1301508--2/23/2007--KKR_Financial

related topics

{investment, property, distribution}

{tax, income, asset}

{loan, real, estate}

{stock, price, share}

{provision, law, control}

{loss, insurance, financial}

{interest, director, officer}

{competitive, industry, competition}

{acquisition, growth, future}

{operation, international, foreign}

{debt, indebtedness, cash}

{cost, regulation, environmental}

{regulation, change, law}

Risks Related to Our Management and Our Relationship with Our Manager We are highly dependent on our Manager and may not find a suitable replacement if our Manager terminates the management agreement. The departure of any of the senior management of our Manager or the loss of our access to KKR s investment professionals and principals may adversely affect our ability to achieve our investment objectives. If our Manager ceases to be our manager pursuant to the management agreement, financial institutions providing our credit facilities may not provide future financing to us. Our Manager has limited experience in managing a REIT or specialty finance company, and our investment focus differs from those of most other KKR funds. Our board of directors has approved very broad Investment Guidelines for our Manager and does not approve individual investment decisions made by our Manager except in limited circumstances. The incentive fee provided for under the management agreement may induce our Manager to make certain investments, including speculative investments. There are various potential conflicts of interest in our relationship with our Manager and its affiliates, including KKR, which could result in decisions that are not in the best interests of holders of our shares. Affiliates of our Manager and KKR compete with us and there may be conflicts arising from allocation of investment opportunities. Certain of our investments may create a conflict of interest with KKR and other affiliates. We compete with other investment entities affiliated with KKR for access to KKR s investment professionals and principals. Termination by us of the management agreement with our Manager without cause is difficult and costly. Our access to confidential information may restrict our ability to take action with respect to some investments, which, in turn, may negatively affect the potential return to holders of our shares. Our Manager s liability is limited under the management agreement, and we have agreed to indemnify our Manager against certain liabilities. Risks Related to Our Operation and Business Strategy If credit spreads widen before we obtain long-term financing for our assets, we may experience a material reduction in the economic value of the assets that we have acquired. We have a limited operating history and limited experience as a REIT. We operate in a highly competitive market for investment opportunities. Failure to obtain adequate capital and financing would adversely affect our results and may, in turn, negatively affect the market price of our shares and our ability to make distributions to holders of our shares. We leverage our portfolio investments, which may adversely affect our return on our investments and may reduce cash available for distribution. If we are unable to continue to securitize our portfolio successfully, we may be unable to grow or fully execute our business strategy and our earnings may decrease. An increase in our borrowing costs relative to the interest we receive on our portfolio investments may adversely affect our profitability, which may negatively affect cash available for distribution to holders of our shares. We may enter into derivative contracts that could expose us to contingent liabilities in the future. Hedging against interest rate exposure may adversely affect our earnings, which could adversely affect cash available for distribution to holders of our shares. Hedging instruments often are not traded on regulated exchanges, guaranteed by an exchange or its clearing house, or regulated by any U.S. or foreign governmental authorities and involve risks and costs. We make investments in non-U.S. dollar denominated investments, which subject us to currency rate exposure and the uncertainty of foreign laws and markets. Risks Related to Our Investments We may not realize gains or income from our investments. Declines in the market values of our investments may adversely affect periodic reported results and credit availability, which may reduce earnings and, in turn, cash available for distribution to holders of our shares. Some of our portfolio investments are recorded at fair value as determined by our Manager and, as a result, there is uncertainty as to the value of these investments. Changes in interest rates could negatively affect the value of our investments, which could result in reduced earnings or losses and negatively affect the cash available for distribution to holders of our shares. Our assets include leveraged loans, high-yield securities and common and preferred equity securities, each of which has greater risks of loss than secured senior loans and, if those losses are realized, it could adversely affect our earnings, which could adversely affect our cash available for distribution to holders of our shares. Prepayments can adversely affect the yields on our investments. The mortgage loans we invest in and the mortgage loans underlying the mortgage and asset-backed securities we invest in are subject to delinquency, foreclosure and loss, which could result in losses to us. In the future we may invest in RMBS backed by non-prime or sub-prime residential mortgage loans which are subject to higher delinquency, foreclosure and loss rates than prime residential mortgage loans which could result in losses to us. A significant portion, of our investment portfolio is invested in non-agency RMBS and non-conforming residential mortgage loans. Our investment portfolio of residential mortgage loans, RMBS, commercial real estate loans, and CMBS may have material geographic concentrations. Our investments in subordinated CMBS are generally in the second loss position and therefore subject to losses. Our rights under corporate leveraged loans we invest in may be more restricted than investments in other loans. The high yield bonds that we invest in have greater credit and liquidity risk than more highly rated bonds. Asset-backed securities are subject to credit risks that may arise due to defaults by the borrowers in the underlying collateral or the issuer s or servicer s failure to perform and other risks. Collateralized debt obligations, or CDO, are subject to the risk that the collateral underlying the CDOs are insufficient to make payments on the CDO securities. Total return swaps are subject to risks related to changes in interest rates, credit spreads, credit quality and expected recovery rates of the underlying credit instrument as well as renewal risks. Credit default swaps, or CDS, are subject to risks related to changes, credit spreads, credit quality and expected recovery rates of the underlying credit instrument. Our dependence on the management of other entities may adversely affect our business. Due diligence conducted by our Manager may not reveal all of the risks of the businesses in which we invest. A prolonged economic slowdown, a recession or declining real estate values could impair our investments and harm our operating results. Many of our investments are illiquid and we may not be able to vary our portfolio in response to changes in economic and other conditions. Risks Related to our Organization and Structure Our ability to make future distributions may be affected by, and the amount of such distributions may be reduced by, among other factors, a change in the return on our investments, our operating expense levels and certain restrictions imposed by Maryland law. The terms of our indebtedness may restrict our ability to make future distributions and impose limitations on our current and future operations. Our Investment Company Act exemption limits our investment discretion and loss of the exemption would adversely affect us and negatively affect the market price of shares of our common stock and the ability to make distributions to our stockholders. Rapid changes in the values of our mortgage-backed securities and other real estate related investments may make it more difficult for us to maintain our REIT status or exemption from the Investment Company Act. Maryland takeover statutes may prevent or make difficult a change of control of our company that could be in the interests of our stockholders. Our charter and bylaws contain provisions that may inhibit potential acquisition bids that our stockholders may consider favorable, and the market price of our common stock may be lower as a result. Our rights and the rights of our stockholders to take action against our directors and officers are limited, which could limit their recourse in the event of actions not in their best interests. Complying with the REIT requirements may cause us to forgo otherwise attractive opportunities or engage in marginal investment opportunities. The prohibited transactions tax will limit our ability to engage in transactions, including certain methods of securitizing mortgage loans, that would be treated as sales for federal income tax purposes. We may be subject to the prohibited transactions tax on the loans we sold or will sell to our CLO issuers if the Internal Revenue Service challenges our characterization of those transactions. Our excess inclusion income will likely increase the tax liability of our tax-exempt shareholders, foreign shareholders, and shareholders with net operating losses and may subject us to an entity-level tax. Failure to qualify as a REIT would subject us to U.S. federal income tax, which would reduce the cash available for distribution to our stockholders. Failure to make required distributions would subject us to tax, which would reduce the cash available for distribution to our stockholders. Ownership limitations and certain provisions of our charter may restrict a change of control in which our stockholders might receive a premium for their shares. Our ownership of and relationship with our taxable REIT subsidiaries will be limited and a failure to comply with the limits would jeopardize our REIT status and may result in the application of a 100% excise tax. Our stockholders may receive lower distributions because TRS Inc. will likely retain its earnings. We may lose our REIT status if the IRS successfully challenges our characterization of our income from our foreign taxable REIT subsidiaries. If our foreign taxable REIT subsidiaries, including our CDO and CLO issuers that are treated as corporations for federal income tax purposes, are subject to federal income tax at the entity level, it would greatly reduce the amounts those entities would have available to distribute to us and that we would have available to pay their creditors. The taxation of corporate dividends may adversely affect the value of our common stock. Complying with REIT requirements may limit our ability to hedge effectively. We may be subject to adverse legislative or regulatory tax changes that could reduce the market price of our common stock. Risks Related to Proposed Conversion Transaction After the Conversion Transaction KKR Financial Holdings LLC intends over time to allocate significantly more capital to non-real estate investments, which may result in a riskier investment portfolio and increased volatility in its earnings, and as a result may adversely affect the market price of its shares. KKR Financial Holdings LLC will not be able to immediately reallocate its capital, which may adversely affect the market price of its shares. Under the proposed limited liability company structure of the Conversion Transaction, the Manager may receive an increased incentive fee since it will be allocating more capital to investments with a higher return on equity, which investments may be riskier and more volatile than other investments. The Conversion Transaction may not be completed, which may harm the market price of KKR Financial Corp. s common stock. Because KKR Financial Holdings LLC, the limited liability company into which we intend to convert, is not taxed as a REIT, it will not be subject to the same distribution requirements to which we are subject and therefore may distribute a lower percentage of its taxable income to the holders of its shares. Following completion of the Conversion Transaction, KKR Financial Holdings LLC may be able to engage in more transactions with companies that are controlled by or affiliated with KKR, which may result in or create the appearance of conflicts of interest. The current market price of our common stock may not be indicative of the market price of shares of KKR Financial Holdings LLC following the Conversion Transaction. Substantial sales of shares of KKR Financial Holdings LLC could occur in connection with the Conversion Transaction, which could cause its share price to decline. Certain of KKR Financial LLC s directors, officers and the Manager have interests in the proposed merger that will be part of the Conversion Transaction that are different from, and in addition to, the interests of other KKR Financial Corp. stockholders. Certain provisions of the limited liability company agreement of KKR Financial Holdings LLC will make it difficult for third parties to acquire control of KKR Financial Holdings LLC and could deprive its shareholders of the opportunity to obtain a takeover premium for their shares. Future sales of KKR Financial Holdings LLC s shares may affect the market price of its shares KKR Financial Holdings LLC may issue additional debt and equity securities which are senior to its shares as to distributions and in liquidation, which could materially adversely affect the market price of it shares. KKR Financial Holdings LLC s earnings and cash distributions may affect the market price of its shares. The market price, trading volume and marketability of KKR Financial Holdings LLC s shares may, from time to time, be significantly affected by numerous factors beyond its control, which may adversely affect the market price of its shares and its ability to raise capital through future equity financings. Broad market fluctuations could negatively impact the market price of shares. An increase in market interest rates may have an adverse effect on the market price of shares. The board of directors of KKR Financial Holdings LLC will have the authority to change many of the terms of the shares of KKR Financial Holdings LLC in ways with which its shareholders may disagree without approval of holders of its shares. While KKR Financial Holdings LLC intends to make regular cash distributions to holders of shares of KKR Financial Holdings LLC, the board of directors of KKR Financial Holdings LLC will have full authority and discretion over the distributions and it may decide to reduce or eliminate distributions at any time, which may adversely affect the market price for its shares. Maintenance of KKR Financial Holdings LLC s Investment Company Act exemption imposes limits on its operations, which may adversely affect its results of operations. If KKR Financial Holdings LLC fails to satisfy the qualifying income exception, all of its income will be subject to an entity-level tax, which could result in a material reduction in cash flow and after-tax return for holders of its shares and thus could result in a substantial reduction in the value of those shares. Complying with certain tax-related requirements may cause KKR Financial Holdings LLC and KKR Financial Corp. to forego otherwise attractive business or investment opportunities. The REIT tax rules may limit KKR Financial Holdings LLC s ability to liquidate mortgage assets and/or transfer non-mortgage assets from KKR Financial Corp. to KKR Financial Holdings LLC. KKR Financial Holdings LLC could incur a significant tax liability if the IRS successfully asserts that the anti-stapling rules apply to KKR Financial Holdings LLC s investments in KKR Financial Corp. and certain of its foreign CDO and CLO issuers, which could result in a reduction in cash flow and after-tax return for holders of shares and thus could result in a reduction of the value of those shares. The merger that is part of the conversion transaction may be recharacterized as a taxable exchange. Shareholders of KKR Financial LLC will be subject to U.S. federal income tax on their share of KKR Financial Holdings LLC s taxable income, regardless of whether or when they receive any cash distributions from KKR Financial Holdings LLC. The ability of shareholders of KKR Financial Holdings LLC to deduct certain expenses of KKR Financial Holdings LLC may be limited. Shareholders of KKR Financial Holdings LLC may recognize a greater taxable gain (or a smaller tax loss) on a disposition of shares of KKR Financial Holdings LLC than expected because of the treatment of debt under the partnership tax accounting rules. Tax-exempt holders of shares of KKR Financial Holdings LLC will likely recognize significant amounts of unrelated business taxable income. There can be no assurance that the IRS will not assert successfully that some portion of KKR Financial Holdings LLC s income is properly treated as effectively connected income with respect to non-U.S. holders. Dividends paid by, or certain income inclusions derived with respect to KKR Financial Holdings LLC s ownership of, foreign corporate subsidiaries and KKR Financial Corp. will not qualify for the reduced tax rates generally applicable to corporate dividends paid to taxpayers taxed at individual rates. Although KKR Financial Holdings LLC anticipates that its foreign corporate subsidiaries will not be subject to U.S. federal income tax on a net basis, no assurance can be given that such subsidiaries will not be subject to U.S. federal income tax on a net basis in any given taxable year. KKR Financial Holdings LLC s structure involves complex provisions of U.S. federal income tax law for which no clear precedent or authority may be available, and which is subject to potential change, possibly on a retroactive basis. Any such change could result in adverse consequences to the holders of shares of KKR Financial Holdings LLC. Ownership limitations in KKR Financial Holdings LLC s limited liability company agreement that apply so long as KKR Financial Holdings LLC owns an interest in a REIT, such as KKR Financial Corp., may restrict a change of control in which shareholders of KKR Financial Holdings LLC might receive a premium for their shares. The failure of KKR Financial Corp. to qualify as a REIT would generally cause it to be subject to U.S. federal income tax on its taxable income, which could result in a material reduction in cash flow and after-tax return for holders of shares of KKR Financial Holdings LLC and thus could result in a reduction of the value of those shares. The IRS Schedule K-1 provided by KKR Financial Holdings LLC will be significantly more complicated than the IRS Forms 1099 provided in prior years by KKR Financial Corp. and shareholders of KKR Financial LLC may be required to request an extension of the time to file their tax returns.

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1301508--2/23/2007--KKR_Financial_Corp