Description

KKR Financial Holdings (KFN) is a leveraged finance company that has successfully completed its transformation from hybrid REIT/lender to a pure leveraged lending vehicle.  It trades below mark-to-market fair book value, and has successfully expanded its balance sheet, allowing it to be opportunistic in the widened spread environment.

KFN is trading at 91.5% of their quarter end book value (adjusted to fair value), and is operating at a net income annual run rate of $2.13, for an earnings yield of 14.1%.

Now, this is a stock that will simply have a certain appeal or it won’t.  I completely understand those who have an aversion—whether it is based on avoidance of leverage, lenders, non-investment grade loans, or simply a flight response when seeing those combined attributes mentioned in the same breath as recession fears.  Having a healthy flight response myself, I completely understand.

On the other hand, for those who believe that the market has already discounted some sufficiently negative scenarios into the lending market, KFN’s valuation provides some compelling attributes and valuation.  While I would not expect anything dramatic in the near-term, things can change dramatically within our investment horizons.  Given KFN’s ability to expand, coupled with the historical multiples that are given BDC’s, finance companies, and bank based lenders (KFN’s E/A ratio falls somewhere along that continuum), the total return for the stock should well be appreciably higher than for a basket of self-managed similar assets.

Perhaps most importantly, and this is going to be a challenging assumption for anyone to accept at face value, I believe that management is truly risk aware and has a good handle on how to measure and value credit risk.  More on that later, as it is an important discussion.

KFN was originally structured as a REIT, and for their REIT-compliant activity, invested in high-quality jumbo loans and AAA rated securities of prime mortgages.  This activity was segregated from the rest of KFN, and was funded by commercial paper.  When that market dried up in mid-August, KFN shut things down.  Concurrently, they announced an equity raise, which they completed in September, receiving $500m in additional capital.  Subsequently, they also obtained an additional $180m in cash from the backstop commitment of the rights offering ($56m) and the sale of private equity investments ($124m).

As a result, the continuing operations of the company are focused on making first senior secured lending to high quality businesses, with some selective investment in mezzanine and bond investments.

Their commercial paper conduit wasn’t rolled over, and the repercussions continue for those CP holders—including more headlines today regarding the Florida Local Government Investment Pool, which had been an investor in that commercial paper.  However, beyond the losses already taken, management claims that there is no further recourse to KFN, nor have I seen any evidence to the contrary.

KFN is run by KKR employees, and with access to KKR’s resources and expertise.  There seemed to be an all-hands-on-deck crisis management mode by KKR in response to the difficulties at KFN back in August, and management’s diligence and communication seem above average.  It is instructive to read some recent conference call transcripts to get a better sense of how they think and operate.

KFN has really ramped up their lending—they are not purely on the defensive, to say the least.  Spreads considerably widened in the third quarter, and KFN’s quarter purchases were done at more attractive spreads:

Corporate Loans                   Libor +376                 (80% of investments)
Corporate Bonds:                 Libor +589                 (16% of investments)

CLO financing:                      Libor +87       (for leverage of 4.7x)

By way of comparison, prior to last quarter, financing cost KFN L+53—as management put it: “back to May (when) it was as good as we’ve seen”.  Meanwhile, bank loans at L+376 are 100 to 150 basis points wider than May.

Another important point of comparison is that prior to last quarter, they literally had hundreds of competitors.  Now, they perceive that this number has dwindled to something closer to a dozen, given that the market is unwilling to fund lenders without the infrastructural and historical record that KKR brings to the business.  Note that the recent CLO deal was done at 4.7x leverage—so these narrow spreads are not comparable to other funding being raised for considerably lower leverage vehicles.

Of course, leverage goes hand-in-hand with risk.  KFN admits that they would not be comfortable employing 4x leverage if they weren’t 83% in senior loans.  Here are some other important facts regarding the composition of the balance sheet:

As of 9/30/07, KFN’s outstanding borrowings had a weighted average maturity of 7.3 years.

GAAP book value is $15.01, while Fair Value book value is $16.47.  97% of their portfolio is considered Level 2 securities, whose market value is determined by quotes from dealers, market-makers, and/or subscription-based pricing services.  Only 1% of their portfolio is based on an internally assigned value.

As of 9/30^th:

Assets:           $8,462m
Liabilities:      $6,628m
Equity:            $1,883m

KFN projects the run-rate to get to 2.22 by Q2, once its capital has been fully deployed. 

KFN had been reducing its exposures to homebuilding, mortgage and consumer for several quarters going into its mortgage funding debacle.  (The irony isn’t lost on management.)  While they hope to harvest some recovery, given that a normalized market valuation would provide for a meaningful recovery, they haven’t seen any signs of that.  In any case, the problem is not the asset performance, but as they stated, and we have all witnessed: “It is simply the inability to fund those assets in the current financial system.”

The company still has some of its mortgage REIT loans, in order to run-out that book and also enable it to retain its REIT tax status for 2007.  Adjusted for those loans, which traditionally use a higher leverage multiple, the corporate credit portfolio has leverage of 4.0x.  That leverage, net of cash, is 3.6x.

Management provided extensive color regarding their approach to risk management.  One of my questions is simply how can an investor be assured that KFN is not just a “market taker” on prices and deals?  Every company talks a good talk, but in the end, most of them travel in large herds and have money to put to work each quarter in competition with each other for if not the same, then similar deals.  How do they measure their risk against recessionary scenarios?

To that end, let me use management’s own words from their most recent conference call, when asked about how they consider recessions and otherwise stress test their portfolio.

After stating that they are known to be dour guys about economic context and environment, the founding partner and CEO (Saturnino Fanlo) and CFO (Michael McFerran) state (I’ve clipped quotes from both):

• “The last recession, the one that we test for when we evaluate credit, is really 1990 to 1992.”
• “So for example, yesterday when we went to our credit committee we were looking at a company in the chemical space.  We made an investment of about $20 million in that company and we looked at how the margins and the volumes and how a share handle for that company in that period of time. The way we anticipate is that companies hopefully can perform through that. Now I should be very clear, if we have a 1990 through 1992 recession, some companies invariably will struggle more than we thought, but that is how we go measure our risk profiles. We don't look at how they are trending. We don't see can they cover the cash if they keep growing. In fact I can tell you for every one of our analysts, I've never been terribly interested in what their forward-looking projections are because we rarely get too many people that seek to sell capital that suggests that their earnings projections are going down.”
• “Also equally, if not more important we're looking at valuation multiples from peak-to-trough. So we go into these credit wide open in terms of what has happened in the last couple recessions and it's clearly an important part of the overall credit decision. We haircut the heck out of everything going forward; we like to look backwards.”
• “And I would say the final part in this is a function, not only the history Dave and I had working with Wells Fargo with Paul Hazen, but also of our private equity perspective. We like to have very specific conversations with logical business combiners in the industry to understand where they might purchase the asset in a distressed time to think about source of repayment in stress times and when we look at credits that are performing poorly, we have really a two-way analysis, not just cash flows because cash flows obviously deal with debt service, but how these companies may fit in other people's business strategies.”

Valuation and multiple expansion:

KFN uses more leverage than a BDC, but not as much as a finance company or a bank.  So it isn’t perfectly comparable to any of those, and has differing funding advantages and disadvantages.  However, as a stock, it will tend to be valued both at a dividend/earnings yield, and at a multiple to NAV.  While today’s environment has depressed both multiples for financial stocks, some of this reflects the as yet unadmitted impairment of book value, as current mark-to-markets haven’t all flowed through yet to the reported numbers.  Furthermore, those financials stocks that need to make non-accretive capital raises, or are otherwise limited in their ability to expand or take advantage of the widened levels of spreads, have had some growth premium removed from their valuation.  Rightly so.

However, KFN just closed on a substantial CLO ($1.5 billion) and an 800 million euro warehouse facility.  The company has the ability to expand to meet current opportunities.

I’m comfortable with KFN’s reported NAV, and am using their fair value book, since other measures are slightly cloaked by the GAAP measurement of their non-continuing RMBS operations.  Furthermore, while it isn’t built in to my numbers or to management’s guidance, there does exist the possibility of some meaningful recovery on those operations.  But since it is such a messy situation, I’ll treat that as a remote possibility for a windfall.  But for some perspective, this RMBS book wasn’t all junk.  In fact, since inception, their mortgage portfolio has had $1.5 million of losses on a weighted average outstanding balance of $6.5 billion.  That seems fairly slight.  They are holding about $340 million in mortgages which they intend to sell in the first quarter (they only need them for tax compliance—sounds like they’ll sell them as a first order of business in January).  They had a $3 million reserve for those mortgages, but they had assumed $29 million during the original underwriting (these are sub-pieces).  The losses are coming in at 1/15^th of that assumption, and ½ the reserve number.

Net of those assets, KFN is running at ROE’s in the low 20’s.  Leon Cooperman of Omega Advisors is an investor (about 2% of KFN), and he asked a question about the sustainability of those ROE’s.  They responded that the improved environment (wider spreads) has probably ratcheted ROE’s up 3, 4, 500 basis points at the gross level.  ROE’s on new invested capital today is probably running net to investors after all expenses in the high teens.  They could achieve a $2.22 run rate as early as the end of this quarter.

With incremental capital, and possibly some recovery or sales from their remaining private equity positions, they see room to increase the dividend (currently $2.00/year).  Their dividend goal is to retain some run rate headroom so that the dividend can be both stable and increasing.

The current indicated dividend yield is 13.2% ($15.19 close, $2.00 dividend).  Looking at other some familiar BDC’s, their indicated yields are:

AINV:              11.7%
ARCC:            11.2%
ACAS:            10.6%

Keeping in mind that these are historically high dividend yields (they’ve gotten as low as 8%), if KFN were to simply reprice to a 12% yield, the stock would rally 10%.  On top of the dividend, that provides a total return better than 20%.

Closer to its peers and/or a small step toward historically attractive dividend yields, an 11% dividend yield (applied to 95% of its anticipated year end run rate of $2.22) would suggest that the stock could be north of $19.00 by the end of next year, for a total return of 40%.  That all-in $21.20 target would also imply 1.15x NAV, which is not unreasonable.  In fact, both the 11% dividend yield and 1.15x NAV would still represent historically attractive multiples.