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KKR Financial 10-Q 2010
UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
FORM 10-Q
(Mark One)
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2010
or
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission file number: 001-33437
KKR FINANCIAL HOLDINGS LLC (Exact name of registrant as specified in its charter)
Registrant’s telephone number, including area code: (415) 315-3620
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. x Yes o No
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). o Yes x No
The number of shares of the registrant’s common shares outstanding as of October 28, 2010 was 158,412,565.
KKR Financial Holdings LLC and Subsidiaries Condensed Consolidated Balance Sheets (Unaudited) (Amounts in thousands, except share information)
See notes to condensed consolidated financial statements.
KKR Financial Holdings LLC and Subsidiaries Condensed Consolidated Statements of Operations (Unaudited)
See notes to condensed consolidated financial statements.
KKR Financial Holdings LLC and Subsidiaries Condensed Consolidated Statement of Changes in Shareholders’ Equity (Unaudited)
See notes to condensed consolidated financial statements.
KKR Financial Holdings LLC and Subsidiaries Condensed Consolidated Statements of Cash Flows (Unaudited)
See notes to condensed consolidated financial statements.
KKR Financial Holdings LLC and Subsidiaries Notes to Condensed Consolidated Financial Statements (Unaudited)
Note 1. Organization
KKR Financial Holdings LLC together with its subsidiaries (the “Company” or “KKR Financial”) is a specialty finance company with expertise in a range of asset classes. The Company primarily invests in financial assets including below investment grade corporate debt, including senior secured and unsecured loans, mezzanine loans, high yield corporate bonds, distressed and stressed debt securities, marketable equity securities, and private equity. Additionally, the Company has made or may make investments in other asset classes including natural resources and real estate. The corporate loans the Company invests in are generally referred to as syndicated bank loans, or leveraged loans, and are purchased via assignment or participation in either the primary or secondary market. The majority of the Company’s corporate debt investments are held in collateralized loan obligation (“CLO”) transactions that the Company uses as long term financing for these investments. The Company’s CLO transactions are structured as on-balance sheet securitizations of corporate loans and high yield debt securities. The senior secured notes issued by the CLO transactions are generally owned by third party investors who are unaffiliated with the Company and the Company owns the majority of the subordinated notes in the CLO transactions. The Company executes its core business strategy through majority-owned subsidiaries, including CLOs.
KKR Financial Advisors LLC (the “Manager”), a wholly owned subsidiary of KKR Asset Management LLC (formerly known as Kohlberg Kravis Roberts & Co. (Fixed Income) LLC), manages the Company pursuant to a management agreement (the “Management Agreement”). KKR Asset Management LLC is a wholly-owned subsidiary of Kohlberg Kravis Roberts & Co. L.P. (“KKR”).
Note 2. Summary of Significant Accounting Policies
Basis of Presentation
The accompanying condensed consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”). The condensed consolidated financial statements include the accounts of the Company and entities established to complete secured financing transactions that are considered to be variable interest entities and for which the Company is the primary beneficiary.
These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009. The Company’s results for any interim period are not necessarily indicative of results for a full year or any other interim period. In the opinion of management, all normal recurring adjustments have been included for a fair statement of this interim financial information.
Use of Estimates
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the Company’s condensed consolidated financial statements and accompanying notes. Actual results could differ from management’s estimates.
Consolidation
Effective January 1, 2010, the Company adopted new guidance which amended the accounting for the transfers of financial assets, eliminated the concept of a qualified special purpose entity and significantly changed the criteria by which an enterprise determines whether or not it must consolidate a variable interest entity (“VIE”). Under the new guidance, consolidation of a VIE requires both the power to direct the activities that most significantly impact the VIE’s economic performance and the obligation to absorb losses of the VIE or the right to receive benefits of the VIE that could potentially be significant to the VIE.
As a result of the adoption of the new guidance regarding the amended consolidation model based on power and economics, the Company determined that six residential mortgage loan securitization trusts, which were previously consolidated by the Company as it was deemed to be the primary beneficiary, were required to be deconsolidated. The Company determined that it did not have the power to direct the activities that most significantly impact the economic performance of the securitization trusts or the performance of the securitization trusts’ underlying assets as the Company was never the servicer of the trusts nor did it participate in any servicing activities. Accordingly, the Company determined that it was no longer the primary beneficiary of the six securitization trusts under the new guidance and deconsolidated them as of January 1, 2010. This resulted in the reduction of both assets and liabilities of approximately $2.0 billion. In addition, loan interest income, interest expense, loan servicing expense, and net unrealized and realized
gain (loss) associated with the residential mortgage loan securitization trusts will no longer be reported on the Company’s condensed consolidated financial statements. The deconsolidation of the six residential mortgage loan securitization trusts had no net impact on the Company’s shareholders’ equity, results of operations and cash flows. Refer to Note 6 to these condensed consolidated financial statements for further discussion of the Company’s residential mortgage-backed securities (“RMBS”) and to Note 7 to these condensed consolidated financial statements for the impact of the deconsolidation.
KKR Financial CLO 2005-1, Ltd. (“CLO 2005-1”), KKR Financial CLO 2005-2, Ltd. (“CLO 2005-2”), KKR Financial CLO 2006-1, Ltd. (“CLO 2006-1”), KKR Financial CLO 2007-1, Ltd. (“CLO 2007-1”) and KKR Financial CLO 2007-A, Ltd. (“CLO 2007-A”) are entities established to complete secured financing transactions. These entities are VIEs which the Company consolidates as the Company has determined it has the power to direct the activities that most significantly impact these entities’ economic performance and the Company has both the obligation to absorb losses of these entities and the right to receive benefits from these entities that could potentially be significant to these entities.
These five CLOs, through which the Company finances the majority of its corporate debt investments, include $7.3 billion par amount, or $6.8 billion estimated fair value, of corporate debt investments. The assets in each CLO can be used only to settle the related entities’ debt which in aggregate total $5.6 billion of senior and junior secured notes outstanding and $371.1 million of junior notes outstanding that are held by an affiliate of the Manager. In CLO transactions, subordinated notes have the first risk of loss and conversely, the residual value upside of the transactions. As such, these CLOs are considered non-recourse leverage.
In addition, the Company continues to consolidate all non-VIEs in which it holds a greater than 50 percent voting interest.
All inter-company balances and transactions have been eliminated in consolidation.
Fair Value of Financial Instruments
Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Where available, fair value is based on observable market prices or parameters, or derived from such prices or parameters. Where observable prices or inputs are not available, valuation models are applied. These valuation techniques involve some level of management estimation and judgment, the degree of which is dependent on the price transparency for the instruments or market and the instruments’ complexity for disclosure purposes. Assets and liabilities recorded at fair value in the condensed consolidated balance sheets are categorized based upon the level of judgment associated with the inputs used to measure their value. Hierarchical levels, as defined under GAAP, are directly related to the amount of subjectivity associated with the inputs to fair valuations of these assets and liabilities, and are as follows:
Level 1: Inputs are unadjusted, quoted prices in active markets for identical assets or liabilities at the measurement date.
The types of assets carried at level 1 fair value generally are equity securities listed in active markets.
Level 2: Inputs, other than quoted prices included in level 1, are observable for the asset or liability, either directly or indirectly. Level 2 inputs include quoted prices for similar instruments in active markets, and inputs other than quoted prices that are observable for the asset or liability.
Fair value assets and liabilities that are generally included in this category are certain corporate debt securities, certain corporate loans held for sale, certain equity investments at estimated fair value, certain securities sold, not yet purchased and certain financial instruments classified as derivatives.
Level 3: Inputs are unobservable inputs for the asset or liability, and include situations where there is little, if any, market activity for the asset or liability. In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, the level in the fair value hierarchy within which the fair value measurement in its entirety falls has been determined based on the lowest level input that is significant to the fair value measurement in its entirety. The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment and consideration of factors specific to the asset.
Assets and liabilities carried at fair value and included in this category are certain corporate debt securities, certain corporate loans held for sale, certain equity investments at estimated fair value, RMBS, residential mortgage loans, residential mortgage-backed securities issued (“RMBS Issued”) and certain derivatives.
A significant decrease in the volume and level of activity for the asset or liability is an indication that transactions or quoted prices may not be representative of fair value because in such market conditions there may be increased instances of transactions that are not orderly. In those circumstances, further analysis of transactions or quoted prices is needed, and a significant adjustment to the transactions or quoted prices may be necessary to estimate fair value.
The availability of observable inputs can vary depending on the financial asset or liability and is affected by a wide variety of factors, including, for example, the type of product, whether the product is new, whether the product is traded on an active exchange or in the secondary market, and the current market condition. To the extent that valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires more judgment. Accordingly, the degree of judgment exercised by the Company in determining fair value is greatest for instruments categorized in level 3. In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, for disclosure purposes, the level in the fair value hierarchy within which the fair value measurement in its entirety falls is determined based on the lowest level input that is significant to the fair value measurement in its entirety. The variability of the observable inputs affected by the factors described above may cause transfers between levels 1, 2, and/or 3, which the Company recognizes at the end of the reporting period.
Many financial assets and liabilities have bid and ask prices that can be observed in the marketplace. Bid prices reflect the highest price that the Company and others are willing to pay for an asset. Ask prices represent the lowest price that the Company and others are willing to accept for an asset. For financial assets and liabilities whose inputs are based on bid-ask prices, the Company does not require that fair value always be a predetermined point in the bid-ask range. The Company’s policy is to allow for mid-market pricing and adjusting to the point within the bid-ask range that meets the Company’s best estimate of fair value.
Depending on the relative liquidity in the markets for certain assets, the Company may transfer assets to level 3 if it determines that observable quoted prices, obtained directly or indirectly, are not available. The valuation techniques used for the assets and liabilities that are valued using level 3 of the fair value hierarchy are described below.
Residential Mortgage-Backed Securities, Residential Mortgage Loans, and Residential Mortgage-Backed Securities Issued: Residential mortgage-backed securities, residential mortgage loans, and residential mortgage-backed securities issued are initially valued at transaction price and are subsequently valued using industry recognized models (including Intex and Bloomberg) and data for similar instruments (e.g., nationally recognized pricing services or broker quotes). The most significant inputs to the valuation of these instruments are default and loss expectations and market credit spreads.
Corporate Debt Securities: Corporate debt securities are initially valued at transaction price and are subsequently valued using market data for similar instruments (e.g., recent transactions or broker quotes), comparisons to benchmark derivative indices or valuation models. Valuation models are based on discounted cash flow techniques, for which the key inputs are the amount and timing of expected future cash flows, market yields for such instruments and recovery assumptions. Inputs are determined based on relative value analyses, which incorporate similar instruments from similar issuers.
Over-the-counter (“OTC”) Derivative Contracts: OTC derivative contracts include forward, swap and option contracts related to interest rates, foreign currencies, credit standing of reference entities, and equity prices. The fair value of OTC derivative products can be modeled using a series of techniques, including closed-form analytic formulae, such as the Black-Scholes option-pricing model, and simulation models or a combination thereof. Many pricing models do not entail material subjectivity because the methodologies employed do not necessitate significant judgment, and the pricing inputs are observed from actively quoted markets, as is the case for generic interest rate swap and option contracts.
Cash and Cash Equivalents
Cash and cash equivalents include cash on hand, cash held in banks and highly liquid investments with original maturities of three months or less. Interest income earned on cash and cash equivalents is recorded in other interest income.
Restricted Cash and Cash Equivalents
Restricted cash and cash equivalents represent amounts that are held by third parties under certain of the Company’s financing and derivative transactions. Interest income earned on restricted cash and cash equivalents is recorded in other interest income.
On the condensed consolidated statement of cash flows, net additions or reductions to restricted cash and cash equivalents are classified as an investing activity as restricted cash and cash equivalents reflect the receipts from collections or sales of investments, as well as payments made to acquire investments held by third parties.
Residential Mortgage-Backed Securities
The Company carries its residential mortgage-backed securities at estimated fair value with unrealized gains and losses reported in income. The Company elected the fair value option for its residential mortgage investments for the purpose of enhancing the transparency of its financial condition as fair value is consistent with how the Company manages the risks of its residential mortgage investments.
Securities Available-for-Sale
The Company classifies its investments in securities as available-for-sale as the Company may sell them prior to maturity and does not hold them principally for the purpose of selling them in the near term. These investments are carried at estimated fair value, with unrealized gains and losses reported in accumulated other comprehensive income (loss). Estimated fair values are based on quoted market prices, when available, on estimates provided by independent pricing sources or dealers who make markets in such securities, or internal valuation models when external sources of fair value are not available. Upon the sale of a security, the realized net gain or loss is computed on a weighted-average cost basis. Purchases and sales of securities are recorded on the trade date.
The Company monitors its available-for-sale securities portfolio for impairments. A loss is recognized when it is determined that a decline in the estimated fair value of a security below its amortized cost is other-than-temporary. The Company considers many factors in determining whether the impairment of a security is deemed to be other-than-temporary, including, but not limited to, the length of time the security has had a decline in estimated fair value below its amortized cost and the severity of the decline, the amount of the unrealized loss, recent events specific to the issuer or industry, external credit ratings and recent changes in such ratings. In addition, for debt securities, the Company considers its intent to sell the debt security, the Company’s estimation of whether or not it expects to recover the debt security’s entire amortized cost if it intends to hold the debt security, and whether it is more likely than not that the Company will be required to sell the debt security before its anticipated recovery. For equity securities, the Company also considers its intent and ability to hold the equity security for a period of time sufficient for a recovery in value.
The amount of the loss that is recognized when it is determined that a decline in the estimated fair value of a security below its amortized cost is other-than-temporary is dependent on certain factors. If the security is an equity security or if the security is a debt security that the Company intends to sell or estimates that it is more likely than not that the Company will be required to sell before recovery of its amortized cost, then the impairment amount recognized in earnings is the entire difference between the estimated fair value of the security and its amortized cost. For debt securities that the Company does not intend to sell or estimates that it is not more likely than not to be required to sell before recovery, the impairment is separated into the estimated amount relating to credit loss and the estimated amount relating to all other factors. Only the estimated credit loss amount is recognized in earnings, with the remainder of the loss amount recognized in other comprehensive income (loss).
Unamortized premiums and unaccreted discounts on securities available-for-sale are recognized in interest income over the contractual life, adjusted for actual prepayments, of the securities using the effective interest method.
Equity Investments, at Estimated Fair Value
The Company has elected the fair value option of accounting for certain marketable and private equity investments. The Company elects the fair value option of accounting for private equity investments received through restructuring debt transactions or issued by an entity in which the Company may have significant influence. The Company elected the fair value option for certain equity investments for the purpose of enhancing the transparency of its financial condition as fair value is consistent with how the Company manages the risks of these equity investments. Equity investments, at estimated fair value, are managed based on overall value and potential returns. Investments carried at fair value are presented separately on the condensed consolidated balance sheets with unrealized gains and losses reported in net realized and unrealized gains and losses on investments on the condensed consolidated statements of operations.
Securities Sold, Not Yet Purchased
Securities sold, not yet purchased consist of equity and debt securities that the Company has sold short. In order to facilitate a short sale, the Company borrows the securities from another party and delivers the securities to the buyer. The Company will be required to “cover” its short sale in the future through the purchase of the security in the market at the prevailing market price and deliver it to the counterparty from which it borrowed. The Company is exposed to a loss to the extent that the security price increases during the time from when the Company borrowed the security to when the Company purchases it in the market to cover the short sale.
Corporate Loans
The Company purchases participations and assignments in corporate loans in the primary and secondary market. Loans are held for investment and the Company initially records loans at their purchase prices. The Company subsequently accounts for loans based on their outstanding principal plus or minus unaccreted purchase discounts and unamortized purchase premiums. Interest income on loans includes interest at stated coupon rates adjusted for accretion of purchase discounts and the amortization of purchase premiums. Unamortized premiums and unaccreted discounts are recognized in interest income over the contractual life, adjusted for actual prepayments, of the loans using the effective interest method.
A loan is typically placed on non-accrual status at such time as: (i) management believes that scheduled debt service payments may not be paid when contractually due; (ii) the loan becomes 90 days delinquent; (iii) management determines the borrower is incapable of, or has ceased efforts toward, curing the cause of the impairment; or (iv) the net realizable value of the underlying collateral securing the loan decreases below the Company’s carrying value of such loan. As such, loans placed on non-accrual status may or may not be contractually past due at the time of such determination. While on non-accrual status, previously recognized accrued interest is reversed if it is determined that such amounts are not collectible and interest income is recognized using the cost-recovery method, cash-basis method or some combination of the two methods. A loan is placed back on accrual status when the ultimate collectability of the principal and interest is not in doubt.
Corporate Loans Held for Sale
Corporate loans held for sale consist of loans that the Company has determined to no longer hold for investment. Corporate loans held for sale are stated at lower of cost or estimated fair value.
Allowance for Loan Losses
The Company’s allowance for loan losses represents its estimate of probable credit losses inherent in its corporate loan portfolio held for investment as of the balance sheet date. Estimating the Company’s allowance for loan losses involves a high degree of management judgment and is based upon a comprehensive review of the Company’s loan portfolio that is performed on a quarterly basis. The Company’s allowance for loan losses consists of two components, an allocated component and an unallocated component. The allocated component of the allowance for loan losses pertains to specific loans that the Company has determined are impaired. The Company determines a loan is impaired when management estimates that it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. On a quarterly basis, the Company performs a comprehensive review of its entire loan portfolio and identifies certain loans that it has determined are impaired. Once a loan is identified as being impaired, the Company places the loan on non-accrual status, unless the loan is already on non-accrual status, and records a reserve that reflects management’s best estimate of the loss that the Company expects to recognize from the loan. The expected loss is estimated as being the difference between the Company’s current cost basis of the loan, including accrued interest receivable, and the loan’s estimated fair value.
The unallocated component of the Company’s allowance for loan losses reflects its estimate of probable losses inherent in the loan portfolio as of the balance sheet date where the specific loan that the loan loss relates to is indeterminable. The Company estimates the unallocated component of the allowance for loan losses through a comprehensive review of its loan portfolio and identifies certain loans that demonstrate possible indicators of impairment. This assessment excludes all loans that are determined to be impaired and as a result, an allocated reserve has been recorded. Such indicators include, but are not limited to, the current and/or forecasted financial performance and liquidity profile of the issuer, specific industry or economic conditions that may impact the issuer, and the observable trading price of the loan if available. Loans that demonstrate possible indicators of impairment are aggregated on a watch list for monitoring and are sub-divided for categorization based on the seniority of the loan in the issuer’s capital structure, whether the loan is secured or unsecured, and the nature of the collateral securing the loan, for purposes of applying possible default and loss severity ranges based on the nature of the issuer and the specific loan. The Company applies a range of default and loss severity estimates in order to estimate a range of loss outcomes upon which to base its estimate of probable losses that results in the determination of the unallocated component of the Company’s allowance for loan losses.
Leasehold Improvements and Equipment
Leasehold improvements and equipment are carried at cost less depreciation and amortization and are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets might not be recoverable. Equipment is depreciated using the straight-line method over the estimated useful lives of the respective assets of three years. Leasehold improvements are amortized on a straight-line basis over the shorter of their estimated useful lives or lease terms. Leasehold improvements and equipment, net of accumulated depreciation and amortization, are included in other assets.
Borrowings
The Company finances the acquisition of its investments, including loans, residential mortgage-backed securities and securities available-for-sale, primarily through the use of secured borrowings in the form of securitization transactions structured as secured financings and other secured and unsecured borrowings. The Company recognizes interest expense on all borrowings on an accrual basis.
Trust Preferred Securities
Trusts formed by the Company for the sole purpose of issuing trust preferred securities are not consolidated by the Company as the Company has determined that it is not the primary beneficiary of such trusts. The Company’s investment in the common securities of such trusts is included in other assets on the Company’s condensed consolidated financial statements.
Derivative Financial Instruments
The Company recognizes all derivatives on the condensed consolidated balance sheet at estimated fair value. On the date the Company enters into a derivative contract, the Company designates and documents each derivative contract as one of the following at the time the contract is executed: (i) a hedge of a recognized asset or liability (“fair value” hedge); (ii) a hedge of a forecasted transaction or of the variability of cash flows to be received or paid related to a recognized asset or liability (“cash flow” hedge); (iii) a hedge of a net investment in a foreign operation; or (iv) a derivative instrument not designated as a hedging instrument (“free-standing derivative”). For a fair value hedge, the Company records changes in the estimated fair value of the derivative instrument and, to the extent that it is effective, changes in the fair value of the hedged asset or liability in the current period earnings in the same financial statement category as the hedged item. For a cash flow hedge, the Company records changes in the estimated fair value of the derivative to the extent that it is effective in other comprehensive (loss) income and subsequently reclassifies these changes in estimated fair value to net income in the same period(s) that the hedged transaction affects earnings. The effective portion of the cash flow hedges is recorded in the same financial statement category as the hedged item. For free-standing derivatives, the Company reports changes in the fair values in other (loss) income.
The Company formally documents at inception its hedge relationships, including identification of the hedging instruments and the hedged items, its risk management objectives, strategy for undertaking the hedge transaction and the Company’s evaluation of effectiveness of its hedged transactions. Periodically, the Company also formally assesses whether the derivative it designated in each hedging relationship is expected to be and has been highly effective in offsetting changes in estimated fair values or cash flows of the hedged item using either the dollar offset or the regression analysis method. If the Company determines that a derivative is not highly effective as a hedge, it discontinues hedge accounting.
Foreign Currency
The Company makes investments in non-United States dollar denominated securities and loans. As a result, the Company is subject to the risk of fluctuation in the exchange rate between the United States dollar and the foreign currency in which it makes an investment. In order to reduce the currency risk, the Company may hedge the applicable foreign currency. All investments denominated in a foreign currency are converted to the United States dollar using prevailing exchange rates on the balance sheet date. Income, expenses, gains and losses on investments denominated in a foreign currency are converted to the United States dollar using the prevailing exchange rates on the dates when they are recorded. Foreign exchange gains and losses are recorded in the condensed consolidated statements of operations.
Manager Compensation
The Management Agreement provides for the payment of a base management fee to the Manager, as well as an incentive fee if the Company’s financial performance exceeds certain benchmarks. Additionally, the Management Agreement provides for the Manager to be reimbursed for certain expenses incurred on the Company’s behalf. See Note 13 to these condensed consolidated financial statements for additional discussion on the payment of the base management fee and incentive fee. The base management fee and the incentive fee are accrued and expensed during the period for which they are earned by the Manager.
Share-Based Compensation
The Company accounts for share-based compensation issued to its directors and to its Manager using the fair value based methodology in accordance with accounting guidance. Compensation cost related to restricted common shares issued to the Company’s directors is measured at its estimated fair value at the grant date, and is amortized and expensed over the vesting period on a straight-line basis. Compensation cost related to restricted common shares and common share options issued to the Manager is initially measured at estimated fair value at the grant date, and is remeasured on subsequent dates to the extent the awards are unvested. The Company has elected to use the graded vesting attribution method to amortize compensation expense for the restricted common shares and common share options granted to the Manager.
Income Taxes
The Company intends to continue to operate so as to qualify as a partnership, and not as an association or publicly traded partnership that is taxable as a corporation, for United States federal income tax purposes. Therefore, the Company generally is not
subject to United States federal income tax at the entity level, but is subject to limited state and foreign taxes. Holders of the Company’s shares will be required to take into account their allocable share of each item of the Company’s income, gain, loss, deduction, and credit for the taxable year of the Company ending within or with their taxable year.
During 2010, the Company owned an equity interest in KKR Financial Holdings II, LLC (“KFH II”) which elected to be taxed as a real estate investment trust (a “REIT”) under the Internal Revenue Code of 1986, as amended (the “Code”). KFH II holds certain real estate mortgage-backed securities. A REIT generally is not subject to United States federal income tax to the extent that it currently distributes its income and satisfies certain asset, income and ownership tests, and recordkeeping requirements, but it may be subject to some amount of federal, state, local and foreign taxes based on its taxable income.
The Company has wholly-owned domestic and foreign subsidiaries that are taxable as corporations for United States federal income tax purposes and thus are not consolidated with the Company for United States federal income tax purposes. For financial reporting purposes, current and deferred taxes are provided for on the portion of earnings recognized by the Company with respect to its interest in the domestic taxable corporate subsidiaries, because each is taxed as a regular corporation under the Code. Deferred income tax assets and liabilities are computed based on temporary differences between the GAAP consolidated financial statements and the United States federal income tax basis of assets and liabilities as of each consolidated balance sheet date. The foreign corporate subsidiaries were formed to make certain foreign and domestic investments from time to time. The foreign corporate subsidiaries are organized as exempted companies incorporated with limited liability under the laws of the Cayman Islands, and are anticipated to be exempt from United States federal and state income tax at the corporate entity level because they restrict their activities in the United States to trading in stock and securities for their own account. However, the Company will be required to include their current taxable income in the Company’s calculation of its taxable income allocable to shareholders. CLO 2005-1, CLO 2005-2, CLO 2006-1, CLO 2007-1, CLO 2007-A and KKR Financial CLO 2009-1, Ltd. (“CLO 2009-1”) are foreign subsidiaries of the Company that elected to be treated as disregarded entities or partnerships for United States federal income tax purposes. These subsidiaries were established to facilitate securitization transactions, structured as secured financing transactions.
Earnings Per Share
The Company calculates earnings per share (“EPS”) using the two-class method which is an earnings allocation formula that determines EPS for common shares and participating securities. Unvested share-based payment awards that contain non-forfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities and shall be included in the computation of EPS using the two-class method. Accordingly, all earnings (distributed and undistributed) are allocated to common shares and participating securities based on their respective rights to receive dividends.
The Company presents both basic and diluted earnings (loss) per common share in its condensed consolidated financial statements and footnotes thereto. Basic earnings (loss) per common share (“Basic EPS”) excludes dilution and is computed by dividing net income or loss by the weighted-average number of common shares, including vested restricted common shares, outstanding for the period. Diluted earnings (loss) per share (“Diluted EPS”) reflects the potential dilution of common share options and unvested restricted common shares using the treasury method, as well as the potential dilution of convertible senior notes using the number of shares it would take to satisfy the excess conversion obligation (average Company share price for the period in excess of the conversion price related to the Company’s convertible senior notes), if they are not anti-dilutive. See Note 3 to these condensed consolidated financial statements for earnings per common share computations.
Recent Accounting Pronouncements
Consolidation
In February 2010, the Financial Accounting Standards Board (“FASB”) issued new guidance deferring the application of the amended consolidation requirements related to VIEs for a reporting entity’s interest in an entity that has all the attributes of an investment company or for which it is applies measurement principles that are consistent with those followed by investment companies. The guidance was expected to most significantly affect reporting entities in the investment management industry. Entities including, but not limited to, securitization entities or entities with multiple levels of subordinated investors such as a CLO for which the primary purpose of the capital structure of the entity is to provide credit enhancement to senior interest holders, will not qualify for the deferral. The guidance was effective for interim and annual reporting periods beginning after November 15, 2009. The adoption of this new guidance did not have an effect on the Company’s condensed consolidated financial statements.
Financing Receivables and Allowance for Credit Losses
In July 2010, the FASB issued new guidance to amend existing disclosure requirements to provide a greater level of disaggregated information about the credit quality of financing receivables and allowance for credit losses. The two levels of disaggregation defined by the FASB are portfolio segment and class of financing receivable. The amendments also require an entity to disclose credit quality indicators, past due information, and modifications of financing receivables. The guidance is effective for interim and annual reporting periods ending on or after December 15, 2010. The Company will include the required disclosures beginning with its consolidated financial statements for the year ending December 31, 2010.
Note 3. Earnings per Share
The following table presents a reconciliation of basic and diluted net income per common share, as well as the distributions declared per common share for the three and nine months ended September 30, 2010 and 2009 (amounts in thousands, except per share information):
(1) An immaterial conversion premium related to the convertible senior notes was included in the diluted earnings per share for the three and nine months ended September 30, 2010. Potential anti-dilutive common shares excluded from diluted earnings per share related to common share options were 1,932,279 for both the three and nine months ended September 30, 2010 and 2009.
Note 4. Securities Available-for-Sale
The following table summarizes the Company’s securities classified as available-for-sale as of September 30, 2010 and December 31, 2009, which are carried at estimated fair value (amounts in thousands):
The following table shows the gross unrealized losses and estimated fair value of the Company’s available-for-sale securities, aggregated by length of time that the individual securities have been in a continuous unrealized loss position, as of September 30, 2010 and December 31, 2009 (amounts in thousands):
The unrealized losses in the table above are considered to be temporary impairments due to market factors and are not reflective of credit deterioration. The Company considers many factors when evaluating whether an impairment is other-than-temporary. For corporate debt securities included in the table above, the Company does not intend to sell them and does not believe that it is more likely than not that the Company will be required to sell any of its corporate debt securities prior to recovery. In addition, based on the analyses performed by the Company on each of its corporate debt securities, the Company believes that it should be able to recover the entire amortized cost amount of the corporate debt securities included in the table above.
During the three and nine months ended September 30, 2010, the Company recognized losses totaling $0.5 million and $1.7 million, respectively, for corporate debt securities that it determined to be other-than-temporarily impaired based on the criteria above. During the three and nine months ended September 30, 2009, the Company recognized losses totaling nil and $40.0 million, respectively, for corporate debt securities that it determined to be other-than-temporarily impaired based on the criteria above. The Company intends to sell these securities and as a result, the entire amount is recorded through earnings in net realized and unrealized gain (loss) on investments in the condensed consolidated statements of operations.
As of September 30, 2010 and December 31, 2009, the Company had no corporate debt securities in default.
The following table shows the net realized gains (losses) on the sales of securities (amounts in thousands):
Note 8 to these condensed consolidated financial statements describes the Company’s borrowings under which the Company has pledged securities available-for-sale for borrowings. The following table summarizes the estimated fair value of securities available-for-sale pledged as collateral as of September 30, 2010 and December 31, 2009 (amounts in thousands):
Note 5. Corporate Loans and Allowance for Loan Losses
The following table summarizes the Company’s corporate loans as of September 30, 2010 and December 31, 2009 (amounts in thousands):
(1) Principal amount is net of charge-offs and other adjustments totaling $42.9 million and $158.8 million as of September 30, 2010 and December 31, 2009, respectively.
The following table summarizes the changes in the allowance for loan losses for the Company’s corporate loan portfolio during the three and nine months ended September 30, 2010 and 2009 (amounts in thousands):
As of September 30, 2010 and December 31, 2009, the Company had an allowance for loan losses of $209.0 million and $237.3 million, respectively. As described in Note 2 to these condensed consolidated financial statements, the allowance for loan losses represents the Company’s estimate of probable credit losses inherent in its loan portfolio as of the balance sheet date. The Company’s allowance for loan losses consists of two components, an allocated component and an unallocated component. The allocated component of the allowance for loan losses consists of individual loans that are impaired. The unallocated component of the allowance for loan losses represents the Company’s estimate of losses inherent, but not identified, in its portfolio as of the balance sheet date.
As of September 30, 2010, the allocated component of the allowance for loan losses totaled $53.0 million and relates to investments in certain loans issued by six issuers with an aggregate par amount of $228.0 million and an aggregate amortized cost amount of $151.0 million. In addition, certain impaired loans from three of these issuers with an aggregate par amount of $85.1 million and an aggregate amortized cost amount of $16.9 million had no associated allowance for loan losses as the Company’s amortized cost basis for these loans was below the estimated fair value as of September 30, 2010. As of December 31, 2009, the allocated component of the allowance for loan losses totaled $81.7 million and relates to investments in loans issued by six issuers with an aggregate par amount of $223.6 million and an aggregate amortized cost amount of $121.2 million.
The unallocated component of the allowance for loan losses totaled $156.0 million and $155.6 million as of September 30, 2010 and December 31, 2009, respectively. During the three and nine months ended September 30, 2010, the Company recorded charge-offs totaling $9.3 million and $36.4 million, respectively, comprised primarily of loans transferred to loans held for sale. The Company recorded charge-offs totaling $3.0 million and $50.4 million for the three and nine months ended September 30, 2009, respectively.
As of September 30, 2010, the Company had $667.2 million of loans held for sale, a decrease of $258.5 million from December 31, 2009.
As of September 30, 2010 and December 31, 2009, the Company had loans on non-accrual status with a total amortized cost of $167.1 million and $439.9 million, respectively. The average investment in impaired loans during the three and nine months ended September 30, 2010 was $178.4 million and $262.5 million, respectively, and during the three and nine months ended September 30, 2009, average recorded investment in the impaired loans was $717.3 million and $544.2 million, respectively. As of September 30, 2010 and 2009, the allocated component of the allowance for loan losses included all impaired loans for the respective periods. The amount of interest income recognized using the cash-basis method during the time within the period that the loans were impaired was $4.1 million and $11.1 million for the three and nine months ended September 30, 2010, respectively, and $8.2 million and $15.0 million for the three and nine months ended September 30, 2009, respectively.
As of September 30, 2010, the Company held corporate loans that were in default with a total amortized cost of $19.7 million from two issuers. As of December 31, 2009, the Company held loans that were in default with a total amortized cost of $392.5 million from seven issuers. The majority of corporate loans in default during 2010 and 2009 were included in the loans for which the allocated component of the Company’s allowance for losses was related to, or for which the Company determined were loans held for sale as of September 30, 2010 and December 31, 2009, respectively.
Note 8 to these condensed consolidated financial statements describes the Company’s borrowings under which the Company has pledged loans for borrowings. The following table summarizes the amortized cost of total corporate loans, including corporate loans held for sale, pledged as collateral as of September 30, 2010 and December 31, 2009 (amounts in thousands):
Note 6. Residential Mortgage-Backed Securities
The Company held RMBS with an estimated fair value of $106.3 million and $47.6 million as September 30, 2010 and December 31, 2009, respectively. As of January 1, 2010, RMBS increased $74.4 million due to the deconsolidation of six residential mortgage loan securitization trusts (see “Consolidation” under Note 2 to these condensed consolidated financial statements). The $74.4 million represents the estimated fair value of the Company’s RMBS which were issued by these six residential mortgage securitization trusts.
Note 8 to these condensed consolidated financial statements describes the Company’s borrowings under which the Company has pledged RMBS. The following table summarizes the estimated fair value of RMBS pledged as collateral as of September 30, 2010 and December 31, 2009 (amounts in thousands):
Note 7. Deconsolidation of Residential Mortgage Loan Securitization Trusts
On January 1, 2010, the Company deconsolidated six residential mortgage securitization trusts as a result of the Company’s adoption of new guidance regarding the consolidation model for variable interest entities. The Company has no exposure to loss in excess of the estimated fair value of the $74.4 million RMBS which were issued by these six residential mortgage securitization trusts (see Note 6 to these condensed consolidated financial statements).
The following information represents the assets and liabilities removed from the Company’s condensed consolidated balance sheet as of January 1, 2010 as a result of the deconsolidation of the six residential mortgage loan securitization trusts (amounts in thousands):
(1) Excludes $74.4 million which represents the estimated fair value of the Company’s RMBS which were issued by the six residential mortgage loan securitization trusts that were deconsolidated under GAAP as of January 1, 2010.
As a result of the deconsolidation of the six residential mortgage loan securitization trusts, all references to residential mortgage loans interest income, RMBS Issued interest expense, net realized and unrealized gain (loss) on residential mortgage loans and RMBS Issued, and loan servicing expense relate to prior period balances and activities.
Residential mortgage loans
The Company carried its residential mortgage loans at estimated fair value with unrealized gains and losses reported in income. The Company had elected the fair value option for its residential mortgage loans for the purpose of enhancing the transparency of its financial condition as fair value was consistent with how the Company managed the risks of its residential mortgage investments.
As of December 31, 2009, residential mortgage loans at estimated fair value, totaled $2.1 billion, which excluded real estate owned (“REO”) as a result of foreclosure on delinquent loans of $11.4 million as of December 31, 2009. Loans were transferred to REO at the lower of cost or fair value. REO was recorded within other assets on the Company’s condensed consolidated balance sheets.
The following table summarizes the estimated fair value of residential mortgage loans pledged as collateral as of December 31, 2009 (amounts in thousands):
The following is a reconciliation of carrying amounts of residential mortgage loans for the year ended December 31, 2009 (amounts in thousands):
The following table summarizes the delinquency statistics of the residential mortgage loans, excluding REOs, as of December 31, 2009 (dollar amounts in thousands):
As of December 31, 2009, 26 of the residential mortgage loans owned by the Company with an outstanding balance of $11.4 million were REOs as a result of foreclosure on delinquent loans. As of December 31, 2009, the Company had 277 loans that were either 90 days or greater past due or in foreclosure and placed on non-accrual status.
As of December 31, 2009, the loss exposure or uncollected principal amount related to the Company’s delinquent residential mortgage loans in the table above exceeded their fair value by $20.2 million.
Residential mortgage-backed securities issued
RMBS Issued consisted of the senior tranches of six residential mortgage loan securitization trusts that the Company previously consolidated under GAAP and for which the Company reported the debt issued by these trusts that it did not hold on its condensed consolidated balance sheets. The Company carried RMBS Issued at estimated fair value with unrealized gains and losses reported in income. The Company elected the fair value option for its RMBS Issued for the purpose of enhancing the transparency of its financial condition as fair value was consistent with how the Company managed the risks of its residential mortgage portfolio.
As of December 31, 2009, RMBS Issued had an outstanding amount of $2.6 billion and an estimated fair value of $2.0 billion. As of December 31, 2009, the weighted average coupon of the RMBS Issued was 2.3% and the weighted average years to maturity were 25.8 years.
Note 8. Borrowings
Certain information with respect to the Company’s borrowings as of September 30, 2010 is summarized in the following table (dollar amounts in thousands):
(1) Collateral for borrowings consists of RMBS, securities available-for-sale, equity investments at estimated fair value and corporate loans.
(2) CLO 2007-1 junior secured notes to affiliates consist of (x) $175.3 million of mezzanine notes with a weighted average borrowing rate of 5.4% and (y) $130.3 million of subordinated notes that do not have a contractual coupon rate, but instead receive a pro rata amount of the net distributions from CLO 2007-1.
(3) CLO 2007-1 junior secured notes consist of (x) $55.9 million of mezzanine notes with a weighted average borrowing rate of 3.7% and (y) $5.8 million of subordinated notes that do not have a contractual coupon rate, but instead receive a pro rata amount of the net distributions from CLO 2007-1.
(4) CLO 2007-A junior secured notes to affiliates consist of (x) $55.0 million of mezzanine notes with a weighted average borrowing rate of 6.7% and (y) $10.5 million of subordinated notes that do not have a contractual coupon rate, but instead receive a pro rata amount of the net distributions from CLO 2007-A.
(5) CLO 2007-A junior secured notes consist of (x) $6.2 million of mezzanine notes with a weighted average borrowing rate of 7.2% and (y) $4.6 million of subordinated notes that do not have a contractual coupon rate, but instead receive a pro rata amount of the net distributions from CLO 2007-A.
Certain information with respect to the Company’s borrowings as of December 31, 2009 is summarized in the following table (dollar amounts in thousands):
(1) Collateral for borrowings consists of RMBS, securities available-for-sale, equity investments, at estimated fair value, private equity investments, corporate and residential mortgage loans and common stock warrants.
(2) Calculated weighted average remaining maturity based on the amended maturity date of November 10, 2011.
(3) CLO 2007-1 junior secured notes to affiliates consist of (x) $256.9 million of mezzanine notes with a weighted average borrowing rate of 5.2% and (y) $180.8 million of subordinated notes that do not have a contractual coupon rate, but instead receive a pro rata amount of the net distributions from CLO 2007-1.
(4) CLO 2007-1 junior secured notes consist of (x) $8.4 million of mezzanine notes with a weighted average borrowing rate of 5.2% and (y) $5.8 million of subordinated notes that do not have a contractual coupon rate, but instead receive a pro rata amount of the net distributions from CLO 2007-1.
(5) CLO 2007-A junior secured notes to affiliates consist of (x) $81.5 million of mezzanine notes with a weighted average borrowing rate of 6.5% and (y) $14.6 million of subordinated notes that do not have a contractual coupon rate, but instead receive a pro rata amount of the net distributions from CLO 2007-A.
(6) CLO 2007-A junior secured notes consist of (x) $2.6 million of mezzanine notes with a weighted average borrowing rate of 6.5% and (y) $0.5 million of subordinated notes that do not have a contractual coupon rate, but instead receive a pro rata amount of the net distributions from CLO 2007-A.
CLO Notes
The indentures governing the Company’s CLO transactions include numerous compliance tests, the majority of which relate to the CLO’s portfolio profile. In the event that a portfolio profile test is not met, the indenture places restrictions on the ability of the CLO’s manager to reinvest available principal proceeds generated by the collateral in the CLOs until the specific test has been cured. In addition to the portfolio profile tests, the indentures for the CLO transactions include over-collateralization tests (“OC Tests”) which set the ratio of the collateral value of the assets in the CLO to the tranches of debt for which the test is being measured, as well as interest coverage tests. If a CLO is not in compliance with an OC Test or an interest coverage test, cash flows normally payable to the holders of junior classes of notes will be used by the CLO to amortize the most senior class of notes until such point as the OC test is brought back into compliance. During the three and nine months ended September 30, 2010, the Company paid down nil and $90.3 million of original CLO 2007-1 senior secured notes, respectively, due to the failure of OC Tests. As of September 30, 2010, all of the Company’s CLO transactions were in compliance with their respective OC and interest coverage tests.
During the three months ended March 31, 2010, in an open market auction, the Company purchased $10.3 million of mezzanine notes issued by CLO 2007-A for $5.5 million and $72.7 million of mezzanine and subordinate notes issued by CLO 2007-1 for $38.8 million, both of which were previously held by an affiliate of the Company’s manager. These transactions resulted in the Company recording an aggregate gain on extinguishment of debt totaling $38.7 million for the three months ended March 31, 2010.
Senior Secured Credit Facility
On May 3, 2010, the Company entered into a credit agreement for a four-year $210.0 million asset-based revolving credit facility (the “2014 Facility”), maturing on May 3, 2014, that is subject to, among other things, the terms of a borrowing base derived from the value of eligible specified financial assets. The borrowing base is subject to certain caps and concentration limits customary for financings of this type. The Company may obtain additional commitments under the 2014 Facility so long as the aggregate amount of commitments at any time does not exceed $600.0 million. On May 5, 2010, the Company obtained additional commitments of $40.0 million, bringing the total amount of commitments under the 2014 Facility to $250.0 million.
The Company has the right to prepay loans under the 2014 Facility in whole or in part at any time. Loans under the 2014 Facility bear interest at a rate equal to the London interbank offered rate (“LIBOR”) plus 3.25% per annum. The 2014 Facility contains customary covenants applicable to the Company, including a restriction from making distributions to holders of common shares in excess of 65% of the Company’s estimated annual taxable income.
As of September 30, 2010, the Company had no borrowings outstanding under the 2014 Facility.
As of September 30, 2010, the Company believes it was in compliance with the 2014 Facility covenant requirements.
On May 26, 2010, the Company terminated its credit agreement, dated as of November 10, 2008, maturing on November 10, 2011 (the “2011 Credit Agreement”). The 2011 Credit Agreement was terminated in connection with the Company’s initial borrowing under its new credit facility entered into on May 3, 2010 as described above. At the time of termination, there was $150.0 million of borrowings outstanding under the 2011 Credit Agreement which the Company prepaid. There were no early termination or prepayment fees associated with the Company’s termination and repayment of all outstanding borrowings. The termination resulted in a $6.5 million write-off of unamortized debt issuance costs.
Convertible Debt
During January and February 2010, the Company repurchased $95.2 million par amount of its 7.0% convertible senior notes maturing on July 15, 2012 (the “7.0% Notes”), reducing the amount outstanding from $275.8 million as of December 31, 2009 to $180.6 million as of September 30, 2010. These transactions resulted in the Company recording a gain of $1.3 million, which was partially offset by a write-off of $0.6 million of unamortized debt issuance costs.
On January 15, 2010, the Company issued $172.5 million of 7.5% Convertible Senior Notes due January 15, 2017 (“7.5% Notes”). The 7.5% Notes bear interest at a rate of 7.5% per annum on the principal amount, accruing from January 15, 2010. Interest is payable semiannually in arrears on January 15 and July 15 of each year, beginning on July 15, 2010. The 7.5% Notes will mature on January 15, 2017 unless previously redeemed, repurchased or converted in accordance with their terms prior to such date. Holders of the 7.5% Notes may convert their notes at the applicable conversion rate at any time prior to the close of business on the business day immediately preceding the stated maturity date subject to the Company’s right to terminate the conversion rights of the notes. The Company may satisfy its obligation with respect to the 7.5% Notes tendered for conversion by delivering to the holder either cash, common shares, no par value, issued by the Company or a combination thereof. The initial conversion rate for each $1,000 principal amount of 7.5% Notes is 122.2046 shares, which is equivalent to an initial conversion price of approximately $8.18 per share. The conversion rate is adjusted under certain circumstances, including the occurrence of certain fundamental change transactions and the payment of a quarterly cash distribution in excess of $0.05 per share, but will not be adjusted for accrued and unpaid interest on the 7.5% Notes. As of September 30, 2010, the conversation rate for each $1,000 principal amount of 7.5% Notes was 124.3675 shares. Net proceeds from the offering totaled $167.3 million, reflecting $172.5 million from the issuance less $5.2 million for underwriting fees.
In accordance with accounting for convertible debt instruments that may settled in cash upon conversion, the Company separately accounted for the liability and equity components to reflect the nonconvertible debt borrowing rate. The Company determined that the equity component of the 7.5% Notes totaled $10.0 million and is included in paid-in-capital on the Company’s condensed consolidated balance sheet as of September 30, 2010. The remaining liability component of $163.3 million, included within convertible senior notes on the Company’s condensed consolidated balance sheet as of September 30, 2010, is comprised of the principal $172.5 million less the unamortized debt discount of $9.2 million. The total debt discount amortization recognized for the three and nine months ended September 30, 2010 was $0.3 million and $0.8 million, respectively. The debt discount will continue to be amortized at the effective interest rate of 8.6%. For the three and nine months ended September 30, 2010, the total interest expense recognized on the 7.5% Notes was $3.2 million and $9.2 million, respectively.
Note 9. Derivative Financial Instruments
The Company enters into derivative transactions in order to hedge its interest rate risk exposure to the effects of interest rate changes. Additionally, the Company enters into derivative transactions in the course of its portfolio management activities. The counterparties to the Company’s derivative agreements are major financial institutions with which the Company and its affiliates may also have other financial relationships. In the event of nonperformance by the counterparties, the Company is potentially exposed to losses. The counterparties to the Company’s derivative agreements have investment grade ratings and, as a result, the Company does not anticipate that any of the counterparties will fail to fulfill their obligations.
Cash Flow Hedges
The Company uses interest rate derivatives consisting of swaps to hedge a portion of the interest rate risk associated with its borrowings under CLO senior secured notes as well as certain of its floating rate junior subordinated notes. The Company designates these financial instruments as cash flow hedges.
During June 2010, the Company entered into a $100.0 million notional pay-fixed, receive-variable interest rate swap. The swap has been designated as a cash flow hedge, the objective of which is to eliminate the variability of cash flows in the interest payments of the Company’s floating rate junior subordinated notes debt due to fluctuations in the indexed rate. Changes in value of the interest rate swap are recorded through other comprehensive income, with gains or losses representing hedge ineffectiveness, if any, recognized in earnings during the reporting period. The hedged transaction period is through October 2036, which is the stated maturity of the floating rate debt.
Free-Standing Derivatives
Free-standing derivatives are derivatives that the Company has entered into in conjunction with its investment and risk management activities, but for which the Company has not designated the derivative contract as a hedging instrument for accounting purposes. Such derivative contracts may include credit default swaps (“CDS”), foreign exchange contracts, and interest rate derivatives. Free-standing derivatives also include investment financing arrangements (total rate of return swaps) whereby the
Company receives the sum of all interest, fees and any positive change in fair value amounts from a reference asset with a specified notional amount and pays interest on such notional amount plus any negative change in fair value amounts from such reference asset.
The table below summarizes the aggregate notional amount and estimated net fair value of the derivative instruments as of September 30, 2010 and December 31, 2009 (amounts in thousands):
(1) Represents forward contracts and options intended to offset the gains or losses resulting from the settlement of the underlying foreign currency denominated asset. Amounts presented were converted to U.S. dollars based on the exchange rates at the end of each fiscal quarter.
A CDS is a contract in which the contract buyer pays, in the case of a short position, or receives, in the case of long position, a periodic premium until the contract expires or a credit event occurs. In return for this premium, the contract seller receives a payment from or makes a payment to the buyer if there is a credit default or other specified credit event with respect to the issuer (also known as the referenced entity) of the underlying credit instrument referenced in the CDS. Typical credit events include bankruptcy, dissolution or insolvency of the referenced entity, failure to pay and restructuring of the obligations of the referenced entity.
As of September 30, 2010 and December 31, 2009, the Company had sold protection with a notional amount of approximately $13.5 million and $51.0 million, respectively. The Company sells protection to replicate fixed income securities and to complement the spot market when cash securities of the referenced entity of a particular maturity are not available or when the derivative alternative is less expensive compared to other purchasing alternatives.
The following table shows the net realized gains on the Company’s CDS for the three and nine months ended September 30, 2010 and 2009 (amounts in thousands):
For all hedges where hedge accounting is being applied, effectiveness testing and other procedures to ensure the ongoing validity of the hedges are performed at least quarterly. During the three and nine months ended September 30, 2010 and 2009, the Company recognized an immaterial amount of ineffectiveness in income on the condensed consolidated statements of operations from its cash flow and fair value hedges.
Note 8 to these condensed consolidated financial statements describes the Company’s borrowings under which the Company has pledged warrants for borrowings. The following table summarizes the estimated fair value of warrants pledged as collateral as of September 30, 2010 and December 31, 2009 (amounts in thousands):
Note 10. Accumulated Other Comprehensive Income (Loss)
The components of accumulated other comprehensive income were as follows (amounts in thousands):
The components of changes in other comprehensive income (loss) were as follows (amounts in thousands):
(1) Excludes an impairment charge of $0.5 million and $1.7 million for investments which were determined to be other-than-temporary for the three and nine months ended September 30, 2010, respectively, and nil and $40.0 million for the three and nine months ended September 30, 2009, respectively.
Note 11. Commitments and Contingencies
Loan Commitments
As part of its strategy of investing in corporate loans, the Company commits to purchase interests in primary market loan syndications, which obligate the Company to acquire a predetermined interest in such loans at a specified price on a to-be-determined settlement date. Consistent with standard industry practices, once the Company has been informed of the amount of its syndication allocation in a particular loan by the syndication agent, the Company bears the risks and benefits of changes in the fair value of the syndicated loan from that date forward. As of September 30, 2010 and December 31, 2009, the Company had committed to purchase corporate loans with aggregate commitments totaling $108.2 million par and $156.5 million par, respectively. In addition, the Company participates in certain contingent financing arrangements, whereby the Company is committed to provide funding of up to a specific amount at the discretion of the borrower. As of September 30, 2010 and December 31, 2009, the Company had unfunded financing commitments totaling $31.9 million and $40.5 million, respectively. The Company does not expect material losses related to those corporate loans for which it committed to purchase and fund.
Contingencies
The Company has been named as a party in various legal actions which include the matters described below. It is inherently difficult to predict the ultimate outcome, particularly in cases in which claimants seek substantial or unspecified damages, or where investigations or proceedings are at an early stage and the Company cannot predict with certainty the loss or range of loss that may be incurred. The Company has denied, or believes it has a meritorious defense and will deny liability in the significant cases pending against the Company discussed below. Based on current discussion and consultation with counsel, management believes that the resolution of these matters will not have a material impact on the Company’s condensed consolidated financial statements.
On July 10, 2009, the Company surrendered for cancellation, without consideration, approximately $64.0 million of mezzanine notes issued to the Company by CLO 2005-2 (the “2005-2 Notes”) and approximately $222.4 million of mezzanine and junior notes issued to the Company by CLO 2006-1 (the “2006-1 Notes”), as well as certain other notes issued to the Company by another CLO. The surrendered notes were cancelled by the trustee under the applicable indenture, and the obligations due under such surrendered notes were deemed extinguished.
Holders constituting a majority of the controlling class of senior notes of CLO 2005-2 (the “2005-2 Noteholders”) notified the related trustee of purported defaults under the indentures related to the surrender of the 2005-2 Notes. The Company announced on November 29, 2009 that it reached an agreement on November 23, 2009 with the 2005-2 Noteholders pursuant to which the 2005-2
Noteholders have agreed, subject to the terms and conditions of the agreement, not to challenge the July 2009 surrender for cancellation transaction. In exchange, the Company has agreed to certain arrangements, including, among other things, to refrain from undertaking a comparable surrender for cancellation, of any other mezzanine notes or junior notes issued to it by CLO 2005-2. In addition, the Company has agreed with the 2005-2 Noteholders that, for so long as no legal action or similar challenge is brought to the Company’s prior surrender of notes in any of its CLO transactions, the Company will not undertake a comparable surrender for cancellation, without consideration, of any mezzanine notes or junior notes issued to it by CLO 2005-1, CLO 2006-1, CLO 2007-1 or CLO 2007-A.
In addition, during the first quarter of 2010, certain holders of the senior notes of CLO 2006-1 (the “2006-1 Noteholders”) notified the related trustee of purported defaults under the indenture related to the surrender of the 2006-1 Notes. The Company does not believe based on discussions with counsel that an event of default has occurred and is engaged in discussions with the 2006-1 Noteholders to resolve this matter. Accordingly, the Company does not believe that this matter will have a material effect on its financial condition.
The parent company of the Manager has furnished information to the SEC in response to a request from the SEC for information in connection with its examination of certain investment advisors in order to review trading procedures and valuation practices in the collateral pools of CLOs for which it acts as collateral manager. The parent company of the Manager also provided information regarding the surrender by the Company for cancellation, without consideration, of certain notes that had been issued to the Company by collateral pools of CLOs. The parent company of the Manager is fully cooperating with the SEC’s examination.
On August 7, 2008, the members of the Company’s board of directors and certain of its former executive officers and the Company were named in a putative class action complaint filed by Charter Township of Clinton Police and Fire Retirement System in the United States District Court for the Southern District of New York, or the Charter Litigation. On March 13, 2009, the lead plaintiff filed an amended complaint, which deleted as defendants the members of the Company’s board of directors and named as defendants only the Company’s former chief executive officer Saturnino S. Fanlo, the Company’s former chief operating officer David A. Netjes, the Company’s former chief financial officer Jeffrey B. Van Horn and the Company. The amended complaint alleges that the Company’s April 2, 2007 registration statement and prospectus and the financial statements incorporated therein contained material omissions in violation of Section 11 of the Securities Act, regarding the risks and potential losses associated with the Company’s real estate-related assets, the Company’s ability to finance its real estate-related assets and the adequacy of the Company’s loss reserves for its real estate-related assets. The amended complaint further alleges that, pursuant to Section 15 of the Securities Act, Messrs. Fanlo, Netjes and Van Horn each have legal responsibility for the alleged Section 11 violation. On April 27, 2009, the defendants filed a motion to dismiss the amended complaint for failure to state a claim under the Securities Act. Oral argument on the defendants’ motion to dismiss took place on October 5, 2010, and the parties are awaiting a decision from the Court.
On August 15, 2008, the members of the Company’s board of directors and its executive officers (collectively, the “Kostecka Individual Defendants”) were named in a shareholder derivative action brought by Raymond W. Kostecka, a purported shareholder, in the Superior Court of California, County of San Francisco (the “California Derivative Action”). The Company was named as a nominal defendant. The complaint in the California Derivative Action asserts claims against the Kostecka Individual Defendants for breaches of fiduciary duty, abuse of control, gross mismanagement, waste of corporate assets, and unjust enrichment in connection with the conduct at issue in the Charter Litigation, including the filing of the Company’s April 2, 2007 registration statement with alleged material misstatements and omissions. By order dated January 8, 2009, the Court approved the parties’ stipulation to stay the proceedings in the California Derivative Action until the Charter Litigation is dismissed on the pleadings or the Company files an answer to the Charter Litigation.
On March 23, 2009, the members of the Company’s board of directors and certain of its executive officers (collectively, the “Haley Individual Defendants”) were named in a shareholder derivative action brought by Paul B. Haley, a purported shareholder, in the United States District Court for the Southern District of New York (the “New York Derivative Action”). The Company was named as a nominal defendant. The complaint in the New York Derivative Action asserts claims against the Haley Individual Defendants for breaches of fiduciary duty, breaches of the duty of full disclosure, and for contribution in connection with the conduct at issue in the Charter Litigation, including the filing of the Company’s April 2, 2007 registration statement with alleged material misstatements and omissions. By order dated June 18, 2009, the Court approved the parties’ stipulation to stay the proceedings in the New York Derivative Action until the Charter Litigation is dismissed on the pleadings or the Company files an answer to the Charter Litigation.
Note 12. Share Options and Restricted Shares
On May 4, 2007, the Company adopted an amended and restated share incentive plan (the “2007 Share Incentive Plan”) that provides for the grant of qualified incentive common share options that meet the requirements of Section 422 of the Code, non-qualified common share options, share appreciation rights, restricted common shares and other share-based awards. The Compensation Committee of the board of directors administers the plan. Share options and other share-based awards may be granted to the Manager, directors, officers and any key employees of the Manager and to any other individual or entity performing services for the Company.
The exercise price for any share option granted under the 2007 Share Incentive Plan may not be less than 100% of the fair market value of the common shares at the time the common share option is granted. Each option to acquire a common share must terminate no more than ten years from the date it is granted. As of September 30, 2010, the 2007 Share Incentive Plan authorizes a total of 8,464,625 shares that may be used to satisfy awards under the 2007 Share Incentive Plan.
The following table summarizes restricted common share transactions:
The Company is required to value any unvested restricted common shares granted to the Manager at the current market price. The Company valued the unvested restricted common shares granted to the Manager at $8.78 and $4.62 per share at September 30, 2010 and September 30, 2009, respectively. There were $2.2 million and $3.1 million of total unrecognized compensation costs related to unvested restricted common shares granted as of September 30, 2010 and 2009, respectively. These costs are expected to be recognized over three years from the date of grant.
The following table summarizes common share option transactions:
As of September 30, 2010 and December 31, 2009, 1,932,279 common share options were exercisable. As of September 30, 2010, the common share options were fully vested and expire in August 2014. For the three and nine months ended September 30, 2010 and 2009, the components of share-based compensation expense are as follows (amounts in thousands):
Note 13. Management Agreement and Related Party Transactions
The Manager manages the Company’s day-to-day operations, subject to the direction and oversight of the Company’s board of directors. The Management Agreement expires on December 31 of each year, but is automatically renewed for a one-year term each December 31 unless terminated upon the affirmative vote of at least two-thirds of the Company’s independent directors, or by a vote of the holders of a majority of the Company’s outstanding common shares, based upon (1) unsatisfactory performance by the Manager that is materially detrimental to the Company or (2) a determination that the management fee payable by the Manager is not fair, subject to the Manager’s right to prevent such a termination under this clause (2) by accepting a mutually acceptable reduction of management fees. The Manager must be provided 180 days prior notice of any such termination and 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 immediately preceding the date of termination, calculated as of the end of the most recently completed fiscal quarter prior to the date of termination.
The Management Agreement contains certain provisions requiring the Company to indemnify the Manager with respect to all losses or damages arising from acts not constituting bad faith, willful misconduct, or gross negligence. The Company has evaluated the impact of these guarantees on its condensed consolidated financial statements and determined that they are not material.
For the three and nine months ended September 30, 2010, the Company incurred $4.9 million and $13.7 million, respectively, in base management fees. In addition, the Company recognized share-based compensation expense related to restricted common shares granted to the Manager of $1.9 million and $4.4 million, respectively, for the three and nine months ended September 30, 2010 (see Note 12 to these condensed consolidated financial statements). For the three and nine months ended September 30, 2009, the Company incurred $3.7 million and $11.0 million, respectively, in base management fees. In addition, the Company recognized share-based compensation expense related to restricted common shares granted to the Manager of $2.3 million and $2.2 million, respectively, for the three and nine months ended September 30, 2009 (see Note 12 to these condensed consolidated financial statements).
Base management fees incurred and share-based compensation expense relating to common share options and restricted common shares granted to the Manager are included in related party management compensation on the condensed consolidated statements of operations. Expenses incurred by the Manager and reimbursed by the Company are reflected in the respective condensed consolidated statements of operations, non-investment expense category based on the nature of the expense.
The Manager is waiving base management fees related to the $230.4 million common share offering and $270.0 million common share rights offering that occurred during the third quarter of 2007 until such time as the Company’s common share closing price on the NYSE is $20.00 or more for five consecutive trading days. Accordingly, the Manager permanently waived approximately $2.2 million of base management fees during each of the three months ended September 30, 2010 and 2009 and $6.6 million during each of the nine months ended September 30, 2010 and 2009.
During the three and nine months ended September 30, 2010, the Manager earned $9.4 million and $30.3 million, respectively, of incentive fees. The $30.3 million of incentive fees earned for the nine months ended September 30, 2010 is net of a $9.7 million amount waived. During the three months ended March 31, 2010, the Manager permanently waived payment of $9.7 million of incentive fees that were related to the $38.7 million gain recorded by the Company as a result of the repurchase of $83.0 million of mezzanine and subordinate notes issued by CLO 2007-1 and CLO 2007-A. Incentive fees are included in related party management compensation on the Company’s condensed consolidated statement of operations. For both the three and nine months ended September 30, 2009, the Manager earned $4.5 million of incentive fees.
An affiliate of the Manager has entered into separate management agreements with the respective investment vehicles for CLO 2005-1, CLO 2005-2, CLO 2006-1, CLO 2007-1, CLO 2007-A and CLO 2009-1 and is entitled to receive fees for the services performed as collateral manager. Previously, the collateral manager had waived the fees it earned for providing management services for the Company’s CLOs. Beginning April 15, 2007, the collateral manager ceased waiving fees for CLO 2005-1 and beginning January 1, 2009, the collateral manager ceased waiving fees for CLO 2005-2, CLO 2006-1, CLO 2007-1, CLO 2007-A and Wayzata Funding LLC (restructured and replaced with CLO 2009-1 on March 31, 2009). Beginning in July 2009, the collateral manager reinstated waiving the CLO management fees for CLO 2005-2 and CLO 2006-1. In addition, due to CLO 2007-A and CLO 2007-1 regaining compliance with their respective OC Tests during the first quarter of 2010, the collateral manager also reinstated waiving the CLO management fees for CLO 2007-A and CLO 2007-1. For the three and nine months ended September 30, 2010, the collateral manager waived an aggregate of $8.7 million and $21.9 million, respectively, for CLO 2005-2, CLO 2006-1, CLO 2007-1 and CLO 2007-A. For each of the three and nine months ended September 30, 2009, the collateral manager waived $2.6 million for CLO 2005-2 and CLO 2006-1. In addition, due to the deleveraging of CLO 2009-1 completed in July 2009 whereby all the senior notes were retired, the collateral manager is no longer entitled to receive management fees from CLO 2009-1. The Company recorded an expense for CLO management fees of $1.3 million and $4.1 million for the three and nine months ended September 30, 2010, respectively. The Company recorded an expense for CLO management fees of $4.2 million and $18.4 million for the three and nine months ended September 30, 2009, respectively.
In addition, beginning January 1, 2009, the Manager permanently waived reimbursable general and administrative expenses allocable to the Company in an amount equal to the incremental CLO management fees received by the Manager. Effective June 2010, all incremental CLO management fees received by the Manager in 2009 had been fully applied to offset reimbursable general and administrative expenses allocable to the Company. Accordingly, reimbursable general and administrative expenses were charged and paid by the Company beginning in June 2010. For the three and nine months ended September 30, 2010, the Manager permanently waived reimbursement of nil and $2.4 million in allocable general and administrative expenses, respectively. For the three and nine months ended September 30, 2009, the Manager permanently waived reimbursement of $2.4 million and $7.7 million, respectively, in allocable general and administrative expenses.
The Company has invested in corporate loans, debt securities and other investments of entities that are affiliates of KKR. As of September 30, 2010, the aggregate par amount of these affiliated investments totaled $2.3 billion, or approximately 29% of the total investment portfolio, and consisted of 24 issuers. The total $2.3 billion in affiliated investments were comprised of $2.0 billion of corporate loans, $339.0 million of corporate debt securities available-for-sale and $11.8 million of equity investments, at estimated fair value. As of December 31, 2009, the aggregate par amount of these affiliated investments totaled $2.8 billion, or approximately 35% of the total investment portfolio, and consisted of 21 issuers. The total $2.8 billion in investments were comprised of $2.3 billion of corporate loans, $466.0 million of corporate debt securities available for sale, and $61.8 million notional amount of total rate of return swaps referenced to corporate loans issued by affiliates of KKR (included in derivative assets and liabilities on the condensed consolidated balance sheet).
Note 14. Fair Value of Financial Instruments
Fair Value of Financial Instruments
The fair value of certain instruments including securities available-for-sale, corporate loans, derivatives and loan commitments is based on quoted market prices or estimates provided by independent pricing sources. The fair value of cash and cash equivalents, interest receivable and interest payable, approximates cost as of September 30, 2010 and December 31, 2009, due to the short-term nature of these instruments.
The table below discloses the carrying value and the estimated fair value of the Company’s financial instruments as of September 30, 2010 and December 31, 2009 (amounts in thousands):
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