Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message| ()  

Executives

Laurie Poggi – Head of Investor Relations

William Sonneborn – Head of Asset Management and CEO

Michael McFerran – CFO and COO

Analysts

Steven Kwok – KBW

Michael Sarcone – Sandler O'Neill

John Hecht – JMP Securities

Gabe Poggi – FBR Capital Markets

Lee Cooperman – Omega Advisors

Wayne Cooperman – Cobalt Capital

Robert Schwartzberg - Compass Point

Aaron Kabucis – Adaptive Capital

KKR Financial Holdings LLC (KFN) Q4 2010 Earnings Call February 18, 2011 5:00 PM ET

Operator

(Operator Instructions) Good day ladies and gentleman. Thank you for standing by. Welcome to the KKR Financial Holdings LLC fourth quarter and 2010 year-end earnings conference call. During today's presentation all parties will be in a listen-only mode. Following management's prepared remarks, the conference will be open for questions. Today's call is being recorded. I would now like to turn the call over to Laurie Poggi. Laurie, please go ahead.

Laurie Poggi

Thank you, Nancy, and good afternoon everyone. Joining me on the call today are Bill Sonneborn, our Chief Executive Office and Michael McFerran, our chief operating and financial officer. This afternoon's call is being webcast on our website at www.kkr.com in the investor relations section. There will be a repay of the call available as well.

Our financial results release for the fourth quarter and year ended December 31, 2010 was issued today, and as of prior quarters the supplemented information packet is available on our website.

Before we get started, I would like to caution you that this conference call and webcast contain 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've made with the Securities and Exchange Commission. These filings are available on the FCC website on www.fcc.gov.

KFN's actual results may vary materially from those expressed in the forward-looking statements. Some of the discussion today will include references to non-GAAP financial measures. Information about these measures as well as their corresponding GAAP reconciliation may be found in the supplemental information packet, also available on our website. With that, I'll turn the call over to Bill.

William Sonneborn

Thank you Laurie, and thanks to all of you joining for our call today. Mike will take you through the quarter in detail, but first I want to provide a few highlights, including the progress we have made to deploy capital, and briefly comment on the markets in our portfolio.

First, the highlights of the quarter. We generated $0.48 in earnings per share, representing a 21% return on equity and run rate income per share of $0.40 or an 18% run rate return on equity during the quarter. You recall that run rate earnings per share is a non-GAAP financial measure that excludes the impact of other income including gains, realized run, realized gains and losses, share-based compensation, and an incentive fee the expense from earnings. We highlight this metric as an indication of the recurring earnings power of our business. Run rate cash earnings per share for the quarter, another key metric we focus on as it represents cash that we could either distribute to our shareholders as part of our dividends or retain for future growth, excluding accelerated principal amortization. With $0.27 per share representing a 12% cash conversion return on equity.

Earlier this month, on February 3, we announced that our board of directors had declared a cash distribution of $0.15 per common share for the first quarter of 2010. This represents a $0.01 increase in our cash distribution per share sequentially from the third quarter of 2010 and over 100% from the $0.07 per share for the fourth quarter of 2009 that we distributed. This represents our fifth quarterly consecutive increase in our cash distribution to shareholders.

The difference between our run rate cash earning per share, if you just neglect the gains recorded in the last several quarters, and our distribution per share of $0.12 represents a rough estimate of run rate retained cash that we will reinvest back into our business. Actual retained cash was higher, due to realized gains and accelerated amortization of discount accretion of our loan portfolio. Our book value per share totaled $9.24 as of year end, which represents an increase of $0.64 per share or 7% sequentially from September 30 2010. The increase in book value this quarter primarily reflects retained earnings, appreciation in the market value of our high-yield bond position, as well as appreciation in the values of our cash flow hedges as a result of rising long term interest rates and the steepening of the yield curve. For the calendar year, book value per share grew by $1.87 or 25% for the full year.

Now on to our portfolio, which continues to perform very well. As of year end, the weighted average estimated market value of our corporate debt portfolio was 95% of par value. You compare that to the weighted average carrying value, which is used for purposed of calculating our GAAP book value of $9.24 at year end, of 92% of par. In other words, the fair market value of our portfolio at year end was approximately $1.20 higher per share than the $9.24 book value share. We continued to focus on capturing value between the 95% fair market value price and par value across over our over $7 billion in credit exposure in addition to the difference between fair market value and our carrying value. Mike will review the accounting treatment that drives this differential between carrying value and fair market value later on during the call.

I do want to highlight that our our results for the quarter reflect some dilution as a result of the higher share count reflective of our issuance of some 19.4 million shares in the December 2010. As you know, we raised approximately $175 million during December at a price of just over $9 per share. Our rationale for this offering was straightforward. It was our intent recently during the year last year to issue a modest amount of equity at the right price to provide us with incremental capital for deployment of new opportunities that we believe will be accretive to shareholders consistent with our capital allocation strategy. We are already deploying this capital, and we fully expect it to be fully deployed by the end of the third quarter of this year. We are focused on how this capital, once reinvested, will have a future positive impact on the three key metrics we continue to discuss with investors: earnings per share, cash earnings per share, and book value per share.

With respect to capital deployment, during the quarter we deployed or committed to deploy approximately $125 million of incremental capital to opportunities across the strategies we have discussed previously with investors. Of this $125 million in capital deployed or committed to be deployed, approximately $42 million was to mezzanine opportunities in RBS World Pay, a leading global payment services business, IMCD, a leading European chemicals distribution business being acquired by Bain Capital in Europe, and J. Gill, the woman's apparel retailer owned by Golden Gate Capital all at expected rates of return in the mid teens.

We deployed approximately $33 million gross to non-recourse asset-based financing to oil and gas working interests in 170 active wells in both the Barnett Shale and the Wilcox formation in East Texas at targeted mid teens rates of returns. We also deployed or committed to deploy approximately $32 million to four private equity transactions that targeted high teens to low twenties percent rate of return.

Next, I wanted to provide you an update on the markets after which I will hand this over to Mike to review detailed results for the quarter. I will close with a discussion on where our focus is relative to deploying the capital we have and have raised.

Markets continue their upward momentum in the fourth quarter of 2010 and so far through the first six weeks through 2011. The S&P 500 finished the quarter up 10.8%. The Merrill Lynch High Yield Master II returned 3.1% and up 15.2% for the year, and the S&P/LSTA Leveraged Loan Index returned 3.2% up 10.1% for the year. Present high yield tightened another 81 basis points, the overall market now trading in the cash yield of around 7.5% and leveraged loan spreads came in 32 basis points and then a flood of new issuance. Total high-yield new issuance was $91 billion in the quarter to the record, and leveraged loan issuance was $55.6 billion, which is the most active quarter during 2010 and the most volume seen since the recovery of the capital markets first began in 2009.

Credit markets continue their strength so far through the first six weeks of 2011 with loans up over 2.5%. Investors continue to sate their thirst for yield with liquid credit assets. Retail fund flows into below investment grade credit totaled $8.1 billion. As a result, we are now experiencing a wave of repricings and refinancing at lower effective spreads. But still substantially wider than the trough levels of 2006 and 2007, we put the bulk of our CLO liabilities(inaudible). It will become a little more difficult for us to continue to grow net interest margin or CLOs at the same pace that we have been able to in the previous eight quarters.

Finally, we continue to find value in private, mezzanine, and distressed credit markets, particularly in the US middle market as well as in Europe and Australia. With that I will turn the call over to Mike to review fourth quarter performance.

Michael McFerran

Thanks, Bill and good afternoon, everyone. I'll start my remarks today with a review of our results for the quarter and then give you an update on our capital structure and our CLOs.

Earnings per share for the quarter totaled $0.48 compared to $0.52 per share for the third quarter. Our return on GAAP equity was 21% for the quarter as compared to 25% for the third quarter. Last quarter we introduced a new metric – run rate cash earnings per share. This metric simply represents cash income excluding one-time items included in other income net of all cash expenses. This number will fluctuate through the timing of interest payments on our convertible notes, which are paid semiannually in July and January, and the timing of receipts of interest payments in certain bond and loan positions that have semiannual payment frequencies. I refer you to page 12 in our supplemental material for reconciliation of this metric to GAAP.

The quarter run rate cash earnings per share was $0.27 which is flat compared to the third quarter which also was $0.27 and $0.20 for the second quarter of 2010. Run rate cash earnings for the quarter represents a 12% cash conversion return on equity and can be used for distributions or reinvestment in our business. Our run rate cash earnings per share for 2010 totaled $0.88 or an average of approximately $0.22 per share per quarter this year. We declared aggregate dividends of $0.51 per share for the fourth quarter 2010, retaining $0.37 for reinvestment in our growth.

Run rate income per share, a non-GAAP financial measure, calculated of net investment income less (inaudible) expenses, excluding the impact of share-based compensation and incentive fee expense, was $0.40 for the quarter or an 18% run rate return on equity. Run rate income for the quarter of $0.40 compared to $0.43 for the third quarter of 2010. That investment income for the quarter includes a provision for loan losses of $21 million that was offset by $21 million of interest income resulting from accelerated discount accretion from prepayments of holdings during the quarter. The amount of interest income attributable to prepayments fluctuates considerably quarter to quarter. For example, during the second quarter this amount was $9.5 million and for the third quarter of 2010 was $4.4 million.

We continue to drive net interest margin and ensure earnings and cash flow by redeploying capital at higher yields to new opportunity. The fourth quarter is the fifth consecutive quarter of increases of in net interest margin of holdings in our CLOs. Within our CLO structures, we increased the net interest spread from 4.13% for the fourth quarter of 2009 to 4.72% for the fourth quarter of 2010. Across our entire portfolio, we were able to generate a 20% increase in net interest margin for the year.

Other income for the quarter totaled $22.4 million as compared to $26.6 million for the third quarter. This amount was primarily driven by a $22.5 million of realized gains from asset dispositions during the quarter. Our book value per share totaled $9.24 as of year end, which represents an increase of $0.64 per share from September 30.

As Bill mentioned, the carrying value of our corporate debt portfolio was 92% of par value at year end as compared to an estimated 95% of fair value as of year end. This difference means that our book value reflects a $1.20 discount in net asset value on a fair-value basis. This difference is due to our accounting for loans and our GAAP. As disclosed in our accounting policies in our annual and quarterly filings with the SEC, our loan holdings are classified as either held for investment or held for sale. As of quarter end, $6.1 billion in advertised cost amount, or 93% of our total loan portfolio was classified as held for investment. Loans held for investment are accounted for at advertised cost less an allowance for credit losses. Loans classified as held for sale, which represent 7% of our portfolio at year end, are accounted for the lower of advertised costs or market value. As a result of our accounting for loans, our loan portfolio does not reflect changes in the estimated market value of our holdings.

Next topic I want to cover is liquidity in our capital structure. As of year end, we reported approximately $314 million of unrestricted cash, which includes the $175 million of proceeds from our December equity raise. Additional or cash position, we have $250 million of capacity available in our revolving credit facility. Our liquidity position is strong and provides for the flexibility to continue to deploy capital and new opportunities.

As for our capital structure, today KFN operates with a modest amount of holding company leverage. This * $186.6 million of convertible notes due July 2012, $175.2 million of convertible notes due January 2017, and $283.5 million of trust-preferred securities due in 2036 and 2037. As we continue to grow KFN, we will evaluate opportunities in the future to utilize long-term debt as an alternative to equity for raising capital.

Next, our CLOs. During the fourth quarter our CLOs generated $52 million of cash for KFN. Our CLOs continue to perform well, and our ability to recycle capital in these transactions over the past few years has benefited both our earnings and cash flows. As we discussed last quarter, CLO 2007-A has entered this reinvestment period as of October 2010, and approximately $110 million of senior notes were paid down subsequent to year end. Both CLO 2005-1 and 2005-2 were under reinvestment periods during the second quarter of this year. We expect the amortization of these transactions to take several years, and we hope these structures will continue to generate attractive cash flows to us for the foreseeable future. Also, it is worth highlighting that the reinvestment period for CLO-2007-1, our largest CLO structure, with $3.5 billion in assets, runs until mid May 2014.

Before I hand this back to Bill, I do want to spend a minute providing you with our views on the CLO market and how we're thinking about future transactions. To begin, we managed KFN based on our strategic capital allocation frame that we introduced to you a year ago, which Bill will discuss in more detail in a few minutes. Liquid credit, which refer to as leveraged loans and high-yield bonds, is one of the asset classes that we deploy capital to, and historically is represented in most of our business. While we seek exposure to several asset classes, we deploy capital based on the relative opportunity set and to transactions that meet our investment objectives, risk return hurdles.

Historically, we have deployed capital or liquid credit strategy through utilizing non-matched market leverage in the form of CLOs. Our intention is to continue to deploy capital of this strategy with non-matched market structures that provide liability duration greater than the asset they are used to finance. Given our liquidity position and available capital, our broad market mandate, the amount of runway in our CLOs for reinvestment, we are not dependent for CLOs to grow KFN. The CLO market has experienced increased activity, and we think 2011 volume will be considerably higher than in 2010. That said, we are focused on committing capital to a structure that provides an attractive return for our file while maintaining the structural flexibility necessary to protect the capital we deploy.

If we had done a deal three to six months ago, not only would we have locked in the comparatively high financing costs, we also would be ramping a portfolio during a period of increasing asset prices and repricings of existing loans. As a result, any CLO we would have done in 2010 would appear disadvantageous today for shareholders based on what we know.

Rather, as we have a broad capital mandate, we are not dependent on CLOs to grow KFN and we're seeking to actually diversify our portfolio with other opportunities. We are engaged with investors and banks in the CLO market and remain patient for the right returns, embedded optionality, and profile. In addition, we are also evaluating unique, non-CLO market opportunities to provide similar term financing for our liquid credit strategy. We will continue to keep you posted on the progress we make on this front. With that, I'm going to hand this back to Bill.

William Sonneborn

Thank you, Mike. Looking ahead at 2011 and beyond, let me review how we think about the business and how we plan to execute under our strategic capital allocation model. We remind investors we focus only on areas that one, meet our return on capital hurdle rates, and two, where our manager has a competitive advantage and expertise. Everything we do is driven by our unwavering goal to achieve three key objectives: growing earnings per share, book value per share, and cash EPS per share. And to achieve this while growing an attractive distribution to our shareholders.

We expect 2011 to be characterized by meaningful capital deployment as we continue to diversity and grow. We have developed a proprietary but flexible model to optimize how we allocate capital while mitigating risk which we introduced to you last year. Our capital allocation framework seeks to balance near-term cash flow production and total return potential.

Our model is built on several tenets. One, to generate a reliable cash-flow stream to support a secure cash distribution to shareholders that is maintained at an attractive premium to the 10-year US Treasury rate even during a high inflation-rate induced environment while retaining capital when economically attractive in periods where we can find opportunities that meet our previously-stated hurdle rates, and when we can't to return that capital to shareholders.

Two, provide opportunities for capital appreciation and positive return skew by participating in transactions such as private equity, private mezzanine origination, and distressed where the return potential is more than just the coupon interest payment and a recovery of par.

And three, be diversified so the cash flow and earnings aren't solely dependent on one beta exposure. And our balance sheet financing will never put the business in harm's way. The asset classes that we are currently targeting consist of the following: senior secured debt and some modest high yield, as Mike mentioned, primarily financed through both existing and prospective CLOs in similar type transactions. Second, natural resources, including working interest in oil and gas producing wells as well as royalty ownership interests in producing developed properties. Third, mezzanine on a global basis. Fourth, special situations transactions, and finally, private equity co-investment opportunities alongside KKR's private equity funds.

We have set allocation ranges in each of these asset classes that afford us flexibility as the opportunity set changes. Markets do change quickly. Mike has covered the CLO component or liquid credit strategy of our business and some detail as to what are plans are there, so I will talk about the other strategic areas of our focus, what we mean by our views in the market opportunity, and our competitive advantage.

First I'll start, since we talked in previous quarters about natural resources. Our current focus is purely focused on acquiring conventional oil- and gas-producing assets for royalty interest with little expiration risk and substantial producing developed reserves. Conventional oil and gas producers are

reorienting their development portfolios and they're shifting their focus to unconventional assets given market incentives to do so, particularly if they're public. Most notably, abundant reserve capacity, high returns on capital, and premium public market valuations associated with high-growth new development finds. As a result, operators are devoting less attention to their legacy conventional assets and are divesting of the same. The bridge funding gaps created by capital needs of nonconventional other assets such as Blaze in the (inaudible) or the Eagle Ford Shales.

The embedded options in such assets in our view, are currently substantially mispriced. Our manager is able to leverage its partnership with premier natural resource to source opportunities to acquire already-producing wells with long production histories and to drive value creation through our operating partners' knowledge, including developing incremental resources in the same properties in either new or previously exploited zones. Above such operational value add, these assets include this embedded optionality of reserve increases in periods of increasing commodity prices. As a previously uneconomic resource for which we paid absolutely nothing, it becomes economic as a development opportunity.

In addition, as we have seen over the past 100 years, holding mineral interests also included the second embedded option as a result of technological change in development which makes extraction faster and more efficient. This development potential, as well as the free cash flow and real asset exposure relative to our financial assets that we hold, make these compelling opportunities for KFN, and combined with our long short-term rate exposure, further insulates our cash flow production to increases in inflationary expectations in the market.

Next mezzanine. Our focus in this strategy is in sourcing private debt transactions with equity upside for third-party sponsors primarily focused in the US and Europe, but we see the potential for attractive total returns when aggregating the debt and equity components of proprietary source transactions, which enable third-party private equity sponsors or in some cases sponsorless situations to acquire control of another business. Mezzanine investments we have made or committed to make in 2010 for sponsors such as Bain Capital, Advent, Trident, and Golden Gate Capital, including AMBIA, RBS World Pay, IMCD, and J. Jill, represent a portfolio today with a weighted average contractual coupon of 14% plus equity upside.

Now turning to special situations. As its name implies, our special situation strategy encompasses unique and special situations which primarily focus on control and non-control distressed opportunities as well as private rescue finance transactions. Given the current low default rates in the US, most of the opportunities we've been deploying capital to are abroad, particularly in Europe, where banks are beginning to unload parts of portfolios of legacy loan positions as well as in Australia. We target returns above our mid teens hurdle rates for such investments. And lastly, private equity. We expect a modest amount of capital to be invested alongside our manager's private equity business in select situations we find compelling.

While the economy continues to show fundamental improvement and credit spreads continue to march tighter, we continue to generate attractive returns for our shareholders on both an income and cash-flow basis with a run rate ROE of 18%. In addition, while such large shifts will become harder in the context of our net interest margin, we believe we can continue to try an attractive net interest margin enhancement within our CLOs and cash flows from the capital we are investing outside our CLOs to grow our per-share metrics. We have embedded value in our corporate debt portfolio, the carrying value of 92% of par which equates to a discount to par of our portfolio company of approximately $3.5 per share.

And finally, Mike and I would like to thank all of you and all of our colleagues at KKR, who everyday help us to maximize long term shareholder value. Our managers' global footprint and idea origination capability continue to drive unique opportunities for our business. Thank you all, now it's time to open up the call for questions. Operator, please go ahead.

Operator

Thank you, sir. (Operator Instructions)

Question-and-Answer Session

Operator

We'll go first to Steven Kwok with KBW.

Steven Kwok – KBW

Hi, thanks for taking my question. I guess the first question I had was with regards to the comment you made on fully deploying the proceeds from the equity raise by third quarter. How should we think about that going forward? Will it be fairly lumpy? And is there any investment that is currently in your horizon that you see?

William Sonneborn

We do have some investments in the horizon. Some of the investments in certain of the areas where we're allocating capital, Steven, thanks for your question, are a little lumpy That being said, we think it's reasonable to assume in the context of (inaudible) the dilution of the equity raise that it will be kind of pro rata over the course of the next three quarters.

Steven Kwok – KBW

Okay, and then I guess I had a question on the provision for loan losses. That was $21 million for the quarter. I was curious as to what it relates to, and how we should think about that line item going forward?

William Sonneborn

Sure, Steven if you took a look in our financials from last quarter to this quarter, and you'll see in more detail when we file our 10-K at the end of the month, we had charge offs for the quarter of $21 million, which really reflects moving loans from held for investment to held for sale. So with that $21 million provisionally blocked, was really just to keep the allowance flat or at about 3% of the amortized cost of our loan portfolio. Going forward, frankly, think about the allowance not just based on market values of the portfolio, but we're very focused on making sure we're well reserved for potential losses in the future that may be in the portfolio today. For the last several quarters, we've maintained an allowance of around 3.5% of our portfolio.

Michael McFerran

Exactly right. And on that point, you'll see that when the 10-K is filed, the specific component of the allowance, **** and losses continues to decline as a result of obviously where we are from an economic and credit recovery perspective. But we still believe that any time you have a reasonably large loan portfolio you need to reserve for future potential. So the unallocated portion of our reserve has continued to grow and the unaggregated amount of our reserve from a top-down perspective maintains its level relative to our aggregate loan portfolio.

Steven Kwok – KBW

Sure. And finally a question on G&A side. I noticed there was a significant uptick showing this quarter. I was wondering if there are any one-time items that you could call out?

Michael McFerran

Nothing we can call out. Obviously it sometimes has to do with timing of when certain expenses are incurred by nothing specific (inaudible). I would say that G&A ran higher this quarter than the other quarters but I would look to the average for the year of the four quarters if you want to develop a trend.

Steven Kwok – KBW

Alright, thanks.

William Sonneborn

I wouldn't take the fourth quarter and annualize it at all, because there are some one-time items there.

Michael McFerran

Yep.

Steven Kwok – KBW

Sure, thanks.

Operator

We'll go next to Michael Sarcone from Sandler O'Neill.

Michael Sarcone – Sandler O'Neill

Hey guys.

William Sonneborn

Michael.

Michael McFerran

Hi Michael.

Michael Sarcone – Sandler O'Neill

So just really just one question. The investment income ticked up or increased pretty substantially. You said most of that was on accelerated discount accretion. But X that, what would you think is more of a run rate number?

Michael McFerran

Michael, we're always going to have, on our remarks in the call, some level of that accelerated income because loans can be prepaid at any time. During the past fourth quarters, that amount has ranged from $5-20 million a quarter. If you looked at this quarter and we said during our prepared remarks that if back out the $20 million provision we booked for the quarter was offset by the $20 million we had of that accelerated prepayment income, the net investment income number would have actually been a run rate number net of both those because they washed each other out.

Michael Sarcone – Sandler O'Neill

Okay. And the new investments on the loan side, what kind of spreads are you putting those investments on at?

Michael McFerran

There's two points. One, Bill mentioned that on the mezzanine investments we made, as an example, to date this year are burning at a 14% coupon on them. That doesn't reflect the upside and the equity. As far as the loan investments that we do in the CLOs, obviously spreads continue to tighten. We're still receiving some marginal benefit, as, we had price those CLOs back in 2005 to 2007 when spreads were still tighter than today, but we're now investing in loans in the high 90s.

Michael Sarcone – Sandler O'Neill

Okay. Thanks, guys.

Operator

And we'll go next to John Hecht from JMP Securities

John Hecht – JMP Securities

Good afternoon, thanks for taking my questions.

Unidentified Executive

Hi John.

John Hecht – JMP Securities

How are you? Real quick follow-on to the provision questions just because we don't have the K yet. Can you tell us was there any material change in non-accruals or defaults during the quarter?

Michael McFerran

There was no change in non-accruals during the quarter, and I apologize John, (inaudible) I think the number probably went down.

John Hecht – JMP Securities

Okay.

Michael McFerran

As far as - there were no real changes of the credit quality of the portfolio during the quarter. Again, the number we bought was really just to keep the percentage of the loan portfolio at the same reserve level that we had maintained last quarter.

William Sonneborn

Exactly. So you'll see in the detail, John, that basically our overall allowance is $209 million as of September 30, it's $209 million at December 31. There are a couple of positions Mike mentioned, we moved from held for investment to available for sale. The result in that $20 million charge-off exactly because those positions traded in a slight discount to par, and as a result of that we basically take a hit to reserve and then we just rebooked our provision of 21 to restate the allowance to the $209 million. And the amount of allocated reserve declined by about – because of improving credit metrics – 6% during the quarter.

John Hecht – JMP Securities

Okay, and then Mike you gave the year-to -year increase in the CLO. Do you have that on a quarter results basis?

Michael McFerran

Actually I do, John. Besides the CLO year-over-year, an increase from about 410 basis points to about 472 basis points. Quarter over quarter they've increased 20 basis points in the CLOs, from 4.52% to 4.72%.

John Hecht – JMP Securities

Okay, great.

William Sonneborn

And that's excluding any accretion pay-downs from amortization from purchasing loans at discounts. If you look at it all in, it went from 472 to 589.

John Hecht – JMP Securities

Wow, okay. And the last question I have is, out of naivete, how are these natural resource MLPs structured? What are the terms, the duration, what kind of leverage can you get on them? And do the returns vary based on production from the specific asset class?

William Sonneborn

An excellent question, and yes, there is always some aspect of risk because you're taking some commodity exposure. It's ***pee sub we're making investments by buying actual working interest in live, operating wells that have been drilled sometime in the last 30 years and includes the rights to all the minerals, oil, and gas in the ground as well as the equipment and the drilling rigs that are pumping that oil and gas. Generally speaking, you can finance non-recourse to KFN at that field level at approximately half the cost of purchasing the field. Through a borrowing-based credit facility that has some exposure, when you hedge against that exposure to underlying commodity prices, and the expected returns generally we're focusing on are in the teens. The investments we're focusing on are the lower-risk kind, you can move up the development risk scale, which is not our intent, in which returns can into the 20% range. But we tend to focus and believe the right mismatch in terms of mispriced options is in the conventional, producing wells, where there is really little exploration risk need.

John Hecht – JMP Securities

Okay, and the fashion in which you hedge that, would returns increase in an inflationary environment Or stay flat?

William Sonneborn

Well, you know, you're hedging some cash flows for purposes of maintaining your credit facility appropriately, but your actual underlying asset you owned is unhedged. You may hedge a year or two or three of production to be able to satisfy the non-recourse financing you have, but your actual exposure, you may have a certain amount of oil equivalent energy resource in the ground that ultimately will appreciate in value in future cash flows as commodity prices increase or decrease as commodity prices decrease.

John Hecht – JMP Securities

Okay. Thanks very much.

William Sonneborn

It's our intention not to hedge (inaudible) principal. Thank you.

John Hecht – JMP Securities

Okay, thanks very much and congratulations on a good year.

William Sonneborn

Thanks, John.

Michael McFerran

Thanks, John.

Operator

And we'll move next to Gabe Poggi from FBR Capital Markets.

William Sonneborn

Hi Gabe. Did we lose you, Gabe?

Operator

Gabe, we're having a hard time hearing you.

Gabe Poggi – FBR Capital Markets

Is this better?

William Sonneborn

Much better.

Gabe Poggi – FBR Capital Markets

Sorry about that, messed up phone. Bill, you had mentioned there's a wave of refinancing activity, spreads are getting tighter, we also have the two '05 CLOs that are going to be closing their reinvestment window. I just want to get a gauge of about how you guys think about those CLOs entering their amortization stage, and then you still have 07-1 and 06-1 I believe that have longer reinvestment windows and the ability to maintain the cash flows. You said you'd have a tougher time growing into the pace that you have over the past 18 months, but how do you think about maintaining that level of cash flows as three of the five under management are now closed and the remaining two are open.

William Sonneborn

You remember that 2007-1 is bigger than the three others in terms of size?

Gabe Poggi – FBR Capital Markets

Right.

William Sonneborn

-which is an important fact. The second thing which is relevant is the amount of capital we have in our CLOs is only less than half of our overall capital. So you have to look at what returns we're producing on capital being deployed outside of that, which is a key element in the context of both stability and our goal, which is growing cash flows per share.

Gabe Poggi – FBR Capital Markets

Right.

William Sonneborn

So the issue you're talking about is something we've known and expected now for a while, and some of the moves we've made in terms of how we've allocated capital, why we waited to not do a CLO until the timing is right in the context of liability costs, also part and parcel with that same issue. But at some point it will make sense for us to do another CLO to help offset some of that, but we feel pretty good about how we're handling that issue in the context of both stability of cash flows and our ultimate goal of continuing to grow them sequentially in future quarters.

Gabe Poggi – FBR Capital Markets

Okay, thank you.

Michael McFerran

Gabe, just one other point to add, and to remind you, is all those three CLOs are outside of their non-call periods. So if the prepayments continue to increase at this rate and we saw the earnings profiles as decreased, we always have the option to call the deal and replace it with another transaction or deploy the capital (inaudible)

William Sonneborn

Exactly. So we can call and refinance a transaction just like a company can call and refinance their capital structure.

Gabe Poggi – FBR Capital Markets

Right. Great. That's exactly what I was looking for. Thanks a lot, and the color you guys provided was fantastic. Thanks.

Operator

We'll take the next question from Lee Cooperman from Omega Advisors.

Lee Cooperman – Omega Advisors

Hi, thank you very much. I have a bunch of questions but maybe I'll only ask half a dozen then we can talk offline on the others. First, maybe if you wouldn't mind, I'll kind of throw them out there, and you can handle them in the order that you feel comfortable. First, which measure of profitability do you think is the best economic measure to look at for the company? I'm assuming cash is king, so the profitability is the cash earnings, which is at $0.27 run rate, but I would like to get your view of that.

Secondly, as you guys analyze the equity offering you did, was the fourth quarter dilutive by virtue of the delta in the shares outstanding versus the delta in the incremental return in the money you invested? Or was that kind of a push?

Third, I noticed I think at the end of the year, the bank loan index was 93 and as of yesterday was 96.41, and the high-yield index at year end was yielding 8.32 and yesterday was yielding about 7.8 – the Bloomberg indexes. Since you guys probably close your books on a daily basis, I'm wondering if you'd care to share with us the book value presently as opposed to the book value at year end.

Fourth, you made a leading comment about – don't annualize the earnings in the fourth quarter, or don't expect them to be the same or whatever, I forget the exact wording you used, but do you anticipate higher cash earnings if I said the $0.27run rate times four was the run rate at year end, do you anticipate higher cash earnings in '011 than you had in fourth quarter of '010 annualized? Or are you leading us to think about lower earnings?

And then, I guess in terms of the $20 million loan loss, is that a provision or actually losses incurred? So provision or actual losses? Then, eighth, about the tax efficiency of your energy investments. A lot of people who are investing in the oil and gas business get a tax benefit. Is our structure of LLC allow us to get the benefit of that, or are we losing that benefit not being a C corporation? And I have other questions but I'd like to ask you them later.

Michael McFerran

Okay. Those are all excellent questions, Lee. I hope you're doing well.

Lee Cooperman – Omega Advisors

Thank you.

William Sonneborn

The answer to your first question is we all believe cash is king, but it's not the only metric that's really important, it's one. The $0.27 is operating cash earnings per share, so it's important. It's one of the absolute key things, but that neglects our ability to actually make money on investments above and beyond a coupon string. And if we're doing our jobs as a team, we're going to bat a lot better than 500 in the context of generating gains just like I know you try to do at Omega. So you have to factor the cash, the operating kind of run rate cash piece with the gains that we hope to produce, which we've fortunate and we hope to continue to be fortunate to produce quarter in and quarter out, year in and year out, that ultimately will help drive book value and the stock price. But that cash run rate is a key element, because that's ultimately, Lee, going to drive the distributions, which I know are near and dear to your heart.

The second question – the fourth quarter was dilutive. There's no doubt about it. We raised $175 million, it's not like we could reinvest it at 14% the next day, because there's not a lot of things you can invest at 14% the next day without doing something really stupid. And so, that's why it was dilutive, it will continue to be dilutive, but less dilutive each quarter over the course of the next three, and we expect it'll be anti-dilutive, that is, it will be accretive by the end of the third quarter of this year.

And your point on bank loan and high yield, yes the credit rally continues to march upward. The way to think about book value is to look at when you get our 10-K, because we can't really give you anything other than the points to look at, look at the amount of high-yield bonds we have. You could take that compared to the index appreciation and that will give you an idea of the other comprehensive income increase that will show up in book value as of any one day. Given our loan portfolio is static from the health of our investment perspective, that really doesn't flow into book value until we sell loans.

Lee Cooperman – Omega Advisors

Just out of curiosity, you're on a roll, so I don't really want to interrupt you. But since you're on an open mike and this is an open call and it's e world, what's confidential about telling people my book value is $10,000.27 as of yesterday's close? It's an open world, you're not talking in a private meeting. But it's okay, if that makes you feel better, it's fine with me I don't care.

William Sonneborn

It's not been our practice to provide interim financial...

Lee Cooperman – Omega Advisors

Try new things, it makes for excitement.

William Sonneborn

I know you would like that, Lee.

Lee Cooperman – Omega Advisors

Okay, go ahead, go ahead, go ahead. I don't want to take you off your game. Go ahead.

William Sonneborn

And then...

Lee Cooperman – Omega Advisors

Are you anticipating higher results in '011, just directional, I don't need a specific number.

William Sonneborn

In terms of overall earnings, I think we were pretty clear, that we – even though some of the tailwinds that we experienced in the context of wide spreads and credit markets we were able to take advantage of are abating a bit. You're still seeing obviously markets very attractive for a lot of the assets we hold, and so we're still feeling pretty good about 2011 in the context of our ability to hit the key metrics we focus on, which is growing earnings, book value, and cash flow per share.

Lee Cooperman – Omega Advisors

So I should take that as a yes.

Michael McFerran

And Lee, I think, just to emphasize, as we're deploying the capital that we raise from December, we're focused on finishing '11 with a higher run rate of earnings and cash flows that we started the year with, but recognizing that we have to put that money to work.

Lee Cooperman – Omega Advisors

Right. Okay.

William Sonneborn

And so you'll see some of the – you'll have a full quarter of dilution as opposed to a partial quarter of dilution in the first quarter but some of it's going to be invested and that will help offset some of that. So you're going to have a little bit of noise over the next couple of quarters but when we look at the full year we feel pretty good.

Michael McFerran

Lee, on the question on that was a provision for losses of $21 million, that was not losses that actually took place during the quarter. As Bill mentioned, we moved some of our loans. This is more like a GAAP function, we moved some of our loans from held for investment to held for sale. You write off the difference between par and the market value. We write that off for allowance, we replenished it with the allowance for the quarter at the exact same place we started the quarter at, but we had no real losses during the quarter that impacted our allowance.

William Sonneborn

And then on your final question on tax efficiency for our natural resource investments, we hope those

(inaudible) flow though, so all the tax benefits that you mentioned will (inaudible) to the benefit of our shareholders.

Lee Cooperman – Omega Advisors

Just one other question. If you take the approach, let's say, that cash earnings at 12% return on cash earnings, and I guess in the quarter you just paid out 56% of earnings. You could pay I guess with your bank agreement up to 65%. Would it be fair to think that an investor in the company, if you'll allow me to use round numbers, 50% ROE, 50% retention rate and a 12% ROE, a 50% payout rate, there's something like (inaudible) financial growth rate of around 6%, and we're going to yield 5% plus and that the investor gets 11-12% parameter? Against 360 government bond yield and whatever else the short rates are. Would you be happy delivering to your investor an 11-12% total return on average?

William Sonneborn

That's not total return, that's cash on cash because you're neglecting our ability to generate gain, which you can discount highly, but hopefully we can do that.

Lee Cooperman – Omega Advisors

To you I won't discount that highly, I'll only discount that modestly with you.

William Sonneborn

Okay, thank you Lee.

Lee Cooperman – Omega Advisors

Thank you, thank you very much.

William Sonneborn

And so the answer is hopefully better, but your math generally is accurate.

Lee Cooperman – Omega Advisors

Thank you very much and again, as I said before, I appreciate your whole team's efforts on our behalf.

Operator

And we'll move next to Wayne Cooperman from Cobalt Capital.

Wayne Cooperman – Cobalt Capital

Hey guys.

William Sonneborn

Hi Wayne.

Wayne Cooperman – Cobalt Capital

On the natural resource play, I think you might have mentioned it but I'm a little bit confused. Do you guys own an MLP? You have an MLP partner? You're lending to them, or you're actually buying resources? Just kind of explain it a little bit.

William Sonneborn

We have an operating partner which is Premier Natural Resources, which is a world-class team that we -

Wayne Cooperman – Cobalt Capital

But do you own 100% of that?

William Sonneborn

No, we have a joint venture structure with them where we use them as the operator. So when we buy working interests in an oil and gas field, we replace the operator with our partner. We think it's probably the best -

Wayne Cooperman – Cobalt Capital

You're only buying working interest, not minority interest for someone else is operating?

William Sonneborn

That's exactly right. I mean, on occasion we could buy royalty interest where there's a third-party operator but generally speaking, our break in the middle of the fairway is focused on situations where we can operationally add value above and beyond the actual resource on the ground.

Wayne Cooperman – Cobalt Capital

You're buying the resource, they're operating it. And that's on an equity basis? Are you providing financing as well?

William Sonneborn

We generally are using a bank to provide non-recourse finance at the working-interest level, so (inaudible) financing. We're not providing it because we're trying to get that done (inaudible) or plus 250 at the (inaudible) level, which boosts our overall return on the equity we're employing into our mid teens target rates of return and hedging some of the profile of the cash flows relative to that non-recourse financing but they're cash flow positive immediately in terms of positive rates of return.

Wayne Cooperman – Cobalt Capital

And when you're buying these, who's the competition? Is it these publicly traded MLPs? Is that the main competitors?

William Sonneborn

It depends, MLPs typically focus on midstream assets, so MLPs aren't real big competitors for what we're doing. It's other small cap E&P companies. Those typically from a public company perspective don't want to buy a conventional resource that's in its decline curve, because that doesn't help their values much. And that's really why we're seeing this opportunity. It may not be there forever, but over the course of the next couple of years, we see a pretty good runway of available properties that we can get our hurdle rates with very low risk in the context of any development or expiration. It has very high cash flow production and hedges against one of the things we worry a lot about that since we hold a lot of financial assets, which is inflation. So having a little bit of real asset exposure on our balance sheet is an interesting hedge to our ability to produce attractive dividend yields if that does do too much and overshoots.

Wayne Cooperman – Cobalt Capital

Do you see this being part of KFM long term, or is this something you see as being kind of a separate vehicle?

William Sonneborn

Is your question: can we ever spin off this business to other shareholders or some other -

Wayne Cooperman – Cobalt Capital

Well, you could always do whatever you want, I guess. If you're thinking about this long term and you grow it, do you see how that makes more sense to be a separate vehicle?

William Sonneborn

It may at some point, it's dependent upon the market timing, including the time to get in and get out of any asset, and right now we see it's the time to get in, and we're not at the point where we're deciding that it doesn't make sense anymore, and if it doesn't make sense anymore, and there's a greater fool willing to pay too much for something, we'll take advantage of that.

Wayne Cooperman – Cobalt Capital

I hope it's not me. Thanks a lot guys.

William Sonneborn

Thank you, Wayne.

Operator

And we'll go finally to Robert Schwartzberg from Compass Point.

Robert Schwartzberg - Compass Point

Good afternoon. One quick bookkeeping question. You mentioned difference between market value and carrying value on a per-share basis. Did I hear that at about $1.20?

Unidentified Executive

Right.

Robert Schwartzberg - Compass Point

Okay, and then following up on some of the questions on your supplement, you have an example of tomorrow and you have as much as 35% of your assets in natural resources, which is up from about 1%, so that's a pretty big increase and a pretty significant change in the direction of the company, and so over what time frame do you see that happening?

William Sonneborn

That's just a hypothetical graphic depiction and I don't think you should take anything else from it. But theoretically it's possible if we continue to see the opportunities we are seeing, it could become a more material part of KFN. If we're getting low rent, mid teens rates of returns with high cash flows, where the cash component of immediate return is in excess of 85% of the total rate of return, if you're getting equity rates of return with a fixed-income level of risk and inflation protection, and you look at what that does to the overall income stream and book value and cash flow growth opportunity at the business, it's reasonable. But clearly that's there for hypothetical purposes.

Robert Schwartzberg - Compass Point

So that was one of my questions, actually you just answered, that the cash component is about 85% and I guess 15% is from the value of the joint venture over time? Or is that -

William Sonneborn

The operational improvements we do over time, that's correct.

Robert Schwartzberg - Compass Point

What would be an example of an operation improvement? Expanding the capacity of a well?

William Sonneborn

A perfect example, we purchased a number of wells. Our operator was able to renegotiate the lease rates for all of the compressors that were used on the property, lowered that by several million dollars because it was a big major that we bought the assets from, and they had a very young inexperienced person from an engineering perspective overseeing this field that they've owned for 30 years. There's just a lot of efficiencies in the cost side in terms of decreasing leasing compressor cost, thinking about how, in certain cases, to refrack a well to increase production because it may have been fracked 30 years ago and a slight change to a refrack could massively increase flow from the well. There's lots of ways operationally to increase the rate at which you're extracting the resource which boosts the rate of return. Or reduce expenses of just maintenance and operation at the field level.

Robert Schwartzberg - Compass Point

Okay, again, you put in 35 as a reason, so obviously it's not necessarily going to 35, but what would be your best forecast for say, 12 months from today, what percentage of new investments would be in natural resources?

Michael McFerran

You know, Robert, it's hard to predict. We put that slide there as illustrative of how we view the future as being more diversified than the past. If the opportunities presented themselves to keep deploying capital at that return profile we like, 35% over several years would be an attractive place to be. The reality is that you have capital is that's going to be redeployed and takes much longer. Where it is a year from now is hard to predict because it's a function both of capital being returned from other places and opportunities being times with that to deployed to that specific class.

William Sonneborn

Exactly. So if everyone on this call went out and started trying to compete with us to buy some of these things, we would never get there, because we'd go find something else to do. Because the opportunity is unique, and we're taking advantage of it.

Robert Schwartzberg - Compass Point

Interesting. I appreciate all your efforts. I think it's going to change a little bit of the character of the company in terms of it's morphing a little bit from a pure financial company to a company that just provides outstanding adjusted returns. It's going to make it a little bit more complicated to understand I think. But I'm not saying you're not doing the right thing. I'm just saying it changes things a little bit.

William Sonneborn

We understand. You're right, it does, and we'll plan as part of that business, if it does grow to provide more factors and disclosure to make it easier to understand. But the types of investments we're doing there we think are very financial-like in terms of fixed income because of the substantial field orientation immediately Of the types of things we're doing. So we can provide more detail and case studies in the future.

Michael McFerran

And just to add, Robert, Bill made an important point earlier, where we're focusing on natural resources, is we're not focusing on an exploration activity where we're out looking for oil and you're putting a lot in the CapEx hoping to find something. No,what we're buying are wells that have proven reserves that are producing the day we them. So depending on what level you hedge to, there is a frankly reasonable amount of predictability of what you think your cash flow stream would be and then similar to interest rates, for our floating rate assets, here you're looking at the forward curves or what you think the commodity price will be, will drive with those, where the actual future of the cash flows are. It's less complicated that it would be, again, if we were taking on exploration strategy.

William Sonneborn

If we hedged 100% of the cash flows, you have a fixed income instrument.

Robert Schwartzberg - Compass Point

I understand. Okay, thank you.

William Sonneborn

Thank you.

Operator

And we'll take the next question from Aaron Kabucis from Adaptive Capital.

Aaron Kabucis – Adaptive Capital

Hi, thanks for taking my call, guys. Congratulations on a good quarter and year. Sorry for going back to this, but can you talk generally about the leverage employed currently and how that may relate to your decision to raise additional equity instead of using the credit facilities available?

William Sonneborn

Sure. At the firm balance sheet level, I think Mike mentioned in his comments that one of the things we focus on collectively as a team is in the future how we lower our cost to capital as opposed to using equity to finance our business expansion or growth, being able to use low-cost debt financing. So some sort of long-term bond would be an attractive avenue in the context of doing so versus using a revolving credit facility or other types of more expensive types of capital, and I think Mike mentioned that in his comments.

Aaron Kabucis – Adaptive Capital

I know in previous calls you went into a little bit more color as to some of the low-cost of financing that you guys secured through a few facilities, and are those still available and in relation to the capital raise as well?

Michael McFerran

I think when you think about low cost, you differentiate between what we do at the holding company, which is really unsecured debt, which is today, the (inaudible), which if you think about it from a holding company level, the company has raised a low amount of leverage. Then if you think about the asset level, you have our CLOs. We're benefiting still from having done deals where the senior notes were issued between LIBOR plus 35 and LIBOR plus 80. The CLO market has been improving as we talked about on the call but not there yet. So we think about financing in both forms at both set level non-recourse financing and then as well what Bill talked about from thinking about doing long-term debt at the holding company structure that we could use flexibility across asset classes.

William Sonneborn

And we were just trying to optimize cost of capital with the most insulation of our balance sheet (inaudible) finance company, in other words we want all of our maturities outside of the assets which we purchase. So with no market value triggers or margin posting requirement. So with those kinds of rules of engagement, it's all a question about optimizing cost of capital generating the highers return on capital which generally adds to shareholder value.

Aaron Kabucis – Adaptive Capital

Okay, great. Thanks very much.

Operator

And that concludes the question-and-answer session today. At this time I'd like to turn the conference over to Mr. Sonneborn for any additional or closing remarks.

William Sonneborn

Thank you all, I appreciate all of your confidence and trust. We'll continue to try to do well for you. Have a good evening.

Operator

That concludes today's presentation. Thank you for your participation.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: KKR Financial CEO Discusses Q4 2010 Results - Earnings Transcript
This Transcript
All Transcripts