KKR FINANCIAL HOLDINGS LLC KFN
June 22, 2011 - 7:35pm EST by
piggybanker
2011 2012
Price: 9.75 EPS NA NA
Shares Out. (in M): 178 P/E NA NA
Market Cap (in $M): 1,735 P/FCF NA NA
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT NA NA

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Description

KFN has a 6.5% div yield, trades at ~83% of book, and has over 30% upside in our view over the next 12 months.
 
 
Business Overview
KFN is a specialty finance company. They have a broad mandate which allows them to invest in several different asset classes. Their balance sheet consists of total assets of ~$8.5bn, with an investment portfolio of nearly $8.0bn. The largest component of their investment portfolio is leveraged loans (over $6.5bn).  These are loans made to large companies, which are often highly-levered. However, this paper is generally the most senior part of the company's capital structure. The S&P/LSTA Leveraged Loan 100 Index tracks the prices of the largest 100 leveraged loans by market-weight (SPBDLLB Index on Bloomberg).  The index price was near 100 for 2005, 2006 and the first half of 2007, then dropped to a low of 60 during the crisis, and has steadily climbed back to 94. Because KFN is an active leveraged loan manager, KFN's leveraged loan investment portfolio does not look exactly like the S&P Index, but there does appear to be significant overlap.
 
Summary Investment Thesis
We refrain in this write-up from taking a position on the future direction on the leveraged loan market, but assume, in aggregate, that KFN's positions are fairly valued by the market. Additionally, there are a number of investment options available for one to take a view (positive or negative) on this market.
 
As such, what we will focus on in this write-up are the idiosyncratic elements of KFN that we believe make it a unique investment opportunity:
First, we believe KFN's accounting distorts the true market-based value of the company, and causes the company to look more expensive than its peers on a book value basis.
Second, we believe KFN's corporate structure distorts its dividend yield potential, and causes it to screen poorly on a dividend yield basis vs. its peers.
 
We believe the combination of both factors causes KFN to be misunderstood and under-valued in the marketplace.
 
 
The Accounting
Most, if not all, of KFN's comps mark-to-market their investment portfolios to fair value on a daily basis. This causes underlying book value to fluctuate with market prices. KFN, on the other hand, accounts for the vast majority of their leveraged loan investments as banks do. They record their loans initially based on their purchase prices, and establish an allowance for loss against those loans. Currently, KFN has a significant unrealized gain in their investment portfolio (simply put, their asset values have increased from the levels where they bought them). This unrealized gain as of Q1 was $2.04 per share. Said another way, if KFN marked their assets to market, like their comps, their book value at Q1 would have been $2.04 higher than reported under GAAP. GAAP book value at Q1 was $9.73 per share. Therefore, adjusted book value is $11.77, and the stock is trading at a multiple of 0.83x adjusted book value. What is particularly interesting is that this "hidden book value" is not trapped forever, with no hope of being realized. Rather, this unrealized gain will flow through the income statement over the course of the next ~3 years as their loans repay/prepay. It could come through more quickly as KFN actively manages their portfolio and reinvests (ie, sells winners).
 
 
The Structure
KFN is structured as a partnership, which is unique. Most of its peers are structured as REITs or BDCs (Business Development Companies). Unlike REITs or BDCs, which must pay out the vast majority of their taxable earnings as dividends, and therefore can generally only grow book value through dilutive equity issuance, KFN has discretion over how it sets its dividend. KFN management has chosen to pay out only a portion of their income in dividends. Their most recently declared quarterly dividend payment on April 27th was for $0.16 (6.5% annualized yield), and they have raised their dividend in each of the past six quarters. KFN's GAAP EPS was $0.51 in Q1 (or $0.25, excluding realized/unrealized gains), which means that in addition to paying a healthy dividend, they are also growing book value. Again, this is in sharp contrast to REITs or BDCs which can generally only grow book value through equity issuance. More importantly, to the extent that investors evaluate these companies based on dividend yield (which we believe they do), KFN is at a disadvantage with their 6.5% yield vs. yields in the 8-10+% range for the BDCs. However, significant value exists in the ability to grow book value, especially if management can earn the mid-teens rate of return that they are guiding towards on new investments (and which we believe they can achieve). Also of note is that KFN's management team has pledged not to raise additional equity until the stock is trading above the adjusted book value of $11.77, which in our view eliminates a large risk embedded with any company in the BDC industry (dilutive capital raise risk).
 
The Valuation
Our valuation of KFN is relatively straightforward. Over the next few years, the true economic asset value of KFN will flow into book value, and hopefully the market will catch on sooner. It is not uncommon for high-ROE BDCs to trade at a premium to book. If we assume that KFN trades at 1.0x adjusted book value, can grow book value by 50c per year (ex realized gains), and will continue paying dividends at current levels of 64c annualized (we believe the dividend will continue to rise), then we can conservatively estimate total value to shareholders of ~$13.00 in a 12 month time period, or a return of over 30%.
 
The Risks
At 83% of book value, we see significant downside protection. However, unfortunately, the story is not quite as simple as that. The majority of KFN's liabilities are in the form of collateralized loan obligation secured debt (CLO debt). In short, KFN owns a portfolio of leveraged loans which it financed through long-term CLO debt structures. These assets are placed in trusts outside of KFN's parent company. In terms of the accounting, KFN consolidates these trusts (The leveraged loans are consolidated on the asset side, and the CLO debt is consolidated as a liability). In addition to the consolidated balance sheet, the company also shows the parent company (unconsolidated) balance sheet, which shows the equity balance in the CLO trusts (leveraged loan assets less CLO debt) as an asset on the parent company balance sheet. What is important to note is that this CLO debt is non-recourse to KFN (ie, KFN can only lose the amount of equity currently in the CLOs.  The reason why we mention this is that there are certain tests in each of the CLO liabilities that determine whether KFN as equity holder can receive cash flows from the trusts. If the collateral deteriorates to a point where the tests are breached, the trusts could stop cash flowing. Additionally, if collateral deteriorated dramatically, KFN could potentially stand to lose all or a portion of the equity in the trusts (which equates to ~$6.00 per share of book value). All of KFN's CLO trusts were cash-flowing as of Q1, and we believe the probability of the aforementioned events is remote, and would only occur in a draconian economic scenario, however we wanted to make potential investors aware of this unique structure. We actually view the CLO liabilities as a large positive, in that they are long-term financing at very attractive rates (< L+1.00), and given that they were done in 2005-2007, we believe have covenants/features that are quite attractive to KFN.
 
Additional Upside
KFN's balance sheet is asset-sensitive. They will benefit from a rise in short term rates because their assets re-price upwards more quickly than their liabilities. A 3% move upward in LIBOR would add ~16c per share in annual earnings. This upside could be worth another $1.50-$2.00 per share in value, which is not included in our valuation analysis above.
Summary 
We believe that the equity of KFN is misunderstood and offers an extremely attractive risk-reward, with over 30% upside, and limited downside in all but the most draconian economic scenario. We thank you for reading and we look forward to your questions/comments.

Catalyst

KFN's book value accretes toward economic value
Dividend is sustained/raised
Capital is retained and re-deployed into attractive investment opportunities
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    Description

    KFN has a 6.5% div yield, trades at ~83% of book, and has over 30% upside in our view over the next 12 months.
     
     
    Business Overview
    KFN is a specialty finance company. They have a broad mandate which allows them to invest in several different asset classes. Their balance sheet consists of total assets of ~$8.5bn, with an investment portfolio of nearly $8.0bn. The largest component of their investment portfolio is leveraged loans (over $6.5bn).  These are loans made to large companies, which are often highly-levered. However, this paper is generally the most senior part of the company's capital structure. The S&P/LSTA Leveraged Loan 100 Index tracks the prices of the largest 100 leveraged loans by market-weight (SPBDLLB Index on Bloomberg).  The index price was near 100 for 2005, 2006 and the first half of 2007, then dropped to a low of 60 during the crisis, and has steadily climbed back to 94. Because KFN is an active leveraged loan manager, KFN's leveraged loan investment portfolio does not look exactly like the S&P Index, but there does appear to be significant overlap.
     
    Summary Investment Thesis
    We refrain in this write-up from taking a position on the future direction on the leveraged loan market, but assume, in aggregate, that KFN's positions are fairly valued by the market. Additionally, there are a number of investment options available for one to take a view (positive or negative) on this market.
     
    As such, what we will focus on in this write-up are the idiosyncratic elements of KFN that we believe make it a unique investment opportunity:
    First, we believe KFN's accounting distorts the true market-based value of the company, and causes the company to look more expensive than its peers on a book value basis.
    Second, we believe KFN's corporate structure distorts its dividend yield potential, and causes it to screen poorly on a dividend yield basis vs. its peers.
     
    We believe the combination of both factors causes KFN to be misunderstood and under-valued in the marketplace.
     
     
    The Accounting
    Most, if not all, of KFN's comps mark-to-market their investment portfolios to fair value on a daily basis. This causes underlying book value to fluctuate with market prices. KFN, on the other hand, accounts for the vast majority of their leveraged loan investments as banks do. They record their loans initially based on their purchase prices, and establish an allowance for loss against those loans. Currently, KFN has a significant unrealized gain in their investment portfolio (simply put, their asset values have increased from the levels where they bought them). This unrealized gain as of Q1 was $2.04 per share. Said another way, if KFN marked their assets to market, like their comps, their book value at Q1 would have been $2.04 higher than reported under GAAP. GAAP book value at Q1 was $9.73 per share. Therefore, adjusted book value is $11.77, and the stock is trading at a multiple of 0.83x adjusted book value. What is particularly interesting is that this "hidden book value" is not trapped forever, with no hope of being realized. Rather, this unrealized gain will flow through the income statement over the course of the next ~3 years as their loans repay/prepay. It could come through more quickly as KFN actively manages their portfolio and reinvests (ie, sells winners).
     
     
    The Structure
    KFN is structured as a partnership, which is unique. Most of its peers are structured as REITs or BDCs (Business Development Companies). Unlike REITs or BDCs, which must pay out the vast majority of their taxable earnings as dividends, and therefore can generally only grow book value through dilutive equity issuance, KFN has discretion over how it sets its dividend. KFN management has chosen to pay out only a portion of their income in dividends. Their most recently declared quarterly dividend payment on April 27th was for $0.16 (6.5% annualized yield), and they have raised their dividend in each of the past six quarters. KFN's GAAP EPS was $0.51 in Q1 (or $0.25, excluding realized/unrealized gains), which means that in addition to paying a healthy dividend, they are also growing book value. Again, this is in sharp contrast to REITs or BDCs which can generally only grow book value through equity issuance. More importantly, to the extent that investors evaluate these companies based on dividend yield (which we believe they do), KFN is at a disadvantage with their 6.5% yield vs. yields in the 8-10+% range for the BDCs. However, significant value exists in the ability to grow book value, especially if management can earn the mid-teens rate of return that they are guiding towards on new investments (and which we believe they can achieve). Also of note is that KFN's management team has pledged not to raise additional equity until the stock is trading above the adjusted book value of $11.77, which in our view eliminates a large risk embedded with any company in the BDC industry (dilutive capital raise risk).
     
    The Valuation
    Our valuation of KFN is relatively straightforward. Over the next few years, the true economic asset value of KFN will flow into book value, and hopefully the market will catch on sooner. It is not uncommon for high-ROE BDCs to trade at a premium to book. If we assume that KFN trades at 1.0x adjusted book value, can grow book value by 50c per year (ex realized gains), and will continue paying dividends at current levels of 64c annualized (we believe the dividend will continue to rise), then we can conservatively estimate total value to shareholders of ~$13.00 in a 12 month time period, or a return of over 30%.
     
    The Risks
    At 83% of book value, we see significant downside protection. However, unfortunately, the story is not quite as simple as that. The majority of KFN's liabilities are in the form of collateralized loan obligation secured debt (CLO debt). In short, KFN owns a portfolio of leveraged loans which it financed through long-term CLO debt structures. These assets are placed in trusts outside of KFN's parent company. In terms of the accounting, KFN consolidates these trusts (The leveraged loans are consolidated on the asset side, and the CLO debt is consolidated as a liability). In addition to the consolidated balance sheet, the company also shows the parent company (unconsolidated) balance sheet, which shows the equity balance in the CLO trusts (leveraged loan assets less CLO debt) as an asset on the parent company balance sheet. What is important to note is that this CLO debt is non-recourse to KFN (ie, KFN can only lose the amount of equity currently in the CLOs.  The reason why we mention this is that there are certain tests in each of the CLO liabilities that determine whether KFN as equity holder can receive cash flows from the trusts. If the collateral deteriorates to a point where the tests are breached, the trusts could stop cash flowing. Additionally, if collateral deteriorated dramatically, KFN could potentially stand to lose all or a portion of the equity in the trusts (which equates to ~$6.00 per share of book value). All of KFN's CLO trusts were cash-flowing as of Q1, and we believe the probability of the aforementioned events is remote, and would only occur in a draconian economic scenario, however we wanted to make potential investors aware of this unique structure. We actually view the CLO liabilities as a large positive, in that they are long-term financing at very attractive rates (< L+1.00), and given that they were done in 2005-2007, we believe have covenants/features that are quite attractive to KFN.
     
    Additional Upside
    KFN's balance sheet is asset-sensitive. They will benefit from a rise in short term rates because their assets re-price upwards more quickly than their liabilities. A 3% move upward in LIBOR would add ~16c per share in annual earnings. This upside could be worth another $1.50-$2.00 per share in value, which is not included in our valuation analysis above.
    Summary 
    We believe that the equity of KFN is misunderstood and offers an extremely attractive risk-reward, with over 30% upside, and limited downside in all but the most draconian economic scenario. We thank you for reading and we look forward to your questions/comments.

    Catalyst

    KFN's book value accretes toward economic value
    Dividend is sustained/raised
    Capital is retained and re-deployed into attractive investment opportunities
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