bond and low bid prices are up about 10 points between December 16 and February 19.

We believe that a substantial amount of the technical pressure on loans is abating. What remains is effectively zero LIBOR conundrum. In addition, credit selection is finally once again starting to show its true importance as a large divergence has appeared between good credits and poor ones in terms of the market’s perception of the underlying loan values.

During today's call, we will be covering a considerable amount of information that is summarized in the presentation we posted to our website this morning. Our goal is to give our shareholders as much transparency as possible with respect to our results for the past quarter and the challenges and opportunities we face going forward. Our bottom-line net loss of $1.2 billion for the quarter, although large when compared to KFN’s shareholders equity as of September 30, 2008, or for that matter in any historical context, reflects the balance sheet actions we have considered necessary and appropriate in today's environment, the most significant of which relates to taking large increases in our allowance for loan losses for our leverage loan portfolio as well as impairment charges related to our high yield bond holdings.

With that, I'm going to hand this over to Mike to provide you details on this quarter's results as well as the status of our CLOs in Wayzata. After we go through the details of this quarter with you, I will close by providing an update on our near term management priorities.

Michael McFerran

Thanks, Bill and good morning. As Bill mentioned, I will walk you through the results for the quarter, but before doing so I'm going to spend just a few minutes to explain the impact that GAAP has on both our balance sheet and income statements.

To start, on an unconsolidated bases, our investment holdings consist of the following. First, $1.3 billion par value of mezzanine and subordinated notes issued by five cash flow

CLOs that are managed by KKR Asset Management. These transactions were executed as long-term financing for KFN. However, from a legal ownership perspective, we own the notes on these transactions.

Second, $500 million par value of junior notes issued by Wayzata. Similar to our cash flow CLOs, Wayzata was executed as a long-term financing transaction. Third, leverage loans and high yield securities with an amortized cost basis of $352 million, residential mortgage-backed securities with an estimated fair value of $271 million. In addition, we hold investments in private equity totaling $23 million as of year-end, as well as certain investments in derivative transactions including total rate of return swaps and credit default swaps.

Our five cash flow CLOs consists of two transactions completed in 2005, one transaction completed in 2006, and two transactions in 2007. A summary of our CLO transactions is shown on pages 14 to 16 of the presentation. We own 100% of the subordinated notes issued by the first three CLO transactions, but only 63% of the subordinated notes issued by the transactions completed in 2007.

A separate private investment fund, managed by KKR Asset Management holds the remaining 37% interest in the two 2007 CLO transactions. In addition, we own 80% of the junior notes issued by Wayzata, and the same investment fund managed by KKR asset management holds the remaining 20%.

For purposes of GAAP reporting, we consolidate 100% of the cash flow CLOs in Wayzata, and reflect the respective amounts owned by the separate investment fund as debt on our consolidated balance sheet. While consolidated notes on CLO transactions in Wayzata have certain economic characteristics of equity, they are treated as debt and not equity under GAAP. And negative results of this inconsistency is that while well one might expect a certain percentage of the economics of our CLOs in Wayzata to be allocated to a minority interest older of these three financing vehicles, this is not the case.

Our own $.2 billion net loss for the quarter includes approximately $255 million or approximately $1.70 per common share of losses that would otherwise be allocable to the minority interest holder in these transactions. This is the result of GAAP and is effectively a long-term timing difference that will remain through the life of the CLO transactions and Wayzata.

Upon either a decision by yes to call these transactions early or upon their ultimate maturity this resulting liability will likely be reversed and absent other changes, our book value under GAAP would show a corresponding increase. Pro forma for this affect, our book value per share as of December 31 would have been $6.10.

Page 3 of the presentation provides a summary of the components of our results for the quarter, and pages 4 and 5 provide our income statements for both the fourth quarter and year-ended December 31, 2008.

Our net loss for the quarter totaled $1.2 billion or a loss of $7.85 per diluted common share. This compares to net income of $59.9 million or $0.52 per diluted common share for the fourth quarter of 2007.

As Bill mentioned, our losses for the quarter reflect several portfolio and balance sheet actions that we took during the quarter. First, we recorded a provision for loan losses totaling $471.5 million, and had a charge off of $25.7 million during the quarter. This resulted in our allowance for loan losses increasing from $35 million as of September 30 to $480.8 million or $3.19 per common share as of December 31.

Our allowance for loan losses consists of two components, an allocated reserve and an unallocated reserve. The allocated component represents $320.6 million or $2.12 per common share of the $480.8 million reserve, and relates to investments in leverage loans issued by 11 issuers with an aggregate cost basis of $715.4 million. This component relates to specific loans that we have determined are impaired and for which we have reserved the estimated losses, which we believe we will realize on these positions.

Included in the 11 positions are Tribune, which filed for bankruptcy in December, and Lyondell, which filed for bankruptcy this past January. The cost basis of our investment in Tribune totaled $226 million as of year-end and the cost basis of our investment in Lyondell total $122 million as of year end.

The unallocated components of our allowance for loan losses totaled $160.2 million or $1.06 per common share as of December 31st. We estimate the amount of the unallocated components by assigning estimated default probabilities, and loss severities to loans for which we have moderate concern.

During the quarter, we also had net realized an unrealized losses on our investments totaling $745.5 million. There were three components of this loss. First, we recognized an impairment loss on securities available for sale totaling $454.3 million. This loss was recorded to write-down to market value investments in high yield debt securities from seven issuers, and two preferred stock investments. Of this amount, $216.5 million relates to investments in senior and subordinated bonds issued by one company, where we had a total costs basis [ph] bonds of $262 million.

As a result of our re-underwriting of every provision in the portfolio, we have sold the investments in this company subsequent to year-end. The remaining $237.8 million or $1.58 per common share relates to investments which we still hold today.

Second, we realized $156.3 million of losses on our investments during the quarter, of which $137.5 million relates to sales of assets which were held in Wayzata. These sales were undertaken to deleverage the vehicle, as part of our negotiations with the senior note holder, and pursuant to the terms of the documents governing Wayzata, which at the time required the sale of any asset, downgraded to CCC.

The third component of the $745.5 million of losses is a loss totaling $137.3 million on amounts designated as held for sale as of year end. This loss relates to the lower cost for market adjustments on these loans, which have either been sold or which we continue to hold for sale. A portion of the sales were in conjunction in with the refinancing of the company's revolver, whereby $378 million drawn on the old revolver was replaced with $300 million drawn on the new revolver.

During the quarter, we also recognized $72.9 million in net realized and unrealized losses on derivatives and foreign exchange. This amount consisted of net realized an unrealized losses on total returns swaps of approximately $100 million, which is partially offset by gains totaling approximately $5 million and $22 million on FX forward contracts, and credit default swap positions respectively.

Our total returns swaps are summarized on page 13 on the presentation. We used total rate of return swaps to finance certain leverage loan positions, primarily those which are denominated in foreign currencies since those investments are prohibited from being held in our CLOs. While at the same time total rate of return swaps provide perfect FX hedges.

Although analogous to financing from an economic standpoint, total returns swaps are included in derivatives in our consolidated financial statements, since they are treated as derivatives under GAAP. The total notional amount of our total return of returns swaps decreased over 50% from $442 million as of December 31, 2007, to $208 million as of December 31st 2008.

As certain loans on swap have declined materially in value, we have purchased them off-swap since the amount of cash were we were holding against them under our recent agreements was economically undesirable. As of year-end, the weighted average maturity of our total rate of return swaps was approximately 11 months, and we had a net debt under these swaps of approximately $50 million as of year-end.

During the quarter, we also recognized mark-to-market losses totaling $34.2 million on our RMBS investments. As of year-end, our investment in mortgage-backed securities had an aggregate cost basis of $353.7 million, and an estimated fair value of $270.7 million. I do want to spend a minute describing how RMBS investments are presented on our financial statements.

Of the $278.7 million fair value of RMBS, $167.9 million on the six securitization trusts, we are the primary beneficiary, and therefore consolidate the trust under GAAP. By doing so, we show the underlying assets of those troughs on our balance sheet as mortgage loans, and show the debt issued by those troughs and held by third parties as liabilities.

While we reflect these amounts in our financial statements, we have no exposure to RMBS above $270.7 million, we actually own. In order to reconcile our GAAP balance sheet to this amount, simply take the $102.8 million of mortgage debt securities on our balance sheet, the $2.62 billion of mortgage loans in our balance sheet, and $10.8 million of real estate owned those included in other assets in our balance sheet, as described in Note 8, to our consolidated financial statements, and subtract the $2.46 billion of residential mortgage-backed securities issued from our balance sheet.

Of the residential mortgage-backed securities we hold, approximately 90% is rated investment-grade, as well as 90% consists of mortgages and securitizations that we structured earlier in mid-2005. The original mortgage collateral underline our mortgage-backed security investment totaled over $10 billion. At year-end, the inception to date losses has been approximately $10 million or 10 basis points of the original collateral amount.

We currently find these assets performing in line with our expectations and intend to hold them through their maturity.

Next, I will spend a few minutes reviewing noninvestment expenses, which totaled $18.3 million for the quarter as compared to $21.2 million for the fourth quarter of 2007. During 2008, base management fees averaged just under $3 million per month. Through the losses recorded during the fourth quarter of 2008, the multi-base management fee during 2009 will be approximately $1.2 million a month resulting in an annual expense reduction of approximately $18 million.

As Bill will discuss later in this call, our management company has also agreed to defer payments of a percentage of our base management fee through the end of 2009.

Now, I will spend a few minutes reviewing our investment portfolio, which is summarized on pages 7 through 11 of the presentation. As of year-end, the total carrying value of our corporate loan and high yield debt investments, excluding loans held for total returns swaps, was $8.1 billion, and the total par amount of these investments was $9.7 billion.

As we have articulated in the past, our portfolio is heavily concentrated in senior secured loans of large cap companies. Approximately 90% of our leverage loans are senior secured in the capital structure and approximately 75% of our portfolio is concentrated in the 50 companies. Our top 20 holdings represent approximately 50% of our investment portfolio.

Page nine of the presentation provides a summary of our top 50 holdings by issuer, ranging from largest to smallest. And page 10 provides a stratification of our portfolio on Moody’s industry classification.

Through year-end, we had three defaults of loans on our portfolio with the total cost basis of $312.7 million. One of these loans, restructured by converting our debt for a 28% interest in the equity of the company. Also included in the default amount is Tribune, which represents $226 million or just over 70% of our total defaults during the quarter.

Next, I will spend some time reviewing the current status of Wayzata and our CLOs. At the time we closed Wayzata in 2007, it was $2 billion market value CLO transaction that was ramped up to full utilization during the second quarter of 2008. Our investment in Wayzata consisted of purchasing $320 million of the $400 million of the aggregate amount of junior notes issued. The remaining $80 million of junior notes was purchased by a separate fund managed by KKR Asset Management.

The senior notes issued by Wayzata totaled $1.6 billion and were held by a single counterparty or senior lender to the transaction. As Wayzata was structured as a market value transaction, material price declines in corporate loans during 2008, most notably during the fourth quarter, led to us posting $180 million of additional cash collateral to the transaction through the purchase of additional junior notes.

The posting of additional cash collateral as well as the sale of assets from Wayzata totaling $628.9 million during that fourth quarter of 2008 were both undertaken to avoid defaults under the transaction that could have led to the senior lender for closing on Wayzata’s collateral.

On January 12, 2009, Wayzata was amended to eliminate the market value-based covenants, and of equal importance, the requirement to sell any assets downgraded to CCC. Consequently, we are no longer required to post additional cash margin as a result of declining market values of the underlining collateral.

This amendment has allowed us to preserve our equity value in the Wayzata structure and participate in potential appreciation of this value as and if when prices improve. Wayzata is a valuable asset given the relatively low pro forma leverage it provides KFN. Nevertheless, under the amended facility, cash flow generated by the collateral will not be distributed to junior note holders, including us, until all senior obligations of Wayzata are paid in full or otherwise satisfied through hyper amortization of senior notes through our cash flow.

As such, our cash flow forecast assumes that Wayzata will not generate any cash to the company for the foreseeable future, and we cannot predict at this time, how long the cessation of cash flows will last. However, we do retain the right to call the structure at any time if to do so is economically attractive to KFN.

Several additional changes are made to Wayzata as part of the amendment process, including first, to increase the coupon on the senior secured notes to 3 months LIBOR plus 3.75%, which under certain circumstances may increase to a maximum of three-month LIBOR plus 5%. Second, reduce the aggregate outstanding par amount of senior secured notes to approximately $675 million using both free cash in the structure, and proceeds from the sale of certain assets designated for liquidation by the senior note holder. And third, significantly limit our right to reinvest principal proceeds from the collateral in new assets.

In addition, as we previously mentioned we were able to substantially modify the portfolio eligibility criteria, so that we will be no longer required to sell downgraded securities. Also, the parties have agreed to use their reasonable best efforts to restructure the vehicle to convert Wayzata into cash flow at CLO, extending its maturity from 2012 to 2017, substantially improving the refinancing risk containment in the structure.

With respect to our cash flow CLO transactions, as of December 31, the majority of our investments in corporate loans, and corporate debt securities were held in five cash flow CLOs. Our holdings in these cash flow transactions are summarized on pages 14 to 16 of the presentation. These transactions contain certain interest coverage and over-collateralization tests that have not met resultant cash flows that would be paid to the mezzanine and subordinated note holders, including us. We need to deleverage the transaction, until such time as the respective tests are in compliance.

The December 2008 monthly reports from the CLO transactions showed that four out of the five cash flow CLO transactions were out of compliance with one or more of the respective over-collateralization tests. Page 17 of the presentation provides a summary of our CLOs and the various key metrics from the December 2008 reports. As shown on this page, of our CLOs, with the exception of CLO 2005-1, were failing their respect subordinated over-collateralization test as a year-end and CLO 2005-1 had a small cushion of $1.1 million under this test.

As the majority of our cash flow CLOs, excuse me, as a majority of our cash flows from CLOs come from the subordinated notes, we believe that this is the most important OC test. We believe that during 2009 each of our cash flow CLO transactions will be out of compliance with OC tests for intermittent periods, and certain if not all of our CLOs will be out of compliance throughout the entire year.

The fact that CLOs trap cash, and use the cash to deleverage is material to our cash flow. For 2009, based on current interest rates, approximately 70% of our total cash inflows from investments, would otherwise come from CLOs if they are not trapping cash and deleveraging. We do not expect our CLOs to generate significant amounts of cash for the foreseeable future, and we cannot predict at this time how long this will last.

Our cash flow forecast for 2009 assumes that we do not receive any cash inflows from either Wayzata or our five cash flow CLOs. Instead, our cash inflows will come from the assets that we hold outside of the CLOs, consisting of certain residential mortgage backed securities and investments in corporate loans and high-yield securities.

Based on our current liquidity and access to liquidity, the $100 million standby credit facility provided by KKR, we believe that we are able to meet our obligations for at least the next 12 months.

With that Jeff is going to discuss tax issues related to our structure and estimated timings for the 2008 K-1 to our shareholders.

Jeff Van Horn

Thanks Mike. As you know, KFN is a publicly traded partnership that is not treated as a corporation for tax purposes because it satisfies certain requirements in the tax code for continued treatment as a partnership or flow-through entity. As a result, KFN is generally not subject to federal and state taxes at the entity level. Instead KFN shareholders are taxed on their allocable share of KFN’s items of income, gains, losses, and deduction regardless of whether or when they receive cash distributions from KFN.

In addition, some of our investments, especially our interest in CLOs may produce taxable income to KFN and thus KFN shareholders, regardless of whether or when the investments distribute cash to us. This is a situation, for example, with respect to our interest in CLOs, whose investments have still paying interest income currently, but that have failed certain over-collateralization tests, which results in the excess cash flow from such investments that will normally be distributed to KFN to instead be used to pay down the principal on the senior issued by the CLOs.

Since a substantial portion of KFN’s investments are financed by these CLOs, a substantial portion of KFN’s taxable income is non-cash or phantom taxable income that will be allocated to KFN’s shareholders, who will then be subject to federal and tax taxes. Further, losses recognized by KFN on the sale or exchange of its investments will generally result in a capital loss allocable to our shareholders, which cannot be used to offset the ordinary taxable income generated by KFN’s investments, including the CLO interest that I just mentioned.

Notwithstanding these tax issues, we believe that a KFN shareholder who held shares during all of calendar year 2008, should have received cash distributions in calendar year 2008, in an amount sufficient to satisfy the shareholders federal and state tax liabilities on their estimated allocable share of KFN 2008 items of taxable income, gains, losses, and deduction.

Providing estimates for 2009 is difficult at best. However, if we assume that KFN’s run rate earnings during 2009 will be approximately $0.30 per share per quarter or a $1.20 per share for all of calendar year 2009, and the shareholders federal tax rate is 35% and state tax rate is 9.3%, then the shareholder’s combined federal and state tax liabilities, net of federal benefits for the deduction of state taxes will be approximately $0.49 per share.

For the purposes of this example, run rate earnings is estimated to approximate taxable income before realized an unrealized gains and losses, and assumes full deductibility of our G&A expenses. Taxable income can vary substantially depending upon numerous factors relating to the shareholders individual tax characteristics, as well as holding period among other items.

As a partnership, KFN is required to file 2008 tax returns and issue scheduled K-1s to shareholders honorable for April 15, 2009, unless an extension of time to file the tax assurance and issue scheduled K-1 is granted by the IRS, in which case the due date for these filings is September 15, 2009.

Notwithstanding these due dates, KFN will make every effort possible and expects to issue 2008 scheduled K-1s to shareholders by the end of March 2009. The scheduled K-1s will first be available electronically from our website, and they will be mailed as well. Similar to 2007, KFN experienced a technical termination for tax purposes due to the heavy trading volume in its shares during 2008. As a result, under the tax rules, KFN will be required to file and prepared two tax returns and issued two sets of scheduled K-1s to shareholders for the 2008 tax year. Despite these additional filing requirements, we still expect to issue both sets of K-1s to shareholders by the end of March 2009.

With that I'm going to hand the call back over to Bill.

Bill Sonneborn

Thanks Jeff. Our management team is focused on four key priorities. First, continue to aggressively address near-term liquidity issues. Second, ensure that the company’s capital structure protects long-term value for our shareholders. Third, proactively manage our investment portfolio, which will include some credit sales as well as playing a lead role in certain work out restructuring and default situations. And fourth, continue to invest in our world-class investment and operating platform, which serves as the external manager of the company.

Now, let us go through these points in more detail. First, liquidity. To withstand the substantial increase in volatility of credit prices, we had to reduce the potential need to gross margin on any market value financing facilities. We believe we have done so. Net debt under total rate of return swaps declined by approximately $125 million during the quarter from approximately $175 million as of September 30 to approximately $50 million as of December 31.

Additionally, we paid off approximately $100 million of the revolver during the quarter, by reducing it from $378 million outstanding under our previous credit facility as of September 30 to $276 million outstanding under our current credit facility that we closed in November.

We have also successfully completed step one of the restructuring of Wayzata by obtaining agreement from the senior note holder to remove both the mark-to-market and portfolio eligibility criteria restrictions within the transaction. We have now turned our efforts towards the hopeful completion of step two of the Wayzata restructuring to reduce the refinancing risk that is within the structure. This will involve converting the structure to a cash flow CLO with the corresponding extension of the maturity of its liability from 2012 to 2017.

Other than capital structure issues, which I will address shortly, the largest remaining component of market value or margin debt relates to our total rate of return swaps, whereas we show on slide 13 of the presentation, we currently have 50 million of net debt outstanding. As most of these swaps mature in late 2009, we are working on solutions to refinance this that or pay it off without having to sell a significant portion of the assets that are financed by it.

In a scenario where we cannot extend the financing or obtain new financing for these assets, we would seek to sell the assets held on swap and generate sufficient proceeds to pay off their existing debt. If we did sell the assets, it would eliminate the option to recover something closer to par value on these assets, thereby realizing the loss.

Note that the assets underlying the swaps are already marked-to-market through our GAAP book value. As Mike previously stated, we believe that we are able to meet obligations for at least the next 12 months. As for our CLOs the use of otherwise distributable cash to deleverage these transactions significantly reduces our free cash flow. Ultimately, we expect our CLOs to provide long-term value to KFN. In the meantime, the trapping of cash and the deleveraging of these structures will impact our ability to make any cash distributions to shareholders for the foreseeable future.

Our strategy for the CLOs is to continue to focus on active portfolio management, based on the credit fundamentals of the underlying loan collateral to realize maximum value for new structures over the long term. We will accomplish this through rotating out of certain assets into other assets with higher spreads and reduced risk of loss.

It is also worth noting here that we are retaining valuable opportunities within a number of these CLOs. We have the ability under the agreements covering them to purchase additional subordinated notes to effectively enhance their collateralization and maintain the low-cost liabilities within these structures until their final stated maturity.

As a firm, we at KKR have taken certain steps to support KFN’s liquidity position. First, KKR provided an unsecured $100 million credit facility to KFN last November that as of today remains undrawn. Second, KKR has agreed to defer payment of 50% of the management fees for the period from January to November 2009 to be paid in December 2009.

As mentioned previously, this deferral is based on the management fee that is less than half the amount that was in 2008 and puts the payment date post the expiration of the first part of our revolver. In January 2009, we also took the additional step of activating the management fees for all of our CLOs including Wayzata, and we will refund to KFN its share of this amount, as a reduction of general and administrative expenses.

This is a way of getting cash into KFN that would otherwise be used to the leverage the CLOs, given that the senior collateral management fees at the CLO levels are treated within the structures within the senior notes.

From an income statement standpoint, this activation of CLO management fees will be P&L neutral, but from a cash flow standpoint it should add approximately $10 million to KFN’s liquidity during calendar year 2009. Now that we have taken action to address near-term liquidity issues, we must begin to focus on our next priority, our capital structure, particularly as it relates to any item in the future might stress liquidity or act as an impediment to our ability to protect long-term value for our shareholders.

As we disclosed last quarter, our $300 million revolving credit facility with the final maturity in November 2010 will be reduced to $150 million in November 2009, unless we successfully syndicate $150 million of the balance. Accordingly, we need to either syndicate, refinance, or pay off this $150 million excess balance.

While syndication remains an option, today's environment makes that extremely challenging. In addition, by November 2009, we must also comply with borrowing base restrictions contained within the facility, which may require a further reduction in the aggregate borrowings below the $150 million total facility value.

As of December 31, we had $275.6 million in borrowings outstanding under the revolver. The other significant liquidity challenge we faced is the maturity of our convertible notes in July 2012. We recognized that our long-term plan needs to address these future maturities. A summary of our holding company debt is shown on page 12 of the presentation posted on our website.

As of December 31, 2008, we had not drawn on the $100 million standby credit facility provided by KKR. Regarding our legal structure, our current PTP structure presents challenges. Most notably, the phantom tax issue that Jeff previously described. However, we believe that this structure is currently the best alternative given our liquidity situation.

The third point I mentioned previously is portfolio management. As we work through the current credit cycle, we are clearly not expecting the eventual economic recovery to be V shaped or quick. We also anticipate default rates could be larger than those forecasted by S&P and Moody’s.

Our portfolio investment strategy includes leveraging our deep resources across KKR, including our private equity professionals and the KKR Capstone operations team as appropriate. This will be most reflective in certain work out situations, where we lead or participate in a turnaround effort. An example relates to an existing investment in which our debt interest was converted into a 28% equity interest during the quarter, but where we now also have board seats at the company. To support the realization of a positive outcome from this investment, we brought in the KKR Capstone operations team to assist this business during its restructuring, and are working closely with our private equity professionals to develop value creation alternatives for this business.

KFN’s book value at year-end was $4.40 per share. As Mike described earlier, this is in part reflecting KFN absorbing all of the losses that are economically allocable to the minority interest holder of two of our cash flow CLOs and Wayzata. After adjusting for this economic allocation of minority interest, the book value per share on a pro forma basis is $6.10 per share. The total effective “reserved losses” reflected in our balance sheet have after excluding loans held for sale in the $216.5 million impairment charge recorded on the $262 million high-yield securities we sold subsequently to year-end are $718.6 million or approximately $4.75 per share, which consists of our allowance for loan losses of $480.8 million, and the impairment charges totaling $237.8 million on securities we still hold.

That $4.75 has not been realized. It is our best estimate of future losses in our portfolio. That said the ultimate amount of losses realized can be more or less in this amount, and could therefore impact book value either positively or negatively in the future.

The leverage loan in high yield bond markets has stabilized since mid-December, and has started to delink from the equity markets. Technical pressure in leverage loan and high yield prices is abating at present, as we have seen a reversion to fundamentals emerge.

While we remain cautiously optimistic, that fundamentals will continue to drive prices, we are not operating as if that was the case. We are continuing to position the company for a variety of market environments.

The fourth point relates to our deep and experienced team. We have a team of over 30 world-class investment professionals with diverse and complimentary industry backgrounds. In addition, our talented operations and support team of over 40 professionals are focused on financial and risk management. We continue to invest in KKR Asset Management team in capital through adding resources to both of these teams.

Before we move on to answering your questions, I want to share some final thoughts with you. KFN today represents unique leverage opportunity to participate in the ultimate recovery of predominantly senior secured loans. In addition, its financing structures represent intriguing options on new investments.

I'm very proud of our team of the 72 investments professionals and operating team members who are working extraordinarily hard on behalf of our company. I'm also deeply appreciative of all my colleagues and partners within KKR’s Private Equity and Capital Markets businesses, who continue to provide substantial support in maximizing the value of KFN to its shareholders.

We have a very impressive team focused on the business. Mike and I as well as the rest of the management team and professional across KKR continue to work hard to maximize the value of your investment in KFN.

Thank you again for joining us on this call. Now we welcome your questions. Operator can you please open the lines.

Question-and-Answer Session

Operator

Thank you. (Operator instructions) We will take our first question from John Hecht with JMP Securities.

John Hecht – JMP Securities

Good morning and thanks for taking my questions. Can you guys hear me?

Bill Sonneborn

Yes we can. Good morning.

John Hecht – JMP Securities

Good morning. I wonder if you guys could just looking at page nine in your top 50 holdings, may be take us through what might perceive as a watch list for some of the investments where you kind of trying to watch for incremental risk in high degrees of risk.

Bill Sonneborn

Sure. We can spend a little bit of time talking about we think is watch list. There are a number of names on the list on page 9, which we do hold in our watch list and a number of these names that we also reflect in both our specific and general reserve from a probability of loss perspective. Going through the list, if you kind of look in the top 10, obviously Realogy is one that has been on our watch list for a considerable period of time which is listed as number 10 on the list. In addition number 14, Las Vegas Sands is on that list, Lyondell number 22 is on the list, Marsico number 26 is on the list, Michaels Stores number 28 is on that list, Harrah's number 37 is on that list, and NXP number 33 is on that list, Nuveen Investments number 39, Freescale number 40. I think that Neiman Marcus number 50 is on that list.

John Hecht – JMP Securities

Will you guys put together a general provision this quarter, I guess in the context of that type of watch list? What kind of frequency and recovery rates would you be assuming given the credit markets right now?

Bill Sonneborn

We look at each credit on its own, depending upon the circumstances of the credit and forecast both the probability as well as the severity of loss based upon the underlying position we hold in the capital structure, the fundamentals of how that business is performing, our own expectations of what the asset value of that business, what would happen to the extent that business went into restructuring, and what we think the ultimate realized losses would be. So it is hard to say as a general rule what that number is because it is case-by-case, company specific.

John Hecht – JMP Securities

Okay. Is there a range of understanding a specific – you might have a wide variety but is there a range of recovery or maybe an average rate of recovery you might expect in this cycle and maybe can you discuss how that might differ from prior cycles?

Bill Sonneborn

Sure. Well, Michael will give probably at a weighted average across their portfolio of what we expect, even though again it is company by company specific. Go ahead Mike.

Michael McFerran

Sure. Hi John. You know we look at the portfolio as of year-end, and if we back out you know, the adjustments we took for loans held for sale and kind of carve that out of the portfolio, and carve out the bonds that we sold subsequent to year-end. They were in excess of $200 million, and our reserves effectively provide a 13% loss protection for our aggregate loan of bond portfolio as a percent – we are retaining the portfolio at 87% of power. You know, you could run through any permutation you want, what default probabilities and loss severity scenarios get you there. As Bill stated, you know, we start with kind of a bottoms up asset by asset analysis. We do obviously look at it from the top down and see if it makes sense big pictures. So, if you look at our portfolio and assume something between, you know, 15% and 20% defaults, and somewhere between 30% and 50% loss severities, you know where we are today accounts for that. As far as you know, the ultimate outcome, you know, it is going to wait and see obviously.

Bill Sonneborn

And that is weighted average across the whole portfolio. And currently, we are going to have a number of situations which are power recoveries and other situations which will be much, much worse ultimate recoveries, but the weighted average is roughly that 13% loss expectation as of December 31st.

John Hecht – JMP Securities

Okay, great. I appreciate that color. And the last question I have is, you mentioned that 30% of the cash flow is to support the business reside from outside the CLOs and the Wayzata structure. I assume that portion from the MBS portfolio, but I'm wondering if you can give us the characteristics of the bonds, maybe the par amount and the type of spreads in those bonds that are providing for the cash flows as well.

Bill Sonneborn

Yes John. As we started the call, we said we had about $350 million cost spaces of investments in loans, bonds held outside of the CLOs and Wayzata. So, if you look at those assets you know, the cash coupon on bonds averages around 11% and cash coupon on leverage loans, issuance around the LIBOR plus 250 range, and then you have the MBS assets, which are, you know, generating cash yields at the current market value, just north of 20%.

John Hecht – JMP Securities

But the total par outside of the CLOs is about $880 million.

Bill Sonneborn

Yes, $880 million.

John Hecht – JMP Securities

Okay, thank you guys very much.

Operator

(Operator instructions) We will take our next question from Louis Margolis, Select Advisors.

Louis Margolis – Select Advisors

Good morning gentleman. Could you describe the way you allocate loans across your three distinct pools. I guess you have the KFN Financial, you have a hedge fund, and you have managed accounts. I think you announced last year you took in $3 billion. How do you allocate across those structures. Could you also tell us the returns of the hedge fund's last year?

Bill Sonneborn

Sure, I'll talk about allocation. I don’t think it is something we will disclose in terms of returns in the hedge fund on this call, but in terms of allocation, we pro rata allocate any trade across all of our pools of capital based upon their underlying investment restrictions within those vehicles. So, in the event, we were buying a security, we would be buying that and pro rata allocating across to all of our vehicles based upon their available capital, so that the effective treatment if any of the entities is equal.

Louis Margolis – Select Advisors

The returns at KFN were catastrophic last year. Were they materially different than the hedge funds?

Bill Sonneborn

There are differences between KFN and any hedge fund most materially being holding company leverage.

Louis Margolis – Select Advisors

Have you given any thought to trying to recover historical fees. There were very high fees charged over the last several years. Communications with shareholders have been – to say they are very least, poor. Have you given any thought to try and recover fees from any of the individuals or entities who took them?

Jeff Van Horn

When we looked back on the situation and see, you know, net-net when you think of kind of the history of KFN as a legal entity, KKR has put more into KFN than it has received economically in terms of management fees or in financial fees over its life. So, it has been supported consistently by KKR and you will see that you know in connection with it still having, you know, a full 72 person team supporting KFN’s business and operations, even though our management fees are down as a result of allowance for loan loss and other balance sheet items we took in the fourth quarter by half 2009 versus 2008 on an expected basis, and we are deferring the receipt of half of those management fees until after the date when we deal with the revolver situation this year.

Operator

There are no further questions at this time. Mr. Sonneborn, I like to turn the conference back over to you for any additional or closing remarks.

Bill Sonneborn

Thank you all. I appreciate you being patient listening to this lengthy call. We appreciate your support and will keep you abreast of any further actions we take. Have a good day.

Operator

That concludes today's conference. We thank you for your participation. You may disconnect at any time.

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