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KKR Financial Holdings LLC (KFN) got some media attention this weekend when Barron’s included the stock in its “The Trader” section. The company is a spin-off from its well known private equity parent Kohlberg Kravis Robers & Co. KFN is in the business of buying corporate debt at attractive prices and then realizing a return from both the interest paid on these loans as well as the expected capital appreciation.

Over the past 2 years the stock has fallen sharply as unrealized losses in its bond portfolio accumulated quickly. Although the stock hit $30 in early 2007, the very real fear of insolvency caused shares to hit a low of $0.40 in March. Since that time, the rebound in credit markets has helped investors regain confidence and KFN is pushing above $4.00 per share. While the price is still significantly lower than investors could have imagined before the market crash, the company appears to be sustainable and has some interesting potential for future gains.

KFN uses a “moderate” amount of leverage according to its public statements. This essentially means that in addition to the balance sheet equity, the company borrows additional capital in order to invest in its target securities. The goal is to purchase investments that have a greater yield than the capital being borrowed which creates an attractive spread. Today, the borrowing costs are historically low due to FOMC actions and federal programs aimed at keeping capital cheap and available to businesses. At the same time, the potential return when purchasing debt securities can be very high as investors are still relatively skeptical and risk averse when it comes to investing in corporate debt.

Ahh, the risk… This is the most difficult of KFN’s business to judge because as the company adds more leverage, the investment decisions are magnified. Successful investments will yield an even greater return as they are financed not with the company’s capital, but with borrowed funds. But as we have seen in the past 2 years, that leverage can become a huge burden as asset prices theoretically can fall to the point where no true equity remains (liabilities are greater than assets). As of June 30, the company’s assets totaled $10.45 billion with the liabilities at $9.55 billion. This means that the company is using a bit more than 10 to 1 leverage which is extremely high, but also indicates some improvement as the asset prices have risen.

KKR Financial Holdings (<a href='http://seekingalpha.com/symbol/kfn' title='KKR Financial Holdings LLC'>KFN</a>)

According to the most recent press release (issued June 30), the actual book value of the company stands at $5.69 per share which is significantly above the actual stock price. Securities like KFN can sometimes trade below book value due to investor pessimism about the future value of its assets. But this price may turn out to be excessively conservative as rumors have begun circling that the parent company may have an interest in taking KFN private once again. This sort of move would make sense as KKR could buy the company at roughly 74 cents on the dollar and then either hold the assets to maturity, liquidate them and pocket the profit, or eventually spin the business unit back to the public or to another private investor.

If you are really curious (or just need some help falling asleep) you can view the entire schedule of the company’s investments. The value of these holdings should have increased since June 30 as the credit markets continue to show improvement. So while the long-term risk is certainly an issue in owning this leveraged play, the odds seem stacked in the favor of investors due to the level of assets and the potential for a takeover if the stock continues to trade at a discount to NAV.

KFN Chart

Disclosure: Author does not have a position in KFN.

Source: KKR Financial: A Specialty Finance Opportunity