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Executives

Angela Yang – IR

Bill Sonneborn – CEO

Michael McFerran – CFO and COO

Analysts

John Hecht – JMP Securities

Jasper Burch – Macquarie Capital

Stephen Laws – Deutsche Bank

Wayne Cooperman – Cobalt Capital

Daniel Furtado – Jefferies

Lee Cooperman – Omega Advisers

KKR Financial Holdings LLC (KFN) Q4 2011 Earnings Call February 6, 2011 5:00 PM ET

Operator

Good day and welcome to the KKR Financial Holdings LLC Fourth Quarter 2011 Earnings Conference Call.

Today’s call is being recorded.

At this time I would like to turn the conference over to Angela Yang, Investor Relations. Please go ahead.

Angela Yang

Thank you, operator, and good afternoon everyone. I'm Angela Yang, part of Investor Relations for KKR Financial Holdings LLC. And joining me on the call today are Bill Sonneborn, our Chief Executive Officer, 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 replay of the call available as well.

Our financial results for the fourth quarter and year ended December 31, 2011 were issued today, and as with prior quarters, a supplemental information packet is available in the Investor Relations section of our website.

Before we get started, I’d like to caution you that this conference call and webcast contains forward-looking statements that are based on the belief of the management team regarding the operations and the results of operations of the company as well as general economic condition. 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 Securities and Exchange Commission and a supplemental information packet available on our website. These filings are available on the Securities and Exchange Commission’s website at www.sec.gov. KFN’s actual results may differ materially from those reflected in the forward-looking statements.

In addition, some of the discussion today will include references to non-GAAP financial measures. Information about these measures as well as their corresponding GAAP reconciliations may be found in the supplemental information packet available on our website. The supplemental information packet and scheduled holdings on our website include information that we will be referring to on our call today, and we encourage you to have those information available during the call.

With that, I will turn the call over to our CEO, Bill Sonneborn.

Bill Sonneborn

Thank you, Angela, and thank you to all of you for joining our call today. We will begin today’s call with a review of fourth quarter highlights, and then Mike will review our financial results and performance by strategy in detail. After that, I’ll provide you with an update on our views on the market, the economy and our areas of focus as we look ahead.

Today we announced that our Board of Directors declared an $0.18 per share cash distribution on our common shares. This distribution is payable on March 1 to shareholders of record as of February. In addition, we announced that our Board of Directors declared a special distribution on our common shares of $0.08 per share that is payable on March 29 to shareholders of record as of March 15. In total, we will be distributing $0.26 per share.

Consistent with the company’s distribution policy, the company’s Board of Directors considered a number of factors in determining to declare this special distribution including current market conditions, existing restrictions in the company’s borrowing agreement, the amount of ordinary taxable income or loss earned by the company, and gains or losses the company recognized on the disposition of assets during the year, as well as company’s liquidity.

Reported net income for the fourth quarter of $77 million or $0.43 per diluted common share, which represents an 18% return on equity. And we reported book value per share as of December 31, 2011 of $9.41.

For the fourth quarter, our run rate cash earnings per share totaled $0.30 per common share, which equates to a 13% cash return on equity. And total net cash earnings per share totaled $0.39, which equates to a 16% cash-on-cash return on equity.

Earnings for the fourth quarter included a $5 million or $0.03 per share gain from the exit of a $13.6 million special situations investment we had made in the distressed senior debt of an Australian-headquartered scrap metal recycling business, including interest income we received in this transaction which generated a 75% IRR on this investment.

During the quarter, we deployed or committed to deploy approximately $200 million of capital to new opportunities. Of this amount, approximately $120 million was through our natural resources strategy to three distinct opportunities.

The first was an approximate $65 million investment in a joint venture we structured with Quicksilver Resources to form a midstream partnership dedicated to the acquisition of existing pipeline and construction and operation of additional natural gas midstream pipeline, as well as treatment facility in the Horn River Basin in Western Canada. This investment carries with it a 15% contractual return, including return of our (inaudible) over 10 years plus the terminal value in year 10 and beyond of all the infrastructure underlying the assets in the JV.

The second transaction we made was a $15 million private equity investment in Samson Investment Company. It’s one of the largest private exploration and production companies in the United States.

And the third and final within natural resources, we committed approximately $70 million to acquire working interest in conventional oil and gas properties located in East Texas, Louisiana and Mississippi, consistent with the strategy we’ve discussed. The assets consist of interest in over 625 active producing wells across over 48,000 acres in over 20 distinct fields. We are funding this acquisition with approximately $41.5 million of cash and $28.5 million of borrowings through our non-recourse asset-based natural resources credit facility.

In addition to the approximately $120 million of capital we deployed or committed to deploy within our natural resources strategy to acquire $150 million of assets, we also deployed or committed to deploy approximately $45 million to several different special situation distressed opportunities, predominantly located in Europe.

We also committed to deploy approximately $37 million to our commercial real estate strategy to acquire an interest in a family-owned but under-managed super-regional Midwest mall comprised of approximately 1.5 million square feet on land covering over 130 acres.

In addition to these transactions, we sourced incremental capital during the quarter through the issuance of $258.8 million of 30-year senior notes that bear interest at 8-and-3/8. As we discussed on our last quarter’s call, we’ve been rated BBB by Fitch rating and BBB-minus by Standard & Poor’s. Receiving investment grade ratings represented a key milestone in the evolution of KFN as it has provided us the flexibility to lower our cost of capital through increasing leverage on our balance sheet with few key characteristics that serve to protect shareholders capital, being leveraged but is long-dated and not subject to any margin posting based upon market value changes in our holdings.

In addition to sourcing incremental capital through issuing holding company debt, another source of potential capital is through possibly divesting certain related tranches we hold in our CLO subsidiary. Today we completed one such transaction through the sale of approximately $25 million face amount of Class D notes from CLO 2007-1 at a price greater than $75. This transaction enables us to redeploy capital that had an 8% expected yield to maturity, a sub-4% cash yield based on that sales price, incremental opportunities that we believe will be accretive to both earnings and cash flow. We will continue to explore transactions like this in the future as an additional source of capital that enables us to reallocate lower-earning capital held in rated notes in our CLOs to higher-yielding and returning opportunities that are accretive to our shareholders.

Now I'm going to hand this call over to Mike to review the quarter’s results and provide you with an update on our capital structure as well as the performance we generated during the quarter by strategy. Mike?

Michael McFerran

Thanks, Bill, and good afternoon everyone.

Today we announced net income for the fourth quarter of 2011 of $77 million or $0.43 per diluted common share, as compared to the net income for the third quarter of 2011 of $39.8 million or $0.22 per diluted common share and net income for the fourth quarter of 2010 of $78.2 million or $0.48 per diluted common share.

Net income for the fourth quarter, consisting primarily of net investment income of $90 million, net realized and unrealized gains from investments of $15.8 million, net realized and unrealized losses from derivatives and foreign exchange of $3.5 million primarily due to unrealized losses on certain credit default swaps and foreign currency translations net of hedges, partially offset by unrealized gains to commodity hedges and general and administrative expenses totaling $27.1 million.

Net investment income of $90 million for the fourth quarter of 2011 represents an increase of 4% from the third quarter of 2011 and an 11% year-over-year increase over net investment income for the fourth quarter of 2010. Net realized and unrealized gains from investments totaling $15.8 million consists of net realized gains in sales of certain debt holdings totaling $31.2 million which are partially offset by $15.4 million of net unrealized losses on certain debt and equity holdings.

We reported book value per share as of December 31 of $9.41 per share. This represents a 3% increase in book value per share for September 30, 2011, a 2% increase in book value per share, $9.24 as of December 31, 2010. As of the end of January 2012, we have seen an estimated incremental $0.17 per share gain in book value primarily due to an increase in the value of our securities classified as available for sale, our interest rate swaps classified as cash flow hedges, and [certain] loans held for sale which are carried at the [low end of] cost to estimated fair value.

Page 14 and 15 of the supplemental presentation that Angela referred to provides a run rate and total rate of return on equity analysis of our performance by strategy. The run rate ROE and the schedule reflects net investment income, while total rate of return ROE includes realized and unrealized gains and losses. As you will see, the performance of each of our strategy depends on the nature of the strategy and the nature of the earnings from the underlying assets within it. For purposes of this analysis, we have allocated our holdings company debt across our strategies and cash, calculated based on a pro rata portion of total holding company capital except for private equities which we solely through equity capital.

As illustrated on page 15 of the supplemental presentation, the best way to think about the financial performance of our strategies, to visualize the spectrum from left to right, the strategies that legitimately have the largest component of their returns (inaudible) returning income captured in the ROE analysis as run rate ROE on the left and strategies that would generate the least return on income on the right. GAAP P&L performance, which factors in realized and unrealized gains and losses for each strategy is primarily being reflected in total rate of return ROE.

Special situations would be the left of private equity on the spectrum and holdings in this strategy may take the form of debt and/or equity and generally consists of capital deployed to [DP] discounted secondary market opportunities, rescue financing transactions, different [active] facilities, and other distressed opportunities. Our mezzanine strategy lies on the theoretical spectrum between bank loans and high yields, special situation due to the nature of producing both recurring income as well as one-off gain realization opportunities.

For the fourth quarter, our run rate ROE from our bank loan and high yield strategy was 27%. Over the long term, we target a mid to high-teens run rate ROE from this strategy, and we do expect the run rate to reduce over the coming years as we replace our existing amortizing CLOs with new structures, or redeploy our equity (inaudible) opportunities. The total ROE from our bank loan a strategy and high yield strategy was 33%, which includes net realized/unrealized gains during the quarter earned from holdings in this strategy.

The run rate ROE from our natural resources strategy was 16% for the quarter and reflects continued ramp-up of this strategy through requiring incremental private equity and real estate, assuming real assets, in the form of [work-in] royalty interest. Total rate of return on equity from our natural resources strategy is 37% and reflects marked-to-market unrealized gains on our commodity hedges.

Our mezzanine strategy generated a run rate ROE of 14% and a negative total rate of return of 19% due to an unrealized fair market value write-down of a single private equity holding in (inaudible) adhesives business.

Our special situation strategy generated a run rate ROE of 10%, a total rate of return of 12%. As previously mentioned, we expect the run rate ROE of this strategy to be high single digits to low teens based on the recurring income general nature of the holdings we have in this strategy in a given point in time.

Our private equity strategy did not generate any run rate ROE, which is consistent with the nature of this asset class (inaudible) P&L resulting from realized and unrealized gains or losses (inaudible) included in total return, and which was 0.5% for the strategy.

The last strategy to reference is our legacy residential mortgage-backed securitization holding which generated a 14% ROE and 18% total rate of return. As we’ve discussed previously, it’s a small asset class for us as remnant from when we were a REIT and is currently (inaudible).

That’s our review of the liquidity and capital structure.

As of December 31, we reported unrestricted cash and cash equivalents on our balance sheet of $392.2 million. This amount includes $134.3 million that we have reserved for the upcoming retirement of our 7% convertible notes (inaudible) this coming July. Net of this amount, unrestricted cash amount, is $257.9 million. Both existing opportunities that (inaudible) describe in the pipeline of transactions which we are currently working we believe we will continue -- excuse me, we believe we will deploy the majority of our investible cash by the end of the second quarter, assuming suitable market conditions for finding value. Accordingly, we remain focused on optimizing our existing capital structure to fund future growth.

With respect to our current capital structure, we have $834 million of debt reported on our balance sheet that consists of our convertible note, senior unsecured notes that were issued this past quarter, and trust-preferred securities that have an aggregate -- across (inaudible) category’s face value of $850 million, a weighted average maturity of 18-1/2 years from December 31, and a weighted average interest rate as of yearend of 7%.

And as of December 31, net of cash reserves for our 7% convertible notes due in July, our holding company leveraged the shareholders equity with 0.43 times. (inaudible) average coupled with (inaudible) dated non-marked-to-market financing affords us flexibility for growth and selective risk-taking.

Now I'm going to hand this back to Bill.

Bill Sonneborn

Thank you, Mike.

With respect to the financial market, the fourth quarter was a return to much calmer waters, renewed risk-taking, and the continued search for yield. And this environment has been even more prevalent through the month of January. The S&P500 in the fourth quarter gained 11.8% to end the year almost exactly where it started. The VIX measure of volatility declined over 45% from 45.5 to 23.4. Credit markets followed equities, albeit at a slower pace. And Merrill Lynch High Yield Master 2 Index gained 6.2%, and the S&P/LSTA leveraged loan index was up 2.9%, while both the credit and equity markets are on fire, particularly so far in 2012. We are on the lookout for the next catalyst of volatility.

Standing on the precipice of 2012, it strikes us that the major drivers of the volatility that engulfed the markets in 2011 remain unresolved. After a 20-year bull run, we see an inflection point within the developed sovereign fixed income markets. We believe the global developed country sovereign bond simply cannot be used as meaningful shock absorbers within a capital allocation framework.

From a historical perspective, it’s worth noting that nominal 10-year treasury yields in 2011 were at the lowest official level since record-keeping began in 1871. At the same time, credit spreads have compressed but maintained historically wide levels. Using the Moody’s corporate BAA as a proxy, credit spreads as measured against 10-year treasury yields now stand at 1.3 standard deviations above the long-term historical average.

While we remain bullish on continued opportunities in credit, we believe volatility is likely to continue over the next several months, despite the stabilization trend we are seeing as evidenced for example in residential home prices. We like the markets within which we operate. As we have articulated in the past, volatility creates opportunities for those who express patience and enhanced insights, and we believe KFN is well-positioned to benefit from such periods as and when they occur.

In early 2010 we identified a new strategic direction for KFN that was based on diversifying KFN from being primarily almost exclusively focused on syndicated credit held through CLO subsidiaries to being a growth net income and yield-focused specialty financed company that would deploy capital across several strategies, asset classes and capital structures as well as geographies globally with the following key objectives.

One, to focus on preservation of shareholder capital. Second, diversification for both flexibility in pursuing opportunities and risk management. Third, generation of a steady income stream that provides recurring cash flow for both distributions to our shareholders as well as capital for redeployment. Four, creation of long-term value for our shareholders. And finally, the construction of a portfolio that in the aggregate has many embedded options to further increase shareholder value in different market cycles, interest rate cycles, as well as economic condition.

Not being beholden to a single asset class or geography and being able to identify and evaluate opportunity globally, leverage the information that’s in the firm sets KFN apart. Our capital structure affords us the flexibility to be opportunistic during periods of increased volatility as we aren’t constrained by marked-to-market financing and have holding company debt with the weighted average maturity, as Mike mentioned, of over 18 years. These are the types of markets where one can drive differentiated outcomes. Our capital deployment decisions are based on conviction found through comprehensive effort and with the focus on developing the competitive advantage that KKR brings to such ideas.

With that, we’ll open this call for questions. Operator, can you open it up for questions please?

Question-and-Answer Session

Operator

Yes, sir. (Operator Instructions).

Our first question comes from John Hecht with JMP Securities. Please go ahead.

John Hecht – JMP Securities

Good afternoon, guys. Thanks for taking my questions.

Bill Sonneborn

Hi, John.

John Hecht – JMP Securities

How are you? Afternoon.

First question, Mike, you mentioned that D note sale in the call. Can you tell us where that -- the value was greater than $75 million? It sounded like $0.75 on the dollar. Could you tell us where the most recent accounting mark was on that?

Michael McFerran

Yeah, John. It’s actually, from an accounting standpoint, since we consolidate the CLOs, those notes actually reflect our equity in the CLOs, so those bonds aren’t on the balance sheet. So by in fact reissuing or selling those notes out of our holding company on unconsolidated basis, the accounting treatment would actually be shown as issuance of additional non-recourse debt in our CLO structures. You could think of it as effectively increasing the leverage in the CLOs via divesting of the lower return assets we have in them.

Bill Sonneborn

Another way of thinking about it, John, in the subsidiaries, is we just raised debt at 8% coupon of which 3% is cash and 5% is pick.

John Hecht – JMP Securities

Yes. So more of average and better cash flow returns to the equity side of that?

Bill Sonneborn

That’s correct.

Michael McFerran

Right.

John Hecht – JMP Securities

Okay. And then the 10-K is not available, so you may not be able to tell me this, but can you tell -- do you have handy what either the non-accrual or delinquent assets were at the end of the year?

Michael McFerran

Apologies, I don’t have that in front of us, but it will be in the 10-K which will be coming shortly.

John Hecht – JMP Securities

Okay. Third question is, Bill, it seems if you look at 2011, that a lot of the emphasis in terms of strategic direction was in the natural resource arena. Looking to 2012, it’s being shaped out the way you see them or think about them right now. Is it going to be a shift from the natural resources to something else, maybe special situations, or how should we think about asset deployment this year?

Michael McFerran

Well, I mean I think, John, consistent with prior quarters, we’ve been focused, on the credit side, a lot in Europe, where we see continued fallout in the second derivative of the recession and the sovereign debt crisis in Europe at the corporate level, not necessarily focused as much on bank portfolio purchases, looking at the underlying borrowers that are struggling to obtain credit.

We continue to see opportunity in natural resources. It continues to be an interesting arbitrage role to the flow we’re seeing, whether in royalty interest, underlying production interest and conventional oil and gas, or helping to finance (inaudible) over existing (inaudible) particularly with natural gas prices where they are.

So I think the key theme from industry perspective as we look forward, energy, healthcare, in particular, because of reimbursement pressures. Geographically, Europe is interesting particularly in special situations with energy, we like being close to the assets (inaudible) real asset exposure within (inaudible).

John Hecht – JMP Securities

Okay, great. Thanks for the color.

And the last question, either maybe can you review repayment trends during Q4 and more recently and what that specifically might mean to the duration of the cash flows for the CLOs (inaudible) repayment phase?

Michael McFerran

Sure. We’re still seeing broadly in the [low] markets, I think about the assets in our CLOs, John, we’re still seeing kind of a single-digit CPR. So, prepayment rates through the end of the -- through the fourth quarter still remained low by historical standards. You're starting to see an uptick. As credit spreads have tightened, we expect that to pick up pace this quarter, actually in February. So with respect to how the CLO one-off walks, it’s going to -- it’s, based on these prepayment levels, it should still be very slow. And as you know, if we start to see a significant uptick, we would expect that to be accompanied by hopefully tighter spreads in the CLO market which would give us increased optionality in trying to accelerate our plans too when we play those structures of new transactions.

John Hecht – JMP Securities

Yeah. Okay, good point. Thanks very much, guys.

Bill Sonneborn

Thank you, John.

Operator

We’ll take the next question from Jasper Burch with Macquarie Capital.

Jasper Burch – Macquarie Capital

Hey, good afternoon, gentlemen, and nice job on the quarter. I guess just starting off how you look at the capital structure, you're getting up around book value, so hopefully within the next couple of months there might be opportunities to issue equity capital. I'm just wondering if you could speak a little bit on how you view your cost of capital in terms of tapping the debt markets, issuing equity once you're above book value, and also what sort of opportunity you see continuing within the portfolio of divesting some of these lower-yielding assets?

Bill Sonneborn

Sure. I mean if you think about our cost of equity capital, we’re generating -- we generated an ROE in the quarter of 18%, cash return on equity of 16% in terms of total cash. And so that gives you an idea of what the cost of capital is from an equity perspective. Selling, as we just talked about, a little piece of the 2007-1a notes at a 3% cash, 8% total cost of capital, or issuing 30-year debt at 8-and-3/8 like we did in the fourth quarter is clearly highly accretive relative to the types of returns or the returns that (inaudible) on pages 14 and 15 in the supplemental material.

Jasper Burch – Macquarie Capital

That’s helpful. And then could you give us a little more color on what -- if you can give us more color on what portion of assets, maybe yielding under 10%, yielding under maybe 12%, whatever special you sort of set for yourself in terms of when you might -- what you might be willing to sell?

Michael McFerran

I think where it goes, Jasper, to Bill’s on the CLO transaction, the way our equity in the CLOs is constructed is we are on the subordinate tranches, but we also have interest in mezzanine tranches up the sack and indicates 2007-1, these are the investment grade rated notes which we own $200 million prior to the sale today, so [plus] $180 million thereafter. So, subject to opportunities in the CLO secondary market, that’s the place we go back to, to redeploy capital away from that single-digit held to maturity and (inaudible).

Jasper Burch – Macquarie Capital

Okay. Thank you.

Bill Sonneborn

And one last point to your question, Jasper, is Angela mentioned that the schedule of holdings is also available on our website. So you can go through, and the math is all there to look at the percentage of assets and what their rates of return are.

Jasper Burch – Macquarie Capital

Okay, I’ll do that. Thank you very much. That’s helpful.

Operator

We’ll hear next from Stephen Laws with Deutsche Bank. Please go ahead.

Stephen Laws – Deutsche Bank

Hi, good afternoon. Congratulations on a nice quarter.

You kind of hit on kind of investment targets as far as full deployment kind of middle of this year. Can you maybe talk -- provide a little color on primarily the sourcing abilities you guys have when you're sourcing investments in both the natural resources strategy as well as asset purchases out of Europe? Are those people coming to you? Are those deals you guys identifying yourselves and pursuing? If you could maybe talk a little bit about how you source your pipeline on those two fronts please.

Bill Sonneborn

Good question. Thank you, Stephen. Generally we’re very much focused on originating our own proprietary ideas and that’s whether it’s in Europe or in natural resources. We’re focused on developing relationships, using those relations to come up with unique investment ideas that we can develop and formulate a competitive view from a return profile and understanding risks and what could go wrong.

Case in point is we recently made an investment in Europe where we purchased the securities of a very large hotel operator in Europe. And that was really predominantly dealt with by a proprietary sourcing and it was not available through others generally.

And the same in the context of many of the energy investments that we have made, whether it’s (inaudible) process or no process at all in the context of the origination that we [have seen], [but that we had] competitive [use] as a result of other investments we made in those specific areas where we understood the asset value or the ability to create value (inaudible) operation.

Stephen Laws – Deutsche Bank

Great. And then I’ve got one follow-up question on a comment earlier I believe on potential future capital raises. Can anybody talk about how management will look at raising kind of a from a permanent capital standpoint more with the unsecured notes or will it be common issuance? Given the cost of each, how do you guys look at a ratio you’d like to keep, or kind of how you’re going to look at that going forward?

Bill Sonneborn

Mike, why don’t you talk a little bit about holding company leverage and kind of where we feel comfortable and where we start to feel less comfortable, and then describe again what we’ve done with CLO 2007-1?

Michael McFerran

Well, Stephen, as we look ahead, I think there’s -- I mean you named probably the three obvious options out there, one is common equity; second, increasing and doing more of the 30-year or similar-type transactions for the long-dated secure bonds, these are investment grade rating; and the third being what we did today which was increasing the leverage in our CLO to [attract] capital for redeployment.

The third is obviously the most appealing, subject to market conditions, as it involves no transaction cost friction and it allows us to redeploy capital that’s already out there in the higher-yielding opportunities. So we hope to be able to do more of that in the future. And again, that’s why it’s subject on as the prices go in the CLO market.

On the 30-year note side, those transactions similar to that, continue to consider. Those notes that we issue are trading at a premium to where we offer them at. So they’re doing well, which implies there’s additional market opportunity there. I think as far as long-term leverage, we’ve said our objective would be to always (inaudible) leverage, and we mentioned we’re at 0.4 today. So I think somewhere in that range is an attractive long-term place. And again, a lot of it will be driven by just market conditions and picking the right attachment points.

And then, as we think about equity, over time obviously we issue more debt, to kind of maintain that ratio, you’d be conscious (inaudible).

Stephen Laws – Deutsche Bank

Great. Thanks a lot for the color there, and look forward to speaking with you again soon.

Michael McFerran

Thank you.

Bill Sonneborn

Thanks, Stephen.

Operator

Our next question comes from Wayne Cooperman with Cobalt Capital.

Wayne Cooperman – Cobalt Capital

Hey, guys.

Bill Sonneborn

Hi, Wayne.

Wayne Cooperman – Cobalt Capital

Congratulations.

Run rate earnings kind of keep ticking up a little bit. Do you guys look at that -- I mean, is that what you look at as the best performance indicator, or is there anything else you look at, or you just look at everything altogether?

Bill Sonneborn

It’s a great question, Wayne. We focus on, you know, we highlighted on a run rate basis because (inaudible) strategies it’s most relevant, indicated on slides 14 and 15 of the supplemental presentation. We highlighted specifically bank loans and high yields, you would expect the majority of your return on a long-term basis to come from that run rate.

Wayne Cooperman – Cobalt Capital

Right.

Michael McFerran

Other strategies like private equity or special situations (inaudible) significant component of the total return that comes through realized and unrealized gains and losses (inaudible). So it really depends on how we deploy capital. That’s why we (inaudible) and the way we think would be to encourage investors and analysts to look at this, take more of a strategy view, and for things like private equity and special situation (inaudible) focus on the total rate of return, and (inaudible) high yield (inaudible) rate of return, I’d be more focused predictability on the run rate.

Wayne Cooperman – Cobalt Capital

And if we look forward, can you give us some -- where you think the return on the assets is going to go? And is your overall cost of capital going up or going down? I know because you raised some debt at a relatively higher rate versus some of the debt you were borrowing before, if you can give some guidance on that.

Bill Sonneborn

I’ll jump in on that, Wayne. If you think about we’ve been pretty consistent on these calls talking about having a mid-teens return on capital goal, and so we really don’t deploy capital unless we feel as a team highly comfortable that the KFN shareholders, we can generate a mid-teens rate of return.

So, yes, we raised debt at 8%, which -- but it’s 30-year debt. And the nice thing about 30-year debt is it’s well in excess --

Wayne Cooperman – Cobalt Capital

You won’t be around to pay it back.

Bill Sonneborn

Well, we make 30-year investments, right? I mean some of the natural resource investments we’ve made may be around on our weighted average duration for 12 or 13 years, but they’re not going to be here for 30. And so, we’re paying for the comfort of having basically more than [matched] funding relative to a return on capital (inaudible). If we get lucky and something we think is going to be 15 like natural resources is 37, that’s better than we thought. We didn’t underwrite it thinking it was 37, but we’re really focused on making sure it’s not 10.

Wayne Cooperman – Cobalt Capital

Right.

Bill Sonneborn

And so we if we would be surprised on the upside, that’s great. And so we’re starting to provide a lot more transparency, we’ll see in the supplemental materials, so you can start to measure us and how we’re doing on each of these strategies both on that recurring cash perspective relative to our cost of capital.

Wayne Cooperman – Cobalt Capital

So if you had a say where you were today for what your incremental borrowing costs were and where you're putting money to work, are those returns as of today better or worse than they were over the last quarter or last year or two?

Bill Sonneborn

I mean it’s hard to say, but we’re still underwriting at the same assumption, getting the same mid-teens return on capital.

Wayne Cooperman – Cobalt Capital

Got you.

Bill Sonneborn

Nothing has changed. And if we can’t find those types of opportunities, we’ll return more capital to shareholders as we said in the past.

Wayne Cooperman – Cobalt Capital

Did you guys, I'm sorry if I missed it, but did you guys give your kind of marked-to-market NAV at the end of the year, or any update as of like January 31?

Michael McFerran

No, we didn’t mention on the call.

Bill Sonneborn

We did give an update. Book value impact as of the end of January was $0.17 higher than the $9.41 just for the loans available for sale and securities available for sale, and basically our swaps mark. But we did not disclose the fair market value, not (inaudible) until the 10-K of the whole portfolio.

Wayne Cooperman – Cobalt Capital

Don’t you guys usually do that?

Michael McFerran

It’s not that we’re keeping it secret, Wayne, we’re happy to put it out there. The debt portfolio which I think had a carrying value of (inaudible) last quarter, 92% of face value, the market value was approximately 91%. So, a small delta there. And I think that’s somewhere across our total holdings (inaudible) real assets.

Wayne Cooperman – Cobalt Capital

That’s as of this 31st?

Michael McFerran

That’s as of this 31st. And to Bill’s point, we gave -- that’s gone up (inaudible) about $0.17 on the things that go through book value, most of the loan portfolio doesn’t.

Wayne Cooperman – Cobalt Capital

Right.

Michael McFerran

So people could do their own math I think on taking a look at our aggregate loan portfolio held for investment, and just look at how the loan markets performed over the -- since the end of the year and kind of make their own assumption on (inaudible) change.

Wayne Cooperman – Cobalt Capital

Got you. All right, thanks.

Bill Sonneborn

And the reason it wasn’t in our prepared remarks is it’s roughly the same carrying value and fair market value during the year, so the $9.41 is a rough approximation.

Wayne Cooperman – Cobalt Capital

Got you.

Operator

(Operator Instructions).

We’ll hear next from Daniel Furtado with Jefferies.

Daniel Furtado – Jefferies

Good afternoon. Thank you for taking the questions.

I just really only have -- just want to kind of focus on this Class D note sale. Can you help me understand the market for these CLO notes as it stands today?

Michael McFerran

Sure. I mean there’s, yeah, whether it be institutional investors, insurance firms and the like, there’s a market that holds both on the primary issue and on the secondary trading front investment grade and a lot of investors are more interested in going down the stack to non-investment grade, mezzanine and equity tranches and CLOs. That’s the same market that when new CLOs are done and we announce, subscribe to those mez tranches, effectively the same buyers buying into (inaudible) deal at current yields.

Daniel Furtado – Jefferies

Understood. And so, how about the difference in the demand for these I guess on-the-run securities between kind of 4Q and 3Q, or how that demand, as you’ve witnessed it, changed? Has it changed materially over the last 90 days or so? Or how do we think about the delta there?

Bill Sonneborn

I think the demand in the secondary market for things like the 07-1 mez notes appreciated demonstrably, and that’s one of the reasons we hadn’t used that technique to lower our cost of capital in previous quarters, but we just announced today that we did it for the first time. And I think we have a saying that if the ducks are quacking, you feed them, and the ducks are quacking.

Daniel Furtado – Jefferies

Understood. Thank you for the color there.

Operator

We’ll go next to Lee Cooperman with Omega Advisers.

Lee Cooperman – Omega Advisers

Thank you. I have good news for you, Bill and company. I only have three questions today.

Bill Sonneborn

Thank you, Lee.

Lee Cooperman – Omega Advisers

Okay. Congratulations on a good quarter. I guess two of the three might -- addressed, but I'm going to give it a shot. I'm just trying to make sure as a very large shareholder that I understand dividend and dividend policy. Assuming your typical owner was a maximum taxpayer and had a cash-based -- cost basis close to the market, we’ll call it between $8 and $9 a share, is the $0.72 recurring quarterly annual -- quarterly dividend annualized plus the $0.08 likely to cover their tax liability come April 15?

Michael McFerran

Lee, you're not going to like this answer, but unfortunately we just can’t answer that question. The reason is the facts and circumstances for every investor, not just a basis and the holding period but also the actual specifics of each person’s on tax situation and whether they’re an individual or a corporation.

Lee Cooperman – Omega Advisers

Sorry, an individual maximum taxpayer, paid between $8 and $9 for the stock and he held it for long term, not interested in short-term traders.

Michael McFerran

Understood. And Lee, again, you're not going to like our answer, which is we just can’t --

Lee Cooperman – Omega Advisers

If you don’t know the answer, it’s fine.

Bill Sonneborn

I don’t know the answer, I'm not a tax expert. I do know that in the context of setting the dividend policy, when we made and created the ability with the Board to do a special distribution, and we disclosed all the factors, that would be evaluated. We did have some tax advice in the context of that discussion.

Lee Cooperman – Omega Advisers

I'm not as good-looking as you, as (inaudible) as you, but let’s say I'm you, you’re a maximum taxpayer, you bought a lot of stock in the $8, $9, region, so the question I’d ask the Board to contemplate is, what is the tax liability of that person and are we giving enough money to pay that tax liability as you build the company? But you’ve answered, you can’t answer it, but you should focus on that.

Second meaningful question, we seem to have a lot of cash, and I don’t know about your cash, my cash is virtually nothing these days, but you have $392 million unrestricted, I think you mentioned $134.2 million reserved for the repayment of the earlier issued converts. So that leaves you with $257.8 million, which you said I think would be invested by the end of the second quarter, and you have $399 million of restricted cash. So my question is, what is the return on your cash on average (inaudible) cash, what do you consider at the end of the quarter as being excess cash, or maybe asked differently, what is your required minimum cash balance to run the company, and lastly, what is the average lending rate you're looking at these days?

What I'm trying to figure out, to save you time, is the, you know, how much below a prospective run rate of earnings, the 30% run rate of cash earnings or the $0.39 run rate?

Michael McFerran

Yeah, I’ll take the first part, Lee, which is what’s the investible cash (inaudible) cash on the bank account of $258 million at December 31, Bill in his prepared remarks went through a lot of investment opportunities. We’ve used the term deployed or committed to deploy, because a lot of this is just a timing difference. We may sign the commitment for a transaction in December or November and may actually fund that investment in January. So when we made the remarks that we feel comfortable we will have deployed our excess investible cash by the end of the second quarter, as you know, (inaudible) calls, and we say that with a fair, you know, a high degree of confidence.

So I would -- so, during this coming quarter, we will be settling a lot of the trades that -- commitments we had made that were opened at yearend. I think that’s again pretty achievable.

As far as how much cash we need to run the company, we have untapped revolver which helps provide (inaudible) capital [bridges], and we think it’s a nominal amount for working capital, you need sub-$50 million.

Lee Cooperman – Omega Advisers

So, just trying to dig a little deeper, the $258 is largely excess cash. Is that earning like near zero?

Michael McFerran

Basically zero.

Lee Cooperman – Omega Advisers

All right. And you're putting it at 13% to 15%?

Michael McFerran

That’s correct.

Lee Cooperman – Omega Advisers

So if I took 14% of $260 million and annualized that, that’s kind of what the marginal impact on earnings could be looking out over the next 12 months?

Michael McFerran

I think, Lee, that’s the blended total return, it goes back to how we deploy it. If some of that cash go -- if all that went to bank loans and CL loans, it’s a little more predictable for the [themes] like special (inaudible) as we gave you example on the call, the investments we made earlier in 2011 and exited at attractive gain in December, a short holding period, but it wasn’t palatable during that period.

Lee Cooperman – Omega Advisers

And lastly on this question, and I have a third one, the $399 million of restricted cash, what has to happen to make that unrestricted?

Michael McFerran

That’s primarily cash just in the CLOs, Lee. So it’s either cash out for amortization or interest payments. Since we consolidate them, it’s an accounting convention.

Lee Cooperman – Omega Advisers

Right.

Michael McFerran

So that’s not cash that we can make unrestricted. Some of that eventually (inaudible) cash flow.

Lee Cooperman – Omega Advisers

Right, but you can reinvest some of that cash at a better return than it’s invested now.

Michael McFerran

The CLO 07-1 is an example, yes.

Lee Cooperman – Omega Advisers

Right. Okay. Finally, it’s my job in terms of figuring out what securities are worse, but I have such a high regard for you guys and you're so smart, and I say that -- I believe that by the way. You have a 16% return on one measure of earnings, $0.39, and then a 13% cash return on more conservative measure of $0.30. I'm trying to figure (inaudible) earn 13% to 16% on equity, it’s well-financed and well-managed (inaudible) premium to book value, not at discount. I'm just curious how you guys look at your valuation. I mean, [9 58] times [1 2], I don’t think a 20% premium to book for the job you guys are turning in and the opportunities that seem to be in front of you would be unreasonable.

Bill Sonneborn

Lee, I think there’s nothing wrong with your math. I mean we’ve generated 18% to 20% returns on capital on a GAAP basis, which is the traditional way, and then our cash-on-cash realization perspective is at kind of high-teens rate. And I think at some point the market will recognize that’s worth a measurable premium to book value.

Lee Cooperman – Omega Advisers

So my only comment in closing would be, keep that in mind. We don’t want to give away cheap stock.

Bill Sonneborn

You're consistent in that point of view. We appreciate it.

Lee Cooperman – Omega Advisers

Well. I’ve learned from the best. Thank you very much and thank you for doing such a fine job for us.

Bill Sonneborn

Thank you, Lee.

Operator

We’ll take a follow-up question from Jasper Burch.

Jasper Burch – Macquarie Capital

Hello again, gentlemen. Just from a little observation, there wasn’t on this, but I was just wondering, I mean we saw credit spreads tightening obviously, but I mean high yield and broader market defaults were up a bit in the fourth quarter. Can you just remind me, are those (inaudible) are those asset-specific or do you take general provisions? And if they are general, I mean is there a possibility that we could see some (inaudible) going forward?

Bill Sonneborn

Well, we generally have allowance to represent basically 3% of our loan portfolio. And so when you think about historically we’ve spent a lot of time looking at our own experience and the historical, general market rates of default and loss, what we have (inaudible) senior secured as well as portfolio on the corporate credit side, we hadn’t seen an additional provision, we calculate that from both the top down, looking at that 3% in individual asset by asset evaluation. And we do make specific reserve decisions on certain assets and then also have an unallocated general reserve, generally broadly against the portfolio based upon a number of risk input. And the sum total of both of those from the top-down and the bottom-up generates the existing reserve (inaudible) balance sheet. And as of the end of the year, we felt that our allowance was sufficient on all of those measures to cover what we know today as expected potential losses on our car loan portfolio.

Jasper Burch – Macquarie Capital

Okay. And then, I might be wrong, but I thought I remembered in the past quarter you had taken this specific loss and then you increased the general as you decreased that amount. How did that usually work when you do have a specific trouble asset? Do you keep the 3% on the remainder of the portfolio or do you just try and keep the 3% gross?

Michael McFerran

I mean we’re -- the 3%, where we’ve been running is not a number we’ll always sell for. Rather, to Bill’s point, we -- it’s a combination of top-down where we feel, based on historical loan default, let’s say you assume, [pick it], historically, 1% range, and even if you go up to 2%, and look at average severity which runs 20% to 25%, 3% net loss reserve gives you quite a bit of cushion on your current portfolio.

If there were specific situations that we were pushing more of that reserve towards, we’d be conscious of what we would call the general reserve on the rest of the portfolio and how sufficient was that. And that’s where we [solve it] through the bottoms-up or we’re very conscious of name by name analysis.

Jasper Burch – Macquarie Capital

Okay. That color is helpful.

Bill Sonneborn

We do generally focus on the greater of the top-down and the bottoms-up to make sure our allowance is sufficient.

Michael McFerran

Yeah.

Jasper Burch – Macquarie Capital

Excellent. Thank you.

Operator

And ladies and gentlemen, that’s all the time we have today for questions. I’ll turn the call back over to our presenters for any closing comments.

Bill Sonneborn

We thank you all for listening to us on the earnings call today. And we look forward to speaking with you in the ensuing quarters. Thank you very much.

Operator

Once again that does conclude today’s conference call. We thank you for your participation.

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