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Executives

Bill Sonneborn - Chief Executive Officer

Michael McFerran - Chief Operating Officer & Chief Financial Officer

Laurie Poggi – Investor Relations

Analysts

Gabe Poggi - FBR Capital Markets

Michael Sarcone - Sandler O’Neill

Kyle Joseph - JMP Securities

Matthew Howlett – Macquarie

Leon Cooperman - Omega Advisors

Wayne Cooperman - Cobalt Capital

KKR Financial Holdings LLC (KFN) Q3 2010 Earnings Call November 4, 2010 5:00 PM ET

Operator

Good day everyone and welcome to the KKR Financial Holdings LLC third 2010 earnings conference call. Today’s call is being recorded.

At this time I would like to turn the call over to Ms. Laurie Poggi. Please go ahead.

Laurie Poggi

Thank you, Elizabeth and good afternoon, everyone. Joining me on the call today Bill Sonneborn, our Chief Executive Officer and Michael McFerran, our Chief Operating Officer and Financial Officer. As a reminder this call is being recorded and webcast live on our website.

Today, we issued our financial results released for the quarter ended September 30, 2010 and filed our third quarter Form 10-Q with the Securities and Exchange Commission. These documents, together with the supplemental information packet are available in the Investor Relations section of our website at www.kkr.com.

Be for we get started, I’d like to caution you that this conference call and webcast 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 SEC. These filings are available on the Securities and Exchange Commission’s website at www.sec.gov. KFN’s actual results may vary materially from those expressed in the forward-looking statements.

In addition some of the discussion today will include references to non-GAAP financial measures. Information about these measures may be found in the supplemental information packet also available on our website.

With that I’ll turn the call over to, Bill.

Bill Sonneborn

Thank you, Laurie, and thanks to all of you for joining our call today. We appreciate your time and interest in KFN. We had a solid quarter based on the metrics we focus on. We fortunately were able to increase our earnings, book value, cash flow and distributions per share and we identified the unique opportunities for deploying our retained earnings and attractive target returns.

Our third quarter GAAP earnings were $0.52 per common share, which compares to $0.51 per share for the second quarter of this year, and $0.42 for the third quarter of 2009. On a GAAP basis, we generated a 25% return on equity in the quarter. If you subtract the impact of realized gains and other less predictable sources of revenue, as well as share-based compensation and incentive fee expense, we generated run rate earnings per share of $0.43 for the quarter or a pro forma 20% run rate return on equity.

Run rate income is a non-GAAP financial measure and it is a key metric that we use to evaluate the recurring earnings power of our business. Share-based compensation expenses excluded, this is a non-cash charge and incentive fee expenses excluded this amount is generally driven by realized gains at our portfolio that are included in our other income line in our income statement.

Run rate income for the quarter of $0.43 compares to $0.39 for the third quarter of last year. As disclosed in our earnings release yesterday our Board of Directors declared a cash distribution of $0.14 per common share payable on December 1 to shareholders is a record on November 17. This represents a 17% increase from our $0.12 per share dividend for the second quarter and following this payment, we would have distributed $0.36 per share for the first three quarters of this year. This is the fourth consecutive quarter where we have increased distributions per share.

With respect to cash flow, as shown on page 11 of our supplemental materials as new disclosure that we think is useful to investors on a going forward basis. Run rate, cash earnings per share equaled $0.27 for the third quarter as compared to $0.20 for the second quarter. Run rate cash earnings for the quarter represent effectively a 13% cash conversion with return on equity and can be used for either distributions to our shareholders or reinvestments into our business.

This number does fluctuate due to the timing of interest payments on our convertible notes, which are paid semiannually in July and January, so we had a payment this quarter, and the timing of receipts of interest payments and certain bond and loan position that have semiannually payment frequencies. This metric simply represents cash income excluding one-time items included in another income, net of all cash expense, effectively excludes principle accretion, quick interest or gains on any of our private equity investments.

For the first three quarters of 2010, our run rate cash earnings per share totaled $0.61 or an average of $0.20 quarterly per share this year. For the same nine month period, we declared aggregate dividends of $0.36 per share retaining $0.25 per reinvestment in our growth. A 25% ROE, a 20% run rate ROE, and a 13% cash conversion ROE, these are three of the key metrics we focus on and feel fortunate to be able to generate for shareholders such returns in a 2.5% “risk free environment”.

Book value per share at quarter end was $8.60 as compared to $8.08 as of June 30. The increase in book value for this quarter primary reflects earnings growth and appreciation in the market value of our high yield bond position partially offset by decline in the values of our interest rate hedges, which are primary held in our CLOs.

Now on to our portfolio which continues to perform well. As of quarter end both the carrying value and market value of our corporate debt holdings as reflected in our book value of $8.60 per common share totaled 7.3 billion, which is 92% of par value of 8 billion. This is an improvement from June 30 where the weighted average market value of our corporate debt portfolio was 89% of par.

At quarter end the difference between the carrying value and the fair value of our portfolio equates to $4.30 per share. During the quarter, we did book an additional provision for loan losses of 8.1 million predominantly offsetting charge-offs taken during the quarter from loans we move from held to investment to held for sale.

As we have discussed in past calls we deploy capital base on our strategic capital allocation methodology, which reflects our three core tenants to deploying capital. First, we will only deploy capital to opportunities where KKR has the competitive advantage through its global investment team sourcing and relationships. Second, we are focused on constructing a portfolio that is balanced between holdings that generate solid recurring cash flows for distributions to our shareholders and those that present opportunities for a long-term capital appreciation. And finally and third, our goal is to construct a portfolio that performs well across the economic cycles and preserves our ability to maintain a dividend and an attractive premium to the risk-free rate across different rate environment.

Since our last quarter’s earnings call, we have deployed or committed to deploy or retain capital of approximately 100 million to assets across various strategies including the following.

First, with the natural resources; we made our first oil and gas investment purchasing approximately 40 million of assets in conventional producing oil and gas properties with high cash and cash returns, and multifactor embedded option value with respect to underlying commodity price, technology enhancement and additional reserve development.

One of these transactions is already closed, with the second expected to close prior to year end. In addition to these first investments in this strategy we are actively pursuing a significant pipeline of good opportunities.

Next, we are participating in the Mezzanine debt being issued by RBS WorldPay as part of the acquisition of RBS WorldPay by Advent International and Bain Capital Partners. In addition to these transactions, we have also deployed capital to several private equity opportunities, including a unique proprietary opportunity to invest in an Indian Power business, sourced by our mangers team in Mumbai. All of these investments have targeted returns between 15% and 25%.

The transactions we are participating and follow our core tendency to deploying capital, that we have consistently discussed with you, and demonstrate the unique capability and breadth of our franchise to source transaction opportunities that are not generally available to others.

In addition to KFN being a beneficiary of the global skillsets of the KKR organization, KFN also benefits from our world class credit investment team that’s focused on managing KFN’s leveraged loans and high yield bond holding, that are primarily contained in our CLOs

With respect to the CLOs, we continue to actively monitor the CLO new issuance market and continue to evaluate opportunities for a possible future transaction. Each of these capital deployment initiatives relates to our focus on growing cash flow per share, book value per share and distributions per share.

While we consider frequently the vagaries of day-to-day markets, including the tug-of-war between the fundamentals in European and U.S. economics and the flood of liquidity looking for yields and in an zero rate environment, we are focused even more in creating long-term shareholder, value through investing behind large and sustained supply demand and balances with proprietary views and ideas.

Now I’m going to hand this over to Mike to discuss our financial results in more detail.

Mike McFerran

Thanks Bill and good afternoon everyone. Net income for the quarter was $82.3 million or $0.52 per diluted common share, this compares to net income of $81 million or $0.51 per diluted common share for the second quarter of this year and $67.2 million or $0.42 per diluted common share for the third quarter of 2009.

As Bill already described, run rate income per share, a non-GAAP financial measure calculated as net investment income plus non-investment expenses excluding the impact of share based compensation and incentive fee expense was $0.43 for the third quarter. This compares to the $0.42 per share for the second quarter and $0.39 for the third quarter of 2009. The $0.43 of run rate income to the quarter equates to a 20% return-on-equity.

Our earnings for the quarter benefited from an increase in net investment income to $78.3 million for the third quarter from $76.8 million from the second quarter. The quarterly increase in net investment income was driven by an increase in net interest spread of our corporate debt holdings of over 50 basis points as compared to last quarter end. The increase in net interest spread is primarily attributable to our [inaudible] bond holdings in our CLOs for which the weighted average spreads of LIBOR of these holdings increased approximately 20 basis points.

In addition, the percentage of our portfolio now of LIBOR floors [ph] came in at 21%, an increase of 300 basis points from 18% as of June 30. Other income for the quarter totaled $26.6 million of which $21.9 million was from realized gains from sales of certain loan and bond position.

Next our liquidity; as of September 30 we reported unrestricted cash of $97 million. In addition as of quarter end, we had no borrowings outstanding under our $250 million revolving credit facility and had approximately $750 million estimated fair value of holdings outside of our CLOs.

Of the $750 million fair values holding outside of our CLOs approximately $500 million are comparatively liquid investment that could be converted to cash. Accordingly with our existing cash, availability under our credit facility and unlevered assets on our balance sheet, we still have considerable dry powder to pursue future opportunities.

Next, we’ll update on our CLOs. Based on the trustee reports for our CLOs as of September all of our CLOs currently have overcollateralization levels, above the overcollateralization level amounts for each of our CLOs at the time they were issued respectively. Based on this, we are comfortable that our CLOs will continue to be cash flow generative to us.

I do want to highlight that one of our CLOs, 2007-A ended its reinvestment period during October. This means that we are no longer able to reinvest principle proceeds in this transaction. We expect the amortizations of this transaction to take several years and believe that CLO 2007-A will continue to generate attractive cash flows to us for the next several years.

As for our capital structure; we are operating with comparatively low recourse leverage for our specialty finance firm and currently have no mark-to-market financing exposure. The low leverage level we are currently maintaining provides us with the ability to add leverage, if and when desire to further increase the earnings on our deployed equity.

The last topic I want to cover is cash flows. As Bill highlighted we generated $42.5 million of run rate cash earnings this quarter, which equates to $0.27 per share. Our run rate cash inflows for the quarter totaled $76.3 million of which $55.4 million was generated by our CLOs. Our run rate cash outflows for the quarter consist of $17 million of debt service payments, and $16.8 million of non-investment expenses.

I do want to highlight that our cash outflows include approximately $12.9 million of interest payments on our convertible notes, which are made semiannually. The $0.27 per share of run rate cash earnings represents a 13% cash flow return on equity for the quarter.

With that, I’m going to hand this back to Bill.

Bill Sonneborn

Thanks Mike. Before opening this call up to Q-&-A, I’d like to conclude by reiterating some of the key takeaways for the quarter. We are generating attractive returns to our shareholders in both in income and cash flow basis with the run rate ROE of 20% for the quarter and a net cash flow conversion ROE of 13%. These returns are being generated with the lowest level of holding company leverage we have had since our IPO.

We continue to drive net interest margin and in turn earnings and cash flow by redeploying capital at higher yields to new opportunities. The third quarter is the fourth consecutive quarter of increases in net interest margin of the holdings in our CLOs. In the third quarter alone, we were able to generate a 15% sequential quarterly increase and net interest margin based upon our entire credit portfolio.

We have embedded value in our corporate debt portfolio, carrying value 92% of par, roughly the same as it was back in March, which equates to a discount at par of our portfolio $4.30 per share. We have dry powder for deployment in new opportunities including additional investments that tie into our energy thesis and additional CLOs as market returns become more conducive. And as you have heard us discuss before, we are asset sensitive to changes in rates and as a result we effectively embed a free option on short-term LIBOR rising in the future.

Finally; Mike and I, as well as all our colleagues at KKR manage KFN with a mindset that this is a marathon and not a spread. Our objective is to maximize the long-term shareholder value by deploying capital and manner the balances opportunities for capital appreciation with opportunities that generate attractive cash flow yield with supported distribution or dividend level that we believe can be maintained at an attractive premium to the treasury rate whatever that may be. Even during a much higher inflationary period, if one comes to past which we think the risk is elevated

KFN is managed by our entire global firm which provides us with the unparalleled ability to source new opportunities across asset classes and around the globe. From private equity co-investment opportunity such as Pets at Home and Hilcorp Resources to proprietary overseas transaction such as RBS WorldPay and an Indian Power business, to opportunities such as working interest and conventional oil and gas properties, and distressed debt transactions. We are complementing KFN’s leverage loan in high yield bond portfolio with diverse and attractive opportunities.

Thank you again for joining our call today and your continued support. Operator, can you please open the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Gabe Poggi with FBR Capital Markets.

Gabe Poggi - FBR Capital

Hi good afternoon everyone.

Michael McFerran

Hi, Gabe.

Gabe Poggi - FBR Capital

Thanks for the incremental disclosures in the supplemental, that’s helpful regarding cash earnings and run rates et cetera. Bill and Mike my question is really macro oriented, what are your general thoughts on credit today and then kind of as it pertains to what you guys own currently, where you guys seeing, are there any areas you are seeing more pockets of value than other. Just wanted to get a sense of, it’s November 4, where we are heading to end the year and what’s your defensive - I assume it’s a defensive take is kind of lay the land?

Michael McFerran

Thanks. Yes sure its want kind of macro, I mean, I think the technical backdrop for credit is continued to be quite strong in that further liquidity through Q2 and the reaction in the markets over the last 24 hours continues to be very proto-cyclical in terms of bullish for credit and credit spreads.

That being said, we tend to be thoughtful in terms of the thinking defensively from a contrarianism point of view, and there are elements within credit markets which we are starting to back away from because of perception of risk versus return. We are finding opportunities in unique areas and so situations like some of the Mezz investments that we’ve made, some of the special situations investments we’ve made outside the U.S. are offering better sources of value, than we see more traditionally in high yields in the U.S.

We still believe within leverage loan that spreads are very attractive. Overall, spreads and LIBOR for us really has not changed despite the rally in credit over the course of the past several months and so we continue to be quite bullish in the loan side of the credit space, less bullish within high yield.

Gabe Poggi - FBR Capital

That’s helpful. Just generally, say how many pitches are you guys seeing to hit, so to speak in those new asset. You mentioned the oil and gas, the Mezz. There are lot of pitches out there and you guys are obviously culming through what you’d like to hit?

Michael McFerran

Our hit rate is very low because of our standards being high, so we can look at hundreds of opportunities to find one. One that we think offers the best risk adjusted returns, but fortunately we are getting access to many, many opportunities to pick and choose from.

Gabe Poggi - FBR Capital

Great. Thanks. Good quarter guys.

Michael McFerran

Thank you.

Operator

Our next question comes from Michael Sarcone with Sandler O’Neill & Partners.

Michael Sarcone - Sandler O’Neill

Hi, guys.

Michael McFerran

Hi, Michael.

Michael Sarcone - Sandler O’Neill

Can you just talk about asset quality and what you are seeing as it relates to this quarter’s provision and how to think about it going forward?

Michael McFerran

Sure. In fact, the quarter-over-quarter, Michael we’ve kept the allowance flat as, Bill mentioned in his prepared remarks. We booked a small provision that cut the allowance where it was beginning of the quarter, we set the carrying value of the portfolio is on top of the market value, so people can do their own math with what they think, they think the ultimate recovery value is, somewhere between $0 and $4.30 per share from where we are today, but we feel pretty good about how that the balance sheet’s positioned at the moment.

Michael Sarcone - Sandler O’Neill

Okay. And then could you just also give us some color on, what kind of yields you are seeing on new leverage loan purchases?

Bill Sonneborn

Sure, new leverage loans typically have 450 to 500 basis point of credit spread and a general LIBOR 4 of one and three quarters.

Michael Sarcone - Sandler O’Neill

Okay. Thanks guys and congrats. Mike on the new position.

Michael McFerran

Thanks Michael.

Operator

Our next question comes from John Hecht with JMP Securities.

Kyle Joseph - JMP Securities

Hi guys it’s actually Kyle Joseph in place of John this afternoon. So, a few quick questions for you guys. Congrats first on the quarter.

Michael McFerran

Thank you.

Kyle Joseph - JMP Securities

Can you give us your perspective on the LBO and the privatization market right now?

Michael McFerran

Certainly, with the recovery in the high yield markets in particular, there is a tremendous amount of activity going on in private equity within LBO’s both within the U.S. and Europe as we speak. Transaction size is increasing, it wouldn’t surprise me to see transactions with $5 million to $10 billion of total consideration potentially in the next few months or quarters.

And with the amount of dry power in the side line within the private equity industry generally, including our colleagues here at KKR, in a view of equity values being relatively attractive from a multiple and cash flow perspective, we’ve now achieved some reasonably well position from a conservative perspective. We expect the continuous trend we are seeing in buyout activity to actually stay at alleviated levels over the next, at least couple of quarters.

Kyle Joseph - JMP Securities

Okay. Great, thanks and then just one more for you guys. It looks like you had a small up-tick in loans and default status, I was wondering if that has any effect on the provision or if you could give us a little color on what went on there?

Michael McFerran

No, it was too smaller holdings; we got into a default status. One thing to keep in mind is, one is that both are really small positions we had in our portfolio. Two not necessarily a bad thing it depends on the respective assets, but often we view, when something goes in default there is an opportunity for us, as we go through restructuring, you usually expect it to come out at other end the more attractive piece of paper and quite possibly some equity upside.

Bill Sonneborn

One thing you have to realize when you looked at statistics is, we allocate capital to distress, in the special situation’s investments where it’s our goal to take it through default and restructuring. And so you have to keep in mind whether it was a situation purchase at par that’s going into default with potential loss or something, but a substantial discounts at par with the goal of equitation.

Kyle Joseph - JMP Securities

Thanks a lot for answering my questions.

Operator

Our next question comes from Matt Howlett with Macquarie.

Matthew Howlett – Macquarie

Hi guys and thanks for taking my question. Just on the CLOs 2007-A, you don’t see it in the three [ph] investment period. How do we look at, is anything affecting the cash flow, how do we look at sort of the dollar amount of cash flow that will come out of that as the bond, the deal prepay. I mean so what rate we can assume, what can you do, I mean can you still sell stuff if you wanted to and sort of what would be the rate in which that cash will decline over the next few years of that rundown?

Bill Sonneborn

The rate of cash flow decline really depends upon a bunch of activities that can happen going forward. We have the right to sell anything at any time, the proceeds to which of any sales we do would be is to pass the senior financing which then effectively would speed up the amortization if you will, within the transaction and lower future cash flows in that date to any pay downs that can come.

The early pay down effectively results in an accelerated amortization. But based up on the underlying portfolio how we position that portfolio, we don’t expect the downward trend effectively in cash flow out of that transaction to really have any material impact for a while, probably starting a year from now before you start to see any material aspects of cash flow as a result of amortization.

Matthew Howlett – Macquarie

Yes that is true.

Michael McFerran

And Matt, one other things to add Bill’s comment is as you see amend and extend activity continue, which won’t be a surprise for us. You actually, now offset some of the principal pay down because we are seen more of the existing asset portfolio having LIBOR4 for us, but potentially from higher spreads.

Matthew Howlett – Macquarie

Got you. So, I mean we’ve just been hearing that prepay activity is high and things could come down really quickly. You structured in a way, you’ve built in a way where there is not really near term maturities and there is not guys looking to refinance out of that, is that safe to say, as it’s sort of going to drag along.

Bill Sonneborn

Yeah, we try to position the transaction, so it have the greatest net present value adding into the end of the three investment period for those very reasons. For the first time though, I think you bring up a good point, which is going forward over into quarter we have had this period of mid to high teens sequential growth in net interest margin across our CLOs and this will be one of the CLOs, it’s virtually a small CLO that will no longer be able other than through amend and extend as Mike suggests, to continue to increase its net interest spread.

Matthew Howlett – Macquarie

Right. It’s fair enough thanks to you guys. And the same with the 0501, I mean that’s – that could enter its reinvestment period about next year at some point of the time. Can we just assume the same type of structure in terms of so you’re running of slower and…

Michael McFerran

That’s correct.

Matthew Howlett – Macquarie

Okay, good. And then just switching to the new issue market, I mean you talked about kind of like you are looking, also you’re looking into that we’ve heard the pipeline is anywhere between 5 billion and 10 billion, what type of market reaction you’re getting, where could you, where could sort of the indicative price levels coming at, could you even issue one, what are the agencies saying, what about the new financial reform? I know that there are lot of what if. What can you tell us about accessing of this new CLO market?

Michael McFerran

Sure, I mean I think one of the challenges of the CLO market, securitization market is actually an advantage for us, because we do have a desire to hold all of the subordinated charges and have a material economic interests, which is one of the issues that the Regulatory Act is trying to pursue effectively incentive wise.

Right now there’s six yields in the market today. The pricing of structure leverage levels, flexibility around reimbursement period and call continue to improve. I think our goal is to see the market receptivity on a number of these transactions, we’ve been actively engaged in considering and thinking about those terms and structuring, and working with the street and potential investors, but our goal is to try to bring the best economic deal for our shareholders not the first.

Matthew Howlett – Macquarie

So the execution is it’s just not there yet, AAA’s aren’t tied enough to make the deal work or the levels, or it’s just not low enough that....

Michael McFerran

It works but our goal is really focusing on the right returns to our shareholders at KFN and our belief is that the returns are going to be better after some of these transactions get done and...

Matthew Howlett – Macquarie

Okay. Got you. So more of a 2011 event?

Michael McFerran

Potentially, yes.

Matthew Howlett – Macquarie

Okay. And then just on the facility, any plans to draw that down, for some of your sort of specialty investments or possibly will have some loans before doing the CLO. Any plans to start on that facility?

Michael McFerran

We already have a reasonably large, warehouse pool of loans on our balance sheet for CLO, we would draw on the credit facility opportunistically based upon investor opportunities we see to maximize the alignment of our capital structure in the return profile generally investments.

Matthew Howlett – Macquarie

Great. Okay, guys. Thanks a lot.

Michael McFerran

Thank you.

Operator

We’ll now hear from Leo Cooperman with Omega Advisors.

Leon Cooperman - Omega Advisors

Thank you very much. First let me congratulate all of those who have been promoted. Nice to see and hope everything goes well for you.

Michael McFerran

Thank you, Lee.

Leon Cooperman - Omega Advisors

You’re welcome. I have a half dozen questions. If you don’t mind, I like to just kind of throw them out and you can handle them in a sequence if you like to handle them. The first is what definition of earnings guides, the dividend declaration. Is it page 11, in the supplemental when you talk about the cash run rate of earnings? And does that coincide that definition with the 65% allowed payment of dividends in your bank agreements? That’s question one.

Question two, basically I see within your CLOs, you hold roughly $200 million, I think of cash, and that’s excluding 2007-A. What incremental distribution should shareholders expect from this capital deployment as you reinvest that money?

Third question basically is I think it’s about 750 million of assets to HoldCo, and what is the strategy for optimizing these assets as you look ahead? Then, basically your thoughts on the equity raise, several times on the call you talked about the lowest level of leverage in the recent history of the company, et cetera.

Can I assume that if you would resolve to an equity raise that it would be at no discount to book value net of underwriting cost? Do you still want to raise capital in the context of existing leverage and let me just see, another one I have here. You guys close your books on a daily basis. Credit has been on fire. Is it fair to say that we have the book value - well the book value we know was 860 on September 30, the book value today is higher than it was at the end of the quarter and maybe some thing will come to mind later, but I’ll have that for openness?

Michael McFerran

Good question. The first question that you asked was definition of earnings; we really look at for purposes of distribution policy. I mean obviously the board makes a variety of debates and deliberations on dividend policy with respect to trying to distribute dividends to our shareholders that we know they look forward, but also in terms of what reinvestment rate from retained earnings we would like to redeploy back into the business to generate returns and we talked about the cash earnings figure as you suggest on page 11 is probably the best phases, is that the only way to think about distribution policy, but that would be a theoretically available cash, excess cash for distribution to shareholders to the extent that we could not find reinvestment uses of those proceeds at mid-teens rates of returns, which is what we are doing.

So if you think we’ve kind of retained about $0.25 through the first nine months of this year. We’ve reinvested that in our view at target rates of returns that should add another $0.04 of EPS on that $0.25 on an annualized basis going forward about $0.01 a quarter on target return threshold.

And your second question, within our CLOs we do have restricted cash. That cash, a lot of it has been invested. It’s just a question of was it on trade versus settlement day cash. But that cash is being effectively reinvested typically out of loans that were priced to LIBOR plus 250 to 300 into loans that have LIBOR 4 175 to LIBOR plus kind of 4 to 450. And so incremental spread will result in additional cash within those structures to our shareholders going forward, which is really how our net interest margin has been expanding and therefore our cash earnings have been expanding over the past several quarters. Your third question, there is 750 million assets at HoldCo you mentioned.

Leon Cooperman - Omega Advisors

Right.

Bill Sonneborn

What’s our strategy of maximizing and optimizing rates of return? We talked in previous conference calls; we have a couple of million of assets in our balance sheet that are effectively warehoused for purposes of giving the CLO when the terms and leverage levels and structures become attractive to our shareholders.

The remainder of our portfolio is to focus on special situations as private equity and energy and natural resource investments, where we expect – I think the unleverage rate of return on those investment is very attractive to our shareholders. And so we constantly think about where the world is going, how we are positioned, and try to optimize the make up mix and specific investments in that part of our portfolio for returns.

Leon Cooperman - Omega Advisors

In terms of – you mentioned that, to me looking at all the various credit industries, credit has been on fire here for some time. Is it safe to assume without guessing a specific number that our book value is in excess of the book value that existed on September 30th?

Bill Sonneborn

We don’t comment on forward-looking statements with respect to...

Leon Cooperman - Omega Advisors

This is not forward-looking, this is the book value as of yesterday.

Bill Sonneborn

That is forward-looking from September 30th. And so, you know, I think that you can look at some of the correlations over the course of the past several quarters as to how book value has moved relative to numerous credit industries and make your own informed opinion as to what book value could be today. But we don’t disclose our daily book value to investors.

Leon Cooperman - Omega Advisors

Okay. Just one additional, one question on the answer and that was kind of philosophically the game plan on the equity raise. So I think that’s been affecting the stock. And I get a lot of calls from my friends who have got into the stock, they say about the – when is the equity offering coming. So, maybe if you can kind of explain your view there, that would be helpful. But also getting back to page 11, I’m assuming with the reinvestment opportunities that exist, all things being equal, you would expect that cash earnings number to rise?

Bill Sonneborn

Yes. We would not be doing our job before not growing that number over time.

Leon Cooperman - Omega Advisors

So it was not yet a normalized dividend payout ratio. Technically is the cash earnings, the 65% limitation on dividends that the bank is looking at, are they looking at reported net income number?

Bill Sonneborn

No, the limitation is based upon estimated taxable income, which can differ from that cash number, because gains effectively, which were excluded from that cash number can trigger taxation. So taxable income could be higher or lower than that number depending upon whether there are gains, losses or other tax impacting items in any one quarter a year.

Leon Cooperman - Omega Advisors

Got you. Okay. And could you tell us a little bit about the – on the one hand you’re saying that we have the lowest level of leverage that we’ve employed in quite some time, but I think there is a general desire to raise capital of what it was four or five months ago. Can you give us some insight into your thought process?

Bill Sonneborn

Sure. We’ve talked about this in the last quarter. I mean, in our comments, we have no – we will not raise capital or discount the book value. Our shareholders, in fact, we are very focused on what the cost of the capital is if we were to raise growth capital to continue to grow or expand the business relative to all the investments we are planning and sourcing.

And so as we talk about when we pulled the equity offering last May, the cost of that capital was high relative to the arbitrage, we found attractive for our shareholders, we pulled that offering and we will not come back to the market unless we believe that it’s attractive for our shareholders full stop. This is not about diluting anyone, it’s about only positioning KFN to grow its cash flow per share earnings per share and book value per share for the foreseeable future. And the only reason to raise capital is the fact earlier is those goals.

Leon Cooperman - Omega Advisors

Okay. It’s nice to have a tailwind, but you’ve done great job with that tailwind. Congratulations.

Bill Sonneborn

Thank you, Lee.

Operator

Our next question will come from Wayne Cooperman with Cobalt Capital.

Wayne Cooperman - Cobalt Capital

Hi guys, not as many questions. Just the provision for the loan that you took in the quarter, could you just mention, go over that again. And then secondly if you were to do a CLO today, what do you think the indicative pricing might be? And then my third question would just be about, you still hold a big portfolio, or not big but not small of RMBS. Could you talk about the RMBS market, is that affected by these mortgage put back issues and what’s happening with either still held well below par value?

Michael McFerran

Sure. On the first one, the allowance, we booked a provision of 8 million. We had a couple of charge-offs Wayne. It’s more accounting than anything, we moved two loans to our Held for Sale category, so we have brought them down the market.

Wayne Cooperman - Cobalt Capital

But does that mean you were planning and you didn’t want to hold them anymore?

Michael McFerran

No, it’s just – especially at our CLOs, we always are looking to rebalance our holdings. We frequently move loans to Held for Sale to give us flexibility straight out of the things that have run up in price or we may have credit concern around the trade...

Wayne Cooperman - Cobalt Capital

But in this case, you moved it to Held for Sale when it went down in price, I think.

Michael McFerran

Correct, but it’s from our original cost basis, but based on risk return analysis, we may think it might be the right place to get out of something. So, our objective is at this point was to keep your allowance effectively flat, so we booked the provision of 8 million as the percentage of assets are obviously very small.

Wayne Cooperman - Cobalt Capital

No the numbers [inaudible]

Michael McFerran

On the second one, around CLOs, pricing is not the key to determine, Wayne, it’s important but there is several other variables we look at. But one is obviously leverage, which goes part and parcel with pricing. In addition to that, we are also especially focused on structure dynamics, notably reinvestment periods and non-call periods.

Wayne Cooperman - Cobalt Capital

Right.

Michael McFerran

And so those seems to us are equally important as pricing, pricing definitely seems as if it’s come under, where you could do senior notes, say below LIBOR plus 200, that seems to be pushed downwards, but Bill’s prior comments we’re very, very focused around the entire structure and as we’ve been saying throughout 2010, frankly being patient would be in our benefit versus trying to rush to market with a deal, and as markets evolved throughout the year, we feel that we’re pleased that we’ve been patient and we’ll continue to watch it.

Wayne Cooperman - Cobalt Capital

Anything you did something by the end of the year, if you wanted to?

Michael McFerran

I think we do a deal when we would want. The market seems to be picking up.

Wayne Cooperman - Cobalt Capital

I mean, at terms you are comfortable at...

Michael McFerran

Yes. Well obviously the holiday is coming up, we’ll see that. But I think we’ll continue to stay close. Because we have a lot of, what we would call, recycling ability in our existing CLOs, we really benefit from the ability of not having to do a deal right now. Because we don’t recycle that capital on those deals we have and we don’t feel constrained by not being able to participate in new opportunities by having to do a CLO, but when it feels right we’ll do them.

Bill Sonneborn

We just want to go to the structure where the auction values is in our favor and not, potentially not in our favor of expected shareholder returns if credits spreads tighten.

Wayne Cooperman - Cobalt Capital

And the last part was just the RMBS portfolio?

Michael McFerran

Yes, it’s down to 100 million, Wayne. This is the run rates of our week days, its small; it’s got a par value of about 2.5 times market.

Wayne Cooperman - Cobalt Capital

Yes.

Michael McFerran

If the road improves a lot, maybe there’s a little upside there we would hope, but this is, I guess, again a one-off portfolio that I expect to see half the size, 12 to 18 months from now.

Wayne Cooperman - Cobalt Capital

I know guys were trying a buy up a lot of these things and get control of the trenches [ph] and put them back to the banks, I don’t know, are you involved with that, I mean are you seeing that affect the pricing at all?

Bill Sonneborn

We’ve been looking into a variety of aspects, we expect to what’s going generally in the financial institution sector with respect to put backs and mortgages back to the original bank lenders. I have no comments to your disclosure and I think you’re expecting that, but it’s something that we are watching because it could present an opportunity for us down the road, but still developing.

Michael McFerran

Correct, there is a 140 million GAAP between par and market right now.

Wayne Cooperman - Cobalt Capital

Thanks a lot.

Operator

Our next question comes from [inaudible].

Unidentified Analyst

Hi, guys. I just have a quick question, I was wondering if you were one of the parties that participated in the disrupt exchange at TXU and maybe if you guys could just talk a little bit generally about how you manage potential conflict of interest between your credit investment in KKR sponsored deals.

Michael McFerran

Sure, absolutely. I don’t think it’s probably -- I just expect to what commissions we have within 3Q other than in previous quarters we talked about virtually all of our investments being in the senior secured loan, which is secured by – which is senior to where all the exchanges took place and secured by both on core and retail in the generation business.

We generally have a number of protections with respect to investors and conflicts of interest governed by our independent directors through a committee that’s been formed called the Affiliate Transaction Committee. They review and oversee any sort of investment exposures or potential conflicts involving our private equity funds or KFN.

In addition to that, the manager has established a number of policies and procedures to protect against any harm to investors at KFN from existing or potential conflicts of interest, which is ultimately overseen by a global conflicts committee at the manager level. And so, there is a number of checks and balances made to make sure that none of those things are being done in any way shape or form to damage gas and/or its investors or potential return. And in the case of the aforementioned exchange, again we are pretty much just focused on the senior secured term loan and our exposure.

Operator

Ladies and gentlemen, that concludes today’s question-and-answer session. I would like to turn the call back over to Bill for any additional or closing comments.

Bill Sonneborn

Thank you all for your time today, and your continued support. Our team is doing a great job. We’ll get back to work and try to continue to grow and expand the business. Thank you.

Operator

Ladies and gentlemen, that does conclude today’s conference call and we thank you for your participation.

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