KKR Financial Corporation's CEO Discusses Second Quarter Results - Earnings Call Transcript

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 |  About: KKR (KKR)
by: SA Transcripts

KKR Financial Corporation (KFN) Q2 2012 Earnings Conference Call July 26, 2012 5:00 PM ET

Operator

Good day, everyone. Welcome to the KKR Financial Holdings, LLC second quarter 2012 earnings conference call. As a reminder, today's presentation is being recorded. At this time, I would like to turn the call over to Pam Testani. Please go ahead, ma'am.

Pam Testani

Thank you, (Doris), and thank you all for joining us for KKR Financial Holdings second quarter 2012 earnings call. I’m Pam Testani and I have recently joined the KFN team as Head of Investor Relations.

I've spent time with many of you in my prior role on the KKR IR team but for those of you I haven't met, I look forward to working together.

And Angela Yang, who has been working with our investors over the last year will be assuming some additional responsibilities related to KFN's SEC and investor reporting and I'd like to extend our thanks to her for contributing a great deal to building KFN's IR function.

With me this afternoon are Bill Sonneborn, our Chief Executive Officer and Michael McFerran, our Chief Operating and Financial Officer.

This call is being webcast and can be accessed at ir.kkr.com under the KKR Financial Holdings heading. A replay will be available later today. You can also find our second quarter supplemental information packet, which Bill and Mike will refer to during the call on the website.

We'd like to remind everyone that this call will contain forward-looking statements based on management's beliefs about KFN's operations and results as well as about general economic conditions.

These statements are subject to substantial uncertainties and risks that are described in greater detail, both on our supplement and our filings we've made with the SEC, which you can access on our website. KFN's actual results may vary materially from the views we express today.

In addition, some of our discussion will include references to non-GAAP financial measures. Information about these measures as well as their corresponding GAAP reconciliations can be found in the supplements.

And before we get started, we'd like to announce that we're holding our first investor day in New York on the morning of September 5th. This will be a half day event giving you a detailed look at KFN's investment strategies and the outlook for the business as a whole.

We'll put out a press release in mid-August with further details, including information on the live webcast so anyone interested can participate. And with that, I'll turn the call over to Bill.

Bill Sonneborn

Thank you, Pam, and thanks to all of you for joining our call today. As usual, I'll begin with some second quarter highlights then Mike will go over our financial results. I'll warp up with a review of the market and our outlook.

Today we announced that our board of directors declared a $0.21 cash distribution on all our common shares for the quarter. This represents a 17% increase over the regular distribution we paid in each of the last four quarters.

The distribution is payable on August 23rd to shareholders of record as of August 9th. Our net income for the second quarter was $71 million or $0.39 per diluted common share, reflecting a 16% return on equity. Our book value per share as of June 30th was $9.79, effectively flat from $9.81 at March 31st.

Looking at run rate cash earnings, we generated $0.32 per common share in second quarter, up from $0.26 in the first quarter. This implies a 13% cash ROE for the quarter. If you normalize for semi-annual coupon payment son our convertible notes, which reduce our first and third quarter cash earnings, we generated $0.30 per common share in Q2 compared to $0.29 per common share in Q1.

On the capital deployment front, we invested about $54 million to acquire $84 million of working interest in oil and gas properties. The $30 million difference was financed to our non-recourse natural resources credit facility.

In addition, we deployed $30 million to our royalties joint venture with Chesapeake Energy, which is discussed on Page 13 of our supplemental presentation.

Together, these bring aggregate capital deployment on our natural resources strategy to $84 million for the quarter.

We also deployed or committed to deploy about $40 million to our special situation strategy this quarter, which consisted primarily of investments in distressed European companies. Net of $25 million in realizations, our Q2 capital deployment to special situations is approximately $15 million.

We continued to source incremental investment capital by selling rated (trenches) we hold in our CLO subsidiaries. During the second quarter, we sold $18 million paramount of Class D notes from CLO 2007-1 resulting in net proceeds of $13 million.

In addition, we sold another $18 million paramount of these notes this week, generating an additional $14 million of proceeds. In total, we have generated nearly $60 million of cash proceeds this year by divesting these bonds, which have a stated cash coupon of LIBOR plus 2.25%, so effectively less than a 3% cash cost to the company.

Through these sales, we were able to extract lower yielding capital held in these CLOs and redeploy it to higher yielding opportunities elsewhere.

After the sale this week, we currently still hold 128 million of these bonds. I'll now turn it over to Mike for a more detailed review of this quarter's financial results. Mike?

Michael McFerran

Thanks, Bill. Good afternoon, everyone. Today we announced second quarter net income of $71 million or a $0.39 per diluted common share. This compares to $88 million or $0.48 per diluted common share for the first quarter.

Second quarter net income consisted of net investment income of $86 million, other income of $19 million and non-investment expenses of $34 million. Net investment income was up slightly from $84 million in the first quarter to $86 million in the second quarter if you back out last quarter's $46 million provision for our losses. We did not record a provision for loan loss this quarter.

Interest expense, including interest to affiliates, increased 3% from the first quarter to $55 million primarily because we accrued a full quarter of interest on the senior notes we issued at the end of March.

I should also note that $2 million of our second quarter interest expense was related to our 7% convertible notes, which matured to be paid in full this month.

Other income for the quarter totaled $19 million, helped by $18 million of realized and unrealized investment gains. These gains were mostly from sales of (inaudible) holdings and the full repayment at part of our approximately $200 million face value loan positions and (interglobal) solutions, which was held primarily through our CLO subsidiaries.

I'll move now to our performance by strategy, which is shown on Pages 19 and 20 of our supplemental presentation.

Our total return on equity for the second quarter was 16.4% while run rates return on equity was 15.9%. This run rate compares to 6.8% in Q1 as the Q1 figure reflected our provision for loan losses.

These measures quantified the performance of KFN's average net equity deployed to each of our strategies. The difference between them is that the run rate include (only) net investment income, which is more of a cash figure, while total ROE includes other income and losses like mark to market.

The differing nature of our strategies means that some are better measured by run rate performance and others by total rate of return.

For the second quarter, our bank loans and high yield strategies generated a run rate of return on equity of 31.5% and a total return on equity of 39.7%. This strategy, which is primarily executed through our CLO subsidiaries, represents 70% of our average net equity during the second quarter.

While gains and losses do impact the ultimately performance of this strategy, because of its high recurring cash yield components, this performance is best measured by run rate returns.

The strategy's run rate ROE includes $15 million of interest income and accelerated discount recognition n search and loan holdings repaid during the second quarter of which $9 million came from (interglobal).

If you exclude the prepayment related discount accretions, the run rate ROE would have still exceeded 25%. Our second largest strategy is natural resources, which represented just under 12% of our average net equity during the second quarter.

Here we generated a 16.2% run rate loss on equities and a 16.9% total loss on equity for the quarter. Run rate performance is more relevant to the strategy as well since returns largely come from recurring cash flow.

It was, however, negatively impacted by three factors during the quarter that I'll review for you. First, (the report) recognized an impairment charge of $3 million, a (inaudible) to the (inaudible) formation in Texas, the $9 million during the fourth quarter of 2010.

The impairment was caused by underperformance of these fields which currently represent less than 1% of our total (proven) reserves.

Second, we did incur $1 million of one-time expenses related to new acquisitions we completed during the second quarter. Third, our revenue performance is being impacted by current prices of natural gas and natural gas liquids, or NGLs.

While we hedged the majority of our production, our (unhedged) production, particularly NGLs was exposed to the 37% decline in NGL prices during the quarter.

Our special situations strategy, which represented 8% of our average net equity in the quarter, generated a modest 9.4% run rate and 9.9% total rate of return on equity.

This strategy sits in the middle of the spectrum in terms of generating run rate versus total returns. Generally we expect special situations to deliver a high single digit cash yield, we target a mid to high teens total return (inaudible) gains.

On a cumulative basis, we've more than achieved this performance to date. Through June 30th we've made special situations investments totaling over $300 million since the inception of the strategy.

Of this cost basis, over $85 million has been fully realized, generating an average IRR of approximately 40% and our unrealized investments had an IRR of 14% based on estimated market values at the end of the second quarter.

Our aggregate IRR through June 30th and the entire $300 million that's been invested through this strategy is approximately 21%.

Next I'll spend a minute on book value and liquidity. Book value declined $0.02 from March 31st to $9.79 per share at June 30th. This is attributable to a decline in other comprehensive income of $0.24 per share due to two components.

First, realization of gains during the quarter that were previously included out of accumulated and other comprehensive income and an $0.08 per share decline in the fair value of interest rate swaps that were designated as cash flow hedges of our trust preferred securities.

These swaps provide the benefit of converting the rate on our trust from (flooding) to our blended 3.8% fixed rate through the maturity dates in 2036 and 2037.

In terms of liquidity, Pro Forma for the recent $112 million repayment of our 7% converts this month, we had over $360 million of unrestricted cash on our balance sheet at the end of the second quarter. As we discussed last quarter, we believe this dry powder is a major asset in today's environment and being patient in deploying it is essential because the best time to have capital to invest is often the same time that it's hardest to obtain.

And I'll hand it back to Bill.

Bill Sonneborn

Thanks, Mike. The market seems to have registered, at least in part, that the economy is not quite out of the woods yet. The "risk-on" mentality we saw form the start of the year through the first half of Q2 reversed in May with the renewed focus on fiscal issues in the US and Europe and signs of slowdown in global growth, especially in China.

The result was a 2.75% drop in the S&P500 total return during the quarter. Credit market sentiment initially followed the weak performance in equities with high yield bond yields riding the five-month high of an early June.

But by the end of the quarter, leverage credit was ultimately resilient. On a total return basis, the Merrill Lynch High Yield Master 2 index gained about 1.8%. But the S&P (LSD) Leverage Loan index was up 75 basis points.

It's hardly surprising that credit indices outperformed equities during the quarter. Retail investors have kept up their search for yield in a world where rates don't seem to be increasing any time soon. And in fact, it appears global governments continue to rive rates lower to protect their economies and their currencies.

High yield net inflows hit $20 billion for the year to June 30 compared to $4 billion in the first half of last year and $16 billion for all of 2011 and we haven't seen that demand find an outlet in new supply lately.

New issue market hit its lowest monthly total of the year in June ending a quarter in which leveraged credit new issuance was down 27% from Q1. If the new issue market experiences its typical August slowdown, it's hard to see that correcting in Q3.

So what does this backdrop mean for KFN strategies? Well, let's start with credit. As a reminder, our credit business is executed through three strategies: bank loans and high yield, special situations and mezzanine.

For bank loans and high yield, this environment means a couple of things. In light of technicals, the market has been stable to somewhat outright (froggy) lately. This benefits the value of our current portfolio.

We also have the added value of an option on short-term rates through our asset sensitivity because of our exposure to floating rate bank loans. As shown on Page 26 of the supplemental presentation, we are long LIBOR by approximately $1.8 billion, which means that if three-month LIBOR increases by 300 basis points, we would expect a $0.15 per share increased in annual income.

We are cushioned by any decrease in short-term rates, if that's theoretically possible given where LIBOR is today because over 40% of our portfolio currently has LIBOR floors.

As Mike mentioned, we implement our bank loan and high-yield strategy primarily through CLOs. There are other forms of low-cost financing readily available today like total rate of return swaps or repo financing.

Because our objective is to play offense when markets are dislocated, we don't typically use these short-term market value-based financing sources. In fact, they got the company in trouble in 2008.

We don't want to be on our back foot having to manage liquidity and margin calls when prices decline. Instead, we want to be opportunistic during volatility deploying capital when supply-demand imbalances are the most prevalent.

This is why we favor cash flow CLO financing. It's driven much more by actual credit performance than by movements in market technicals that we cannot control.

The domestic CLO market has been quite active this year, hitting a four-year issuance high of $12 billion in the second quarter. With $18 billion of CLO issuance so far in 2012, we're well on the way to surpassing 2008 total volume of $23 billion.

In Europe, on the other hand, there hasn't been a single CLO transaction since the end of 2007 when the credit crisis began.

In light of this market receptivity, we'd like to issue more transactions over the next few years than we have in the last few. As for when and how, we're currently exploring syndicated US cash flow CLOs in addition to opportunities due to the first transaction in five years in Europe where if you can get something done, the current arbitrage between asset and debt spreads is quite attractive.

If conditions permit, our aim is to be back in the market with one or even both of these before year-end.

Moving to special situations, our strategy is focused on investing in primarily distressed investments stemming from dislocations in the capital markets. Today we're seeing opportunities around four key themes.

The first is obvious. It's European deleveraging. The second is global healthcare and the impacts that austerity measures, whether in the US, Canada or UK are having on reimbursements.

The third is the perception of slowing growth in Asia and the comment on impacts that may have on local markets and capital allocation. And the fourth is global energy in light of commodity price declines and the capital intensity of that specific industry.

As Mike referenced through June 30th, our inception to date asset level (NYSE:IRR)s in special situations is about 20% or nearly 40% if you look just at the investments we have fully realized so far.

In terms of mezzanine, the opportunity depends on the region. In the US high-yield in flows combined with lower levels of supply from M&A have enabled companies to get capital much more cheaply from the liquid markets or the high yield market or through highly competitive (NASDAQ:BBC) participation than the middle market.

While the US market seems less compelling today, we are seeing a robust pipeline abroad, especially in Europe given capital scarcity. Our recent investments reflect this dichotomy.

Our mezzanine portfolio today consists of eight investments and four issuers with an aggregate carrying value of north of $50 million. Of that carrying value, 93% represent investments in European businesses fortunately located in either the UK or Northern Europe.

Supplementing our financial asset exposure through credit are holding of real assets and cash. Approximately 12% of our net equity is allocated to real assets and 18% is allocated to cash. Why? Because in a world where printing presses hum 24/7 and central bank balance sheets continue to grow at multiples of what they were during the great depression, we believe real assets can protect shareholder returns against potential inflationary pressures. And the time to purchase them is when inflation is far from peoples' minds.

Throughout history, negative real yields have often produced inflation. The last similar period to what we're experiencing today was in the mid 1970s. In a world scary enough to force government to undertake such desperate behavior, we think our cash position is equally as wise.

Not only will it facilitate opportunism in the even of a significant short-term market shock like we experienced last August, it also hedges shareholder returns against the prospect of the opposite of inflation, an austerity-driven deflation over the next three years.

In the natural resources space, we continue to see a significant need for capital as the industry shifts its focus to unconventional assets. KFN is stepping into that supply-demand disconnect and particularly given low commodity prices and providing capital to facilitate both conventional and unconventional development.

And thanks to our managers' relationships and expertise in energy, we've been able to access differentiated returns in today's low-yield world.

Take our first royalty investment, for example. This is an investment we made in March 2011 for approximately $56 million. We've already received $20 million of our original investment back and we're generating north of a 20% cash on cash return even at today's low natural gas prices.

In addition to current yield, our natural resources strategy provides KFN's upside from two substantial embedded options. The first is on natural gas prices. We've been acquiring interest in these assets at a time when natural gas prices is relatively cheap and getting cheaper. And we continue to bring down our weighted average commodity price exposure to further investments.

As prices go up, we can earn materially more by developing currently untapped proven reserves and by not rolling over the hedges on our proved developed and producing reserves.

For a little more clarity on these different types of reserves, Page 9 of our supplement is a good resource.

The second option relates to inflation. Commodity spot prices tend to be closely correlated to inflation. So if we do see inflation pick up, it should be reflected in the prices we earned from selling the resource we continue to produce.

Finally, we continue to work on opportunities in commercial real estate. As with many KFN strategies, this is a space with a material supply-demand mismatch since most traditional providers of capital in the industry have a limited ability to play that role today.

It's also a space with embedded optionality, specifically as it relates to inflation in times of lower interest rates. So how does this all get weaved together and how do we think about where KFN is where it's going?

Sticking with the core tenants of capital deployment that we have discussed, today our portfolio reflects the following: first, deployment of capital across our targeted strategies to opportunities that we know and like; second, strong recurring earnings and cash flow generation, which supported the increase in our quarterly dividend from $0.18 to $0.21 for this quarter; third, a portfolio that balances high cash generating assets such as through our bank loans and high yield strategy with assets that provide attractive total return opportunities like special situation and private equity.

Fourth, a portfolio that reflects growing exposure to real assets, most notably through our natural resources holdings and the completion of our commercial real estate investment in the York Town Mall outside Chicago; fifth, a portfolio that has enabled us to capture valuable, embedded options, whether in short-term rates or corporate debt portfolio for longer-term rates and inflation to our real assets and to do so quite cheaply by acquiring underpriced assets across our strategies when everyone's running away from them.

And finally, all of these embedded options with a capital structure measured by both low net leverage and a long duration which can uniquely protect against the down side that has plagued financial service businesses for centuries.

Looking ahead, we are operating in a world where we expect volatility to persist, where the headline issues that have driven instability in the debt and equity markets since the Greek flash crash in May 2010 remain.

Having a portfolio that is producing strong earnings in cash flow without having any mark to market or short-term debt financing has us really well positioned with ample dry powder to continue work in a comprehensive pipeline of opportunities to grow value for our shareholders.

I'm pleased with our ability to capitalize in the environment we are operating in and I’m excited about the amazing team we have, what we are doing and where we are going.

Thank you all for taking the time to listen to our call today and both Mike and I appreciate your continued support and interest in KFN. With that, we can open it up for questions. (Doris), can you start Q&A?

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Your first question comes from the line of Stephen Laws – Deutsche Bank.

Stephen Laws – Deutsche Bank

A couple of questions, first, (pretty safe color) on Europe; just wanted to kind of – maybe if you could tell us a little bit more about what your evaluating or where you think the nearest term opportunities are as it is. Is it buying distressed assets? Is it buying performing assets but that are being sold by delivering financial institutions? Is it new originations? Kind of where do you see the best opportunity on a risk adjusted return basis over there in this environment?

Bill Sonneborn

It's a little bit of all of the above depending upon the situation, Stephen. But I'd say where we're focused predominantly is on the situation at the issuer level, so at the underlying company that is operating in Europe, particularly if that company has substantial operations and customers outside of Southern Europe.

They really are struggling to get access to credit and deal with the challenges that they face in terms of thinking about how they grow and expand their business because of the status of the overleveraged banks that are operating at 50% higher leverage than US banks.

And so as a result of that – and I'll give you an example of a situation we're working on. We're seeing very high expected rates of return by effectively working with the banks and underlying borrowers to solve some of their capital structure issues.

The Spanish company we're working with that has leveraged through around 5.5 times debt to EBITDA, its underlying banks are a group of Spanish banks that really want to get repaid to par. They don't want to sell the assets at a discount, which effectively would increase their leverage.

They want to get as much pay down at par as possible to meet their deleveraging targets. The company just needs access to credit to continue to grow. This company's operations are predominantly outside of Spain.

But ultimately the only want to solve both the company's issues and the bank's issues is to provide some second lien capital for warrants at a very high coupon to bridge the gap to pay down half the bank's exposure and to allow the company to continue to thrive.

So the more that we're finding these types of situations that are originating through relationships we've built in Europe over the last 15 years in the firm, the greater the opportunity we see.

And we see these priced at mid teens coupons, so we don't know when Europe will get better but we're happy to get paid mid teens while we wait. And to the extent we have warrants for equity upside, when and if that happens, we'll get added return above and beyond that.

Stephen Laws – Deutsche Bank

And I guess the follow-up, to the point of any, say, financial institutions selling, I would imagine they would be looking to kind of take their own leverage down. So should I read into that that they're probably not in a position where they'll provide seller financing to help you guys finance the purchase or are you looking other places for that if kind of the debt term financing markets kind of remain closed or less liquid?

Bill Sonneborn

That's right. So seller financing is very tough to do in Europe. And the challenge European banks are facing is if they're carrying value of a loan net of their loan allowance is 95 and that asset that they need to delever is worth 70, to sell it at 70 actually increases their effective leverage.

So they need effectively that asset to be purchased at something closer to 90 and that's difficult unless you can figure out what the underlying borrow how to effect a repayment of part of that bank's loan, extend the remaining part of the loan and get enough control rights to where you're coming in subordinate in the capital structure that you feel comfortable to sleep at night.

Stephen Laws – Deutsche Bank

One other quick question and I may have missed it in your commentary. I apologize if I did. But the natural resources, ROE, there's a page in here – I can't find it – Page 20 I believe it breaks it out by ROE by sector.

In the footnote it talks about reclassification of some general and administrative expenses to the natural resources component. Is that a one-time thing? Is that something where the cash flow is coming through another part of the – coming to you guys in another way? Or can you maybe talk about what we should think of as a targeted or normalized ROE for that natural resources investment category?

Michael McFerran

Our hope and intention is that it's not negative 16.2%. As we mention sort of our prepared remarks (we did attach on) (inaudible) lead to this (poorest) performance. So really three contributing factors; the first is that our initial acquisition in this space (done with) natural gas was around $5.

Back in December of 2010, we had purchased some acreage in the (Wilcox) formation in Texas. We did take a $3 million impairment this quarter on that acreage. While optimistic, it's still actually (on top) of a better outcome as our joint venture partner here recently took operating control, under the accounting rules it was impaired.

Second, we did have one-time charges during the quarter totaling just over $1 million related to the acquisitions we completed during the quarter. So as you recall, Stephen, we talked about on the past calls three periods where we actual complete acquisitions.

Under the accounting rules, we expense (really those) transaction costs. (Inaudible) can't capitalize (them). And third, as we complete acquisitions, there is a delay factor from the time you deploy the capital to actually start benefitting from the production. It usually runs anywhere from 30 to 90 days, so that was a contributor as well as the fact that energy prices were down this quarter, especially on natural gas liquids.

Bill Sonneborn

But the answer to the second part of your question is you typically were buying that portfolio of natural resources with the hiccup on the (forward) curve which we hedge the majority of our production, to somewhere in the range of an 8% to 9% immediate current yield and a 15% total expected return based upon the upward slope of the (forward) curve as we locked in that kind of positive slope, if you will, into the cash (inaudible).

Stephen Laws – Deutsche Bank

Yes, and then the comment about kind of a 60 day give or take, 30 lag time on kind of initial revenues off investment. Is that going to be consistent kind of across all natural resource investments or just the one specific to the second quarter?

Michael McFerran

That was where it relates (reacquiring) working and trusts where, frankly, it's a very operationally intensive business, so there is a time delay. So if the transaction is to be completed in the second quarter or closed in late May, so we normally realize a full quarter of benefit off those as we would expect we'll have going forward.

So there is a – that really is the nature of working in trust investments. It does differ depending on our strategy. We require royalties; it's fairly similar. If you – Bill made reference to the $56 million investment we made last year that's (inaudible) 20% cash return through which we've already received $20 million of our original investment back.

That's something where for the first couple months as we were drilling and the information delay (that's) on the property level up through the processing or time we receive cash, it then takes you back to 45 or 60 days.

Stephen Laws – Deutsche Bank

One last quick thing, I always like to hear you guys kind of talk about the dividend and clearly as a partnership structure you guys have a lot more flexibility that many other peers don't enjoy. And that's really (inaudible) the first portion of your earnings for new investments.

So can you talk about the pros and cons of how you set the dividend level? I know you typically target a roughly 60% payout given tax obligations of investors. But how do you balance increasing the dividend and how do you guys think about internally versus payout more versus retain earnings for increased growth?

Bill Sonneborn

Yes, that's a discussion that we have with the board every quarter and this particular quarter, if you looked at it on a cash net EPS basis, we paid out approximately 62% of cash earnings per share and retained 38% for additional deployment.

And over the last several quarters, you've seen that percentage – last year I guess you've seen that percentage creep up a little bit. We've been clear with investors that in periods where we can't find unique opportunities to reinvest capital at our target hurtle rates, which is mid teens expected return for investors, we will return more capital to shareholders either through increased distribution rates or other means, which could affect share repurchases.

And so right now that's not the case. But you've seen clearly we're sharing more of those profits real current period with shareholders, including the special distribution we made at the end of last year.

Operator

Your next question comes from the line of Lee Cooperman – Omega Advisors.

Lee Cooperman – Omega Advisors

And I have a few questions, a little bit – one off of the questions asked by the previous questioner. I think I recall, Bill, hearing you say that you never, ever want to be in a position you have to cut the dividend.

And of course, obviously, there's always going to be some unusual circumstances – I hope not – where that might happen. But I'm assuming that the $0.21 dividend was set because you believe it's sustainable based upon your current earnings. Is that a fair statement?

Bill Sonneborn

We have said on previous earnings calls exactly what you just regurgitated, Lee, which is our current plan and desire and hope that once a dividend is established it never has to be reduced. But obviously, as you suggest, that's reviewed every quarter by the board.

Lee Cooperman – Omega Advisors

Secondly, Mike mentioned $360 million of unrestricted cash. I think that was at June 30th. But the debt repayment you had I think it was July 15th, what is roughly the unrestricted cash now?

Michael McFerran

The $360 million was actually Pro Forma after that debt repayment.

Lee Cooperman – Omega Advisors

$350 million?

Michael McFerran

$360 million.

Lee Cooperman – Omega Advisors

Yes, so basically – I don't know whether you have a view of what minimum operating cash is. I've always been kind of more interested in earning power rather than earnings. Is it fair to assume we're seeing a $350 million earning near zero in a world that over time you're going to be able to invest that money at 12%, 13%, 14%?

Michael McFerran

Yes, (see it) exists. It's actual 20% of our net equity capital is earning zero today and the goal is to deploy that at the right time into mid teens earning assets.

Lee Cooperman – Omega Advisors

So basically we hit $0.30 in cash earnings, we retained 30%, we paid out 70%, so kind of a 16% ROE. You can grow the business at 5%, then we have a stock yielding 10% and yielding 10% is still with a fair amount of money that's not yet been employed. Is that one way of looking at it?

Michael McFerran

That's one way of looking at it.

Operator

Your next question comes from the line of Michael Sarcone – Sandler O'Neill

Michael Sarcone – Sandler O'Neill

First question, as it relates to the targeting of a US CLO before year-end, can you elaborate on specific characteristics, CLO characteristics that you'd be looking for? And by that I mean potential size of the CLO and would it be amortizing like 2011-1 or would it have more of a revolving collateral structure like your other CLOs?

Michael McFerran

Look, we mentioned there are two paths we're looking for future CLOs. As Bill said, we hope over the next few years to do more transactions than we've done in the last few, which consisted of one.

And we're looking at both Europe and the US. I think when it comes to Europe we'll have to be more creative than what the market is from a structure standpoint because there's nothing happening there.

In the US front, we like 2011-1 (inaudible) turn out to be 1.5 years past it; economically a very good deal for us (inaudible) options for that. It's a more conventional CLO market that you're seeing syndicated. It is also appealing to us at the right time.

The CLO market has been kind of rolling along this year. Recently we've seen kind of an anomaly of loan prices having appreciated over the last 30, 45 days while CLO spreads have (inaudible). You're again seeing a little bit of that net equity return compressed.

So I think what we're focused on is being in a position where the market's right. We can move quickly and put a deal out there and have those pieces in place. But as we've said in the past, we're definitely not going to do a deal for the sake of doing a deal (inaudible) when the time is right.

Bill Sonneborn

And creative.

Michael Sarcone – Sandler O'Neill

And so in terms of the European CLO, you said we haven't seen one completed in five years. Are you relying more on being creative to actually get that CLO done or have you been gauging investor interest and think there is some interest there?

Michael McFerran

We are definitely, I mean, we've made the comments that we're hoping to do something there. So we have thoughts in mind of how we would go about it but it is something creative recognizing (inaudible) is not a traditional market for CLOs (inaudible).

But (a means) in which we can, again leverage CLO technology to create an attractive structure allows us to benefit from (inaudible) arbitrage (inaudible) right or wrong spreads are potentially not as (inaudible).

Bill Sonneborn

And in the spirit, I mean, securitization markets broadly have been closed in Europe since the financial crisis, (inaudible) necessarily going to make (inaudible) problems a faster resolution.

Michael Sarcone – Sandler O'Neill

Then in terms of the G&A expenses, you guys mentioned you had around $1 million in costs related to natural resource acquisitions. Can you walk us through kind of the rest of the increase there?

Michael McFerran

There's a couple components. One, in addition to the $1 million was the $3 million of impairments, so you've got what I would call $4 million of one-time costs in G&A. In addition, what you also see flow through G&A will still be more color around when we file our 10-Q is increased costs related to the additional natural resource acquisitions we made, so specifically lease operating costs and (DD&A).

As we buy more assets we'll depreciate and deplete them and there will be costs of operating them. That all flows through G&A. So as far as what I would call G&A excluding natural resources business related expenses is fairly constant with what we've seen in the past quarters.

Operator

Your next question comes from the line of Daniel Furtado – Jefferies.

Daniel Furtado – Jefferies

The first question is just touching on the CLOs, when we think of the 2011-1 and you're thinking about a perspective deal over the relatively near term, is it safe to kind of assume similar leverage levels in a perspective deal as there was in 2011-1?

Michael McFerran

It depends on the structure. I think if you look – another structure like 2011-1 which doesn't have a reinvestment period and then there's roughly a media (prorata) amortization or principal return (inaudible) residual order as senior lender, (inaudible) we have similar leverage characteristics.

More traditional US CLOs would have higher leverage comparable to what we see in the market today. So I would say whereas 11-1 structures guide around three terms, I'd expect more conventional syndicated deal to be around five.

Daniel Furtado - Jefferies

And just would that more conventional syndicated deal be more attractive to you because of that leverage level?

Bill Sonneborn

Not really because the CLO 2011-1 structure, which we drive and finally negotiated, and so it's not subject to rating agency and other (inaudible), permits us a lot of flexibility to create something that drives and locks in a very high cash on cash (IRR) for the life of the transaction.

Traditional marketed CLO that's rated and issued in the context of securities in a more broad distribution has other advantages but also (gets) advantages which is your trading reinvestment opportunity and higher leverage for the fact that you're locking in liability costs in a non-call period that can turn you upside down.

So we look at those very uniquely and differently to the extent that we can get a higher risk adjusted return for one versus the other, we'll pursue.

Daniel Furtado - Jefferies

Then just how do – if you can help me understand, how do you think about selling mezz pieces out of your CLOs today versus just using the cash that's on your balance sheet?

Michael McFerrance

As we've said the last couple quarters, the best time to extract capital from those deals is going to be when credit spreads are tighter, which is what you're seeing today and what you've seen for the last few quarters and where we're able to actually extract cash out of those CLOs that we generated on a 3% cash yield.

The times where we're going to most want that capital is when spreads are wider and those opportunities to divest in those low-yielding assets won't be available.

Daniel Furtado - Jefferies

So I guess by extension, continued tightness in spreads should lead you to opportunistically sell additional mezz pieces.

Michael McFerran

Yes, I mean, look, we've raised almost $60 million since the beginning of the year doing this, so we're going to take – we've got almost $60 million in capital. Those are earnings sub 3% cash and we believe – we apply that hopefully at a much higher rate of return at a much higher cash yield.

Again, it goes to the benefit of wanting to have cash on the balance sheet to be opportunistic about it.

Bill Sonneborn

Yes, we're borrowing money, as Mike suggested, at a 3% cash interest cost where we did a couple of bond deals at the end of last year, beginning of this year where we're paying in kind of 7.5% cash cost. So it's a cheaper form, effectively, of borrowing money for the company for capital redeployment for the next down cycle.

Operator

Your next question comes from the line of Gabe Poggi – FBR.

Gabe Poggi – FBR

I wanted just to ask you a kind of 20,000 foot question about Europe, Bill, and thanks for the additional disclosure in the supplemental and your comments. A lot of investors talk about doing things in Europe. You guys are actually doing it or talking about doing additional kind of creative structures a la CLO, etc cetera.

Can you just give me a general sense of kind of what the competitive landscape is for you? I know you're leveraging the whole KKR platform but, again, there's so many people that talk about the "interesting opportunities in Europe." You guys are doing it, generating new ROEs.

I just wanted to kind of get a gauge of how many other folks you come up against and is it really kind of you're out there and you get to be a cherry picker, so to speak, if you get comfortable with the issuer and then in the example you gave, working with the banks, etc cetera?

Bill Sonneborn

The manager at KFN has a unique benefit because it is a lot of people there setting up in shop in Europe, Gabe. But (take care) has been there for 15 years. We're the longest standing places building relationships with companies across all markets. We have country heads. We have relationships with lots of corporates around the region. We have existing portfolio companies that have relationships in the region, senior advisors that are ex-CEOs of companies in the region.

And because of the duration of the time that we, as a firm, have been there and the cumulative body of expertise and knowledge that the manager has developed, we feel like we're uniquely positioned to source proprietary investments and transactions that provide very interesting return profiles at a moderate amount of risk.

And so that, I think, while there is a lot of people moving into Europe to try to focus on these opportunities, if you haven't been there for a long time, it's going to be hard to find them.

And a lot of them are focusing on waiting for the banks to call and auction off assets. As you see, we've never participated in an auction that has occurred for many of the banks disposing assets. The reason being is those are being priced to perfect (with broad) options.

And we're finding a lot better risk adjusted returns privately negotiated one-off situations as opposed to participating in broad asset disposition auctions.

Operator

Your next question comes from the line of Wayne Cooperman – Cobalt Capital.

Wayne Cooperman – Cobalt Capital

Just a question, I saw KKR the other day announced they were going to raise some equity in debt funds from the retail investors and – I don't know – it just seems like you guys keep getting in each others' businesses more and more.

And I just wondered if you could comment on that – on what they're doing and how that affects your interaction with them over time.

Bill Sonneborn

Yes, as you probably know, you can find the filings on file with the SEC. Two fun products were filed recently with the SEC. Those clearly are not effective, so it's in the quiet period.

But what KFN does and focuses on which is long duration investments in credit are very different than what (inaudible). They're very different than what they're going to be doing.

I think one of the funds if you look at on file is daily price, daily liquidity, high yield fund. That's pretty different than using CLOs and investing in credit mezzanine transactions.

Wayne Cooperman – Cobalt Capital

Do you guys have any sort of agreement or a way of dealing with conflicts?

Bill Sonneborn

We do have a lot of process to deal with conflicts, yes.

Wayne Cooperman – Cobalt Capital

So are they prohibited from doing things that you do? Or just maybe you could elaborate just a little bit.

Bill Sonneborn

Just to remind you, KFN is expertly managed by KKR and so in the context of the management of KFN, everything at KKR is designed to focus on making sure that as a fiduciary to KFN we're using all of our efforts to do the right thing.

And ultimately, the independent directors and the employee transactions committee of the board oversees all of those conflicts, mitigation policies that have been put in place.

Wayne Cooperman – Cobalt Capital

Are you guys satisfied with how that's working out?

Bill Sonneborn

Very much so.

Operator

Your next question comes from the line of Jason Stewart – Compass Point.

Jason Stewart – Compass Point

It relates to the dividend and the increase in distribution. It seems like the distribution increased more on a percentage basis than run rate cash earnings and I just wanted to get a little bit more color around your thought process there and how much related to current earnings versus your expectation for future earnings and just your thoughts and discussions around those two points.

Bill Sonneborn

I think if you look back, Jason, we've gone four now consecutive quarters without a distribution increase and then a 17% increase in the distribution per share here for the second quarter.

The factors and circumstances of the board now includes, now includes the previous quarter's performance in current market conditions but also restrictions in the company's borrowing agreements and expectations of the ability, as we talked about with Lee Cooperman's question to meet that distribution in the future.

Operator

And at this time, there are no further questions in the queue. I'll turn the call back to our speakers for any closing or additional remarks.

Pam Testani

No additional remarks at this point I don't think.

Bill Sonneborn

Thank you all very much. We'll get back to work. I hope you enjoy the rest of your summer.

Operator

And ladies and gentlemen, that does conclude today's presentation. We thank you for your participation.

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