William C. Sonneborn – Chief Executive Officer
KKR Financial Holdings LLC (KFN) dbAccess 2013 Global Financial Services Investor Conference Call June 4, 2013 10:05 AM ET
I would like to introduce Bill Sonneborn, CEO of KKR Financial. It’s a $2.1 billion market cap company; invest primarily in the investment grade corporate debt, as well as private equity interests and natural resources backed investments. So with that Bill, I’ll turn it over to you for a quick presentation.
William C. Sonneborn
Thank you Steve. Welcome everyone, as Steve mentioned Bill Sonneborn, CEO of KKR Financial and it’s an honor to speak a little bit about the firm today and what we’re trying to achieve. What is KFN? For those of you that haven’t followed the company, it’s a specialty finance company and it’s different from any other comparable out there and we’ll spend time talking about that specifically.
The ultimate goal of what we’re trying to achieve, leveraging all the network and capabilities of KKR or manager should deliver to shareholders a return of the 1000 basis points above the tenure treasury on a consistent basis. And how do we do that? We try to think about the world holistically in the context of how much risk we’re willing to take. And given that amount of risk, we go where the opportunities are and we think holistically of how to build a better finance company relative to the history of what are poor examples that have failed or no longer exist.
And when we think about how we’re able to do that is leveraging a firm of 1000 people over 400 investment professionals located in almost any geography around the world, and always sourcing specific individual investments, we’re feeding information in data to holistically help us, think about how we allocate capital to deliver those returns.
We got two core investment teams that we’ve developed over the course of the past four or five years, really thinking holistically in a context to the finance company business of how financial assets, which were traditional assets within a finance company play alongside the real assets.
(Inaudible) financial assets, we broadened and how we think about the credit markets. We started initially predominantly financing senior secured terms loans even CLO technology to get term financing with no mark-to-market risk. We've overlaid that using holding company leverage or resource of funding to invest in global special situation, which are rescue finance or distressed investments that you source globally providing mezzanine finance to third-party sponsors to help them facilitate M&A transactions and selectively and only selectively participating in specific private equity transactions that KKR does in its private equity funds, like the element of how that specific business plays within the overall return profile of the business and provide some positive equity skew in periods when equity markets are very strong.
But we really thought a lot about, if we have a lot of financial assets in thinking about the macro environment we are in, real assets have a place in a finance company. And we stated initially thinking about real assets through really structural and fixed income equivalent exposures to really hard assets. How do you do that?
Well the initial pullover was in buying, producing interests in conventional oil and gas fields, wells that have been drilled five years, 10 years, 15 years, 20 years ago that will be producing natural gas or oil over the course of the 20 year period, we can really hedge your commodity exposure over a five year period lock in a coupon, which is the cash-on-cash return that we are targeting mid teens and then have kind of unhedged residual. So you have effectively a part of our balance sheet that’s exposed to longer field and longer duration points of view, given that the bulk of our investment portfolio with LIBOR floating rate based.
On top of that we started to selectively see opportunities in commercial real estate. And so KFN today operates through its credit business, through a REIT subsidiary and through an MLP subsidiary. What makes KFN different from [BDC] the question that I frequently get and it’s so we can be opportunistic, we can’t think about real assets, we can think about selectively allocating the private equity in addition to focus thing on what we do in corporate credit and below investment grade, we also can grow. Most flow through vehicles they are structured similar to KFN pay out 100% of their earnings to their shareholders every year. We generate an 18% annualized return on capital in the first quarter, paid out about half of that to shareholders, retaining the rest to reinvest in the business and continue to grow.
In addition, as a specialty finance company we use bank accounting on the bulk of our assets. So our bank loan portfolio has really held at it’s cost with an allowance for loan loss, similar to how a bank would hold its investment portfolio and we provided disclosure in the past in our supplemental material that provide what the difference between fair value if we were able to just liquidate those loans at the end of the quarter end versus our carrying value which represents what you see in book value per share.
And at the end of the first quarter the fair value, we just liquidated the balance sheet of KFN was about $10.86 compared to a book value per share of $10.16 so about a $0.80 difference of conservative and if you will in which our allowance for loan losses is actually higher than what it would it be just to liquidate the underlying loans at their current market prices. So it provides some downside protection or if you will margin and safety in the context of our balance sheet.
The final difference of how we’re unique is our holding company funding; we have no mark-to-market debt. Nothing with a market value trigger and now that we’ve locked in fixed rate in long duration financing, 27 years average life next maturity not till 2036, which allows us to think very long duration in some of our capital deployment decisions to help build shareholder value over a long period of time.
One of the things we've talked a lot with investors is picking up options, they are either free or miss priced and today as we've said and think about KKR Financial of 35% of our book value in cash, ability to generate mid to high teens returns on capital consistently over the past couple of years, we have collected a lot of options, whether it’s in rising commodity prices, whether it’s in raising short-term rates, whether it’s in rising or increasing inflation expectations as referenced by what the tenure has done over the course of the past couple of weeks.
If you think about European markets and particularly the credit markets and the (inaudible) of private capital providers moving towards more capital markets led European recovery were able to participate. If you think about our natural resources investments starting with those producing interests moving into drilling interest and royalty interest, we have a massive free option that we didn’t pay for improved drilling technology for reduced operating expenses, in addition to underlying commodity price increases that could enter to the benefit of shareholders.
And finally, while we have a lot of credit spread risk. We also have maintained some positive equity skew through special situations and warrant positions we typically get in those types of transactions, and a small part of our portfolio focused in private equity. So that we can generate returns when equity markets go up and people are thinking of that big switch from – the big trade if you will from fixed income or credit or yield into a more equity oriented market opportunities. And that’s the reconciliation of fair value per share.
And with that I’m going to sit back down with Steven, and we will have some discussion and then open it up to everyone in the audience for questions.
Great, thanks Bill, I appreciate the prepared remarks. I guess after a review of opportunities, you guys sourcing in your pipeline, maybe talk about what you are seeing is most attractive investment opportunities today, where do you see the biggest supply demand and balances that you guys are targeting in this environment today.
William C. Sonneborn
There is really three Steven that we are focused on today, I’d say one is in the period of time over the course of the past 24 months you have seen in credit spreads tighten pretty substantially. In those types of environments, we like to move up to the top of company capital structure, senior security lender, attachment appointed zero and their capital structures and finance them with CLOs.
On top of that well over the last couple of weeks you have had some new retention rules on top of the 122a European retention rule that was out there revised risk retention rules coming out of the, and so as a result of that the ability of issuers of CLOs to tap global investor appetite is now being reduced, because of these new rules that you have to comply with the old and the new rules. And so we like the opportunity in CLOs today as a result, because a number of competitors will not be able to comply with those constraints that are one.
The second is the shale plays in the U.S. It’s $2 trillion of capital that’s going to be needed over the course of the next decade. Historically, oil and gas operators particularly in the mid cap E&P Swiss have gone to their friends and asked them to form in to help fund the capital expenditures and share the risk and rewards. But because every single mid cap E&P company today has a portfolio of drilling opportunities bigger than what they can actually fund, that creates a gap. And being the private capital provider with engineers on staff and a team of operators that can really understand and diligence these opportunities, structure them senior in the context of more of a debt like investment and help fund that CapEx need is an extraordinary opportunity we see that will last over the next at least five to seven years.
And then third and finally, we’ve been talking for the past year and a half about opportunities in the Europe credit, really driven by the de-leveraging of European banks which still have very substantial average relative to the U.S. counterparts. The lack of the true capital markets solutions and similar to a robust high yield market and syndicated leverage loan market like we have domestically here in the U.S. And the true opportunity is not calling up a bank and asking them to sell their assets at $0.70 because they wont do that, when have a market 90, because that does not de-leverage their situation.
The real opportunity is to go with that bank’s customers and provide a solution both to the bank that wants to get pay down some of their exposure and to their company that needs a solution to help them continue to fund their business. And we've done several transactions over the course of the past couple of quarter and we have a robust pipeline of similar transactions right now in which we can be that solutions provider.
Great. Following up from the CLO comment, can you talk about asset collection for future CLOs, you mention advantage with sourcing some of those against some comparators, may be what the demand is for bonds from other side and talk about CLO market today and may be how they are different than say six or four months ago.
William C. Sonneborn
Sure, I mean I think the biggest change of CLOs over the course of the past couple of quarters has been the advent in Europe, which is now being discussed in the U.S. of risk retention, which is really in the case of European rule that any one as a sponsor or originator of the CLO must hold at least 5% of that transaction. When we think about the CLO market, it was really built in terms of the technology for asset managers to issue CLOs to manage loans to get a fee typically around 50 basis points of management fee.
However, those firms that have traditionally been a very large part of the CLO market don’t have a capital source to fund that 5% risk retention. And so as you’re starting to see more and more of financial regulation trying to avoid situations of over securitization or that we saw from the last financial crisis and the regulation now coming out that means it starts to limit the playing filed of a number of people they can use the technology.
Particularly to the extent that you want to attract today as we speak at this moment any of European bank insurance company or financial services hedge fund or investment management capital, because the capital charge associated with them, investing in a non-risk intention compliance structure is very, very high relative to one that can comply and so I encourage people to think about the changes and dynamics in the market of those that can come up with the solution to that can undrawn versus those accounts.
And looking at the investment pace, switching gears to portfolio growth at the end of the first quarter you got a little over $700 million of cash, undrawn capacity of $150 million credit facility as you mentioned in your prepared remarks you do have the ability unlike perhaps some other financial companies to retain earnings and grow the portfolio organically. Can you talk about investment pace, have you accelerated this quarter end or are you more cautious given that environment out there today with some rate volatility and how are you guys go in the pipeline in this environment?
William C. Sonneborn
It’s a great question. So yeah we had about $750 million of cash, the credit facility plus we have an additional near $100 million of Mezz notes from legacy CLOs that have effective cash yields of sub to us, of sub 2.5% cash yields and sub kind of 6% total rate of returns all of which represent opportunities to reinvest in our treasuries plus 1000 rate of return to be accretive to shareholders.
We think that’s a, we’re not going to make investments when markets are extremely robust in this pricing risk and we’re looking for those idiosyncratic more privately sourced opportunities or in the case of waiting for the CLO market to get to the risk retention state that its in to deploy capital. We really think about supply demand imbalances on a global basis and want to find those unique sources that can help us lock in very attractive rates of return in this priced options for a long period of time. And so clearly heading into the end of last year and the first quarter of this year, and we've deployed capital that prudently and we’ll continue to do that as we move on later this year. We feel very good about the pipeline of opportunities that we're looking at today.
And Bill following up on that with regards to the pipeline, it’s a traditional, but are the investments you’re seeing more attractive today in the corporate debt world, are they more new focus about the natural resources or potentially commercial real estate, where are you are seeing the biggest pockets of opportunities today.
William C. Sonneborn
In this environment when you see kind of spreads on bank loans and high yield bonds which are typically more subordinated to the loan in the company's capital structure roughly on top of each other. And you are seeing more demand on kind of spread product, you would like to move up company capital structures this is where the CLO technology comes in handy, so we can term finance longer duration with no mark-to-market of debt underlying senior secured loan portfolio.
And while we are seeing opportunities more junior company's capital structures continues to be in Europe whether it’s a rescued finance transactions, like the [EuroVita] transaction we announced at the end of the first quarter. We have another one that we're getting very close to announce in the next couple of weeks in northern Europe. Those opportunities continue to represent a robust pipeline.
Natural resources the opportunity moves to really funding through these form and arrangements shale development, where you have existing wells you de-risk in the context of how you think about extracting the underlying resources, its not wildcat drilling, its basically a company has drilled 40 wells, they need to drill 40 more, but they don't have the money for it. And you already know exactly where those wells are going to go and you have the option to terminate every two or three wells and you structure senior cash participation, so you get your money out faster with a higher yield, those opportunities are numerous here in North America and in Canada to be honest with you, and so if the question of finding the right ones that you’ll get the best rate of return, in those types of opportunities targeting 15% to 25% IRS.
And I guess one last question regarding some comments from the first quarter call maybe an update, in your prepared remarks you talked about targeting a return of a 1000 basis points over the tenure. On your Q1 conference call, you guys discussed a view that rates would move to tenure rate of 3% and 14% and clearly seeing a pretty big rate move during May. Can you talk about maybe I guess both one I guess review on rates from where you said, but also how that’s change in your business, and as you look at I guess by your forecast another almost 100 basis point increase over the next few quarters, how is that changing your asset allocation investment [decision]?
William C. Sonneborn
It’s a good question, yeah, we did say that we expect the tenure to potentially double over the course of the next 12 months in 2014 really driven by economic recovery, likely reduction of defense $85 billion a month purchase of mortgage backed securities. Well, we are seeing from our discussions with Sovereign Wealth pools in particular in Asia and the Middle East that are reducing our Treasury holdings through what England mature and not reinvesting in the context there is an ongoing discussions, the fact that we feel that is more likely they are not, Ben Bernanke is not going to be the Head of the Fed going into 2014, which the market will take as probably a more [doublish] replacement coming in.
And so we've had that view for a while, and why one of the reasons we really built out now over 15% of our capital devoted to real assets its really to protect and actually provide a profit opportunity for investors as not only short-term rates rise, which we have an embedded 1.6 billion net LIBOR long position, so we wanted part of our capital to really participate in a long-term increase of the long end of the curve, so we could hit our metrics plus for shareholders.
Great well that’s great. I appreciate the color there especially the post Q1 update, and with that we have about 10 minutes left. We’ll open it up to Q&A from the audience. Any questions?
William C. Sonneborn
Thank you all for coming…
Well that’s good, Bill let me ask a few more then if nobody else wants to take step up. Can you may be talk about the underwriting characteristics, what were attachment points are, what you are looking at specifically from cash flows or other characteristics when your making the corporate debt investments and really how that’s changed any past through the four quarters.
William C. Sonneborn
Sure, I mean I think in corporate credit generally is spreads have tightened, you’re starting to see much more issuer friendly structures in addition to pricing. So more covenant like transactions across the board typically with more room for incremental facilities, underlying documentation from a structural perspective, plus strong. So you’ve seen a kind of gradual weakening if you will of how credit instruments are really set as a result of that supply demand moving more towards the issuer friendly side. And what we focus on is specific aspects about a business where we at KKR can develop a competitive advantage.
We may own through one of our private equity portfolio companies or competitor, we may own a supplier, we may have owned a business very similar to the one we are thinking about lending but its [holding]. We think holistically of how tap that into capital, so we can really understand not just what the base case is or what the bank book says the company will perform, but what are the three four or five key risks to that business and we think historically, we’ve invested in corporate credit for example high yield and mezzanine since 2004 and 2005, we’ve had one default in high yield, we’ve had one default in mezzanine both of them had positive IRRs in recovery of four principle.
And so when you think of that it’s all about how you leverage that intellectual capital to make the right decision upfront, which means we may not be the fastest mover in the context of decision making on making a loan or we are going to know everything there is to know about what can go wrong.
And so we have an investment grade process, a detailed due diligence process, that whole process has been set, it helps to avoid mistakes, which is when you’re thinking about investing in securities even though you’re financing them where your upside is get your money back plus a coupon, your downside is you lose money, you have to get it right upfront, and so we spent an enormous amount of effort leveraging all of the firms to do that and it’s paid off over the course of the past several years in terms of return profile.
And I guess kind of trying to tie together the CLO comments with the potential opportunities in Europe. How do you look at European currency denominated investments, how are you handling the hedging of that currency risk that you’re looking at potentially of euro denominated CLO in the future of those markets there, how do you see that playing out as your investments in Europe continue to grow?
William C. Sonneborn
Currently we hedge all European currency back to the U.S. when we make investments like few examples the URSA loan we did in the first quarter in Spain, so when you start to think about the (inaudible) we also a lot of times want to structure it, so the underlying instrument automatically converts to dollars of that domicile no longer supports the euro, so we are effectively putting that risk on the issuer as opposed to taking it as a business, so we’ve done that in number of situations.
And another way to hedge currency risk attractively is to do a CLO in Europe to comprise with the European risk retention rules and effectively finances euro based assets with euro liabilities, that’s something that we've been talking about on several quarterly earnings call that strategically is interesting to us, but as you’ve seen regulation keeps changing two weeks ago it changed again and so we want to make sure of that the right time to do that is when the ball stops moving.
Great and as you continue to grow the portfolio and given your structure as a partnership, you don't have the distribution requirement many others have, clearly plenty of liquidity now, how do you see your capital structures evolving over the next few years as you do raise more capital will be through the equities, some other type of capital raise or how do you look at management your total overall capital structure?
William C. Sonneborn
Well when your stock trades below its liquidation value, equity is extraordinarily expensive. And one of the advantages we have in addition to the $750 million of cash, the undrawn credit facility, the ability to recycles some of the existing capital off the balance sheet is we have a lot of room to run. Now that we have ample room to issue additional long-term 30 year debt financing, we did approximately six months ago a perpetual preferred which is also open in the context of the current market environment. So I’d say that there are ways we can continue to lower the cost of capital at KFN to make our ability to generate treasuries plus the 1000 or better even more likely.
And I think one investment opportunity you guys do comment on commercial real estate; I think we are getting more competitive, a lot of capital has been raised recently especially about the mortgage REIT to target commercial real estate investment. So what are you seeing there, how big of an opportunity is that for you today versus a year ago and where do you see that going, going forward?
William C. Sonneborn
We’re highly selective and opportunistic in the context of commercial real estate. So a lot of capital that’s been formed is going after more broad opportunities that really don’t – we don’t feel competition with how we’re both originating and structuring investments, leveraging the same kind of one firm culture and how we look at ideas. We talked about the opportunity in multi-family in the Bakken Shale and Williston, North Dakota, which really came out of eyes and ears of one of portfolio companies, Samson, was one of the members of KKR’s Board, John Houston has petroleum and had a very large position in the Bakken Shale in North Dakota and we’re struggling to find housing for their employees.
We just happen to find 40 acres of undeveloped land in the prime area just outside of Williston, which is becoming the headquarters in the Bakken Shale and the process of selling off single-family and developing a multi-family unit, which will contract out to some of the majors and oil services companies, which is really it is syncretic risk profile in the context of commercial real estate, where you don’t see a lot of the traditional players in this space, competing.
Great, William. If there any questions from the audience, happy to take a couple if there are any.
Yes, hello, (inaudible) from New Credit Asset Management. May be if you just give a short kind of overview on how you work with compensation, variable compensation, how you ensure that your employees have long-term incentives, but also get short-term benefit of the successful projects they’re working on?
William C. Sonneborn
Great question. That really goes now to thinking more holistically about KKR – KKR Financial externally managed, it pays KKR a management fee and an incentive fee based upon heading a hurdle rate. In addition the independent directors had the ability based upon business plan that management puts in place of what we’re – say we’re going to do in terms of projects and returns and how well we do relative to targets to allocate restricted stock to employees that help create that.
But in the context to KKR, we have a one firm, one P&L profit pool, so all of the management and center piece that go from KFN to KKR go into that integrated profit pool, they then get allocated to employees based upon how well they have performed, and what they are accountable for, how well that was achieved. And so we carve up that pie that way to create a true meritocracy and it also provides this network where everyone is incentivised to get the best outcomes.
So if we are thinking about making a loan out of KFN to a business that the CEO says they have state of art factory in China that gives it a competitive advantage to withstand 2008 or 2009 recession and still be profitable. It’s easy for us to call David Lou, who runs our China private equity business in Beijing and have him get in his car and drive out and see if that factory is really state of the art. And he has just as much incentive to do that is I would, if he is thinking about making investment in China that has some implications in the U.S. market of me helping him make sure he gets the right answer.
And so everyone is treated the right way, commercial outcomes and results is the most important, but that teamwork and collaboration is absolutely critical to what helps us achieve the results we've been able to achieve and come up with the kind of how we’re thinking about capital allocation today within KFN.
Okay, well Bill thanks a lot for joining us. We really appreciate your time.
William C. Sonneborn
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