We are a specialty finance company that invests in multiple asset classes and uses leverage with the objective of generating competitive risk-adjusted returns. We seek to achieve our investment objective by allocating capital primarily to the following asset classes: (i) residential mortgage loans and mortgage-backed securities; (ii) corporate loans and debt securities; (iii) commercial real estate loans and debt securities; (iv) asset-backed securities; and (v) marketable and non-marketable equity securities. We also make opportunistic investments in other asset classes from time to time.
Our objective is to provide competitive returns to our investors through a combination of distributions and capital appreciation. As part of our multi-asset class strategy, we seek to invest opportunistically in those asset classes that can generate competitive leveraged risk-adjusted returns, subject to maintaining our status as a real estate investment trust, or REIT, under the Internal Revenue Code of 1986, as amended, or the Code, and our exemption from regulation under the Investment Company Act of 1940, as amended, or the Investment Company Act. Our income is generated primarily from the difference between the interest and dividend income earned on our investments and the cost of our borrowings, plus (i) realized and unrealized gains and losses on our derivatives that are not accounted for as hedges, (ii) realized gains and losses from the sales of investments, and (iii) fee income.
We are externally managed and advised by KKR Financial Advisors LLC, our Manager, pursuant to a management agreement. Our Manager is an affiliate of KKR, a leading sponsor of private equity funds and other investment vehicles. Certain individuals associated with KKR serve on our board of directors and our Manager’s investment committee.
We are a Maryland corporation that is taxed as a REIT for federal income tax purposes. We were organized in July 2004 and completed our initial private placement of shares of our common stock in August 2004.
On June 29, 2005, we completed our initial public offering, or IPO. Our common stock is listed on the NYSE under the symbol “KFN” and began trading on June 24, 2005.
Our board of directors has approved a restructuring transaction, or the “Conversion Transaction”, whereby we would become a subsidiary of a recently formed Delaware limited liability company that would be publicly traded. The Delaware limited liability company, named KKR Financial Holdings LLC, will not be taxed as a REIT, but is intended to be a pass-through entity for U.S. federal income tax purposes. The Conversion Transaction would result in each share of currently issued and outstanding KKR Financial Corp. stock being converted into an equal number of limited liability company shares in KKR Financial Holdings LLC. The Conversion Transaction is subject to shareholder approval and, if approved, we expect that it will be completed by June 30, 2007.
We are externally managed and advised by KKR Financial Advisors LLC, an affiliate of KKR, pursuant to a management agreement. Our Manager was formed in July 2004. All of our executive officers are employees or members of our Manager or one or more of its affiliates. The executive offices of our Manager are located at 555 California Street, 50th Floor, San Francisco, California 94104 and the telephone number of our Manager’s executive offices is (415) 315-3620.
Pursuant to the terms of the management agreement, our Manager provides us with our management team, along with appropriate support personnel. Our Manager is responsible for our operations and performs all services and activities relating to the management of our assets, liabilities and operations. Our Manager is at all times subject to the direction of our board of directors and has only such functions and authority as we delegate to it.
We seek to achieve our investment objective by allocating capital primarily to the following asset classes: (i) residential mortgage loans and mortgage-backed securities; (ii) corporate loans and debt securities; (iii) commercial real estate loans and debt securities; (iv) asset-backed securities; and (v) marketable and non-marketable equity securities. We also make opportunistic investments in other asset classes from time to time. Our objective is to provide competitive returns to our investors through a combination of distributions and capital appreciation. As part of our multi-asset class strategy, we seek to invest opportunistically in those asset classes that can generate competitive leveraged risk-adjusted returns, subject to maintaining our status as a REIT and our exemption from regulation under the Investment Company Act.
Our Manager utilizes its access to the resources and professionals of KKR, along with the same philosophy of value creation that KKR employs in managing private equity funds, in order to create a portfolio that is constructed to provide competitive returns to investors. We make asset class allocation decisions based on various factors including: relative value, leveraged risk-adjusted returns, current and projected credit fundamentals, current and projected supply and demand, credit and market risk concentration considerations, current and projected macroeconomic considerations, liquidity, all-in cost of financing and financing availability, and maintaining our REIT status and exemption from the Investment Company Act.
From time to time, we make certain investments, including debt, equity and derivative investments, utilizing KKR TRS Holdings, Inc., or TRS Inc., our domestic taxable REIT subsidiary. We will opportunistically pursue this strategy whenever we are constrained by the rules related to maintaining our REIT status and exemption from the Investment Company Act and, in the case of non-real estate or derivative investments, whenever the projected returns on these investments, net of income taxes, are comparable to the projected leveraged risk-adjusted returns on investments that are made in the REIT. We are not required to distribute the earnings of our domestic taxable REIT subsidiary; accordingly, we may retain in our domestic taxable REIT subsidiary some or all of its net income.
Our Financing Strategy
We use leverage in order to increase potential returns to our investors. As of December 31, 2006, our leverage was 9.1 times the amount of our stockholders’ equity. Our investment guidelines (“Investment Guidelines”) require no minimum or maximum leverage and our Manager and its investment committee will have the discretion, without the need for further approval by our board of directors, to increase the amount of our leverage. Our use of leverage may, however, also have the effect of increasing losses when economic conditions are unfavorable.
We maintain access to various sources of capital to mitigate the risk that we are unable to source additional capital when it is necessary or desirable. We also maintain access to various forms of financing, including collateralized loan obligations, warehouse facilities, repurchase agreements, asset-backed secured liquidity notes, total rate of return swaps, junior subordinated notes in the form of trust preferred securities, a senior secured credit facility, and demand note. The majority of our residential mortgage loans and residential mortgage-backed security investments are financed using repurchase agreements and asset-backed secured liquidity notes. Our repurchase agreement counterparties include large commercial and investment banks.
The manner in which we finance our non-residential mortgage investments is dependent upon the nature and form of the investment and its corresponding credit rating. Our investments in non-residential mortgage related investments are financed using collateralized loan obligations, warehouse agreements, repurchase agreements, total rate of return swaps, junior subordinated notes in the form of trust preferred securities, our senior secured credit facility, and demand note.
Our Hedging and Interest Rate Risk Management Strategy
Our repurchase agreements are floating rate and generally have maturities of 30 days. As a result, interest rates are generally reset every 30 days. Our floating rate residential mortgage investments generally have interest rates that are reset every 30 days. Our hybrid residential mortgage investments initially have fixed interest rates and after the initial fixed rate period has expired are converted to floating rate with interest rates that generally reset annually.
We use interest rate derivatives to hedge a portion of our interest rate risk associated with our borrowings. Our use of interest rate derivatives must comply with the provisions of the Code applicable to REITs; accordingly, as a REIT, the applicable provisions of the Code may materially restrict our ability to enter into certain hedging transactions that may mitigate our interest rate risk or market risk.
We engage in a variety of interest rate management strategies that seek to mitigate changes in interest rates or potentially other influences on the market values of our assets. Our interest rate management strategies may include: interest rate swaps; interest rate swaptions; cancellable interest rate swaps; interest rate caps; interest rate corridors; eurodollar futures contracts and options; and other interest rate and non-interest rate derivatives.
Our strategies may also be used in an attempt to protect us against unfavorable changes in the market value of our assets and liabilities.
We enter into interest rate swap agreements to offset the potential adverse effects of rising interest rates under certain short-term borrowings. The interest rate swap agreements have historically been structured such that we receive payments based on a variable interest rate and make payments based on a fixed interest rate. The variable interest rate on which payments are received is calculated based on various reset mechanisms for the London Interbank Offered Rate (“LIBOR”). The repurchase agreements generally have maturities of 30 days and carry interest rates that correspond to LIBOR rates for those same periods. The interest rate swap agreements are intended to fix our borrowing cost and are not held for speculative or trading purposes.
Interest rate management strategies do not eliminate interest rate risk and market risk but seek to mitigate interest rate risk and market risk. For example, if both long-term and short-term interest rates were to increase significantly, it could be expected that: the weighted-average life of the fixed rate mortgage investments would be extended because prepayments of the underlying mortgage loans would decrease; and the market value of fixed rate mortgage investments would decrease.
In order for our interest rate derivatives to qualify as fair value or cash flow hedges under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, or SFAS No. 133, we must fulfill many complex requirements including, but not limited to, hedge correlation requirements.
As stated above, our income is generated primarily from the net interest spread on our investment portfolio. Set forth below are factors that may adversely impact our net interest spread.
Match Funding. We expect to use long-term financing on a match funded basis to minimize interest rate risk in our investment portfolio. Match funding is the financing of our investments on a basis where the duration of the investments approximates the duration of the borrowings used to finance the investments. For any period during which our investment portfolio and related borrowings are not match funded, we may be exposed to the risk that our investment portfolio will reprice more slowly than the borrowings that we use to finance a significant portion of our investment portfolio. Increases in interest rates under these circumstances, particularly short-term interest rates on our short-term borrowings, may significantly adversely affect the net interest income that we earn on our investment portfolio.
Prepayments. Prepayment rates experienced on loans and securities in our investment portfolio may be influenced by changes in the overall level of interest rates, changes in the shape of the yield curve, and a variety of economic, geographic and other factors beyond our control, and consequently, we can not accurately predict prepayment rates. The yield on our investment portfolio may be affected by the difference between the actual prepayment rates that we realize on our investment portfolio and the prepayment rates that we project on our investment portfolio.
Hedging. We use interest rate derivatives to hedge a portion of the interest rate risk associated with our borrowings and certain fixed rate investments. There are limitations in our ability to hedge all of the negative consequences associated with changes in interest rates and prepayment rates. Furthermore, we are subject to the costs associated with hedging our interest rate risk and market risk.
Credit Losses. We believe that we will experience credit losses on our investment portfolio and such credit losses will have an adverse affect on our investment portfolio performance.
Leverage. We use borrowings to finance a significant portion of our investment portfolio. The use of leverage involves risks, including the risk that losses are materially increased or magnified and increasing liquidity risk in the event that one or more of our financing counterparties terminate our financings and/or require us to provide additional collateral to secure their financing facilities.
Investment Company Act Exemption
We operate our business so as to be exempt from regulation under the Investment Company Act. We monitor our portfolio of investments to confirm that we and each of our subsidiaries continue to qualify for the applicable exemptions from the definition of an investment company under the Investment Company Act. We monitor our portfolio to ensure that at least 55% of our assets constitute “qualifying real estate assets,” and an additional 25% of our assets constitute “real estate-related assets” or additional qualifying real estate assets, thereby allowing us to qualify for the exemption from the definition of an investment company as provided for in Section 3(c)(5)(C) of the Investment Company Act. We measure and satisfy the tests with respect to our assets on an unconsolidated basis.
We generally expect that a material amount of our investments in residential mortgage loans, residential mortgage-backed securities and commercial real estate debt will be considered qualifying real estate assets under the Section 3(c)(5)(C) exemption from the Investment Company Act. We also generally expect that any residential mortgage loans, residential mortgage-backed securities and commercial real estate debt that we invest in that do not constitute qualifying real estate assets will constitute real estate-related assets. The treatment of our other real estate investments will be based on the characteristics of the underlying collateral and our rights with respect to the collateral, including whether we have foreclosure rights with respect to the underlying real estate collateral. Our investments in corporate leveraged loans, corporate mezzanine loans, high yield corporate securities, asset-backed securities, and marketable and non-marketable equity securities will not constitute qualifying real estate assets or real estate-related assets.
Maintaining our exemption from regulation under the Investment Company Act limits our ability to make certain favorable investments and we must make investments in qualifying real estate assets or real estate-related assets to ensure that we maintain our exemption under the Investment Company Act.
We are party to a management agreement with our Manager, pursuant to which our Manager will provide for the day-to-day management of our operations.
The management agreement requires our Manager to manage our business affairs in conformity with the Investment Guidelines that are approved by a majority of our independent directors. Our Manager is under the direction of our board of directors. Our Manager is responsible for (i) the selection, purchase and sale of our portfolio investments, (ii) our financing and risk management activities, and (iii) providing us with investment advisory services.
The management agreement expires on December 31, 2007 and is automatically renewed for a one-year term each anniversary date thereafter. Our independent directors review our Manager’s performance annually and the management agreement may be terminated annually (upon 180 day prior written notice) upon the affirmative vote of at least two-thirds of our independent directors, or by a vote of the holders of a majority of the outstanding shares of our common stock, based upon (i) unsatisfactory performance by the Manager that is materially detrimental to us or (ii) a determination that the management fees payable to our Manager are not fair, subject to our Manager’s right to prevent such a termination pursuant to clause (ii) by accepting a mutually acceptable reduction of management fees agreed to by at least two-thirds of our independent directors and our Manager. We must provide a 180 day prior written notice of any such termination and our Manager will be paid a termination fee equal to four times the sum of the average annual base management fee and the average annual incentive fee for the two 12-month periods preceding the date of termination, calculated as of the end of the most recently completed fiscal quarter prior to the date of termination, which may make it more difficult for us to terminate the management agreement.
We may also terminate the management agreement without payment of the termination fee with a 30 day prior written notice for cause, which is defined as (i) our Manager’s continued material breach of any provision of the management agreement following a period of 30 days after written notice thereof, (ii) our Manager’s fraud, misappropriation of funds, or embezzlement against us, (iii) our Manager’s gross negligence in the performance of its duties under the management agreement, (iv) the commencement of any proceeding relating to our Manager’s bankruptcy or insolvency, (v) the dissolution of our Manager or (vi) a change of control of our Manager. Cause does not include unsatisfactory performance, even if that performance is materially detrimental to our business. Our Manager may terminate the management agreement, without payment of the termination fee, in the event we become regulated as an investment company under the Investment Company Act. Furthermore, our Manager may decline to renew the management agreement by providing us with a 180 day prior written notice. Our Manager may also terminate the management agreement upon 60 days prior written notice if we default in the performance of any material term of the management agreement and the default continues for a period of 30 days after written notice to us, whereupon we would be required to pay our Manager the termination fee described above.
We do not employ personnel and therefore rely on the resources and personnel of our Manager to conduct our operations. For performing these services under the management agreement, our Manager receives a base management fee and incentive compensation based on our performance. Our Manager also receives reimbursements for certain expenses, which are made on the first business day of each calendar month.
Base Management Fee. We pay our Manager a base management fee monthly in arrears in an amount equal to 1¤12 of our equity multiplied by 1.75%. We believe that the base management fee that our Manager is entitled to receive is generally comparable to the base management fee received by the managers of comparable externally managed specialty finance companies. Our Manager uses the proceeds from its management fee in part to pay compensation to its officers and employees who, notwithstanding that certain of them also are officers of us, receive no cash compensation directly from us.
For purposes of calculating the base management fee, our equity means, for any month, the sum of the net proceeds from any issuance of our common stock, after deducting any underwriting discount and commissions and other expenses and costs relating to the issuance, plus our retained earnings at the end of such month (without taking into account any non-cash equity compensation expense incurred in current or prior periods), which amount shall be reduced by any amount that we pay for the repurchases of our common stock. The foregoing calculation of the base management fee is adjusted to exclude special one-time events pursuant to changes in accounting principles generally accepted in the United States, or GAAP, as well as non-cash charges, after discussion between our Manager and our independent directors and approval by a majority of our independent directors in the case of non-cash charges.
Our Manager is required to calculate the base management fee within fifteen business days after the end of each month and deliver that calculation to us promptly. We are obligated to pay the base management fee within twenty business days after the end of each month. We may elect to have our Manager allocate the base management fee among us and our subsidiaries, in which case the fee would be paid directly by each entity that received an allocation.
Reimbursement of Expenses. Because our Manager’s employees perform certain legal, accounting, due diligence tasks and other services that outside professionals or outside consultants otherwise would perform, our Manager is paid or reimbursed for the documented cost of performing such tasks, provided that such costs and reimbursements are no greater than those which would be paid to outside professionals or consultants on an arm’s-length basis.
We also pay all operating expenses, except those specifically required to be borne by our Manager under the management agreement. The expenses required to be paid by us include, but are not limited to, rent, issuance and transaction costs incident to the acquisition, disposition and financing of our investments, legal, tax, accounting, consulting and auditing fees and expenses, the compensation and expenses of our directors, the cost of directors’ and officers’ liability insurance, the costs associated with the establishment and maintenance of any credit facilities and other indebtedness of ours (including commitment fees, accounting fees, legal fees and closing costs), expenses associated with other securities offerings of ours, expenses relating to making distributions to our stockholders, the costs of printing and mailing proxies and reports to our stockholders, costs associated with any computer software or hardware, electronic equipment, or purchased information technology services from third party vendors, costs incurred by employees of our Manager for travel on our behalf, the costs and expenses incurred with respect to market information systems and publications, research publications and materials, and settlement, clearing, and custodial fees and expenses, expenses of our transfer agent, the costs of maintaining compliance with all federal, state and local rules and regulations or any other regulatory agency, all taxes and license fees and all insurance costs incurred by us or on our behalf. In addition, we will be required to pay our pro rata portion of rent, telephone, utilities, office furniture, equipment, machinery and other office, internal and overhead expenses of our Manager and its affiliates required for our operations. Except as noted above, our Manager is responsible for all costs incident to the performance of its duties under the management agreement, including compensation of our Manager’s
employees and other related expenses, except that we may elect to have our Manager allocate expenses among us and our subsidiaries, in which case expenses would be paid directly by each entity that received an allocation.
Incentive Compensation. In addition to the base management fee, our Manager receives quarterly incentive compensation in an amount equal to the product of: (i) 25% of the dollar amount by which: (a) our Net Income, before incentive compensation, per weighted-average share of our common stock for such quarter, exceeds (b) an amount equal to (A) the weighted-average of the price per share of our common stock in our August 2004 private placement and the prices per share of our common stock in our initial public offering and any subsequent offerings by us multiplied by (B) the greater of (1) 2.00% and (2) 0.50% plus one-fourth of the Ten Year Treasury Rate for such quarter, multiplied by (ii) the weighted average number of shares of our common stock outstanding in such quarter. The foregoing calculation of incentive compensation will be adjusted to exclude special one-time events pursuant to changes in GAAP, as well as non-cash charges, after discussion between our Manager and our independent directors and approval by a majority of our independent directors in the case of non-cash charges. The incentive compensation calculation and payment shall be made quarterly in arrears. For purposes of the foregoing: ‘‘Net Income’’ shall be determined by calculating the net income available to stockholders before non-cash equity compensation expense, in accordance with GAAP; and ‘‘Ten Year Treasury Rate’’ means the average of weekly average yield to maturity for U.S. Treasury securities (adjusted to a constant maturity of ten years) as published weekly by the Federal Reserve Board in publication H.15 or any successor publication during a fiscal quarter.
Our ability to achieve returns in excess of the thresholds noted above in order for our Manager to earn the incentive compensation described in the preceding paragraph is dependent upon the level and volatility of interest rates, our ability to react to changes in interest rates and to utilize successfully the operating strategies described herein, and other factors, many of which are not within our control.
Our Manager is required to compute the quarterly incentive compensation within 30 days after the end of each fiscal quarter, and we are required to pay the quarterly incentive compensation with respect to each fiscal quarter within five business days following the delivery to us of our Manager’s written statement setting forth the computation of the incentive fee for such quarter. We may elect to have our Manager allocate the incentive management fee among us and our subsidiaries, in which case the fee would be paid directly by each entity that received an allocation.
The Collateral Management Agreements
An affiliate of our Manager has entered into separate management agreements with KKR Financial CLO 2005-1, Ltd., or CLO 2005-1, KKR Financial CLO 2005-2, Ltd., or CLO 2005-2, and KKR Financial CLO 2006-1, Ltd., or CLO 2006-1, and is entitled to receive fees for the services performed as the collateral manager under the management agreements. As of December 31, 2006, the collateral manager has permanently waived approximately $2.6 million of management fees payable to it from CLO 2005-1 which covered the period commencing in March 2005 and ending in December 2006, has permanently waived approximately $1.7 million of management fees payable to it from CLO 2005-2 which covered the period commencing November 2005 and ending in December 2006 and has permanently waived approximately $1.4 million of management fees payable to it from CLO 2006-1 which covered the period commencing September 2006 and ending in December 2006. The current waivers for CLO 2005-1, CLO 2005-2, and CLO 2006-1 expire in April 2007, May 2007, and May 2007, respectively. There are no assurances that the collateral manager will waive such management fees subsequent to those dates.