KKR Financial Holdings LLC (KFN) Q3 2012 Earnings Conference Call October 25, 2012 5:00 PM ET
Pam Testani – Head-Investor Relations
Bill Sonneborn – CEO
Mike – COO & CFO
Stephen Laws – Deutsche Bank
Gabe Poggi – FBR Capital Markets
Daniel Furtado – Jefferies
Good day, ladies and gentlemen, and welcome to the KKR Financial Holdings LLC Third Quarter 2012 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. (Operator Instructions) As a reminder, this call may be recorded.
I would now like to introduce your host for today’s conference, Pam Testani, Head of Investor Relations for KKR Financial. Ma’am, you may begin.
Thank you, Sam. Welcome to our third quarter 2012 earnings call. I’m joined by Bill Sonneborn, our CEO; and Mike McFerran, our COO and CFO.
We’d like to remind everyone that this call will contain forward-looking statements based on management’s beliefs, which do not guarantee future events or performance. These statements are subject to substantial risks that are described in greater detail both in our SEC filings and in the supplemental information presentation posted to our website. Actual results may vary materially from today’s statements.
We’ll also refer to non-GAAP measures on this call, which are reconciled to GAAP figures in the supplements.
I’ll kick things off with some third quarter highlights. Then, Mike will review our financial results, and Bill will give you a sense of what we’re seeing in the market and how that aligns with our strategic direction.
This afternoon, we reported third quarter net income of $112 million, or $0.61 per diluted common share, up 57% from last quarter. That results in a 20% LTM return on equity.
From a cash perspective, we generated $0.26 run rate cash earnings per share in Q3, down from $0.32 in Q2. Part of the decline here is due to the semi-annual coupon payments on our convertible notes, which were paid in the first and third quarters. Normalized for that, we generated $0.29 of run rate cash earnings, or a 12% annualized cash ROE, versus $0.30 and a same ROE in Q2. Since we retired our 7% converts in July, the cash impact of the convert payments should be lower in future quarters.
Looking at total net cash earnings, we generated $0.18 per share in Q3, or $0.21 per share, when you adjust for the impact of the convert coupon payment. Note that this quarter’s total net cash earnings don’t reflect the benefit of all the gains we’ve realized in the quarter, because many of those realizations were in our CLOs, which hadn’t yet distributed the cash to us at September 30. So you’ll see a positive cash impact from that next quarter.
In light of these results, our Board of Directors declared a $0.21 cash distribution on our common shares for the quarter, which is payable on November 21, to shareholders of record as of November 7. We told you at our Investor Day in September that KFN is differentiated by our flexibility. We can pivot among our strategies to capture the best opportunities in a given market. This quarter was proof. As you’ll hear from Mike and then Bill, our allocation adaptability was a meaningful contributor to our Q3 results.
And I’ll now turn the call over to Mike.
Thanks, Pam, and good afternoon, everyone. We appreciate you joining our call today. Today, we announced net income of $112 million for the third quarter, which as Pam mentioned, is up 57% from last quarter. This equates to $0.61 per diluted common share versus $0.39 last quarter.
Third quarter net income consisted of $90 million of net investment income, $73 million of other income and $51 million of non-investment expenses. Net investment income rose 5% from $86 million in the second quarter. There are two main drivers here.
First the weighted average interest rate in our loans increased about 25 basis points from the second to the third quarter. Second, we had higher gross income for our natural resources strategy to increase production during the quarter.
Keep in mind that this reflects unhedged revenue in the investment income line, because the impact of our commodity hedges are shown below the line in other income.
Despite offsets from lower loan discount accretions due to reduced prepayments during the quarter and bond coupon income, we’ve had four consecutive quarters of increasing gross investment income. We didn’t record any incremental provision for loan losses in the quarter, so our allowance continues to represent approximately 4% of our loans held for investment at September 30.
However, we did decide to designate our in TXU’s term loans as impaired. This means we’re now carrying a specific reserve of approximately $52 million against our $322 million par position in this loan, which we currently hold in amortized cost of $310 million. The reserve reflects an implied recovery value of 80% of par.
For context, TXU’s term loan is currently trading around 70% of par versus about 60% at June 30 and 55% at March 31.
This impairment shifted TXU from unallocated to allocated reserves, but it didn’t impact the overall reserve. For the duration of the impairment, interest income will be recognized on a cash basis.
Moving to other income, this was the biggest component of our strong third quarter performance. It was $73 million for the third quarter, almost four times last quarter’s level of $19 million. The key contributors here were all related to the recent value experienced in credit and equity prices.
First, as Bill will get into, we took advantage of increasing prices in the bond market to reduce our high yield holdings during the quarter. On a par basis across our strategies, we pared our exposure from $744 million at June 30 to $500 million at September 30. This generated over $50 million – excuse me, over $40 million of one time realized gains.
The rally also drove sizeable unrealized mark-to-market gains, largely on the equity holdings we carry at fair value and our loans held-for-sale, which are carried at the lower of cost or market value.
Partially offsetting net investment income and other income were higher non-investment expenses. The increases here were from manager compensation and natural resources, administration and operating expenses.
Together, these results totaled $0.63 of basic earnings per share, which helped boost our book value from $9.79 at June 30 to $10.9 at September 30.
Next, I’ll move to our return on equity by strategy, which you can find on pages 19 through 22 of our supplemental presentation posted in our website.
Now that we’ve been reporting strategy return on equity computations for four consecutive quarters, we’ve introduced the last 12 months of ROEs on pages 21 and 22, which are what I’ll be referring to.
Our LTM total return on average net equity was 20% across all our strategies. On a run rate basis, which excludes other income, ROE was 14%, and bank loans and high yield, which is our largest strategy by average net equity and is pursued mostly through our CLOs, we generated a run rate ROE of 24% and a total ROE of 41%.
Total ROE has benefited in recent quarters from high levels of realization activity in our corporate credit portfolio. In our second largest strategy by average net equity, natural resources, we had a 1% run rate loss on equity, but a 2% total return on equity. While GAAP-based return on equity measures are accurate, non cash expenses, primarily depletion, depreciation and amortization or DD&A, result in net economics being presented differently than how we, as a management team, measure performance for our natural resources business.
In addition to the GAAP results, we also consider the business on a cash basis, which is similar to how they’re measured for upstream MLPs. During the third quarter, we received over $6 million of cash proceeds from our working interest and our Blackhawk royalty interest, which had a cost basis of approximately $200 million at the beginning of the quarter resulting in an annualized cash receipts at a rate of 13% on invested capital.
In mezzanine, we generated a 15% run rate and a 6% total return on equity. Total return on equity in this strategy is still being impacted by a mark-to-market hit to earnings in the fourth quarter of 2011.
In special situations, we generate a 10% run rate and a 24% total return on equity. Because our special situation strategy is less reliance on coupon income, and because these assets are often distressed and subject to quarterly marks, ROEs don’t always tell the full performance picture here. To capture returns over the life of the strategy, we tend to focus on IRR as the best measure of performance.
Through September 30, approximately $340 million of cost basis of assets in special situations has generated a cumulative IRR of 19%. This includes an IRR of 36% on fully realized investments that we have exited and 14% on investments that we’re still in based on September 30 values.
And finally, I’ll provide you with an update on our liquidity position. We ended the third quarter with $331 million of unrestricted cash on our balance sheet, following the $112 million repayment of our 7% convertible notes in July, which are now fully retired.
As you remember, in the last few quarters, we’ve been selling rated tranches in our CLOs, taking capital in which we were earning LIBOR plus 225 basis points and redeployment it into strategies where we expect to generate mid-teens returns.
In the third quarter, we sold an additional $60 million of par of Class D notes issued from CLO 2007-1, yielding net proceeds of approximately $50 million. At this point, we’ve raised $95 million of net proceeds year-to-date and we still hold approximately $85 million face value of these notes.
Having 18% of our book value in cash and still being able to produce the returns we have gives us significant comfort. In markets like today’s, we like having the flexibility to keep ample cash on hand, both as deflation hedge and for opportunistic deployment, considering that we operate an asset classes that have definite cycles. We think being patience and deploying that cash during corrections could have a more meaningful impact on earnings, than pulling it to work everyday.
I’m now going to hand this over to Bill.
Thank you, Mike. We spoke at our last call about the market potentially recognizing that asset prices may have gotten ahead of themselves. The global economic issues that it triggers spurt of volatility in the last two years, seem largely unresolved to us. Despite this “risk on” came back in full force by August buoyed by open-ended inflationary policy measures from Central Banks globally.
On a total return basis the S&P was up 6% in the quarter, reaching five year highs. The S&P/LSTA Leverage Loan Index was up 3% during the quarter and the Merrill Lynch Master High Yield II Index gained 5%, with yields reaching a record low near 6% during September, almost 60% basis points beneath the previous all time low.
The effects of that backdrop on KFN vary by strategy. As we’ve articulated for the past few years, during periods of material spread tightening we will look to move up capital structures from high yield or second lien mezzanine or even special situations into loans to reduce our risk. And that’s exactly what we did in the third quarter.
We sold a third of our high yield par value exposure and renewed our focus on senior secured loans, which would shore up our protection from defaults and losses and reduce fixed rate duration risk that’s inherent in bonds. In other words, reduce volatility and risk. And given that current market loan yields are directionally within 100 basis points of bonds, we’re not sacrificing much yield to do this.
We’ve also said that markets like these are conducive to CLO issuance. You’ve seen that this year. U.S. CLO issuance in September set a monthly high since 2008 of $6.2 billion and a year-to-date high since 2007 of $32 billion. With spreads getting tight and the relative attractiveness of loans versus bonds on the rise, we think CLO issuance is the right capital allocation strategy for KFN now in this environment.
In the U.S., we continue to see how levels of activity in the traditional syndicated CLO market and we remain focused on taking advantage of that opportunity. In Europe, as we’ve discussed on our last call, we continue to do work on a more creative framework for doing a CLO in that market. We’ll keep you posted as we make progress.
In natural resources, we completed our first two transactions through our drilling strategy we previewed at our Investor Day. This is where we provide capital to operators to fund their drilling new wells in exchange for working interest in their developed wells and undeveloped acreage. During the quarter, we deployed an initial $25 million to these transactions.
In special situations, we deployed or committed to deploy about $26 million during the third quarter. And in mezzanine, the broadly credit markets have meant a more attractive opportunity profile outside the U.S., consistent with our statements in previous quarters.
Given the levels of demand for leverage loans in high yields within the U.S., U.S. companies have been able to finance themselves with cheaper debt capital than private mezzanine can offer. This has only become more exaggerated with tighten spreads and substantial BDC competition in the U.S. since the second quarter.
The picture remains somewhat different abroad, where capital scarcity and a pullback in bank lending has kept mezzanine borrowing relatively attractive. We deployed over $50 million of capital to mezzanine in the third quarter in two new transactions in Northern Europe.
These investments, Stork and BSN Medical, have a weighted average yield of 16% on the debt we acquired. Including previous investments we’ve made over the past several years, we’re earning a weighted average yield of 15% across our portfolio. So these new transactions we just closed this quarter have actually had a positive marginal contribution to our coupon.
We think this yield is highly attractive when you consider the relatively low weighted average leverage levels through our mezzanine position, which is sub five times EBITDA. In real estate, we’ve seen a lack of development capital in construction financing, limit supply growth in mini markets and property types. This trend has resulted in two new transactions for KFN this quarter.
The first is a joint venture to develop single-family finished lots and multi-family housing adjacent to a significant U.S. shale play, where active resource development has created a severe housing supply demand imbalance.
This opportunity is a perfect example of how we benefit from the one firm sourcing engine within our manager at KKR. This idea came about through dialogue between KKR’s real estate and energy private equity teams and as was well as through employees at KKR portfolio companies that operate within that specific play. We will fund this investment over the next 18 months or so.
The second new investment is a joint venture with global developer, Hines, right in their backyard near their headquarters in Houston. We negotiated a costless option to control up to 970 acres of well located fully entitled industrial land for build-to-suite development, where we can use our credit expertise to evaluate counterparty risk.
We deployed an initial $8 million of a much larger commitment to these two opportunities during the quarter, bringing our real estate portfolio to three assets with about $45 million of costs invested.
Our previous investment in Yorktown continues to perform well ahead of budget. While we’ve been pleased with our ability to take advantage of the market exuberance this quarter, we remain wary of asset prices.
And they seem to reflect desperation for yield rather than a true improvement in economic and political fundamentals and recent run ups don’t seem to be pricing in today’ material macro risks as we head into election and a potential fiscal cliff. That’s why we continue to hold on to cash. It positions us well both for the possibility of deflation and to extract value from any dislocation and ability to put capital to work quickly. It’s also why we now hold nearly 15% of our net equity in real assets, which tend to be less correlated with financial assets when markets correct or the dollar might get debased.
Reflecting on the quarter as a whole, we’re proud of the performance we’ve delivered. We’ve used our allocation flexibility to de-risk pivoting our leverage credit portfolio to a higher weighting of senior secured loans as loan and bond spreads converged.
We continue to deploy capital to our most attractive strategies as the market ebbs and flows. As we wait to harvest that capital, we’re delivering shareholders a consistent distribution and capital appreciation in the form of book value growth and expansion.
Book value per share has grown 10% since the same time last year. And that’s without realizing any of the multiple embedded options we have within our portfolio on rates and energy prices.
Because KFN benefits from a diverse range of environment, we expect to continue to drive strong returns for shareholders. Our goal is simple, to produce steady and increasing cash earnings, returns on capital and growth in book value. By all those measures, I feel great about the position we’re in.
Thanks for joining us today and thanks again to those of you who joined our first Investor Day in September. We appreciate your interest in KFN and we’re now happy to open up the call to any of your questions.
Operator, if you could open it up for Q&A.
Thank you. (Operator Instructions) Our first question comes from Stephen Laws of Deutsche Bank. Your line is now open.
Stephen Laws – Deutsche Bank
Hi, how are you?
Stephen Laws – Deutsche Bank
Good, good. Appreciate and congratulations on a quarter-end and it looks (inaudible). Can you maybe talk about the, I guess, some gains to be realized, how much of that cash will be redeployed? I realized you guys talked a lot about how you protected portfolios from a risk standpoint. Can you maybe talk about the pipeline?
Stephen, you’re breaking up, so I – we couldn’t quite hear your question, I got something about pipeline and natural resources versus other, but I wasn’t sure.
Stephen Laws – Deutsche Bank
Yeah, that’s really. I’ll drop off because I’m in a hotel having connection problems, but that line (inaudible) natural resources, just kind of (inaudible)?
Absolutely, I think the way to think about pipeline is in the case of, in particular bank loans, which we’ve made the strategic decision to allocate more to during this past quarter, that’s done through the potential issuance of new CLO transactions. And there is, just given the market environment, ample opportunity to have a pipeline to potentially pursue that, both in the U.S. and potentially we’re working on something unique in Europe.
Secondly at natural resources the pipeline is healthy. And that’s really driven, as we discussed at Investor Day, by the tremendous shift that’s occurring and how energy is produced in the United States, from conventional to unconventional. And as that shift occurs, it opens up opportunities across the spectrum, which range from buying conventional resource from major oil and gas companies to free up capital for them to invest and fund there $2.5 trillion of CapEx that they will need to fund over the next five or six years for the U.S. to become energy non-dependent or energy self-sufficient.
The second is in the case of those shale plays partnering with operators through production interest like what we did this quarter to effectively farm in alongside those operators and participate in low risk development. And then, finally, through the technology and knowledge base we have at the firm, operating in a variety of specific basins to be able to aggregate royalty interest from mineral rights owners to effectively be able to purchase those with an information advantage ahead of potential future developments and then therefore cash flow production. So we’re focused on that chain. And that pipeline across the spectrum remains pretty ample.
Third, real estate, which we’ve started to build over the course of this year, we’re seeing selective opportunities where we can use KKR’s competitive advantage in the context of understanding diligencing and creating a unique proprietary sourcing and ability to enhance value, similar to what we just discussed in the development play and the shales from the real estate perspective, Hines in Houston, where we can create a unique competitive advantage to both factor and value and ultimately operational improvement. We’re seeing those opportunities not just in the U.S., but we’re also seeing them in Europe, mainly in the U.K. and Northern Europe. Thanks, Stephen.
Thank you. Our next question comes from Gabe Poggi of FBR. Your line is now open.
Gabe Poggi – FBR
Good afternoon, guys. Thanks for taking the time. And thanks for the additional energy disclosure, the natural resources disclosure, in the supplemental. It’s hugely helpful.
You guys have talked about – you mentioned in last quarter, you talked about it this quarter, the potential to kind of reengage the CLO market. Obviously, Bill, based on your commentary, the markets, it’s white hot and actually open. I assume that just based on your prior commentary, even the last two quarters, the last two year, folks have been asking and asking when you’re going to get back into it. I assume that from your guys’ vantage point or is it safe to assume that you guys were seeing the liability side, the actually – the all in cost of the CLO structure being advantageous to hit that market. And then, is it safe to say that from a new CLO perspective we’d be looking at the in the 15% ROE-ish hurdle at a minimum kind of going forward, because that seems to be what your guys targeted rate of return is?
And then, if you could just talk about where you’re kind of seeing reinvestment windows non-call periods, et cetera? Just generally speaking, how you’re thinking about a domestic CLO potential?
Hey, Gabe. Starting with the first question on CLOs and how we’re seeing the market. Bill in his comments highlighted a key point for us, which is; one, we see finding the economics of the CLOs attractive per your question. We also like to risk profile of CLOs. As Bill mentioned, we’re definitely in an environment where we want to move up capital structures, and that means senior secured loans and CLOs are the most efficient non-recourse, non mark-to-market technology of which to access that asset class.
As far as the economics, there is a lot of demand out there from buyers. The market’s hot. So we do like the return – frankly, the return models for it. And it does meet our mid-teens targets based on what we’re seeing today. As far as terms, what you’re seeing I would expect transactions you see done in the coming months from issuers probably be consistent with what you’ve seen recently, which is generally four year reinvestment, two year non-call, which is something we definitely find more attractive.
If you recall going back to a year or two, when people were asking us about CLOs, we said, one, the economic has to make sense, but the economics are not just a function of the liability costs. They’re function of the structure and the optionality embedded in it. When CLOs were staring to really make a resurgence in early 2011, you saw a non-call and reinvestment periods matched up at two years, which we didn’t like the optionality around. Now that you see more extended reinvestment periods – non-call periods inside of it that kind of have that option value potential we really like.
And just further on what Mike said, you’re actually now seeing technology developing in CLOs that at the end of the call, non-call period, you actually can reprice the liability.
So if liabilities get cheaper you can actually reprice them lower. And so that takes that naked kind of exposure risk off of the underlying equity investor and since that’s what we are focusing on, as a important new technology.
Gabe Poggi – FBR
That’s very helpful. Thanks guys, another good quarter.
Thank you. Our next question comes from Daniel Furtado of Jefferies. Your line is now open.
Daniel Furtado – Jefferies
Thanks everybody for taking the time. I appreciate it. Just following up on Gabe’s question – and I apologize, I missed one of the very beginning of the call. When you talk about potential CLOs in the market today, are you willing to – or can you help us understand where ballpark leverage and LIBOR spreads are on new potential deals?
If you look at recent deals in the market, you’re seeing AAAs getting done probably inside of 145 over LIBOR today. So you’ve definitely seen some tightening. We think that’s probably going to continue, as you’re seeing an investor appetite expand for this. We’re seeing people enter the asset class that haven’t been in it for a while and new interest in it.
The first real 18 months, the CLO market come back is really limited to a very frankly isolated group of AAA investors, but that’s been broadening pretty quick. So we like that profile.
Daniel Furtado – Jefferies
Understood. And then I guess the demand for the mezzanine tranches has improved commensurate with AAAs as well?
(Inaudible) in the old world pre-credit crisis, the mezzanine stuff used to be the hardest paper to place and today it is the easiest to place, because we’re definitely in more of a yield start world. So mezz is very easy to get done today.
Daniel Furtado – Jefferies
A big contributor to that, Daniel, is that through the credit crisis from kind of the 2005 vintage to now there has not been a CLO where mezzanine investors have been impaired.
Daniel Furtado – Jefferies
Understood, excellent. And then, not to get too doom and gloom on you, but if we could turn just briefly to the fiscal cliff and kind of how you guys see that playing out in your response to it? I get it that you’ve taken some risk exposure off the table. I mean, should investors think that you’ll continue to do that as we get closer to this potential cliff? And what are your expectations for the interest rate environment as we head to and potentially over that cliff – without divulging too much of your competitive strategy?
I’ll try to give you a little bit (inaudible), a lot of this is not dependent upon the fiscal cliff, i.e. where we get to in January, but a little about where this election ends up. In other words, to the extent that President Obama is re-elected, which if you look in interim data is most likely outcome, that would imply more worry and concern on our part on the fiscal cliff issue, because of the lower likely than not outcomes of Congress and the Senate relative to the presidential election, and how they will wrestle over dealing with the economy and the deficit. And so, I’d say that’s heightened risk in the context of potential market volatility and the downside that we want to be on our front foot to jump in and participate in.
The second thing is we’re going to have a new Fed Chairman, whether – regardless of who wins the election, but whoever wins the election will have an influence on that. And we do feel likely that the – if a Republican wins, the Presidential election will have a more hawkish anti-inflation Federal Reserve Chairman. If the Democrats win the election, we will have a more comfortable with reasonable inflation Fed Chairman. And so a little bit of how we’ve positioned our portfolio is to be able to drive returns regardless of those two outcomes.
Daniel Furtado – Jefferies
Understood. Thank you for the insight. I appreciate everybody and congratulations on a very strong quarter.
Thank you. (Operator Instructions) And at this time, I’m not showing any questions on the phone line.
Thank you, Sam, and thank you all for listening to our call today. We’ll get back to work on your behalf. We appreciate you listening and thank you very much.
Ladies and gentlemen, thank you for your participating in today’s conference. This concludes today’s program. You may all disconnect. Everyone have a great day.
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