KKR Financial Holdings LLC (KFN) Analyst Day Call September 5, 2012 8:30 AM ET
Good morning everyone. You can all take a seat. We're going to get started here in just a minute. Thank you for joining us today. I am Pam Testani, Head of IR for KFN and before we get underway with our first Investor Day here, I just want to touch on our legal disclosures for a minute. You have the fine print in your books, but as a quick reminder, today's remarks will contain forward-looking statements which don't guarantee future events or performance.
Please have a look at these pages for all of the legal disclosures related to the presentations this morning and with that, I would like to hand things over to Henry Kravis, Co-founder, Co-Chairman and Co-CEO of KKR.
Pam. Thank you very much and welcome all of you to our first KFN Investor Day. This is an important event for all of us at KFN and certainly at KKR. So I thank you very much for being here and I hope that when you finish this morning's series of presentations, you come away with a very good feeling about the depth and quality of what we have at KFN and one thing I want to make very clear to all of you. It's important that you understand KFN is an extremely valuable asset to KKR. This is not some island subsidiary that doesn't really matter to us. It matters a lot. It is an integral part of what we do at KKR.
You're going to hear a lot today about our strategy at KFN. You're going to hear a lot today about our strategy at KFN, you are going to hear about the results and the businesses that we're in, but before you do let me just gave you a couple of reasons why I think that KFN is so important to KKR. First without a doubt, KFN is the public face to KKR and so many of the strategies across our firm, particularly everything that we do is touched on and plays an important role at KFN.
It's a flagship of our capabilities and bank loans high yield, mezzanine special situations, natural resources and commercial real estate and you're going to hear from all the people that are part of KFN and part of KKR that cover these areas you'll hear about those today. And the one thing I also want you not to forget. If you have any doubts about how important it is to George Roberts and to myself and KFN, our name is on the door. And we put our name on the KFN door just as we have it on the KKR door for a reason and that's because we believe in it and we believe that this has an incredible future and a real opportunity to grow and to take advantage of the number of the dislocations in markets.
And as we stress to all employees at KKR, which they are a little lower 900 employees today that we believe that people do business with people that they like and that they trust. Well, there is nothing really any different as far as what working the way we think for KFN. We want you to trust us and the way you are going to trust us is that we're going to give you the best results. And we're going always be straight forward with you, we will tell the good, we will tell with the bad. But we are going to give you the straight results.
And that means that earning that trust means delivering to all of you at investors at KFN. And another reason that KFN is so important to all of us is we believe that we have created something pretty unique at KFN and the world of specialty finance companies. We are not a franchise business, but rather we are people, the people at KFN who manage these different businesses are also very much the same people, the same investment people at KKR.
We are one and we worked very well together. So we have complete attention at KFN of all the people at KKR. Now the one thing you also have to understand any of you that have come to the KKR Investor Day have to understand one of things we like to talk about a lot is the one firm concept. And that one firm concept is very important and that means that the people that KFN get all of the ideas that we have across a broader ray of products across KKR, not just in the US, not just in Europe, not just in Asia but globally and people help each other, work together and so you are getting that opportunity.
We have over 400 investment professionals around the world and you will be surprised how many ideas actually percolate up from some other part of KKR. It could be an idea that's coming out of Asia that has nothing to do with KFN directly, but they find an idea and the way our compensation system works overall, they are incentivized to bring those ideas to KFN or to anybody else for that matter, but the focus is on how can they help KFN.
We don't believe that there is any other $1.6 billion mid caps specialty finance company with a sourcing engine like we have and it's because of this one firm, it is because of the way we operate in working together. We are focused today at KFN, you are going to hear a lot about this. If on areas of really capital imbalances, supply demand imbalances that take place and that's where we think you find the most important and the most interesting ideas.
You don't just necessarily follow a macro trend, but fine is there is an imbalance, is there a dislocation in a capital market that we can take advantage of by doing the kind of in depth work that the people at KFN do and over and over again we find numerous opportunities in the whole area of capital imbalances.
The good thing about it also as the world is becoming more and more global, we almost don't care where those ideas come from. If it is a good idea, get on a plane, we are going to go find it and work on it and we have people that can certainly help. So in short, all of us at KKR all of us at KFN are focused on one thing.
And that is to get you the best returns that we possibly can by deploying capital where we have the highest conviction that those are the areas for good returns that you are going to hear today for example us talk about our commercial real estate opportunities, you are going to hear us talk about our commercial real estate opportunities. You're going to hear us talk about our natural resources, our special situations, our high yield and our other areas and these are areas that we are very high on at KFN and also very high on at KKR.
So, I am going to turn it over to my partner, Bill Sonneborn, but before I do, let me just tell you how proud that George Roberts and I are of this team. The team is an incredible team and headed by Bill Sonneborn, Mike McFerran, you're going to hear from today, Fred Goltz, you will also hear from today and people that are on the trading desk.
We have created an incredible team of people that have developed awfully good record and we're going to continue focusing on that. We're going to continue doing everything we can to make sure that record stays intact. So with that, let me turn it over to my partner, Bill Sonneborn.
Good morning everyone. I am Bill Sonneborn, CEO of KKR Financial and welcome to KKR Financials' first ever Investor Day, something we should have done many years ago.
Today we're going to focus across all of the spectrums that Henry mentioned. Starting with an overview that I'll provide, we'll move quickly to a macro backdrop where an independent thinker, Henry McVey, who is our Global Head of Asset Allocation and Macro, will provide some insights into what he sees from both proprietary data sources, public data sources and meetings with policymakers that he has on a global basis, then [forums] how we think about capital allocation and a search for the supply and demand imbalances that Henry mentioned.
Following Henry's presentation, we will turn it to Fred Goltz. He is the Global Head of KKR Credit Strategies, responsibility for everything we do in bank loans and high yield that we typically finance through CLO's to more privately originated transactions like mezzanine as well as opportunities in global distress in our special situations strategy.
Following Fred, Marc Lipschultz, he is a Global Head of Energy and Infrastructure. We'll talk about some the supply demand imbalances we found over the course of the past several years in the energy space.
And why that fits in the contacts to the specialty finance model. Following Marc's presentation as we continue in this real asset [theme] combined with our financial asset exposure, Ralph Rosenberg who is our Global Head of Real Estate at the firm. We'll talk about why real estate now.
But we have been patiently thinking about when is the right time following the financial crisis for the best opportunities in commercial real estate? And we think that supply demand imbalances very attractive in investor's favor.
Following a break, Mike McFerran partner in managing KFN will do deep dive into the financial results that we've achieved over the last several years make you understand the simplistic way of what may appeared to be a complex business how to model it to understand the predictability of the cash flows and the returns. As well as provide some summaries on our CLO's strategy going forward. I'll do a closing and then we'll have the whole team upon on the stage to commit any Q&A from the audience.
Before we start to think about KFN and where it is today and where it's going, it helps to understand its past. And I was thinking you know flying over from Europe to New York yesterday, a little bit about where KFN has been and I remember 4.5 years ago when I was in a meeting when Henry Kravis's office here in New York, I saw a sign he had in his office. It said arrogance kills.
I remembered that sign then I flew back to the West Coast after that meeting and I was greeted at the door of my house with my wife, she said you have to talk to your son, he did that thing again. I can't remember what that thing was but it probably involved beating up his little sister.
So I went upstairs and sat on the bed of my son and I asked him what had happened and he said, well daddy because I know you and mommy say don't make the same mistake twice, but I have a big problem, I forget that I make the mistake, can you help me think of a process so I can record and remember when I make mistakes. So I don't do them again.
And so the story of Henry Kravis and the sign in his office and a lesson my son taught me, all really implies a little bit in the context to the history of KFN. We started out in 2004 as a mortgage, it was a corporate structure that allowed us to focus on building our leverage credit capabilities and bank loans and high yield using [CLOs] as financing source, but the problem was that a lot of our assets were in the residential mortgages which we did not have a concrete expertise at the firm, it's lesson number one.
In 2007 with the beginning of the financial crisis, we are smart in the context to [de-reading], we sold majority of those [real] assets and converted to a publicly traded partnership, and then exclusively focused on things that we could know and understand related to corporate credit.
That time we had to a lot of work on the right hand side of the balance sheet because we had a lot of market value leverage, total rates, returns, swap, market value, CLO structures and so we were trying to deal with that mismatch aspect of mismatch duration between assets and liabilities, that was cleaned up in 2009 and from 2010 onward it's a new strategy.
Liabilities they are always in excess of length of the underlying assets in which we purchase. It's thinking about where the greatest supply demand and balances are globally and it's thinking about how we maximize individual investment returns using the KKR network to drive value creation, and it's thinking about what we are today which is the same thing we were three years ago. We are and will be a specialty finance company but we are focused not just on income like a lot of specialty finance companies that you may all follow, not just yield, we want growth.
We want that yield to grow, we want our earnings to grow, our cash earnings to grow, our book value to grow and we are targeting returns of 1000 basis points in excess of the 10 year treasury on a consist basis similar to what we have been able to achieve in the past several years.
And we don't want to be fixed in how we think about capital deployment. We want to be opportunistic and tactical. Right now we have focus on two core investment themes, financial assets in a broad sense and real assets.
Financial assets which is really the core of what we have done and we'll continue to do in bank loans, high yield and mezzanine and global distressed leveraging our credit teams in New York, San Francisco and Europe and real assets which is concrete points in natural resources in the energy space and commercial real estate probably we can add value and we combine that all together and leveraging the firms' intellect and in this one firm brain that Henry mentioned, we can create even further value for investors.
I am going to talk a little bit these two core investment themes because they are not truly something that investors and finance companies typically see. Including the left hand side of the slide you see in front of you is relatively typical focus on lending high yield bonds, term finance in the context of the structure so that we don't have market-to-market leverage, moving down to more direct originated credit like your mezzanine in U.S. or Europe, which we can capture in a liquidity risk premium above and beyond what regular credit markets provide.
And there are times tactically, when you want to move up in to the capital structures of businesses and hold that senior secured loan and finance it with low cost term liabilities and there are times when that liquidity risk premium is very, very high and you can get equal expected returns as you can in senior secured credit levered in a CLO. And we want to take advantage of those opportunities and then generally, virtually somewhere in the world there's some sort of stress and our global special situations capability has been built to find those places of distress, leveraging the same diligent framework of the firm and pursue those opportunities.
On the right hand side of page is, some of the new things that we thought about. We thought about how financial assets and real assets play together to create negative correlation in terms of outcomes, improve effectively the risk of the overall business and help drive consistent cash flow in returns. And natural resources we referred to mid and upstream oil and natural gas assets predominantly. We're targeting similar mid-teens returns and a similar profile opportunistically focused on real estate entry points either through debt or equity predominantly in North America and Europe.
What you see on that previous slide is a large allocation to private equity. We've done some, we'll continue to do some, but it'll always be a small part of our capital allocation. We like the option value and the capabilities, of our private equity team but we're really focused on those key themes of predictable cash flow production and total return.
I talked about not being static and thinking about how we allocate capital. We want to pit it opportunistically. There's times when energy is really attractive relative to credit and there's timed when commercial real estate is really attractive relative to mezzanine. And we think constantly about where is the best place to be in the context of generating those risks adjusted returns and really in the process of the exploiting supply demand imbalances.
Credit markets in different aspects get unbalanced that we pursue opportunities similarly different parts of the commodities chain in the context to natural resources appear to be more interesting at different points in the cycle.
If you look at the right hand side of the slide this is a very simplistic depiction. Just shows some macro variables and when some of these assets classes likely would come in or out of favor this does not reflect actual market dependencies, which means that market prices can not necessary reflect what the market Marco environment is.
And really what the market's telling you is more important than what the macro environment is from perspective you can see like in a healthy economy we'd rather be very senior secured in the context of credit using CLOs, likely credit spreads on the liability side or very tight, we want to lock in on that options.
Similarly in a difficult to troubled economy, real estate likely becomes even a more attractive assets class there's global distressed opportunities to rescue finance through restructurings and likely capital markets will be disrupted and more frequent periods that creates opportunities to just intermediate the high yield market with private mezzanine solutions.
But above and beyond all the three key things to take from how we think about allocating capital regardless of the economic environment is what we target. We want market agnostic consistent cash yield. We're driving cash earnings today of roughly 12% return on capital, total return on equity of 16% this past quarter, but we want to do that by reducing the cyclicality that normally affects financial services firms.
We want o cut the mountain tops off and fill in the valleys so the predictability not only of our cash on cash returns but also our total rate of return goes up. But we would also don't just want to be a (inaudible) yield vehicles I mentioned before, we want opportunities for capital appreciation, substantial opportunities for capital appreciation, many of which we don't pay for through options.
Want to talk about the business of KFN and collecting embedded miss-priced or free options. For example in our CLO strategy, where we lock in low-cost liabilities in periods of tight credit spreads. That allows today to participate any increase we have a free option in participating and having cash earnings and distribution growth if any increase in short-term rates LIBOR goes up by 100, we're going to start participating in any incremental increases in short-term rates.
We also want to be protected in terms of our cash flow by rising long-term rates because we're targeting returns above a 10 year treasury real assets with a much a longer duration in the context of thinking about where they fit on the interest rate curve in terms of sensitivity help protect some of our cash flows on that longer end of the curve.
Natural resources and real estate, likely appreciate in an inflationary environment. There's lots of other options we collect, warrants on a specific investment, we may have done in mezzanine or a rescue finance transaction, there is multiple options we have collected in natural gas, which aren't reflected on this slide and Marc will talk about them many of which we didn't pay for. Not just the option if natural gas rises our natural gas cash flows from our investments will increase but reserves we never paid for because they were uneconomic at current natural gas prices.
All of a sudden can become economic if natural gas prices rise to say $5 or $6. We didn't pay for those reserves but all of a sudden they become reserves that are developable, if and when natural gas prices rise this, just a example of some of the collection.
The other option we have is cash. 20% of our net equity today is in cash, so what? Why is it there, on one hand short term we're kind of worried little bit about deflation, you know global CPI continues to come down there's no better asset for us to hold, if we're worried about deflation than cash to protect shareholders interest, but then cash also has option value in the event of the market downturn not just a 2008 like catastrophic, event but on August 2011, trade down over concerns in Europe, May 2011 create opportunities for us to deploy that cash very quickly at a very attractive rates of return, that will increase our cash flow and increase the capital appreciation.
we also have a very low risk balance sheet, low leverage, not only we have low leverage, but our existing recourse holding company leverage has a weighted average maturity of 23 years that's way beyond the duration of any single investment we have, multiples of beyond the duration of expected hold of any investment. That also allows us to take these embedded options and maximize their value. We have 23 years of life to figure out when those options hit the money, we're not sure when, necessarily all these options, we're going [go in] the money and drive capital appreciation, well sure pretty good if we have 23 years. We're going to collect a lot of value for shareholders.
We talked a lot about KFN being very unique as a specialty finance business. It's flexible. As a publicly traded partnership, it is not limited like a BDC to investing in specific types of assets and a specific geography like the United States. We can be global, if credit is more interesting in Europe than the US we go there. If credit is more interesting in Asia than Europe, we can go there.
In addition, we're not required by statute to distribute a 100% of our cash earnings like BDCs or REITs typically are or MLPs. We can retain cash. If see opportunities to reinvest it at a very attractive rate of return that's accretive for shareholders. We can distribute it if that in our view is the best outcome because no available investments are attractive, but we can't retain it and that allows us to grow and create that total rate of return in capital appreciation upside for shareholders above a [capitated] yield play.
And Henry mentioned the one firm culture of KKR. KFN benefits from a massive amount of resources that KKR brings to it. Its unique investments that are sourced by the firm on a global basis, its diligence capabilities to help us avoid mistakes on a specific credit or an investment and allows us to get macro insights until thinking about what's going on in the world and how it impacts an investment or how we strategically allocate capital.
We're going to talk about that in a little bit more.
Henry mentioned the importance of KFN and KKR. Yes KKR benefits if KFN performs well financially because of the incentive fee structure and an external managed arrangement, but more importantly as Henry mention KFN is a public flagship of everything we are doing at the firm. Our credit business, bank loans, high yield mezzanine and special situations how that performs matters a lot to KKR and this is in a very public forum. Similar in nature resources and our energy capabilities and commercial real estate, how that performs matters a lot.
And the one firm culture of the firm with an incentive system aligned, to align those individuals with the success of KFN means that we get the power of 450 KKR executives. 80 portfolio companies around the world that we can access for data or diligence subject to our compliance policies and procedures to make sure we are making informed decision. We get a first look relationships through our relationships with major Wall Street firms. We get access to opportunities that are proprietary and unique just because of the presence of the firm around the world in 10 countries.
And above and beyond in addition to all that investment, talent and capability we get macro research, risk management resources, the operational expertise of KKR Capstone. Let me give you two examples, one just recent. We're looking at a credit investment in a consumer products business a couple weeks ago. We're trying to understand whether this business had a bullish future or you know was questionable on the context of a fad. We're able within a day to talk to one of our directors, he's the president of a major retailer to talk to the Dollar General team which is one of our portfolio companies and the largest discount retailer.
We're able to talk to Alliance Boots in the UK which is the largest retailer in the UK and we're able to consistently develop a theme from all of those sources on this particular product that it's not a fad, that it's countercyclical from a macroeconomic perspective, whether increasing shelf space to permit it.
That individuals buy more of this when economies are doing particularly well and it's been proven statistically over long periods of time and that there are competitive advantage of this product relative to other competitors, that's how we can tap into an internal network to make better decisions and avoid mistakes.
A second is an investment that we have talked about publicly and midstream, Quicksilver Resources, one of our head of North American infrastructure had developed a theme of basically the need for a lot of midstream infrastructure in the US as a result of the shale play exploration and so it started building relationships with lots of executives of the E&P companies operating in natural gas. It came across and built a relationship with Quicksilver Resources management team and family.
They had a need, they had a need for capital support to build that infrastructure for their Horn River shale play in Western Canada. They didn't have not enough capital to fund that on their own. That didn't -- was not suitable in terms of investment structure for our infrastructure fund because it was a below investment grade counter-party single B rated firm, but it was perfectly suitable for what we do.
We can understand Quicksilver from a credit perspective, we can structure an investment that gives us further downside protection and even a Single B corporate guarantee can provide and it was a perfect investment for KFN sourced by the head of North American infrastructure.
In summary, KFN is not your typical specialty finance company. Differentiated sourcing, diligence capabilities, asset by asset, investment by investment, factoring into how we think about allocating capital across the various business. We are flexible in what we can do and pursue, both in terms of assets that we can invest in and whether we retain or distribute cash. We are focusing on enhancing returns to these embedded options to be able to drive returns across the economic cycles and again remove some of the cyclicality of normal historical financial services firms and certainly in the specialty finance base.
And ultimately end result there that we are focused on is stronger and growing cash distributions to shareholders while pursuing capital appreciation when these embedded options hit the money. With that, I would like to turn it over to Henry McVey to provide his insights in the macro backdrop. Thank you.
Good morning, I am Henry McVey. I work at KKR and I run our global macro and asset allocation effort and so we spend a lot of time doing two things. One is harnessing the 79 companies that we have looking at the data and using that to hopefully to make better macro and investment decisions throughout the firm. And then second is we work with deal teams across the firm to try to make better decisions, combining the macro and the micro and given what is going on in the world today, I think that is particularly relevant as we think about this specialty finance company.
So what I wanted to do over the next few minutes is talk about some key macro beliefs and then give you some views in terms of what we are seeing in the economy and around the world. First thing, I just want to drive home is the environment we are in is about deleveraging and rebalancing. Deleveraging in the developed market and rebalancing in the emerging markets including areas like China.
Second is, clearly, there is a lot of debate right now about whether we're going to have inflation or deflation, our near term view of KKR is that we will have a low inflation environment. However, I want to drive that what policymakers are doing is inherently inflationary in nature and overtime, you can't run what nominal GDP, above nominal interest rates for an extended period of time without some form of inflation.
When we think about asset allocation, which is where my background is, really what we're trying to do is arbitrage imbalances in the market. That drives us towards things like real assets, spicy credit and other alternative investments that have yield and growth.
And then finally I want to wrap up a little bit on what I think are some of the biggest concerns out there. Clearly from my viewpoint, I think Europe is and I'll touch on that because I think they're making some structural mistakes on how they're dealing with their sovereign debt issues.
So let's start with the US. Our basic framework at KKR is it we are in the third and final phase of a debt deleveraging cycle that started in 2000. Think about 2000 with Enron, WorldCom, Tyco, all over levered corporates subsequently delevered in the 2001-2002 period. That debt load was picked up by Wall Street and the Main Street in the form of financial leverage in the housing market; you see that in the Phase II where Wall Street leverage went to 31 to 1 from 15 to 1.
Subsequently, you had the 2007-2008 busts and that debt came on to the government in the most recent years. So government debt has increased by 88% over the past couple of years. Overall debt has nearly doubled from $24 trillion to $52 trillion and when you think about what that means for investments and Bill touched on this and you see this on the right hand side of the chart is that you're looking in an environment where economic cycle is compressed, right. Your averaged duration of your economic cycle when your government debt to GDP gets to a high level particularly above about 60% or 70% it shrinks to about 35 months to 50 months which is right about where we are right now.
So we're expecting is this kind shallow recessionary conditions followed by some upturn but it's not really sustainable, that's what the history books would suggest and that's what our base view is in KKR.
And within that I also want to highlight that when you think about the US think about a private sector that's actually growing of north of 3% at the same time the government is contracting between 50 basis points and a 100 basis points.
So you end up with about 2% GDP but there is a lot more going on under the hood. Europe simply put I think they had the wrong playbook which is when you have sovereign debt crisis, you have three options. You can default on your debt which is what I shown on the top left, you can devalue your currency where you can deflate your wages. But ultimately you have to get and I showed on the top right, you have to get your nominal GDP above your nominal interest expense otherwise a debt is not going down.
Europe is gone with one strategy wage austerity; that's typically your longest running most severe way to deal with the problem. On the debt side, Greece is defaulted by the way Greece has been defaulting 60% of the time since 1800 that's what they do so I wouldn't be surprise about that, but the other countries we don't see default condition.
The way the European Union works the currency can't really acts as major tailwind so you are forced to wage austerity which means slowing consumption and it means a longer work out.
We went back and we looked over the European history of deleveraging cycles, the average is about 12 years, the minimum is four years and typically they had growth of about 2.3% real GDP.
Right now Europe is contracting. So the idea that you are going to get this quick debt pay down and fix it's not going to work. So I think what I would stay focused on in Europe is how long does it take to get the wages competitive that you can actually get nominal GDP above nominal interest expense? Our base view at KKR is that's going to be a pretty long standing headwind.
So let's turn to another imbalance which is financial deleveraging, which is my background I covered financials for over decade, when I look at this left hand side I see the pinnacle of Wall Street, this is their assets-to-equity in 2007 down almost on 37% on average to where we are right now. What does that mean for you, it means the amount of liquidity that banks and brokers and other financial intermediaries can provide has shrunk and somebody has got to fill that hole and by the way whether it's individual investors in the form of asset managers or individual investors they don't lever the way Wall Street does. So the hole that's created by that deleveraging is much more substantial than just what the aggregate data would show.
The second point I want to drive home is on the right hand side which is about Europe, again the US is dealing with the government deleveraging. Europe is dealing with two things, both a financial deleveraging their Phase II as well as a government deleveraging at the same time, but when it comes to financial intermediaries, their leverage is much more substantial and I know there is some accounting tricks between government debt and derivatives that overstates the European leverage a little bit, but the bottom line is that's an extraordinary imbalance and I can tell you because there is been a lot of time over there recently the deleveraging is having a huge impact not only in Europe but also in places like Asia.
If you didn't see report that Morgan Stanley put out on this you should. In 2010, 43% of Chinese trade finance was financed by European banks. Today that is 3%, so these imbalances are affecting not only the European continent but they are also being pervasive around the world that's what Henry Kravis talked about and Bill talked about in terms of being global in nature, that's one of the things I think the specialty finance company brings to bear.
Now let's turn to one of the bigger macro issues which is inflation or deflation. It will be hard to argue if you added monetary and fiscal stimulus is a percentage of GDP which comes out to about 38% that we haven't put a heck of a lot of liquidity in the system, that's five times the great depression.
If you go back and look, we put in as a nation almost five times what we did during the great depression in terms of liquidity in the system. Yet we don't have any inflation. But it's not just in US, it's also Bank of England, Bank of Japan, ECB; they are all ramping their balance sheets. And why are they doing this? Ultimately, they are trying to solve for the deleveraging from the financial institutions that happens during debt crisis. And so the government is jamming in the liquidity and raising their balance sheets but you haven't had inflation because you haven't had an increase in the money multiplier.
Think about in this way, Morgan Stanley has reduced their balance sheet $400 billion right and their five or six investment banks with similar capability that is about $2 trillion in assets that's exactly what the Feds put into the system, and so all we really have been doing is running in place. But over time, I would argue that strategy is hard to come back from and it will create inflationary pressures.
And so when you think about what's going on here, we are talking about the Fed funds right now, that is way below nominal GDP. It's the exact opposite of what Volcker had and what we see right now is a policy where nominal, fed funds that low, that far below nominal GDP typically leads to inflation every time.
I wasn't a statistics major but when you look at the right hand side that just shows you that relationship on a three-year rolling basis when you hold fed funds, that far below nominal GDP, where at about 4.3% now, you typically get some type of inflationary condition. Our view is it will be delayed because the European deleveraging but I think this is an important area to focus on.
So let's quickly move through what we see on a more near-term basis. Our predictive models that we use are suggesting GDP around 2% this year. I think more importantly I would just highlight over the next couple of years, we're talking about a 1.8% next year and in to the twos as we go in to 2014 and 2015.
What I think is important to highlight though is this compositional difference in GDP and I'll start on the left hand side. If you look at motor vehicle growth or in terms of jobs, mining and logging, which is essentially energy, durable goods, we're having a strong rebound in some key sectors in the U.S. but at the same time, you're seeing government job growth negative and you're seeing the IT sector that sells into the government, also contracting. Why is that happening?
Clearly, what we see when you dig in to the weeds is you've got a government sector that typically adds about 3% of jobs at this point in cycle contracting almost 3%. So 600,000 job drag at the same time, the private sector in certain areas is growing. That in our base view is going to be the playbook for the next couple years. All that job contraction in the fed – in the government thus far has been at the state and local level. As we get in to 2013, 2014, 2015, that all change over to the federal level and that's where you'll see further contraction.
So what's that mean, it means we have a low inflation environment in the near term, slower growth driven by a better private sector than the government sector, which I think argues quite well for lot of things we're doing in a specialty finance, vehicle and when we think about the world that exits out there in fixed income. You're talking about government bonds yielding essentially nothing on a real basis in very little on a nominal and that gives to the arbitrage that we see and what we call spicy credit.
Fred Goltz, will talk more about that we think it's a wonderful area where when you look across the spectrum, you have to have a lot of things go wrong in the corporate sector mez and high yield to not be able to meaningfully our perform what's being offered in government yields. And ironically this is happening in a time when the government's doing better excuse me the government doing worse than the private sector and inherently has more leverage.
And so when we try to simplify it what we come up with there is a waterfall charge. Normal yields of 2% and what we think it's a default premium of over stated of about 300 basis points creating a spread of a treasuries of about 6.4% and then you go into what we think is an illiquidity premium of about 350 basis points get you someone in the low double-digits and that's exactly what Bill Sonneborn talked about.
And what give us confidence in this is the right hand side of the chart. That is Wall Street dealer inventory which has dropped 72% since the peak, whether it's any investment bank or commercial bank they can't hold the inventory that they used to in today's environment and that is creating an arbitrage that investors like you and KKR can exploit through vehicles like KFN.
And so then we will move to something real assets, we talked about low inflation in the near term but we also think that this whole policy of nominal GDP so far above nominal interest rates will create inflationary pressures overtime. And what we see here is and I think you'll hear Marc Lipschultz talk about this we don't want to buy things like tips when we accept to pay to get the privilege to have an inflation protection vehicle.
And I think Marc will talk about some of the things we're doing in the energy patch where we can actually get to a high single digit, low double-digit yields with some growth and with some inflation hedging capabilities. I would also just highlight that there's a wall of money trying to get into real assets through liquid vehicles that typical Goldman Sachs commodity swap.
Well by the way here's what the performance of that's been since 2004 nobody has made a nickel. So if you're not thinking outside of the box, and you go into real assets you're missing one of the – what I view as one of the great arbitrages in the market.
The notes and swaps that you see a lot of these multi asset class liquid funds go into, they substantially underperform through fees, roll costs and other innuendos. And our bottom line at KKR is we think there's a tremendous opportunity to exploit this using our capital, to using our relationships to find things not only in the U.S. but also globally that get yield growth and inflation hedging.
And then I think you'll hear from Ralph a very similar theme, on real estate if you think about the effectiveness of real estate in a low inflation environment it's actually a better hedge there than in any environment. And we show that on the left hand side the correlation with inflation in a 0 to 4% interest rate is actually the best for real estate. And I don't think that's widely known by the market.
The second thing is, I think Ralph will spend more time on this as, yes we could go into liquid vehicles like REITs but are we creating and idiosyncratic diversified investments for you. And I think when you look at the correlation of REITs at 86% with financials that's too high for us, and we think we can do a better job using our expertise as a firm and specifically within the real estate are to drive investment results.
So let me close with what I want to take away from today. First I want you think about shorter economic cycles and more volatile capital markets we want to embrace that volatility to, and use it to our advantage second is that, there's no question in my mind that the European deleveraging will create another wave of low inflation or deflation risk in the near term, but it's hard to argue that government policy around the world of holding nominal interest rates below normal GDP is not inherently inflationary over time. And we want to have that balance between near term low inflation but preparing for rainy day of inflation.
And so when we think about asset allocation we think about yield, growth and inflation hedging, and spending a tremendous amount of time focused on this growth component. We don't want to buy assets that are just wasting that have high yield, what the market is bearing out is the combination of these three. And you see this in the public markets the private markets and across all assets yield growth and inflation hedging and then finally, I think what we're seeing on the financials within the financial services system and the deleveraging and what it means it's creating a tremendous illiquidity premium that we think we can harness across a variety of investments to drive returns.
So I'm going to turn it over to my colleagues now and we can drill into the specific individual products and we'll take it from there, so thank you.
Thanks, Henry. My name is Fred Goltz and I am here to talk to you this morning about KFN's credit allocation, which as you can see by this slide is one of the largest and earliest in core allocations within the KFN portfolio. In fact credit represents about 80% of KFN's assets spread between the bank on high yield product, the mezzanine product and the special Sits product and just to put some definition around this, obviously bank loans and high yield, our flow credit allocations held largely through CLOs and that has been part of the portfolio from the beginning.
The mezzanine product is originated, typically subordinated debt capital in sponsored transactions and it's a capability that we've really built out within KKR and [KFN] over the last four years and KFN has been a large beneficiary of that and when we talk about special situations, that's really our distressed and rescue business that's also been built out over the last several years.
And as you will see, when we talk about these various strategies, you know, the approach that we've taken in creating these capabilities for our asset management business and specifically for KFN, has really been to build complementary types of strategies where we can take advantage of the core credit capabilities of KKR and KFN.
And you will see as we move through my presentation that you know, what started off as a core credit capability largely in flow credit products like bank loans and high yield has really translated well into the more originated credit products like mezzanine and special situations.
The other thing I will note is that when we talk about these various products and we talk about the allocation to these various products, you are going to see we pick up on many of the themes that Henry spent the last 15 to 20 minutes talking about which boiled down to Henry's first and most important takeaway I think is that we expect the world to be volatile for the next several years and what we've tried to do is build the capabilities that take advantage of the volatility, not only in the economic environment, but in the capital markets environment. In a world with shorter cycles both in capital markets as well as economic systems, in a world where a lot of the cushion that used to be in the system has been removed as dealer inventories have shrunk and the risk appetite of large banks has shrunk.
We expect volatility to be with us for some time and so by creating a suite of capabilities within KFN to take advantage of the various markets at various points in time, we think we can take advantage of that sort of volatility. And so when the world feels relatively sanguine we can focus on flow credit names in very dislocated markets, we tend to find bigger opportunities in originated credit where the illiquidity risk premium that Henry talked about manifest itself more significantly.
Our investment philosophy is relatively straight forward and it's driven by the fundament nature of the products in which we invest and that is what when you buy securities with capped upside and unlimited downside, you don't have to be a rocket scientist to figure out the empirical key to success is to not make mistakes and we've built our entire platform around that very philosophy.
The origins of KFN back in 2004-2005 was really to take the fundamental rounds up approach that we use within our private equity business and apply that to the credit business and so when we built out our credit team, we build it with parallel industry groups. We built it with parallel capabilities so that we could really effectively access the intellectual capital around the firm and take advantage of what Henry and Bill mentioned earlier which is our one firm approach to business.
And that approach has really created what we think is a differentiated capability whereby we have significant credit capabilities in San Francisco and New York and in Europe, but those capabilities are very much complemented by the intellectual capital of the entire firm.
And as a result of that we think we have created the processes that allow us as best as one can to avoid mistakes which we view as our fundamental mandate. The equity business is all about trying to find diamonds in the rough, we view our business as trying to find or to avoid landmines and make sure that the risk of any landmines is priced appropriately and that's really how we focus.
And if you think about it, the value chain of being a successful credit investor if you will is not that complicated. You have to see lots of deals, you have to pick the right ones to do and then you have to monitor your portfolio. Again it boils down to relatively simple concepts and when you think about the capabilities that we as a platform and as a firm can bring to those three areas, we think it's extremely differentiated.
The competitive advantage of being able to utilize the entire global KKR network to source transactions is immense. Henry and Bill talked earlier about some specific examples of that, but there is just frankly not that many transactions that go on around the world that we don't see, whether they are transactions or intermediated by banks and investment banks with whom we have long-standing relationships or whether they are one-off originated transactions, there is just not many deals that we miss.
And when you can take that broad-sourcing platform and then they apply the credit discipline and approach that I talked about earlier with the insights that can be gathered through the rest of the firm, it really creates a powerful tool and complimented not only by our private equity executives and our credit executives, but also by our portfolio companies, our senior advisors and the like and the truth is Bill and I sit on our credit investment committee and we see all the deals that are brought across all of our strategies.
And it is hard for me to even think of an example of the situation where a credit was brought before the investment committee where some portfolio company of KKR was not either a competitor or a customer or a supplier of that business and when you can go directly to those portfolio companies, and get direct access to the trends that are driving the industries and direct access to the very specific questions that one should ask when reviewing those types of investments.
It is an extraordinarily powerful tool and then you compliment that with a very active portfolio management strategy that we implement. I think you get the best of all worlds, we have over 350 credits in our portfolio today and we sit in a conference room every quarter and reunderwrite all of them and that is a discipline that I don't think applies across all the firms in the credit space, but it is one that we feel is incredibly important and again it's really born out of the fundamental grounds of approach that we bring to the business and following in close parallel the same sort of fundamental grounds of portfolio managed approach we bring to our private equity business and other businesses within KKR.
And so when we sit in that room and we analyze whether each of these companies met, exceeded or didn't quite meet our expectations for the quarter, we ask some very fundamental and simple questions, the most important of which is why. And if we don't understand the answer to why, then we probably shouldn't be in that name and it's that discipline I think that's allowed us to perform on a consistent basis for your benefit over the last several years.
I thought it might bring into life a little bit to talk a specific example of how this process works and a situation where we were able to bring all of the tools I just mentioned to bear and a decision that ultimately was again to all of your benefits as shareholders as KFN made it large investment in a company called our RBS WorldPay which was a transaction that was sourced by our mezzanine group in London.
RBS WorldPay was the transaction processing division of the RBS Bank, which as I am sure has become a word of the state in the UK and RBS was mandated to sell their transaction processing business in 2010, and the process that resulted was an extraordinarily long process but it was one in which we were able to partner with a very qualified financial sponsor group led by Advent and Bain Capital to look at the mezzanine financing for the transaction and what ensued was an extraordinarily long and intensive diligence process but it was one in which we were really able to differentiate ourselves as a platform.
We knew the transaction processing business within KKR and KFN because of our position within (inaudible) corporation which is the largest US transaction processing business. Our private equity theme which owns that business also knew fair amount about the space.
And in addition to that, we were able to draw upon our capstan colleagues which is our internal consulting business within KKR to really help us to understand what ultimately became the key diligence question in that transaction which was the (inaudible) risk of pulling this business out of the RBS WorldPay network and turning into a standalone business.
And over time by taking advantage of all of those capabilities, we were really able to differentiate ourselves and put ourselves in a position to lead what was one of the largest mezzanine transaction has been done in the last several years. And again in which you all participated, and in the end the economics we were able to command in that situation were very attractive and were driven I think by the fact that we were the value added provider of capital to that financial sponsor and while that was able to act quickly and take advantage of a network that no other provider could take advantage of and as a result again, I think it was a differentiated deal and one that I think we'll perform well for all of us.
Talking about some specific strategies, the bank loan and high yield bond strategies as I mentioned has been the longest standing credit strategy within KFN. As you can see that this largely done through CLO structures and those structures are generating 70% cash-on-cash return, GAAP returns are a bit higher than that and you can see that the coupon within the portfolios for the various assets are in the mid-to-high single digits and then obviously the leverage within the structure is what enhances the returns.
The credit markets today, as I am sure you are all aware are and a very interesting time for all the reasons that Henry mentioned earlier, the fundamental economic backdrop for the next several years is cloudy to say the least and as I mentioned earlier expected to be quite volatile, but in that environment ultimately the prevailing consideration as we have seen here today is the fact that alternatives to higher yielding credit like treasuries are just providing no return on probably negative real rates of return in the long run and so as a result there has been huge inflows into the high yield and leverage credit markets and we have seen spreads tighten and ultimately the high yield market is now 7%.
I think and as a result of that, it's become sort of a tug of war between very uncertain fundamentals but very strong technical and as a result of that we have been cautious in our allocation to capital to the space but it's one that ultimately is a big part of our strategy and to the extent that certainly we hope that the market will start to (inaudible) itself as the fall proceeds here and we are hoping to see some significant new deal activity to soak up some of the large inflows of capital into the space and take the pressure off of what has been a pretty difficult environment in which to defined.
The mezzanine strategy specifically has put together a portfolio with a weighted average coupon approaching 14% of credits that I would say by and large are single B like and I think this is specifically the point around the liquidity risk premium that Henry raised when we sit in a world where high yield is obviously been volatile but as I said today it's on the cash basis yielding close to 7% being able to have a portfolio of comparable credits yielding close to 14%. I think it's really representative of the liquidity risk premium. People that are prepared to underwrite deals and prepared to take two or three years of their liquidity risk are being compensated in an extraordinary way in today's market, especially at times of extreme volatility. And what we have been trying to do within KFN is take advantage of the dislocation when it happens to allocate capital to the space and to the extent that we are in a period like today where the public markets are creating alternatives that have driven down the attractiveness of these products, we step back and wait for the dislocation to come again which we have every expectation it will.
One of the more interesting phenomenon that we have seen over the last several years within the originated credit space at least has been the fact that frankly, the amount of transaction volume that we have seen has been surprisingly low, in a world with pretty significant private equity over hang and absolute cost of capital probably as low as any of us have seen in our careers. It has been extra ordinary that there hasn't been as much private equity demand for new credit.
Our expectation is that this will change as people get more conviction around the global economy whether that conviction is that there is going to be strong growth and whether that conviction is there is going to be no growth.
We are hoping that people will ultimately get the courage of whatever conviction they have and start deploying capital again, so I think it will create more opportunities within our private credit space. This is a product that benefits from volatility. This is a product that benefits from traditional financial institutions backing away from risk. And I think as Henry pointed out earlier those are two things that we expect to really characterize the market over the next several years.
Special situations, which as I mentioned earlier, is really our distressed and rescue business has also been very busy. Again this is type of strategy where one has to be very opportunistic not only in terms of the structures that we pursue but also the geographies in which we pursue them over the course of the last several years, we've been busy in the U.S. last fall where we've been busy pretty consistently in Europe that we've seen some opportunities in Asia all driven by the same volatility that we've talked about.
And our expectation is again that that will continue the deleveraging process that is ongoing in Europe, continues to create opportunities in distress rescue area. We think there are some macro trends in the U.S. that are also going to continue to drive opportunities like the transformation, of the healthcare business that is expected to take place over the next several years, some issues within the energy business, Bill mentioned earlier that the Quicksilver transaction which was really an interesting one where we took advantage of a view within the energy infrastructure group and combined that with a real understanding of counter party credit to create an interesting opportunity for KFN.
And we expect those sorts of things again to continue. Asia, I was just in Japan last week and it's very clear that things are slowing down pretty materially there. Especially on the export side and that could also create some real opportunities within Asia. And so our special sits seats business is by definition and opportunistic one. It's generated returns. So we think more than compensate for the risk as you can see here on a total basis, IRR is over 20% and realized IRR is close to 40%, and our expectation is that as the world continues to wobble along these opportunities will can be needed presents themselves.
And finally as you can see I think the takeaway here is the real power of the platform that I've described is that it allows you as a shareholders of KFN to really take advantage of this world in which we live and in which the attractive opportunities set changes on a much more rapid basis then perhaps it has in the past.
Henry talked and he abstract about shorter economic cycles and capital market cycles, well we live those every day for years you know we used to think about credit cycles being measured in years. And ultimately driven by the default rates and the general economic cycle. Well now we think that our credit cycles being measured in months and over the last three or four years it feels like things have (Inaudible) side back and forth several times, even within many of those years.
And as a result it's very important to have the capability to be nimble. Now, it's very important to have the capability to take advantage of the situation as they present themselves and to put yourself in a place where when things are stable and clam you can put in place structures to allow you to earn appropriate rates return in that world. But then when things get stormy, you'll have the origination capabilities and the relationship with counter parties and financial sponsors to take advantage of their liquidity premiums.
And as a result of the work that we've done over the last several years I think we've created that capability within [KFN] and you all are direct beneficiaries of that and hopefully I've been able to demonstrate that through examples and I expect that we'll be able to continue to do that over the next several years because I don't anticipate things getting much clearer or less volatile anytime soon.
So with that I'll turn the podium over to my colleague and partner Marc Lipschultz.
Good morning, I'm Marc Lipschultz. I'm the Global Head of Energy and Infrastructure at KKR and it's a real privilege to be able to be here today to talk to you all about the revolutionary changes that are going on in the energy industry. And the really special investment opportunities that has created and we think we will continue to create for KFN.
During that time of tremendous change there is also a tremendous opportunity and if you have the right capabilities we think there's ways to make really compelling investments. And when KFN has developed its strategy and this is think a very important part of what we'll talk about today is they've really developed a capability to invest at the real asset level, generate really attractive risk rewards, do that in the form of current yield with strong inflation protection. And that's a tough package to come by these days and it's one that KFN has and is delivering to you all today.
Before I get into sort of how that strategy has been assembled and a little more about that revolution, let me just talk a moment about KKR's history. Now this is a very busy slide but I think that's actually the good news. There are three takeaways I believe with you from this slide.
First, is the longevity of KKR's history of investment in the energy sector. Second is the breadth and depth of that involvement. And third is really the focus and the acceleration of that investment and activity in this post revolution world in this post shale revolution world because it really is a paradigm shift. And investing in the world post-2008 and the world pre-2008 is actually radically different and I'll talk quite a bit about that because that's part of what has opened up this really wide set of opportunities for KFN.
So first on longevity as you can see, the investment history at KKR around the oil and gas and energy sector goes back to the 80s, investing in Union Texas Petroleum and it actually goes back before that and Henry Kravis and George Roberts both their families actually come from the energy sector, so it's actually in the DNA of the firm it has always been very much a part of the ethos of the organization.
Second with respect to breadth and depth, as you can see looking at the slide we've been able to successfully invest across time up and down the supply chain around the world. And we think having that comprehensive understanding of the energy landscape is actually quite critical to making successful investments in any particular sector within the energy landscape.
And so again I think as you'll look here you'll see participations in so many different areas, and we think that is another quite important attribute when you think about the ability to invest through this time of change.
And then third and very importantly, is really the concentration and development of distinctive capabilities in this post revolution period. So you look at the bursting of the energy bubble and the great amount of activity after that that really represents what we have found to be a compelling entry point a total paradigm change in the nature of the investments. And one we think that's going to persist for quite some time. So you can see that breakpoint at all the activity they're after and again I think that's quite important when we think about the opportunities ahead, and the capabilities that we'll talk about today.
So I've used this term, revolutionary change already a few times and I'll use it probably quite a few more because I think the significance of this conversion from conventional production to unconventional production or as probably commonly referred to as this shale development is really as significant to the energy industry as the advent of the internet was to technology, except it probably happened faster. And it probably affects more the economy. So actually it's arguably even more significant than the internet revolution. I think we all appreciate what kind of discontinuity that represented and what kind of opportunity it represented if you were properly positioned. And actually the analogy holds even more tightly and that the revolution isn't really about geology. This really isn't about rocks. It's really about technology. It's about the ability to go to rocks, we have always known are there, these so-called shales.
And go and drill in to them directly to extract oil and gas and that's had a lot of implications. Now the most important implications probably are captured in essence on this slide, which is the change in the nature of what we used to do in the pre-shale revolution era to what we do today and at the bottom, most importantly, the amount of capital that takes and this is probably a pretty dramatic underestimate of the amount of capital in total when we think of both the development of the resource as well as the relevant infrastructure to move that product from source of supply to center of demand.
So on the far left hand side of this chart, which you can see, is the traditional oil well where we basically used to go around and kind of hunt in pack. We look for places where there are pockets of oil and gas. We would drill down vertically in to those pockets, extract what we could and then go look for another and it was a bit of a hit or miss business and we all know that frankly, the oil and gas business has been a sort of hit, boom and bust kind of cycle.
The change that's going on as opposed to waiting for millions of years of mother nature's activities to bring that oil and gas from those shale rocks up in to those little pockets were as conventional non-associated gas. We now instead have the technology to go right down to that rock, drill in to it and extract the oil and gas. And what that has done is taken this country for example and other parts of the world following suit from a place where we were about to run out of natural gas, common wisdom being back in '07, '08 that we have maybe 17 years worth of supply to a time where we now have a 100 plus years worth of supply.
But much more importantly is the repeatability of what we now do. That is to say once we understand the rock and once we understand the technology the particular way to complete a well in that area, this becomes much more of a manufacturing process and changes the whole nature of risk.
And it also changes as I mentioned in the nature of capital. It takes a lot of money to develop these new resources. These old wells might have cost $1 million or $2 million, a shale well today can cost you $8 million or $9 million or $10 million and has to be done now in a rapid succession as we make this conversion from old to new.
So I know this is probably familiar to a lot of you, but I am just going to spend a minute on a primer on a few kind of terms of art that I will use and a sense of where KFN has focused its strategy, but we think very wisely in this area. So first when I talk about conventional production as I mentioned I am talking about those traditional vertical wells where you are going into a pooled resource. So you are looking for a reservoir, they are quite easy to drill, they are quite easy to complete but whether you are going to actually find gas and oil or not is a matter of quite some uncertainty.
When we talk about unconventional, we are talking about these so called resource plays much more expensive to produce, but as I said also much more predictable and repeatable once you understand what you have. Now KFN has invested through two primary forms of participation in the oil and gas sector in the real asset side of this. Working interest, working interest are direct ownership in the oil and gas wells and the production that comes out of those wells.
Royalty interests are a direct participation in the revenues, the profits of a well without any responsibility for the underlying cost, but also without any control over the pace at which some of those assets are developed. So each of these are quite interesting ways to participate in the shale revolution and I'll talk about how KFN has architected a very distinctive strategy for doing so.
On the right hand side of this chart, it's just a bit of a sense of the nature of risk in oil and gas. Because when we talk about oil and gas, there is a very wide range of risks that one can choose to take and different kinds of returns to be expected. KFN is focused in what we would characterize as the low risk end of the spectrum. That is by an existing producing properties or investing in relatively low risk development opportunities as opposed to and in contrast the far right hand side we will be going after for example large new exploration exercises, that is nothing that KFN does, a very, very different business.
So what does KFN do, so KFN is capitalizing on a couple of major impacts or implications of the shale revolution. So this conversion from conventional to unconventional that need for trillions of dollars is leading companies to -- on the one hand dispose off some of their existing assets. So their existing PDP, stands for proved develop producing. So those are the lowest risk assets, the assets that are already producing oil and gas today.
So one way to fund your exciting new ventures and new developments and some of them are very exciting is to dispose off some of your old legacy properties. These are now the properties that are no longer growing, they are in decline, they are not getting your financial capital and they are not getting your human capital attention.
So one way is through those disposals for us to acquire with our technical teams and our investment teams those assets and operate them more efficiently, optimize them. So it's really taking a non-core asset from an existing producer and making it a core asset for KFN. The other is to help provide some of that capital to cross the bridge to basically go over that chasm from old to new and to do that in a manner where we can get very close to the assets.
So we call that investing in development capital or development drilling. So together that leads to ownership and working interest, royalties, the two terms I just described and then other opportunistic investments that are either more structured investments to support the first two things I described or could be things like the Quicksilver example that was described before which is to provide capital to present the infrastructure needed to connect that supply at these centers of demand.
Because remember the supply is often in places where it didn't exist before and it is certainly in quantities in those places that we have not experienced before. The result of all that which presumably is what matters most to all of you and certainly matters most to us is what do you get. So what you get is direct asset ownership, hard asset ownership, you are going to buy oil and gas in the ground, have direct interest in those wells, you are going to get strong predictable yield. That is to say by working in a combination of production with a lot of hedging which we do, you are able to produce a lot of current income which is a really high priority of course for all of you as investors and for us.
And inflation protection by virtue of the tie between commodity prices and of course inflation assuming you believe the two are connected, history would tell you those two are highly connected. We certainly accept the wisdom that inflation and commodity prices will be very much correlated over time.
So what has KFN so far done in this area, it is really very distinct relative to I think just about anything you are going to see in the market place in terms of the portfolio, KFN has been able to develop by virtue of this view and this participation in the revolution.
So about half the portfolio today are those working interests. So as producing properties, that interest in wells that are already produced in oil and gas today where KFN has a real asset ownership. About another quarter is in royalties. Now in royalties we don't tend to do as much hedging because in royalties of course, we don't control the pace of development. But once those wells on our properties are developed and we are getting those royalty checks on a monthly basis, then we can do more in terms of hedging that cash flow profile over time.
And then third as I mentioned is other that opportunistic structure and that's about a quarter of the KFN portfolio. So we think this actually presents a very nice balance, actually probably a nice presentation of how we will see this develop over time, but indeed we are going to be very opportunistic.
There are times when we're going to see different parts, different categories here will be more interesting to us and obviously we're going to lean in and out as we develop this portfolio for you overtime.
Within that working interest category, so that largest area of KFN's current asset ownership. The bulk of that asset today is in natural gas. Now that represents a couple of phase.
First, the history of production in the US of course is natural gas, when we look onshore. That's the bulk of what the existing production has been, as we now move to this revolution, a lot of it's been about natural gas but a lot now is also about oil and liquids.
And I will talk about our participation in both. We find that acquiring existing producing properties, those working interest are often tilted toward natural gas, when we do development drilling and royalties that tends to be tilted toward liquids and oil.
So once again through the strategy, we're able to create a very balanced portfolio in terms of participation with the underlying commodity.
Now our most active period for acquisition has been over this last nine months. So as the natural gas market cracks as there was extreme pressure in the marketplace, both on the commodity price but also on the owners.
So as people looked around and said Gee I need to find some capital because my operating cash flow is far below my CapEx requirements. Of course that led to a lot of asset sales, we found this to be very, very productive time to be an acquirer. We like this exposure today because we're able to buy it at a time when natural gas was, if you all will recall, not so many months ago, down around $2 in terms of spot gas and now we're back up to something close to three with a forward curve, it takes up to four and beyond.
We also have liquids within that portfolio, natural gas liquids which are things like propane and butane that are more tied to the price of oil. So these are more oil linked products and then we have some amount of crude oil production as well.
So once again a balance mix, we do a lot of hedging. As you can see particularly in things like natural gas where there is a deep long markets; we actually hedge the bulk of this production.
So we really are not taking day-to-day, year-to-year volatility in commodity prices. We are owning the long-term exposure. We think that's when we get that inflation protection from. But my hedging in the near term, we actually stabilize the cash flow so we can present, produce, deliver strong cash yields during these years of ownership of the assets.
So maybe to kind of bring this a bit to life it's worth using a case study as oppose sort of the abstract notion of working interest and a producing well. Let me talk about an example of the property of the KFN invested in. So ConocoPhillips obviously terrific oil and gas company but a very large oil and gas company.
This company like many other well run ones will look through its portfolio and that's quite consistently say look what's no longer core for us.
So ConocoPhillips had a set of properties in the Barnett Shale. The Barnett Shale to some will be familiar as really kind of the original shale assets. The original shale actually started on the scene maybe a decade plus ago and really began the shale revolution.
And at that time like many of these shales people went out lease out lots of land and over time we found out where they really good parts were. Where that repeatable process will work and whether they were non-core parts.
While Conoco turned out had a fairly non-core part certainly as the world had change in terms of natural gas prices. So they had an asset when gas was $7, $8, $10, $12 make a lot of sense to drill. When gas was $2, $3, $4 or $5 did make any sense to be developed.
So they basically took all their people and moved on to other higher return projects. But they nonetheless had about a 130 producing wells at every single day, they were producing gas and natural gas liquids and needed to be operated and operated well.
So we ultimately required this set of properties, a 100% true developed producers that is we paid only for the existing producing asset and yet with that came a lots of fascinating optionality. Another feature of this whole area of investment that we think is quite interesting for all of us is the embedded options that we think are quite mispriced by the market.
So once you own a piece of land whether you own that as a working interest owner or frankly as a royalty owner, we have the right to anything that's developed on your land or in your minerals. You have the right to that over the long-term and you have the right to that is technology works and technology tends to work in one direction which is the Barnett shale today and this area is on economic to grow.
Now overtime, technology may change that or quite frankly the price of the commodity may change that, put in another way, a $6 gas environment would have the very different view of the development potential of these assets for which we pay nothing that is the incremental development locations than you were today in a $3 and $4 world.
And so when you think about actually the financial implications of that call up your friendly commodity desk and ask what it would cost to buy a 10 year call option on $6 gas, that's a pretty pricy option. It's actually free in this case. We don't pay anything for that we pay for the producing assets, we get the options for free, that's another nice asset embedded in the KFN portfolio.
But in any case, there is a lot of help in the strategy because it has to do with what you do with that asset once you own it. So we have a team of operators, very technical people that come from a company called Vintage Petroleum which was sold to [Occi] that free them up to come work with us.
We now have about a 100 people based in Tulsa that work exclusively on KKR and KFN's oil and gas properties. We go in and we look at costs through a very different lens. We look at each well and say what's the way to optimize production in that asset and so we have been able to take an asset that was run by obviously a very capable oil and gas company and take it to a very different level in terms of how we allocate capital, the expenses and the production rate, and that's how you create [alpha] on top of just if you will debate of owning these assets overtime.
The other category that I talked about was royalty interest. So here today KFN has a participation in about over 100,000 acres. So that means anything that is developed on those acres KFN gets a share of the revenues from. So here what we are able to do is participate for the very long-term. Once you own that mineral you own it forever and anything that is developed on it you get your share of. You have no exposure to the cost. We are not responsible for drilling. When well cost cycle up as we all probably know well cost have cycled up a lot over the last couple of years, that is not the responsibility of the royalty owner. We get paid right of the top.
So this is actually the [lease] volatile way to invest in oil and gas because you have no cost structure underneath you. This actually is another example or by taking a view and having a really distinctive technical understanding of the plays in the way that they are developing, one can actually make some really interesting investments. And this is also an area that is very untraffic from our point of view.
When we look around there are very few people that participate at institutional scale in royalties because this is actually a business we have to go around and buy up all the small pieces of land.
We have developed again a distinctive capability to do so and so we have been able to acquire a lot of strong royalty positions in many of the place you all heard about as some of the emerging growing development shale place around the country.
Another again, I think a sort of big hidden referenced a little bit earlier but this is where we can come in and make investments that are more structured things like midstream, things like participations or someone wants to say a preferred participation in the wells as opposed to direct ownership in the wells but the theme is always the same.
We are looking to be close to the assets and generate yield and have inflation protection and durable payouts and durable yields for you all. Here is a case study on how royalties can work. Now by no measure we are suggesting how it will work quite as well but it is pretty good example of how having insights into the development of a particular play married with the right kind of asset exposure royalties in this case can yield some really attractive results.
So the Eagle Ford shale is an area that we all identified as really one of the prime liquids developments in the United States. We have now participated in the Eagle Ford Shale, I think probably five different ways. This is one of them, by having to view on how the wells were going to develop and having a proprietary understanding of the production profile of these wells, the likely plans that producers would therefore implement, given the economics, the attractiveness of drilling in these areas.
We were able to go out and make an acquisition of a royalty interest, a large acreage position and do that based on the knowledge we had that we thought was quite distinct from the marketplace. Now the time we bought this royalty, the time KFN made this investment, the cash on cash yield was actually only a few percent. By rule of thumb standards in the land of royalties, that was considered very low. These are traditionally traded, that is historic royalties in conventional oil and gas fields have traded for high single-digit kind of returns. There is sort of regular monthly checks, it's a bit of a retail product.
And actually in some regards, interesting but probably not really something that KFN and we can deliver in a very unique way. However, when we look at shale development, what we're talking about is having a very different view of the future from what the current landowner very well would understand, or frankly a risk they're willing to take.
So we paid actually a very high multiple if you will by cash flow standards. So started with a 3% yield but if you look as you can here, over the course of just a year and a half, we went from a 3% yield to now in over 50% cash on cash yield by virtue of the fact that this field had now been developed. We didn't pay for any of that. a strong operator came in, drilled wells just as we predicted they would. The wells performed extremely strongly as we predicted they would and we're getting our checks in the mail. So this is a really interesting way to participate that we find very few people doing today.
So what does this really do for KFN at the end of the day. So I think if you pull away from the jargon and you pull away from some of the underlying technical questions, which indeed one has to be very competent in but that's where our job comes in which is to bring that technical expertise and then investment expertise to the table. Pull away from all that, what this really does is creates some diversification for KFN. What it does, it's created uncorrelated assets alongside some of the other assets just for example heard Fred talking about.
But with some of the same if you will deliverable some of the same capabilities which is we can deliver yield we can deliver inflation protection and we can deliver, in this case, energy exposure as well. So we really think this is nice extension to the KFN strategy and really a point of differentiation that we don't think others are positioned to take advantage of or have the capability to take advantage of.
So what I'd leave you with is this, we're going through a time of the extraordinary change this really is a revolution in the nature of the energy, it's probably the most significant change certainly in a generation in the energy complex. It arguably is the most significant change since sort of the inception of the industry. And in that period of change, if you have the right technical skills and you have the right investments skill and we do with KFN today.
One can put together a package of investments that deliver that assets ownership with yield and inflation protection. And when we think about the world around us we think about trying buy yield and inflation protection, the sort of risk free alternative is a tip right. So tips traded at negative return you pay for the right to have a inflation protection over time, as opposed to having the opportunity to earn extremely attractive cash on cash yields and have inflation protection over time and KFN is in a very special position to delivery that.
We're excited to do it we think this opportunity is actually going to persist for quite some time as we go through that multi trillion dollar transition and we certainly look forward to keeping you all a price updated on our progress as we go, and we certainly thank you for your support.
With that let me introduced my Partner and friend Ralph Rosenberg.
Okay, great. Hello, my name is Ralph Rosenberg and I run the commercial real estate business at KKR. We're to take a short break after my presentation, so if you can bear with us that will be terrific.
In the next few minutes I'm going to handle the following topic. So I'm going to walk you through the strategy of KFN and how we think about commercial real estate, I'm going to talk briefly about why now is a great time in the economic cycle to focus on commercial real estate.
I'm going to talk you through briefly the KFN approach to how we tackle commercial real estate opportunities. I'll walk you through a brief case study to demonstrate how KFN is has already participated in the real estate sector through the KKR network. And then we'll summarize with the benefits to KFN of having a commercial real estate strategy.
Plain and simply the KFN strategy is to leverage the KKR brand, the KKR relationships, the KKR access to knowledge to find differentiated opportunities in commercial real estate and both debt and equity. We look for operationally intensive situations where we can utilize our real estate capabilities and we also look for complicated capital structures, where we can utilize the firm's knowledge base and ability to structure in the capital markets.
For the most part we look for control or influence positions in commercial real estate in both debt or equity we really can influence the outcome of a given situation. We utilize a moderate amount of leverage in terms of how we think about the risk profile of these opportunities, and in doing so we're targeting to earn mid to high rates of return on our real estate investment activity.
I'm sure I'm not the first person standing in front of you to put up a slide like this, so we won't spend a lot of time on it, but the fact of matter is there is a tremendous amount of leverage in the commercial real estate sector that has to unwind over the next handful of years.
This is a chart that demonstrates United States at about $1.2 trillion worth of commercial real estate loans are going to mature in the next four years all these loans have to effectively, re-price and disseminated into the commercial real estate sector for more natural holders of this asset class then the banks that have these assets on their balance sheet today.
What's interesting about this cycle relative to the prior real estate cycles is that effectively there is a financial bubble that effectively caused a real estate crisis, there was not a fundamental real estate bubble. This chart effectively shows you that the actual supply of real estate product from a new build perspective is actually historic lows from a cyclical perspective, and the combination of having pretty good balance of the supply demand level of the asset level and a financial bubble creates actually some very interesting opportunities for us is the cycle continues to play itself out.
In Europe you have similar things going on what's unique about Europe with respect to commercial real estate is that primarily all the commercial real estate lending activity was done through the banking sector. As many of you know there are hundreds of anecdotes about how the banks have yet to mark to market most of the real estate exposure in Europe ultimately as Henry McVey said Europe is going to have to deleverage and as Europe deleverage, so the commercial real estate industry in Europe.
And that real estate has to find more natural holders of the product in more normalized capital structures, additionally effectively in the four biggest countries in Europe, there's over a trillion euros worth of exposure sitting on the balance sheet of the banks, which again demonstrates that this exposure has to effectively find a more normal place in the marketplace than on the balance sheets of these banks. Let's spend a second on the market opportunity as it exists today. As I mentioned, the financial bubble was caused during the crisis. These capital structures have to effectively reprice and reset. Secondly, there is a lack of available capital for the banking industry and the shadow banking industry to effectively provide liquidity to allow for that deleveraging.
As Henry showed you before, the financial industry is effectively in the process of continuing to delever all of the bad actors in the real estate space that took advantage of CREs, CDOs, and other effectively derivative capital sources to effectively fund liquidity into the commercial real estate are effectively are either gone or a fraction of their former size, which effectively there is a gap in the real estate funding markets to allow people like us, the flexible balance sheets to effectively solve real estate related capital problems.
Thirdly, there are fewer capital providers. As I just mentioned, additionally, one of the benefits that KFN has is that we have no legacy portfolio in commercial real estate. Most of the players that we interact with to find differentiated deal sourcing for KFN are very intrigued by the fact that we are not distracted by legacy problems on our existing book that take a lot of time to manage their way through and we have the ability to effectively be in our front foot at all times.
And lastly as I demonstrated in an earlier slide, there are very favorable supply demand dynamics at the property level. All these observations effectively lead to very interesting opportunities for KFN. Let's spend a moment on the investment strategy of KFN with respect to commercial real estate.
Firstly, we focused on distress for control, very similar to what Fred alluded to with respect to our special situations business more broadly. We spend our time really finding complicated legacy capital structures, but we effectively can find a very attractive entry basis for KFN capital to effectively own the underlying real estate at a very compelling fundament valuation level and ultimately over time either influence the outcome of that capital structure or take control or influence the actual underlying real estate.
This effect is indeed a debt for controller influence strategy. Secondly, we look for a recap or repositioning opportunities at the assets level. Many of the assets that were effectively recapitalized during the bubble are now capital starved ironically because the real estate developers are effectively out of the money and because the banking system doesn't have a lot of capital to effectively put into real estate that they effectively implicitly controlled.
There are lots of opportunities where real estate assets are capital starved and new capital has to effectively come in and provide capital to effectively improve or solve problems at the fundamental real estate level. We have a strategy of proactive management at the real estate level. We deal day in and day down with a numerous stable of operating partners that we KFN/KKR have developed relationships with over the last 20 years.
Many of those are personal relationships of myself or the 10 members of my team who focus exclusively on commercial real estate investing to have lots of broad tentacles in to the market with actual real estate operating capability to allow us to participate and recapture and reposition it.
Thirdly, we focused on structured credit opportunities in commercial real estate, one of the amazing benefits of KFN's balance sheet is that we do not feel a need to be siloed into any one of the portion of the commercial real estate market. We can look with intellectual honesty across capital structures to find the best risk award available in the marketplace and effectively use KFN's flexible balance sheet to effectively execute on those opportunities.
Any player in the market who [hopefully] has a siloed fund strategy does not have the ability to look fluidly across the capital structure, it's a huge advantage for the KFN shareholders. And lastly as you would expect off of the structured credit strategy is because you have the ability to move up in the capital structure, you have the ability to play for more defensive positions in capital structures which typically are positions where there is a more predictable cash flow attribute to that opportunity.
Our fourth strategy as you might expect coming from the KKR history is a corporate strategy around commercial real estate. We look very actively at real estate opportunities that come in corporate form. The overwhelming majority of commercial real estate assets in the world are not actually held in public market corporate form, they are held in private corporate form and those opportunities effectively are very ripe for new capital that come in to help those platforms grow or reposition themselves or to deleverage.
We look very closely at all the public market opportunities that are on offer as you guys know a lot of the public opportunities in the United Sates were there for a nano second, there is a lot of deleveraging that took place through the REIT market et cetera as the REITs access the capital markets in the US, but on the other hand in Europe the opposite is true right now. Many of the players who are public are looking for capital to help them deleverage or to help them effectively take advantage of some idiosyncratic growth opportunities. We get lots of phone calls to the KKR sourcing channels to effectively have very differentiated dialogues with these public companies who are looking for capital.
And as I mentioned earlier, by definition a lot of our time is spent looking at private market opportunities as well in corporate form. Interestingly enough as you might expect, we have a very differentiated capability in helping to actually build platforms that are real estate intensive, but also have an operating capability.
So for example we are in the middle of a couple of very interesting dialogues in the healthcare space where there is a very interesting convergence between the KKR expertise from the private equity healthcare orientation and the corporate form and on the real estate side in my business unit to effectively converge our two expertise to effectively look at some interesting platform opportunities to provide capital to the real estate space and health care.
And then lastly on the corporate side, we look by definition at any spin offs coming out of corporates where there is a real estate intensive angle to the opportunity where effectively it is not a core business for the incumbent or the seller who is a corporate looking to spin off real estate exposure. So when you think about it from a 70,000 foot level and you think about KFN's edge in commercial real estate, you have to think about the four attributes on the left hand side of this slide.
We have a very interesting differentiated sourcing network, we have 900 employees at KKR. They all have a commercial real estate knowledge base from education that we've provided them in terms of what they should be looking for in the market place and how they should effectively on reverse enquiry come into our business unit to effectively to still and digest when there are not opportunities that exist.
We've a very robust senior advisory network at KKR that sources a tremendous amount of real estate opportunities for us, either because they're directly involved in the real estate space or they know captains of the industry who have exposure to real estate, who are looking for partnerships with capital providers like KFN and as you would expect, our KKR private equity verticals that touch real estate. Those verticals are a very, very, very powerful sourcing channel for real estate activities, if you think about our infrastructure business, our healthcare business, our retail business, our telecom business.
These are all parts of the ecosystem that touch commercial real estate in a very meaningful way. Historically, KKR, before I joined the firm would not have executed on those strategies. Now that I am part of the firm and we have a group of core people who can dedicate effort and expertise to real estate and complement that expertise with the flexible capital of KFN, we can create very interesting sourcing channels through our private equity business.
And then lastly, as I would say are the differentiated sourcing. By definition, we have great intermediary access in the capital markets, the banks of which we are, I don't know probably or not so probably very large key payers. It shows very unique and differentiated deal flow and in the real estate business we are very high touch points with some of the major players who are effectively the capital markets intermediaries to real estate transaction.
We've a very rigorous deal selection process at KKR. We triage our pipeline three times a week. I share that pipeline every weekend with the management committee of the firm. So the team is responsible for KFN has seen our deal flow literally real time, every week. Bill and I talk all the time about what's appropriate and important for KFN to get exposure too in terms of our real estate deal flow and so there is a very dynamic and vigorous process in terms of how we [back] and go after real estate opportunities.
Additionally, we have very strong operating capabilities as I mention through operating partnerships that we've established over my career and the careers of others at the firm. And lastly, they are very favorable process dynamics in environment like we're in today where there are counterparts who are looking for not only capital but effectively for partners who they can trust to provide that capital.
When you add those four attributes up with an environment where there is not as much capital assuming not as much flexible capital as one might have historically expected and you think about the complement of that observation with the ability to buy cash flow in a commercial real estate base. These things collectively create very interesting differentiated opportunities for KFN.
Let's talk more specifically about how we effectively are targeting the market today. On the one hand, you would expect us to be opportunistic as I mentioned, the deal sourcing network that I just described brings in opportunities literally every day, so we are very nimble in terms of responding those opportunities.
In other hand, we are thematic. There are basically three themes that we've been targeting resources to focus on today, one is a retail theme to leverage off the retail vertical on a private equity business and take advantage of lot of the retail dislocations that have taken place as that industry has evolved and also to take advantage in lot of the excess capital structure they were created retail space during the cycle.
Secondly, we're focus very thoroughly on the hospitality space particularly in Europe as you guys know the hospitality industry is the high fixed cost business. So it's very responded to cycles and when you are in a tough economic environment like in Europe, you are talking about hotel assets that have fixed costs structures, the cash flows have gotten hit pretty hard, the capital markets capital structures that are in place from the bubble have to effectively be repriced to show the new norm with respect to evaluations at the property level and guys like us can come in with operating capability and access the deal flow to help effectively deleverage the hospitality industry particularly in Europe.
And then thirdly from a thematic approach, I mentioned this earlier, the senior housing industry is a very interesting intersection between our private equity healthcare capabilities and effectively our real estate capabilities and in a world where it's tough to find development capital when you can marry those capabilities that have conviction around the demand for a real estate asset and healthcare, we can put money to work in a very, very compelling risk adjusted way in the healthcare space.
I will give you a quick case study of a transaction that KFN has participated in, in the commercial real estate space that we closed on back in March. We bought a 1.5 million square foot shopping center outside of Chicago, Illinois. What was interesting about this transaction is that the shopping center was developed, owned, managed and leased by one family and the family needed liquidity because there was a divorce taking place in the family and we teamed up with operating partner expertise that we have had from historic relationships through myself and others on the team to effectively buy this asset which is approximately 85% leased, but lives in a trade area where retail assets are over 90% leased and we bought these asset with the intent and opportunity to effectively reposition this asset, provide new capital to improve its position in the trade area and effectively to reposition the asset and increase the yield from a 7.4% cap rate or NOI yield up to what we believe will be about a 9.5% yield over the next three years.
And we did so by utilizing 62.5% leverage at 5% when you cut through it all what we really did here is take a great asset that was mismanaged; we can come in with capital and expertise and effectively create a lot of value.
To summarize the KFN platform and commercial real estate, there are lots of catalysts out there in the market. There is a need for liquidity to effectively reprice assets and to effectively provide capital to help reposition assets and to take advantage of lot of these orphaned assets that are sitting on the balance sheets of finance institutions or in the hands of incumbent real estate players who effectively are getting out of the business. The opportunities that we are looking for center around operational opportunities at the asset level but also opportunities at the capital structure level with respect to effectively repricing balance sheets and figuring out ways to effectively come in higher up in the capital structure than just playing in the equity environment.
Thirdly, we got to differentiated sourcing network as I mentioned, which leverages off of all the resources of KKR to effectively create a KFN opportunity.
And lastly, we can leverage off of the knowledge base of the KKR employees and our portfolio companies to get very interesting insights into how markets are behaving that effect commercial real estate.
So for example, on the Yorktown shopping centre that I mentioned, we were able to go into our private equity team on the retail side and go through Dollar General and Academy Sports and Toys R Us and about 55 other retailers that our private equity team has relationships with to effectively reverse engineer the P&L of the shopping mall from the perspective of the retailers to effectively give us a gut check on the conviction that we had on the real estate side that from a retailing perspective that this was going to be a high probability opportunity to effectively take advantage of the repositioning of that asset.
The ability to touch and feel library of that knowledge is a huge differentiator for KFN and we're doing that not only in the retail space, we're doing it in the healthcare space and we're doing it in the energy space. As Marc mentioned earlier, there are lots of opportunities where the proliferation of the shale plays creating real estate in infrastructure opportunities that we're taking advantage of.
Lastly, just to summarize. Why is the real estate strategy important for KFN. Firstly, it complements the growth and income story that Fred and Marc articulated earlier. Secondly, it provides an inflation protected, non-commodity asset to the KFN portfolio construction, which is a very valuable element of the KFN strategy. And thirdly, it allows us to create cash flow through cycles and we're living a world where as Henry alluded to, cycles are going to be shorter, having sustainable capital structure with predictable cash flow is going to be a differentiator for KFN.
And lastly I would say, as Henry alluded to also we're not in the business of "buying" the market in commercial real estate. We're in the business of trying to establish very interesting risk reward opportunities in the idiosyncratic form to allow you the KFN shareholders to benefit from our expertise in the real estate markets.
So with that, I am going to turn it over to a break. We're going to take about a 20 minute break and then we'd would like everybody to come back promptly, so that we can continue the session. Thanks a lot.
Good morning, I'm Michael McFerran. I am the Chief Operating and Financial Officer for KFN. So we'll pick back up and really cover three topics with you. First, I'm going to talk about our capital structure and liquidity. Second, I'm going to talk about our CLO transactions and how we see market opportunities and issue new transactions. And third I'm going to review for you our key financial metrics and how we think about performance and each these strategies that you heard about today.
So our capital structure before going in details with where you have today, I'll just probably useful to give you some background about how we think about leverage and how we position our balance sheet. As Bill mentioned, we've learned from some mistakes when we assumed management of KFN. Before the credit crisis KFN had nearly $3 billion of short term mark to market debt in the form of [Saudi Arabia] return swaps, repurchase agreements, warehouse facilities and before we drawn credit facility.
So when Bill and I took over management of KFN in December 2008, we came up with a couple of basic principles how we wanted to manage the balance sheet. First, we realized not all leverage to treated equal. We have a half turn of debt equity today but I have turn a leverage in the form of 30 year bonds is very different than half of ton of leverage in 30 day 90 day repos with mark to market risk.
Second, we wanted to use leverage that was long dated so most importantly had a tenure that was extended past the life of the assets we are using its finance. And third most important we didn't want to have leverage on a balance sheet that was tied to the values of assets we were using the finance.
And because as you've heard everyone talk about today the strategy for KFN is it we'll be opportunistic and pursue assets where there's dislocation, so we could buy things that we think got attractive prices. So what we don't want to do is be a cyclical financial business that when prices are really high and leverage is cheap, borrow as much as we can against the value of our assets and then when asset prices go down during dislocations during this different asset classes we faced with rather having that ability to be opportunistic with capital and put on the back foot and having a husband capital to ensure we have enough to meet margin calls that was the situation we found ourselves in late 2008.
As Bill mentioned, we spent most of 2009 on working that situation and by the end of the year we removed all mark-to-market leverage.
So where are we today? First and foremost we're investment grade rated. So this happened in November 2011, key to our strategy, wanting to use long term non mark-to-market debt, was being able to open up the channels through which we can issue debt capital. And having investment grade rating was essential to do so.
Right after receiving our investment grade rating in November of 2011 from Standard & Poor's and Fitch we seized upon the opportunity and issue $259 million of 30 year unsecured notes at (inaudible). We did a second offering of these notes this past March by issuing a $115 million at 7.5%.
Second as I talked about our holding company recourse debt is just under a half [tune] to equity. Third as far as the duration of our debt our weighted average remaining maturity on our recourse balance sheet debt is 23 years. So, if you think about where our mindset started, learning from the crisis as we entered 2009 and where we are today, in the – our balance sheet actually reflects where we wanted it to.
The other key element of how we manage capital is having liquidity available to deploy all the strategies that you heard about today. So when we look at our balance sheet at June 30 we reported $474 million of unrestricted cash of that amounts we have earmarked a $112 million to retire our 7% convertible notes which were due and we paid past July.
That left us with just over $360 million of unrestricted cash available for new opportunities. In addition to a fairly decent amount of cash, which actually represented more than 20% of our market cap, at June 30 we offset (Inaudible) to source capital from within our balance sheet without having to issue additional debt or equity.
This really comes to our hoarding to CLO notes the structure of CLO from 2005 to 2007 we trenched up our ownership interest. So specifically the most valuable part of the CLOs that we own that we focus on are the subordinate notes, that's where the residual value of the equity or the deal.
We also tranche to that so we held a combination of rated and unrated mezzanine notes. So over the past year we've actually sourced an additional $73 million of cash by selling $94 million phase amounts of D notes from CLO 2007 1 these are rated of single A by Moody's and based on the price we sold them at we're generating under a 4% cash yield and close to a 7% yield to maturity that is several years out so by being able to effectively exact capital from our existing structures, we're freeing up cash for redeployment for opportunities that we think will be accretive.
In addition to those sales we did in the most recently was on August 10th where we sold about $17.5 million of these notes at a price just over $81 we still have another $110 million of these notes. So that's theoretically another $110 million face amount of assets that we sold at the last price we did trade that it could generate over another $90 million of cash, which when you add to our existing $360 million, gives us almost $0.5 billion of dry powder. And by the way, we will talk about financial results later. We said on over 20% of our market cap in cash and generated a 16% return on equity last quarter, have consistently generated mid-teens, GAAP and cash returns on equities for the last several quarters and that's still probably not much dry powder to be opportunistic.
Drilling down to what our debt profile looks like today. After the retirement of the $112 million of notes in July, we have $830 million of debt. Again this has a weighted average remaining maturity of 23 years. It consists of a $173 million of convertible notes due in 2017 and after that, we don't have another debt maturity until 2036.
We have issued the two tranches of the senior notes which mature in 2041 and 2042. We also have $284 million of trust preferred securities maturing in 2036 and 2037. Of that $284 million, about a $125 million is floating rate at LIBOR plus 245 that we actually put on interest rate swaps through maturity of those notes to convert them to a fixed rate of 3.8%. The remaining notes have a bearing interest rate fixed rate of around 7.5%.
So going back to what Bill and I thought about the day when we took over management of the company, balance sheet's positioned with long date of debt, no mark-to-market leverage. There is actually an alternative to this, which we had in past and a lot of financial services business explore, especially in times like today where the repo markets are open, the swap markets are open and yet actually borrow at a pretty low rate and pretty easily against assets of market value.
The challenge again is we can go ahead and take all of our assets, borrow against them, get probably a cheaper rate by borrowing against the market value of those assets. Take that cash and buy more assets and keep that cycle turning. But we all learned that in the credit crisis you know how that turns out. So while we hope we want to experience a repeat of the fourth quarter 2008, we've heard everyone talk about today is we expect volatility to remain.
So lastly that we want to do is be positioned where we have to worry that when the asset prices do go down we have to think about how far they're going to -- they may go and start to actually creating liquidity reserves. So we are very proud that the system we have in our middle office to manage collateral management and are posting a margin as cobwebs on it.
We would like to keep it that way by not issuing that type of debt. We think it is a superior model that not only creates, give us a flexibility to be opportunistic, the markets are dislocated, but actually protect shareholder value by protecting us from the downside of loosing value through leverage that frankly could disappear and eat or erode your capital.
Our CLO transactions as you heard today is the largest strategy since we have deployed capital to. We currently have about a $1.4 billion deployed to six CLOs. Five of these transactions were traditional syndicated market deals done between 2005 and 2007. Those deals originally issued at a total of $8 billion of assets. The CLO market during the crisis had to be shut down and when you think about the time on what's happened to the CLO market in 2005, there was about $50 billion of issue, 2006 you reached a peak at about $95 billion of issue and just a little bit less in 2007. 2008-2009, the market was effectively shut down and started coming back in 2010 with about $5 billion of issue.
When you look at our CLO, this is a strategy through which we execute our bank loan high yield strategy, as we know senior secure loans held unlevered don't provide attractive returns. But the CLO technology we have, we actually very liked from a financing perspective, so it allows us to have a cash flow vehicle and that's important. CLOs aren't based on mark-to-market, so unlike other securitizations where certain market value test or trip and they explode and they're going through a rapid amortization, CLOs or cash flows.
And the performance of the deal is based on the cash flows of the deal, so ultimately credit selection and management of that portfolio determines the ultimate outcome and performance of a CLO. If you look at our transactions today of the legacy CLOs which again are those once done between 2005-2007 where just under a $1.3 billion of capitals deployed to, we generated over $57 million of cash income, not principle, the cash income last quarter.
That results in our cash return on equity of 17% on our invested capital and that let alone any leverage we use to help fund those deals. (inaudible) in the market have changed a lot, we wanted to reenter in 2011, we were conscious of the downside risk of doing CLOs and by the downside risk, the benefit of our ‘05 and ‘07 deals were the liabilities were priced very tight which meant of asset spreads, probably one can go much further because we ramp those portfolios and loans of trading at par and with an implied spread of LIBOR plus 275.
And that our abilities were at LIBOR plus 82 bps. However, in 2011 the world was very different. So the risk you had is you may be create a portfolio of assets, let's say a LIBOR plus 500, as for example and may be you could do liabilities at L plus 200. So you pick up a net spread of 300 basis points for a return of leverage.
Let's say you put on four turns of leverage, you get a leverage return at 12%, you add on the other 5% for the equity turn and 17% knock off a point for expenses and administrator and all that, you get a 16% to 16.5% return on equity, which sounds great. The problem with CLO is at the time 2011 were, non-call periods were effectively matching reinvestment periods. So you were trapped into the deal, so reinvestment is very powerful, the spreads widen because you've actually locked in the liability cost, you could actually replenish your portfolio with higher yielding assets, but it is also very dangerous as spreads tighten. Leverage loans that you put in CLOs are very similar to mortgages and different than bonds.
They are generally pre payable without penalty. So more as markets tighten, people repay loans and replace them with tighter spread assets. So [phase] with that and with what we considered long non-call periods, so generally in 2011 you are seeing non-call periods of CLOs of two to three years matching reinvestment periods of two to three years.
And if right away, how do we reenter this market, but again protect our portfolio from what could be a 16% to 17% return, but if the world tightens up as it has you find yourself with a 10% return which to get if you feel it real easily because all asset spreads have to do is tighten a $150 basis points. And you have lost 7% of return on the CLO.
So we went from being a mid to high teens return to if we are hopeful at least low teens and more like the high single digits. So you came up to CLO 2011 one, leveraging our firms relationships with an overseas bank that was looking for a solution of how to reenter the CLO market as an investor and was looking for loan growth. We worked together on coming up with an innovative transaction that really solved what we needed at what the counter parties needs were.
The structure of CLO where we held the equity as we are doing our current deals rather than issuing the notes they put a loan to the SPE we created. This was also a little different because unlike traditional CLOs, we were capital (inaudible) first in last out, the CLO actually returned to capital from principle repayments pro rata between the senior lender and us. That allowed us to do was maintain leverage at a fixed level as the deal amortized because there was no reinvestment period. So while we had a declining capital base in the CLO, we were able to maintain that [IRRs] as capital goes down.
The other benefit this gave to us was a six-month non-call period. So spreads literally tightened up on the liability side. If you call this transaction, we place it with a new deal and that we can syndicate in the market.
Focusing back in our CLOs, one of the key tests, that's something I think a lot of you'll focus on the past, but I'll spend a minute explaining what it is for those of you that aren't familiar with it is the over collateralization test. There is really the key text to measure the performance of the CLOs cash flows.
If you fail this test , the cash flows that we would get as the equity holder in the deal are actually re-routed to amortize the more senior bond holders until we has (inaudible) back in the components. So KFN is another challenge in late 2008, early 2009 as we're failing these tests.
So if look a the grey chart on the screen, the first CLO 2005 one, left hand side you see our OC level and the deal was printed in 2005 and stamp AAA by two agencies. We have an OC level a little over 2%.
In September 2008, so right before leverage loan prices collapsed for price just below 60, you saw an OC level of around 4%. Year-end was 5.5 and today it's over 9. This CLO never failed an OC test. It had more cushion going into the prices that were dealing since it was first issued and today as almost four times as much over collaterization as it was when it was first issued.
Now 2005 two and 2006 one in the next two CLOs you see on the screen, they had OC level slightly below where they were when they were first issued. Both these CLOs failed an OC test for one quarter. So for one quarter, the CLO is delivered, test came back in compliance and cash flows to us most deals reserved. 2007 as you see when it entered the [crisis] had no over collateralization. The CLO was out compliance for year. 2007 [A] had less than half of its original over collateralization (inaudible) when we went into the [crisis].
If look at the far right for each of those deals, you'll see for every transaction we have the [CLO] levels today are multiple what they were when they first issued. To some (inaudible), we could repeat the events to the fourth quarter of 2008, we are actually quite comfortable we won't fail NOC test for any of these transactions.
So now we've talk about little bit about our legacy deals everything about the market going forward. I mentioned how in 2011 we are trying to protect against that down side risk of refinancing marketing and expense liabilities.
Frankly, liabilities spreads today are much different they were in 2011. Lot of people are looking issue CLO's. So it's been really more of a buyers' market and while assets spreads have tightened over the last year, LIBOR expense really haven't.
If you look at deals done in the last month, liabilities still set around L plus 200. Assets have tightened from a year ago of L plus six to say around L plus 525 to 550. So knowing that the economics are still attractive but they are ideal. What has changed though meaningfully in the market is the non-call period. Today you are seeing deals rather than being two or three year non-call periods with matching reinvestments periods a year to year and half ago.
Today you are seeing deals getting done with four year reinvestments periods and one or two year non-call periods. That's not more attractive to us because it takes a lot of that risk off the table. So we are starting to as we touched on our last earnings call, four opportunities to reenter the CLO market to reconsider traditional syndicated US leverage loans CLO transaction.
In addition, building upon the innovation of CLO 2011 one, want to figure out how to capitalize that and it's been that took new opportunities as well and one of those opportunities you heard us talk about today is Europe where there is an illiquidity premium assets. We actually think by issuing CLOs at comparable leverage cost to what we will do for US deal if you could actually capture couple of hundred basis points of asset yield by filling the CLO with your paying assets.
So that's another option you were starting to work on is how to do what we would consider something that's kind of side step to conventional CLO market working more innovative transactions, both of these are opportunities we are pursuing today and we expect before the end of the year though we have progress to share with you on both runs.
That takes us to the financial review. There is a series of financial metrics we focus on and we talk about our earnings calls. Few years back, we talked a lot about a metric that we no longer share because we don't think it's meaningful anymore that was a run rate earnings. The run rate earnings used to be meaningful when KFN was a net spread business with mortgages and leverage loans financed with debt net spread less non-investment expenses was really mattered as we buy your assets at near par and realized gains or losses were really more of an episodic thing they weren't frequent. The businesses of all a significant portion of our capital today has been deployed to other strategies where the way we present our financial statements, the income or losses from those performance has been reflected through other income other loss, so why we think if you wanted to focus on GAAP earnings and GAAP metrics, GAAP net income or loss is the most important one.
We do think cash flow is a little different because we have a cash distribution or dividend to our shareholders to support. So we do provide two cash metrics. The first is run rate cash earnings per share which was $0.32 for the second quarter which represented 13% net cash return on our equity of this run rate so recurring cash flows from our different strategies nothing else was episodic from onetime gains.
On a total cash earnings basis which does include those onetime gains and other items on the cash basis and other income, we generate $0.34 or 14% of the cash return on equity.
Now, I don't want to spend a lot of time comparing and contrasting us to other specialty finance companies, I think we all agree especially finance reported earnings and the teams is doing pretty well.
We are not just showing reported earnings, we are showing cash earnings. Our reported earnings were higher and most of that's due to the difference between cash income on your debt portfolio and discount attrition for positions you buy at par that's where the timing difference when you take those gains, that was 16% for the quarter.
Another metric we focus on is book value per share which was $9.79. However, this is worthy of little bit of background. KFN doesn't follow investment company accounting. So BDC which and public investment funds do, so all their assets are mark-to-market. For us, our portfolio is primarily consist of leverage loans, investment that are carried at amortized costs, less evaluation for credit losses. So they are now mark-to-market.
So our book value per share reflects the current value of our balance sheet doesn't necessarily reflect the fair value of our balance sheet. If you check our loan portfolio at June 30, actually mark-to-market. You find that we had another $15 million of [unrealized] gains over and above the current value of these loans which is based at $0.30 per share.
So on a pro forma basis, if tomorrow the (inaudible) we waved a magic wand and we converted KFN into fair value accounting for all of its financial assets, our book value per share would have been $10.9.
So again book value per share is a useful metric, it doesn't capture fair value. You will find that the math is real simple if you look at our MD&A in our quarterly filings, you'll see the carrying value of our assets, you know, see the fair value. Take the difference between the two whether it's positive or negative, adjust your book value by that you can re-compute the $10.09. Last metric that we know everyone's really focused on is distributions per share which were $0.21 for the last quarter, which was an increase of almost 17% from $0.18 from the prior quarter.
One unattended consequence for the better life of us now diversifying KFN on the different strategies you heard about today is that it has made KFN more complex to understand and more complex to model. Obviously it was easier if you had a portfolio of loans that had an average spread of x, financed with debt with a spread of y, took the difference between the two, backed out some 3% of its expenses. You came up with a net return, very simple to model.
And that will be great and make a lot of easier but doesn't necessarily provides superior performance. So again a negative repercussion of how we effectively evolve KFN is finance reporting is more challenging. We recognize that and we're trying to improve upon that by introducing new disclosures from the last few quarters and talk about some of the interims we're doing going forward. Most notably, I want to share with you how we review our financial performance.
KFN, we think about our capital. That's the key metric is we have capital deployed, capital comes from debt that we raised through long-term bonds, capital comes from our equity. When we evaluate our performance in terms of our strategies, we're focused and we evaluate investment opportunities, most focused on return on equity or the return on that capital. So, the best way to share with you how to understand the performance of our strategies is that you view with our eyes and see our returns on equity by strategy.
So, if you look at our supplemental presentation, that's posted on our website every quarter. At the same time, we do our earnings release, you will see our returns on equity by strategy, which breaks down for you actually an allocation of our income statement and our debt so each of the strategies you've heard about today and this is paramount today because if you look at just at the end 2010 little more than year and a half ago 90% of our balance sheet was bank loans and high yield. So again that's spread of business and simple to model today it's less than 70%.
Now, Bill talked about how we always expect the majority of our portfolio to assist of credit. Because now almost the third of it is not credit we do need to continue to improve upon providing transparency deal hard to understand and try to predict our performance of different strategies around a minimum understand what the key variable are that will impact performance.
In our earnings calls we try to articulate a spectrum how to think about our earnings by strategy. The left hand of the spectrum is bank loans and high yield assets that you purchase at prices that are closer to par, the exception extreme situations in the markets, where you can capitalize in dislocation that 68% of a portfolio, 68% of our assets have high income and cash predictability.
As you start moving down the spectrum you move further away from that. Mezzanine were about 95% or 90% of what we own is debt with a [coupon] what about 10% of our mezzanine in consist of a company equity positions, those businesses.
Then we move to natural resource, which over time will move further to left hand side of the spectrum that's were soon expansionary face of a acquiring properties in developing reserves kind sits in the middle and a little through right of mezzanine. Commercial real estate some were actual resources is in that early stage of less income predictability but as development occur over time and based on what we own specially if it's debt versus equity becomes more predictable. That you have special situation which is that strategy focus on capturing dislocation.
So that strategy is less yield-focused while does generating is more focused on actual realize gain from the investments. And the last is private equity which is we all know doesn't generate any recurring income depends on when you actually monetize private equity investments.
This slide shows you an example of the reporting we have in our quarterly supplement to shareholders. The quarterly supplement provides more detail around these numbers and the distributing factors to them or we just wanted to show this with you just kind of illustrate how to think about reporting at a strategy level.
So what impacts the major components of our P&L, well investment total investment income on the asset side is based on a recurring basis because everything it's not recurring gains or losses or other income loss recurring basis its net investment income which primarily interest income and our debt portfolio less interest expense on both our holding company debt and our CLO subsidiaries, as well as income from our natural resources investments.
Natural resource investments, a little different, because unlike loans or bonds that have a face value in the coupon you can multiply it out they are really driven by a couple of variables, first is production, the second is what you sold the production for.
Interest expense fairly straight forward, the footnote lays out for you what our debt is and the borrowing rate of the debt and it's fairly simple to recalculate. Non investment expenses are another place in our income statement that will become more complicated really due to these natural resources strategy. So if you look at the second quarter of this year, we reported $34 million of non investment expenses of that amount $16 million was actually related to our natural resources business.
So it wasn't what I would consider a true corporate G&A of that $16 million, $5 million of that was DD&A which was non cash depletion reflecting reserve sales we had another $4 million reflected one-time items related to acquisition costs and we buy properties actually expense the cost of acquisitions rather than capitalize them and a one-time impairment charge of $1 million.
And the last bit was $7 million of recurring these operating cost work over expenses it really the expenses inherent to strategy. So on a perfect road you would see that $7 million of expenses lined up with your net investment income from the strategy.
Then you have other income loss and this especially is a great example of how GAAP sometimes and when you look at an income statement, it doesn't give you the whole picture. As Marc talked about earlier we hedged the majority of our production from a natural resources working interest, however while we see revenue from the working interest of top our investment income line we actually done see the realized hedges or relate to it and that is really we got the two together because ultimately what we're getting is the realized hedged price on those reserves that we sell. That's buried down in other income loss as well as the marked to market which reflects the present value of those hedges.
so how do we simplify this going forward, most notably strategy reporting and moving to segment reporting between now and the end of the year, which will actually show you capitalized CLOs, not CLOs, I mean, capitalized income statements for each of our strategies.
We think that will simplified a lot of the reporting needs in addition we don't see a lot more disclosure in our 10Q some of which I'll talk about in a moment another which will be implemented in our supplemental presentation it will continue to provide more metrics that will allow you to be in a position A) how we're making money, what variables are that are driving improved or worse performance and when you see events happen in the markets, especially in things like natural resources, we can actually start forming expectations.
How much production is KFN generate last quarter of natural gas what have natural gas price is done how much is KFN hedged and what pricing when KFN hedge at based on the forward curve.
Doing a quick run-through of our strategies, Fred mentioned earlier bank loans and high yields execute through our CLOs we have $6.7 billion of assets on the strategy and 98% of those are in CLOs, and the residual 2% reflects in European opportunistic investments made pre crisis.
One thing Bill had talked about auctions and caption auctions embedded in our business. One of the valuable options embedded in our business is what we consider our free option on LIBOR and we talked about CLOs have generally a 17% cash return on equity and over a 20% reported return on equity.
However, in addition to that, we have $1.8 billion free embedded option on a short-term LIBOR. If that option takes us to monetize and if LIBOR returns to pre-crisis levels of around 5.5%, you will see our income go up almost $65 million per year or about $0.30 per share, pretty meaningful.
Moving under our special situation strategy, you will see about 75% of it which is debt holding, to another 25% equity holdings and that strategy today has got a market value of $190 million, against a cost basis of those assets of about $170 million.
One thing we've disclosed last quarter, which we think is important is how we are actually performing here because you can't measure it like yield because this isn't a long-term hold strategy for at least from a debt instrument, and if it is, it's often because it is going through a restructuring and we're looking to be the equity holder.
So, what we talked about was we've purchased since the inception of the strategy in early 2010, $300 million of investments in special situations. Today we monetized almost $90 million of investments made through that strategy at a realized internal rate of return of 40% and if you look at the strategy as a whole and based on our market values for our holdings as of June 30, we're still at around 21% IRR.
Again these are metrics we will continue to share with you going forward, so you can understand the same way we do how the strategy is performing. Fred had talked about mezzanine for a bit as well. As again, but 90% of what we own, we would make mez investments as debt and that debt has an unlevered yield of around 15%. So very different than the CLO rather than being at the top of the capital structure where you are attaching leverage into an SPE to create a mid teens return, the mezzanine investments are levered to generate that 15% return.
You have the 10% in equity which is if you think about it as far as the mezzanine strategy, you want have upside to the business because you're taking a view by being at the bottom of the capital structure.
Next private equity Bill mentioned this will be a small part of our business and it has been. But nevertheless we've generated some attractive gains, over the past year we've reported significant gains from investments we made like [Kilcorp]
Today we have about $50 million deployed with a comparable fair value to a handful of private equity investments made by KKR's private equity funds. When you need benefit KFN has, as we have the ability to participate in private equity deals that KKR does through its private equity funds on a no-fee basis. So KFN has access to a very valuable pipeline of those opportunities. Again we will never expect this to be a significant part of capital, we like the optionality for growth afforded by having some exposure to these investments.
Next is natural resources. Marc spent some time walking you through what our holdings look like. So we've about $385 million of carrying value of natural resources as of June 30. Of this amount the majority is working interest which is about $236 million. If $79 million of royalty interest, of that about $55 million relates to the investment Marc talked about in the Eagle Ford Shale and the remainder relates to a partnership that we have at Chesapeake to source royalty opportunities.
And we have deployed almost $30 million to it since its inception. The remainder represents, if you look at the top two boxes, the $69 million is that other bucket Marc talked about. And this kind of represents what we consider the opportunistic side of natural resources.
Looking at our holding international resources and this is I think for some information Marc talked about, proven developed reserves are things at day one are producing represents 67% of our total reserves. Proven undeveloped represent 23%, so the key metric to think about as you monitor our financial performance is monitoring our reserves. Overtime as you will see, natural gas prices rise and also based on the timing of when we acquire new properties and the drilling commences or continues, you would expect to see proven developed producing reserves go up and the proven undeveloped potential go down.
That ideally should increase revenues if prices are flat, if prices are up then you will see an exponential increase in the revenues from that strategy. The other benefits of those proven undeveloped reserves that we talked about similar to LIBOR is that optionality. So when we buy the investments, we invest in working interest opportunities, we are coming up with an investment thesis with an IRR based on capital deployed through the proven reserves.
So we have that embedded option that when and if energy prices rise, especially natural gas we are now able to tap that opportunity by drilling those proven undeveloped reserves and there is a third component that we don't spend which I am talking about which is unproven reserves which we don't focus a lot on because it's a little more difficult to quantify. As far as hedging that Marcshared that we have hedged the majority of our production. So our natural gas, we have hedged 73% of our production through 2016 and enterprise just over $4.
Natural gas represents about 70% of our total reserves with the remainder primarily in liquids and a small amount of exposure accrued. This chart shares with you how this business has grown. In June 2012 we had almost 1400 wells producing. As you look at the far right you will see the transactions we have done since the inception of the strategy. We made our first two acquisitions in the fourth quarter of, one being the acquisition Marc talked about from Conoco and the second being a smaller acquisition, also it actually was not in the Barnett, with the Wilcox formation. We made some acquisitions in 2011 and 2012 when the natural gas fell to $2 we were able to be opportunistic and we have a lot more capital to work and as a result as we've acquired more properties, you're seeing the increase in our monthly volume on a million cubic feet equivalent basis.
So what are the metrics we are going to start to sharing with you and help you understand the business, it is really three. The first one we realized revenue per Mcfe and we think that's going to be a useful metric you will start seeing next quarter that will actually help you understand how well we are doing from – and that is impacted by actual prices that we are selling production at, the performance of our hedges which gets incorporated in there as well as operating costs.
You will see operating expenses as a percentage of Mcfe which are really our cash expenses of running our working interests and these include everything from traditional lease operating costs at the wells to work over expenses and some taxes associated with that business. Last we are going to break out for you separately DD&A. The reason we are separating that from the operating expenses is it is meaningful in the sense that it is a GAAP expense and actually reflects the depletion of our portfolio reserves, it is a non cash item.
So we wanted to separate that for you going forward, so you can understand the difference between cash, revenue, cash expenses and non-cash expenses. So a couple of things I want to leave you with. When we look at KFN's balance sheet, the one thing that really resonates with us is since the company was formed in August of 2004, we don't think the balance sheet has been better positioned than it is today with a half turn of leverage, leverage in the form of long dated unsecured non-mark-to-market debts combined with significant dry [powder] both on cash on balance sheets of over $350 million, access to pull more capital out of our balance sheet without having issued additional debt or equity, it takes us closer to $0.5 billion. We think we're really well positioned to pursue opportunities and all the strategies you heard about today.
From a financial performance standpoint, you will see, if you look at our slides from the last few investor presentations, every quarter we consistently generated mid-teens, cash and reported returns on equity. We think both metrics are very important, while GAAP captures value in the balance sheet, cash ultimately is most important as we will have cashes available, both paying out dividend to you and for reinvestment in the business and grow the value of the company.
And last, recognizing the complexity of KFN, we're taking a lot of measures to try to simplify this for you. So when you look at KFN, it's not this mixed bag or there is some energy in there or special real estate, or some banks loans and bond, (inaudible) model this thing. And where it starts with is the basic building blocks, thinking about the way we do which is ultimately talking capital, deployment to strategies, unless you return on the capital. That's the foundation to building blocks. If you start with that, then you can layer upon that with wanting to understand actually some of the key movements and the strategies, mezzanine (inaudible) maturity, how much is equity. You can make your own assessment of what you think that equity is worth and natural resources, understand the key performance metrics.
In special situations, understand our performance quarter in and quarter out to see if we were executing successfully in those strategy or not and where we make mistakes trying to understand why. And then bank loans and high yield what spreads are we capturing and where are we in the CLO market? Are we, have our consistent deals run off or we are going to maintain and resume our leadership role through a new and innovative transactions.
So, thank you for your time, I appreciate your support in KFN.
I want to thank all my colleagues Henry McVey's view from a Marco perspective, Fred Goltz talking about our Credit Strategies, Marc Lipschultz on Energy and Infrastructure, Ralph Rosenberg on Real Estate and then Mike talking about our CLO Strategy and Financials.
Before we get to a Q&A where we can make this little more interactive, I wanted to summarize kind of what you heard from all of us today. And think about how we positioning KFN for the future.
You know, going back to their previous statement that a lot of my colleagues have said KFN's not something that you see every day.
So especially finance business, the real assets allocation done for risk management purposes, true but for return purposes primarily. The flexibility of our publicly traded partnership perspective is a finance company allows us to pursue numerous asset classes but we see mispriced options in the greater source of return per unit of risk.
We make market based allocations; they are not fixed and set. They are may come at a time and day when our MLP that were holding our energy is overvalued and we want to it take a public.
We may decide that real estate is over valued at some point, and [not] want to be in it. But at the end of the day, we're focusing on trying to find those places of greatest supply and demand imbalance and in those areas where we have a competitive advantage of KKR through our sourcing network, our ability to create diligence and technical resources to understand things better than others.
Because we make fewer mistakes going to a point Fred made, we'll win in the long run given the low leverage nature of our capital structure.
Total return finding and seeking these mispriced or free options like we have in the case of our energy exposure where we obtained in the context of our liabilities and CLOs done in 2007 allowed us to continue to create value. What's great about all these options we have collected over the last four years is that in shareholders today get paid away.
Those options are starting to show up in our total returns going through the financial information Mike went through the difference between our GAAP, total returns and our cash kind of run rate EPS, they are starting to show, but if you are getting paid in mid-teens cash-on-cash why you are waiting for those options to get in the money, it's a pretty good deal. Usually you have to pay money to wait for an option to get in the money here you get paid away.
A shareholder after our earnings call called me and had one question and he said what keeps you awake at night? I said where we are today not much, the right hand side of our balance sheet is well positioned with 23 years of weighted average life and the death we have in our capital structure, we can actually call it and refinance it even more cheaply just over four. So I feel good about how that options set.
When I think of the left hand side, the investments we have made whether it's in loans, whether it's in mezzanine, whether in special situations in Europe or Asia, the natural resource investments we made and our strategy now of real estate including the shopping mall we acquired outside of Chicago, I feel really good about where we are positioned. It's a diversified portfolio I think our allowance for loan losses is reflective of any potential risks in our credit exposure and so I (inaudible) you today as we enter the Q&A with a lot of optimism on the future and I thank you all for your participation and for your gracious patience over the course of the last three hours and feel free to fire away any questions. So I am going to ask my colleagues to come up and Pam Testani will moderate any
All right. Thanks again like Bill said for spending the morning with us here and we will be turning floor over to you all for questions in just a minute. I am going to call on you by table number. So if you can just make sure to hold the mike close so that everyone the webcast can hear questions that would be great. And with that we will open it up. Please table three.
Let me first congratulate, you and your colleagues are doing a very excellent job, very interesting and very informative. My normal style is to have more than one question so. I actually have seven but I think it will be of interest to the group as a whole. So with your permission hopefully your intention, as good the presentation was, there wasn't anything tying it together in terms of what your expectations are looking forward? So we (inaudible) ask a question is we were sitting five years from today we are all healthy, above the ground what do you think we look like? In other words do I take a DuPont formula of 15% ROE we are retaining that half to 60% or 40% of the earnings that we can take the 9% dividend yield and grow that 5% to 6% a year, will that be kind of your expectation?
Based upon the information presented there of 15% mid-teens started returns on capital that a very fair based case.
Going on, we have line of low core CLO liabilities that the reinvestment period is ending, as you look at it how important is that to the growth profile of the company going forward.
If you think, they have been running off. The first CLO at the end of reinvestment period was [07A] back in October 2010, based on the last quarterly cash flows, our equity returns on that deal were still over 30%. So, we think we have a fair amount of runway to let those deals continue to amortize and still part north of 20% returns, high teens cash flows before we have to replace them.
Looking at how the CLO markets improved and most notably, we've talked a little bit about CLO volume year-to-date, there's been $22 billion of CLOs done. Last year they were $12 billion and if you compare that to the pace back in a very heated CLO market like 2005 and it was $50 billion, you see the CLO market is slowly starting to recover back to those levels or pretty comfortable we can be opportunistic and do deals periodically without having been faced with a big cliff in front of us.
Last one but not least is our largest CLO, 071 doesn't end reinvestment until May 14. So we have a fair amount of runway after that deal.
Going to your first question, if you've seen a 15% return on capital right now in certain ports of our allocation or earning, way greater than that due to these legacy liabilities but to a extent that through amortization as returns come downly, we can refinance those structures and still maintain that overall 15% return on capital.
New CLOs you are looking at, what kind of return on equity is this obtains (Inaudible).
You know, based on, if you look at the last two or three deals done in the market, today's asset spreads through 15% or 17% returns.
We miss Henry on the upside of the business he left but your comment was that though we expect shorter economic cycles, I wonder more appropriate phraseology where you expect lesser economic growth because without picking at it, you have economic growth in your slide until 2015. You have 2% growth. The economic expansion started in June of '09 if we're still growing by 2015 that six years and the average economic expansion has been six years. So maybe what we're seeing is a slower economic growth as opposed to shorter.
I think the good question. I think there are components one is I would highlight this dichotomy between the private sector and the government where the private sector is growing about 3% a government actually contracting. And so I think you'll gets these rolling times where what you end with as you get have a quarter to install speed as the private sector comes down and the government has to reaccelerate. And so my best view is that you'll have a – you won't have deep recessions like 2001 or 2007 and '08 but you also won't have the same high.
So if you go back and you think about summer of 2010 summer of 2011 and what I think potentially could happen in the fall it almost feels like you're having a recession along the way. And the analogy I am using is that I think the central banks have essentially, if you remember in old days you take your kids blowing they'd put form in the gutter, so that the ball couldn't go in the gutter, that's what the central banks have done and the consequence of that is twofold.
One is they're slowing down the economic pace of growth the ball going down to the isle, it goes slower and two is I think the central banks and this is why and I think we've focused on real assets. I think central bank is no longer at least in the developed markets have the ability to direct growth up or down by rates.
I think they given they've given the – in exchange for creating the buffer they have created a situation where real asset input cost you know dictate the overall pace of economic growth. And when in commodity price get very high things slow and when they come down they reaccelerate and that's the world we're going to leave and so I think that's create a good back drop for corporate but also think when you hear what we're talking about we also want to have that exposure to real assets that gives us said buffer when things when prices do go up.
Just a few more again hopefully the interest of Group, what do you think the minimum operating cash of the business requires we have $360 million presently earning, if you're earning like me zero, and you can probably earn prudently 10%, 12% is their what do you need in the way of minimum cash to operate the business.
As far as $360 million obviously is ain't more than zero we have an untapped revolver with a $250 million of capacity, we wouldn't our objective for using that would be actually to manage working capital so we can manage the business day in and day out with very little cash.
Looking at it was $360 million that we can make 10%, 12% on that's earnings zero right now.
In addition to the $110 million where we're earning a cash return today at 3% so that we can reinvest from CLO 2007-1 note.
I am very happy owner, I've been for long time obviously there is something that the market didn't like, I don't know whether it's the K1 tax structure where in some instances you can wind up having more taxable income, you have cash income is there anything in the tax code or in the world of (Inaudible) could we done to address this issue what is, or it is what it is?
Let me address that one question, I mean clearly over the last several years from the period of 2008 through calendar year 2011 there were some pretty substantial tax impacts to shareholders for two primary reasons, one was the tax [selection] was made in early 2008 that set the tax basis of the company's assets at a low because it was the beginning of the financial crisis.
And the second is the share price was very low it reached $0.40 at the end of 2008 and has obviously rebounded a lot of that's negative tax implications to particularly individual shareholders as (Inaudible) impact institutional or mutual fund shareholders are behind us and we should expect most likely 2012 and onwards you'll have less of that kind of impact on returns.
Last two, you seem to leave out which I think is important that the alignment of interest if I recall correctly the management KKR head of KFN Financial are very substantial owners, I remember that the 40 to 40 financing on the way down to $0.40 the part that KKR put in $75 million in that financing but have you ever aggregated the insider ownership between employees and KKR?
Employees of KKR own approximately 9% of KFN shares outstanding.
And lastly if you had to make guess at the embedded option value what do you think the real book value is supposed to the 979 or whatever it is stated.
I would – no speculation on that point but clearly we talked about a lot of options that we have some that you know we little bit further we think we paid a lot less than we should have and some of them we got for free that has to be each individual investor determination what that's ultimately can be worked.
You are view is the book value understates the value of the franchise.
We have all those options that don't show up on the balance sheet yes thank you very much on the very good presentation.
All right table four.
Given what you know today in terms of what your outlook and given what the portfolio looks like at this point in terms of the mix between financial assets and real assets. I am curious in terms of say 12 months from now how deliberate you are going to be in term of moving into real assets we get to the points where real assets make up 50% of the portfolio?
We've made it clear in previous earning calls that we expect a majority always of KFN's capital to be allocated into credit as a specialty finance company so that would put the upward limit if the opportunity presented itself and it was very attractive like a period they have experienced over the course of the last 12 months, that you can see that total exposure between commercial real estate and energy be in the range of 40 plus %.
I also have a few questions if you'll bear with me. First of all, do you see any risks from tax reform to the partnership structure and your ability to pay a dividend?
No, I mean obviously there is lot of uncertainty of what could happen. Like I think the worst case scenario for KFN is I think is unlikely is you know, if this concept of a passive partnership, this is oft, we would become a (inaudible), which while is why – which we view less attractive today than our current structure, you know, I wouldn't consider that the end of the world.
At the same time, if they did went down that path, there would be much bigger issues to solve because if you change the partnership structure, the MLP business which is quite large, you would be doing away with that and then all the capital that's formed to pursue energy which mainly consists with what a lot of people on the hill want to do, you will be terminating all that capital.
So I think the positive for us is our structure that it matters maximum in the partnerships, which is really a lot of the capital for energy, midstream and upstream as identical.
Okay, now I have a question for Marc on Quicksilver please. Could you take me through the rationale of the investment, when do you expect to get -- from what I understand Quicksilver is unconventional gas and in an inaccessible region, they can't be producing economically right now?
So, and maybe Fred and I will both comment on this because I think it's actually an intersection of a credit investment really with an underlying energy thesis and in fact in an energy company. So we're not in this case direct investors in Quicksilver. So actually I sort of not qualified to give and express an opinion on the company in total. Our investments are very structured. So what we made the investment around is actually providing some of that critical midstream infrastructure that I talked about before and there is need to disconnect sort of production to standard of demand. In this case up in their Horn River development which is a very important strategic asset from Quicksilver's point of view as they have talked about publicly.
So what we invested in was not Quicksilver but rather what we invested in was development of that processing and transportation infrastructure with a very, very strong contract back to Quicksilver, the parent effectively and so our exposure to Quicksilver is effectively as an unsecured lender for intents and purposes.
So what we did is we identified a need they had, met that need in a sort of creative structured fashion and then turn it over to the credit world and perhaps Fred you want to comment on how we thought about you know the ultimate result which was, what amounted to an unsecured commitment of Quicksilver to use that infrastructure that we are building in partnership with them.
I think in the end if you cut right through it all, we had an unsecured guarantee from Quicksilver in terms of the CapEx and throughput in that particular complex and we were able to price that liability of Quicksilver and to have sort of mid high teens rates of return for what amounted to you know an unsecured claim on Quicksilver itself and so it wasn't just lending to those particular assets, but it was in fact you know part of you know the Quicksilver complex and they are required to spend the CapEx and do the development there to generate those rates of return.
So when we looked at it on a risk adjusted basis and looked it on a relative value basis and we felt like we were getting you know Quicksilver unsecured risk at several 100 basis points wide of where it was trading then and even where it is trading now and in spite of the downturn in gas prices.
And I would add one point to Fred's statement which is that investment de-risk every day, why Quicksilver is unsecured high yield at the parent company pretty much keeps the same risk. There isn't a de-risk everyday is because every day they are spending CapEx in the Horn river drilling new wells, poking new holes in the ground which creates new gases that's going to flow through the pipes that we own. And so over the course of the first year, the effective reliance on the unsecured guarantee of Quicksilver holding company becomes less and less important to the investment because we are closer to the assets in Canada.
So does that cash flow from beginning or does the cash flow when they start using that or what's the --
Cash flow from the beginning for the initial assets we acquired and every new dollar we spend immediately begins 15% additional cash flow on that, yeah.
Keeping on the deal front, my next question is to Ralph in terms of acquiring commercial real estate assets, A assets or certainly well bid by REITs that have very low cost of capital, assets that are positioned for turnaround are subject to bid by opportunity (inaudible) that were raised that can't find enough opportunities, how do you see positioning yourself to continue to generate attractive opportunities in real estate?
Sure, I think you are correct in pointing out that the core property market for the most part is a market that has appreciated very significantly and theoretically I would be more of a seller of the core market than a buyer of the core market, which I think is consistent with your comment.
In terms of your comment on opportunistic capital in many respects, what we have is a combination of opportunistic capital in the equity space coupled with opportunistic capital in the credit space with a differentiated sourcing network that allows us to find opportunities at some of the more traditional opportunity funds just don't access to.
So for example we worked very closely with Marc and what is going in the energy sector and we are looking at a number of opportunities around how to effectively play the real state derivative off of what is happening in the energy sector and similarly speaking as I alluded to earlier between the same type of work in the healthcare space we are leveraging off of the sourcing channels in the relationships of the firm to create opportunities in the healthcare world which effectively is leveraging off our private equity franchise.
So it is a long waited way of saying that on the one hand, I know all the players out there who are dealing in siloed fund form who effectively don't have differentiated sourcing channels and I juxtaposed their deal flow with a deal flow that we create on a weekly basis and it is night and day. And I think you can never underestimate the power of the KKR brand and the power of the KKR global reach to create very interesting deal flow, that is real estate related.
So I am actually very encouraged by our pipeline and you know we could put out hundreds of millions of dollars of capital in the next six to nine months.
Two more quick ones. First of all how is the carrying value of your assets determined?
Sure the bulk of our assets are loans, so loans held for investment are carried at amortized cost or purchase price, less valuation allowance for credit losses. So we follow effectively the same accounting that Wells Fargo or Citi does for their balance sheet. But several of our other assets specially in our newer strategies like mezzanine or special situations we actually like the fair value accounting when you buy those assets. So we are marking those to market, same with our private equity.
The natural resources front, similar more to the loan world, the book in the reserves that we acquire at purchase price and then we walk down a purchase price as we [sell] often reserves. So that's the depletion we're talking about.
Okay and lastly, I am interested in your outlook for your dividend policy to expect to be paying out more or less level dividend or what are you looking to achieve in dividend policy?
Unidentified Company Representative
Well, we don't make forward-looking statements about dividend policy and that's a board level decision but you can kind of look at the past to get an indication of the future. We had dividend of $0.18 a quarter for four quarters, this last quarter that increased 17% and so in the context of thinking about our dividend policy when the board discusses it, the things that they factor in not limited by but including or the company's financial performance or what our cash earnings have been and what they look like on a going forward basis, what potential tax liabilities might be allocated to underlying shareholders and similar to what we've done in prior years, we also have the flexibility under our disclosures to make a special distribution at the end of the calendar year to the extent that we want to increase the distribution above and beyond the regular quarterly rate.
Okay, thank you.
Great, how about table 11?
Hey, just a couple of questions. I guess starting off from Mike and Fred. Looking at the CLO market, there is a huge number of CLOs, probably about $150 billion earning in the reinvestment periods in the next two years, I was just wondering if you could give us a little color on where the funding will come from the broader market to absorb that capacity and what the impacts would be one on, your investment strategy and then two, on your funding strategy?
Sure. I'll take the first part what it means the CLOs running off. And Fred can talk a bit about the new issue bank loan market because the two are really inter-related. Definitely the CLO is coming out of reinvestment. That said, a lot of the CLOs are coming out of reinvestment where we investing especially during the crisis because that task we talked about, most CLOs were failing that.
So our CLOs are again reinvested today, they are really turning the secondary market in a lot of frankly lack of supply of new loans has helped to push us loan prices up to the high 90s because of that issue. The positive thing I think CLOs they are in the reinvestment sounds they have to sell the loans. CLO managers are actually disincentivize to run down this portfolio any faster they need too because we use CLOs for financing, other manager in the business are focused on using CLO solely as a revenue play as the assets management business.
So they (inaudible) that those portfolios naturally mature like their underlying assets, so they are not going to be looking to rush to sell those assets. I think Fred if you want to comment on it.
I mean I think in the new issue loan market certainly today there's been between the reinvestment of interest and some incremental CLO creation which is already current this year and funds flows into this space whether there hasn't been a lack of supply of new capital to that space. I mean in fact quite the countries I mentioned in my presentation, I think the technical bid has continued to be very, very strong and as Mike mentioned as because assets prices in the secondary market to go up significantly and spreads are tightened. I think what we're waiting for and I think it will be interesting to see, how over what timeframe is ultimately plays out is you know, the demand side of the equation to come back and really start to see you know significantly new loan creation from financial sponsors or below investment great companies that we've been waiting for but haven't seen.
Now the new issue calendar as we sit here today as we were to be very, very strong for the next month on the back of again the strong technical is driving up prices through the summer. I hope we see that because ultimately right now there has been a fair amount of fund flows into the space and you just haven't seen the demand pick up that one would expect from the sponsor community and others.
It's been interesting just to draw a point that Henry raised earlier that if you look over the last 12 months to 18 months, it's been fascinating to watch the retail investors' attitude towards inflation change pretty materially. 18 months ago, it was probably an even fund flow into the bank loans and high yield largely because people were concerned about inflation and viewed the floating rate nature of the bank loan market as an inflation hedge.
What we have seen happened over the last 12 months has been that the funds was much more heavily into the high yield market where people are just chasing absolute cash-on-cash yield as opposed to placing a whole lot of value on the inflation hedge.
I think overtime as we take closer and closer to the issues that Henry talked about and ultimately the long-term implication of monetary policy around the world, I think that will change as well and that will create incremental flows.
Yeah, thank you. Two questions, first is to Mike, when you said you expect that the 15% to 17% ROE, newer CLOs, what does that imply for expected loss rates and what's your general thought on corporate credit at this point of the cycle?
Sure, I will ask Fred and Bill comment on corporate credit. For loss rates, we look at historical publish (inaudible) rights its generally run around default rates around 1% historical loss rates on senior loans of average 25%. So that's the system kind of we think distress it and annualized.
When we think about the other assumptions in their loans today could (inaudible) are yielding around 550 since the last three CLOs all had pretty identical fairly consistent constant caps constant debts which is about 200.
So again for us, you can do a little more leverage that we have done in the past but I assume we are going to do a deal that's got four terms as that we get to around that 17%.
In terms of the general market I would say that right now defaults have been extraordinarily low, capital markets have been forgiving. We haven't seen a ton of defaults in the US. I think as we roll forward, there are certainly some large credits out there that are reaching a point where it going to be (inaudible) time and there could be some larger defaults in the market especially if we don't start to see meaningful economic growth here in the next two years.
Longer term, it's harder to say I mean if you would ask me the question a year ago, I would have said look I think that the loan market especially is been a lot more thoughtful about structuring and covenant packages and security packages. I thought it would have been much more conservative than they been in the past but given the technical bid that we have seen in the lack of new supply, we have actually seen the loan market can get lot more aggressive and so overtime I think that I am not sure there is going to be that much of difference over the next cycle in terms of defaults because we sort of migrated back to a lot of issue refinery structures that I thought would have been out of the market longer than it happen.
Okay and the second question is you guys didn't discuss residential real estate. I'm wondering what if you could pontificate on it both in terms of your perspective on its impact of the general economy, and second does it present any investment opportunities for you. Thank you.
We're as a firm, we're constructive on residential real estate. We think it's going to add somewhere between 20 and 60 basis points of GDP over the next two years. I think if you look at what drives residential real estate, it's household formation and household formation is about 50% of where it's been. It's just starting to snap back and so we published a white paper on this and as a firm, we also done a deal with (inaudible) in this area. We think it's going to be one of the surprises on the upside.
When I look at the U.S. economy, I think what I am seeing in Marc's area, what I am seeing in housing, what are you seeing in autos and what are you seeing in manufacturing, you can make a strong case of those four tenants, will drive economic growth and what's important about manufacturing as well as housing and energy is they have a very strong multiplier effect and so, it makes constructive on not only the housing part but also home improvement and things like that.
And just following on Henry's point, we see that same theme and we've been playing that theme but it's not by buying a bunch of individual homes where we don't feel we have a competitive advantage to pick a house in the neighborhood in Sacramento or New Jersey better than anyone else. But looking at building products manufacturers, manufacture windows or doors, we made a number of distressed and distressed for control investments in that space through the negative part of the cycle that are starting to really show fruit as residential construction returns. And so we're playing a little bit through that avenue. The recovery of the residential real estate market.
Do you have any one else. Table, seven.
Has the LIBOR controversy impacted KFN in any way?
The Libor pricing.
The LIBOR, it hasn't impacted KFN other than theoretically KFN maybe entitled to claims depending upon the alternate resolution of the various forms of litigation given its substantial exposure to LIBOR paying instruments. So that will play its way through the court system and in future quarters and years.
Henry, I am just curious how important the US selections are to your forecast you know for the next few years.
Okay, give me a half --
You can question?
Give me (Inaudible) I think if you look just statically and take politics out of it over the last four years S&P revenues have been growing 35% above historical average at the same time business formation is been growing 35% below and that's obviously had a huge impact on job creation so at a minimum reducing some uncertainties is fair amount. So I would put it in the very, very high category.
And table seven.
This question for Ralph just on the CRE part you guys doing deal with the FDIC when they cease portfolios and distress investing through that channel?
The answer is we have not for couple of reasons, number one the competitive dynamic and the process to if actually, if you're talking about partnering with FDIC it is very cumbersome and very burdensome and there are a lot of fragmented players in the marketplace to effectively penetrate that channel.
And if you're talking about buying from the FDIC, as a counter party I would say that market is extremely transparent, it's a very efficient and effectively asset straight to the guys who pay the highest price with the worst contracts the FDIC is notorious for selling as it is where it is with no reps I don't think you are really getting paid for the risk there is no inefficiency that you are taking advantage of in fact it's very efficient.
At the end of the question and then in your deck slide 64 you list retail as an attractive opportunity for real estate investing now with online retailing and some of the problems that we're seeing in the big box retailers have how does that drive your longer-term thesis on large CRE properties with anchor tenants like the Best Buy or something like that?
Sure, I think one of the great things about the paradigm shift in terms of how retail behavior has evolved over the cycle is that when you have a differentiated view on retail generally, and in individual retailer specifically that you can leverage off of through our private equity team, you can effectively take advantage of trying to pick your spots in terms of taking a view on how retailer behavior is going to progress over time. So therefore on something like your example of Best Buy we have not been buyers or even interested in looking at effectively big box anchored centers effectively power centers in real estate speak. We have been more focused on the areas of the retail experience where it is more of a consumer experience where differentiated retailers can actually attract the consumer as a destination as oppose to a commodity.
And then one last question, so on the somewhat bullish comments on residential housing do you see pockets of strength in particularly United States anywhere?
I made two just to get back on the retail one things I would the power the firm is between Ralph's team and my caliber in retail and the macro team and also remember we have First Data variable to see a lot of different things and that is something where at the firm, we're just connecting the different parts of the firm. And so we think to have a pretty educated view on that.
I think what would surprise you on the residential housing and this is public data you can now look at it by state and I think some of the things that Ralph highlighted about energy, and Marc has talked about you're earlier seeing whether it is Texas or North Dakota that's where you are seeing a lot of growth, you're also seeing a surprising amount of rebound in some of the press markets like Arizona and far more than what people would think but I think the basic message is housing went from being a regional market during the bubble and went to being a national market where everything went up and now it is back to regional. But if you focus on those proceeds of the economy that we have been talking about the down the line trends are quite positive.
And then finally you sighted how transformation is a main driver to home sales have you factored in mortgage credit availability in your analysis of the overall housing market?
And this is in the KKR website you can kind of go through our math but the bottom line is we try and not to take a major view on that household formation was either 120 million households in the US it has been typically been growing at 1 and 1.5 % we have been growing between a quarter and a half of that so all we are arguing is it slowly starts to meet and revert back up towards the loan so we are not taking a hugely bullish user firm we are just saying that it will be some form of meaner version of household formation and as that groups back up from half percent back to 1% which is still in line or below the average that we will draft some demand and you are seeing that and if you look at the latest published statistics they came ahead of our 2013 estimate. So we are ending up looking bullish but I think it is more of a things are just starting to get little momentum.
All right thank you
Any last questions we probably have time for one or two more. Table eight.
Maybe just a quick question on investment where there is overlap in the KKR funds and KKR's balance sheet, whether it been a Barnet shale properties in energy or other private equity investments, who in the firm decides how much of an investment, who and how decides how much of an investment is going to be made through KFN and how much of investment is going to be made in KKR's fund over the balance sheet?
It's a great question, you want to take up.
KFN is an investment committee. It consists of Paul Hazen who is the Chairman of the firm, Fred Goltz and me and we make all the decisions with respect to sizing and or participation in those specific investments but it is a long side, either private equity firm or the firm's balance sheet.
In the case of the energy investments, we own those production interest separate and apart from different balance sheet or any other investors and finance separately as well.
Great. Alright well if that's it. I guess, maybe we'll wrap a few minutes early. Thank you all for coming, we know it's a really busy week and please feel free to reach out to us with any questions that you have after today.
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