KKR's New Debt: Barbarian Baby Bonds

Apr.13.12 | About: KKR (KKR)

I recently wrote an article on MFA Financial's (MFA) 8% 30-year debt (which I viewed as a good swap for the preferred holders) and in one of the comments, I was asked what I thought of KFN's new debt issue. I saw the deal when it was announced, but had too much on my plate to get into the details. When the commenter asked my opinion of the deal, however, I pushed a couple things to the side and decided to look at the barbarians at the gate (or perhaps better put, son of barbarians at the gate).

The Deal (prospectus):

Issuer: KKR Financial Holdings LLC.

Coupon: 7.50%

Listing: Listed on the NYSE as (KFI)

Ranking: Senior Unsecured

Par: $25.00

Issue Size: $100,000,000 ($115MM w/ greenshoe)

Maturity: March 20, 2042

Optional Redemption: On or after March 20, 2017 (at par)

Interest Payments: Payable quarterly 3/20, 6/20, 9/20 and 12/20

Covenants (emphasis mine):

  • Change of control: If a Change of Control Repurchase Event occurs, unless KFN has exercised its option to redeem the Notes, they will make an offer to each holder of Notes to repurchase all or any part of that holder's Notes at a repurchase price of 101% plus any accrued and unpaid interest. "Change of Control Repurchase Event" means the occurrence of a Change of Control and a Below Investment Grade Rating Event (below investment grade by both agencies).
  • Limitation on liens: KFN will not create, assume, incur or guarantee any indebtedness for money borrowed that is secured by a pledge, mortgage, lien or other encumbrance (other than Permitted Liens) on any voting stock or profit participating equity interests of their Subsidiaries without making these notes equally and ratably secured. This covenant will not limit our ability to incur indebtedness or other obligations secured by liens on assets other than the voting stock or profit participating equity interests of our Subsidiaries.
  • Consolidation, Merger and Sale of Assets: KFN will not be party to a Substantially All Merger or participate in a Substantially All Sale, unless: They are the surviving Person, or the Successor Party is an entity organized and existing under the laws of the United States of America, any state thereof or the District of Columbia and has expressly assumed by supplemental indenture all of our obligations under the Notes and the Indenture; and there is no event of default.

I view the covenants as weak, as they can lien all assets with the exception of voting stock or profit participating equity interests of their subs. Why is this weak? Their subsidiaries can secure everything and, in the event of bankruptcy or distress, wipe out any equity value. The consolidation, merger and sale of assets is your typical investment grade "no teeth" covenant. Just set up an LLC in Delaware, buy the assets, assume the obligations and the deal is done - this is only protected by the 101% COC if the entity is below investment grade. Yes, these are somewhat typical IG covenants, with the exception of the "we can secure everything including the kitchen sink, just not the equity" covenant. Not a fan.

The Company:

KKR& Co. L.P. (KFN), is a specialty finance company with expertise in a range of asset classes. The core business strategy is to leverage the proprietary resources of their manager with the objective of generating both current income and capital appreciation by deploying capital to their strategies, which include bank loans and high yield securities, natural resources, special situations, mezzanine, commercial real estate and private equity. KKR's holdings across these strategies primarily consist of leveraged loans, high yield debt securities, private equity and working and royalty interests in oil and gas properties.

The majority of the holdings consist of corporate loans and high yield debt securities held in collateralized loan obligation ("CLO") transactions that are structured as on-balance sheet securitizations and are used as long term financing for their investments in corporate debt. The senior secured debt issued by the CLO transactions is primarily owned by unaffiliated third party investors and the company owns the majority of the subordinated notes in the CLO transactions.

KFN operates its business through two reportable business segments, which are credit and other segments. The credit segment includes primarily below investment grade corporate debt. The other segments include all other portfolio holdings, including oil and natural gas working interests and overriding royalty interests.

KFN is externally managed and advised by KKR Financial Advisors LLC, a wholly-owned subsidiary of KKR Asset Management LLC ("KAM") which is a wholly-owned subsidiary of Kohlberg Kravis Roberts & Co. L.P. (NYSE:KKR).

Perhaps the best way to understand the company's "product" or investments is to understand the basics of a CLO structure. While many might think these vehicles are somewhat esoteric, they are simpler than you would think. Think of a bank's balance sheet, with loans and investments as assets, deposits, wholesale funding, debt and notes as liabilities and equity. Now let's look at a simplified CLO structure (they can get complicated in the slicing and dicing, but the model is the same):

Click to enlarge

Source: Me.

Note how the majority of the deal is the AAA tranche. This allows the funding arbitrage to occur - invest at $400MM at 8%, sell $250MM at 4% the difference goes to support the sub-tranches and the equity. At the same time, when there are defaults, the equity gets eaten up, then the subs - this supports the senior tranche and helps it get those AAA ratings. This is why so many people got on this train at one point - the sub-tranches and equity tranche can be lucrative.

A great guide to cash flow collateralized debt obligations can be found here.

One of my greatest concerns with KFN is the self-liquidating nature of the company's assets (and hence liabilities). Consider the following:

KFN has six CLO transactions outstanding:

  1. KKR Financial CLO 2005-1, Ltd. ("CLO 2005-1"),
  2. KKR Financial CLO 2005-2, Ltd. ("CLO 2005-2"),
  3. KKR Financial CLO 2006-1, Ltd. ("CLO 2006-1"),
  4. KKR Financial CLO 2007-1, Ltd. ("CLO 2007-1"),
  5. KKR Financial CLO 2007-A, Ltd. ("CLO 2007-A"), and
  6. KKR Financial CLO 2011-1, Ltd. ("CLO 2011-1")

It is their investment in the mezzanine and equity portions of these CLO's that form the foundation of their financials. Yet, as disclosed in the financial statements, these assets are (or shortly will be) running off. From their 10-K (emphasis mine):

Our CLOs generally have periods during which, subject to certain restrictions, their managers can sell or buy assets at their discretion and can reinvest principal proceeds into new assets, commonly referred to as a "reinvestment period." Outside of a reinvestment period, the principal proceeds from the assets held in the CLO must generally be used to pay down the related CLO's debt, which causes the leverage on the CLO to decrease. Such leverage decreases may cause our return on investment to be lower. In addition, in the past the ability to reinvest has been important in maintaining compliance with the overcollateralization and interest coverage tests for certain of our CLOs. Outside of a reinvestment period, our ability to maintain compliance with such tests for that CLO may be negatively impacted. The reinvestment periods for CLO 2005-1, CLO 2005-2 and CLO 2007-A have ended and the reinvestment periods for CLO 2006-1 and CLO 2007-1 will end in August 2012 and May 2014, respectively.

Unless the company can create new CLOs to replace those that will be unwinding, the returns to the company from a significant portion of their assets will be diminishing. Fortunately, the market for structured product has been increasing, but at a slower pace (and lower risk to senior tranches) than was historically the case. This, in addition to increasing defaults (which are expected from our current low default level), could inhibit revenue/income growth and therefore the health of the company.

While the company was able to issue $600 million of CLO-2011-1, the market for CLOs is not picking up as fast as many (including myself) would have hoped. I am concerned about the market for their product and their potential need to switch gears and strategies to accommodate a changing market. While I have no doubt there are very talented managers at KKR, I would be more inclined to buy best in breed in the oil and gas space (if I have to deal with a K1, it had better count).

Bottom line: KKR Financial Holdings has a talented manager and a decent product, but the composition of assets is changing and the primary focus of the firm is slowly unwinding. Due to these factors, I am not a buyer of their debt unless or until their direction and business model can be ascertained.

For what it is worth, similar baby bonds - KKR Financial Holdings LLC 8.375% Senior Notes due 2041 (KFH) - currently trade at $26.31 which is a yield of approximately 7.95%. If I was a buyer, care to guess which one I am buying? I will sell one year of call protection for 45bps (actually more as KFI is at a premium to par).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.