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Executives

Pam [Testani] - Head-Investor Relations

Craig Farr - Chief Executive Officer

Mike McFerran - Chief Operating Officer and CFO

Analysts

Daniel Furtado - Jefferies

KKR Financial Holdings LLC (KFN) Q4 2013 Earnings Conference Call January 31, 2014 9:00 AM ET

Operator

Good day, ladies and gentlemen, and welcome to the KKR Financial Holdings LLC Fourth Quarter 2013 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).

As a reminder, this conference call is being recorded. I would now like to introduce your host for today's conference, Pam [Tolan], Head of Investor Relations. Ma'am you may begin.

Pam Testani

Thank you, operator. Welcome to our fourth quarter 2013 earnings call. I’m joined this morning by Craig Farr, our CEO; and Mike McFerran, our COO and CFO.

As a reminder, we’ll be discussing forward-looking statements on today’s call, which do not guarantee future events or performance and 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. Any non-GAAP measures, we reference are reconciled to GAAP figures in our supplement.

I’ll start the call off with fourth quarter performance highlights and a quick update on the acquisition by KKR that we announced on December 16th. Then Mike will give you more detail on our results and Craig will go over progress against the goals we laid out last quarter.

This morning we reported fourth quarter net income available to common shareholders of $62 million or $0.30 per diluted common share. This compares to $33 million or $0.16 per diluted common share for Q3. The increase was driven primarily by a higher level of gains on investments in a quarter where we saw rallies in both credit and equity markets.

We ended the year with book value per common share of $10.58, up from $10.42 at September 30th. And in connection with these results, our Board of Directors declared a cash distribution of $0.22 per common share for the fourth quarter which is consistent with the third quarter. The distribution is payable on February 27th to common shareholders of record as of February 13th.

And before I hand things over to Mike, I want to touch quickly on the transaction that we announced with KKR. As you’ll recall, based on the unanimous recommendation of an Independent Transaction Committee, our Board approved KKR’s acquisition of KFN, the 0.51 KKR common units per KFN common share. The transaction is still subject to approval by a majority of KFN common shares as well as satisfaction of various other closing conditions including customary regulatory approval.

On January 15th, KKR filed a preliminary S-4 registration statement with the SEC. The S-4 is currently under review and has not yet become effective, so unfortunately we’re limited in terms of questions you can ask at the moment. But that said we are working to hold a shareholders’ meeting as soon as possible.

We urge you to read the proxy statement and the prospectus included in the S-4 as well as any other relevant materials that we or KKR files, because they’ll contain important information regarding the transaction.

And I’ll now pass it to Mike.

Mike McFerran

Thank you, Pam. And thank you everyone for joining our call this morning. As Pam mentioned, we generated $62 million of net income to common shareholders for the fourth quarter, which implies an annualized return on equity of over 11% for the quarter. This compares with $33 million or 6% return on equity for the third quarter. This quarter-over-quarter improvement in earnings was primarily driven by a $27 million increase in other income, nearly all from net investment gains.

For the third quarter, net investment gains totaled only $6 million. In contrast for the fourth quarter, they were $32 million as strong equity and credit market performance growth unrealized and to a lesser extent realized gains. While investment gains will inherently be lumpy from quarter-to-quarter as we’ve talked about in the past, on average we’d expect them to be somewhere between these last two quarters’ results, given our current portfolio mix. Included in our $32 million of net investment gains is a $10 million charge against certain of our natural resources properties.

We took an impairment due to a combination of unfavorable pricing in one asset and uneconomic [growth] in another. But it doesn’t compromise our general outlook for the reminder of the assets in the strategy.

With respect to top line results, total revenues increased quarter-over-quarter by 8% for a $129 million to a $140 million. This was primarily driven by a few items. First, we received $4 million in dividends in certain mezzanine and private equity holdings, these tend to be non-recurring. Second, interest income increased $4 million. This was driven primarily from higher coupon income in our loan portfolio, which grew about 5% since the third quarter. Finally, oil and gas revenue increased $3 million quarter-over-quarter. The improvements in revenues and other income were partly offset by expenses, both investment related and operating.

On the investment side, we added $12 million to our allowance for loan losses. This was driven by two factors. First, two of our impaired loan positions, Longview Power and [Large Net] declined in price during the quarter. This increased the allocated components of our allowance, since we have a specific reserve against both of these.

Second, our loans held for investment portfolio increased in size by $278 million or approximately 5% as we previously mentioned. Our total allowance for loan loss at year end as a percentage of our held for investment portfolio remains constant to what it was in the third quarter at 3.6%.

Next, cash results. On a cash basis, we generated $0.17 of run rate and $0.25 of total net cash earnings per common share for the fourth quarter.

As you’ve seen our supplement, we've also shown a pro forma version of these figures on page 34, which vary in how we recognize cash from our development focused natural resource assets. Our historical approach uses GAAP DD&A to determine cost recovery with any access in cash received above the DD&A amount being attributable to cash income.

The pro forma number includes, on the other hand, cost recovery based on total proved reserves, which GAAP DD&A doesn’t entirely capture for these development assets. On this basis, run rate cash earnings were $0.19 per common share and total net cash earnings were $0.27 per common share.

We think this alternative method provides a more consistent way of looking at our equity amortization across all of our sub-strategies, especially as development assets have become a bigger part of the portfolio.

In terms of deployment, we had a very active fourth quarter, which Craig will discuss in a moment. In addition to cash on hand, we have funded this in a few ways. We saw certain rated notes in our 2007-1 and 2007-A CLOs for $94 million of proceeds. We also drew $75 million of the 150 available under our revolving credit facility to bridge timing differences of asset funding and realizations.

We ended the quarter with $157 million of unrestricted cash, all of which was committed to opportunities we expect to fund in coming months.

And with that I’m going to hand this to Craig.

Craig Farr

Thanks Mike. Overall, we are pleased with the fourth quarter as we’ve fallen true in some of our key objectives; we laid those out in our third quarter call. First, we wanted to simplify our portfolio by narrowing future capital commitments to three strategies from six. And second, we really wanted to increase our capital deployment, in particular cash yielding strategies like CLOs. We thought this would help us grow our cash EPS over time which we are (inaudible) this key objective.

And our activity in the fourth quarter was consistent with those priorities. In the fourth quarter alone, we deployed or committed more than $420 million across the strategies, net of turnover such as situation portfolio. Over $315 million of that was deployed during the quarter and about $240 million of that went into those three core strategies; CLOs, specialty lending, opportunistic credit.

While we continue to fund our historical commitments to non-core strategies such as real estate and natural resources, as Mike just went through, we’re continuing to emphasize migrating our capital to areas where we believe KFN’s differentiated capital base is especially advantageous.

Let’s look at those three core areas. In CLOs, we mentioned increasing our exposure by tapping three sources, KKR CLOs; third-party CLOs, the new area for us; and then Avoca CLOs. While KKR has not completed the Avoca acquisition yet, we did execute in those first two areas.

We placed the new CLO in late December, CLO 2013-2, which just closed last week. This was a $384 million deal with $45 million of sub-notes, all of which KFN retained. We also participated in our first third-party control deal where we acquired approximately $30 million of subordinated notes and a new CLO managed by Sound Point. Sound Point is an affiliate of Stone Point who we all know well through our joint venture with KKR at MerchCap Solutions. Additionally, we added to our position in our own 2012-1 transaction by buying more of the sub-notes in the secondary market. We’d only bought 52% of those had issuance.

And on the specialty lending side, we continue to see opportunities by managing long duration hard asset. You're all witnessing the regulatory environment for banks where they are being forced to focus on appropriately short-lived more liquid assets. And we funded an additional $32 million of our $150 million commitment to Maritime Finance Company.

We also executed on two more of these specialty lending opportunities in the fourth quarter. First, as many of you saw from our press release a few weeks ago, we committed $105 million to LCI Helicopters to help extend their global helicopter leasing business, partnering with Libra Group. We funded $50 million in the fourth quarter. We're very excited about the opportunity there. We believe it's an underpenetrated market in leasing and we continue to be focused again in those types of opportunities.

And then, we committed $20 million to a business called Battery Point Financial, of which we funded $2.5 million in the fourth quarter. This is a new entity focused on acquiring a portfolio of contracts for deal, which is a form of non-mortgage home financing that we believe offers attractive risk adjusted returns. Similar to Maritime Finance, we've taken an equity interest in both of these companies and we expect these to generate regular distributions of course over time as their portfolios are ramped.

And lastly, opportunistic credit. This continues to be an exciting year, which includes mezzanine and stock situation. We deployed $80 million net of proceeds from sales during the quarter and we committed another $28 million that we expect to fund shortly.

As we've been saying, we continue to believe that illiquidity premium associated with these private credit transactions is attractive for all of you as shareholders. The remainder of our deployment in the fourth quarter was the legacy commitments into our non-core strategies.

So we’ve made good progress on our objectives as we last talked. We’re continuing to focus on the best risk adjusted returns the high yielding opportunities where capital is most viable.

Thank you very much for joining us. And we’re happy to take any questions you have.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). Our first question comes from Daniel Furtado of Jefferies. Your line is now opened.

Daniel Furtado - Jefferies

Good morning everybody. Thank you for the opportunity.

Craig Farr

Hi, Daniel.

Daniel Furtado - Jefferies

I just have two or three real quick questions, the first was the fallen the interest expense to affiliates. I assume that some CLO redemption is driving that but not sure?

Mike McFerran

Yeah. To affiliates you have to really look at interest expense to affiliates adjust interest expense on the CLO [allowance] and any affiliates no longer owned allowance from third parties due that is just a reclassification of line items.

Daniel Furtado - Jefferies

Understood, that’s what I figured. And then the second question was just on the run rate slide for the bank loans and high yield, it looks like it came in pretty materially from quarter-to-quarter. Is that just some noise or how should I think about that delta there?

Mike McFerran

(Inaudible) but that’s fine Dan, let me take a look at it.

Daniel Furtado - Jefferies

Sure. And when you look at that Mike if I could throw my last one in there, just kind of some update I get it on the helicopter play and the liquidity premium, but in terms of Maritime Finance specifically in that space, do you still see that as attractive as you did when you initially got into the business?

Craig Farr

We do. Dan, it’s Craig. I think like every asset class there is no question that yields are starting to, obviously come down in every single class as you said have a lot of more cap in the markets. But the team has found especially in the area they’re looking at given the size of the loan rates that there [is a plan] above a lot of the market and are really still sourcing really interesting opportunities.

Daniel Furtado - Jefferies

Great. Well, thank you for the color on that point.

Mike McFerran

And Daniel, on the interest income point, you know the run rate of the bank yield and loan strategy is actually expanding. What you’re really seeing is the timing of deployment versus when we actually started receiving revenues from that.

Daniel Furtado - Jefferies

Okay.

Mike McFerran

So as Craig talked about some of those transactions we did were really at the end of the quarter. You can see the benefit of those (inaudible) is taken into Q1.

Daniel Furtado - Jefferies

Okay.

Craig Farr

We are facing probably (inaudible) some of that compression through that CLO issuance and some of the other credit strategy, Daniel so I think that’s exactly what we are trying to [outstand] I think. Going forward as Mike said, it was doing better with that trending.

Daniel Furtado - Jefferies

Great, thank you for the color everybody. I really appreciate it.

Mike McFerran

Thanks, Daniel.

Craig Farr

Thank you.

Daniel Furtado - Jefferies

Yeah.

Operator

Thank you. (Operator Instructions). Our next question comes from Charles Matthews of Wells Fargo. Your line is now open.

Unidentified Analyst

Good morning and thank you for taking my question. You had mentioned $157 million in unrestricted cash which are expected to fund in the future. But you obviously have some other financing sources. I was wondering could you give us a sense for what your total investment commitments are at this point? I am assuming it’s above that $157 million?

Mike McFerran

Yeah, unfunded, it’s actually about that amount. Today, we view ourselves as fully deployed. And while there is always a little bit of timing between when you monetize certain positions or when you deploy capital of others, I’d say our unfunded commitments are about that amount.

Unidentified Analyst

And if I could, if could just ask a quick follow-up, I know you mentioned that investments during the quarter. If I could recap you said it was $350 million during the fourth quarter and $50 million subsequent to that, is that correct?

Craig Farr

Yeah.

Unidentified Analyst

Okay, great. Thank you.

Operator

Thank you. (Operator Instructions). And at this time, I am not showing any further questions. I’d like to turn the call back to management for any further remarks.

Pam Testani

I think we are all set for now. Thank you very much operator. Thanks everyone.

Operator

Ladies and gentlemen, thank you for participating in today’s conference. That does conclude today’s program. You may all disconnect. Everyone have a wonderful day.

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