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UNITED STATES
SECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549



FORM 10-K

(Mark One)ý

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the fiscal year ended December 31, 2010oro

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the transition period
from                                   to


Commission file number: 001-33437



KKR FINANCIAL HOLDINGS LLC(Exact name of registrant as specified in its charter)

Delaware(State or other jurisdiction of
incorporation or organization)

11-3801844(I.R.S. Employer
Identification No.)555 California Street, 50th Floor
San Francisco, CA(Address of principal executive offices)

94104(Zip Code)


Registrant's
telephone number, including area code:(415) 315-3620

Securities
registered pursuant to Section 12(b) of the Act: Shares representing limited liability company membership interests listed on the New York Stock Exchange

Securities
registered pursuant to section 12(g) of the Act:None



Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities
Act. ý Yes  o No

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the
Act. o Yes  ý No

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. ý 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). o Yes
  o No

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this
chapter) is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this
Form 10-K or any amendment to this Form 10-K. ý

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):

Large accelerated filer ý

Accelerated filer o

Non-accelerated filer o (Do not check if a
smaller reporting company)

Smaller reporting company o


Indicate
by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the
Act). o Yes  ý No

The aggregate market value of the voting common shares held by non-affiliates of the registrant as of June 30, 2010 was $1,090,385,275, based
on the closing price of the common shares on such date as reported on the New York Stock Exchange.

The
number of shares of the registrant's common shares outstanding as of February 22, 2011 was 178,123,525.

DOCUMENTS INCORPORATED BY REFERENCE

Portions
of the registrant's Proxy Statement for the 2011 Annual Shareholders' Meeting to be filed within 120 days after the close of the registrant's fiscal year are
incorporated by reference into Part III of this Annual Report on Form 10-K.



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Except where otherwise expressly stated or the context suggests otherwise, the terms "we," "us" and "our" refer to KKR Financial Holdings LLC and its
subsidiaries; the "Manager" refers to KKR Financial Advisors LLC; and "KKR" refers to Kohlberg Kravis Roberts & Co. L.P. and its affiliated
companies.

CAUTIONARY STATEMENT FOR PURPOSES OF THE "SAFE HARBOR" PROVISIONS OF  THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995

Certain information contained in this Annual Report on Form 10-K constitutes "forward-looking" statements within the
meaning of Section 27A of the Securities Act of 1933, as amended, or the Securities Act, and Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act, that are
based on our current expectations, estimates and projections. Pursuant to those sections, we may obtain a "safe harbor" for forward-looking statements by identifying and accompanying those statements
with cautionary statements, which identify factors that could cause actual results to differ from those expressed in the forward-looking statements. Statements that are not historical facts, including
statements about our beliefs and expectations, are forward-looking statements. The words "believe," "anticipate," "intend," "aim," "expect," "strive," "plan," "estimate," and "project," and similar
words identify forward-looking statements. Such statements are not guarantees of future performance, events or results and involve potential risks and uncertainties. Accordingly, actual results and
the timing of certain events could differ materially from those addressed in forward-looking statements due to a number of factors including, but not limited to, changes in interest rates and market
values, financing and capital availability, changes in prepayment rates, general economic and political conditions and events, changes in market conditions, particularly in the global fixed income,
credit and equity markets, the impact of current, pending and future legislation, regulation and legal actions, and other factors not presently identified. Other factors that may impact our actual
results are discussed under "Risk Factors" in Item 1A of this Annual Report on Form 10-K. We do not undertake, and specifically disclaim, any obligation to publicly release
the result of any revisions that may be made to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements,
except for as required by federal securities laws.

WEBSITE ACCESS TO COMPANY'S REPORTS

Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on
Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act are available free of charge through our website, www.kkr.com/kfn_ir/kfn_sec.cfm, as soon as reasonably practicable after they are electronically filed with, or furnished to, the Securities and Exchange
Commission, or SEC. Our Corporate Governance Guidelines, board of directors' committee charters (including the charters of the Affiliated Transactions Committee, Audit Committee, Compensation
Committee, and Nominating and Corporate Governance Committee) and Code of Business Conduct and Ethics are available on our website. Information on our website does not constitute a part of, and is not
incorporated by reference into, this Annual Report on Form 10-K.

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KKR FINANCIAL HOLDINGS LLC  2010 FORM 10-K ANNUAL REPORT  TABLE OF CONTENTS



PagePart IItem 1.

Business


4Item 1A.

Risk Factors


16Item 1B.

Unresolved Staff Comments


49Item 2.

Properties


49Item 3.

Legal Proceedings


49Item 4.

[Removed and Reserved]


50Part IIItem 5.

Market for Registrant's Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities


51Item 6.

Selected Consolidated Financial Data


55Item 7.

Management's Discussion and Analysis of Financial Condition and Results of Operations


57Item 7A.

Quantitative and Qualitative Disclosures about Market Risk


95Item 8.

Financial Statements and Supplementary Data


95Item 9.

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure


95Item 9A.

Controls and Procedures


95Item 9B.

Other Information


96Part IIIItem 10.

Directors, Executive Officers and Corporate Governance


96Item 11.

Executive Compensation


96Item 12.

Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters


96Item 13.

Certain Relationships and Related Transactions, and Director Independence


96Item 14.

Principal Accounting Fees and Services


96Part IVItem 15.

Exhibits and Financial Statement Schedules


97


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PART I

Item 1.    BUSINESS

Our Company

We are a specialty finance company with expertise in a range of asset classes. Our core business strategy is to leverage the
proprietary resources of our manager with the objective of generating both current income and capital appreciation. We primarily invest in financial assets such as below investment grade corporate
debt, marketable equity securities and private equity. Additionally, we have made and may make additional investments in other asset classes including natural resources and real estate. Below
investment grade corporate debt includes senior secured and unsecured loans, mezzanine loans, high yield bonds, and distressed and stressed debt securities.

The
corporate loans we invest in are primarily 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 our corporate debt investments are held in collateralized loan obligation ("CLO") transactions that are structured as on-balance sheet securitizations and
are used as long term financing for our corporate debt investments. The senior secured notes issued by the CLO transactions are primarily owned by unaffiliated third party investors and we own the
majority of the subordinated notes in the CLO transactions. Our CLO transactions consist of five cash flow CLO transactions, 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" and, together with CLO 2005-1, CLO
2005-2, CLO 2006-1, and CLO 2007-1, each a "Cash Flow CLO" and, collectively, the "Cash Flow CLOs"). We execute our core business strategy through
majority-owned subsidiaries, including CLOs.

We
are a Delaware limited liability company and were organized on January 17, 2007. We are the successor to KKR Financial Corp., a Maryland corporation. Our common shares are
publicly traded on the New York Stock Exchange ("NYSE") under the symbol "KFN". We intend to continue to operate so as to qualify, for United States federal income tax purposes, as a partnership and
not as an association or publicly traded partnership taxable as a corporation.

Our Manager

We are externally managed and advised by KKR Financial Advisors LLC (our "Manager"), a wholly-owned subsidiary of KKR Asset
Management LLC ("KAM" or "the parent of our Manager") (formerly known as Kohlberg Kravis Roberts & Co. (Fixed Income) LLC), 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").

Our
Manager is responsible for our operations and performs all services and activities relating to the management of our assets, liabilities and operations. Pursuant to the terms of the
Management Agreement, our Manager provides us with our management team, along with appropriate support personnel. All of our executive officers are employees or members of KKR or one or more of its
affiliates. Our Manager is under the direction of our board of directors and is required to manage our business affairs in conformity with the Investment Guidelines that are approved by a majority of
our independent directors.

The
executive offices of our Manager are located at 555 California Street, 50th Floor, San Francisco, California 94104 and the telephone number of our Manager's
executive offices is (415) 315-3620.

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Our Strategy

Our objective is to provide long-term value for our shareholders by generating an attractive total return through cash
distributions and increased share price. We seek to achieve our objective by deploying capital opportunistically across capital structures and asset classes. As part of our strategy, we seek
opportunities in those asset classes that can generate competitive leveraged risk-adjusted returns, subject to maintaining our exemption from registration under the Investment Company Act
of 1940, as amended (the "Investment Company Act").

Our
Manager utilizes its access to the global resources and professionals of KKR, along with the same philosophy of value creation that KKR employs, in order to create a portfolio that
is constructed to generate recurring cash flows, long-term capital appreciation and overall competitive returns to investors. We make asset class allocation decisions based on various
factors including: relative value, leveraged risk-adjusted returns, current and projected credit fundamentals, current and projected supply and demand, credit risk concentration
considerations, current and projected macroeconomic considerations, liquidity, all-in cost of financing and financing availability, and maintaining our exemption from the Investment
Company Act.

Partnership Tax Matters



We intend to continue to operate so as to qualify, for United States federal income tax purposes, as a partnership and not as an
association or a publicly traded partnership taxable as a corporation. Holders of our common shares are subject to United States federal income taxation and generally other taxes, such as state, local
and foreign income taxes, on their allocable
share of our taxable income, regardless of whether or when they receive cash distributions. In addition, certain of our investments, including investments in foreign corporate subsidiaries, CLO
issuers (which are treated as partnerships or disregarded entities for United States federal income tax purposes) and debt securities, may produce taxable income without corresponding distributions of
cash to us or produce taxable income prior to or following the receipt of cash relating to such income. In addition, we have recognized and may recognize in the future cancellation of indebtedness
income upon the retirement of our debt at a discount. Consequently, in some taxable years, holders of our common shares may recognize taxable income in excess of our cash distributions. Furthermore,
even if we did not pay cash distributions with respect to a taxable year, holders of our common shares may still have a tax liability attributable to their allocation of our taxable income during such
year.



We intend to continue to operate so as to qualify, for United States federal income tax purposes, as a partnership and not as an
association or a publicly traded partnership taxable as a corporation. In general, if a partnership is "publicly traded" (as defined in the Internal Revenue Code of 1986, as amended (the "Code")), it
will be treated as a corporation for United States federal income tax purposes. A publicly traded partnership will be taxed as a partnership, however, and not as a corporation, if it is not required
to register under the Investment Company Act and at least 90% of its gross income for each taxable year constitutes "qualifying income" within the meaning of Section 7704(d) of the Code. We
refer to this exception as the "qualifying income exception." Qualifying income generally includes rents, dividends, interest (to the extent such interest is neither derived from the "conduct of a
financial or insurance business" nor based, directly or indirectly, upon "income or profits" of any person), income and gains derived from certain activities related to minerals and natural resources,
and capital gains from the sale or other disposition of stocks, bonds and real property. Qualifying income also includes other income derived from the business of investing in, among other things,
stocks and securities.

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If
we fail to satisfy the "qualifying income exception" described above, items of income, gain, loss, deduction and credit would not pass through to holders of our common shares and such
holders would be treated for United States federal (and certain state and local) income tax purposes as shareholders in a corporation. In such case, we would be required to pay income tax at regular
corporate rates on all of our income. In addition, we would likely be liable for state and local income and/or franchise taxes on all of our income. Distributions to holders of our common shares would
constitute ordinary dividend income taxable to such holders to the extent of our earnings and profits, and these distributions would not be deductible by us. If we were taxable as a corporation, it
could result in a material reduction in cash flow and after-tax return for holders of our common shares and thus could result in a substantial reduction in the value of our common shares
and any other securities we may issue.

Tax Consequences of Investments in Natural Resources

As referenced above, we have made and may make certain investments in natural resources. It is likely that the income from such
investments will be treated as effectively connected with the conduct of a United States trade or business with respect to holders of our shares that are not "United States persons" within the meaning
of Section 7701(a)(30) of the Code. Furthermore, any notional principal contracts that we enter into, if any, in connection with investments in natural resources likely would generate income
that would be treated as effectively connected with the conduct of a United States trade or business. To the extent our income is treated as effectively connected income, a holder who is a
non-United States person generally would be required to (i) file a United States federal income tax return for such year reporting its allocable share, if any, of our income
or loss effectively connected with such trade or business and (ii) pay United States federal income tax at regular United States tax rates on any such income. Moreover, if such a holder is a
corporation, it might be subject to a United States branch profits tax on its allocable share of our effectively connected income. In addition, distributions to such a holder would be subject to
withholding at the highest applicable tax rate to the extent of the holder's allocable share of our effectively connected income. Any amount so withheld would be creditable against such holder's
United States federal income tax liability, and such holder could claim a refund to the extent that the amount withheld exceeded such holder's United States federal income tax liability for the
taxable year. Finally, if we are engaged in a United States trade or business, a portion of any gain recognized by an investor who is a non-United States person on the sale or exchange of
its shares may be treated for United States federal income tax purposes as effectively connected income, and hence such holder may be subject to United States federal income tax on the sale or
exchange.

In
addition, for all of our holders, investments in natural resources would likely constitute doing business in the jurisdictions in which such assets are located. As a result, holders
of our shares will likely be required to file foreign, state and local income tax returns and pay foreign, state and local income taxes in some or all of these various jurisdictions. Further, holders
may be subject to penalties for failure to comply with those requirements.

Our Investment Company Act Status

Section 3(a)(1)(A) of the Investment Company Act defines an investment company as any issuer that is, holds itself out as being,
or proposes to be, primarily engaged in the business of investing, reinvesting or trading in securities and Section 3(a)(1)(C) of the Investment Company Act defines an investment company as any
issuer that is engaged or proposes to engage in the business of investing, reinvesting, owning, holding or trading in securities and owns or proposes to acquire "investment securities" (within the
meaning of the Investment Company Act) having a value exceeding 40% of the value of the issuer's total assets (exclusive of United States government securities and cash items) on an unconsolidated
basis (the "40% test"). Excluded from the term "investment securities" are, among others, securities issued by majority-owned subsidiaries unless the subsidiary is an investment company

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or
relies on the exceptions from the definition of an investment company provided by Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act (a "fund"). The Investment Company
Act defines a "majority-owned subsidiary" of a person as any company 50% or more of the outstanding voting securities (i.e., those securities presently entitling the holder thereof to vote for
the election of directors of the company) of which are owned by that person, or by another company that is, itself, a majority owned subsidiary of that person.

We
are organized as a holding company. We conduct our operations primarily through our majority-owned subsidiaries. Each of our subsidiaries is either outside of the definition of an
investment company in Sections 3(a)(1)(A) and 3(a)(1)(C), described above, or excepted from the definition of an investment company under the Investment Company Act. We believe that we are not,
and that we do not propose to be, primarily engaged in the business of investing, reinvesting or trading in securities and we do not believe that we have held ourselves out as such. We intend to
continue to conduct our operations so that we are not required to register as an investment company under the Investment Company Act.

We
monitor our holdings regularly to confirm our continued compliance with the 40% test. In calculating our position under the 40% test, we are responsible for determining whether any of
our subsidiaries is majority-owned. We treat subsidiaries in which we own at least 50% of the outstanding voting securities, including those that issue CLOs, as majority-owned for purposes of the 40%
test. Some of our subsidiaries may rely solely on Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act. In order for us to satisfy the 40% test, our ownership interests in
those subsidiaries or any of our subsidiaries that are not majority-owned, together with any other "investment securities" that we may own, may not have a combined value in excess of 40% of the value
of our total assets on an unconsolidated basis and exclusive of United States government securities and cash items. However, most of our subsidiaries either fall outside of the general definitions of
an investment company or rely on exceptions provided by provisions of, and rules and regulations promulgated under, the Investment Company Act (other than Section 3(c)(1) or
Section 3(c)(7) of the Investment Company Act) and, therefore, are not defined or regulated as investment companies. In order to conform to these
exceptions, these subsidiaries are limited with respect to the assets in which each of them can invest and/or the types of securities each of them may issue. We must, therefore, monitor each
subsidiary's compliance with its applicable exception and our freedom of action, and that of our subsidiaries, may be limited as a result. For example, our subsidiaries that issue CLOs generally rely
on Rule 3a-7 under Investment Company Act, while KKR Financial Holdings II, LLC ("KFH II"), our subsidiary that is taxed as a REIT for United States federal income tax
purposes, generally relies on Section 3(c)(5)(C) of the Investment Company Act. Each of these exceptions requires, among other things that the subsidiary (i) not issue redeemable
securities and (ii) engage in the business of holding certain types of assets, consistent with the terms of the exception. Similarly, any subsidiaries engaged in the ownership of oil and gas
assets may, depending on the nature of the assets, be outside the definition of an investment company or rely on exceptions provided by Section 3(c)(5)(C) or Section 3(c)(9) of the
Investment Company Act. While Section 3(c)(9) of the Investment Company Act does not limit the nature of the securities issued, it does impose business engagement requirements that limit the
types of assets that may be held.

We
do not treat our interests in majority-owned subsidiaries that are outside of the general definition of an investment company or that rely on Section 3(c)(5)(C) or
Section 3(c)(9) of, or Rule 3a-7 under, the Investment Company Act as investment securities when calculating our 40% test.

We
sometimes refer to our subsidiaries that rely on Rule 3a-7 under the Investment Company Act as "CLO subsidiaries." Rule 3a-7 under the Investment
Company Act is available to certain structured financing vehicles that are engaged in the business of holding financial assets that, by their terms, convert into cash within a finite time period and
that issue fixed income securities entitling holders to receive payments that depend primarily on the cash flows from these assets, provided that, among other

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things,
the structured finance vehicle does not engage in certain portfolio management practices resembling those employed by mutual funds. Accordingly, each of these CLO subsidiaries is subject to an
indenture (or similar transaction documents) that contains specific guidelines and restrictions limiting the discretion of the CLO subsidiary and its collateral manager. In particular, these
guidelines and restrictions prohibit the CLO subsidiary from acquiring and disposing of assets primarily for the purpose of recognizing gains or decreasing losses resulting from market value changes.
Thus, a CLO subsidiary cannot acquire or dispose of assets primarily to enhance returns to the owner of the equity in the CLO subsidiary; however, subject to this limitation, sales and purchases of
assets may be made so long as doing so does not violate guidelines contained in the CLO subsidiary's relevant transaction documents. A CLO subsidiary generally can, for example, sell an asset if the
collateral manager believes that its credit quality has declined since its acquisition or that the credit profile of the obligor will deteriorate and the proceeds of permitted dispositions may be
reinvested in additional collateral, subject to fulfilling the requirements set forth in Rule 3a-7 under the Investment Company Act and the CLO subsidiary's relevant transaction
documents. As a result of these restrictions, our CLO subsidiaries may suffer losses on their assets and we may suffer losses on our investments in those CLO subsidiaries.

We
sometimes refer to KFH II, our subsidiary that relies on Section 3(c)(5)(C) of the Investment Company Act, as our "REIT subsidiary." Section 3(c)(5)(C) of the Investment
Company Act is available to companies that are primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on and interests in real estate. While the SEC has not
promulgated rules to address precisely what is required for a company to be considered to be "primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on and
interests in real estate," the SEC's Division of Investment Management, or the "Division," has taken the position, through a series of no-action and interpretive letters, that a company
may rely on Section 3(c)(5)(C) of the Investment Company Act if, among other things, at least 55% of the company's assets consist of mortgage loans, other assets that are considered the
functional equivalent of mortgage loans and certain other interests in real property (collectively, "qualifying real estate assets"), and at least 25% of the company's assets consist of real
estate-related assets (reduced by the excess of the company's qualifying real estate assets over the required 55%), leaving no more than 20% of the company's assets to be invested in miscellaneous
assets. The Division has also provided guidance as to the types of assets that can be considered qualifying real estate assets. Because the Division's interpretive letters are not binding except as
they relate to the companies to whom they are addressed, if the Division were to change its position as to, among other things, what assets might constitute qualifying real estate assets our REIT
subsidiary might be required to change its investment strategy to comply with the changed position. We cannot predict whether such a change would be adverse.

Based
on current guidance, our REIT subsidiary classifies investments in mortgage loans as qualifying real estate assets, as long as the loans are "fully secured" by an interest in real
estate on which we retain the right to foreclose. That is, if the loan-to-value ratio of the loan is equal to or less than 100%, then the mortgage loan is considered to be a
qualifying real estate asset. Mortgage loans with loan-to-value ratios in excess of 100% are considered to be only real estate-related assets. Our REIT subsidiary considers
agency whole pool certificates to be qualifying real estate assets. Examples of agencies that issue whole pool certificates are the Federal National Mortgage Association, the Federal Home Loan
Mortgage Corporation and the Government National Mortgage Association. An agency whole pool certificate is a certificate issued or guaranteed as to principal and interest by the United States
government or by a federally chartered entity, which represents the entire beneficial interest in the underlying pool of mortgage loans. By contrast, an agency certificate that represents less than
the entire beneficial interest in the underlying mortgage loans is not considered to be a qualifying real estate asset, but is considered to be a real estate-related asset.

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Most
non-agency mortgage-backed securities do not constitute qualifying real estate assets because they represent less than the entire beneficial interest in the related pool
of mortgage loans; however, based on Division guidance, where our REIT subsidiary's investment in non-agency mortgage-backed securities is the "functional equivalent" of owning the
underlying mortgage loans, our REIT subsidiary may treat those securities as qualifying real estate assets. Moreover, investments in mortgage-backed securities that do not constitute qualifying real
estate assets will be classified as real estate-related assets. Therefore, based upon the specific terms and circumstances related to each non-agency mortgage-backed security that our REIT
subsidiary owns, our REIT subsidiary will make a determination of whether that security should be classified as a qualifying real estate asset or as a real estate-related asset; and there may be
instances where a security is recharacterized from being a qualifying real estate asset to a real estate-related asset, or conversely, from being a real estate-related asset to being a qualifying real
estate asset based upon the acquisition or disposition or redemption of related classes of securities from the same securitization trust. If our REIT subsidiary acquires securities that, collectively,
receive all of the principal and interest paid on the related pool of underlying mortgage loans (less fees, such as servicing and trustee fees, and expenses of the securitization), and that subsidiary
has foreclosure rights with respect to those mortgage loans, then our REIT subsidiary will consider those securities, collectively, to be qualifying real estate assets. If another entity acquires any
of the securities that are expected to receive cash flow from the underlying mortgage loans, then our REIT subsidiary will consider whether it has appropriate foreclosure rights with respect to the
underlying loans and whether its investment is a first loss position in deciding whether these securities should be classified as qualifying real estate assets. If our REIT subsidiary owns more than
one subordinate class, then, to determine the classification of subordinate classes other than the first loss class, our REIT subsidiary will consider whether such classes are contiguous with the
first loss class (with no other classes absorbing losses after the first loss class and before any other subordinate classes that our REIT subsidiary owns), whether our REIT subsidiary owns the entire
amount of each such class and whether our REIT subsidiary would continue to have appropriate foreclosure rights in connection with each such class if the more subordinate classes were no longer
outstanding. If the answers to any of these questions is no, then our REIT subsidiary would expect not to classify that particular class, or classes senior to that class, as qualifying real estate
assets.

We
have made or may make oil and gas and other mineral investments that are held through one or more subsidiaries and would refer to those subsidiaries as our "Oil and Gas Subsidiaries".
Depending upon the nature of the oil and gas assets held by an Oil and Gas Subsidiary, such Oil and Gas Subsidiary may rely on Section 3(c)(5)(C) or Section 3(c)(9) of the Investment
Company Act or may fall outside of the general definition of an investment company. An Oil and Gas Subsidiary that does not engage primarily, propose to engage primarily or hold itself out as engaging
primarily in the business of investing, reinvesting or trading in securities will be outside of the general definition of an investment company provided that it passes the 40% test. This may be the
case where an Oil and Gas Subsidiary holds a sufficient amount of oil and gas assets constituting real estate interests together with other assets that are not investment securities such as equipment.
Oil and Gas Subsidiaries that hold oil and gas assets that constitute real property interests, but are unable to pass the 40% test, may rely on Section 3(c)(5)(C), subject to the requirements
and restrictions described above. Alternately, an Oil and Gas Subsidiary may rely on Section 3(c)(9) of the Investment Company Act if substantially all of its business consists of owning or
holding oil, gas or other mineral royalties or leases, certain fractional interests, or certificates of interest or participations in or investment contracts relating to such royalties, leases or
fractional interests. These various restrictions imposed on our Oil and Gas Subsidiaries by the Investment Company Act may have the effect of limiting our freedom of action with respect to oil and gas
assets (or other assets) that may be held or acquired by such subsidiary or the manner in which we may deal in such assets.

As
noted above, if the combined values of the investment securities issued by our subsidiaries that must rely on Section 3(c)(1) or Section 3(c)(7) of the Investment
Company Act, together with any

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other
investment securities we may own, exceeds 40% of the value of our total assets (exclusive of United States government securities and cash items) on an unconsolidated basis, we may be deemed to
be an investment company. If we fail to maintain an exception, exemption or other exclusion from the Investment Company Act, we could, among other things, be required either (i) to change
substantially the manner in which we conduct our operations to avoid being subject to the Investment Company Act or (ii) to register as an investment company. Either of these would likely have
a material adverse effect on us, our ability to service our indebtedness and to make distributions on our shares, and on the market price of our shares and any other securities we may issue. If we
were required to register as an investment company under the Investment Company Act, we would become subject to substantial regulation with respect to our capital structure (including our ability to
use leverage), management, operations, transactions with certain affiliated persons (within the meaning of the Investment Company Act), portfolio composition (including restrictions with respect to
diversification and industry concentration) and other matters. Additionally, our Manager would have the right to terminate our Management Agreement. Moreover, if we were required to register as an
investment company, we would no longer be eligible to be treated as a partnership for United States federal income tax purposes. Instead, we would be classified as a corporation for tax purposes and
would be able to avoid corporate taxation only to the extent that we were able to elect and qualify as a regulated investment company ("RIC") under applicable tax rules. Because our eligibility for
RIC status would depend on our assets and sources of income at the time that we were required to register as an investment company, there can be no assurance that we would be able to qualify as a RIC.
If we were to lose partnership status and fail to qualify as a RIC, we would be taxed as a regular corporation. See "Partnership Tax MattersQualifying Income
Exception".

We
have not requested approval or guidance from the SEC or its staff with respect to our Investment Company Act determinations, including, in particular: our treatment of any subsidiary
as majority-owned; the compliance of any subsidiary with Section 3(c)(5)(C) or Section 3(c)(9) of, or Rule 3a-7 under, the Investment Company Act, including any
subsidiary's determinations with respect to the consistency of its assets or operations with the requirements thereof; or whether our interests in one or more subsidiaries constitute investment
securities for purposes of the 40% test. If the SEC were to disagree with our treatment of one or more subsidiaries as being excepted from the Investment Company Act pursuant to
Rule 3a-7, Section 3(c)(5)(C) or Section 3(c)(9), with our determination that one or more of our other holdings do not constitute investment securities for purposes of
the 40% test, or with our determinations as to the nature of the business in which we engage or the manner in which we hold ourselves out, we and/or one or more of our subsidiaries would need to
adjust our operating strategies or assets in order for us to continue to pass the 40% test or register as an investment company, either of which could have a material adverse effect on us. Moreover,
we may be required to adjust our operating strategy and holdings, or to effect sales of our assets in a manner that, or at a time or price at which, we would not otherwise choose, if there are changes
in the laws or rules governing our Investment Company Act status or that of our subsidiaries, or if the SEC or its staff provides more specific or different guidance regarding the application of
relevant provisions of, and rules under, the Investment Company Act. Such guidance could provide additional flexibility, or it could further inhibit our ability, or the ability of a subsidiary, to
pursue a chosen operating strategy, which could have a material adverse effect on us.

If
the SEC or a court of competent jurisdiction were to find that we were required, but failed, to register as an investment company in violation of the Investment Company Act, we would
have to cease business activities, we would breach representations and warranties and/or be in default as to certain of our contracts and obligations, civil or criminal actions could be brought
against us, our contracts would be unenforceable unless a court were to require enforcement and a court could appoint a receiver to take control of us and liquidate our business, any or all of which
would have a material adverse effect on our business.

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Management Agreement

We are party to a Management Agreement with our Manager, pursuant to which our Manager will provide for the
day-to-day management of our operations.

The
Management Agreement requires our Manager to manage our business affairs in conformity with the Investment Guidelines that are approved by a majority of our independent directors.
Our Manager is under the direction of our board of directors. Our Manager is responsible for (i) the selection, purchase and sale of our investments, (ii) our financing and risk
management activities, and (iii) providing us with investment advisory services.

The
Management Agreement expires on December 31, 2011 and is automatically renewed for a one-year term on such date and each anniversary date thereafter, unless
terminated. Our independent directors review our Manager's performance annually and the Management Agreement may be terminated annually (upon 180 day prior written notice) upon the affirmative
vote of at least two-thirds of our independent directors, or by a vote of the holders of a majority of our outstanding common shares, based upon (1) unsatisfactory performance by
the Manager that is materially detrimental to us or (2) a determination that the management fees payable to our Manager are not fair, subject to our Manager's right to prevent such a
termination under this clause (2) by accepting a mutually acceptable reduction of management fees. We must provide a 180 day prior written notice of any such termination and our Manager
will be paid a termination fee equal to four times the sum of the average annual base management fee and the average annual incentive fee for the two 12-month periods preceding the date of
termination, calculated as of the end of the most recently completed fiscal quarter prior to the date of termination.

We
may also terminate the Management Agreement without payment of the termination fee with a 30 day prior written notice for cause, which is defined as (i) our Manager's
continued material breach of any provision of the Management Agreement following a period of 30 days after written notice thereof, (ii) our Manager's fraud, misappropriation of funds, or
embezzlement against us, (iii) our Manager's gross negligence in the performance of its duties under the Management Agreement, (iv) the commencement of any proceeding relating to our
Manager's bankruptcy or insolvency, (v) the dissolution of our Manager, or (vi) a change of control of our Manager. Cause does not include unsatisfactory performance, even if that
performance is materially detrimental to our business. Our Manager may terminate the Management Agreement, without payment of the termination fee, in the event we become regulated as an investment
company under the Investment Company Act. Furthermore, our Manager may decline to renew the Management Agreement by providing us with a 180 day prior written notice. Our Manager may also
terminate the Management Agreement upon 60 days prior written notice if we default in the performance of any material term of the Management Agreement and the default continues for a period of
30 days after written notice to us, whereupon we would be required to pay our Manager the termination fee described above.

We
do not employ personnel and therefore rely on the resources and personnel of our Manager to conduct our operations. For performing these services under the Management Agreement, our
Manager receives a base management fee and incentive compensation based on our performance. Our Manager also receives reimbursements for certain expenses, which are made on the first business day of
each calendar month.

Base Management Fee.We pay our Manager a base management fee monthly in arrears in an amount equal to 1/12 of our equity, as defined in
the
Management Agreement, multiplied by 1.75%. We believe that the base management fee that our Manager is entitled to receive is generally comparable to the base management fee received by the managers
of comparable externally managed specialty finance companies. Our Manager uses the proceeds from its management fee in part to pay compensation to its officers and employees who, notwithstanding that
certain of them also are officers of us, receive no compensation directly from us.

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For
purposes of calculating the base management fee, our equity means, for any month, the sum of (i) the net proceeds from any issuance of our common shares, after deducting any
underwriting discount and commissions and other expenses and costs relating to the issuance, (ii) the net proceeds of any trust preferred stock issuances and convertible debt issuances that are
approved by our board of directors, and (iii) our retained earnings at the end of such month (without taking into account any non-cash equity compensation expense incurred in
current or prior periods), which amount shall be reduced by any amount that we pay for the repurchases of our common shares. The foregoing calculation of the base management fee is adjusted to exclude
special one-time events pursuant to changes in accounting principles generally accepted in the
United States of America ("GAAP"), as well as non-cash charges, after discussion between our Manager and our independent directors and approval by a majority of our independent directors
in the case of non-cash charges.

Our
Manager is required to calculate the base management fee within fifteen business days after the end of each month and deliver that calculation to us promptly. We are obligated to pay
the base management fee within twenty business days after the end of each month. We may elect to have our Manager allocate the base management fee among us and our subsidiaries, in which case the fee
would be paid directly by each entity that received an allocation.

Our
Manager waived 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 our common share closing price on the NYSE is $20.00 or more for five consecutive trading days. Accordingly, our Manager permanently waived approximately
$8.8 million of base management fees during each of the years ended December 31, 2010, 2009 and 2008. For the year ended December 31, 2010, $19.1 million of base management
fees were earned by our Manager.

Reimbursement of Expenses.Because our Manager's employees perform certain legal, accounting, due diligence tasks and other services
that outside
professionals or outside consultants otherwise would perform, our Manager is paid or reimbursed for the documented cost of performing such tasks, provided that such costs and reimbursements are no
greater than those which would be paid to outside professionals or consultants on an arm's-length basis.

We
also pay all operating expenses, except those specifically required to be borne by our Manager under the Management Agreement. The expenses required to be paid by us include, but are
not limited to, rent, issuance and transaction costs incident to the acquisition, disposition and financing of our investments, legal, tax, accounting, consulting and auditing fees and expenses, the
compensation and expenses of our directors, the cost of directors' and officers' liability insurance, the costs associated with the establishment and maintenance of any credit facilities and other
indebtedness of ours (including commitment fees, accounting fees, legal fees and closing costs), expenses associated with other securities offerings of ours, expenses relating to making distributions
to our shareholders, the costs of printing and mailing proxies and reports to our shareholders, costs associated with any computer software or hardware, electronic equipment, or purchased information
technology services from third party vendors, costs incurred by employees of our Manager for travel on our behalf, the costs and expenses incurred with respect to market information systems and
publications, research publications and materials, and settlement, clearing, and custodial fees and expenses, expenses of our transfer agent, the costs of maintaining compliance with all federal,
state and local rules and regulations or any other regulatory agency, all taxes and license fees and all insurance costs incurred by us or on our behalf. In addition, we will be required to pay our
pro rata portion of rent, telephone, utilities, office furniture, equipment, machinery and other office, internal and overhead expenses of our Manager and its affiliates required for our operations.
Except as noted above, our Manager is responsible for all costs incident to the performance of its duties under the Management Agreement, including compensation of our Manager's employees and other
related expenses, except that we may elect to have our Manager
allocate expenses among us and our subsidiaries, in which case expenses would be paid directly by each entity that received an allocation.

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Incentive Compensation.In addition to the base management fee, our Manager receives quarterly incentive compensation in an amount
equal to the
product of: (i) 25% of the dollar amount by which: (a) our Net Income, before incentive compensation, per weighted average share of our common shares for such quarter, exceeds
(b) an amount equal to (A) the weighted average of the price per share of the common stock of KKR Financial Corp. in its August 2004 private placement and the prices per share of the
common stock of KKR Financial Corp. in its initial public offering and any subsequent offerings by KKR Financial Holdings LLC multiplied by (B) the greater of (1) 2.00% and
(2) 0.50% plus one-fourth of the Ten Year Treasury Rate for such quarter, multiplied by (ii) the weighted average number of our common shares outstanding in such quarter. The
foregoing calculation of incentive compensation will be adjusted to exclude special one-time events pursuant to changes in GAAP, as well as non-cash charges, after discussion
between our Manager and our independent directors and approval by a majority of our independent directors in the case of non-cash charges. The incentive compensation calculation and
payment shall be made quarterly in arrears. For purposes of the foregoing: "Net Income" will be determined by calculating the net income available to shareholders before non-cash equity
compensation expense, in accordance with GAAP; and "Ten Year Treasury Rate" means the average of weekly average yield to maturity for United States Treasury securities (adjusted to a constant maturity
of ten years) as published weekly by the Federal Reserve Board in publication H.15 or any successor publication during a fiscal quarter.

Our
ability to achieve returns in excess of the thresholds noted above in order for our Manager to earn the incentive compensation described in the preceding paragraph is dependent upon
various factors, many of which are not within our control.

Our
Manager is required to compute the quarterly incentive compensation within 30 days after the end of each fiscal quarter, and we are required to pay the quarterly incentive
compensation with respect to each fiscal quarter within five business days following the delivery to us of our Manager's written statement setting forth the computation of the incentive fee for such
quarter. We may elect to have our Manager allocate the incentive fee among us and our subsidiaries, in which case the fee would be paid directly by each entity that received an allocation.

For
the year ended December 31, 2010, $38.8 million of incentive fees were earned by our Manager.

The Collateral Management Agreements

An affiliate of our Manager has entered into separate management agreements with 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") and is entitled to receive fees for the
services performed as the collateral manager under the management agreements. The collateral manager has the option to waive the fees it earns for providing management services for the CLOs and has
done so in prior periods.

Beginning
April 2007, the collateral manager ceased waiving fees for CLO 2005-1 and beginning January 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). However, starting in July 2009, the collateral manager reinstated waiving the CLO management fees for CLO 2005-2 and CLO 2006-1, and starting in 2010, the collateral
manager reinstated waiving the CLO management fees for CLO 2007-A and CLO 2007-1. 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 fees for CLO 2009-1. As such, the CLO management fees for all CLOs, except for CLO 2005-1,
are being waived or are no longer entitled to be received as of December 31, 2010.

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The aggregate amounts waived are inversely related to the total CLO management fees expensed. Accordingly, for the year ended December 31, 2010, the collateral manager waived
aggregate CLO management fees of $30.6 million and we recorded an expense for CLO management fees totaling $5.4 million.

General
and administrative expenses include expenses incurred by our Manager on our behalf that are reimbursable to our Manager pursuant to the Management Agreement. Beginning
January 1, 2009, our Manager permanently waived reimbursable general and administrative expenses allocable to us in an amount equal to the incremental CLO management fees received by the
Manager. For the year ended December 31, 2010, our Manager permanently waived reimbursement of allocable general and administrative expenses totaling $2.4 million. Due to the
reinstatement of waived CLO management fees described above, effective June 2010, all incremental CLO management fees received by our Manager had been fully applied to offset these reimbursable
expenses. Accordingly, for the year ended December 31, 2010, we reimbursed our Manager for allocable general and administrative expenses totaling $4.6 million.

Competition

Our net income depends, in large part, on our ability to acquire assets at favorable spreads over our borrowing costs. A number of
entities compete with us to make the types of investments that we make. We compete with financial companies, public and private funds, commercial and investment banks and commercial finance companies.
Several other entities have recently raised, or are expected to raise, significant amounts of capital, and may have investment objectives that overlap with ours, which may create competition for
investment opportunities. Some competitors may have a lower cost of funds than us and access to financing sources that are not available to us. In addition, some of our competitors may have higher
risk tolerances or different risk assessments, which could allow them to consider a wider variety of investments and establish more relationships than us.

We
cannot assure our shareholders that the competitive pressures we face will not have a material adverse effect on our business, financial condition and results of operations. Also, as
a result of this competition, we may not be able to take advantage of attractive investment opportunities from time to time, and we do not offer any assurance that we will be able to identify and make
investments that are consistent with our investment objectives.

Staffing

We do not have any employees. We are managed by KKR Financial Advisors LLC, our Manager, pursuant to the Management Agreement.
Our Manager is a wholly-owned subsidiary of KAM and all of our executive officers are members or employees of KKR or one or more of its affiliates.

Income Taxes

We intend to continue to operate so as to qualify, for United States federal income tax purposes, as a partnership and not as an
association or publicly traded partnership taxable as a corporation. Therefore, we generally are not subject to United States federal income tax at the entity level, but are subject to limited state
income taxes. Holders of our shares will be required to take into account their allocable share of each item of our income, gain, loss, deduction, and credit for our taxable year ending within or with
their taxable year.

During
2010, we owned an equity interest in a REIT subsidiary, KFH II. KFH II has elected to be taxed as a REIT under 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.

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We
have wholly-owned domestic and foreign subsidiaries that are taxable as corporations for United States federal income tax purposes and thus are not consolidated by us 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 us with respect to our 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, we will be required to include their current taxable income in our calculation of our taxable income allocable to shareholders. CLO 2005-1,
CLO 2005-2, CLO 2006-1, CLO 2007-1, CLO 2007-A and CLO 2009-1 are our foreign subsidiaries 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.

REIT Matters

As of December 31, 2010, we believe that KFH II qualified as a REIT under the Code. The Code requires, among other things, that
at the end of each calendar quarter at least 75% of a REIT's total assets must be "real estate assets" as defined in the Code. The Code also requires that each year at least 75% of a REIT's gross
income come from real estate sources and at least 95% of a REIT's gross income come from real estate sources and certain other passive sources itemized in the Code, such as dividends and interest. As
of December 31, 2010, we believe KFH II was in compliance with all requirements necessary to be taxed as a REIT. However, the sections of the Code and the corresponding United States Treasury
Regulations that relate to qualification and taxation as a REIT are highly technical and complex, and KFH II's qualification and taxation as a REIT depends upon its ability to meet various
qualification tests imposed under the Code (such as those described above), including through its actual annual operating results, asset composition, distribution levels and diversity of share
ownership. Accordingly, no assurance can be given that KFH II will be deemed to have been organized and to have operated, or to continue to be organized and operated, in a manner so as to qualify or
remain qualified as a REIT.

Restrictions on Ownership of Our Common Shares

Due to limitations on the concentration of ownership of a REIT imposed by the Code, our amended and restated operating agreement, among
other limitations, generally prohibits any shareholder from beneficially or constructively owning more than 9.8% in value or in number of shares, whichever is more restrictive, of any class or series
of the outstanding shares of our company. Our board of directors has discretion to grant exemptions from the ownership limit, subject to terms and conditions as it deems appropriate.

Distribution Policy

The amount and timing of our distributions to the holders of our common shares are determined by our board of directors and is based
upon a review of various factors including current market conditions, existing restrictions to pay dividends or make certain other restricted payments in accordance with our credit facility agreement
and our liquidity needs.

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Compliance with Applicable Environmental Laws

We have made and may continue to make certain investments in the oil and gas industries. These industries present inherent
environmental and safety risks and are subject to stringent and complex foreign, federal, state and local environmental laws, ordinances and regulations. Under these laws, ordinances and regulations,
regardless of fault, owners and operators of oil and gas properties and facilities can be held jointly and severally liable for the cost of remediating contamination and providing compensation for
damages to natural resources. The oil and gas industries also present inherent risk of personal and property injury. On-going compliance with environmental laws, ordinances and regulations
applicable to the oil and gas industries, including compliance with more stringent legal requirements that may be imposed in the future, may entail significant expense and can require permits that may
be difficult to obtain. Environmental and safety obligations and liabilities can be substantial and could adversely impact the value of our investments, our ability to use these investments as
collateral and may otherwise have a material adverse effect on our results of operations.

Item 1A.    RISK FACTORS

Our shareholders should carefully consider the risks described below. The risks described below are not the only risks we face. We have
only described the risks we consider to be
material. However, we may face additional risks that are viewed by us as not material or are not presently known to us.

This
Annual Report on Form 10-K contains a summary of some of the terms of our operating agreement and the Management Agreement. Those summaries are not complete and
are subject to, and qualified in their entirety by reference to, all of the provisions of our operating agreement and the Management Agreement, copies of which have been included as exhibits to the
quarterly report on Form 10-Q that we filed with the SEC on August 6, 2009 and are available on the SEC website at www.sec.gov.

Risks Related to Our Operations, Business Strategy and Investments

Our business and the businesses in which we invest are materially affected by conditions in the global financial markets and economic conditions generally.

Our business and the businesses of the companies in which we invest are materially affected by conditions in the global financial
markets and economic conditions generally. For example, beginning in the third quarter of 2007, and particularly during the second half of 2008, the credit and securities markets were materially and
adversely affected by significant declines in the values of nearly all asset classes and by a serious lack of liquidity. This was initially triggered by declines in the values of subprime mortgages,
but spread to all mortgage and real estate asset classes, leveraged bank loans and nearly all asset classes, including equities. The decline in asset values caused increases in margin calls for
investors, requirements that derivatives counterparties post additional collateral and redemptions by mutual and hedge fund investors, all of which increased the downward pressure on asset values and
outflows of client funds across the financial services industry. In addition, the increased redemptions and unavailability of credit required hedge funds and others to rapidly reduce leverage, which
increased volatility and further contributed to the decline in asset values.

Although
the global financial markets exhibited signs of recovery in 2010, there can be no assurance that these markets will continue to improve in the near term or at all. If the
overall business environment worsens, our results of operations may be adversely affected.

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Dislocations in the corporate credit sector could adversely affect us and one or more of our lenders, which could result in increases in our borrowing costs, reductions in
our liquidity and reductions in the value of the investments in our portfolio.

Dislocations in the corporate credit sector, such as those experienced beginning in the third quarter of 2007 through the beginning of
2010, could adversely affect one or more of the counterparties providing funding for our investments and could cause those counterparties to be unwilling or unable to provide us with additional
financing which may adversely affect our liquidity and financial condition. This could potentially limit our ability to finance our investments and operations, increase our financing costs and reduce
our liquidity. This risk is exacerbated by the fact that a substantial portion of our financing is provided by a relatively small number of counterparties. If one or more major market participants
were to fail or withdraw from the market, it could negatively impact the marketability of all fixed income securities and this could reduce the value of the securities in our portfolio, thus reducing
our net book value. Furthermore, if one or more of our counterparties were unwilling or unable to provide us with ongoing financing, we could be forced to sell our investments at a time when prices
are depressed.

Liquidity is essential to our businesses and we rely on external sources to finance a significant portion of our operations. If we are unable to raise funding from these
external sources, we may be forced to liquidate certain of our assets and our results of operations may be adversely affected.

Liquidity is essential to our business. Our liquidity could be substantially adversely affected by an inability to raise funding in the
long-term or short-term debt capital markets or the equity capital markets or an inability to access the secured lending markets. Factors that we cannot control, such as
disruptions in the financial markets or negative views about corporate credit investing and the specialty finance industry generally, could impair our ability to raise funding. In addition, our
ability to raise funding could be impaired if lenders develop a negative perception of our long-term or short-term financial prospects. Such negative perceptions could develop
if we incur large trading losses, or we suffer a decline in the level of our business activity, among other reasons. If we are unable to raise funding using the methods described above, we would
likely need to liquidate unencumbered assets, such as our investment and trading portfolios, to meet maturing liabilities. We may be unable to sell some of our assets, or we may have to sell assets at
a discount from market value, either of which could adversely affect our results of operations and may have a negative impact on the market price of our shares and any other securities we may issue.

Periods of adverse market volatility may require us to post additional collateral, which could adversely affect our financial condition and liquidity.

During periods of adverse market volatility, such as the periods we observed during the global credit crisis, we are exposed to the
risk that we may have to post additional margin collateral, which may have a material adverse impact on our liquidity. Certain of our financing facilities allow the counterparties, to varying degrees,
to determine a new market value of the collateral to reflect current market conditions. If a counterparty determines that the value of the collateral has decreased, it may initiate a margin call and
require us to either post additional collateral or repay a portion of the outstanding borrowing, on minimal notice. A significant increase in margin calls could harm our liquidity, results of
operations, financial condition, and business prospects. Additionally, in order to obtain cash to satisfy a margin call, we may be required to liquidate assets or raise capital at a disadvantageous
time, which may cause us to incur further losses or otherwise adversely affect our results of operations and financial condition, may impair our ability to pay distributions to our shareholders and
may have a negative impact on the market price of our shares and any other securities we may issue. Our contingent liquidity reserves may not be sufficient in the event of a material adverse change in
the credit markets and related market price market volatility.

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We leverage a portion of our portfolio investments, which may adversely affect our return on our investments and may reduce cash available for distribution.

We leverage a portion of our portfolio investments through borrowings, generally through the use of bank credit facilities, total rate
of return swaps ("TRS"), securitizations, including the issuance of CLOs, and other borrowings. The percentage of leverage varies depending on our ability to obtain credit facilities and the lenders'
and rating agencies' estimate of the stability of the portfolio investments' cash flow. As of December 31, 2010, the only contractual limitation on our ability to leverage our portfolio is a
covenant contained in our senior secured credit facility that our leverage ratio cannot exceed 2.0 to 1.0, computed on a basis that generally excludes the debt of variable interest entities that we
consolidate under GAAP such as our CLO subsidiaries. Our ability to generate returns on our investments and make cash available for distribution to holders of our shares would be reduced to the extent
that changes in market conditions cause the cost of our financing to increase relative to the income that can be derived from the assets acquired and financed.

If we are unable to continue to utilize CLOs successfully, we may be unable to grow or fully execute our business strategy and our results of operations may be adversely
affected.

We finance a substantial portion of our investments through, and derive a substantial portion of our revenue from, our CLO
subsidiaries. These CLOs serve as long-term, non-recourse financing for fixed income investments and as a way to minimize refinancing risk, minimize maturity risk and secure a
fixed cost of funds over an underlying market interest rate. An inability to continue to utilize CLOs successfully could limit our ability to fund future investments, grow our business or fully
execute our business strategy and our results of operations may be adversely affected.

We may enter into derivative contracts that could expose us to contingent liabilities in the future.

Part of our investment strategy involves entering into derivative contracts that could require us to fund cash payments in the future
under certain circumstances, including an event of default or other early termination event, or the decision by a counterparty to request margin securities under the terms of the derivative contract.
The amounts due with respect to swaps would generally be equal to the unrealized loss of the open swap positions with the respective counterparty and could also include other fees and charges. These
payments are contingent liabilities and therefore may not appear on our balance sheet. Our ability to fund these contingent liabilities will depend on the liquidity of our assets and access to capital
at the time, and the need to fund these contingent liabilities could adversely impact our financial condition.

The derivatives that we use to hedge against interest rate exposure are volatile and may adversely affect our results of operations, which could adversely affect our ability
to make payments due on our indebtedness and cash available for distribution to holders of our shares.

From time to time, we enter into interest rate swap agreements and may enter into other interest rate hedging instruments as part of
our interest rate risk management strategy. Our hedging activity varies in scope based on the level of interest rates, the type of portfolio investments held, and other changing market conditions.
Interest rate hedging may fail to protect us from interest rate volatility or could adversely affect us because, among other things:



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The
cost of using hedging instruments increases as the period covered by the instrument increases and during periods of rising and volatile interest rates. We may increase our hedging
activity and thus increase our hedging costs during periods when interest rates are volatile or rising and hedging costs have increased.

Any
hedging activity we engage in may adversely affect our results of operations, which could adversely affect our ability to make payments due on our indebtedness and cash available for
distribution to holders of our shares. Therefore, while we may enter into such transactions to seek to reduce interest rate risks, unanticipated changes in interest rates may result in poorer overall
investment performance than if we had not engaged in any such hedging transactions. In addition, the degree of correlation between price movements of the instruments used in a hedging strategy and
price movements in the portfolio positions or liabilities being hedged may vary materially. Moreover, for a variety of reasons, we may not seek to establish a perfect correlation between such hedging
instruments and the portfolio holdings or liabilities being hedged. Any such imperfect correlation may expose us to risk of loss.

The impact of the Dodd-Frank Act on our business is currently uncertain.

On July 21, 2010, the United States enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act (the
"Dodd-Frank Act"). The Dodd-Frank Act affects almost every aspect of the United States financial services industry, including certain aspects of the markets in which we
operate. For example, the Dodd-Frank Act will impose additional disclosure requirements for public companies and generally require issuers or originators of asset-backed securities to
retain at least five percent of the credit risk associated with the securitized assets. In addition, the Dodd-Frank Act:



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Many
of the provisions of the Dodd-Frank Act are subject to further rule making and to the discretion of regulatory bodies, such as the Financial Stability Oversight Council,
and there can be no assurance that, as result of such rule making or decision making, we will not become subject to the restrictions or other requirements for financial firms deemed to be systemically
significant to the financial health of the United States economy. As a result, we currently are uncertain as to whether the Dodd-Frank Act will have a significant and potentially adverse
impact on our business.

Hedging instruments often are currently subject to limited regulation and involve risks and costs.

While provisions of the Dodd-Frank Act granted specified United States regulatory bodies the authority to regulate the
trading of derivatives, including hedging instruments, these provisions remain subject to final rule making. As a result, hedging instruments are currently only subject to limited regulation.
Consequently, there are currently no requirements with respect to record keeping, financial responsibility or segregation of customer funds and positions. Furthermore, the enforceability of agreements
underlying hedging transactions may depend on compliance with applicable statutory, commodity and other regulatory requirements and, depending on the identity of the counterparty, applicable
international requirements. The business failure of a hedging counterparty with whom we enter into a hedging transaction will most likely result in a default. Default by a party with whom we enter
into a hedging transaction may result in the loss of unrealized profits and force us to cover our resale commitments, if any, at the then current market price. It may not always be possible to dispose
of or close out a hedging position without the consent of the hedging counterparty, and we may not be able to enter into an offsetting contract in order to cover our risk. We cannot assure our
shareholders that a liquid secondary market will exist for hedging instruments purchased or sold, and we may be required to maintain a position until exercise or expiration, which could result in
losses.

We make non-United States dollar denominated investments, which subject us to currency rate exposure and the uncertainty of foreign laws and markets.

We purchase investments denominated in foreign currencies, including investments in both developed and emerging overseas markets. A
change in foreign currency exchange rates may have an adverse impact on returns on any of these non-dollar denominated investments. Although we may choose to hedge our foreign currency
risk, we may not be able to do so successfully and may incur losses on these investments as a result of exchange rate fluctuations. Investments in foreign countries also subject us to certain
additional risks, including risks relating to the potential imposition of non-United States taxes, compliance with multiple and potentially conflicting regulatory schemes and political and
economic instability abroad, any of which could adversely affect our returns on these investments.

We may not realize gains or income from our investments.

We seek to generate both current income and capital appreciation. The assets in which we invest may not appreciate in value, however,
and, in fact, may decline in value, and the debt securities in which we invest may default on interest and/or principal payments. Accordingly, we may not be able to realize gains or income from our
investments. Additionally, any gains that we do realize may not be sufficient to offset any other losses we experience or offset our expenses.

The terms of our indebtedness may restrict our ability to make future distributions, make cash payments in respect of any conversion or repurchases of indebtedness and
impose limitations on our current and future operations.

The agreement governing our senior secured credit facility, maturing on May 3, 2014 (the "2014 Facility") contains, and any
future indebtedness may also contain, a number of restrictive covenants that impose operating and other restrictions on us, including restrictions on our ability to engage in our

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current
and future operations or to make distributions to holders of our shares. The 2014 Facility credit agreement includes covenants restricting our ability to:



In
addition, the 2014 Facility credit agreement also includes financial covenants, including requirements that we:



As
a result of these covenants, we are limited in the manner in which we conduct our business and we may be unable to engage in favorable business activities or finance future operations
or capital needs. Our ability to comply with the covenants and restrictions contained in the agreements governing our indebtedness may be affected by economic, financial and industry conditions beyond
our control. A breach of any of these covenants could result in a default under the 2014 Facility credit agreement. Upon the occurrence of an event of default under the 2014 Facility credit agreement,
the lenders are not required to lend any additional amounts to us and could elect to declare all borrowings outstanding thereunder, together with accrued and unpaid interest and fees, to be due and
payable, which could also result in an event of default under our other agreements relating to our borrowings. If we were unable to refinance these borrowings on favorable terms, our results of
operations and financial condition could be adversely impacted by increased costs and less favorable terms, including higher interest rates and more restrictive covenants. The instruments governing
the terms of any future refinancing of any borrowings are likely to contain similar or more restrictive covenants.

We currently have indebtedness, some of which matures in the near term. We may not be able to generate sufficient cash to service or make required repayments of our
indebtedness and we may be forced to take other actions to satisfy our obligations under our indebtedness, which may not be successful.

As of December 31, 2010, we had approximately $636.6 million of total recourse debt outstanding.

Our
debt level and related debt service obligations:



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A
breach of any of the covenants in our debt agreements could result in a default under our 2014 Facility, 7.0% convertible senior notes ("7.0% Notes") and 7.5% convertible senior notes
("7.5%
Notes"). If a default occurs under any of these obligations and we are not able to obtain a waiver from the requisite debt holders, then, among other things, our debt holders could declare all
outstanding principal and interest to be immediately due and payable. If our outstanding indebtedness were to be accelerated, we cannot assure you that our assets would be sufficient to repay in full
that debt and any potential future indebtedness, which would cause the market price of our common shares to decline significantly. We could also be forced into bankruptcy or liquidation.

There can be no assurances that our operations will generate sufficient cash flows or that credit facilities will be available to us in an amount sufficient to enable us to
pay our indebtedness or to fund other liquidity needs.

Our ability to make scheduled payments or prepayments on our debt and other financial obligations will depend on our future financial
and operating performance and the value of our investments. There can be no assurances that our operations will generate sufficient cash flows or that new sources of credit will be available to us in
an amount sufficient to enable us to pay our indebtedness or to fund our other liquidity needs. Our financial and operating performance is subject to prevailing economic and industry conditions and to
financial, business and other factors, some of which are beyond our control. Our substantial leverage exposes us to significant risk during periods of economic downturn such as the one we recently
experienced, as our cash flows may decrease, but our required principal payments in respect of indebtedness do not change and our interest expense obligations could increase due to increases in
interest rates.

If
our cash flows and capital resources are insufficient to fund our debt service obligations, we will likely face increased pressure to dispose of assets, seek additional capital or
restructure or refinance our indebtedness. These actions could have a material adverse effect on our business, financial condition and results of operations. In addition, we cannot assure that we
would be able to take any of these actions, that these actions would be successful and permit us to meet our scheduled debt service obligations or that these actions would be permitted under the terms
of our existing or future debt agreements, including our 2014 Facility credit agreement. For example, we may need to refinance all or a portion of our indebtedness on or before maturity. There can be
no assurance that we will be able to refinance any of our indebtedness on commercially reasonable terms or at all. In the absence of improved operating results and access to capital resources, we
could face substantial liquidity problems and might be required to dispose of material assets or operations to meet our debt service and other obligations. The 2014 Facility credit agreement restricts
our ability to dispose of assets and use the proceeds from such dispositions. We may not be able to consummate those dispositions or to obtain the

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proceeds
realized. Additionally, these proceeds may not be adequate to meet our debt service obligations then due.

If
we cannot make scheduled payments or prepayments on our debt, we will be in default and, as a result, among other things, our debt holders could declare all outstanding principal and
interest to be due and payable and we could be forced into bankruptcy or liquidation or required to substantially restructure or alter our business operations or debt obligations.

Variable rate indebtedness subjects us to interest rate risk, which could cause our debt service obligations to increase significantly.

As of December 31, 2010, approximately $128.9 million of our recourse borrowings, consisting of our junior subordinated
notes issued in connection with our trust preferred securities, were at variable rates of interest and expose us to interest rate risk. If interest rates increase, our debt service obligations on the
variable rate indebtedness would increase even though the amount borrowed remained the same. We may use interest rate derivatives such as interest rate swap agreements to hedge the variability of the
cash flows associated with our existing or forecasted variable rate borrowings. Although we may enter into additional interest rate swaps, involving the exchange of floating for fixed rate interest
payments, to reduce interest rate volatility, such hedging may increase our costs of funding. We cannot provide assurances that we will be able to enter into interest rate hedges that effectively
mitigate our exposure to interest rate risk.

Declines in the fair values of our investments may adversely affect our results of operations and credit availability, which may adversely affect, in turn, our ability to
make payments due on our indebtedness and our cash available for distribution to holders of our shares.

A substantial portion of our assets are, and we believe are likely to continue to be, classified for accounting purposes as
"available-for-sale" so long as it is management's intent not to sell such assets and we have sufficient financial wherewithal to hold the investment until its scheduled
maturity.

Changes
in the fair values of those assets will be directly charged or credited to our shareholders' equity in each period even if no sale is made. As a result, a decline in values would
reduce the book value of our assets. Moreover, if the decline in value of an available-for-sale security is considered by our management to be other than temporary, such
decline will be recorded as a charge which will adversely affect our results of operations.

A
decline in the market value of our assets may adversely affect our results of operations, particularly in instances where we have borrowed money based on the market value of those
assets. If the market value of those assets declines, the lender may require us to post additional collateral to support the loan. If we were unable to post the additional collateral, we would have to
sell the assets at a time when we might not otherwise choose to do so. A reduction in credit available may adversely affect our
results of operations, our ability to make payments due on our indebtedness and cash available for distribution to holders of our shares.

Further,
financing counterparties may require us to maintain a certain amount of cash or to set aside unlevered assets sufficient to maintain a specified liquidity position intended to
allow us to satisfy our collateral obligations. As a result, we may not be able to leverage our assets as fully as we would choose, which may reduce our return on equity. In the event that we are
unable to meet these contractual obligations, our financial condition could deteriorate rapidly because we may be required to sell our investments at distressed prices in order to meet such margin or
liquidity requirements.

Market
values of our investments may decline for a number of reasons, such as causes related to changes in prevailing market rates, increases in defaults, increases in voluntary
prepayments for those investments that we have that are subject to prepayment risk, and widening of credit spreads.

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If credit spreads on our borrowings increase and the credit spreads on our investments do not also increase, we are unlikely to achieve our projected leveraged
risk-adjusted returns. Also, if credit spreads on investments increase in the future, our existing investments will likely experience a material reduction in value.

We make investment decisions based upon projected leveraged risk-adjusted returns. When making such projections we make
assumptions regarding the long-term cost of financing such investments, particularly the credit spreads associated with our long-term financings. We define credit spread as the
risk premium for taking credit risk which is the difference between the risk free rate and the interest rate paid on the applicable investment or loan, as the case may be. If credit spreads on our
long-term financings increase and the credit spreads on our investments are not increased accordingly, we will likely not achieve our targeted leveraged risk-adjusted returns
and we will likely experience a material adverse reduction in the value of our investments.

The terms of our settlement agreement with certain holders of securities issued by one of our CLOs restricts our ability to restructure certain CLO debt obligations in the
future, which may reduce our financial flexibility in the event of future adverse market or credit conditions. In addition, certain noteholders of one of our other CLOs have notified us of a similar
dispute and we may be notified of similar disputes by other noteholders of our CLOs in the future.

On July 10, 2009, we surrendered for cancellation, without consideration, approximately $298.4 million in aggregate of
mezzanine and junior notes issued to us by CLO 2005-1, CLO 2005-2 and CLO 2006-1. The surrendered notes were cancelled by the trustee under the applicable
indentures, and the obligations due under such surrendered notes were deemed extinguished.

As
a result, the over-collaterization tests for these CLOs were brought into compliance, enabling the mezzanine and subordinated note holders, including us, to resume
receiving cash flows from these CLOs during the period the over-collaterization tests remain in compliance. We believe, in consultation with our outside advisers, that none of the actions
taken in connection with these note cancellation transactions were in violation of either the respective indentures governing each CLO transaction or applicable law. Nevertheless, holders constituting
a majority of the controlling class of senior notes of CLO 2005-2 (the "2005-2 Noteholders") challenged the July 2009 surrender for cancellation and notified the related
trustee of purported defaults under the indenture related to the surrender and cancellation of the notes issued to us by CLO 2005-2. We subsequently reached an agreement with the
2005-2 Noteholders pursuant to which the 2005-2 Noteholders agreed, subject to the terms and conditions of the agreement, not to challenge the July 2009 surrender for
cancellation, without consideration, of $64 million of mezzanine notes issued to us by CLO 2005-2. In exchange, we 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 us by CLO 2005-2. In addition, we agreed with the 2005-2
Noteholders that, for so long as no legal action or similar challenge is brought to our July 2009 surrender of notes in any of our CLOs, we will not undertake a similar surrender for cancellation
without consideration of any mezzanine notes or junior notes issued to us by CLO 2005-1, CLO 2006-1, CLO 2007-1 and CLO 2007-A.

Because
the terms of the agreement with the 2005-2 Noteholders restrict our ability to effect certain restructuring activities in the future with respect to our CLOs such as
the July 2009 surrender for cancellation, our ability to effect similar note surrender transactions to mitigate future adverse market or credit conditions or to enhance liquidity will be negatively
impacted.

In
addition, certain holders of the senior notes of CLO 2006-1 (the "2006-1 Noteholders") challenged the July 2009 surrender for cancellation and notified the
related trustee of purported defaults under the indenture related to the surrender of the notes issued to us by CLO 2006-1. It is also possible that holders of notes issued by CLO
2005-1 may challenge our surrender for cancellation of notes issued to us by CLO 2005-1.

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No
assurance can be given that we will be able to reach resolutions with the 2006-1 Noteholders, or, if such a challenge is made, with any CLO 2005-1 Noteholders,
similar to those reached with the 2005-2 Noteholders. Despite our determination that our actions in connection with the note cancellation transactions were permitted and our agreement with
the 2005-2 Noteholders, if we are unable to reach an amicable resolution with the 2006-1 Noteholders, or, if such a challenge is made, with any 2005-1
Noteholders, then in connection with any ensuing litigation, we could incur significant legal fees or face material interruption of cash flows from the affected CLOs or other material damages or
restrictions while such dispute is being contested or if such transactions were to be found a violation of the applicable indenture.

Downturns in the global credit markets may adversely affect our cash flow CLO investments.

Among the sectors particularly challenged by adverse economic conditions, including those experienced from late 2007 into early 2010,
are the CLO and leveraged finance markets. We have significant exposure to these markets through our investments in CLO 2005-1, CLO 2005-2, CLO 2006-1, CLO
2007-1 and CLO 2007-A (collectively, "our cash flow CLOs"), each of which is a Cayman Islands incorporated special purpose company that issued to us and other investors notes
secured by a pool of collateral consisting primarily of corporate leveraged loans. In most cases, our cash flow CLO investments are in deeply subordinated securities issued by the CLO issuers,
representing highly leveraged investments in the underlying collateral, which increases both the opportunity for higher returns as well as the magnitude of losses when compared to other investors in
these CLO structures that rank more senior to us in right of payment. As a result of our subordinated position in these CLO structures, we and our investors are at greater risk of suffering losses on
our cash flow CLO investments during periods of adverse economic conditions.

During
an economic downturn, the CLO issuers in which we invest may experience increases in downgrades, depreciations in market value and defaults in respect of leveraged loans in their
collateral. The CLO issuers' portfolio profile tests set limits on the amount of discounted obligations a CLO can hold. During any time that a CLO issuer exceeds such a limit, the ability of the CLO's
manager to sell assets and reinvest available principal proceeds into substitute assets is restricted. In addition, discounted assets and assets rated "CCC" or lower in excess of applicable limits in
the CLO issuers' investment criteria are not given full par credit for purposes of calculation of the CLO issuers' over-collateralization tests. As a result, these CLO issuers may fail one
or more of their over-collateralization tests, which would cause diversions of cash flows away from us as holders of the more junior CLO securities in favor of investors more senior than
us in right of repayment, until the relevant over-collateralization tests are satisfied. This diversion of cash flows may have a material adverse impact on our business and our ability to
make distributions to shareholders. In addition, it is possible that our cash flow CLO issuers' collateral could be depleted before we realize a return on our cash flow CLO investments.

Specifically,
during 2010, CLO 2007-A and CLO 2007-1 were out of compliance with certain compliance tests (specifically, over-collaterization tests)
outlined in their respective indentures and as a result, cash flows we would expect to receive from our CLO holdings were paid to the senior note holders of the CLOs that were out of compliance.

The
ability of the CLO issuers to make interest payments to the holders of the senior notes of those structures is highly dependent upon the performance of the CLO collateral. If the
collateral in those structures was to experience a significant decrease in cash flow due to an increased default level, the issuer may be unable to pay interest to the holders of the senior notes,
which would allow such holders to declare an event of default under the indenture governing the transaction and accelerate all principal and interest outstanding on the senior notes. In addition, our
CLO structures also contain certain events of default tied to the value of the CLO collateral, which events of default could also cause an acceleration of the senior notes. If the value of the CLO
collateral within a CLO were to be

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less
than the amount of senior notes issued and outstanding, the senior note holders would have the ability to declare an event of default.

There
can be no assurance that market conditions giving rise to these types of consequences will not occur, subsist or become more acute in the future. Because our CLO structures involve
complex collateral and other arrangements, the documentation for such structures is complex, is subject to differing interpretations and involves legal risk.

Our investment portfolio is and may continue to be concentrated in a limited number of companies and industries, which will subject us to a risk of significant loss if any
of these companies defaults on its obligations to us or if there is a downturn in a particular industry.

Our investment portfolio is and may continue to be concentrated in a limited number of companies and industries. For example, as of
December 31, 2010, the 20 largest issuers which we have invested in represented approximately 47% of our total debt investment portfolio on an estimated fair value basis. As a result, our
results of operations, financial condition and ability to pay distributions to our shareholders may be adversely affected if a small number of borrowers default in their obligations to us or if we
need to write down the value of any one investment. Additionally, a downturn in any particular industry in which we are invested could also negatively impact our results of operations and our ability
to pay distributions.

Certain of our investments are illiquid and we may not be able to vary our portfolio in response to changes in economic and other conditions.

The securities that we purchase in privately negotiated transactions are not registered under the relevant securities laws, resulting
in restrictions on their transfer, sale, pledge or other disposition except in a transaction that is exempt from the registration requirements of, or is otherwise in accordance with, securities laws.
For example, a majority of the mortgage-backed securities
that we own are traded in private, unregistered transactions and are therefore subject to restrictions on resale or otherwise have no established trading market. As a result, our ability to vary our
portfolio in response to changes in economic and other conditions may be limited relative to our investment in securities that trade in more liquid markets. In addition, if we are required to
liquidate all or a portion of our portfolio quickly, we may realize significantly less than the value at which we have previously recorded our investments. Furthermore, our Manager conducts diligence
on our investments that may provide our Manager with material non-public information with respect to business entities in which we invest. As a result, we may face additional restrictions
on our ability to liquidate an investment in such business entities to the extent that we or our Manager has, or could be attributed with, material non-public information.

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.

Some of our portfolio investments are, and we believe are likely to continue to be, in the form of loans and securities that have
limited liquidity or are not publicly traded. The fair value of investments that have limited liquidity or are not publicly traded may not be readily determinable. We generally value these investments
quarterly at fair value as determined by our Manager pursuant to applicable United States GAAP accounting guidance. Because such valuations are inherently uncertain and may fluctuate over short
periods of time and be based on estimates, our determinations of fair value may differ materially from the values that would have been used if a ready market for these investments existed. The market
value of our shares and any other securities we may issue could be adversely affected if our determinations regarding the fair value of these investments are materially higher than the values that we
ultimately realize upon their disposal.

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Our assets include leveraged loans, high yield securities, mezzanine bonds and loans, marketable equity securities and private equity, each of which has greater risks of
loss than secured senior loans and, if those losses are realized, it could adversely affect our results of operations, our ability to service our indebtedness and our cash available for distribution
to holders of our shares.

Our assets include leveraged loans, high yield securities, mezzanine bonds and loans, marketable equity securities and private equity,
each of which involves a higher degree of risk than senior secured loans. The leveraged loans and high yield securities may not be secured by mortgages or liens on assets. Even if secured, these
leveraged loans and high yield securities may have higher loan-to-value ratios than senior secured loans. Furthermore, our right to payment and the security interest in any
collateral underlying such loans may be subordinated to the payment rights and security interests with respect to a more senior lender. Therefore, we may be limited in our ability to enforce our
rights to collect these loans and to recover any of the loan balances through a foreclosure of collateral.

Certain
of these leveraged loans and high yield securities may have an interest-only payment schedule, with the principal amount remaining outstanding and at risk until the
maturity of the loan. In this case, a borrower's ability to repay its loan may be dependent upon a refinancing or a liquidity event that will enable the repayment of the loan.

High
yield bonds are rated below investment-grade by one or more nationally recognized statistical rating organizations or are unrated but of comparably low credit quality. This lower
rating, or lack of a rating, reflects a greater possibility that the obligor may fail to make payments of principal and interest, and ultimately default, under these securities. For example, many
issuers of high yield bonds are highly leveraged, and their relatively high debt-to-equity ratios create increased risks that their operations might not generate sufficient
cash flow to service their debt obligations. As a result, high yield securities are often less liquid than higher rated bonds.

In
addition to the above, numerous other factors may affect a company's ability to repay its loan, including the failure to meet its business plan, a downturn in its industry or negative
economic conditions. A deterioration in a company's financial condition and prospects may be accompanied by deterioration in the collateral for the high yield securities and leveraged loans. Losses on
our high yield securities and leveraged loans could adversely affect our results of operations, which could adversely affect our ability to service our indebtedness and cash available for distribution
to holders of our shares.

In
addition, marketable equity securities and private equity may also have a greater risk of loss than senior secured loans since such equity investments are subordinate to debt of the
issuer and are not secured by property underlying the investment.

The mortgage loans underlying the mortgage-backed securities we invest in are subject to delinquency, foreclosure and loss, which could result in losses to us.

As of December 31, 2010, we held residential mortgage-backed securities with an aggregate estimated fair value of
$93.9 million. Residential mortgage-backed securities evidence interests in or are secured by pools of residential mortgage loans. Accordingly, the mortgage-backed securities we invest in are
subject to all of the risks of the underlying mortgage loans. Residential mortgage loans are secured by single-family residential property and are subject to risks of delinquency, foreclosure and
risks of loss. The ability of a borrower to repay a loan secured by a residential property is dependent upon the income or assets of the borrower. A number of factors, including a general economic
downturn, acts of God, terrorism, social unrest and civil disturbances, may impair borrowers' abilities to repay their loans. Foreclosure of a mortgage loan can be an expensive and lengthy process
that could have a substantial negative effect on our anticipated return on the foreclosed mortgage loan.

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Our rights under our indirect investments in corporate leveraged loans may be more restricted than direct investments in such loans.

We hold interests in corporate leveraged loans originated by banks and other financial institutions. We acquire interests in corporate
leveraged loans either directly by a direct purchase or an assignment, or indirectly through a participation. The purchaser of an assignment typically succeeds to all the rights and obligations of the
assigning institution and becomes a lender under the credit agreement with respect to the debt obligation. In contrast, participation interests in a portion of a debt obligation typically result in a
contractual relationship only with the institution participating out the interest, not with the borrower. Thus, in purchasing participations, we generally will have no right to enforce compliance by
the borrower with the terms of the credit agreement, nor any rights of offset against the borrower, and we may not directly benefit from the collateral supporting the debt obligation in which we have
purchased the participation. As a result, we will assume the credit risk of both the borrower and the institution selling the participation.

There is an inherent risk that we may incur environmental costs and liabilities as a result of our oil and gas investments.

We have made and may continue to make certain investments in the oil and gas industries. These industries present inherent
environmental and safety risks and are subject to stringent and complex foreign, federal, state and local environmental laws, ordinances and regulations.
Under these laws, ordinances and regulations, regardless of fault, owners and operators of oil and gas properties and facilities can be held jointly and severally liable for the cost of remediating
contamination and providing compensation for damages to natural resources. The oil and gas industries also present inherent risk of personal and property injury. On-going compliance with
environmental laws, ordinances and regulations applicable to the oil and gas industries, including compliance with more stringent legal requirements that may be imposed in the future, may entail
significant expense and can require permits that may be difficult to obtain. Environmental and safety obligations and liabilities can be substantial and could adversely impact the value of our
investments, our ability to use these investments as collateral and may otherwise have a material adverse effect on our results of operations.

Total rate of 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.

We may enter into TRS to finance certain of our investments. TRS 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. A TRS agreement is a two-party contract under which an agreement is made
to exchange returns from predetermined investments or instruments. TRS allow investors to gain exposure to an underlying credit instrument without actually owning the credit instrument. In these
swaps, the total return (interest, fixed fees and capital gains/losses on an underlying credit instrument) is paid to an investor in exchange for a floating rate payment. The investor advances a
portion of the notional amount of the TRS which serves as collateral for the TRS counterparty. The TRS, therefore, is a leveraged investment in the underlying credit instrument. The gross returns to
be exchanged or "swapped" between the parties are calculated based on a "notional amount," which is valued monthly to determine each party's obligation under the contract. We recognize all cash flows
received (paid) or receivable (payable) from swap transactions, together with the change in the market value of the underlying credit instrument, on a net basis as realized or unrealized gains or
losses in our consolidated statement of operations. We are charged a finance cost by counterparties with respect to each agreement. The finance cost is reported as part of the realized or unrealized
gains or losses. Because swap maturities may not correspond with the maturities of the credit instruments underlying the swap, we may wish to renew many of the swaps as they mature. However, there is
a limited number of providers of such swaps, and there is no assurance the initial

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swap
providers will choose to renew the swaps, and, if they do not renew, that we would be able to obtain suitable replacement providers.

Credit default swaps are subject to risks related to changes in credit spreads, credit quality and expected recovery rates of the underlying credit instrument.

We may enter into credit default swaps ("CDS") as investments or hedges. CDS are subject to risks related to changes in interest rates,
credit spreads, credit quality and expected recovery rates of the underlying credit instrument. A CDS is a contract in which the contract buyer pays, in the case of a short position, or receives, in
the case of a 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, in the case of a short
position, or makes a payment to, in the case of a long position, the buyer if there is a credit default or other specified credit event with respect to the issuer of the underlying credit instrument
referenced in the CDS.

We may change our investment strategy without shareholder consent, which may result in our making investments that entail more risk than our current investments.

Our investment strategy may evolve, in light of existing market conditions and investment opportunities, and this evolution may involve
additional risks. Investment opportunities that present unattractive risk-return profiles relative to other available investment opportunities under particular market conditions may become
relatively attractive under changed market conditions and changes in market conditions may therefore result in changes in the investments we target. Decisions to make investments in new asset
categories present risks that may be difficult for us to adequately assess and could therefore reduce the stability of our distributions or have adverse effects on our financial condition. A change in
our investment strategy may also increase our exposure to interest rate, commodity, foreign currency or credit market fluctuations. Our failure to accurately assess the risks inherent in new asset
categories or the financing risks associated with such assets could adversely affect our results of operations and our financial condition.

Our dependence on the management of other entities may adversely affect our business.

We do not control the management, investment decisions or operations of the business entities in which we invest. Management of those
enterprises may decide to change the nature of their assets, or management may otherwise change in a manner that is not satisfactory to us. We typically have no ability to affect these management
decisions and we may have only limited ability to dispose of our investments.

Due diligence conducted by our Manager may not reveal all of the risks of the businesses in which we invest.

Before making an investment in a business entity, our Manager typically assesses the strength and skills of the entity's management and
other factors that it believes will determine the success of the investment. In making the assessment and otherwise conducting due diligence, our Manager relies on the resources available to it and,
in some cases, an investigation by third parties. This process is particularly important and subjective with respect to newly organized entities because there may be little or no information publicly
available about the entities. Accordingly, there can be no assurance that this due diligence process will uncover all relevant facts or that any investment will be successful. In addition, we and KKR
have established certain procedures relating to conflicts of interests that may restrict us from accessing certain confidential information in the possession of KKR or one of its affiliates. As a
result, we may pursue investments without obtaining access to such confidential information, which information, if reviewed, might otherwise impact our judgment with respect to such investments.

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We operate in a highly competitive market for investment opportunities.

We compete for investments with various other investors, such as other public and private funds, commercial and investment banks and
other companies, including funds and companies affiliated with our Manager. Some of our competitors have greater resources than we possess or have greater access to capital or various types of
financing structures than are available to us and may have investment objectives that overlap with ours, which may create competition for investment opportunities with limited supply. The competitive
pressures we face could impair our business, financial condition and results of operations. As a result of this competition, we may not be able to take advantage of attractive investment opportunities
from time to time. Furthermore, competition for investments may lead to a decrease in returns available from such investments, which may further limit our ability to generate our desired returns.

Risks Related to our Organization and Structure

Maintenance of our Investment Company Act exemption imposes limits on our operations, which may adversely affect our results of operations.

Section 3(a)(1)(A) of the Investment Company Act defines an investment company as any issuer that is, holds itself out as being,
or proposes to be, primarily engaged in the business of investing, reinvesting or trading in securities and Section 3(a)(1)(C) of the Investment
Company Act defines an investment company as any issuer that is engaged or proposes to engage in the business of investing, reinvesting, owning, holding or trading in securities and owns or proposes
to acquire "investment securities" (within the meaning of the Investment Company Act) having a value exceeding 40% of the value of the issuer's total assets (exclusive of United States government
securities and cash items) on an unconsolidated basis (the "40% test"). Excluded from the term "investment securities" are, among others, securities issued by majority-owned subsidiaries unless the
subsidiary is an investment company or relies on the exceptions from the definition of an investment company provided by Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act
(a "fund"). The Investment Company Act defines a "majority-owned subsidiary" of a person as any company 50% or more of the outstanding voting securities (i.e., those securities presently
entitling the holder thereof to vote for the election of directors of the company) of which are owned by that person, or by another company that is, itself, a majority owned subsidiary of that person.

We
are organized as a holding company. We conduct our operations primarily through our majority-owned subsidiaries. Each of our subsidiaries is either outside of the definition of an
investment company in Sections 3(a)(1)(A) and 3(a)(1)(C), described above, or excepted from the definition of an investment company under the Investment Company Act. We believe that we are not,
and that we do not propose to be, primarily engaged in the business of investing, reinvesting or trading in securities and we do not believe that we have held ourselves out as such. We intend to
continue to conduct our operations so that we are not required to register as an investment company under the Investment Company Act.

We
monitor our holdings regularly to confirm our continued compliance with the 40% test. In calculating our position under the 40% test, we are responsible for determining whether any of
our subsidiaries is majority-owned. We treat subsidiaries in which we own at least 50% of the outstanding voting securities, including those that issue CLOs, as majority-owned for purposes of the 40%
test. Some of our subsidiaries may rely solely on Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act. In order for us to satisfy the 40% test, our ownership interests in
those subsidiaries or any of our subsidiaries that are not majority-owned, together with any other "investment securities" that we may own, may not have a combined value in excess of 40% of the value
of our total assets on an unconsolidated basis and exclusive of United States government securities and cash items. However, most of our subsidiaries either fall outside of the general definitions of
an investment company or rely

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on
exceptions provided by provisions of, and rules and regulations promulgated under, the Investment Company Act (other than Section 3(c)(1) or Section 3(c)(7) of the Investment Company
Act) and, therefore, are not defined or regulated as investment companies. In order to conform to these exceptions, these subsidiaries are limited with respect to the assets in which each of them can
invest and/or the types of securities each of them may issue. We must, therefore, monitor each subsidiary's compliance with its applicable exception and our freedom of action, and that of our
subsidiaries, may be limited as a result. For example, our subsidiaries that issue CLOs generally rely on Rule 3a-7 under Investment Company Act, while KFH II, our subsidiary that
is taxed as a REIT for United States federal income tax purposes, generally relies on Section 3(c)(5)(C) of the Investment Company Act. Each of these exceptions requires, among other things
that the subsidiary (i) not issue redeemable securities and (ii) engage in the business of holding certain types of assets, consistent with the terms of the exception. Similarly, any
subsidiaries engaged in the ownership of oil
and gas assets may, depending on the nature of the assets, be outside the definition of an investment company or rely on exceptions provided by Section 3(c)(5)(C) or Section 3(c)(9) of
the Investment Company Act. While Section 3(c)(9) of the Investment Company Act does not limit the nature of the securities issued, it does impose business engagement requirements that limit
the types of assets that may be held.

We
do not treat our interests in majority-owned subsidiaries that are outside of the general definition of an investment company or that rely on Section 3(c)(5)(C) or
Section 3(c)(9) of, or Rule 3a-7 under, the Investment Company Act as investment securities when calculating our 40% test.

We
sometimes refer to our subsidiaries that rely on Rule 3a-7 under the Investment Company Act as "CLO subsidiaries." Rule 3a-7 under the Investment
Company Act is available to certain structured financing vehicles that are engaged in the business of holding financial assets that, by their terms, convert into cash within a finite time period and
that issue fixed income securities entitling holders to receive payments that depend primarily on the cash flows from these assets, provided that, among other things, the structured finance vehicle
does not engage in certain portfolio management practices resembling those employed by mutual funds. Accordingly, each of these CLO subsidiaries is subject to an indenture (or similar transaction
documents) that contains specific guidelines and restrictions limiting the discretion of the CLO subsidiary and its collateral manager. In particular, these guidelines and restrictions prohibit the
CLO subsidiary from acquiring and disposing of assets primarily for the purpose of recognizing gains or decreasing losses resulting from market value changes. Thus, a CLO subsidiary cannot acquire or
dispose of assets primarily to enhance returns to the owner of the equity in the CLO subsidiary; however, subject to this limitation, sales and purchases of assets may be made so long as doing so does
not violate guidelines contained in the CLO subsidiary's relevant transaction documents. A CLO subsidiary generally can, for example, sell an asset if the collateral manager believes that its credit
quality has declined since its acquisition or that the credit profile of the obligor will deteriorate and the proceeds of permitted dispositions may be reinvested in additional collateral, subject to
fulfilling the requirements set forth in Rule 3a-7 under the Investment Company Act and the CLO subsidiary's relevant transaction documents. As a result of these restrictions, our
CLO subsidiaries may suffer losses on their assets and we may suffer losses on our investments in those CLO subsidiaries.

We
sometimes refer to KFH II, our subsidiary that relies on Section 3(c)(5)(C) of the Investment Company Act, as our "REIT subsidiary." Section 3(c)(5)(C) of the Investment
Company Act is available to companies that are primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on and interests in real estate. While the SEC has not
promulgated rules to address precisely what is required for a company to be considered to be "primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on and
interests in real estate," the SEC's Division of Investment Management, or the "Division," has taken the position, through a series of no-action and interpretive letters, that a company
may rely on Section 3(c)(5)(C) of the Investment Company Act if, among other things, at least 55% of the company's assets consist of

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mortgage
loans, other assets that are considered the functional equivalent of mortgage loans and certain other interests in real property (collectively, "qualifying real estate assets"), and at least
25% of the company's assets consist of real estate-related assets (reduced by the excess of the company's qualifying real estate assets over the required 55%), leaving no more than 20% of the
company's assets to be invested in miscellaneous assets. The Division has also provided guidance as to the types of assets that can be considered qualifying real estate assets. Because the Division's
interpretive letters are not binding except as they relate to the companies to whom they are addressed, if the Division were to change its position as to, among other things, what assets might
constitute qualifying real estate assets our REIT subsidiary might be required to change its investment strategy to comply with the changed position. We cannot predict whether such a change would be
adverse.

Based
on current guidance, our REIT subsidiary classifies investments in mortgage loans as qualifying real estate assets, as long as the loans are "fully secured" by an interest in real
estate on which we retain the right to foreclose. That is, if the loan-to-value ratio of the loan is equal to or less than 100%, then the mortgage loan is considered to be a
qualifying real estate asset. Mortgage loans with loan-to-value ratios in excess of 100% are considered to be only real estate-related assets. Our REIT subsidiary considers
agency whole pool certificates to be qualifying real estate assets. Examples of agencies that issue whole pool certificates are the Federal National Mortgage Association, the Federal Home Loan
Mortgage Corporation and the Government National Mortgage Association. An agency whole pool certificate is a certificate issued or guaranteed as to principal and interest by the United States
government or by a federally chartered entity, which represents the entire beneficial interest in the underlying pool of mortgage loans. By contrast, an agency certificate that represents less than
the entire beneficial interest in the underlying mortgage loans is not considered to be a qualifying real estate asset, but is considered to be a real estate-related asset.

Most
non-agency mortgage-backed securities do not constitute qualifying real estate assets because they represent less than the entire beneficial interest in the related pool
of mortgage loans; however, based on Division guidance, where our REIT subsidiary's investment in non-agency mortgage-backed securities is the "functional equivalent" of owning the
underlying mortgage loans, our REIT subsidiary may treat those securities as qualifying real estate assets. Moreover, investments in mortgage-backed securities that do not constitute qualifying real
estate assets will be classified as real estate-related assets. Therefore, based upon the specific terms and circumstances related to each non-agency mortgage-backed security that our REIT
subsidiary owns, our REIT subsidiary will make a determination of whether that security should be classified as a qualifying real estate asset or as a real estate- related asset; and there may be
instances where a security is recharacterized from being a qualifying real estate asset to a real estate-related asset, or conversely, from being a real estate-related asset to being a qualifying real
estate asset based upon the acquisition or disposition or redemption of related classes of securities from the same securitization trust. If our REIT subsidiary acquires securities that, collectively,
receive all of the principal and interest paid on the related pool of underlying mortgage loans (less fees, such as servicing and trustee fees, and expenses of the securitization), and that subsidiary
has foreclosure rights with respect to those mortgage loans, then our REIT subsidiary will consider those securities, collectively, to be qualifying real estate assets. If another entity acquires any
of the securities that are expected to receive cash flow from the underlying mortgage loans, then our REIT subsidiary will consider whether it has appropriate foreclosure rights with respect to the
underlying loans and whether its investment is a first loss position in deciding whether these securities should be classified as qualifying real estate assets. If our REIT subsidiary owns more than
one subordinate class, then, to determine the classification of subordinate classes other than the first loss class, our REIT subsidiary will consider whether such classes are contiguous with the
first loss class (with no other classes absorbing losses after the first loss class and before any other subordinate classes that our REIT subsidiary owns), whether our REIT subsidiary owns the entire
amount of each such class and whether our REIT subsidiary would continue to have appropriate foreclosure rights in connection with each such class if the more subordinate classes were no longer

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outstanding.
If the answers to any of these questions is no, then our REIT subsidiary would expect not to classify that particular class, or classes senior to that class, as qualifying real estate
assets.

We
have made or may make oil and gas and other mineral investments that are held through one or more subsidiaries and would refer to those subsidiaries as our "Oil and Gas Subsidiaries".
Depending upon the nature of the oil and gas assets held by an Oil and Gas Subsidiary, such Oil and Gas Subsidiary may rely on Section 3(c)(5)(C) or Section 3(c)(9) of the Investment
Company Act or may fall outside of the general definition of an investment company. An Oil and Gas Subsidiary that does not engage primarily, propose to engage primarily or hold itself out as engaging
primarily in the business of investing, reinvesting or trading in securities will be outside of the general definition of an investment company provided that it passes the 40% test. This may be the
case where an Oil and Gas Subsidiary holds a sufficient amount of oil and gas assets constituting real estate interests together with other assets that are not investment securities such as equipment.
Oil and Gas Subsidiaries that hold oil and gas assets that constitute real property interests, but are unable to pass the 40% test, may rely on Section 3(c)(5)(C), subject to the requirements
and restrictions described above. Alternately, an Oil and Gas Subsidiary may rely on Section 3(c)(9) of the Investment Company Act if substantially all of its business consists of owning or
holding oil, gas or other mineral royalties or leases, certain fractional interests, or certificates of interest or participations in or investment contracts relating to such royalties, leases or
fractional interests. These various restrictions imposed on our Oil and Gas Subsidiaries by the
Investment Company Act may have the effect of limiting our freedom of action with respect to oil and gas assets (or other assets) that may be held or acquired by such subsidiary or the manner in which
we may deal in such assets.

As
noted above, if the combined values of the investment securities issued by our subsidiaries that must rely on Section 3(c)(1) or Section 3(c)(7) of the Investment
Company Act, together with any other investment securities we may own, exceeds 40% of the value of our total assets (exclusive of United States government securities and cash items) on an
unconsolidated basis, we may be deemed to be an investment company. If we fail to maintain an exception, exemption or other exclusion from the Investment Company Act, we could, among other things, be
required either (i) to change substantially the manner in which we conduct our operations to avoid being subject to the Investment Company Act or (ii) to register as an investment
company. Either of these would likely have a material adverse effect on us, our ability to service our indebtedness and to make distributions on our shares, and on the market price of our shares and
any other securities we may issue. If we were required to register as an investment company under the Investment Company Act, we would become subject to substantial regulation with respect to our
capital structure (including our ability to use leverage), management, operations, transactions with certain affiliated persons (within the meaning of the Investment Company Act), portfolio
composition (including restrictions with respect to diversification and industry concentration) and other matters. Additionally, our Manager would have the right to terminate our Management Agreement.
Moreover, if we were required to register as an investment company, we would no longer be eligible to be treated as a partnership for United States federal income tax purposes. Instead, we would be
classified as a corporation for tax purposes and would be able to avoid corporate taxation only to the extent that we were able to elect and qualify as a RIC under applicable tax rules. Because our
eligibility for RIC status would depend on our assets and sources of income at the time that we were required to register as an investment company, there can be no assurance that we would be able to
qualify as a RIC. If we were to lose partnership status and fail to qualify as a RIC, we would be taxed as a regular corporation. See "Partnership Tax
MattersQualifying Income Exception".

We
have not requested approval or guidance from the SEC or its staff with respect to our Investment Company Act determinations, including, in particular: our treatment of any subsidiary
as majority-owned; the compliance of any subsidiary with Section 3(c)(5)(C) or Section 3(c)(9) of, or Rule 3a-7 under, the Investment Company Act, including any
subsidiary's determinations with respect

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to
the consistency of its assets or operations with the requirements thereof; or whether our interests in one or more subsidiaries constitute investment securities for purposes of the 40% test. If the
SEC were to disagree with our treatment of one or more subsidiaries as being excepted from the Investment Company Act pursuant to Rule 3a-7, Section 3(c)(5)(C) or
Section 3(c)(9), with our determination that one or more of our other holdings do not constitute investment securities for purposes of the 40% test, or with our determinations as to the nature
of the business in which we engage or the manner in which we hold ourselves out, we and/or one or more of our subsidiaries would need to adjust our operating strategies or assets in order for us to
continue to pass the 40% test or register as an investment company, either of which could have a material adverse effect on us. Moreover, we may be required to adjust our operating strategy and
holdings, or to effect sales of our assets in a manner that, or at a time or price at which, we would not otherwise choose, if there are
changes in the laws or rules governing our Investment Company Act status or that of our subsidiaries, or if the SEC or its staff provides more specific or different guidance regarding the application
of relevant provisions of, and rules under, the Investment Company Act. Such guidance could provide additional flexibility, or it could further inhibit our ability, or the ability of a subsidiary, to
pursue a chosen operating strategy, which could have a material adverse effect on us.

If
the SEC or a court of competent jurisdiction were to find that we were required, but failed, to register as an investment company in violation of the Investment Company Act, we would
have to cease business activities, we would breach representations and warranties and/or be in default as to certain of our contracts and obligations, civil or criminal actions could be brought
against us, our contracts would be unenforceable unless a court were to require enforcement and a court could appoint a receiver to take control of us and liquidate our business, any or all of which
would have a material adverse effect on our business.

Risks Related to Ownership of Our Shares

Certain provisions of our operating agreement will make it difficult for third parties to acquire control of us and could deprive holders of our shares of the opportunity to
obtain a takeover premium for their shares.

Our operating agreement contains a number of provisions that could make it more difficult for a third party to acquire, or may
discourage a third party from acquiring, control of us. These provisions include, among others:



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These
provisions, as well as other provisions in the operating agreement, may delay, defer or prevent a transaction or a change in control that might otherwise result in holders of our
shares obtaining a takeover premium for their shares.

Certain
provisions of the Management Agreement also could make it more difficult for third parties to acquire control of us by various means, including limitations on our right to
terminate the Management Agreement and a requirement that, under certain circumstances, we make a substantial payment to the Manager in the event of a termination.

We may issue additional debt and equity securities which are senior to our common shares as to distributions and upon our dissolution, which could materially adversely
affect the market price of our shares.

In the future, we may attempt to increase our capital resources by entering into additional debt or debt-like financings
that are secured by all or some of our assets, or issuing debt or equity securities, which could include issuances of secured liquidity notes, medium-term notes, senior notes, subordinated
notes or preferred and common shares. In the event of our dissolution, liabilities of our creditors, including our lenders and holders of our debt securities, would be satisfied from our available
assets in priority to distributions to holders of our common or preferred shares. Any preferred shares may have a preference over our common shares with respect to distributions made at the discretion
of our board of directors, which could further limit our ability to make distributions to holders of our common shares. Because our decision to incur debt and issue shares in any future offerings will
depend on the terms of our operating agreements, market conditions and other factors beyond our control, we cannot predict or estimate the amount, timing or nature of our future offerings or our
future debt and equity financings. Further, market conditions could require us to accept less favorable terms for the issuance of our securities in the future, including, but not limited to, issuing
common shares at a discount to market value. Accordingly, holders of our shares and of any securities we may issue whose value is linked to the value of our shares will bear the risk of our future
offerings reducing the value of their shares or any such other securities and diluting their interest in us. In addition, we can change our leverage strategy and investment policies from time to time
without approval of holders of any of our shares, which could adversely affect the market price of our shares.

Our board of directors has broad authority to change many of the terms of our shares without the approval of holders of our shares.

Our operating agreement gives our board of directors broad authority to effect amendments to the provisions of our operating agreement
that could change many of the terms of our shares without the consent of holders of our shares. As a result, our board of directors may, without the approval of holders of our shares, make changes to
many of the terms of our shares that are adverse to the holders of our shares.

Our board of directors has full authority and discretion over distributions on our shares and it may decide to reduce or eliminate distributions at any time, which may
adversely affect the market price for our shares and any other securities we may issue.

Our board of directors has full authority and sole discretion to determine whether or not a distribution will be declared and paid, and
the amount and timing of any distribution that may be paid, to holders of our shares and (unless otherwise provided by our board of directors if and when it establishes the terms of any new class or
series of our shares) any other class or series of shares we

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may
issue in the future. Our board of directors may, in its sole discretion, determine to reduce or eliminate distributions on our common shares and (unless otherwise so provided by our board of
directors) any other class or series of shares we may issue in the future, which may have a material adverse effect on the market price of our shares, any such other shares and any other securities we
may issue. In addition, in computing United States federal income tax liability for a taxable year, each holder of our shares will be required to take into account its allocable share of items of our
income, gain, loss, deduction and credit for our taxable year ending within or with such holder's taxable year, regardless of whether such holder has received any distributions. As a result, it is
possible that a holder's United States federal income tax liability with respect to its allocable share of these items in a particular taxable year could exceed the cash distributions received by such
holder.

In
addition, as discussed above under "Risks Related to our Organization and StructureThe terms of our indebtedness may restrict our ability to make future distributions and
impose limitations on our current and future operations," our credit facility includes covenants that restricts our ability to make distributions on, and to redeem or repurchase, our shares, including
a prohibition on distributions on, and redemptions and repurchases of, our shares if an event of default, or certain events that with notice or passage of time or both would constitute an event of
default, under the credit facility occur and a requirement that we maintain a specified minimum level of consolidated tangible net worth. In addition, our credit facility contains a covenant which
limits our ability to make distributions to our shareholders in an amount in excess of 65% of our annual taxable income.

We intend to pay quarterly distributions to holders of our common shares, but our ability to do so may be limited, which could cause the market price of our common shares to
decline significantly.

We resumed paying quarterly dividends beginning in the fourth quarter of 2009 and we currently intend to continue paying cash
distributions to holders of our common shares on a quarterly basis. For all quarters during 2010, we have declared cumulative cash distributions on our common shares of $0.51 per share.

Our
ability to pay quarterly distributions will be subject to, among other things, general business conditions, our financial results, the impact of paying distributions on our credit
ratings, and legal and contractual restrictions on the payment of distributions, including restrictions imposed by our 2014 Facility credit agreement. Any reduction or discontinuation of quarterly
distributions could cause the market price of our common shares to decline significantly. Our payment of distributions to holders of our common shares has also resulted, and may in certain future
quarters results, in upward adjustments to the conversion rate of the 7.5% Notes and/or the 7.0% Notes thus resulting in an increase in dilution upon conversion of these notes. Moreover, in the event
our payment of quarterly distributions is reduced or discontinued, our failure or inability to resume paying distributions could result in a persistently low market valuation of our common shares.

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.

We have no employees. Our Manager, and its officers and employees, allocate a portion of their time to businesses and activities that
are not related to, or affiliated with, us and, accordingly, its officers and employees do not spend all of their time managing our activities and our investment portfolio. We expect that the portion
of our Manager's time that is allocated to other businesses and activities will increase in the future as our Manager and KKR expand their investment focus to include additional investment vehicles,
including vehicles that compete more directly with us, which time allocations may be material. We have no separate facilities and are completely reliant on our Manager, which has significant
discretion as to the implementation and execution of our business and investment

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strategies
and our risk management practices. We are also subject to the risk that our Manager will terminate the Management Agreement and that no suitable replacement will be found. We believe that
our success depends to a significant extent upon the experience of our Manager's executive officers, whose continued service is not guaranteed.

The departure of any of the senior management and investment professionals of our Manager or the loss of our access to KKR's senior management and investment professionals
may adversely affect our ability to achieve our investment objectives.

We depend on the diligence, skill and network of business contacts of the senior management and investment professionals of our
Manager. We also depend on our Manager's access to the investment professionals and senior management of KKR and the information and deal flow generated by the KKR investment professionals and senior
management during the normal course of their investment and portfolio management activities. The senior management and the investment professionals of our Manager evaluate, negotiate, structure, close
and monitor our investments. Our future success will depend on the continued service of the senior management team and investment professionals of our Manager. The departure of any of the senior
management or investment professionals of our Manager, or of a significant number of the investment professionals or senior management of KKR, could have a material adverse effect on our ability to
achieve our investment objectives. In addition, we can offer no assurance that our Manager will remain our Manager or that we will continue to have access to KKR's investment professionals or senior
management or KKR's information and deal flow.

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.

The financial institutions that finance our investments may require that our Manager continue to manage our operations pursuant to the
Management Agreement as a condition to making continued advances to us under these credit facilities. Additionally, if our Manager ceases to be our manager, each of these financial institutions under
these credit facilities may terminate their facility and their obligation to advance funds to us in order to finance our current and future investments. If our Manager ceases to be our manager for any
reason and we are not able to continue to obtain financing under these or suitable replacement credit facilities, our growth may be limited or we may be forced to sell our investments at a loss.

Our board of directors has approved very broad investment policies for our Manager and does not approve individual investment decisions made by our Manager except in limited
circumstances.

Our Manager is authorized to follow very broad investment policies (our "Investment Policies") and, in connection with the conversion
transaction, these Investment Policies were revised to provide even greater latitude to our Manager with respect to certain matters relating to transactions with our affiliates. Our directors
periodically review and approve our Investment Policies. Our board of directors generally does not approve any individual investments, other than approving a limited set of transactions with
affiliates that require the pre-approval of the Affiliated Transactions Committee of our board of directors. Furthermore, transactions entered into by our
Manager may be difficult or impossible to terminate or unwind. Our Manager has significant latitude within the broad parameters of the Investment Policies in determining the types of assets it may
decide are proper investments for us.

Certain of our investments may create a conflict of interest with KKR and other affiliates and may expose us to additional legal risks.

Subject to complying with our Investment Policies and the charter of the Affiliated Transactions Committee of our board of directors, a
core element of our business strategy is that our Manager will at times cause us to invest in corporate leveraged loans, high yield securities and equity securities of companies affiliated with KKR,
provided that such investments meet our requirements.

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To the extent KKR is the owner of a majority of the outstanding equity securities of such companies, KKR may have the ability to elect all of the members of the board of directors of a
company we invest in and thereby control its policies and operations, including the appointment of management, future issuances of shares or other securities, the payments of dividends, if any, on its
shares, the incurrence of debt by it, amendments to its certificate of incorporation and bylaws and entering into extraordinary transactions, and KKR's interests may not in all cases be aligned with
the interests of the holders of the securities we own. In addition, with respect to companies in which we have an equity investment, to the extent that KKR is the controlling shareholder it may be
able to determine the outcome of all matters requiring shareholder approval and will generally be able to cause or prevent a change of control of a company we invest in or a change in the composition
of its board of directors and could preclude any unsolicited acquisition of that company regardless as to whether we agree with such determination. So long as KKR continues to own a significant amount
of the voting power of a company we invest in, even if such amount is less than 50%, it will continue to influence strongly, or effectively control, that company's decisions. Our interests with
respect to the management, investment decisions, or operations of those companies may at times be in conflict with those of KKR. In addition, to the extent that affiliates of our Manager or KKR invest
in companies in which we have an investment, similar conflicts between our interests and theirs may arise. In addition, our Manager has implemented policies and procedures to mitigate potential
conflicts of interest, which policies impose limitations on our ability to make certain investments in companies affiliated with KKR.

Our
interests and those of KKR may at times be in conflict because the CLO issuers in which we invest hold corporate leveraged loans the obligors on which are KKR-affiliated
companies. KKR may have an interest in causing such companies to pursue acquisitions, divestitures, exchange offers, debt restructurings and other transactions that, in KKR's judgment, could enhance
its equity investment, even though such transactions might involve risks to holders of indebtedness, which include our CLO issuers. For example, KKR could cause a company that is the obligor on a loan
held by one of our CLO issuers to make acquisitions that increase its indebtedness or to sell revenue generating assets, thereby potentially decreasing the ability of the company to repay its debt. In
cases where a company's debt undergoes a restructuring, the interests of KKR as an equity investor and our CLO issuers as debt investors may diverge, and KKR may have an interest in pursuing a
restructuring strategy that benefits the equity holders to the detriment of the lenders, such as our CLO issuers. This risk may be exacerbated in the current economic environment given reduced
liquidity available for debt refinancing, among other factors.

If
a KKR-affiliated company were to file for bankruptcy or similar action, we face the risk that a court may subordinate our debt investment in such company to the claims of
more junior debt holders or may recharacterize our investment as an equity investment. Any such action by a court would have a material adverse impact on the value of these 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.

We are subject to potential conflicts of interest arising out of our relationship with our Manager and its affiliates. As of
December 31, 2010, our Manager and its affiliates collectively owned approximately 3.1% of our outstanding common shares on a fully diluted basis.

Our
Management Agreement with our Manager was negotiated between related parties, and its terms, including fees payable, may not be as favorable to us as if it had been negotiated with
an unaffiliated third party. Pursuant to the Management Agreement, our Manager will not assume any responsibility other than to render the services called for thereunder and will not be responsible
for any action of our board of directors in following or declining to follow its advice or recommendations. See

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the
risk factor entitled "Our Manager's liability is limited under the Management Agreement, and we have agreed to indemnify our Manager against certain liabilities."

As
noted above, our Manager will at times cause us to invest in loans and securities of companies affiliated with KKR, provided that such investments meet our requirements, and the terms
of which such investments are made may not be as favorable as if they were negotiated with unaffiliated third parties. In addition, from time to time, the Manager may cause us to buy loans or
securities from, or to sell loans or securities to, other clients of KKR or its affiliates. The Manager has implemented policies and procedures to mitigate conflicts of interest in such transactions.

The incentive fee provided for under the Management Agreement may induce our Manager to make certain investments, including speculative investments.

The management compensation structure to which we have agreed with our Manager may cause our Manager to invest in high risk investments
or take other risks. In addition to its base management fee, our Manager is entitled to receive incentive compensation based in part
upon our achievement of specified levels of net income. See "Item 1. BusinessManagement Agreement" for further information regarding our management compensation structure. In
evaluating investments and other management strategies, the opportunity to earn incentive compensation based on net income may lead our Manager to place undue emphasis on the maximization of net
income at the expense of other criteria, such as preservation of capital, maintaining sufficient liquidity, and/or management of credit risk or market risk, in order to achieve higher incentive
compensation. Investments with higher yield potential are generally riskier or more speculative. In addition, the Compensation Committee of our board of directors may make grants of options and
restricted shares to our Manager in the future and the factors considered by the Compensation Committee in making these grants may include performance related factors which may also induce our Manager
to make investments that are riskier or more speculative. This could result in increased risk to the value of our investment portfolio.

Conflicts may arise in connection with the allocation of investment opportunities by affiliates of our Manager.

Our Management Agreement with our Manager does not prevent our Manager and its affiliates from engaging in additional management or
investment opportunities. The Management Agreement does not restrict our Manager and its affiliates from raising, sponsoring or advising any new investment fund, company or other entity, including a
REIT, or holding proprietary investment accounts, unless such fund, account, company or other entity invests primarily in domestic mortgage-backed securities. This restriction is of significantly less
relevance since the May 4, 2007 restructuring pursuant to which we succeeded KKR Financial Corp., because since then our investments in domestic mortgage-backed securities have significantly
decreased and as of December 31, 2010 comprised $93.9 million of our investment portfolio. As a result, our Manager and its affiliates, including KKR, currently are engaged in and may in
the future engage in management or investment opportunities on behalf of others or themselves that would have been suitable for us and we may have fewer attractive investment opportunities.

In
addition, affiliates of our Manager currently manage a separate investment fund and separately managed accounts, including proprietary investment accounts for the purpose of
developing, evaluating and testing potential trading strategies, that invest in the same non-mortgage-backed securities investments that we invest in, including other fixed income
investments. With respect to these other funds and accounts and any other funds or accounts that may be established in the future, our Manager and its affiliates will face conflicts in the allocation
of investment opportunities. Such allocation is at the discretion of our Manager and its affiliates in accordance with their respective allocation policies and procedures. These policies take into
account a number of factors, including mandatory minimum investment rights, investment objectives, available capital, concentration limits, risk profiles and other investment restrictions applicable
to us and these competing funds and accounts. Our Manager and its

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affiliates
have broad discretion in administering these policies and there is no guarantee that in making allocations our Manager and its affiliates will act in the best interests of holders of our
shares or any
other securities we may issue. In addition, certain of such other managed funds and accounts may participate in investment opportunities on more favorable terms than us.

We compete with other investment entities affiliated with KKR for access to KKR's investment professionals.

KKR and its affiliates, including the parent of our manager, manage several private equity funds, other funds and separately managed
accounts, and we believe that KKR and its affiliates, including the parent of our manager, will establish and manage other investment entities in the future. Certain of these investment entities have,
and any newly created entities may have, an investment focus similar to our focus, and as a result we compete with those entities and will compete with any such newly created entities for access to
the benefits that our relationship with KKR provides to us. Our ability to continue to engage in these types of opportunities in the future depends, to a significant extent, on competing demands for
these investment opportunities by other investment entities established by KKR and its affiliates. To the extent that we and other KKR affiliated entities or related parties compete for investment
opportunities, there can be no assurances that we will get the best of those opportunities or that the performance of the investments allocated to us, even within the same asset classes, will perform
as favorably as those allocated to others.

Termination of the Management Agreement with our Manager by us is difficult and costly.

The Management Agreement expires on December 31 of each year, but is automatically renewed for a one-year term on
each December 31 unless terminated upon the affirmative vote of at least two-thirds of our independent directors, or by a vote of the holders of a majority of our outstanding common
shares, based upon (i) unsatisfactory performance by our Manager that is materially detrimental to us or (ii) a determination that the management fee payable to our Manager is not fair,
subject to our Manager's right to prevent such a termination under this clause (ii) by accepting a mutually acceptable reduction of management fees. Our Manager must be provided with
180 days' prior written 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.
These provisions would result in substantial cost to us if we terminate the Management Agreement, thereby adversely affecting our ability to terminate our Manager.

Our access to confidential information may restrict our ability to take action with respect to some investments, which, in turn, may negatively affect our results of
operations.

We, directly or through our Manager, may obtain confidential information about the companies in which we have invested or may invest.
If we do possess confidential information about such companies, there may be restrictions on our ability to make, dispose of, increase the amount of, or otherwise take action with respect to, an
investment in those companies. Our relationship with KKR could create a conflict of interest to the extent our Manager becomes aware of inside information concerning investments or potential
investment targets. We have implemented compliance procedures and practices designed to ensure that inside information is not used for making investment decisions on our behalf. We cannot assure our
shareholders, however, that these procedures and practices will be effective. In addition, this conflict and these procedures and practices may limit the freedom of our Manager to make potentially
profitable investments which could have an adverse effect on our results of operations. Conversely, we may pursue investments without obtaining access to confidential information otherwise in the
possession of KKR or one of its affiliates, which information, if reviewed, might otherwise impact our judgment with respect to such investments.

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Our Manager's liability is limited under the Management Agreement, and we have agreed to indemnify our Manager against certain liabilities.

Pursuant to the Management Agreement, our Manager will not assume any responsibility other than to render the services called for
thereunder in good faith and will not be responsible for any action of our board of directors in following or declining to follow its advice or recommendations. Our Manager and its members, managers,
officers and employees will not be liable to us, any subsidiary of ours, our directors, our shareholders or any subsidiary's shareholders for acts or omissions pursuant to or performed in accordance
with the Management Agreement, except by reason of acts constituting bad faith, willful misconduct, gross negligence, or reckless disregard of their duties under the Management Agreement. Pursuant to
the Management Agreement, we have agreed to indemnify our Manager and its members, managers, officers and employees and each person controlling our Manager with respect to all expenses, losses,
damages, liabilities, demands, charges and claims arising from acts or omissions of such indemnified party not constituting bad faith, willful misconduct, gross negligence, or reckless disregard of
duties, performed in good faith in accordance with and pursuant to the Management Agreement.

Tax Risks

Holders of our common shares will be subject to United States federal income tax and generally other taxes, such as state, local and foreign income tax, on their share of
our taxable income, regardless of whether or when they receive any cash distributions from us, and may recognize income in excess of our cash distributions.

We intend to continue to operate so as to qualify, for United States federal income tax purposes, as a partnership and not as an
association or a publicly traded partnership taxable as a corporation. Holders of our common shares are subject to United States federal income taxation and generally other taxes, such as state, local
and foreign income taxes, on their allocable share of our items of income, gain, deduction, and credit for each of our taxable years ending with or within the holder's taxable year, regardless of
whether or when they receive cash distributions. In addition, certain of our investments, including investments in certain foreign corporate subsidiaries, CLO issuers (which are treated as
partnerships or disregarded entities for United States federal income tax purposes) and debt securities, may produce taxable income without corresponding distributions of cash to us or produce taxable
income prior to or following the receipt of cash relating to such income. Those investments typically produce ordinary income on a current basis, but any losses we would recognize from those
investments would typically be treated as capital losses. In addition, we have recognized and may recognize in the future cancellation of indebtedness income upon the retirement of our debt at a
discount. In addition, because of our methods of allocating income and gain among holders of our common shares, you may be taxed on amounts that accrued economically before you became a shareholder.
Consequently, in some taxable years, holders of our common shares may recognize taxable income in excess of our cash distributions, and holders may be allocated capital losses either in the same or
future years that cannot be used to offset such taxable income. Furthermore, even if we did not pay cash distributions with respect to a taxable year, holders of our common shares may still have a tax
liability attributable to their allocation of our taxable income. Accordingly, each shareholder should ensure that it has sufficient cash flow from other sources to pay all tax liabilities.

If we were treated as a corporation for United States federal income tax purposes, all of our 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 our common shares and thus could result in a substantial reduction in the value of our common shares and any other securities we
may issue.

The value of your investment in us depends in part on our being treated as a partnership for United States federal income tax purposes.
We intend to continue to operate so as to qualify, for

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United
States federal income tax purposes, as a partnership and not as an association or a publicly traded partnership taxable as a corporation. In general, if a partnership is "publicly traded" (as
defined in the Code), it will be treated as a corporation for United States federal income tax purposes. A publicly traded partnership will, however, be taxed as a partnership, and not as a
corporation, for United States federal income tax purposes, so long as it is not required to register under the Investment Company Act and at least 90% of its gross income for each taxable year
constitutes "qualifying income" within the meaning of Section 7704(d) of the Code. We refer to this exception as the "qualifying income exception." Qualifying income generally includes rents,
dividends, interest (to the extent such interest is neither derived from the "conduct of a financial or insurance business" nor based, directly or indirectly, upon "income or profits" of any person),
income and gains derived from certain activities related to minerals and natural resources, and capital gains from the sale or other disposition of stocks, bonds and real property. Qualifying income
also includes other income derived from the business of investing in, among other things, stocks and securities.

If
we fail to satisfy the "qualifying income exception" described above, items of income, gain, loss, deduction and credit would not pass through to holders of our common shares and such
holders would be treated for United States federal (and certain state and local) income tax purposes as shareholders in a corporation. In such case, we would be required to pay income tax at regular
corporate rates on all of our income. In addition, we would likely be liable for state and local income and/or franchise taxes on all of our income. Distributions to holders of our common shares would
be taxable as ordinary dividend income to such holders to the extent of our earnings and profits, and these distributions would not be deductible by us. If we were taxable as a corporation, it could
result in a material reduction in cash flow and after-tax return for holders of our common shares and thus could result in a substantial reduction in the value of our common shares and any
other securities we may issue.

Complying with certain tax-related requirements may cause us to forego otherwise attractive business or investment opportunities.

To be treated as a partnership for United States federal income tax purposes, and not as an association or publicly traded partnership
taxable as a corporation, we must satisfy the qualifying income exception, which requires that at least 90% of our gross income each
taxable year consist of interest, dividends, capital gains and other types of "qualifying income." Interest income will not be qualifying income for the qualifying income exception if it is derived
from "the conduct of a financial or insurance business." This requirement limits our ability to originate loans or acquire loans originated by our Manager and its affiliates. In order to comply with
this requirement, we (or our subsidiaries) may be required to invest through foreign or domestic corporations that are subject to corporate income tax or forego attractive business or investment
opportunities. Thus, compliance with this requirement may adversely affect our return on our investments and results of operations.

Holders of our common shares may recognize gain for United States federal income tax purposes when we sell assets that cause us to recognize a loss for financial reporting
purposes.

We have elected under Section 754 of the Code to adjust the tax basis in all or a portion of our assets upon certain events,
including the sale of our common shares. Because our holders are treated as having differing tax bases in our assets, a sale of an asset by us may cause holders to recognize different amounts of gain
or loss or may cause some holders to recognize a gain and others to recognize a loss. Depending on when our holders purchased our common shares and the fair market value of our assets at that time,
our holders may recognize gain for United States federal income tax purposes from the sale of certain of our assets even though the sale would cause us to recognize a loss for financial accounting
purposes.

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We have made and may make investments, such as investments in natural resources, that generate income that is treated as effectively connected with respect to holders of our
common shares that are not "United States persons."

We have made and may make investments, such as investments in natural resources, the income from which likely will be treated as
effectively connected with the conduct of a United States trade or business with respect to holders of our shares that are not "United States persons" within the meaning of Section 7701(a)(30)
of the Code. Furthermore, notional principal contracts that we enter into, if any, in connection with investments in natural resources likely would generate income that would be treated as effectively
connected with the conduct of a United States trade or business. To the extent our income is treated as effectively connected income, a holder who is a non-United States person generally
would be required to (i) file a United States federal income tax return for such year reporting its allocable share, if any, of our income or loss effectively connected with such trade
or business and (ii) pay United States federal income tax at regular United States tax rates on any such income. Moreover, if such a holder is a corporation, it might be subject to a United
States branch profits tax on its allocable share of our effectively connected income. In addition, distributions to such a holder would be subject to withholding at the highest applicable tax rate to
the extent of the holder's allocable share of our effectively connected income. Any amount so
withheld would be creditable against such holder's United States federal income tax liability, and such holder could claim a refund to the extent that the amount withheld exceeded such person's United
States federal income tax liability for the taxable year. Finally, if we are engaged in a United States trade or business, a portion of any gain recognized by an investor who is a
non-United States person on the sale or exchange of its shares may be treated for United States federal income tax purposes as effectively connected income, and hence such holder may be
subject to United States federal income tax on the sale or exchange.

Holders of our shares may be subject to foreign, state and local taxes and return filing requirements as a result of investing in our shares.

In addition to United States federal income taxes, holders of our common shares may be subject to other taxes, including foreign, state
and local taxes, unincorporated business taxes and estate, inheritance or intangible taxes that are imposed by the various jurisdictions in which we conduct business or own property, even if the
holders of our common shares do not reside in any of those jurisdictions. For example, we will likely be treated as doing business in any foreign, state or local jurisdiction in which our natural
resources investments are located. As a result, our holders may be required to file foreign, state and local income tax returns and pay foreign, state and local income taxes in some or all of these
various jurisdictions. Further, holders may be subject to penalties for failure to comply with those requirements. It is the responsibility of each holder to file all United States federal, state and
local tax returns that may be required of such holder.

The ability of holders of our common shares to deduct certain expenses incurred by us may be limited.

In general, expenses incurred by us that are considered "miscellaneous itemized deductions" may be deducted by a holder of our common
shares that is an individual, estate or trust only to the extent that such holder's allocable share of those expenses, along with the holder's other miscellaneous itemized deductions, exceed, in the
aggregate, 2% of such holder's adjusted gross income. In addition, these expenses are also not deductible in determining the alternative minimum tax liability of a holder. We anticipate that
management fees that we pay to our Manager and certain other expenses incurred by us will constitute miscellaneous itemized deductions. A holder's inability to deduct all or a portion of such expenses
could result in an amount of taxable income to such holder with respect to us that exceeds the amount of cash actually distributed to such holder for the year.

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Holders of our common shares may recognize a greater taxable gain (or a smaller tax loss) on a disposition of our common shares than expected because of the treatment of
debt under the partnership tax accounting rules.

We will incur debt for a variety of reasons, including for acquisitions as well as other purposes. Under partnership tax accounting
principles (which apply to us), our debt is generally allocable to holders of our common shares, who will realize the benefit of including their allocable share of the debt in the tax basis of their
common shares. The tax basis in our common shares will be adjusted for, among other things, distributions of cash and allocations of our losses, if any. At the time a holder of our common shares later
sells its common shares, the holder's amount realized on the sale will include not only the sales price of the common shares but also will include such holder's portion of debt allocable to those
common shares (which is treated as proceeds from the sale of those common shares). Depending on the nature of our activities after having incurred the debt, and the utilization of the borrowed funds,
a later sale of our common shares could result in a larger taxable gain (or a smaller tax loss) than anticipated.

If we have a termination for United States federal income tax purposes, holders of our shares may be required to include more than 12 months of our taxable income in
their taxable income for the year of the termination.

We will be considered to have been terminated for United States federal income tax purposes if there is a sale or exchange of 50% or
more of the total interests in our capital and profits within a 12-month period. A termination of our partnership would, among other things, result in the closing of our taxable year for
all holders. In the case of a holder reporting on a taxable year other than a fiscal year ending on our year end, which is expected to continue to be the calendar year, the closing of our taxable year
may result in more than 12 months of our taxable income or loss being includable in the holder's taxable income for the year of termination. We would be required to satisfy the 90% "qualifying
income" test for each tax period and to make new tax elections after a termination, including a new tax election under Section 754 of the Code. A termination could also result in penalties if
we were unable to determine that the termination had occurred. In the event that we become aware of a termination, we will use commercially reasonable efforts to minimize any such penalties. Moreover,
a termination might either accelerate the application of, or subject us to, any tax legislation enacted before the termination. We have experienced terminations in the past, and it is likely that we
will experience terminations in the future. The IRS has announced a publicly traded partnership technical termination relief program whereby, if the taxpayer requests relief and such relief is granted
by the IRS, among other things, the partnership would only have to provide one Schedule K-1 to most holders of shares for the year notwithstanding two partnership tax years.

We could incur a significant tax liability if the Internal Revenue Service successfully asserts that the "anti-stapling" rules apply to certain of our
subsidiaries, which could result in a reduction in cash flow and after-tax return for holders of common shares and thus could result in a reduction of the value of those common shares.

If we were subject to the "anti-stapling" rules of Section 269B of the Code, we would incur a significant tax
liability as a result of owning (i) more than 50% of the value of both a domestic corporate subsidiary and a foreign corporate subsidiary, or (ii) more than 50% of both a REIT and a
domestic or foreign corporate subsidiary. If the "anti-stapling" rules applied, our foreign corporate subsidiaries would be treated as domestic corporations, which would cause those
entities to be subject to United States federal corporate income taxation, and any REIT subsidiary would be treated as a single entity with our domestic and foreign corporate subsidiaries for purposes
of the REIT qualification requirements, which could result in the REIT subsidiary failing to qualify as a REIT and being subject to United States federal corporate income taxation. Currently, we have
several subsidiaries that could be affected if we were subject to the "anti-stapling" rules, including one

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subsidiary
taxed as a REIT and several foreign and domestic corporate subsidiaries. Because we own, or are treated as owning, a substantial proportion of our assets directly for United States federal
income tax purposes, we do not believe that the "anti-stapling" rules have applied or will apply. However, there can be no assurance that the IRS would not successfully assert a contrary
position, which could result in a reduction in cash flow and after-tax return for holders of common shares and thus could result in a reduction of the value of those shares.

Tax exempt holders of our common shares will likely recognize significant amounts of "unrelated business taxable income."

An organization that is otherwise exempt from United States federal income tax is nonetheless subject to taxation with respect to its
"unrelated business taxable income" ("UBTI"). Generally, a tax-exempt partner of a partnership would be treated as earning UBTI if the partnership regularly engages in a trade or business
that is unrelated to the exempt function of the tax-exempt partner, if the partnership derives income from debt-financed property or if the partner interest itself is
debt-financed. Because we have incurred "acquisition indebtedness" with respect to certain equity and debt securities we hold (either directly or indirectly through subsidiaries that are
treated as partnerships or disregarded entities for United States federal income tax purposes), a proportionate share of a holder's income from us with respect to such securities will be treated as
UBTI. In addition, we have made and may make investments, such as investments in natural resources, that likely will generate income treated as effectively connected with a United States trade or
business. Accordingly, tax-exempt holders of our shares will likely recognize significant amounts of UBTI. Tax-exempt holders of our shares are strongly urged to consult their
tax advisors regarding the tax consequences of owning our shares.

Although we anticipate that our foreign corporate subsidiaries will not be subject to United States federal income tax on a net basis, no assurance can be given that such
subsidiaries will not be subject to United States federal income tax on a net basis in any given taxable year.

We anticipate that our foreign corporate subsidiaries will generally continue to conduct their activities in such a way as not to be
deemed to be engaged in a United States trade or business and not to be subject to United States federal income tax. There can be no assurance, however, that our foreign corporate subsidiaries will
not pursue investments or engage in activities that may cause them to be engaged in a United States trade or business. Moreover, there can be no assurance that as a result of any change in applicable
law, treaty, rule or regulation or interpretation thereof, the activities of any of our foreign corporate subsidiaries would not become subject to United States federal income tax. Further, there can
be no assurance that unanticipated activities of our foreign subsidiaries would not cause such subsidiaries to become subject to United States federal income tax. If any of our foreign corporate
subsidiaries became subject to United States federal income tax (including the United States branch profits tax), it would significantly reduce the amount of cash available for distribution to us,
which in turn could have an adverse impact on the value of our shares and any other securities we may issue. Our foreign corporate subsidiaries are generally not expected to be subject to United
States federal income tax on a net basis, and such subsidiaries may receive income that is subject to withholding taxes imposed by the United States or other countries.

Certain of our investments may subject us to United States federal income tax and could have negative tax consequences for our shareholders.

A portion of our distributions likely will constitute "excess inclusion income." Excess inclusion income is generated by residual
interests in real estate mortgage investment conduits ("REMICs") and taxable mortgage pool arrangements owned by REITs. We own through a disregarded entity a small number of REMIC residual interests.
In addition, KFH II has entered into financing arrangements that are treated as taxable mortgage pools. We will be taxable at the highest corporate income tax rate on

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any
excess inclusion income from a REMIC residual interest that is allocable to the percentage of our shares held in record name by disqualified organizations. Although the law is not clear, we may
also be subject to that tax if the excess inclusion income arises from a taxable mortgage pool arrangement owned by a REIT in which we invest. Disqualified organizations are generally certain
cooperatives, governmental entities and tax-exempt organizations that are exempt from unrelated business tax (including certain state pension plans and charitable remainder trusts). They
are permitted to own our shares. Because this tax would be imposed on us, all of the holders of our shares, including holders that are not disqualified organizations, would bear a portion of the tax
cost associated with our ownership of REMIC residual interests and with the classification of any of our REIT subsidiaries or a portion of the assets of any of our REIT subsidiaries as a taxable
mortgage pool. A RIC or other
pass-through entity owning our shares may also be subject to tax at the highest corporate rate on any excess inclusion income allocated to their record name owners that are disqualified
organizations. Nominees who hold our common shares on behalf of disqualified organizations also potentially may be subject to this tax.

Excess
inclusion income cannot be offset by losses of our shareholders. If the shareholder is a tax-exempt entity and not a disqualified organization, then this income would
be fully taxable as UBTI under Section 512 of the Code. If the shareholder is a foreign person, it would be subject to United States federal income tax withholding on this income without
reduction or exemption pursuant to any otherwise applicable income tax treaty.

Dividends paid by, and certain income inclusions derived with respect to our ownership of, KFH II and foreign corporate subsidiaries will not qualify for the reduced tax
rates generally applicable to corporate dividends paid to taxpayers taxed at individual rates.

Tax legislation enacted in 2003, 2006 and 2010 reduced the maximum United States federal income tax rate on certain corporate dividends
payable to taxpayers taxed at individual rates to 15% through 2012. Dividends payable by, or certain income inclusions derived with respect to the ownership of, passive foreign investment companies
("PFICs"), certain controlled foreign corporations ("CFCs"), and REITs, however, are generally not eligible for the reduced rates. We have treated and intend to continue to treat our foreign corporate
subsidiaries as the type of CFCs whose income inclusions are not eligible for lower tax rates on dividend income. Although this legislation does not generally change the taxation of our foreign
corporate subsidiaries and REITs, the more favorable rates applicable to regular corporate dividends could cause investors taxed at individual rates to perceive investments in PFICs, CFCs or REITs, or
in companies such as us, whose holdings include foreign corporations and REITs, to be relatively less attractive than holdings in the stocks of non-CFC, non-PFIC and
non-REIT corporations that pay dividends, which could adversely affect the value of our shares and any other securities we may issue.

Withholding tax may apply to the portion of our distributions that constitute "withholdable payments" and proceeds of sales in respect of our common shares after
December 31, 2012.

Under current law, holders of our shares that are not United States persons are generally be subject to United States federal
withholding tax at the rate of 30% (or such lower rate provided by an applicable tax treaty) on their share of our gross income from dividends, interest (other than interest that constitutes
"portfolio interest" within the meaning of the Code) and certain other income that is not treated as effectively connected with a United States trade or business. For payments made after
December 31, 2012, in addition to this withholding tax that currently applies, a United States federal withholding tax at a 30% rate will apply to "withholdable payments" made to foreign
financial institutions (and their more than 50% affiliates) unless the payee foreign financial institution agrees, among other things, to disclose the identity of certain United States persons and
United States owned foreign entities with accounts at the institution (or the institution's affiliates) and to annually report

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certain
information about such accounts. "Withholdable payments" include payments of interest (including original issue discount), dividends, and other items of fixed or determinable annual or
periodical gains, profits, and income, in each case, from sources within the United States, as well as gross proceeds from the sale of any property of a type which can produce interest or dividends
from sources within the United States. The withholding tax will also apply to withholdable payments to certain foreign entities that do not disclose the name, address, and taxpayer identification
number of any substantial United States owners (or certify that they do not have any substantial United States owners). We expect that some or all of our distributions will constitute "withholdable
payments." Thus, if a holder holds our shares through a foreign financial institution or foreign corporation or trust, a portion of payments to such holder made after December 31, 2012 may be
subject to 30% withholding.

If
we are required to withhold any United States federal withholding tax on distributions made to any holder of our shares, we will pay such withheld amount to the IRS. That payment, if
made, will be treated as a distribution of cash to the holder of the shares with respect to whom the payment was made and will reduce the amount of cash to which such holder would otherwise be
entitled.

Ownership limitations in the operating agreement that apply so long as we own an interest in a REIT, such as KFH II, may restrict a change of control in which our holders
might receive a premium for their shares.

In order for KFH II to continue to qualify as a REIT, no more than 50% in value of its outstanding capital stock may be owned, directly
or indirectly, by five or fewer individuals during the last half of any calendar year and its shares must be beneficially owned by 100 or more persons during at least 335 days of a taxable year
of 12 months or during a proportionate part of a shorter taxable year. "Individuals" for this purpose include natural persons, private foundations, some
employee benefit plans and trusts, and some charitable trusts. We intend for KFH II to be owned, directly or indirectly, by us and by holders of the preferred shares issued by KFH II. In order to
preserve the REIT status of KFH II and any future REIT subsidiary, the operating agreement generally prohibits, subject to exceptions, any person from beneficially owning or constructively owning
shares in excess of 9.8% in value or in number of our outstanding shares, whichever is more restrictive, excluding shares not treated as outstanding for United States federal income tax purposes. This
restriction may be terminated by our board of directors if it determines that it is no longer in our best interests for KFH II to continue to qualify as a REIT under the Code or that compliance
with those restrictions is no longer required to qualify as a REIT, and our board of directors may also, in its sole discretion, exempt a person from this restriction.

The
ownership limitation could have the effect of discouraging a takeover or other transaction in which holders of our shares might receive a premium for their shares over the then
prevailing market price or which holders might believe to be otherwise in their best interests.

The failure of KFH II to qualify as a REIT would generally cause it to be subject to United States federal income tax on its taxable income, which could result in a material
reduction in cash flow and after-tax return for holders of our shares and thus could result in a reduction of the value of those shares and any other securities we may issue.

We intend that KFH II will continue to operate in a manner so as to qualify to be taxed as a REIT for United States federal income tax
purposes. No ruling from the IRS, however, has been or will be sought with regard to the treatment of KFH II as a REIT for United States federal income tax purposes, and its ability to qualify as a
REIT depends on its satisfaction of certain asset, income, organizational, distribution, shareholder ownership and other requirements on a continuing basis. Accordingly, no assurance can be given that
KFH II will satisfy such requirements for any particular taxable year. If KFH II were to fail to qualify as a REIT in any taxable year, it would be subject to United States federal income tax,
including any applicable alternative minimum tax, on its net taxable income at regular corporate rates, and distributions would not be deductible by it in computing its

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taxable
income. Any such corporate tax liability could be substantial and could materially reduce the amount of cash available for distribution to us, which in turn would materially reduce the amount
of cash available for distribution to holders of our shares and could have an adverse impact on the value of those shares and any other securities we may issue. Unless entitled to relief under certain
Code provisions, KFH II also would be disqualified from taxation as a REIT for the four taxable years following the year during which it ceased to qualify as a REIT.

The IRS Schedules K-1 we will provide will be significantly more complicated than the IRS Forms 1099 provided by REITs and regular corporations,
and holders of our common shares may be required to request an extension of the time to file their tax returns.

Holders of our common shares are required to take into account their allocable share of items of our income, gain, loss, deduction and
credit for our taxable year ending within or with their taxable year. We will use reasonable efforts to furnish holders of our common shares with tax information (including IRS
Schedule K-1), which describes their allocable share of such items for our preceding taxable year, as promptly as possible. However, we may not be able to provide holders of our
common shares with tax information on a timely basis. Because holders of our common shares will be required to report their allocable share of each item of our income, gain, loss, deduction, and
credit on their tax returns, tax reporting for holders of our common shares will be significantly more complicated than for shareholders in a REIT or a regular corporation. In addition, delivery of
this information to holders of our common shares will be subject to delay in the event of, among other reasons, the late receipt of any necessary tax information from an investment in which we hold an
interest. It is therefore possible that, in any taxable year, holders of our common shares will need to apply for extensions of time to file their tax returns.

Our structure involves complex provisions of United States 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 our common shares and any other securities we may issue.

The United States federal income tax treatment of holders of our common shares depends in some instances on determinations of fact and
interpretations of complex provisions of United States federal income tax law for which no clear precedent or authority may be available. The United States federal income tax rules are constantly
under review by the IRS, resulting in revised interpretations of established concepts. The IRS pays close attention to the proper application of tax laws to partnerships and investments in foreign
entities. The present United States federal income tax treatment of an investment in our common shares may be modified by administrative, legislative or judicial interpretation at any time, and any
such action may affect investments and commitments previously made. We and holders of our common shares could be adversely affected by any such change in, or any new tax law, regulation or
interpretation. Our operating agreement permits our board of directors to modify (subject to certain exceptions) the operating agreement from time to time, without the consent of the holders of our
common shares. These modifications may address, among other things, certain changes in United States federal income tax regulations, legislation or interpretation. In some circumstances, such
revisions could have an adverse impact on some or all of the holders of our common shares and of other securities we may issue. Moreover, we intend to apply certain assumptions and conventions in an
attempt to comply with applicable rules and to report income, gain, deduction, loss and credit to holders of our common shares in a manner that reflects their distributive share of our items, but
these assumptions and conventions may not be in compliance with all aspects of applicable tax requirements. It is possible that the IRS will assert successfully that the conventions and assumptions we
use do not satisfy the technical requirements of the Code and/or United States Treasury Regulations and could require that items of income, gain, deduction, loss or credit be adjusted

48

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or
reallocated in a manner that adversely affects holders of our common shares and of any securities we may issue.

We may be subject to adverse legislative or regulatory tax changes that could reduce the market price of our shares.

At any time, the federal income tax laws or regulations governing publicly traded partnerships or the administrative interpretations of
those laws or regulations may be amended. We cannot predict when or if any new federal income tax law, regulation or administrative interpretation, or any amendment to any existing federal income tax
law, regulation or administrative interpretation, will be adopted or promulgated or will become effective and any such law, regulation or interpretation may take effect retroactively. We and our
holders could be adversely affected by any change in, or any new, federal income tax law, regulation or administrative interpretation. Additionally,
revisions in federal tax laws and interpretations thereof could cause us to change our investments and commitments and affect the tax considerations of an investment in us.

Item 1B.    UNRESOLVED STAFF COMMENTS

None.

Item 2.    PROPERTIES

Our administrative and principal executive offices are located at 555 California Street, 50th Floor, San
Francisco, California 94104 and are leased by our Manager. We do not own any real estate or other physical properties materially important to our operations.

Item 3.    LEGAL PROCEEDINGS

We have been named as a party in various legal actions which include the matters described below. We have denied, or believe we have a
meritorious defense and will deny liability in the significant cases pending against us discussed below. Based on current discussion and consultation with counsel, we believe that the resolution of
these matters will not have a material impact on our financial condition or cash flow.

On
August 7, 2008, the members of our board of directors and certain of our former executive officers and we 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 (the "Charter Litigation"). On March 13, 2009, the lead plaintiff
filed an amended complaint, which deleted as defendants the members of our board of directors and named as defendants only our former chief executive officer Saturnino S. Fanlo, our former chief
operating officer David A. Netjes, our former chief financial officer Jeffrey B. Van Horn and us. The amended complaint alleges that our 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 our real estate-related assets, our ability to finance our real estate-related assets and the adequacy of our loss reserves for our 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. On November 17, 2010, the Court
granted the defendant's motion and dismissed the case with prejudice. Plaintiffs' time to take an appeal expired and the judgment was final.

49

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On August 15, 2008, the members of our board of directors and our 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"). We are 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 our 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 we file an answer to the Charter Litigation. On November 17, 2010, the Court dismissed the Charter Litigation with prejudice and that judgment was final. The
plaintiff in the California Derivative Action subsequently agreed to withdraw his complaint, and a stipulated order dismissing the California Derivative Action was entered on February 14, 2011.

On
March 23, 2009, the members of our board of directors and certain of our 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"). We are 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 our 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 we file an answer to the Charter Litigation. On November 17, 2010, the Court dismissed the Charter Litigation with prejudice and that judgment was final. The plaintiff in the New
York Derivative Action subsequently agreed to withdraw his complaint, and a stipulated order dismissing the New York Derivative Action was entered on February 4, 2011.

Item 4.    [REMOVED AND RESERVED]

50

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PART II

Item 5.    MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Market Information

Our common shares are traded on the NYSE under the symbol "KFN."

On
February 22, 2011, the closing price of our common shares, as reported on the NYSE, was $9.73. The following table sets forth the high and low sale prices for our common shares
for the period indicated as reported on the NYSE:

Sales PriceHigh

LowYear ended December 31, 2009First Quarter ended March 31, 2009

$
2.64

$
0.40Second Quarter ended June 30, 2009

$
2.35

$
0.78Third Quarter ended September 30, 2009

$
5.25

$
0.75Fourth Quarter ended December 31, 2009

$
5.95

$
4.10Year ended December 31, 2010First Quarter ended March 31, 2010

$
8.50

$
5.55Second Quarter ended June 30, 2010

$
9.49

$
7.01Third Quarter ended September 30, 2010

$
8.95

$
7.02Fourth Quarter ended December 31, 2010

$
9.50

$
8.50


As
of February 22, 2011, we had 178,123,525 issued and outstanding common shares that were held by 86 holders of record. The 86 holders of record include Cede & Co.,
which holds shares as nominee for The Depository Trust Company, which itself holds shares on behalf of the beneficial owners of our common shares.

Distributions

The amount and timing of distributions to our common shareholders are decided determined by our board of directors and is based upon a
review of various factors including current market conditions, existing restrictions under borrowing agreements and our liquidity needs. See "Item 7. Management's Discussion and Analysis of
Financial Condition and Results of OperationsCash Distributions to Shareholders" for further discussion about the restrictions on the amount of dividends we can pay.

The
following table shows the distributions declared for our 2010 and 2009 fiscal years:

Year ended December 31, 2009

Record Date

Payment Date

Cash Distribution
Declared per
Common ShareFirst Quarter ended March 31, 2009







$
Second Quarter ended June 30, 2009







$
Third Quarter ended September 30, 2009


December 7, 2009


December 21, 2009

$
0.05Fourth Quarter ended December 31, 2009


February 18, 2010


March 4, 2010

$
0.07


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Year ended December 31, 2010

Record Date

Payment Date

Cash Distribution
Declared per
Common ShareFirst Quarter ended March 31, 2010


May 14, 2010


May 28, 2010

$
0.10Second Quarter ended June 30, 2010


August 18, 2010


September 1, 2010

$
0.12Third Quarter ended September 30, 2010


November 17, 2010


December 1, 2010

$
0.14Fourth Quarter ended December 31, 2010


February 18, 2011


March 4, 2011

$
0.15


Equity Compensation Plan Information

The following table summarizes the total number of securities outstanding in the incentive plan and the number of securities remaining
for future issuance, as well as the weighted average exercise price of all outstanding securities as of December 31, 2010.

Number of
securities to be issued
upon exercise of
outstanding options,
warrants and rights

Weighted average
exercise price of
outstanding options,
warrants and rights

Number of securities remaining
available for future issuance
under equity compensation
plans (excluding securities
reflected in the first column)(1)Equity compensation plan not approved by shareholders


1,932,279

$
20.00


1,889,392


(1)The
2007 Share Incentive Plan authorizes a total of 8,464,625 shares that may be used to satisfy awards including restricted shares and share options. As
such, the total number of securities remaining available for future issuance is net of 4,585,464 restricted shares already issued and 57,500 common share options already exercised. See "Item 8.
Financial Statements and Supplementary DataNote 12. Common Shares, Restricted Shares and Share Options" of this Annual Report on Form 10-K for further discussion
on the 2007 Share Incentive Plan.


52

---





Five Year Total Return Comparison

The following graph presents a total return comparison from a $100 investment in our common shares on December 31, 2005 to the
Standard & Poor's 500 Index ("S&P 500 Index") and the Russell 1000 Index ("Russell 1000").

We
obtained information for the table below from sources that we believe to be reliable, but we do not guarantee its accuracy or completeness. The graph assumes that the value of the
investment in our common shares and each index was $100 on December 31, 2005, and that all dividends were reinvested. The total return performance shown on the graph is not necessarily
indicative of future total return performance.

Share Price Performance Graph

GRAPHIC

Base
Period

Years Ending12/31/2005

12/31/2006

12/31/2007

12/31/2008

12/31/2009

12/31/2010KKR Financial Holdings LLC


100


121


71


9


33


55S&P 500 Index


100


116


123


74


98


112Russell 1000


100


116


123


74


99


114


Recent Sales of Unregistered Securities

During fiscal year 2010, the Compensation Committee of our board of directors granted to our non-employee directors an
aggregate of 52,808 restricted common shares pursuant to our 2007 Share Incentive Plan. Each of these grants vests in one-third increments on the first three anniversaries of the date of
grant. In addition, during fiscal year 2010, our non-employee directors deferred a total of $0.4 million in cash compensation in exchange for 50,749 shares of phantom shares
pursuant to the

53

---



KKR
Financial Holdings LLC Non-Employee Directors' Deferred Compensation and Share Award Plan.

The
grants made to our non-employee directors were exempt from the registration requirements of the Securities Act pursuant to Section 4(2) thereof. For further
discussion of the 2007 Share Incentive Plan, see "Item 8. Financial Statements and Supplementary DataNote 12. Common Shares, Restricted Shares and Share Options" of this
Annual Report on Form 10-K.

54

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Item 6.    SELECTED CONSOLIDATED FINANCIAL DATA

The following selected financial data is derived from our audited consolidated financial statements as of and for the years ended
December 31, 2010, 2009, 2008, 2007 and 2006. The selected financial data should be read together with the more detailed information contained in the consolidated financial statements and
associated notes, and "Management's Discussion and Analysis of Financial Condition and Results of Operations" included elsewhere in this Annual Report on Form 10-K.

(in thousands, except per share data)

Year ended
December 31,
2010

Year ended
December 31,
2009

Year ended
December 31,
2008

Year ended
December 31,
2007

Year ended
December 31,
2006Consolidated Statements of Operations Data:Net investment income (loss):Total investment income

$
505,359

$
572,725

$
948,588

$
872,373

$
627,933Interest expense


131,700


268,087


521,313


556,565


430,384Interest expense to affiliates


25,152


21,287


43,301


60,939


Provision for loan losses


29,121


39,795


481,488


25,000


Net investment income (loss)


319,386


243,556


(97,514
)

229,869


197,549Other income (loss):Total other income (loss)


143,352


(96,275
)

(906,837
)

62,012


20,753Non-investment expenses:Related party management compensation


69,125


44,323


36,670


52,535


65,298General, administrative and directors expenses


16,516


10,393


19,038


18,294


12,892Professional services


5,331


7,384


8,098


4,706


4,903Loan servicing





7,961


9,444


11,346


14,341Total non-investment expenses


90,972


70,061


73,250


86,881


97,434Income (loss) from continuing operations before equity in income of unconsolidated affiliate and income tax expense


371,766


77,220


(1,077,601
)

205,000


120,868Equity in income of unconsolidated affiliate











12,706


5,722Income (loss) from continuing operations before income tax expense


371,766


77,220


(1,077,601
)

217,706


126,590Income tax expense


702


284


107


256


964Income (loss) from continuing operations


371,064


76,936


(1,077,708
)

217,450


125,626Income (loss) from discontinued operations








2,668


(317,655
)

9,706Net income (loss)

$
371,064

$
76,936

$
(1,075,040
)
$
(100,205
)
$
135,332Net income (loss) per common share:BasicIncome (loss) per share from continuing operations

$
2.33

$
0.50

$
(7.71
)
$
2.38

$
1.53Income (loss) per share from discontinued operations

$


$


$
0.02

$
(3.53
)
$
0.12Net income (loss) per share

$
2.33

$
0.50

$
(7.69
)
$
(1.15
)
$
1.65DilutedIncome (loss) per share from continuing operations

$
2.32

$
0.50

$
(7.71
)
$
2.38

$
1.53Income (loss) per share from discontinued operations

$


$


$
0.02

$
(3.53
)
$
0.12Net income (loss) per share

$
2.32

$
0.50

$
(7.69
)
$
(1.15
)
$
1.65Weighted average number of common shares outstanding:Basic


157,936


153,756


140,027


89,953


79,626Diluted


158,771


153,756


140,027


89,953


79,926Distributions declared per common share

$
0.43

$
0.05

$
1.30

$
2.16

$
1.86


55

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(in thousands, except per share data)

As of
December 31,
2010

As of
December 31,
2009

As of
December 31,
2008

As of
December 31,
2007

As of
December 31,
2006Consolidated Balance Sheets Data:Cash and cash equivalents

$
313,829

$
97,086

$
41,430

$
524,080

$
5,125Restricted cash and cash equivalents


571,425


342,706


1,233,585


1,067,797


137,992Securities available-for-sale


838,894


755,686


555,965


1,359,541


964,440Corporate loans, net of allowance for loan losses


5,857,816


5,617,925


7,246,797


8,634,208


3,334,260Corporate loans held for sale


463,628


925,718


324,649





Residential mortgage-backed securities


93,929


47,572


102,814


131,688


169,102Residential mortgage loans(1)





2,097,699


2,620,021


3,921,323


4,957,450Equity investments, at estimated fair value


99,955


120,269


5,287





Assets of discontinued operations











3,049,758


7,596,129Total assets


8,418,412


10,300,005


12,515,082


19,046,025


17,565,177Total borrowings


6,642,455


8,970,591


11,461,610


13,425,106


8,681,157Liabilities of discontinued operations











3,644,083


7,083,230Total liabilities


6,775,364


9,133,347


11,851,737


17,401,486


15,841,746Total shareholders' equity


1,643,048


1,166,658


663,345


1,644,539


1,723,431Book value per common share

$
9.24

$
7.37

$
4.40

$
14.27

$
21.42


(1)Residential
mortgage-backed securities, residential mortgage loans and residential mortgage-backed securities issued (included within total borrowings in
the table above) were carried at fair value beginning January 1, 2007 in accordance with the fair value option for financial assets and liabilities, and at amortized cost for all periods prior
to January 1, 2007.


56

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Item 7.    MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Except where otherwise expressly stated or the context suggests otherwise, the terms "we," "us" and "our" refer
to KKR Financial Holdings LLC and its subsidiaries.

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with Part II, Item 6,
"Selected Consolidated Financial Data" and our consolidated financial statements included elsewhere in this Annual Report on Form 10-K. In addition to historical data, this
discussion contains forward-looking statements about our business, operations and financial performance based on current expectations that involve risks, uncertainties and assumptions. Our actual
results may differ materially from those in this discussion as a result of various factors, including but not limited to those discussed in Item I, Part 1A, "Risk Factors" included
elsewhere in this Annual Report on Form 10-K.

Executive Overview

We are a specialty finance company with expertise in a range of asset classes. Our core business strategy is to leverage the
proprietary resources of our manager with the objective of generating both current income and capital appreciation. We primarily invest in financial assets such as below investment grade corporate
debt, marketable equity securities and private equity.
Additionally, we have made and may make additional investments in other asset classes including natural resources and real estate. Below investment grade corporate debt includes senior secured and
unsecured loans, mezzanine loans, high yield bonds, and distressed and stressed debt securities.

The
corporate loans we invest in are primarily 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 our corporate debt investments are held in collateralized loan obligation ("CLO") transactions that are structured as on-balance sheet securitizations and
are used as long term financing for our corporate debt investments. The senior secured notes issued by the CLO transactions are primarily owned by unaffiliated third party investors and we own the
majority of the subordinated notes in the CLO transactions. Our CLO transactions consist of five cash flow CLO transactions, 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" and, together with CLO 2005-1, CLO
2005-2, CLO 2006-1 and CLO 2007-1, each a "Cash Flow CLO" and, collectively the "Cash Flow CLOs"). We execute our core business strategy through
majority-owned subsidiaries, including CLOs.

We
are a Delaware limited liability company and were organized on January 17, 2007. We are the successor to KKR Financial Corp., a Maryland corporation. Our common shares are
publicly traded on the New York Stock Exchange ("NYSE") under the symbol "KFN". We intend to continue to operate so as to qualify, for United States federal income tax purposes, as a partnership and
not as an association or publicly traded partnership taxable as a corporation.

We
are managed by KKR Financial Advisors LLC (our "Manager"), a wholly-owned subsidiary of KKR Asset Management LLC (formerly known as Kohlberg Kravis
Roberts & Co. (Fixed Income) LLC), 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").



During 2010, the high yield debt markets experienced continued price appreciation with the S&P/LSTA Loan index returning 10.2% for 2010
and the Merrill Lynch High Yield Master II index returning 15.2% for 2010. The double digit increases in asset prices witnessed in both the leveraged loan and high yield markets benefited our
corporate debt portfolio with the weighted average estimated

57

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market
value of our corporate loan portfolio increasing 8.3% from 87.0% of par value as of December 31, 2009, to 94.2% of par value as of December 31, 2010, and the weighted average
estimated market value of our corporate debt securities portfolio increasing 9.6% from 90.4% as of December 31, 2009, to 99.1% as of December 31, 2010.



Our net income for the year ended December 31, 2010 totaled $371.1 million (or $2.32 per diluted common share), as
compared to net income of $76.9 million (or $0.50 per diluted common share) and net loss of $1.1 billion (or $7.69 per diluted common share), for the years ended December 31, 2009
and 2008, respectively. The increase in net income of $294.1 million from 2009 to 2010 is attributable to an increase in net investment income of $75.8 million and an increase in other
income of $239.6 million primarily due to realized gains on the sale of certain corporate debt securities driven by capital appreciation, partially offset by an increase in
non-investment expenses of $20.9 million. The increase in net income of $1.2 billion from 2008 to 2009 is attributable to an increase in net investment income of
$341.1 million and an increase in other income of $810.6 million due to the 2008 economic crisis that resulted in historic asset price declines and us recording a provision for loan
losses totaling $481.5 million and impairment losses totaling $474.5 million. The components of these amounts for the years ended December 31, 2010, 2009, and 2008 are detailed
further below under "Results of Operations."



On January 15, 2010, we 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 year 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 our right to terminate the conversion rights of the notes. We may satisfy our obligation with respect to 7.5% Notes tendered for conversion by
delivering to the holder either cash, common shares, no par value, issued by us or a combination thereof. The initial conversion rate for each $1,000 principal amount of 7.5% Notes was 122.2046 common
shares, which is equivalent to an initial conversion price of approximately $8.18 per common 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
December 31, 2010, the conversation rate for each $1,000 principal amount of 7.5% Notes was 125.6251 common shares. Net proceeds from the offering totaled $167.3 million, reflecting
gross proceeds of $172.5 million from the issuance less $5.2 million for underwriting fees.

During
2010, we repurchased $95.2 million par amount of our 7.0% convertible senior notes due 2012, reducing the amount outstanding from $275.8 million as of
December 31, 2009 to $180.6 million as of December 31, 2010. These transactions resulted in a gain of $1.3 million, which was partially offset by a write-off of
$0.6 million of unamortized debt issuance costs during 2010.

On
May 3, 2010, we 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. We 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, we obtained additional

58

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commitments
of $40.0 million, bringing the total amount of commitments under the 2014 Facility to $250.0 million.

We
have 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 us, including a restriction from making annual distributions to holders of common shares in excess of
65% of our estimated annual taxable income.

On
May 26, 2010, we terminated our credit agreement, dated as of November 10, 2008 and maturing on November 10, 2011 (the "2011 Credit Agreement"). The 2011 Credit
Agreement was terminated in connection with our initial borrowing under our 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 we repaid.

On
November 5, 2010, we entered into a credit agreement for a five-year $49.7 million asset-based revolving credit facility (the "2015 Natural Resources
Facility"), maturing on November 5, 2015, that is subject to, among other things, the terms of a borrowing base derived from the value of eligible specified oil and gas assets. The borrowing
base is subject to certain caps and concentration limits customary for financings of this type. We have the right to prepay loans under the 2015 Natural Resources Facility in whole or in part at any
time. Loans under the 2015 Natural Resources Facility bear interest at a rate equal to LIBOR plus a tiered applicable margin ranging from 1.75% to 2.75% per annum. The 2015 Natural Resources Facility
contains customary covenants applicable to us.

As
of December 31, 2010, we had $18.4 million of borrowings outstanding under the 2015 Natural Resources Facility. In addition, under the 2015 Natural Resources Facility,
we had a letter of credit outstanding totaling $1.0 million as of December 31, 2010.

As
of December 31, 2010, we believe we were in compliance with the covenant requirements for both credit facilities.



On December 13, 2010, we completed an underwritten public offering of 18,000,000 common shares at a price of $9.04 per share,
resulting in gross proceeds of $162.7 million. We also granted the underwriter a 30 day option to purchase up to 2,700,000 additional common shares solely to cover
over-allotments. On December 28, 2010, the underwriter exercised its option and purchased 1,436,000 shares, resulting in an additional $13.0 million of gross proceeds. The
total proceeds from this offering will be used to acquire assets in accordance with our core business strategy and for general corporate purposes.



Effective January 1, 2010, we adopted new guidance that 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 either 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, we determined that six residential mortgage loan securitization
trusts, which were previously consolidated by us as we were deemed to be the primary beneficiary, were required to be deconsolidated. We determined that we did not have the power to direct the
activities that most significantly impacted the economic performance of the securitization trusts or the performance of the

59

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securitization
trusts' underlying asset 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 are no longer
reported on our consolidated financial statements. Our deconsolidation of the six residential mortgage loan securitization trusts had no net impact on shareholders' equity, results of operations and
cash flows.

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 all VIEs that we consolidate as we have determined we have the power to direct the activities that most significantly impact these entities' economic performance and we have
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.

As
our consolidated financial statements in this Annual Report on Form 10-K are presented to reflect the consolidation of the CLOs we hold investments in, the
information contained in this Management's Discussion and Analysis of Financial Condition and Results of Operations reflects the CLOs on a consolidated basis which is consistent with the disclosures
in our consolidated financial statements.



During 2010, we paid aggregate cash distributions totaling $68.1 million. The amount and timing of our distributions to our
common shareholders are determined by our board of directors and is based upon a review of various factors including current market conditions, existing restrictions under borrowing agreements and our
liquidity needs.

As
discussed above, the 2014 Facility contains negative covenants that restrict our ability, among other things, to pay dividends or make certain other restricted payments, including a
prohibition on distributions to our shareholders in an amount in excess of what would be required to pay all federal, state and local income taxes arising from the taxable income and gain that our
shareholders incur in connection with the ownership of our common shares. In addition, no dividends shall be paid if a deficiency in the required collateral per the agreement exists or would exist as
a result of such dividend.



We intend to continue to operate so as to qualify, for United States federal income tax purposes, as a partnership and not as an
association or a publicly traded partnership taxable as a corporation. Holders of our shares are subject to United States federal income taxation and generally other taxes, such as state, local and
foreign income taxes, on their allocable share of our taxable income, regardless of whether or when they receive cash distributions. In addition, certain of our investments, including investments in
foreign corporate subsidiaries, CLO issuers (which are treated as partnerships or disregarded entities for United States federal income tax purposes) and debt securities, may produce taxable income
without corresponding distributions of cash to us or produce taxable income prior to or following the receipt of cash relating to such income. Consequently, in some taxable years, holders of our
shares may recognize taxable income in excess of our cash distributions. Furthermore, even if we did not pay cash distributions with respect to a taxable year, holders of our shares may still have a
tax liability attributable to their allocation of our taxable income during such year.



As discussed above, the majority of our investments are held through CLO transactions that are managed by an affiliate of our Manager
and for which we own the majority, and in some cases all, of

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the
economic interests in the transaction through the subordinated notes in the transaction. On an unconsolidated basis, our investment portfolio primarily consists of the following as of
December 31, 2010: (i) mezzanine and subordinated tranches of CLO transactions with an aggregate par amount of $1.1 billion; (ii) corporate loans with an aggregate par
amount of $550.6 million and an estimated fair value of $466.8 million; (iii) corporate debt securities with an aggregate par amount of $114.3 million and an estimated fair
value of $107.7 million; (iv) residential mortgage-backed securities ("RMBS") with a par amount of $227.9 million and estimated fair value of $93.9 million; and
(v) equity and private equity investments with an estimated fair value of $96.3 million. In addition, we hold oil and gas assets as well as other investments including credit default
swap transactions, commodity derivatives, commodity derivatives, foreign exchange hedges and interest rate swaps.

As
our consolidated financial statements in this Annual Report on Form 10-K are presented to reflect the consolidation of the CLOs we hold investments in, the
information contained in this Management's Discussion and Analysis of Financial Condition and Results of Operations reflects the CLOs on a consolidated basis which is consistent with the disclosures
in our consolidated financial statements.



Our investments in corporate debt primarily consist of investments in below investment grade corporate loans, often referred to as
syndicated bank loans or leveraged loans, and corporate debt securities. Loans that are not deemed to be held for sale are carried at amortized cost net of allowance for loan losses on our
consolidated balance sheet. Loans that are classified as held for sale are carried at the lower of net amortized cost or estimated fair value on our consolidated balance sheet. Debt securities are
carried at estimated fair value on our consolidated balance sheet.

These
investments have an aggregate par balance of $7.8 billion, an aggregate net amortized cost of $7.2 billion and an aggregate estimated fair value of
$7.4 billion as of December 31, 2010. Included in these amounts is $7.1 billion par amount or $6.8 billion estimated fair value of investments held in our five Cash Flow
CLOs through which we finance the majority of our corporate debt investments. These
Cash Flow CLOs have aggregate secured notes outstanding totaling $5.6 billion held by unaffiliated third parties and aggregate junior secured notes outstanding totaling $366.1 million
held by an affiliate of our Manager. In CLO transactions, subordinated notes effectively represent the equity in such transactions as they have the first risk of loss and conversely, the residual
value upside of the transactions. As we hold the majority of the subordinated notes in each of the five CLOs, we consolidate all five of the CLOs and reflect all income and losses related to the
assets in these CLOs on our consolidated statement of operations even though a minority interest in two of our CLO transactions is not held by us.



Our residential mortgage investment portfolio consists of investments in RMBS with an estimated fair value of $93.9 million as
of December 31, 2010.



During the fourth quarter of 2010, we acquired working interests in U.S. producing oil and gas fields for approximately
$32.8 million, of which $18.4 million was financed with a five-year $49.7 million non-recourse, asset-based revolving credit facility maturing
November 5, 2015. See "Sources of FundsAsset-Based Borrowing Facility" for further discussion.

Critical Accounting Policies

Our consolidated financial statements are prepared by management in conformity with accounting principles generally accepted in the
United States of America ("GAAP"). Our significant accounting

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policies
are fundamental to understanding our financial condition and results of operations because some of these policies require that we make significant estimates and assumptions that may affect
the value of our assets or liabilities and financial results. We believe that certain of our policies are critical because they require us to make difficult, subjective, and complex judgments about
matters that are
inherently uncertain. We have reviewed these critical accounting policies with our board of directors and our audit committee.



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 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:



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

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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 us 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 we recognize 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 we and others are willing to pay for an
asset. Ask prices represent the lowest price that we and others are willing to accept for an asset. For financial assets and liabilities whose inputs are based on bid-ask prices, we do not
require that fair value always be a predetermined point in the bid-ask range. Our policy is to allow for mid-market pricing and adjusting to the point within the
bid-ask range that meets our best estimate of fair value.

Depending
on the relative liquidity in the markets for certain assets, we may transfer assets to Level 3 if we determine 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.

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 generally determined based on relative value
analyses, which incorporate similar instruments from similar issuers.

Equity Investments, at Estimated Fair Value:Equity investments, at estimated fair value, are initially valued at transaction price and
are
subsequently valued using observable market prices, if available, or internally developed models in the absence of readily observable market prices. Valuation models are generally based on a market
and income (discounted cash flow) approach, from which various internal and external factors are considered. Factors include the price at which the investment was acquired, the nature of the
investment, current market conditions, recent public market and private transactions for comparable securities, and financing transactions subsequent to the acquisition of the investment. The fair
value recorded for a particular investment will generally be within the range suggested by the two approaches.

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.

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.

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We account for share-based compensation issued to members of our board of directors and our Manager using the fair value based
methodology in accordance with GAAP. We do not have any employees, although we believe that members of our board of directors are deemed to be employees for purposes of interpreting and applying
accounting principles relating to share-based compensation. We record as compensation costs the restricted common shares that we issued to members of our board of directors at estimated fair value as
of the grant date and we amortize the cost into expense over the three-year vesting period using the straight-line method. We record compensation costs for restricted common
shares and common share options that we issued to our Manager at estimated fair value as of the grant date and we remeasure the amount on subsequent reporting dates to the extent the awards have not
vested. Unvested restricted common shares are valued using observable secondary market prices. Unvested common share options are valued using the Black-Scholes model and assumptions based on
observable market data for comparable companies. We amortize compensation expense related to the restricted common shares and common share options that we granted to our Manager using the graded
vesting attribution method.

Because
we remeasure the amount of compensation costs associated with the unvested restricted common shares and unvested common share options that we issued to our Manager as of each
reporting period, our share-based compensation expense reported in our consolidated financial statements will change based on the estimated fair value of our common shares and this may result in
earnings volatility. For the year ended December 31, 2010, share-based compensation totaled $6.9 million. As of December 31, 2010, substantially all of the non-vested
restricted common shares issued are subject to remeasurement. As of December 31, 2010, a $1 increase in the price of our common shares would have increased our future share-based compensation
expense by approximately $1.1 million and this future share-based compensation expense would be recognized over the remaining vesting periods of our outstanding restricted common shares. As of
December 31, 2010, the common share options were fully vested and expire in August 2014. As of December 31, 2010,
future unamortized share-based compensation totaled $1.3 million, of which $1.0 million, $0.2 million, and an immaterial amount will be recognized in 2011, 2012 and 2013,
respectively.



We recognize all derivatives on our consolidated balance sheets at estimated fair value. On the date we enter into a derivative
contract, we designate and document 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, we record 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, we record changes in the estimated fair value of the derivative to the extent that it is effective in other comprehensive income
(loss) and subsequently reclassify 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, we report changes in the fair values in other income (loss).

We
formally document at inception our hedge relationships, including identification of the hedging instruments and the hedged items, our risk management objectives, strategy for
undertaking the hedge transaction and our evaluation of effectiveness of our hedged transactions. Periodically, we also formally assess whether the derivative designated in each hedging relationship
is expected to be and has

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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 we determine that a
derivative is not highly effective as a hedge, we discontinue hedge accounting.

We
are not required to account for our derivative contracts using hedge accounting as described above. If we decide not to designate the derivative contracts as hedges or if we fail to
fulfill the criteria necessary to qualify for hedge accounting, then the changes in the estimated fair values of our derivative contracts would affect periodic earnings immediately potentially
resulting in the increased volatility of our earnings. The qualification requirements for hedge accounting are complex and as a result, we must evaluate, designate, and thoroughly document each hedge
transaction at inception and perform ineffectiveness analysis and prepare related documentation at inception and on a recurring basis thereafter. As of December 31, 2010, the estimated fair
value of our net derivative liabilities totaled $57.0 million.



We monitor our 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. We consider 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 we consider our intent to sell the debt security, our estimation of whether or not we expect to recover the debt security's entire amortized cost if we intend to hold the
debt security, and whether it is more likely than not that we will be required to sell the debt security before its anticipated recovery. For equity securities, we also consider our 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 we intend to sell or estimate that it is
more likely than not that we 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 we do not intend to sell or estimate that we are 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).

This
process involves a considerable amount of judgment by our management. As of December 31, 2010, we had aggregate unrealized losses on our securities classified as
available-for-sale of approximately $3.6 million, which if not recovered may result in the recognition of future losses. During the year ended December 31, 2010,
we recorded charges for impairments of securities that we determined to be other-than-temporary totaling $2.6 million.



Our corporate loan portfolio is comprised of a single portfolio segment which includes one class of financing receivables, that is,
high yield loans that are purchased via
assignment or participation in either the primary or secondary market and are held primarily for investment. High yield loans are generally characterized as having below investment grade ratings or
being unrated and generally consist of leveraged loans.

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Our
allowance for loan losses represents our estimate of probable credit losses inherent in our corporate loan portfolio held for investment as of the balance sheet date. Estimating our
allowance for loan losses involves a high degree of management judgment and is based upon a comprehensive review of our loan portfolio that is performed on a quarterly basis. Our allowance for loan
losses consists of two components, an allocated component and an unallocated component. The allocated component of our allowance for loan losses pertains to specific loans that we have determined are
impaired. We determine a loan is impaired when we estimate that it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan agreement. On a
quarterly basis we perform a comprehensive review of our entire loan portfolio and identify certain loans that we have determined are impaired. Once a loan is identified as being impaired we place the
loan on non-accrual status, unless the loan is already on non-accrual status, and record a reserve that reflects our best estimate of the loss that we expect to recognize from
the loan. The expected loss is estimated as being the difference between our current cost basis of the loan, including accrued interest receivable, and the loan's estimated fair value.

The
unallocated component of our allowance for loan losses represents our estimate of probable losses inherent in our loan portfolio as of the balance sheet date where the specific loan
that the loan loss relates to is indeterminable. We estimate the unallocated component of our allowance for loan losses through a comprehensive review of our loan portfolio and identify certain loans
that demonstrate possible indicators of impairment, including internally assigned credit quality indicators. This assessment excludes all loans that are determined to be impaired and as a result, an
allocated reserve has been recorded as described in the preceding paragraph. 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. All loans are first categorized based on their assigned
risk grade and further stratified based on the seniority of the loan in the issuer's capital structure. The seniority classifications assigned to loans are senior secured, second lien and subordinate.
Senior secured consists of loans that are the most senior debt in an issuer's capital structure and therefore have a lower estimated loss severity than other debt that is subordinate to the senior
secured loan. Senior secured loans often have a first lien on some or all of the issuer's assets. Second lien consists of loans that are secured by a second lien interest on some or all of the
issuer's assets; however, the loan is subordinate to the first lien debt in the issuer's capital structure. Subordinate consists of loans that are generally unsecured and subordinate to other debt in
the issuer's capital structure.

There
are three internally assigned risk grades that are applied to loans that have not been identified as being impaired: high, moderate and low. High risk means that there is evidence
of probable loss due to the financial or operating performance and liquidity of the issuer, industry or economic concerns
specific to the issuer, or other factors that indicate that the breach of a covenant contained in the related loan agreement is possible. Moderate risk means that while there is not observable
evidence of loss, there are issuer and/or industry specific trends that indicate a loss may have occurred. Low risk means that while there is no identified evidence of loss, there is the risk of loss
inherent in the loan that has not been identified. All loans held for investment, with the exception of loans that have been identified as impaired, are assigned a risk grade of high, moderate or low.

We
apply a range of default and loss severity estimates in order to estimate a range of loss outcomes upon which to base our estimate of probable losses that results in the determination
of the unallocated component of our allowance for loan losses. As of December 31, 2010, the range of outcomes used to estimate concern as to the probability of default was between 1% and 20%
and the range of loss severity assumptions was between 5% and 85%. The estimates and assumptions we use to estimate our allowance for loan losses are based on our estimated range of outcomes that are
determined from industry information providing both historical and forecasted empirical performance of the type of corporate loans that we invest in, as well as from our own estimates based on the
nature

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of
our corporate loan portfolio. These estimates and assumptions are susceptible to change due to our corporate loan portfolio's performance as well as industry and general economic conditions.
Changes in the assumptions and estimates used to estimate our allowance for loan losses could have a material impact on our financial condition and results of operations.

As
of December 31, 2010, our allowance for loan losses totaled $209.0 million.

Recent Accounting Pronouncements



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. We have included the required disclosures in our consolidated financial statements.

Results of Operations



The following discussion presents an analysis of our results of operations on a comparative basis for the fiscal years ended December
2010, 2009 and 2008. Our results of operations may be materially affected by market fluctuations and current economic events, particularly in the fixed income and equity markets.

A
summary of key financial results year over year were as follows (amounts in thousands, except per share information):

Year ended
December 31,
2010

Year ended
December 31,
2009

Year ended
December 31,
2008Net investment income (loss)

$
319,386

$
243,556

$
(97,514
)Total other income (loss)


143,352


(96,275
)

(906,837
)Total non-investment expenses


90,972


70,061


73,250Income (loss) from continuing operations before income tax expense


371,766


77,220


(1,077,601
)Income tax expense


702


284


107Income (loss) from continuing operations


371,064


76,936


(1,077,708
)Income from discontinued operations








2,668Net income (loss)

$
371,064

$
76,936

$
(1,075,040
)Income (loss) per share from continuing operationsdiluted

$
2.32

$
0.50

$
(7.71
)Income (loss) per share from discontinued operationsdiluted

$


$


$
0.02Net income (loss) per sharediluted

$
2.32

$
0.50

$
(7.69
)


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The following table presents the components of our net investment income (loss) for the years ended December 31, 2010, 2009 and
2008:

Comparative Net Investment Income (Loss) Components  (Amounts in thousands)

For the year ended
December 31, 2010

For the year ended
December 31, 2009

For the year ended
December 31, 2008Investment Income:Corporate loans and securities interest income

$
369,387

$
380,704

$
696,213Residential mortgage loans and securities interest income


23,924


120,985


178,106Other investment income


1,064


580


22,584Dividend income


2,266


339


2,629Net discount accretion


108,718


70,117


49,056Total investment income


505,359


572,725


948,588Interest Expense:Repurchase agreements








34,407Collateralized loan obligation secured notes


59,242


112,798


284,782Senior secured credit facility


12,852


16,356


15,684Secured demand loan








348Convertible senior notes


28,171


20,444


21,825Junior subordinated notes


15,600


16,610


21,974Residential mortgage-backed securities issued





82,052


130,046Interest rate swaps


15,562


14,432


7,800Other interest expense


273


5,395


4,447Total interest expense


131,700


268,087


521,313Interest expense to affiliates


25,152


21,287


43,301Provision for loan losses


29,121


39,795


481,488Net investment income (loss)

$
319,386

$
243,556

$
(97,514
)


Due
to our adoption of the new guidance related to consolidation of variable interest entities (as described above under "Executive Overview"), certain amounts for the years ended
December 31, 2009 and 2008, which were related to the six residential mortgage loan securitization trusts that we deconsolidated effective January 1, 2010, should be disregarded for
comparative purposes. For the years ended December 31, 2009 and 2008, residential mortgage-backed securities issued RMBS Issued interest expense totaled $82.1 million and
$130.0 million, respectively, and residential mortgage loans interest income totaled $90.0 million and $139.5 million, respectively, related to the six residential mortgage loan
securitization trusts which were deconsolidated.

2010 and 2009

As presented in the table above, net investment income increased by $75.8 million from $243.6 million for 2009 to
$319.4 million for 2010. Total investment income, consisting primarily of interest income and discount accretion from our investment portfolio, totaled $505.4 million for 2010 as
compared to $572.7 million for 2009. The decrease in total investment income of approximately $67.4 million is primarily attributable to two factors. First, the majority of our
investment portfolio is floating rate and indexed to either one-month or three-month LIBOR. The average one-month and three-month LIBOR rates were 0.27% and 0.34%,
respectively, for 2010, as compared to 0.33% and

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0.69%,
respectively, for 2009. Accordingly, the declines in LIBOR significantly reduced interest income earned from our investment portfolio in 2010 as compared to 2009. The second factor that
contributed to lower investment income was the reduced size of our investment portfolio during 2010 as compared to 2009. The par value of our corporate loan portfolio decreased by approximately
$0.4 billion, or 5.9%, from $7.4 billion as of December 31, 2009 to $6.9 billion as of December 31, 2010. The decline in the par balances of our corporate loans was
partially attributable to additional paydowns during 2010. The decrease in investment income on our corporate debt portfolio was partially offset by an increase in net discount accretion of
$38.6 million. A significant portion of the net discount accretion was due to accelerated accretion from prepayments on our corporate debt portfolio. During 2010, our corporate debt portfolio
had paydowns of $1.7 billion par value, as compared to $659.9 million par value during 2009.

Interest
expense decreased by approximately $136.4 million from $268.1 million for 2009 to $131.7 million for 2010. Similar to the decline in total investment
income, the decline in interest expense is primarily attributable to the decline in LIBOR as the majority of our debt is floating rate, and reduced debt balances in 2010. The largest decline in debt
was attributable to the decline in CLO senior secured notes of approximately $37.4 million from $5.7 billion as of December 31, 2009 to $5.6 billion as of
December 31, 2010. The decline in CLO senior secured notes was primarily attributable to the retirement of the $1.6 billion of senior secured notes during 2009 that were issued by
Wayzata.

2009 and 2008

Net investment income increased by $341.1 million from a loss of $97.5 million for 2008 to income of
$243.6 million for 2009. Total investment income, consisting primarily of interest income and discount accretion from our investment portfolio, totaled $572.7 million for 2009 as
compared to $948.6 million for 2008. The decrease in total investment income of approximately $375.9 million is primarily attributable to a significant decline in rates earned on our
assets and volume
of our investment portfolio. The average one-month and three-month LIBOR rates were 0.33% and 0.69%, respectively, for 2009, compared to 2.67% and 2.91%, respectively, for 2008. In
addition, the par value of our corporate loan portfolio decreased by approximately $1.1 billion, or 12.9%, from $8.5 billion as of December 31, 2008 to $7.4 billion as of
December 31, 2009. The par value of our corporate debt securities portfolio decreased by approximately $0.4 billion, or 33.3%, from $1.2 billion as of December 31, 2008 to
$0.8 billion as of December 31, 2009. The decline in the par balances of our corporate loans and bonds was primarily attributable to sales of assets undertaken as part of the retirement
of CLO 2009-1 (previously Wayzata) that occurred during 2009.

Interest
expense decreased by approximately $253.2 million, or 48.6%, from $521.3 million for 2008 to $268.1 million for 2009. Similar to the decline in total
investment income, the decline in interest expense is primarily attributable to the decline in LIBOR as the majority of our debt is floating rate, as well as reduced debt balances in 2009 as compared
to 2008. The largest decline in debt was attributable to the decline in CLO senior secured notes of approximately $1.8 billion, or 24.0%, from $7.5 billion as of December 31,
2008, to $5.7 billion as of December 31, 2009. The decline in CLO senior secured notes was primarily attributable to the retirement of the $1.6 billion of senior secured notes
during 2009 that were issued by Wayzata.

The
last significant contributor to the increase in net investment income from 2008 to 2009 was a reduction in the amount of expense recorded as a provision for loan losses. During 2008,
we recorded a provision for loan losses of $481.5 million, which was $441.7 million higher than the $39.8 million provision for loan losses recorded during 2009. The provision for
loan losses recorded in 2008 was in response to rapidly deteriorating market conditions that were deemed to have a material negative impact on our investment portfolio. The amount of provision for
loan losses that we recognize is a function of the balance that we deem necessary to reserve for losses that we estimate to be inherent in

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our
corporate loan investment portfolio. Our allowance for loan losses is described in further detail under "Investment Portfolio" in this Management's Discussion and Analysis of Financial Condition
and Results of Operations.



The following table presents the components of other income (loss) for the years ended December 31, 2010, 2009 and 2008:

Comparative Other Income (Loss) Components  (Amounts in thousands)

For the year ended
December 31, 2010

For the year ended
December 31, 2009

For the year ended
December 31, 2008Net realized and unrealized (loss) gain on derivatives and foreign exchange:Interest rate swaps

$
311

$
(3,328
)
$
3,108Commodity swaps


(226
)




Credit default swaps


1,970


17,632


41,177Total rate of return swaps


1,771


45,607


(188,829
)Common stock warrants


663


457


(799
)Foreign exchange(1)


(9,183
)

540


4,024Total realized and unrealized (loss) gain on derivatives and foreign exchange


(4,694
)

60,908


(141,319
)Net realized loss on residential mortgage-backed securities and residential mortgage loans, carried at estimated fair value


(23,643
)

(17,234
)

(5,761
)Net unrealized gain (loss) on residential mortgage-backed securities, residential mortgage loans, and residential mortgage-backed securities issued,
carried at estimated fair value


12,247


(89,794
)

(43,138
)Net realized and unrealized gain (loss) on investments(2)


122,199


(48,381
)

(330,234
)Net realized and unrealized (loss) gain on securities sold, not yet purchased


(756
)

3,582


50,297Impairment of securities available-for-sale and private equity at cost


(12,890
)

(43,906
)

(474,520
)Net gain on restructuring and extinguishment of debt


39,999


30,836


26,486Other income


10,890


7,714


11,352Total other income (loss)

$
143,352

$
(96,275
)
$
(906,837
)


(1)Includes
foreign exchange contracts and foreign exchange remeasurement gain or loss.(2)Includes
lower of cost or estimated fair value adjustment to corporate loans held for sale and unrealized gain (loss) on investments held at estimated fair
value.


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2010 and 2009

As presented in the table above, other income totaled $143.4 million for 2010 as compared to other loss of $96.3 million
for 2009. Net realized and unrealized gains on investments totaled $122.2 million in 2010 as compared to losses of $48.4 million in 2009. In addition, impairment of securities
available-for-sale and private equity at cost totaled $12.9 million in 2010 as compared to $43.9 million in 2009. The year over year improvement with respect to
both realized and unrealized losses on investments, and impairment losses is primarily due to higher asset prices. The weighted average market value of our corporate debt portfolio, as a percentage of
par, increased 8.4% from 87.3% as of December 31, 2009 to 94.7% as of December 31, 2010. These improvements were partially offset by realized and unrealized loss on derivatives and
foreign exchange.
Net realized and unrealized gains on total rate of return swaps decreased $43.8 million, from $45.6 million in 2009 to $1.8 million in 2010 primarily due to the unrealized gains
on certain foreign denominated total rate of return swaps in 2009. Total rate of return swaps are derivates that are used to finance investments in corporate loans with changes in market value
reflected in income. During 2010, we unwound all of our total rate of return swaps. In addition, net realized and unrealized gains on credit default swaps decreased $15.7 million, from
$17.6 million in 2009 to $2.0 million in 2010 primarily due to the unwind of a certain credit default swap in 2009. Credit default swaps are bilateral contracts between a buyer and
seller of protection as it relates to a credit default or other specified credit event with respect to the issuer.

2009 and 2008

Other loss totaled $96.3 million for 2009 as compared to $906.8 million for 2008. The improvement in other loss for 2009
as compared to 2008 is attributable to several factors. First, total realized and unrealized gain (loss) on derivatives improved by approximately $202.2 million from a loss of
$141.3 million for 2008 to a $60.9 million gain for 2009. The total realized and unrealized loss on derivatives for 2008 was primarily due to a $188.8 million loss on total rate
of return swaps, which was partially offset by a $41.2 million gain on credit default swaps. As a result of material declines in corporate loan asset prices in 2008, our total rate of return
swaps generated significant losses. Similarly, appreciation in corporate loan prices resulted in gains from total rate of return swaps of $45.6 million during 2009.

Another
contributing factor to the improvement in total other loss from 2008 to 2009 relates to investment gains and losses. Net realized and unrealized losses on investments totaled
$330.2 million in 2008 as compared to $48.4 million in 2009. In addition, impairment of securities available-for-sale totaled $474.5 million in 2008 as
compared to $43.9 million in 2009. The year over year improvement with respect to both realized and unrealized losses on investments and impairment losses was primarily due to significantly
higher asset prices in 2009.

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Non-Investment Expenses

The following table presents the components of non-investment expenses for the years ended December 31, 2010, 2009
and 2008:

Comparative Non-Investment Expense Components  (Amounts in thousands)

For the year ended
December 31, 2010

For the year ended
December 31, 2009

For the year ended
December 31, 2008Related party management compensation:Base management fees

$
19,113

$
14,904

$
32,050Incentive fees


38,832


4,472


Share-based compensation


5,784


3,451


(463
)CLO management fees


5,396


21,496


5,083Related party management compensation


69,125


44,323


36,670Professional services


5,331


7,384


8,098Loan servicing





7,961


9,444Insurance


2,443


1,879


923Directors' expenses


2,733


2,117


1,127Other general and administrative


11,340


6,397


16,988Total non-investment expenses

$
90,972

$
70,061

$
73,250


2010 and 2009

As presented in the table above, our non-investment expenses increased from 2009 to 2010 by approximately
$20.9 million. The significant components of non-investment expense are described below.

Management
compensation to related parties consists of base management fees payable to our Manager pursuant to the Management Agreement, incentive fees, collateral management fees, and
share-based compensation related to restricted common shares and common share options granted to our Manager.

The
base management fee payable was calculated in accordance with the Management Agreement and is based on an annual rate of 1.75% times our "equity" as defined in the Management
Agreement. Base management fees increased by $4.2 million from 2009 to 2010 due to the $294.1 million increase in net income for the year ended December 31, 2010.

Our
Manager is also entitled to a quarterly incentive fee provided that our quarterly "net income," as defined in the Management Agreement, before the incentive fee exceeds a defined
return hurdle. Incentive fees of $38.8 million were earned by the Manager during 2010 as compared to $4.5 million in 2009, and served as the primary contributor to the increase in total
non-investment expenses year over year. The increase in incentive fees was also attributable to the increase in net income of $294.1 million primarily driven by corporate debt price
appreciation in 2010.

An
affiliate of our Manager entered into separate management agreements with the respective investment vehicles 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. The collateral manager has the option
to waive the fees it earns for providing management services for the CLOs and has done so in prior periods.

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Beginning April 2007, the collateral manager ceased waiving fees for CLO 2005-1 and beginning January 2009, the collateral manager ceased waiving fees for CLO
2005-2, CLO 2006-1, CLO 2007-1, CLO 2007-A and Wayzata (restructured and replaced with CLO 2009-1 on March 31, 2009). However,
starting in July 2009, the collateral manager reinstated waiving the CLO management fees for CLO 2005-2 and CLO 2006-1, and starting in 2010, the collateral manager
reinstated waiving the CLO management fees for CLO 2007-A and CLO 2007-1. 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 fees for CLO 2009-1. As such, the CLO management fees for all CLOs, except for CLO 2005-1, are being
waived or are no longer entitled to be received as of December 31, 2010.

The
aggregate amounts waived are inversely related to the total CLO management fees recorded. Accordingly, for the years ended December 31, 2010 and 2009, the collateral manager
waived aggregate CLO management fees of $30.6 million and $5.2 million, respectively, while for the years ended December 31, 2010 and 2009, we recorded an expense for CLO
management fees totaling $5.4 million and $21.5 million, respectively. CLO management fees decreased $16.1 million from 2009 to 2010 as all six CLOs were paying CLO management
fees during the first half of 2009.

General
and administrative expenses include expenses incurred by our Manager on our behalf that are reimbursable to our Manager pursuant to the Management Agreement. Beginning
January 1, 2009, our Manager permanently waived reimbursable general and administrative expenses allocable to us in an amount equal to the incremental CLO management fees received by the
Manager. For the years ended December 31, 2010 and 2009, our Manager permanently waived reimbursement of allocable general and administrative expenses totaling $2.4 million and
$9.8 million, respectively. Due to the reinstatement of waived CLO management fees described above, effective June 2010, all incremental CLO management fees received by our Manager had been
fully applied to offset these reimbursable expenses. Accordingly, for the year ended December 31, 2010, we reimbursed our Manager for allocable general and administrative expenses of
$4.6 million, as compared to nil for the year ended December 31, 2009.

Professional
services expenses consist of legal, accounting and other professional services. Directors' expenses represent share-based compensation, as well as expenses and reimbursables
due to the board of directors for their services. The increase in other general and administrative expenses of $4.9 million from December 31, 2009 to 2010 was largely attributable to the
rebated CLO management fees reducing the general and administrative expenses otherwise reimbursable to our Manager.

2009 and 2008

Non-investment expenses decreased by $3.2 million from 2008 to 2009 primarily due to two factors. First, base
management fees decreased $17.1 million from December 31, 2008 to 2009 primarily due to the significant decline in "equity" as a result of the $1.1 billion loss we reported for
the year ended December 31, 2008. Second, as discussed above, all six CLOs began paying CLO management fees during the first half of 2009, while only two CLOs were paying CLO management fees
during the latter half of 2009. During 2008, only CLO 2005-1 was paying CLO management fees. Accordingly, for 2009, the CLOs incurred management fees of $21.5 million while the
collateral manager permanently waived CLO management fees of approximately $5.2 million. In contrast, for 2008, the CLOs incurred management fees of $5.1 million while the collateral
manager permanently waived CLO management fees of approximately $39.0 million. In addition, for 2009 and 2008, we reimbursed our Manager nil and $9.9 million, respectively, for allocable
general and administrative expenses.

Income Tax Provision

We intend to continue to operate so as to qualify, for United States federal income tax purposes, as a partnership and not as an
association or publicly traded partnership taxable as a corporation. Therefore, we generally are not subject to United States federal income tax at the entity level, but are

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subject
to limited state income taxes. Holders of our shares are required to take into account their allocable share of each item of our income, gain, loss, deduction and credit for our taxable year
end ending within or with their taxable year.

During
2010, we owned an equity interest in KKR Financial Holdings II, LLC ("KFH II"), which elected to be taxed as a REIT under the Code. KFH II holds certain real estate
mortgage-backed securities. A REIT 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
their taxable income.

We
have wholly-owned domestic and foreign subsidiaries that are taxable as corporations for United States federal income tax purposes and thus are not consolidated by us 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 us with respect to our 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. They generally will not be subject to corporate income tax in our financial statements on their earnings, and no provisions for income taxes for
the year ended December 31, 2010 were recorded; however, we will be required to include their current taxable income in our calculation of our taxable income allocable to shareholders. CLO
2005-1, CLO 2005-2, CLO 2006-1, CLO 2007-1, CLO 2007-A and CLO 2009-1 are our foreign subsidiaries 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.

While
the remaining REIT subsidiary (KFH II) is not expected to incur a 2010 federal or state tax liability, several of our domestic taxable corporate subsidiaries are expected to
incur a relatively small amount of 2010 federal and state tax liability.

Investment Portfolio

Corporate Investment Portfolio Summary

Our corporate investment portfolio primarily consists of investments in corporate loans and debt securities. Our corporate loans
primarily consist of senior secured, second lien and subordinated loans. The corporate loans we invest in are generally below investment grade and are floating rate indexed to either
one-month or three-month LIBOR. Our investments in
corporate debt securities primarily consist of investments in below investment grade corporate bonds that are senior secured, senior unsecured and subordinated. We evaluate and monitor the asset
quality of our investment portfolio by performing detailed credit reviews and by monitoring key credit statistics and trends. The key credit statistics and trends we monitor to evaluate the quality of
our investments include credit ratings of both our investments and the issuer, financial performance of the issuer including earnings trends, free cash flows of the issuer, debt service coverage
ratios of the issuer, financial leverage of the issuer, and industry trends that have or may impact the issuer's current or future financial performance and debt service ability.

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Our corporate loan portfolio had an aggregate par value of $6.9 billion as of December 31, 2010 and $7.4 billion
as of December 31, 2009. Our corporate loan portfolio consists of debt obligations of corporations, partnerships and other entities in the form of senior secured loans, second lien loans and
subordinated loans.

The
following table summarizes our corporate loans portfolio stratified by type as of December 31, 2010 and 2009. Loans that are not deemed to be held for sale are carried at
amortized cost net of allowance for loan losses on our consolidated balance sheets. Loans that are classified as held for sale are carried at the lower of net amortized cost or estimated fair value on
our consolidated balance sheets.

Corporate Loans  (Amounts in thousands)

December 31, 2010(1)

December 31, 2009(1)Par

Carrying
Value

Amortized
Cost

Estimated
Fair Value

Par

Carrying
Value

Amortized
Cost

Estimated
Fair ValueSenior secured

$
6,110,495

$
5,829,691

$
5,829,691

$
5,820,754

$
6,538,799

$
6,093,463

$
6,093,463

$
5,774,248Second lien


631,896


576,160


576,160


533,450


685,479


638,052


638,052


560,038Subordinated


195,964


129,371


129,371


180,007


147,887


81,073


81,073


79,337Subtotal


6,938,355


6,535,222


6,535,222


6,534,211


7,372,165


6,812,588


6,812,588


6,413,623Lower of cost or fair value adjustment





(4,748
)










(31,637
)




Allowance for loan losses





(209,030
)










(237,308
)




Total

$
6,938,355

$
6,321,444

$
6,535,222

$
6,534,211

$
7,372,165

$
6,543,643

$
6,812,588

$
6,413,623


(1)Includes
loans held for sale.


As of December 31, 2010, $6.9 billion, or 99.8%, of our corporate loan portfolio was floating rate and $15.9 million, or
0.2%, was fixed rate. In addition, as of December 31, 2010, $273.5 million par amount, or 3.9%, of our corporate loan portfolio was denominated in foreign currencies, of which 91.7% was
denominated in euros. As of December 31, 2009, $7.2 billion, or 98.3%, of our corporate loan portfolio was floating rate and $0.1 billion, or 1.7%, was fixed rate. In addition, as
of December 31, 2009, $210.7 million par amount, or 2.9%, of our corporate loan portfolio was denominated in foreign currencies, of which 100% was denominated in euros. Fixed and
floating amounts and percentages are based on par values.

All
of our floating rate corporate loans have index reset frequencies of less than twelve months with the majority resetting at least quarterly. The weighted average coupon on our
floating rate corporate loans was 4.5% and 3.7% as of December 31, 2010 and December 31, 2009, respectively, and the weighted average coupon spread to LIBOR of our floating rate
corporate loan portfolio was 3.8% and 3.1% as of December 31, 2010 and December 31, 2009, respectively. The weighted average years to maturity of our floating rate corporate loans was
4.3 years as of both December 31, 2010 and December 31, 2009.

As
of December 31, 2010, our fixed rate corporate loans had a weighted average coupon of 11.4% and a weighted average years to maturity of 5.3 years, as compared to 13.6%
and 5.4 years, respectively, as of December 31, 2009.

Loans
placed on non-accrual status may or may not be contractually past due at the time of such determination. When placed on non-accrual status, previously
recognized accrued interest is reversed and charged against current income. While on non-accrual status, interest income is recognized using

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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. Our non-accrual loans include both impaired loans held for investment and non-accrual loans held for sale. As of December 31, 2010 and
December 31, 2009, we had loans on non-accrual status with total recorded investment of $165.1 million, which included $149.8 million of impaired loans that were held
for investment, and $439.9 million, which included $121.2 million of impaired loans that were held for investment, respectively. The amount of interest income recognized using the
cash-basis method during the time within the period that the loans were impaired was $12.9 million, which included $11.1 million for impaired loans that were held for investment, for the
year ended December 31, 2010 and $16.9 million, which included $15.2 million for impaired loans that were held for investment, for the year ended December 31, 2009.

As
of December 31, 2010, we held corporate loans that were in default with a total amortized cost of $18.6 million from one issuer. As of December 31, 2009, we held
corporate loan investments that were in default with a total amortized cost amount 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 allowance for losses was related to or in those investments for which we determined were loans held for sale as of December 31,
2010 and December 31, 2009, respectively.

The
following table summarizes the changes in our allowance for loan losses for the years ended December 31, 2010, 2009 and 2008 (amounts in thousands):

2010

2009

2008Balance at beginning of year

$
237,308

$
480,775

$
25,000Provision for loan losses


29,121


39,795


481,488Charge-offs


(57,399
)

(283,262
)

(25,713
)Balance at end of year

$
209,030

$
237,308

$
480,775


As
of December 31, 2010 and December 31, 2009, we had an allowance for loan loss of $209.0 million and $237.3 million, respectively. As described under
"Critical Accounting Policies", our allowance for loan losses represents our estimate of probable credit losses inherent in our corporate loan portfolio held for investment as of the balance sheet
date. Estimating our allowance for loan losses involves a high degree of management judgment and is based upon a comprehensive review of our loan portfolio that is performed on a quarterly basis. Our
allowance for loan losses consists of two components, an allocated component and an unallocated component. The allocated component of our allowance for loan losses pertains to specific loans that we
have determined are impaired. We determine a loan is impaired when we estimate that it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan
agreement. On a quarterly basis we perform a comprehensive review of our entire loan portfolio and identify certain loans that we have determined are impaired. Once a loan is identified as being
impaired we place the loan on non-accrual status, unless the loan is already on non-accrual status, and record a reserve that reflects our best estimate of the loss that we
expect to recognize from the loan. The expected loss is estimated as being the difference between our current cost basis of the loan, including accrued interest receivable, and the loan's estimated
fair value.

The
unallocated component of our allowance for loan losses represents our estimate of probable losses inherent in our loan portfolio as of the balance sheet date where the specific loan
that the loan loss relates to is indeterminable. We estimate the unallocated component of our allowance for loan losses through a comprehensive review of our loan portfolio and identify certain loans
that demonstrate possible indicators of impairment, including internally assigned credit quality indicators. This assessment excludes all loans that are determined to be impaired and as a result, an
allocated reserve has been recorded as described in the preceding paragraph. Such indicators include, but are not limited to, the

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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. All loans are first categorized based on their assigned risk grade and further stratified based on the seniority of the loan in the issuer's capital structure. The seniority
classifications assigned to loans are senior secured, second lien and subordinate. Senior secured consists of loans that are the most senior debt in an issuer's capital structure and therefore have a
lower estimated loss severity than other debt that is subordinate to the senior secured loan. Senior secured loans often have a first lien on some or all of the issuer's assets. Second lien consists
of loans that are secured by a second lien interest on some or all of the issuer's assets; however, the loan is subordinate to the first lien debt in the issuer's capital structure. Subordinate
consists of loans that are generally unsecured and subordinate to other debt in the issuer's capital structure.

There
are three internally assigned risk grades that are applied to loans that have not been identified as being impaired: high, moderate and low. High risk means that there is evidence
of probable loss due to the financial or operating performance and liquidity of the issuer, industry or economic concerns specific to the issuer, or other factors that indicate that the breach of a
covenant contained in the related loan agreement is possible. Moderate risk means that while there is not observable evidence of loss, there are issuer and/or industry specific trends that indicate a
loss may have occurred. Low risk means that while there is no identified evidence of loss, there is the risk of loss inherent in the loan that has not been identified. All loans held for investment,
with the exception of loans that have been identified as impaired, are assigned a risk grade of high, moderate or low.

We
apply a range of default and loss severity estimates in order to estimate a range of loss outcomes upon which to base our estimate of probable losses that results in the determination
of the unallocated component of our allowance for loan losses.

As
of December 31, 2010, the allocated component of our allowance for loan losses totaled $50.1 million and relates to investments in certain loans issued by five issuers
with an aggregate par amount of $225.6 million and an aggregate recorded investment of $149.8 million. 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 recorded investment of
$121.2 million.

The
unallocated component of our allowance for loan losses totaled $158.9 million and $155.6 million as of December 31, 2010 and 2009, respectively. During the year
ended December 31, 2010, we recorded charge-offs totaling $57.4 million, comprised primarily of loans transferred to loans held for sale. We recorded charge-offs
during the year ended December 31, 2009 totaling $283.3 million comprised primarily of loans transferred to loans held for sale and loans exchanged for equity as part of debt
restructuring transactions, certain of which qualified as troubled debt restructurings. We recorded charge-offs during the year ended December 31, 2008 totaling $25.7 million
relating to one investment in a corporate loan.

As
of December 31, 2010, we had $463.6 million of loans held for sale, a decrease of $462.1 million from December 31, 2009 due to the sale of certain loans
and the transfer of loans to held for investment for certain loans that we no longer had the intention of selling. We recorded a net charge to earnings of $14.7 million for the year ended
December 31, 2010 for certain loans held for sale which had a carrying value of $463.6 million as of December 31, 2010. We recorded a net charge to earnings of
$51.0 million for the year ended December 31, 2009 for certain loans held for sale which had a carrying value of $925.7 million as of December 31, 2009. We recorded a
$137.3 million charge to earnings during the year ended December 31, 2008 for certain loans held for sale which had a carrying value of $324.6 million as of December 31,
2008.

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Our corporate debt securities portfolio had an aggregate par value of $843.7 million and $834.1 million as of
December 31, 2010 and 2009, respectively. Our corporate debt securities portfolio consists of debt obligations of corporations, partnerships and other entities in the form of senior secured,
senior unsecured and subordinated bonds. The majority of our corporate debt securities are classified as securities available-for-sale on our consolidated balance sheets.

The
following table summarizes our corporate debt securities portfolio stratified by type as of December 31, 2010 and 2009:

Corporate Debt Securities  (Amounts in thousands)

December 31, 2010(1)

December 31, 2009Par

Carrying
Value

Amortized
Cost

Estimated
Fair Value

Par

Carrying
Value

Amortized
Cost

Estimated
Fair ValueSenior secured

$
281,998

$
287,908

$
276,158

$
287,908

$
178,503

$
156,410

$
99,202

$
156,410Senior unsecured


445,678


448,562


304,622


448,562


455,937


425,683


318,216


425,683Subordinated


116,061


99,800


66,608


99,800


199,690


172,316


143,219


172,316Total

$
843,737

$
836,270

$
647,388

$
836,270

$
834,130

$
754,409

$
560,637

$
754,409


(1)In
addition to securities available-for-sale, these amounts include corporate debt securities carried at estimated fair value with
unrealized gains and losses recorded in the statements of operations.


As
of December 31, 2010, $680.7 million, or 80.7%, of our corporate debt securities portfolio was fixed rate and $163.0 million, or 19.3%, was floating rate. In
addition, as of December 31, 2010, $10.1 million par amount, or 1.2%, of our corporate debt securities portfolio, was denominated in foreign currencies, of which 87.6% was denominated in
British pound sterling. As of December 31, 2009, $647.4 billion, or 77.6%, of our corporate debt securities portfolio was fixed rate and $186.7 million, or 22.4%, was
floating rate. In addition, as of December 31, 2009, we had no corporate debt securities denominated in foreign currencies. Fixed and floating amounts and percentages are based on par values.

As
of December 31, 2010, our fixed rate corporate debt securities had a weighted average coupon of 9.5% and a weighted average years to maturity of 6.3 years, as compared
to 10.0% and 6.2 years, respectively, as of December 31, 2009. All of our floating rate corporate debt securities have index reset frequencies of less than twelve months. The weighted
average coupon on our floating rate corporate debt securities was 6.1% and 3.6% as of December 31, 2010 and December 31, 2009, respectively, and the weighted average coupon spread to
LIBOR of our floating rate corporate debt securities was 5.4% and 3.4% as of December 31, 2010 and December 31, 2009, respectively. The weighted average years to maturity of our floating
rate corporate debt securities was 3.2 years and 4.1 years as of December 31, 2010 and December 31, 2009, respectively.

During
the years ended December 31, 2010 and December 31, 2009, we recorded impairment losses totaling $2.6 million and $43.9 million, respectively, for
corporate debt and equity securities that we determined to be other-than-temporarily impaired. These securities were determined to be
other-than-temporarily impaired either due to our determination that recovery in value was no longer likely or because we decided to sell the respective security in response to
specific credit concerns regarding the issuer. During the year ended December 31, 2008, we recorded losses totaling $474.5 million for corporate debt and equity securities that we
determined to be other-than-temporarily impaired.

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As
of December 31, 2010, we had one corporate debt security in default with an estimated fair value of $1.1 million. As of December 31, 2009, we had no corporate
debt securities in default.



Our residential mortgage investment portfolio consists of investments in RMBS with an estimated fair value of $93.9 million as
of December 31, 2010.

As
our consolidated financial statements included in this Annual Report on Form 10-K are presented to reflect the deconsolidation of the aforementioned six residential
mortgage securitization trusts beginning January 1, 2010, the information contained in this Management's
Discussion and Analysis of Financial Condition and Results of Operations reflects our residential mortgage portfolio presented on a deconsolidated basis consistent with the disclosures in our
consolidated financial statements. See "Executive OverviewConsolidation" for further discussion.

The
table below summarizes the carrying value, amortized cost and estimated fair value of our residential mortgage investment portfolio as of December 31, 2010 and
December 31, 2009. Carrying value is the value that investments are recorded on our consolidated balance sheets and is estimated fair value for RMBS and residential mortgage loans. Estimated
fair values set forth in the tables below are based on dealer quotes, nationally recognized pricing services and/or management's judgment when relevant observable inputs do not exist.

Residential Mortgage Investment Portfolio  (Amounts in thousands)

December 31, 2010

December 31, 2009Carrying
Value

Amortized
Cost

Estimated
Fair Value

Carrying
Value

Amortized
Cost

Estimated
Fair ValueResidential Mortgage Loans(1)

$


$


$


$
2,097,699

$
2,772,216

$
2,097,699Residential Mortgage-Backed Securities


93,929


254,445


93,929


47,572


95,483


47,572Total

$
93,929

$
254,445

$
93,929

$
2,145,271

$
2,867,699

$
2,145,271


(1)Excludes
real estate owned ("REO") as a result of foreclosure on delinquent loans of $11.4 million as of December 31, 2009.


As of December 31, 2009, 26 of our residential mortgage loans owned by us with an outstanding balance of $11.4 million were REO as a
result of foreclosure on delinquent loans.

Portfolio Purchases

We made investment portfolio purchases of $3.1 billion par amount during the year ended December 31, 2010, as compared to
$1.4 billion and $2.3 billion for the years ended December 31, 2009 and 2008, respectively, primarily comprised of the following:

Investment Portfolio Purchases  (Dollar amounts in thousands)

Year ended
December 31, 2010

Year ended
December 31, 2009

Year ended
December 31, 2008Par Amount

%

Par Amount

%

Par Amount

%Corporate debt securities

$
457,133


14.9
%
$
156,094


11.4
%
$
176,747


7.8
%Corporate loans


2,567,007


83.8


1,216,082


88.6


2,074,919


92.2Equity investments, at estimated fair value


38,565


1.3











Total

$
3,062,705


100.0
%
$
1,372,176


100.0
%
$
2,251,666


100.0
%


79

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Shareholders' Equity

Our shareholders' equity at December 31, 2010, 2009 and 2008 totaled $1.6 billion, $1.2 billion and
$0.7 billion, respectively. Included in our shareholders' equity as of December 31, 2010, 2009 and 2008 is accumulated other comprehensive income (loss) totaling $133.6 million,
$152.7 million and $(268.8) million, respectively.

Our
average shareholders' equity and return on average shareholders' equity for the year ended December 31, 2010 was $1.3 billion and 27.9%, respectively, and for the year
ended December 31, 2009 was $0.9 billion and 8.4%, respectively. Our average shareholders' equity and return on average shareholders' equity for the year ended December 31, 2008
was $1.7 billion and (65.0)%, respectively. Return on average shareholders' equity is defined as net income (loss) divided by weighted average shareholders' equity.

Our
book value per share as of December 31, 2010 and 2009 was $9.24 and $7.37, respectively, and was computed based on 177,848,565 and 158,359,757 shares issued and outstanding as
of December 31, 2010 and 2009, respectively. The increase in book value per share from 2009 to 2010 was primarily attributable to the proceeds from issuance of common shares in 2010 totaling
$175.7 million and net income for 2010 totaling $371.1 million. The increase in net income of $294.1 million from 2009 to 2010 was primarily driven by appreciation in the
estimated fair value of certain of our corporate debt securities, resulting in lower impairment losses and net realized and unrealized gains on investments.

On
February 4, 2010, our board of directors declared a cash distribution of $0.07 per share to shareholders of record on February 18, 2010. The aggregate amount of the
distribution of $11.1 million was paid on March 4, 2010.

On
April 29, 2010, our board of directors declared a cash distribution of $0.10 per share to shareholders of record on May 14, 2010. The aggregate amount of the
distribution of $15.8 million was paid on May 28, 2010.

On
August 4, 2010, our board of directors declared a cash distribution of $0.12 per share to shareholders of record on August 18, 2010. The aggregate amount of the
distribution of $19.0 million was paid on September 1, 2010.

On
November 3, 2010, our board of directors declared a cash distribution of $0.14 per share to shareholders of record on November 17, 2010. The aggregate amount of the
distribution of $22.2 million was paid on December 1, 2010.

On
February 3, 2011, our board of directors declared a cash distribution for the quarter ended December 31, 2010 of $0.15 per share to shareholders of record on
February 18, 2011. The distribution is payable on March 4, 2011.

Liquidity and Capital Resources

We actively manage our liquidity position with the objective of preserving our ability to fund our operations and fulfill our
commitments on a timely and cost-effective basis. As of December 31, 2010, we had unrestricted cash and cash equivalents totaling $313.8 million.

Although
we believe our current sources of liquidity are adequate to preserve our ability to fund our operations and fulfill our commitments, we will continue to evaluate opportunities
to issue incremental capital. This may include taking advantage of market timing to issue equity or refinance or replace indebtedness, including the issuance of new debt securities and retiring debt
pursuant to privately negotiated transactions, open market purchases or otherwise.

The
majority of our investments are held in Cash Flow CLOs. Accordingly, the majority of our cash flows have historically been received from our investments in the mezzanine and
subordinated

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notes
of our Cash Flow CLOs. However, during the period in which a Cash Flow CLO is not in compliance with an OC Test as outlined in its respective indenture, the cash flows we would generally expect
to receive from our Cash Flow CLO holdings are paid to the senior note holders of the Cash Flow CLOs. As of December 31, 2010, all our Cash Flow CLOs were in compliance with certain compliance
tests (specifically, their respective OC Tests). As CLO 2007-A and CLO 2007-1 came into compliance during 2010, both CLOs resumed paying mezzanine and/or subordinate note
holders, including us, during 2010.

On
July 10, 2009, we undertook certain actions with respect to CLO 2005-1, CLO 2005-2 and CLO 2006-1 that had a positive cash flow
impact for us. Specifically, we surrendered for cancellation, without consideration, $298.4 million in aggregate of mezzanine notes and junior notes issued to us by these three CLO
transactions. The Surrendered Notes were promptly cancelled upon receipt by the trustee of each transaction and the related debt was extinguished by the issuers thereof. As a result of the
transaction, the OC Tests for these three CLOs were brought into compliance, enabling the mezzanine and subordinated note holders, including us, to resume receiving cash flows from these transactions
during the period when the OC Tests remain in compliance.

In
addition to our Cash Flow CLOs, a portion of our assets were previously held in Wayzata, a market value CLO transaction. On March 31, 2009, we completed the restructuring of
Wayzata and replaced it with CLO 2009-1. As a result of the restructuring, substantially all of Wayzata's assets were transferred to CLO 2009-1, a newly formed special purpose
company, which issued $560.8 million aggregate principal amount of senior notes due April 2017 and $154.3 million aggregate principal amount of subordinated notes due April 2017 to the
existing Wayzata note holders in exchange for cancellation of the Wayzata notes, due November 2012, previously held by each of them. CLO 2009-1 was structured as a cash flow transaction
and does not contain the market value provisions contained in Wayzata. The portfolio manager of CLO 2009-1 was an affiliate of our Manager. The notes issued by CLO 2009-1 were
secured by the same collateral that secured the Wayzata notes, consisting primarily of senior secured leveraged loans. As was the case with Wayzata, at the time of the restructuring, we and an
affiliate of our Manager owned all of the subordinated notes issued by CLO 2009-1. During June 2009, we paid down the senior notes issued by CLO 2009-1 by $516.4 million
and on July 24, 2009, we retired the remaining balance of $44.4 million of outstanding senior notes. Prior to the retirement of the senior notes, an affiliate of ours held a 20% interest
in the subordinated notes issued by CLO 2009-1. As part of the deleveraging of CLO 2009-1, the subordinated notes in CLO 2009-1 held by our affiliate were
retired in exchange for a 20% interest in each of CLO 2009-1's assets which remained following the deleveraging. As a result of the deleveraging transaction and the distribution of assets
to our affiliate, we now hold 100% of the residual assets of CLO 2009-1.

Sources of Funds



On December 13, 2010, we completed an underwritten public offering of 18,000,000 common shares at a price of $9.04 per share,
resulting in gross proceeds of $162.7 million. We also granted the underwriter a 30 day option to purchase up to 2,700,000 additional common shares solely to cover
over-allotments. On December 28, 2010, the underwriter exercised its option and purchased 1,436,000 shares, resulting in additional $13.0 million of gross proceeds. The total
proceeds from this offering will be used to acquire assets in accordance with our core business strategy and for general corporate purposes.



As of December 31, 2010, we had five Cash Flow CLO transactions outstanding. An affiliate of our Manager owns an interest in the
junior notes of both CLO 2007-1 and CLO 2007-A. The aggregate

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carrying
amount of the junior notes in CLO 2007-1 and CLO 2007-A held by the affiliate of our Manager is $366.1 million as of December 31, 2010 and is reflected
as collateralized loan obligation junior secured notes to affiliates on our consolidated balance sheets.

In
accordance with GAAP, we consolidate each of these Cash Flow CLOs as we have the power to direct the activities of these VIEs, as well as the obligation to absorb losses of the VIEs
and the right to receive benefits of the VIEs that could potentially be significant to the VIEs. We utilize CLOs to fund our investments in corporate loans and corporate debt securities. The
indentures governing our Cash Flow CLOs 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 Cash Flow CLOs include 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. For purposes of the calculation, collateral value is the par value of the assets
unless an asset is in default, is a discounted obligation, or is a CCC-rated asset in excess of the percentage of CCC-rated asset limit specified for each Cash Flow CLO.

If
an asset is in default, the indenture for each Cash Flow CLO transaction defines the value used to determine the collateral value, which value is the lower of market value of the
asset or the recovery value proscribed for the asset based on its type and rating by Standard & Poor's or Moody's.

A
discount obligation is an asset with a purchase price of less than a particular percentage of par. The discount obligation amounts are specified in each Cash Flow CLO and are generally
set at a purchase price of less than 80% of par for corporate loans and 75% of par for corporate debt securities.

The
indenture for each Cash Flow CLO specifies a CCC-threshold for the percentage of total assets in the CLO that can be rated CCC. All assets in excess of the CCC threshold
specified for the respective CLO are included in the OC Tests at market value and not par.

Defaults
of assets in Cash Flow CLOs, ratings downgrade of assets in Cash Flow CLOs to CCC, price declines of CCC assets in excess of the proscribed CCC threshold amount, and price
declines in assets classified as discount obligations may reduce the over-collateralization ratio such that a Cash Flow CLO is not in compliance. If a Cash Flow CLO is not in compliance
with an OC 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. As a result of the historic declines in asset prices, particularly in the corporate loan and high yield securities asset classes during the fourth quarter of 2008, one or more of
our Cash Flow CLOs were out of compliance with the OC Tests for periods of time. While being out of compliance with an OC Test would not impact our investment portfolio or results of operations, it
would impact our unrestricted cash flows available for operations, new investments and dividend distributions. As of December 31, 2010, all of our Cash Flow CLOs were in compliance with their
respective OC Tests. The following table summarizes several of the material tests and metrics for each of our Cash Flow CLOs. This information is based on the December 2010 monthly reports
which are prepared by the independent third party trustee for each Cash Flow CLO:



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(dollar amounts in thousands)

CLO 2005-1

CLO 2005-2

CLO 2006-1

CLO 2007-1

CLO 2007-AInvestments

$
1,043,099

$
994,159

$
1,035,631

$
3,320,380

$
1,516,135Senior IC ratio minimum


115.0
%

125.0
%

115.0
%

115.0
%

120.0
%Actual senior IC ratio


635.1
%

1,129.1
%

505.0
%

660.1
%

507.6
%CCC amount

$
40,812

$
35,200

$
113,479

$
459,333

$
201,464CCC percentage of portfolio


3.9
%

3.5
%

11.0
%

13.8
%

13.3
%CCC threshold percentage


5.0
%

7.5
%

7.5
%

7.5
%

7.5
%Senior OC Test minimum


119.4
%

123.0
%

143.1
%

159.1
%

119.7
%Actual senior OC Test


133.3
%

133.8
%

163.5
%

180.4
%

134.2
%Cushion / (Excess)

$
107,078

$
80,289

$
124,109

$
378,213

$
159,663Subordinated OC Test minimum


106.2
%

106.9
%

114.0
%

120.1
%

109.9
%Actual subordinated OC Test


113.9
%

118.8
%

139.5
%

125.6
%

116.1
%Cushion / (Excess)

$
69,992

$
99,424

$
182,130

$
141,497

$
78,456


On
January 4, 2010, CLO 2007-A was brought into compliance with its respective OC Tests. Also, on March 19, 2010, CLO 2007-1, our final remaining
Cash Flow CLO to be failing one or more of its respective OC Tests, was brought into compliance with all of its respective OC Tests. Accordingly, beginning in April 2010, CLO 2007-A
resumed paying mezzanine and subordinate note holders, including us. In addition, beginning in August 2010, CLO 2007-1 resumed paying mezzanine note holders, including us. As reflected in
the table above, each of our Cash Flow CLOs was in compliance with its respective IC ratio tests, senior OC Tests and subordinated OC Tests based on the December 2010 monthly reports for the
respective CLOs.

During
the first quarter of 2010, in an open market auction, we 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 our manager. These transactions
resulted in us recording an aggregate gain on extinguishment of debt totaling $38.7 million during 2010.



On May 3, 2010, we 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

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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. We 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, we
obtained additional commitments of $40.0 million, bringing the total amount of commitments under the 2014 Facility to $250.0 million.

We
have 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 LIBOR plus 3.25% per annum. The
2014 Facility contains customary covenants applicable to us, including a restriction from making annual distributions to holders of common shares in excess of 65% of our estimated annual taxable
income.

As
of December 31, 2010, we had no borrowings outstanding under the 2014 Facility.

On
May 26, 2010, we terminated our credit agreement, dated as of November 10, 2008 and maturing on November 10, 2011 (the "2011 Credit Agreement"). The 2011 Credit
Agreement was terminated in connection with our initial borrowing under our 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 we repaid.



On November 5, 2010, we entered into a credit agreement for a five-year $49.7 million non-recourse,
asset-based revolving credit facility (the "2015 Natural Resources Facility"), maturing on November 5, 2015, that is subject to, among other things, the terms of a borrowing base derived from
the value of eligible specified oil and gas assets. The borrowing base is subject to certain caps and concentration limits customary for financings of this type. We have the right to prepay loans
under the 2015 Natural Resources Facility in whole or in part at any time.
Loans under the 2015 Natural Resources Facility bear interest at a rate equal to LIBOR plus a tiered applicable margin ranging from 1.75% to 2.75% per annum. The 2015 Natural Resources Facility
contains customary covenants applicable to us.

As
of December 31, 2010, we had $18.4 million of borrowings outstanding under the 2015 Natural Resources Facility. In addition, under the 2015 Natural Resources Facility,
we had a letter of credit outstanding totaling $1.0 million as of December 31, 2010.

As
of December 31, 2010, we believe we were in compliance with the covenant requirements for both credit facilities.



On January 15, 2010, we issued $172.5 million of 7.5% convertible senior notes due January 15, 2017. The 7.5%
Notes bear interest at a rate of 7.5% per year 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 our right to terminate the conversion rights of the notes. We may satisfy our 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 us or a combination thereof. The initial conversion rate for each $1,000 principal amount of 7.5% Notes was 122.2046 common 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

84

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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 December 31, 2010, the conversation rate for each $1,000 principal
amount of 7.5% Notes was 125.6251 common shares. Net proceeds from the offering totaled $167.3 million, reflecting gross proceeds of $172.5 million from the issuance less
$5.2 million for underwriting fees.

During
the first quarter of 2010, we repurchased $95.2 million par amount of our 7.0% convertible senior notes due 2012, reducing the amount outstanding from $275.8 million
as of December 31, 2009 to $180.6 million as of December 31, 2010. These transactions resulted in us recording a gain of $1.3 million, which was partially offset by a
write-off of $0.6 million of unamortized debt issuance costs during 2010.



As of December 31, 2010, we had committed to purchase corporate loans with aggregate commitments totaling $90.9 million.
In addition, we participate in certain financing arrangements, including revolvers and delayed draw facilities, whereby we are committed to provide funding at the discretion of the borrower up to a
specific predetermined amount. As of December 31, 2010, we had unfunded financing commitments totaling $31.6 million. We do not expect material losses related to the corporate loans for
which we commit to purchase and fund.



The table below summarizes our contractual obligations as of December 31, 2010 and are subject to material changes based on
factors including interest rates, compliance with OC Tests and pay downs subsequent to December 31, 2010. The table below excludes contractual commitments related to our derivatives and amounts
payable under the Management Agreement that we have with our Manager because those contracts do not have fixed and determinable payments:

Contractual Obligations  (Amounts in thousands)

Payments Due by PeriodTotal

Less than 1 year

1 - 3 years

3 - 5 years

More than 5 yearsAsset-based borrowing facility(1)

$
21,919

$
1,537

$
1,031

$
19,351

$
CLO 2005-1 senior secured notes(2)


865,499


5,106


10,211


10,211


839,971CLO 2005-2 senior secured notes(2)


834,813


4,842


9,684


9,684


810,603CLO 2006-1 senior secured notes(2)


717,801


4,510


9,019


9,019


695,253CLO 2007-1 senior secured notes(2)


2,255,880


17,430


34,861


34,861


2,168,728CLO 2007-1 junior secured notes to affiliates(3)


391,720


8,776


17,551


17,551


347,842CLO 2007-1 junior secured notes(3)


82,125


1,988


3,975


3,975


72,187CLO 2007-A senior secured notes(2)


1,258,586


13,748


27,496


27,496


1,189,846CLO 2007-A junior secured notes to affiliates(3)


89,518


3,539


7,078


7,078


71,823CLO 2007-A junior secured notes(3)


13,770


434


867


867


11,602Convertible senior notes(4)


450,728


25,578


213,299


25,875


185,976Junior subordinated notes(5)


526,454


15,376


30,751


30,751


449,576Loan commitments(6)


122,541


90,937


31,604





Total

$
7,631,354

$
193,801

$
397,427

$
196,719

$
6,843,407


(1)Includes
the letter of credit outstanding of $1.0 million as well as interest to be paid over the maturity of the debt. Interest has been calculated
assuming no prepayments are made and debt


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outstanding
as of December 31, 2010 is held until its final maturity date. The future interest payments are calculated using rates in effect as of December 31, 2010, at spreads to market
rates pursuant to the credit facility agreement, which is 2.8%. Excludes commitment fees on the facility. (2)Includes
interest to be paid over the maturity of the CLO senior secured notes which has been calculated assuming no pay downs are made and debt outstanding
as of December 31, 2010 is held until its final maturity date. The future interest payments are calculated using the weighted average borrowing rates as of December 31, 2010.(3)Includes
interest to be paid over the maturity of the CLO mezzanine notes which has been calculated assuming no pay downs are made and debt outstanding as
of December 31, 2010 is held until its final maturity date. The future interest payments are calculated using the weighted average borrowing rates as of December 31, 2010.(4)Includes
interest to be paid over the maturity of the convertible senior notes which has been calculated assuming no prepayments are made and debt
outstanding as of December 31, 2010 is held until its final maturity date. Represents the principal amount of the notes, which excludes the accounting adjustment for convertible debt
instruments that may be settled in cash upon conversion (see Note 8 to the consolidated financial statements). The future interest payments are calculated using the stated 7.0% and 7.5%
interest rates.(5)Includes
interest to be paid over the maturity of the junior subordinated notes which has been calculated assuming no prepayments are made and debt
outstanding as of December 31, 2010 is held until its final maturity date. The future interest payments are calculated using fixed and variable rates in effect as of December 31, 2010,
at spreads to market rates pursuant to the financing agreements, and range from 2.6% to 8.1%.(6)Represents
commitments to purchase corporate loans, as well as commitments to provide funding at the discretion of the borrower up to a specific
predetermined amount. Refer to "Off-Balance Sheet Commitments" above for further discussion.


Partnership Tax Matters



We intend to continue to operate so that we qualify, for United States federal income tax purposes, as a partnership and not as an
association or a publicly traded partnership taxable as a corporation. Holders of our shares are subject to United States federal income taxation and generally other taxes, such as state, local and
foreign income taxes, on their allocable share of our taxable income, regardless of whether or when they receive cash distributions. In addition, certain of our investments, including investments in
foreign corporate subsidiaries, CLO issuers (including those treated as partnerships or disregarded entities for United States federal income tax purposes) and debt securities, may produce taxable
income without corresponding distributions of cash to us or may produce taxable income prior to or following the receipt of cash relating to such income. In addition, we have recognized and may
recognize in the future cancellation of indebtedness income upon the retirement of our debt at a discount. Consequently, in some taxable years, holders of our shares may recognize taxable income in
excess of our cash distributions. Furthermore, even if we did not pay cash distributions with respect to a taxable year, holders of our shares may still have a tax liability attributable to their
allocation of taxable income from us during such year.



We intend to continue to operate so that we qualify, for United States federal income tax purposes, as a partnership and not as an
association or a publicly traded partnership taxable as a corporation. In general, if a partnership is "publicly traded" (as defined in the Code), it will be treated

86

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as
a corporation for United States federal income purposes. A publicly traded partnership will, however, be taxed as a partnership, and not as a corporation, for United States federal income tax
purposes, so long as it is not required to register under the Investment Company Act and at least 90% of its gross income for each taxable year constitutes "qualifying income" within the meaning of
Section 7704(d) of the Code. We refer to this exception as the "qualifying income exception." Qualifying income generally includes rents, dividends, interest (to the extent such interest is
neither derived from the "conduct of a financial or insurance business" nor based, directly or indirectly, upon "income or
profits" of any person), income and gains derived from certain activities related to minerals and natural resources, and capital gains from the sale or other disposition of stocks, bonds and real
property. Qualifying income also includes other income derived from the business of investing in, among other things, stocks and securities.

If
we fail to satisfy the "qualifying income exception" described above, items of income, gain, loss, deduction and credit would not pass through to holders of our shares and such
holders would be treated for United States federal (and certain state and local) income tax purposes as shareholders in a corporation. In such case, we would be required to pay income tax at regular
corporate rates on all of our income. In addition, we would likely be liable for state and local income and/or franchise taxes on all of our income. Distributions to holders of our shares would
constitute ordinary dividend income taxable to such holders to the extent of our earnings and profits, and these distributions would not be deductible by us. If we were taxable as a corporation, it
could result in a material reduction in cash flow and after-tax return for holders of our shares and thus could result in a substantial reduction in the value of our shares and any other
securities we may issue.



As referenced above, we have made and may make certain investments in natural resources. It is likely that the income from such
investments will be treated as effectively connected with the conduct of a United States trade or business with respect to holders of our shares that are not "United States persons" within the meaning
of Section 7701(a)(30) of the Code. Furthermore, any notional principal contracts that we enter into, if any, in connection with investments in natural resources likely would generate income
that would be treated as effectively connected income with the conduct of a United States trade or business. To the extent our income is treated as effectively connected income, a holder who is a
non-United States person generally would be required to (i) file a United States federal income tax return for such year reporting its allocable share, if any, of our income
or loss effectively connected with such trade or business and (ii) pay United States federal income tax at regular United States tax rates on any such income. Moreover, if such a holder is a
corporation, it might be subject to a United States branch profits tax on its allocable share of our effectively connected income. In addition, distributions to such a holder would be subject to
withholding at the highest applicable tax rate to the extent of the holder's allocable share of our effectively connected income. Any amount so withheld would be creditable against such holder's
United States federal income tax liability, and such holder could claim a refund to the extent that the amount withheld exceeded such holder's United States federal income tax liability for the
taxable year. Finally, if we are engaged in a United States trade or business, a portion of any gain recognized by an investor who is a non-United States person on the sale or exchange of
its shares may be treated for United States federal income tax purposes as effectively connected income, and hence such holder may be subject to United States federal income tax on the sale or
exchange.

In
addition, for all of our holders, investments in natural resources would likely constitute doing business in the jurisdictions in which such assets are located. As a result, holders
of our shares will likely be required to file foreign, state and local income tax returns and pay foreign, state and local
income taxes in some or all of these various jurisdictions. Further, holders may be subject to penalties for failure to comply with those requirements.

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We expect to mail the 2010 Schedule K-1 (Form 1065), Partner's Share of Income, Deductions, Credits, etc. to
shareholders by the end of March 2011.

Our Investment Company Act Status

Section 3(a)(1)(A) of the Investment Company Act defines an investment company as any issuer that is, holds itself out as being,
or proposes to be, primarily engaged in the business of investing, reinvesting or trading in securities and Section 3(a)(1)(C) of the Investment Company Act defines an investment company as any
issuer that is engaged or proposes to engage in the business of investing, reinvesting, owning, holding or trading in securities and owns or proposes to acquire "investment securities" (within the
meaning of the Investment Company Act) having a value exceeding 40% of the value of the issuer's total assets (exclusive of United States government securities and cash items) on an unconsolidated
basis (the "40% test"). Excluded from the term "investment securities" are, among others, securities issued by majority-owned subsidiaries unless the subsidiary is an investment company or relies on
the exceptions from the definition of an investment company provided by Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act (a "fund"). The Investment Company Act defines a
"majority-owned subsidiary" of a person as any company 50% or more of the outstanding voting securities (i.e., those securities presently entitling the holder thereof to vote for the election
of directors of the company) of which are owned by that person, or by another company that is, itself, a majority owned subsidiary of that person.

We
are organized as a holding company. We conduct our operations primarily through our majority-owned subsidiaries. Each of our subsidiaries is either outside of the definition of an
investment company in Sections 3(a)(1)(A) and 3(a)(1)(C), described above, or excepted from the definition of an investment company under the Investment Company Act. We believe that we are not,
and that we do not propose to be, primarily engaged in the business of investing, reinvesting or trading in securities and we do not believe that we have held ourselves out as such. We intend to
continue to conduct our operations so that we are not required to register as an investment company under the Investment Company Act.

We
monitor our holdings regularly to confirm our continued compliance with the 40% test. In calculating our position under the 40% test, we are responsible for determining whether any of
our subsidiaries is majority-owned. We treat subsidiaries in which we own at least 50% of the outstanding voting securities, including those that issue CLOs, as majority-owned for purposes of the 40%
test. Some of our subsidiaries may rely solely on Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act. In order for us to satisfy the 40% test, our ownership interests in
those subsidiaries or any of our subsidiaries that are not majority-owned, together with any other "investment securities" that we may own, may not have a combined value in excess of 40% of the value
of our total assets on an unconsolidated basis and exclusive of United States government securities and cash items. However, most of our subsidiaries either fall outside of the general definitions of
an investment company or rely on exceptions provided by provisions of, and rules and regulations promulgated under, the Investment Company Act (other than Section 3(c)(1) or
Section 3(c)(7) of the Investment Company Act) and, therefore, are not defined or regulated as investment companies. In order to conform to these exceptions, these subsidiaries are limited with
respect to the assets in which each of them can invest and/or the types of securities each of them may issue. We must, therefore, monitor each subsidiary's compliance with its applicable exception and
our freedom of action, and that of our subsidiaries, may be limited as a result. For example, our subsidiaries that issue CLOs generally rely on Rule 3a-7 under Investment Company
Act, while KFH II, our subsidiary that is taxed as a REIT for United States federal income tax purposes, generally relies on Section 3(c)(5)(C) of the Investment Company Act. Each of these
exceptions requires, among other things that the subsidiary (i) not issue redeemable securities and (ii) engage in the business of holding certain types of assets, consistent with the
terms of

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the
exception. Similarly, any subsidiaries engaged in the ownership of oil and gas assets may, depending on the nature of the assets, be outside the definition of an investment company or rely on
exceptions provided by Section 3(c)(5)(C) or Section 3(c)(9) of the Investment Company Act. While Section 3(c)(9) of the Investment Company Act does not limit the nature of the
securities issued, it does impose business engagement requirements that limit the types of assets that may be held.

We
do not treat our interests in majority-owned subsidiaries that are outside of the general definition of an investment company or that rely on Section 3(c)(5)(C) or
Section 3(c)(9) of, or Rule 3a-7 under, the Investment Company Act as investment securities when calculating our 40% test.

We
sometimes refer to our subsidiaries that rely on Rule 3a-7 under the Investment Company Act as "CLO subsidiaries." Rule 3a-7 under the Investment
Company Act is available to certain structured financing vehicles that are engaged in the business of holding financial assets that, by their terms, convert into cash within a finite time period and
that issue fixed income securities entitling holders to receive payments that depend primarily on the cash flows from these assets, provided that, among other things, the structured finance vehicle
does not engage in certain portfolio management practices resembling those employed by mutual funds. Accordingly, each of these CLO subsidiaries is subject to an indenture (or similar transaction
documents) that contains specific guidelines and restrictions limiting the discretion of the CLO subsidiary and its collateral manager. In particular, these guidelines and restrictions prohibit the
CLO subsidiary from acquiring and disposing of assets primarily for the purpose of recognizing gains or decreasing losses resulting from market value changes. Thus, a CLO subsidiary cannot acquire or
dispose of assets primarily to enhance returns to the owner of the equity in the CLO subsidiary; however, subject to this limitation, sales and purchases of assets may be made so long as doing so does
not violate guidelines contained in the CLO subsidiary's relevant transaction documents. A CLO subsidiary generally can, for example, sell an asset if the collateral manager believes that its credit
quality has declined since its acquisition or that the credit profile of the obligor will deteriorate and the proceeds of permitted dispositions may be reinvested in additional collateral, subject to
fulfilling the requirements set forth in Rule 3a-7 under the Investment Company Act and the CLO subsidiary's relevant transaction documents. As a result of these restrictions, our
CLO subsidiaries may suffer losses on their assets and we may suffer losses on our investments in those CLO subsidiaries.

We
sometimes refer to KFH II, our subsidiary that relies on Section 3(c)(5)(C) of the Investment Company Act, as our "REIT subsidiary." Section 3(c)(5)(C) of the Investment
Company Act is available to companies that are primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on and interests in real estate. While the SEC has not
promulgated rules to address precisely what is required for a company to be considered to be "primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on and
interests in real estate," the SEC's Division of Investment Management, or the "Division," has taken the position, through a series of no-action and interpretive letters, that a company
may rely on Section 3(c)(5)(C) of the Investment Company Act if, among other things, at least 55% of the company's assets consist of mortgage loans, other assets that are considered the
functional equivalent of mortgage loans and certain other interests in real property (collectively, "qualifying real estate assets"), and at least 25% of the company's assets consist of real
estate-related assets (reduced by the excess of the company's qualifying real estate assets over the required 55%), leaving no more than 20% of the company's assets to be invested in miscellaneous
assets. The Division has also provided guidance as to the types of assets that can be considered qualifying real estate assets. Because the Division's interpretive letters are not binding except as
they relate to the companies to whom they are addressed, if the Division were to change its position as to, among other things, what assets might constitute qualifying real estate assets our REIT
subsidiary might be required to change its investment strategy to comply with the changed position. We cannot predict whether such a change would be adverse.

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Based
on current guidance, our REIT subsidiary classifies investments in mortgage loans as qualifying real estate assets, as long as the loans are "fully secured" by an interest in real
estate on which we retain the right to foreclose. That is, if the loan-to-value ratio of the loan is equal to or less than 100%, then the mortgage loan is considered to be a
qualifying real estate asset. Mortgage loans with loan-to-value ratios in excess of 100% are considered to be only real estate-related assets. Our REIT subsidiary considers
agency whole pool certificates to be qualifying real estate assets. Examples of agencies that issue whole pool certificates are the Federal National Mortgage Association, the Federal Home Loan
Mortgage Corporation and the Government National Mortgage Association. An agency whole pool certificate is a certificate issued or guaranteed as to principal and interest by the United States
government or by a federally chartered entity, which represents the entire beneficial interest in the underlying pool of mortgage loans. By contrast, an agency certificate that represents less than
the entire beneficial interest in the underlying mortgage loans is not considered to be a qualifying real estate asset, but is considered to be a real estate-related asset.

Most
non-agency mortgage-backed securities do not constitute qualifying real estate assets because they represent less than the entire beneficial interest in the related pool
of mortgage loans; however, based on Division guidance, where our REIT subsidiary's investment in non-agency mortgage-backed securities is the "functional equivalent" of owning the
underlying mortgage loans, our REIT subsidiary may treat those securities as qualifying real estate assets. Moreover, investments in mortgage-backed securities that do not constitute qualifying real
estate assets will be classified as real estate-related assets. Therefore, based upon the specific terms and circumstances related to each non-agency mortgage-backed security that our REIT
subsidiary owns, our REIT subsidiary will make a determination of whether that security should be classified as a qualifying real estate asset or as a real estate-related asset; and there may be
instances where a security is recharacterized from being a qualifying real estate asset to a real estate-related asset, or conversely, from being a real estate-related asset to being a qualifying real
estate asset based upon the acquisition or disposition or redemption of related classes of securities from the same securitization trust. If our REIT subsidiary acquires securities that, collectively,
receive all of the principal and interest paid on the related pool of underlying mortgage loans (less fees, such as servicing and trustee fees, and expenses of the securitization), and that subsidiary
has foreclosure rights with respect to those mortgage loans, then our REIT subsidiary will consider those securities, collectively, to be qualifying real estate assets. If another entity acquires any
of the securities that are expected to receive cash flow from the underlying mortgage loans, then our REIT subsidiary will consider whether it has appropriate foreclosure rights with respect to the
underlying loans and whether its investment is a first loss position in deciding whether these securities should be classified as qualifying real estate assets. If our REIT subsidiary owns more than
one subordinate class, then, to determine the classification of subordinate classes other than the first loss class, our REIT subsidiary will consider whether such classes are contiguous with the
first loss class (with no other classes absorbing losses after the first loss class and before any other subordinate classes that our REIT subsidiary owns), whether our REIT subsidiary owns the entire
amount of each such class and whether our REIT subsidiary would continue to have appropriate foreclosure rights in connection with each such class if the more subordinate classes were no longer
outstanding. If the answers to any of these questions is no, then our REIT subsidiary would expect not to classify that particular class, or classes senior to that class, as qualifying real estate
assets.

We
have made or may make oil and gas and other mineral investments that are held through one or more subsidiaries and would refer to those subsidiaries as our "Oil and Gas Subsidiaries".
Depending upon the nature of the oil and gas assets held by an Oil and Gas Subsidiary, such Oil and Gas Subsidiary may rely on Section 3(c)(5)(C) or Section 3(c)(9) of the Investment
Company Act or may fall outside of the general definition of an investment company. An Oil and Gas Subsidiary that does not engage primarily, propose to engage primarily or hold itself out as engaging
primarily in the business of investing, reinvesting or trading in securities will be outside of the general definition of an investment company provided that it passes the 40% test. This may be the
case where an Oil and Gas

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Subsidiary
holds a sufficient amount of oil and gas assets constituting real estate interests together with other assets that are not investment securities such as equipment. Oil and Gas Subsidiaries
that hold oil and gas assets that constitute real property interests, but are unable to pass the 40% test, may rely on Section 3(c)(5)(C), subject to the requirements and restrictions described
above. Alternately, an Oil and Gas Subsidiary may rely on Section 3(c)(9) of the Investment Company Act if substantially all of its business consists of owning or holding oil, gas or other
mineral royalties or leases, certain fractional interests, or certificates of interest or participations in or investment contracts relating to such royalties, leases or fractional interests. These
various restrictions imposed on our Oil and Gas Subsidiaries by the Investment Company Act may have the effect of limiting our freedom of action with respect to oil and gas assets (or other assets)
that may be held or acquired by such subsidiary or the manner in which we may deal in such assets.

As
noted above, if the combined values of the investment securities issued by our subsidiaries that must rely on Section 3(c)(1) or Section 3(c)(7) of the Investment
Company Act, together with any other investment securities we may own, exceeds 40% of the value of our total assets (exclusive of United States government securities and cash items) on an
unconsolidated basis, we may be deemed to be an investment company. If we fail to maintain an exception, exemption or other exclusion from the Investment Company Act, we could, among other things, be
required either (i) to change substantially the manner in which we conduct our operations to avoid being subject to the Investment Company Act or (ii) to register as an investment
company. Either of these would likely have a material adverse effect on us, our ability to service our indebtedness and to make distributions on our shares, and on the market price of our shares and
any other securities we may issue. If we were required to register as an investment company under the Investment Company Act, we would become subject to substantial regulation with respect to our
capital structure (including our ability to use leverage), management, operations, transactions with certain affiliated persons (within the meaning of the Investment Company Act), portfolio
composition (including restrictions with respect to diversification and industry concentration) and other matters. Additionally, our Manager would have the right to terminate our Management Agreement.
Moreover, if we were required to register as an investment company, we would no longer be eligible to be treated as a partnership for United States federal income tax purposes. Instead, we would be
classified as a corporation for tax purposes and would be able to avoid corporate taxation only to the extent that we were able to elect and qualify as a regulated investment company ("RIC") under
applicable tax rules. Because our eligibility for RIC status would depend on our assets and sources of income at the time that we were required to register as an investment company, there can be no
assurance that we would be able to qualify as a RIC. If we were to lose partnership status and fail to qualify as a RIC, we would be taxed as a regular corporation. See "Partnership Tax
MattersQualifying Income Exception".

We
have not requested approval or guidance from the SEC or its staff with respect to our Investment Company Act determinations, including, in particular: our treatment of any subsidiary
as majority-owned; the compliance of any subsidiary with Section 3(c)(5)(C) or Section 3(c)(9) of, or Rule 3a-7 under, the Investment Company Act, including any
subsidiary's determinations with respect to the consistency of its assets or operations with the requirements thereof; or whether our interests in one or more subsidiaries constitute investment
securities for purposes of the 40% test. If the SEC were to disagree with our treatment of one or more subsidiaries as being excepted from the Investment Company Act pursuant to
Rule 3a-7, Section 3(c)(5)(C) or Section 3(c)(9), with our determination that one or more of our other holdings do not constitute investment securities for purposes of
the 40% test, or with our determinations as to the nature of the business in which we engage or the manner in which we hold ourselves out, we and/or one or more of our subsidiaries would need to
adjust our operating strategies or assets in order for us to continue to pass the 40% test or register as an investment company, either of which could have a material adverse effect on us. Moreover,
we may be required to adjust our operating strategy and holdings, or to effect sales of our assets in a manner that, or at a time or price at which, we would not otherwise choose, if there are changes
in the laws or rules

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governing
our Investment Company Act status or that of our subsidiaries, or if the SEC or its staff provides more specific or different guidance regarding the application of relevant provisions of,
and rules under, the Investment Company Act. Such guidance could provide additional flexibility, or it could further inhibit our ability, or the ability of a subsidiary, to pursue a chosen operating
strategy, which could have a material adverse effect on us.

If
the SEC or a court of competent jurisdiction were to find that we were required, but failed, to register as an investment company in violation of the Investment Company Act, we would
have to cease business activities, we would breach representations and warranties and/or be in default as to certain of our contracts and obligations, civil or criminal actions could be brought
against us, our contracts would be unenforceable unless a court were to require enforcement and a court could appoint a receiver to take control of us and liquidate our business, any or all of which
would have a material adverse effect on our business.

Quantitative and Qualitative Disclosures About Market Risk



From time to time, we may make investments that are denominated in a foreign currency through which we may be subject to foreign
currency exchange risk. As of December 31, 2010, $283.6 million par amount, or 3.6%, of our corporate debt portfolio was denominated in foreign currencies, of which 88.8% was denominated
in euros. In addition, as of December 31, 2010, $28.6 million par amount, or 28.9%, of our equity at estimated fair value was denominated in foreign currencies, of which 36.1% was
denominated in Norwegian krone.

Based
on these investments, we are exposed to movements in foreign currency exchange rates which may impact earnings if the United States dollar significantly strengthens or weakens
against foreign currencies. Accordingly, we may use derivative instruments from time to time, including foreign exchange options and forward contracts, to manage the impact of fluctuations in foreign
currency exchange rates.



Our investments are subject to spread risk. Our investments in floating rate loans and securities are valued based on a market credit
spread over LIBOR and for which the value is affected by changes in the market credit spreads over LIBOR. Our investments in fixed rate loans and securities are valued based on a market credit spread
over the rate payable on fixed rate United States Treasuries of like maturity. Increased credit spreads, or credit spread widening, will have an adverse impact on the value of our investments while
decreased credit spreads, or credit spread tightening, will have a positive impact on the value of our investments. However, tightening credit spreads will increase the likelihood that certain
holdings will be refinanced at lower rates that would negatively impact our earnings.



Interest rate risk is defined as the sensitivity of our current and future earnings to interest rate volatility, variability of spread
relationships, the difference in repricing intervals between our assets and liabilities and the effect that interest rates may have on our cash flows and the prepayment rates experienced on our
investments that have embedded borrower optionality. The objective of interest rate risk management is to achieve earnings, preserve capital and achieve liquidity by minimizing the negative impacts of
changing interest rates, asset and liability mix, and prepayment activity.

We
are exposed to basis risk between our investments and our borrowings. Interest rates on our floating rate investments and our variable rate borrowings do not reset on the same day or
with the same frequency and, as a result, we are exposed to basis risk with respect to index reset frequency. Our

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floating
rate investments may reprice on indices that are different than the indices that are used to price our variable rate borrowings and, as a result, we are exposed to basis risk with respect to
repricing index. The basis risks noted above, in addition to other forms of basis risk that exist between our investments and borrowings, may be material and could negatively impact future net
interest margins.

Interest
rate risk impacts our interest income, interest expense, prepayments, as well as the fair value of our investments, interest rate derivatives. We generally fund our variable
rate investments with variable rate borrowings with similar interest rate reset frequencies. As of December 31, 2010, approximately 23% of our corporate debt portfolio had LIBOR floors with a
weighted average floor of 1.9%. Based on our variable rate investments and variable rate borrowings as of December 31, 2010, we estimated that net interest income would be negatively impacted
by approximately $0.6 million annually in the event interest rates were to increase by 1%.

We
manage our interest rate risk using various techniques ranging from the purchase of floating rate investments to the use of interest rate derivatives. The use of interest rate
derivatives is a component of our interest risk management strategy. The contractual notional balance of our amortizing interest rate swaps was $483.3 million as of December 31, 2010.



Derivative transactions including engaging in swaps and foreign currency transactions are subject to certain risks. There is no
guarantee that a company can eliminate its exposure under an outstanding swap agreement by entering into an offsetting swap agreement with the same or another party. Also, there is a possibility of
default of the other party to the transaction or illiquidity of the derivative instrument. Furthermore, the ability to successfully use derivative transactions depends on the ability to predict market
movements which cannot be guaranteed. As such, participation in derivative instruments may result in greater losses as we would have to sell or purchase an investment at inopportune times for prices
other than current market prices or may force us to hold an asset we might otherwise have sold. In addition, as certain derivative instruments are unregulated, they are difficult to value and are
therefore susceptible to liquidity and credit risks.

Collateral
posting requirements are individually negotiated between counterparties and there is no regulatory requirement concerning the amount of collateral that a counterparty must
post to secure its obligations under certain derivative instruments. Because they are unregulated, there is no requirement that parties to a contract be informed in advance when a credit default swap
is sold. As a result, investors may have difficulty identifying the party responsible for payment of their claims. If a counterparty's credit becomes significantly impaired, multiple requests for
collateral posting in a short period of time could increase the risk that we may not receive adequate collateral. Amounts paid by us as premiums and cash or other assets held in margin accounts with
respect to derivative instruments are not available for investment purposes.

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The
following table summarizes the estimated net fair value of our derivative instruments held at December 31, 2010 (amounts in thousands):

As of
December 31, 2010Notional

Estimated
Fair ValueCash Flow Hedges:Interest rate swaps

$
483,333

$
(58,365
)Free-Standing Derivatives:Commodity swaps





(226
)Credit default swapsprotection sold


13,500


492Total rate of return swaps





104Foreign exchange forward contracts


(154,405
)

(17,296
)Foreign exchange options


130,207


14,791Common stock warrants





3,453Total

$
472,635

$
(57,047
)


For
our derivatives, our credit exposure is directly with our counterparties and continues until the maturity or termination of such contracts. The following table sets forth the fair
values of our primary derivative investments by remaining contractual maturity as of December 31, 2010 (amounts in thousands):

Less than
1 year

1 - 3 years

3 - 5 years

More than
5 years

TotalCash Flow Hedges:Cash flow interest rate swaps

$
(2,822
)
$


$


$
(55,543
)
$
(58,365
)Free-Standing Derivatives:Commodity swaps


(121
)

(105
)







(226
)Credit default swapsprotection sold


18


474








492Total rate of return swaps


104











104Foreign exchange forward contracts





429


(17,725
)




(17,296
)Foreign exchange options





144


14,647





14,791Total

$
(2,821
)
$
942

$
(3,078
)
$
(55,543
)
$
(60,500
)




We have credit risks that are generally related to the counterparties with which we do business. If a counterparty becomes bankrupt, or
otherwise fails to perform its obligations under a derivative contract due to financial difficulties, we may experience significant delays in obtaining any recovery under the derivative contract in a
bankruptcy or other reorganization proceeding. These risks of non-performance may differ from risks associated with exchange-traded transactions which are typically backed by guarantees
and have daily marks-to-market and settlement positions. Transactions entered into directly between parties do not benefit from such protections and thus, are subject to
counterparty default. It may be the case where any cash or collateral we pledged to the counterparty may be unrecoverable and we may be forced to unwind our derivative agreements at a loss. We may
obtain only a limited recovery or may obtain no recovery in such circumstances, thereby reducing liquidity and earnings.

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The preparation of our financial statements requires management to make estimates and assumptions that affect the amounts reported in
our consolidated financial statements and accompanying notes. Significant estimates, assumptions and judgments are applied in situations including the determination of our allowance for loan losses
and the valuation of certain investments. We revise our estimates when appropriate. However, actual results could materially differ from management's estimates.

Item 7A.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

See discussion of quantitative and qualitative disclosures about market risk in "Quantitative and Qualitative Disclosures About Market
Risk" section of Item 7 of this Annual Report on Form 10-K.

Item 8.    FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Our consolidated financial statements and the related notes to the consolidated financial statements, together with the Report of
Independent Registered Public Accounting Firm thereon, are set forth on pages F-1 through F-55 in this Annual Report on Form 10-K.

Item 9.    CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

None.

Item 9A.    CONTROLS AND PROCEDURES



We have carried out an evaluation, under the supervision and with the participation of our management including our Chief Executive
Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures, as that term is defined in Rules 13a-15(e) under the
Securities Exchange Act of 1934, as amended, as of December 31, 2010. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls
and procedures are effective.



Management is responsible for establishing and maintaining adequate internal control over financial reporting. Our internal control
system was designed to provide reasonable assurance to management and the board of directors regarding the preparation and fair presentation of published financial statements.

Management
assessed the effectiveness of our internal control over financial reporting as of December 31, 2010, based on the framework set forth by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO) inInternal ControlIntegrated Framework. Based on
that assessment, management concluded that, as of December 31, 2010, our internal control over financial reporting was effective.

Because
of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future
periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

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Our independent auditors, Deloitte & Touche LLP, an independent registered public accounting firm, have issued an audit report on our internal control over financial
reporting and their report follows.



During the quarter ended December 31, 2010, there has been no change in our internal control over financial reporting that has
materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

Item 9B.    OTHER INFORMATION

None.

PART III

Item 10.    DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

The information required by Item 10 is incorporated herein by reference to information in the Proxy Statement under the captions
"Proposal One: Election of Directions," "Executive Officers," "Section 16(a) Beneficial Ownership Reporting Compliance," "Corporate Governance," "Proposals by Holders of Shares for the Next
Annual Meeting" and "Board of Directors and Committees" to be filed with the SEC pursuant to Regulation 14A within 120 days after December 31, 2010.

Item 11.    EXECUTIVE COMPENSATION

The information required by Item 11 is incorporated herein by reference to information in the Proxy Statement under the caption
"Executive Compensation," "Director Compensation" and "Compensation Committee Report" to be filed with the SEC pursuant to Regulation 14A within 120 days after December 31, 2010.

Item 12.    SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED SHAREHOLDER MATTERS

The information required by Item 12 is incorporated herein by reference to information in the Proxy Statement under the caption
"Security Ownership of Certain Beneficial Owners and Management" and "Equity Compensation Plan Information" to be filed with the SEC pursuant to Regulation 14A within 120 days after
December 31, 2010.

Item 13.    CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

The information required by Item 13 is incorporated herein by reference to information in the Proxy Statement under the captions
"Certain Relationships and Related Transactions" and "Corporate Governance" to be filed with the SEC pursuant to Regulation 14A within 120 days after December 31, 2010.

Item 14.    PRINCIPAL ACCOUNTING FEES AND SERVICES

The information required by Item 14 is incorporated herein by reference to information in the Proxy Statement under the caption
"Audit Committee Matters" to be filed with the SEC Pursuant to Regulation 14A within 120 days after December 31, 2010.

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PART IV

Item 15.    EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

Documents filed as part of this report:



All financial statement schedules are omitted because of the absence of conditions under which they are required or because the
required information is included in our consolidated financial statements or notes thereto, included in Part II, Item 8, of this Annual Report on Form 10-K.



Incorporated by ReferenceExhibit
Number

Exhibit Description

Form

File No.

Exhibit

Filing
Date

Filed
Herewith2.1

Agreement and Plan of Merger, dated as of February 9, 2007, among the Registrant, KKR Financial Holdings Corp. and KKR Financial Merger Corp.

S-4

333-140586

2

02/09/073.1

Amended and Restated Operating Agreement of the Registrant, dated May 3, 2007, as amended May 7, 2009

10-Q

001-33437

3.1

08/06/093.2

Amendment No.1 to the Amended and Restated Operating Agreement of the Registrant, dated February 28, 2010

10-K

001-33437

3.2

03/01/104.1

Form of Certificate for Common Shares

S-4

333-140586

A

02/09/074.2

Indenture, dated as of July 23, 2007, by and among the Registrant, as Issuer, KKR Financial Corp., as Guarantor, and Wells Fargo Bank, N.A., as Trustee

8-K

001-33437

4.1

07/23/074.3

Form of 7.0% Convertible Senior Note due 2012 and Form of Notation of Guarantee

8-K

001-33437

4.1

07/23/074.4

Registration Rights Agreement, dated as of July 23, 2007, among the Registrant, KKR Financial Corp. and Citigroup Global Markets Inc.

8-K

001-33437

4.3

07/23/074.5

Indenture, dated as of January 15, 2010, between the Registrant and Wells Fargo Bank, National Association

8-K

001-33437

4.1

01/15/104.6

Supplemental Indenture, dated as of January 15, 2010, between the Registrant and Wells Fargo Bank, National Association

8-K

001-33437

4.2

01/15/104.7

Form of 7.50% Convertible Senior Note due January 15, 2017

8-K

001-33437

4.2

01/15/10


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Incorporated by ReferenceExhibit
Number

Exhibit Description

Form

File No.

Exhibit

Filing
Date

Filed
Herewith10.1

Amended and Restated Management Agreement, dated as of May 4, 2007, among the Registrant, KKR Financial Advisors LLC and KKR Financial Corp.

8-K

001-33437

10.1

05/04/0710.2

First Amendment Agreement to Amended and Restated Management Agreement, dated as of June 15, 2007, among the Registrant, KKR Financial Advisors LLC and KKR Financial Corp.

8-K

001-33437

10.1

06/15/0710.3

2007 Share Incentive Plan

8-K

001-33437

10.2

05/04/0710.4

Non-Employee Directors' Deferred Compensation and Share Award Plan

8-K

001-33437

10.3

05/04/0710.5

Form of Nonqualified Share Option Agreement

8-K

001-33437

10.4

05/04/0710.6

Form of Restricted Share Award Agreement

8-K

001-33437

10.5

05/04/0710.7

Form of Restricted Share Award Agreement for Non-Employee Directors

8-K

001-33437

10.6

05/04/0710.8

Amended and Restated License Agreement, dated as of May 4, 2007, among the Registrant, Kohlberg Kravis Roberts & Co. L.P. and KKR Financial Corp.

8-K

001-33437

10.8

05/04/0710.9
*
Indenture, dated as of March 30, 2005, by and among KKR Financial CLO 2005-1, Ltd., KKR Financial CLO 2005-1 Corp. and JPMorgan Chase Bank, National Association(1)

S-11/A

333-124103

10.6

06/09/0510.10
**
Letter Agreement, dated as of August 12, 2004, between KKR Financial Corp. and KKR Financial Advisors LLC

S-11/A

333-124103

10.8

06/21/0510.11
**
Collateral Management Agreement, dated as of March 30, 2005, between KKR Financial CLO 2005-1, Ltd. and KKR Financial Advisors II, LLC

S-11/A

333-124103

10.11

06/21/0510.12
**
Fee Waiver Letter, dated April 15, 2005, between KKR Financial CLO 2005-1, Ltd., KKR Financial Advisors II, LLC and JPMorgan Chase Bank, N.A.

S-11/A

333-124103

10.12

06/21/05


98

---



Incorporated by ReferenceExhibit
Number

Exhibit Description

Form

File No.

Exhibit

Filing
Date

Filed
Herewith10.13

$300 million Credit Agreement dated November 10, 2008 among the Company, KKR TRS Holdings, Ltd., KKR Financial Holdings II, LLC, KKR Financial Holdings III, LLC, KKR Financial Holdings, Inc.
and KKR Financial Holdings, Ltd., as Borrowers, Bank of America, N.A. as Administrative Agent and a Lender and Citicorp North America, Inc., as a Lender

8-K

001-33437

99.1

11/12/0810.14

Letter Agreement, dated February 27, 2009, between the Company and KKR Financial Advisors LLC

10-K

001-33437

10.21

03/02/0910.15

Amendment No. 1, dated August 5, 2009, to the $300 million Credit Agreement dated November 10, 2008, among the Registrant, KKR TRS Holdings, Ltd., KKR Financial Holdings II, LLC, KKR
Financial Holdings III, LLC, KKR Financial Holdings, Inc., KKR Financial Holdings, Ltd. and KKR Financial 2009-1, Ltd., as Borrowers, Bank of America, N.A. as Administrative Agent and a Lender and Citicorp North America, Inc.,
 as a Lender

10-Q

001-33437

10.1

08/06/0910.16

Consent and Amendment No. 2, dated January 11, 2010, to the $300 million Credit Agreement dated November 10, 2008, among the Registrant, KKR TRS Holdings, Ltd., KKR Financial Holdings II,
 LLC, KKR Financial Holdings III, LLC, KKR Financial Holdings, Inc., KKR Financial Holdings, Ltd. and KKR Financial 2009-1, Ltd., as Borrowers, Bank of America, N.A. as Administrative Agent and a Lender and Citicorp North
America, Inc., as a Lender

8-K

001-33437

10.1

01/11/1010.17

Credit Agreement, dated as of May 3, 2010, by and among the Borrowers, Citibank, N.A., Bank of America, N.A., Deutsche Bank AG New York Branch and Morgan Stanley Bank, N.A.

10-Q

001-33437

10.17

8/4/1010.18

Credit Agreement, dated as of November 5, 2010, by and among the Borrower, JP Morgan Chase Bank, N.A., Bank of America, N.A., and Bank of Montreal









X


99

---



Incorporated by ReferenceExhibit
Number

Exhibit Description

Form

File No.

Exhibit

Filing
Date

Filed
Herewith12.1

Computation of Ratios of Earnings to Fixed Charges









X21.1

List of Subsidiaries of the Registrant









X23.1

Consent of Deloitte & Touche LLP









X31.1

Certification Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act of 1934, as amended









X31.2

Certification Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act of 1934, as amended









X32

Certification Pursuant to 18 U.S.C. Section 1350









X


(1)The
registrant has, in the ordinary course of business, entered into other substantially identical indentures, except for the other parties thereto, the
amounts of each class issued, the dates of execution and certain other pricing related terms.*Incorporated
by reference to Amendment No. 2 to KKR Financial Corp.'s Registration Statement on Form S-11/A (Registration
No. 333-124103), originally filed with the Securities and Exchange Commission on June 9, 2005.**Incorporated
by reference to Amendment No. 2 to KKR Financial Corp.'s Registration Statement on Form S-11/A (Registration
No. 333-124103), originally filed with the Securities and Exchange Commission on June 21, 2005.


100

---





SIGNATURES

Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the Registrant has duly caused this annual
report on Form 10-K for the fiscal year ended December 31, 2010, to be signed on its behalf by the undersigned, and in the capacities indicated, thereunto duly authorized, on
February 28, 2011.

KKR FINANCIAL HOLDINGS LLC(Registrant)By:

/s/ WILLIAM C. SONNEBORN Name: William C. Sonneborn
Title:Chief Executive Officer


Pursuant
to the requirements of the Securities Exchange Act of 1934, this Annual Report on Form 10-K has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.

Signature

Title

Date/s/ WILLIAM C. SONNEBORN William C. Sonneborn

Chief Executive Officer and Director (Principal Executive Officer)

February 28, 2011/s/ MICHAEL R. MCFERRAN Michael R. McFerran

Chief Financial Officer (Principal Financial and Accounting Officer)

February 28, 2011/s/ PAUL M. HAZEN Paul M. Hazen

Chairman and Director

February 28, 2011/s/ TRACY COLLINS Tracy Collins

Director

February 28, 2011/s/ VINCENT PAUL FINIGAN Vincent Paul Finigan

Director

February 28, 2011/s/ R. GLENN HUBBARD R. Glenn Hubbard

Director

February 28, 2011


101

---



Signature

Title

Date/s/ ROSS J. KARI Ross J. Kari

Director

February 28, 2011/s/ ELY L. LICHT Ely L. Licht

Director

February 28, 2011/s/ DEBORAH H. MCANENY Deborah H. McAneny

Director

February 28, 2011/s/ SCOTT C. NUTTALL Scott C. Nuttall

Director

February 28, 2011/s/ SCOTT A. RYLES Scott A. Ryles

Director

February 28, 2011/s/ WILLY STROTHOTTE Willy Strothotte

Director

February 28, 2011


102

---





KKR FINANCIAL HOLDINGS LLC AND SUBSIDIARIES  CONSOLIDATED FINANCIAL STATEMENTS  AND  REPORTS OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

For
Inclusion in Form 10-K
Filed with
Securities and Exchange Commission
December 31, 2010

F-1

---





KKR FINANCIAL HOLDINGS LLC AND SUBSIDIARIES  Index to Consolidated Financial Statements



PageReports of Independent Registered Public Accounting Firm


F-3Consolidated Balance Sheets


F-6Consolidated Statements of Operations


F-7Consolidated Statements of Changes in Shareholders' Equity


F-8Consolidated Statements of Cash Flows


F-9Notes to Consolidated Financial Statements


F-10


F-2

---







REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To
the Board of Directors and Shareholders of
KKR Financial Holdings LLC
San Francisco, California

We
have audited the internal control over financial reporting of KKR Financial Holdings LLC and subsidiaries (the "Company") as of December 31, 2010, based on criteria
established inInternal ControlIntegrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission. The
Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting,
included in the accompanying Management's Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company's internal control over financial reporting
based on our audit.

We
conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control
over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design
and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a
reasonable basis for our opinion.

A
company's internal control over financial reporting is a process designed by, or under the supervision of, the company's principal executive and principal financial officers, or
persons performing similar functions, and effected by the company's board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those
policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company;
(2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that
receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding
prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.

Because
of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material
misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to
future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In
our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2010, based on the criteria established in Internal ControlIntegrated
Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission.

F-3

---



We
have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year
ended December 31, 2010 of the Company and our report dated February 28, 2011 expressed an unqualified opinion on those financial statements and included an explanatory paragraph
relating to the Company's adoption of the new accounting guidance which amended the accounting for the transfers of financial assets and the consolidation of variable interest entities.

/s/DELOITTE & TOUCHELLP

San
Francisco, California
February 28, 2011

F-4

---





REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To
the Board of Directors and Shareholders of
KKR Financial Holdings LLC
San Francisco, California

We
have audited the accompanying consolidated balance sheets of KKR Financial Holdings LLC and subsidiaries (the "Company") as of December 31, 2010 and 2009, and the
related consolidated statements of operations, changes in shareholders' equity, and cash flows for each of the three years in the period ended December 31, 2010. These financial statements are
the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.

We
conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our opinion.

In
our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2010 and 2009, and the
results of its operations and its cash flows for each of the three years in the period ended December 31, 2010, in conformity with accounting principles generally accepted in the United States
of America.

As
discussed in Note 2 to the consolidated financial statements, effective January 1, 2010, the Company adopted the new accounting guidance which amended the accounting for
the transfers of financial assets and the consolidation of variable interest entities.

We
have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company's internal control over financial reporting as of
December 31, 2010, based on the criteria established inInternal ControlIntegrated Frameworkissued by the Committee of Sponsoring
Organizations of the Treadway Commission and our report dated February 28, 2011 expressed an unqualified opinion on the Company's internal control over financial reporting.

/s/DELOITTE & TOUCHELLP

San
Francisco, California
February 28, 2011

F-5

---





KKR Financial Holdings LLC and Subsidiaries        Consolidated Balance Sheets        (Amounts in thousands, except share information)

December 31,
2010

December 31,
2009AssetsCash and cash equivalents

$
313,829

$
97,086Restricted cash and cash equivalents


571,425


342,706Securities available-for-sale, $728,558 and $740,949 pledged as collateral as of December 31, 2010 and December 31, 2009, respectively


838,894


755,686Corporate loans, net of allowance for loan losses of $209,030 and $237,308 as of December 31, 2010 and December 31, 2009, respectively


5,857,816


5,617,925Corporate loans held for sale


463,628


925,718Residential mortgage-backed securities, at estimated fair value, nil and $47,572 pledged as collateral as of December 31, 2010 and December 31,
2009, respectively


93,929


47,572Residential mortgage loans, at estimated fair value





2,097,699Equity investments, at estimated fair value, $12,036 and $110,812 pledged as collateral as of December 31, 2010 and December 31, 2009,
respectively


99,955


120,269Derivative assets


19,519


15,784Interest and principal receivable


57,414


98,313Reverse repurchase agreements





80,250Other assets


102,003


100,997Total assets

$
8,418,412

$
10,300,005LiabilitiesCollateralized loan obligation secured notes

$
5,630,272

$
5,667,716Collateralized loan obligation junior secured notes to affiliates


366,124


533,786Senior secured credit facility





175,000Asset-based borrowing facility


18,400


Convertible senior notes


344,142


275,800Junior subordinated notes


283,517


283,517Residential mortgage-backed securities issued, at estimated fair value





2,034,772Accounts payable, accrued expenses and other liabilities


14,193


7,240Accrued interest payable


22,846


25,297Accrued interest payable to affiliates


6,316


2,911Related party payable


12,988


3,367Securities sold, not yet purchased





77,971Derivative liabilities


76,566


45,970Total liabilities


6,775,364


9,133,347Shareholders' EquityPreferred shares, no par value, 50,000,000 shares authorized and none issued and outstanding at December 31, 2010 and December 31, 2009





Common shares, no par value, 500,000,000 shares authorized, and 177,848,565 and 158,359,757 shares issued and outstanding at December 31, 2010 and
December 31, 2009, respectively





Paid-in-capital


2,756,200


2,563,634Accumulated other comprehensive income


133,596


152,728Accumulated deficit


(1,246,748
)

(1,549,704
)Total shareholders' equity


1,643,048


1,166,658Total liabilities and shareholders' equity

$
8,418,412

$
10,300,005


See notes to consolidated financial statements.

F-6

---





KKR Financial Holdings LLC and Subsidiaries        Consolidated Statements of Operations        (Amounts in thousands, except per share information)

Year ended
December 31,
2010

Year ended
December 31,
2009

Year ended
December 31,
2008Net investment income (loss):Loan interest income

$
397,634

$
477,044

$
777,510Securities interest income


104,395


94,762


145,865Other investment income


3,330


919


25,213Total investment income


505,359


572,725


948,588Interest expense


131,700


268,087


521,313Interest expense to affiliates


25,152


21,287


43,301Provision for loan losses


29,121


39,795


481,488Net investment income (loss)


319,386


243,556


(97,514
)Other income (loss):Net realized and unrealized gain (loss) on investments


109,309


(92,287
)

(804,754
)Net realized and unrealized (loss) gain on derivatives and foreign exchange


(4,694
)

60,908


(141,319
)Net realized and unrealized loss on residential mortgage-backed securities, residential mortgage loans, and residential mortgage-backed securities issued,
carried at estimated fair value


(11,396
)

(107,028
)

(48,899
)Net realized and unrealized (loss) gain on securities sold, not yet purchased


(756
)

3,582


50,297Net gain on restructuring and extinguishment of debt


39,999


30,836


26,486Other income


10,890


7,714


11,352Total other income (loss)


143,352


(96,275
)

(906,837
)Non-investment expenses:Related party management compensation


69,125


44,323


36,670General, administrative and directors expenses


16,516


10,393


19,038Professional services


5,331


7,384


8,098Loan servicing





7,961


9,444Total non-investment expenses


90,972


70,061


73,250Income (loss) from continuing operations before income tax expense


371,766


77,220


(1,077,601
)Income tax expense


702


284


107Income (loss) from continuing operations


371,064


76,936


(1,077,708
)Income from discontinued operations








2,668Net income (loss)

$
371,064

$
76,936

$
(1,075,040
)Net income (loss) per common share:BasicIncome (loss) per share from continuing operations

$
2.33

$
0.50

$
(7.71
)Income per share from discontinued operations

$


$


$
0.02Net income (loss) per share

$
2.33

$
0.50

$
(7.69
)DilutedIncome (loss) per share from continuing operations

$
2.32

$
0.50

$
(7.71
)Income per share from discontinued operations

$


$


$
0.02Net income (loss) per share

$
2.32

$
0.50

$
(7.69
)Weighted average number of common shares outstanding:Basic


157,936


153,756


140,027Diluted


158,771


153,756


140,027


See notes to consolidated financial statements.

F-7

---





KKR Financial Holdings LLC and Subsidiaries        Consolidated Statements of Changes in Shareholders' Equity        (Amounts in thousands)

Common
Shares

Paid-In
Capital

Accumulated
Other
Comprehensive
Income (Loss)

Accumulated
Deficit

Comprehensive
Income (Loss)

Total
Shareholders'
EquityBalance at January 1, 2008


115,249

$
2,167,156

$
(157,245
)
$
(365,372
)



$
1,644,539Net loss











(1,075,040
)
$
(1,075,040
)

(1,075,040
)Net change in unrealized loss on cash flow hedges








(57,329
)




(57,329
)

(57,329
)Net change in unrealized loss on securities available-for-sale








(54,208
)




(54,208
)

(54,208
)Comprehensive loss













$
(1,186,577
)Cash distributions on common shares











(178,310
)




(178,310
)Cancellation of restricted common shares


(3
)













Grant of restricted common shares


1,135














Proceeds from issuance of common shares, net of offering costs


34,500


383,519











383,519Share-based compensation expense related to restricted common shares





174











174Balance at December 31, 2008


150,881


2,550,849


(268,782
)

(1,618,722
)




663,345Net income











76,936

$
76,936


76,936Net change in unrealized gain on cash flow hedges








34,739





34,739


34,739Net change in unrealized gain on securities available-for-sale








386,771





386,771


386,771Comprehensive income













$
498,446Cash distributions on common shares











(7,918
)




(7,918
)Proceeds from issuance of common shares, net of offering costs


7,258


8,808











8,808Grant of restricted common shares


221














Share-based compensation expense related to restricted common shares





3,977











3,977Balance at December 31, 2009


158,360


2,563,634


152,728


(1,549,704
)




1,166,658Net income











371,064

$
371,064


371,064Net change in unrealized loss on cash flow hedges








(13,935
)




(13,935
)

(13,935
)Net change in unrealized gain on securities available-for-sale








(5,197
)




(5,197
)

(5,197
)Comprehensive income













$
351,932Cash distributions on common shares











(68,108
)




(68,108
)Proceeds from issuance of common shares, net of offering costs


19,436


175,701











175,701Grant of restricted common shares


53














Equity component of convertible notes issuance





9,973











9,973Share-based compensation expense related to restricted common shares





6,892











6,892Balance at December 31, 2010


177,849

$
2,756,200

$
133,596

$
(1,246,748
)



$
1,643,048


See notes to consolidated financial statements.

F-8

---





KKR Financial Holdings LLC and Subsidiaries        Consolidated Statements of Cash Flows        (Amounts in thousands)

Year ended
December 31,
2010

Year ended
December 31,
2009

Year ended
December 31,
2008Cash flows from operating activities:Net income (loss)

$
371,064

$
76,936

$
(1,075,040
)Adjustments to reconcile net income (loss) to net cash provided by operating activities:Net realized and unrealized (gain) loss on derivatives, foreign exchange, and securities sold, not yet purchased


5,378


(64,490
)

91,022Net gain on restructuring and extinguishment of debt


(39,999
)

(59,635
)

(26,486
)Write-off of debt issuance costs


8,160


5,267


1,154Lower of cost or estimated fair value adjustment on corporate loans held for sale


14,725


51,037


137,269Provision for loan losses


29,121


39,795


481,488Impairment on securities available-for-sale and private equity investments at cost


12,890


43,906


474,520Share-based compensation


6,892


3,977


174Net unrealized loss on residential mortgage-backed securities, residential mortgage loans, and residential mortgage-backed securities issued, carried at
estimated fair value


11,396


107,028


25,190Net realized (gain) loss on sales of investments


(136,924
)

(2,656
)

198,726Deferred interest expense


4,427


20,783


Depreciation and net amortization


(103,430
)

(58,118
)

(39,000
)Changes in assets and liabilities:Interest receivable


12,008


43,482


38,020Other assets


(36,739
)

(30,498
)

(15,450
)Related party payable


9,621


491


(6,819
)Accounts payable, accrued expenses and other liabilities


1,151


(46,603
)

4,354Accrued interest payable


(2,451
)

(35,822
)

(53,438
)Accrued interest payable to affiliates


3,405


1,715


(9,881
)Net cash provided by operating activities


170,695


96,595


225,803Cash flows from investing activities:Principal payments from investments


1,765,585


1,247,488


1,502,999Proceeds from sale of investments


1,591,566


1,454,643


2,117,415Purchases of investments


(3,020,798
)

(1,141,180
)

(2,231,215
)Net proceeds, purchases, and settlements of derivatives


13,454


32,510


(117,778
)Net change in reverse repurchase agreements


80,250


8,002


(18,412
)Net change in restricted cash and cash equivalents


(228,719
)

890,879


(165,435
)Net cash provided by investing activities


201,338


2,492,342


1,087,574Cash flows from financing activities:Net change in repurchase agreements








(2,723,608
)Net change in asset-backed secured liquidity notes








(136,596
)Repayment of residential mortgage-backed securities issued





(571,228
)

(639,317
)Issuance of collateralized loan obligation secured notes








1,537,585Retirement of collateralized loan obligation secured notes


(104,734
)

(1,846,738
)

Retirement of collateralized loan obligation junior secured notes to affiliates


(67,519
)




Proceeds from senior secured credit facility, asset-based borrowing facility and secured demand loan


68,719





Repayment of senior secured credit facility, asset-based borrowing facility and secured demand loan


(227,805
)

(100,633
)

Repayment of junior subordinated notes





(1,392
)

(20,956
)Proceeds from convertible senior notes


167,325





Repayment of convertible senior notes


(93,922
)




(2,225
)Repayment of subordinated notes to affiliates








(2,880
)Net proceeds from common share offerings and common share option exercises


175,701





383,519Distributions on common shares


(68,108
)

(7,918
)

(178,310
)Other capitalized costs


(4,947
)

(5,372
)

(13,239
)Net cash used in financing activities


(155,290
)

(2,533,281
)

(1,796,027
)Net increase (decrease) in cash and cash equivalents


216,743


55,656


(482,650
)Cash and cash equivalents at beginning of year


97,086


41,430


524,080Cash and cash equivalents at end of year

$
313,829

$
97,086

$
41,430Supplemental cash flow information:Cash paid for interest

$
99,308

$
290,147

$
663,507Net cash paid (received) for income taxes

$
768

$
373

$
(651
)Non-cash investing and financing activities:Deconsolidation of residential mortgage loans

$
2,034,772

$


$
Deconsolidation of residential mortgage-backed securities issued

$
(2,034,772
)
$


$
Subordinate tranche of the residential mortgage loan securitization trusts included in residential mortgage-backed securities

$
74,366

$


$
Equity component of the convertible senior notes

$
9,973

$


$
Net receivable for securities sold

$


$


$
(2,610
)Issuance of restricted common shares

$
470

$
615

$
16,339Distributions of securities to the asset-backed secured liquidity noteholders

$


$


$
3,623,049Exchange of convertible senior notes to equity

$


$
8,808

$
Exchange of CLO 2009-1 subordinated notes to affiliate for 20% interest in CLO 2009-1 assets

$


$
90,429

$
Loans transferred from held for sale to held for investment

$
510,671

$


$



See notes to consolidated financial statements.

F-9

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KKR Financial Holdings LLC and Subsidiaries        Notes to Consolidated Financial Statements

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's core business strategy is to leverage the proprietary resources of its manager with the objective of generating both current income and capital appreciation. The Company primarily invests in
financial assets such as below investment grade corporate debt, marketable equity securities and private equity. Additionally, the Company may make investments in other asset classes including natural
resources and real estate. Below investment grade corporate debt includes senior secured and unsecured loans, mezzanine loans, high yield bonds, and distressed and stressed debt securities.

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 are structured as on-balance sheet
securitizations and are used as long term financing for its corporate debt investments. The senior secured notes issued by the CLO transactions are generally owned by unaffiliated third party
investors and the Company owns the majority of the mezzanine and 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 consolidated financial statements have been prepared in conformity with accounting principles generally accepted in
the United States of America ("GAAP"). The 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. KKR Financial Corp., which was sold on June 30, 2008, is presented as discontinued operations for
financial statement purposes.

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 consolidated financial statements and accompanying notes. Actual results could differ from management's estimates.

Consolidation

Effective January 1, 2010, the Company adopted new accounting 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 accounting guidance, consolidation of a VIE requires both the power to direct the activities that most significantly impact the VIE's economic

F-10

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KKR Financial Holdings LLC and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

Note 2. Summary of Significant Accounting Policies (Continued)

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 accounting 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 accounting 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 are no longer reported on the Company's 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 consolidated financial statements for further discussion of the Company's residential
mortgage-backed securities ("RMBS") and to Note 7 to these 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 $7.1 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
held by unaffiliated third parties and $366.1 million of junior notes outstanding 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

F-11

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KKR Financial Holdings LLC and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

Note 2. Summary of Significant Accounting Policies (Continued)

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 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:



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

F-12

---



KKR Financial Holdings LLC and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

Note 2. Summary of Significant Accounting Policies (Continued)

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.

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.

Equity Investments, at Estimated Fair Value:Equity investments, at estimated fair value, are initially valued at transaction price and
are
subsequently valued using observable market prices, if available, or internally developed models in the absence of readily observable market prices. Valuation models are generally based on a market
and income (discounted cash flow) approach, from which various internal and external factors are considered. Factors include the price at which the investment was acquired, the nature of the
investment, current market conditions, recent public market and private transactions for comparable securities, and financing transactions subsequent to the acquisition of the investment. The fair
value recorded for a particular investment will generally be within the range suggested by the two approaches.

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.

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

F-13

---



KKR Financial Holdings LLC and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

Note 2. Summary of Significant Accounting Policies (Continued)

(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.

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 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. 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

F-14

---



KKR Financial Holdings LLC and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

Note 2. Summary of Significant Accounting Policies (Continued)

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 equity securities 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 fair value, are managed based on overall value and potential returns. Investments carried at fair value are presented
separately on the consolidated balance sheets with unrealized gains and losses reported in net realized and unrealized gains and losses on investments on the 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. Corporate loans

F-15

---



KKR Financial Holdings LLC and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

Note 2. Summary of Significant Accounting Policies (Continued)

that
the Company transfers to held for investment or held for sale are transferred at the lower of cost or estimated fair value.

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. The Company typically charges-off a corporate loan when management believes the asset to be
uncollectible.

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 and are assessed on an individual basis.

Allowance for Loan Losses

The Company's corporate loan portfolio is comprised of a single portfolio segment which includes one class of financing receivables,
that is, high yield loans that are purchased via assignment or participation in either the primary or secondary market and are held primarily for investment. High yield loans are generally
characterized as having below investment grade ratings or being unrated and generally consist of leveraged loans.

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

F-16

---



KKR Financial Holdings LLC and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

Note 2. Summary of Significant Accounting Policies (Continued)

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 represents 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, including internally assigned credit quality indicators. This assessment excludes all loans that are determined to be
impaired and as a result, an allocated reserve has been recorded as described in the preceding paragraph. 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. All loans are first
categorized based on their assigned risk grade and further stratified based on the seniority of the loan in the issuer's capital structure. The seniority classifications assigned to loans are senior
secured, second lien and subordinate. Senior secured consists of loans that are the most senior debt in an issuer's capital structure and therefore have a lower estimated loss severity than other debt
that is subordinate to the senior secured loan. Senior secured loans often have a first lien on some or all of the issuer's assets. Second lien consists of loans that are
secured by a second lien interest on some or all of the issuer's assets; however, the loan is subordinate to the first lien debt in the issuer's capital structure. Subordinate consists of loans that
are generally unsecured and subordinate to other debt in the issuer's capital structure.

There
are three internally assigned risk grades that are applied to loans that have not been identified as being impaired: high, moderate and low. High risk means that there is evidence
of probable loss due to the financial or operating performance and liquidity of the issuer, industry or economic concerns specific to the issuer, or other factors that indicate that the breach of a
covenant contained in the related loan agreement is possible. Moderate risk means that while there is not observable evidence of loss, there are issuer and/or industry specific trends that indicate a
loss may have occurred. Low risk means that while there is no identified evidence of loss, there is the risk of loss inherent in the loan that has not been identified. All loans held for investment,
with the exception of loans that have been identified as impaired, are assigned a risk grade of high, moderate or low.

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.

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

F-17

---



KKR Financial Holdings LLC and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

Note 2. Summary of Significant Accounting Policies (Continued)

such
trusts. The Company's investment in the common securities of such trusts is included in other assets on the Company's consolidated financial statements.

Derivative Financial Instruments

The Company recognizes all derivatives on the 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 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

F-18

---



KKR Financial Holdings LLC and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

Note 2. Summary of Significant Accounting Policies (Continued)

expenses
incurred on the Company's behalf. See Note 13 to these 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 relevant 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, for United States federal income tax purposes, as a partnership and not as
an association or publicly traded partnership taxable as a corporation. 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

F-19

---



KKR Financial Holdings LLC and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

Note 2. Summary of Significant Accounting Policies (Continued)

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 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 consolidated financial statements for earnings (loss) per common share
computations.

Recent Accounting Pronouncements

Financing Receivables and Allowance for Credit Losses

In July 2010, the Financial Accounting Standards Board ("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 included the required disclosures in its consolidated financial statements for
the year ended December 31, 2010.

F-20

---



KKR Financial Holdings LLC and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

Note 3. Earnings (Loss) per Share

The following table presents a reconciliation of basic and diluted net income (loss) per common share, as well as the distributions declared per common share for the years ended
December 31, 2010, 2009 and 2008 (amounts in thousands, except per share information):

Year ended
December 31, 2010

Year ended
December 31, 2009

Year ended
December 31, 2008Income (loss) from continuing operations

$
371,064

$
76,936

$
(1,077,708
)Less: Dividends and undistributed earnings allocated to participating securities


3,108


614


1,818Income (loss) from continuing operations applicable to common shareholders


367,956


76,322


(1,079,526
)Income from discontinued operations








2,668Net income (loss) applicable to common shareholders

$
367,956

$
76,322

$
(1,076,858
)Basic:Basic weighted average shares outstanding


157,936


153,756


140,027Income (loss) per share from continuing operations

$
2.33

$
0.50

$
(7.71
)Income per share from discontinued operations

$


$


$
0.02Net income (loss) per share

$
2.33

$
0.50

$
(7.69
)Diluted:Basic weighted average shares outstanding


157,936


153,756


140,027Diluted weighted average shares outstanding(1)


158,771


153,756


140,027Income (loss) per share from continuing operations

$
2.32

$
0.50

$
(7.71
)Income per share from discontinued operations

$


$


$
0.02Net income (loss) per share

$
2.32

$
0.50

$
(7.69
)Distributions declared per common share

$
0.43

$
0.05

$
1.30


(1)An
immaterial conversion premium related to the convertible senior notes was included in the diluted earnings per share for the year ended
December 31, 2010. Potential anti-dilutive common shares excluded from diluted earnings per share related to common share options were 1,932,279 for the years ended
December 31, 2010, 2009 and 2008.


F-21

---



KKR Financial Holdings LLC and Subsidiaries

Notes to Consolidated Financial Statements (Continued)




Note 4. Securities Available-for-Sale

The following table summarizes the Company's securities classified as available-for-sale as of December 31, 2010 and 2009, which are carried at estimated
fair value (amounts in thousands):

December 31, 2010

December 31, 2009Amortized
Cost

Gross
Unrealized
Gains

Gross
Unrealized
Losses

Estimated
Fair Value

Amortized
Cost

Gross
Unrealized
Gains

Gross
Unrealized
Losses

Estimated
Fair ValueCorporate debt securities

$
646,638

$
192,496

$
(3,614
)
$
835,520

$
560,637

$
198,242

$
(4,470
)
$
754,409Common and preferred stock


3,117


257





3,374


713


564





1,277Total

$
649,755

$
192,753

$
(3,614
)
$
838,894

$
561,350

$
198,806

$
(4,470
)
$
755,686


The
following table shows the gross unrealized losses and 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 December 31, 2010 and 2009 (amounts in thousands):

Less Than 12 months

12 Months or More

TotalEstimated
Fair Value

Unrealized
Losses

Estimated
Fair Value

Unrealized
Losses

Estimated
Fair Value

Unrealized
LossesDecember 31, 2010Corporate debt securities

$
41,656

$
(1,331
)
$
36,631

$
(2,283
)
$
78,287

$
(3,614
)December 31, 2009Corporate debt securities

$
8,437

$
(113
)
$
70,967

$
(4,357
)
$
79,404

$
(4,470
)


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 is able to recover the entire amortized cost amount of the corporate debt securities included in the table above.

During
the year ended December 31, 2010, the Company recognized a loss totaling $2.6 million for corporate debt securities that it determined to be
other-than-temporarily impaired based on the criteria above. During the year ended December 31, 2009 and 2008, the Company recognized losses totaling
$43.9 million and $474.5 million, respectively, for securities that it determined to be other-than-temporarily impaired. 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 consolidated statements of operations.

As
of December 31, 2010, the Company had one corporate debt security in default with an estimated fair value of $1.1 million. As of December 31, 2009, the Company
had no corporate debt securities in default.

F-22

---



KKR Financial Holdings LLC and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

Note 4. Securities Available-for-Sale (Continued)

Corporate
debt securities sold at a loss typically include those that the Company determined to be other-than-temporarily impaired or had a deteriorated credit
quality. The following table shows the net realized gains (losses) on the sales of securities (amounts in thousands):

Year ended
December 31, 2010

Year ended
December 31, 2009

Year ended
December 31, 2008Gross realized gains

$
68,411

$
24,163

$
5,304Gross realized losses


(7
)

(9,493
)

(111,532
)Net realized gains (losses)

$
68,404

$
14,670

$
(106,228
)


The
following table summarizes the amortized cost and estimated fair value of corporate debt securities by remaining contractual maturity and weighted average coupon based on par values
as of December 31, 2010 (dollar amounts in thousands):

Description

Amortized
Cost

Estimated
Fair Value

Weighted
Average
CouponDue within one year

$
265

$
265


5.1
%One to five years


223,144


352,771


7.8Five to ten years


375,055


404,285


9.5Greater than ten years


48,174


78,199


10.5Total

$
646,638

$
835,520


The
remaining contractual maturities in the table above were allocated assuming no prepayments. Expected maturities may differ from contractual maturities because borrowers may have the
right to call or prepay obligations, with or without call or prepayment penalties.

Note 8
to these 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 December 31, 2010 and 2009 (amounts in thousands):

As of
December 31, 2010

As of
December 31, 2009Pledged as collateral for borrowings under senior secured credit facility

$


$
107,845Pledged as collateral for collateralized loan obligation secured notes and junior secured notes to affiliates


728,558


633,104Total

$
728,558

$
740,949


F-23

---



KKR Financial Holdings LLC and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

Note 5. Corporate Loans and Allowance for Loan Losses

The following table summarizes the Company's corporate loans as of December 31, 2010 and 2009 (amounts in thousands):

December 31, 2010

December 31, 2009Corporate
Loans

Corporate
Loans
Held for Sale

Total
Corporate
Loans

Corporate
Loans

Corporate
Loans
Held for Sale

Total
Corporate
LoansPrincipal(1)

$
6,398,997

$
481,152

$
6,880,149

$
6,180,028

$
1,033,383

$
7,213,411Unamortized discount


(332,151
)

(12,776
)

(344,927
)

(324,795
)

(76,028
)

(400,823
)Total amortized cost


6,066,846


468,376


6,535,222


5,855,233


957,355


6,812,588Lower of cost or fair value adjustment





(4,748
)

(4,748
)




(31,637
)

(31,637
)Allowance for loan losses


(209,030
)




(209,030
)

(237,308
)




(237,308
)Net carrying value

$
5,857,816

$
463,628

$
6,321,444

$
5,617,925

$
925,718

$
6,543,643


(1)Principal
amount is net of charge-offs and other adjustments totaling $58.2 million and $158.8 million as of December 31,
2010 and 2009, respectively.


As
of December 31, 2010 and 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 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.

F-24

---



KKR Financial Holdings LLC and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

Note 5. Corporate Loans and Allowance for Loan Losses (Continued)

The following table summarizes the changes in the allowance for loan losses for the Company's corporate loan portfolio during the years ended December 31, 2010, 2009 and 2008
(amounts in thousands):

2010

2009

2008Allowance for loan losses:Beginning balance

$
237,308

$
480,775

$
25,000Provision for loan losses


29,121


39,795


481,488Charge-offs


(57,399
)

(283,262
)

(25,713
)Ending balance

$
209,030

$
237,308

$
480,775Ending balance: individually evaluated for impairment

$
207,633Ending balance: collectively evaluated for impairment


Ending balance: loans acquired with deteriorated credit quality


1,397$
209,030Corporate loans (recorded investment)(1):Ending balance: individually evaluated for impairment

$
6,065,596Ending balance: collectively evaluated for impairment


Ending balance: loans acquired with deteriorated credit quality


25,007$
6,090,603


(1)Recorded
investment is defined as amortized cost plus accrued interest.


As
of December 31, 2010, the allocated component of the allowance for loan losses totaled $50.1 million and relates to investments in certain loans issued by five issuers
with an aggregate par amount of $225.6 million and an aggregate recorded investment of $149.8 million. 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 recorded investment of
$121.2 million.

The
following table summarizes the Company's recorded investment in impaired loans and the related allowance for credit losses for the year ended December 31, 2010 (amounts in
thousands):

Recorded
Investment

Unpaid
Principal
Balance

Related
Allowance

Average
Recorded
Investment

Interest Income
RecognizedDecember 31, 2010With no related allowance recorded

$
16,219

$
83,215

$


$
12,873

$
2,853With an allowance recorded


133,566


142,377


50,112


133,014


8,256Total

$
149,785

$
225,592

$
50,112

$
145,887

$
11,109


As
of December 31, 2010 and 2009, the allocated component of the allowance for loan losses included all impaired loans. While all of the Company's impaired loans are on
non-accrual status, the Company's non-accrual loans also include those held for sale that are measured at the lower of cost or fair value and are not reflected in the table
above. As of December 31, 2010, the Company had loans

F-25

---



KKR Financial Holdings LLC and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

Note 5. Corporate Loans and Allowance for Loan Losses (Continued)

on
non-accrual status with total recorded investment of $165.1 million, which included $149.8 million of impaired loans that were held for investment and $15.3 million
of non-accrual loans held for sale. The amount of interest income recognized using the cash-basis method during the time within the period that the loans were impaired was $12.9 million, which
included $11.1 million for impaired loans that were held for investment and $1.8 million for non-accrual loans held for sale.

As
of December 31, 2009, the Company had loans on non-accrual status with total recorded investment of $439.9 million, which included $121.2 million of
impaired loans that were held for investment. During the year ended December 31, 2009, the average recorded investment in the impaired loans on non-accrual status was
$600.9 million, which included $530.9 million of impaired loans that were held for investment. The amount of interest income recognized using the cash-basis method during the
time within the period that the loans were impaired was $16.9 million, which included $15.2 million for impaired loans that were held for investment, for the year ended
December 31, 2009.

The
unallocated component of the allowance for loan losses totaled $158.9 million and $155.6 million as of December 31, 2010 and 2009, respectively. As described in
Note 2 to these consolidated financial statements, the Company estimates the unallocated components of the allowance for loan losses through a comprehensive review of its loan portfolio and
identifies certain loans that demonstrate possible indicators of impairments, including credit quality indicators. The following table summarizes how the Company determines internally assigned grades
related to credit quality based on a combination of concern as to probability of default and the seniority of the loan in the issuer's capital structure for the year ended December 31, 2010
(amounts in thousands):

Internally Assigned Grade

Capital Hierarchy

Recorded Investment
December 31, 2010High

Senior Secured Loan

$
945,435Second Lien Loan


389,981$
1,335,416Moderate

Senior Secured Loan

$
494,433Second Lien Loan


38,448Subordinated


4,431$
537,312Low

Senior Secured Loan

$
3,829,458Second Lien Loan


137,182Subordinated


101,450$
4,068,090Total Unallocated

$
5,940,818Total Allocated


149,785Total Loans Held for Investment

$
6,090,603


During
the years ended December 31, 2010, 2009 and 2008, the Company recorded charge-offs totaling $57.4 million, $283.3 million and
$25.7 million, respectively, comprised primarily of loans transferred to loans held for sale. As of December 31, 2010, the Company had $463.6 million of loans

F-26

---



KKR Financial Holdings LLC and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

Note 5. Corporate Loans and Allowance for Loan Losses (Continued)

held
for sale, a decrease of $462.1 million from December 31, 2009 due to the sale of certain loans and the transfer of loans to held for investment for those the Company determined it
no longer had the intention of selling.

As
of December 31, 2010, the Company held corporate loans that were in default with a total amortized cost of $18.6 million from one issuer. 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 December 31, 2010 and
December 31, 2009, respectively.

Note 8
to these 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
corporate loans held for sale and corporate loans pledged as collateral as of December 31, 2010 and 2009 (amounts in thousands):

As of
December 31, 2010

As of
December 31, 2009Pledged as collateral for borrowings under senior secured credit facility

$


$
425,740Pledged as collateral for collateralized loan obligation secured notes and junior secured notes to affiliates


6,152,924


6,354,382Total

$
6,152,924

$
6,780,122


Note 6. Residential Mortgage-Backed Securities

The Company held RMBS with an estimated fair value of $93.9 million and $47.6 million as December 31, 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
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 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 December 31, 2010 and 2009 (amounts in thousands):

As of
December 31, 2010

As of
December 31, 2009Pledged as collateral for borrowings under senior secured credit facility

$


$
42,627Pledged as collateral for collateralized loan obligation secured notes and junior secured notes to affiliates





4,945Total

$


$
47,572


F-27

---



KKR Financial Holdings LLC and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

Note 7. Deconsolidation of Residential Mortgage Loans Securitization Trusts

On January 1, 2010, the Company deconsolidated six residential mortgage securitization trusts as a result of the Company's adoption of new accounting 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 consolidated financial statements).

The
following information represents the assets and liabilities removed from the Company's 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):

As of
January 1, 2010AssetsResidential mortgage loans, at estimated fair value(1)

$
2,023,333Real estate owned (recorded within other assets on the consolidated balance sheets)


11,439Interest receivable


4,529$
2,039,301LiabilitiesResidential mortgage-backed securities issued, at estimated fair value

$
2,034,772Accrued interest payable


4,529$
2,039,301


(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 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 consolidated balance
sheets.

F-28

---



KKR Financial Holdings LLC and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

Note 7. Deconsolidation of Residential Mortgage Loans Securitization Trusts (Continued)

The
following table summarizes the estimated fair value of residential mortgage loans pledged as collateral as of December 31, 2009 (amounts in thousands):

As of
December 31, 2009Pledged as collateral for borrowings under senior secured credit facility

$
74,366Pledged as collateral for residential mortgage-backed securities issued


2,023,333$
2,097,699


The
following is a reconciliation of carrying amounts of residential mortgage loans for the year ended December 31, 2009 (amounts in thousands):

As of
December 31, 2009Beginning balance

$
2,620,021Principal payments


(585,429
)Transfers in to REO


(646
)Net change in unrealized and realized gain/loss and premium/discount


63,753Ending balance

$
2,097,699


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, 2009Delinquency Status

Number
of Loans

Principal
Amount30 to 59 days


84

$
37,26160 to 89 days


47


19,38990 days or more


138


55,697In foreclosure


139


57,497Total


408

$
169,844


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.

F-29

---



KKR Financial Holdings LLC and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

Note 7. Deconsolidation of Residential Mortgage Loans Securitization Trusts (Continued)

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 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 December 31, 2010 is summarized in the following table (dollar amounts in thousands):

Outstanding
Borrowings

Weighted
Average
Borrowing
Rate

Weighted
Average
Remaining
Maturity
(in days)

Fair Value of
Collateral(1)Senior secured credit facility

$



3.51
%

1,219

$
Asset-based borrowing facility(2)


18,400


2.76


1,770


32,760CLO 2005-1 senior secured notes


833,220


0.61


2,308


898,017CLO 2005-2 senior secured notes


801,323


0.60


2,522


887,573CLO 2006-1 senior secured notes


683,265


0.66


2,794


845,342CLO 2007-1 senior secured notes


2,075,040


0.84


3,788


2,452,442CLO 2007-1 junior secured notes to affiliates(3)


300,672





3,788


353,430CLO 2007-1 junior secured notes(4)


61,504





3,788


72,689CLO 2007-A senior secured notes


1,165,099


1.18


2,480


1,218,688CLO 2007-A junior secured notes to affiliates(5)


65,452





2,480


68,462CLO 2007-A junior secured notes(6)


10,821





2,480


11,318Convertible senior notes


344,142


7.24


1,366


Junior subordinated notes


283,517


5.42


9,443


Total

$
6,642,455







$
6,840,721


(1)Collateral
for borrowings consists of securities available-for-sale, equity investments, at estimated fair value and corporate
loans.(2)Collateral
for borrowings consists of oil and gas assets purchased during the fourth quarter of 2010 for an aggregate purchase price of
$32.8 million, whereby no impairment was deemed to exist. These oil and gas assets are included in other assets in the consolidated balance sheets as of December 31, 2010.


F-30

---



KKR Financial Holdings LLC and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

Note 8. Borrowings (Continued)

(3)CLO
2007-1 junior secured notes to affiliates consist of $170.4 million of mezzanine notes with a weighted average borrowing rate of 5.1%
and $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.(4)CLO
2007-1 junior secured notes consist of $55.7 million of mezzanine notes with a weighted average borrowing rate of 3.6% and
$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 $55.0 million of mezzanine notes with a weighted average borrowing rate of 6.4%
and $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.(6)CLO
2007-A junior secured notes consist of $6.2 million of mezzanine notes with a weighted average borrowing rate of 7.0% and
$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):

Outstanding
Borrowings

Weighted
Average
Borrowing
Rate

Weighted
Average
Remaining
Maturity
(in days)

Fair Value of
Collateral(1)Senior secured credit facility(2)

$
175,000


4.23
%

679

$
739,640CLO 2005-1 senior secured notes


832,622


0.61


2,673


868,291CLO 2005-2 senior secured notes


800,504


0.58


2,887


859,457CLO 2006-1 senior secured notes


683,266


0.63


3,159


858,317CLO 2007-1 senior secured notes


2,176,805


0.82


4,153


2,337,779CLO 2007-1 junior secured notes to affiliates(3)


437,730





4,153


468,422CLO 2007-1 junior secured notes(4)


14,185





4,153


15,237CLO 2007-A senior secured notes


1,157,209


1.16


2,845


1,137,077CLO 2007-A junior secured notes to affiliates(5)


96,056





2,845


94,505CLO 2007-A junior secured notes(6)


3,125





2,845


3,074Convertible senior notes


275,800


7.00


927


Junior subordinated notes


283,517


5.41


9,747


Total

$
6,935,819







$
7,381,799


(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.


F-31

---



KKR Financial Holdings LLC and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

Note 8. Borrowings (Continued)

(3)CLO
2007-1 junior secured notes to affiliates consist of $256.9 million of mezzanine notes with a weighted average borrowing rate of 5.2%
and $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 $8.4 million of mezzanine notes with a weighted average borrowing rate of 5.2% and
$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 $81.5 million of mezzanine notes with a weighted average borrowing rate of 6.5%
and $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 $2.6 million of mezzanine notes with a weighted average borrowing rate of 6.5% and
$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. Due to the failure of OC Tests during the year ended December 31, 2009, CLO 2005-2 senior secured notes were paid down by
$9.0 million, CLO 2006-1 senior secured notes were paid down by $32.1 million, CLO 2007-1 senior secured notes were paid down by $149.5 million and CLO
2007-A senior secured notes were paid down by $56.1 million. During the year ended December 31, 2010, the Company paid down $90.3 million of original CLO
2007-1 senior secured notes, due to the failure of OC Tests. As of December 31, 2010, all of the Company's CLO transactions were in compliance with their respective OC and interest
coverage tests.

On
July 10, 2009, the Company surrendered for cancellation, without consideration, approximately $298.4 million in aggregate of mezzanine notes and junior notes
("Surrendered Notes") issued to the Company by CLO 2005-1, CLO 2005-2 and CLO 2006-1. The Surrendered Notes were promptly cancelled upon receipt by the trustee of
each transaction and the related debt was extinguished by the issuers thereof. The Company consolidates its CLO subsidiaries and therefore, this transaction did not have an impact on its consolidated
financial statements. Similarly, as CLO 2005-1, CLO 2005-2 and CLO 2006-1 are treated as disregarded entities for tax purposes, this transaction did not have any
material tax implications for the Company or its shareholders.

F-32

---



KKR Financial Holdings LLC and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

Note 8. Borrowings (Continued)

During
the first quarter of 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 during 2010.

CLO 2009-1

On January 12, 2009, Wayzata Funding LLC ("Wayzata") was amended to eliminate the market value-based covenants and on
March 31, 2009, the Company completed the restructuring of Wayzata whereby substantially all of Wayzata's assets were transferred to CLO 2009-1. CLO 2009-1 was a newly
formed special purpose company which issued $560.8 million aggregate principal amount of senior notes due April 2017 and $154.3 million aggregate principal amount of subordinated notes
due April 2017 to the existing Wayzata note holders in exchange for cancellation of the Wayzata notes, due November 2012, previously held by each of them. CLO 2009-1 was structured as a
cash flow transaction and did not contain the market value provisions previously contained in Wayzata. The portfolio manager of the CLO was an affiliate of the Manager. The notes issued by CLO
2009-1 were secured by the same collateral that secured the Wayzata facility, consisting primarily of senior secured leveraged loans. As was the case with Wayzata, the Company and an
affiliate of the Manager owned all of the subordinated notes issued by the CLO.

The
restructuring of Wayzata and the formation of CLO 2009-1 outlined above qualified as a troubled debt restructuring. Prior to the restructuring on March 31, 2009,
an affiliate of the Manager held an aggregate par amount of $125.0 million of subordinated notes issued by Wayzata (the "Wayzata Subordinated Notes"). In connection with the restructuring, the
Wayzata Subordinated Notes were exchanged for $30.9 million par amount of junior notes issued by CLO 2009-1 (the
"CLO 2009-1 Junior Notes"). The portion of the CLO 2009-1 Junior Notes held by the affiliate of the Manager was carried at $90.4 million which
represented the total future cash payments that the affiliate of the Manager could receive from the CLO 2009-1 Junior Notes. The exchange by the affiliate of the Manager of Wayzata
Subordinated Notes for CLO 2009-1 Junior Notes was treated as a modification of terms of the Wayzata Subordinated Notes. Accordingly, the Company recognized a gain on debt
restructuring totaling $34.6 million.

During
the second quarter of 2009, the proceeds from the sale of certain CLO 2009-1 assets were used to pay down $516.4 million of CLO 2009-1 senior
secured notes. On July 24, 2009, the Company retired the remaining outstanding balance of senior notes issued by CLO 2009-1 totaling $44.4 million. Prior to the retirement of
the senior notes, an affiliate of the Company held a 20% interest in the subordinated notes issued by CLO 2009-1 as described above. As part of the deleveraging of
CLO 2009-1, the subordinated notes in CLO 2009-1 held by the Company's affiliate were retired in exchange for the affiliate's proportionate interest in the assets held
by CLO 2009-1.

The
retirement of the senior notes issued by CLO 2009-1 included the payment of a $28.8 million placement fee to the senior note holders that was paid from the cash
held by CLO 2009-1. The placement fee was structured to be paid by CLO 2009-1 on a quarterly basis over the life of the transaction and the $28.8 million amount reflects
the present value of the future quarterly fee payments. As the Company consolidated CLO 2009-1, this fee was recognized as an expense during the third quarter of 2009 and was partially
offset by a $14.4 million net gain recognized from the

F-33

---



KKR Financial Holdings LLC and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

Note 8. Borrowings (Continued)

retirement
of the subordinated notes issued by CLO 2009-1 to an affiliate. The net loss from the CLO 2009-1 deleveraging was recorded in net gain on restructuring and
extinguishment of debt on the consolidated statements of operations.

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 December 31, 2010, the Company had no borrowings outstanding under the 2014 Facility.

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.

Asset-Based Borrowing Facility

On November 5, 2010, the Company entered into a credit agreement for a five-year $49.7 million
non-recourse, asset-based revolving credit facility (the "2015 Natural Resources Facility"), maturing on November 5, 2015, that is subject to, among other things, the terms of a
borrowing base derived from the value of eligible specified oil and gas assets. The borrowing base is subject to certain caps and concentration limits customary for financings of this type. The
Company has the right to prepay loans under the 2015 Natural Resources Facility in whole or in part at any time. Loans under the 2015 Natural Resources Facility bear interest at a rate equal to LIBOR
plus a tiered applicable margin ranging from 1.75% to 2.75% per annum. The 2015 Natural Resources Facility contains customary covenants applicable to the Company.

As
of December 31, 2010, the Company had $18.4 million of borrowings outstanding under the 2015 Natural Resources Facility. In addition, under the 2015 Natural Resources
Facility, the Company had a letter of credit outstanding totaling $1.0 million.

F-34

---



KKR Financial Holdings LLC and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

Note 8. Borrowings (Continued)

As
of December 31, 2010, the Company believes it was in compliance with the covenant requirements for both credit facilities.



During June 2009, the Company completed two transactions to exchange a total of $15.7 million par value of its 7.0% convertible
senior notes maturing on July 15, 2012 (the "7.0% Notes") for 7.2 million of the Company's common shares. These transactions resulted in the Company recording a gain of
$6.9 million, or approximately $0.05 per diluted common share, which was partially offset by a write-off of $0.1 million of unamortized debt issuance costs and
$0.4 million of other associated costs during the second quarter of 2009.

During
the first quarter of 2010, the Company repurchased $95.2 million par amount of its 7.0% Notes, reducing the amount outstanding from $275.8 million as of
December 31, 2009 to $180.6 million as of December 31, 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 during 2010.

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 was 122.2046 common 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 December 31, 2010, the conversation rate
for each $1,000 principal amount of 7.5% Notes was 125.6251 common shares. Net proceeds from the offering totaled $167.3 million, reflecting gross proceeds of $172.5 million from the
issuance less $5.2 million for underwriting fees.

In
accordance with accounting for convertible debt instruments that may be 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 consolidated balance sheet as of December 31, 2010. The remaining liability component of $163.6 million, included within convertible senior notes on the Company's consolidated
balance sheet as of December 31, 2010, is comprised of the principal $172.5 million less the unamortized debt discount of $8.9 million. The total debt discount amortization
recognized for the year ended December 31, 2010 was $1.0 million. The debt discount will continue to be amortized at the effective interest rate of 8.6%. For the year ended
December 31, 2010, the total interest expense recognized on the 7.5% Notes was $12.4 million.

F-35

---



KKR Financial Holdings LLC and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

Note 8. Borrowings (Continued)

Junior Subordinated Notes

In August 2009, the Company repurchased $5.0 million of junior subordinated notes, which resulted in a gain on extinguishment of
$3.8 million, partially offset by a $0.1 million write-off of unamortized debt issuance costs.

Contractual Obligations

The table below summarizes the Company's contractual obligations (excluding interest) under borrowing agreements as of
December 31, 2010 (amounts in thousands):

Payments Due by PeriodTotal

Less than
1 year

1 - 3 years

3 - 5 years

More than
5 yearsAsset-based borrowing facility(1)

$
19,393

$
993

$


$
18,400

$
CLO 2005-1 senior secured notes


833,220











833,220CLO 2005-2 senior secured notes


801,323











801,323CLO 2006-1 senior secured notes


683,265











683,265CLO 2007-1 senior secured notes


2,075,040











2,075,040CLO 2007-1 junior secured notes to affiliates


300,672











300,672CLO 2007-1 junior secured notes


61,504











61,504CLO 2007-A senior secured notes


1,165,099











1,165,099CLO 2007-A junior secured notes to affiliates


65,452











65,452CLO 2007-A junior secured notes


10,821











10,821Convertible senior notes(2)


353,077





180,577





172,500Junior subordinated notes


283,517











283,517Total

$
6,652,383

$
993

$
180,577

$
18,400

$
6,452,413


(1)Includes
the letter of credit outstanding.(2)Represents
the principal amount of the notes, which excludes the accounting adjustment for convertible debt instruments that may be settled in cash upon
conversion described above.


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.

F-36

---



KKR Financial Holdings LLC and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

Note 9. Derivative Financial Instruments (Continued)

The table below summarizes the aggregate notional amount and estimated net fair value of the derivative instruments as of December 31, 2010 and December 31, 2009 (amounts
in thousands):

As of
December 31, 2010

As of
December 31, 2009Notional

Estimated
Fair Value

Notional

Estimated
Fair ValueCash Flow Hedges:Interest rate swaps

$
483,333

$
(58,365
)
$
383,333

$
(43,800
)Free-Standing Derivatives:Interest rate swaps








89,246


(281
)Commodity swaps





(226
)




Credit default swapsprotection sold


13,500


492


51,000


(385
)Total rate of return swaps





104


104,446


11,809Foreign exchange forward contracts


(154,405
)

(17,296
)




Foreign exchange options


130,207


14,791





Common stock warrants(1)





3,453





2,471Total

$
472,635

$
(57,047
)
$
628,025

$
(30,186
)


(1)As
of December 31, 2009, the total $2.5 million of common stock warrants was pledged as collateral for borrowings described in Note 8
to these consolidated financial statements. Of the $2.5 million, $1.1 million of warrants was pledged as collateral for the senior secured credit facility and $1.4 million of
warrants was pledged for collateralized loan obligation secured notes and junior secured notes to affiliates. There were no warrants pledged as collateral for borrowings as of December 31,
2010.


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.

F-37

---



KKR Financial Holdings LLC and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

Note 9. Derivative Financial Instruments (Continued)

The
following table shows the net (losses) gains recognized in other comprehensive income related to derivatives in cash flow hedging relationships for the years ended
December 31, 2010, 2009 and 2008 (amounts in thousands):

Year ended
December 31, 2010

Year ended
December 31, 2009

Year ended
December 31, 2008(Losses) gains recognized in other comprehensive income on cash flow hedges


(13,935
)

34,739


(57,329
)


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 options, interest rate swaps and commodity 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.

Gains
and losses on free-standing derivatives are reported on the consolidated statements of operations in net realized and unrealized gain (loss) on derivatives and foreign
exchange. Unrealized gains (losses) represent the change in fair value of the derivative instruments and are noncash items.

Credit Default Swaps

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 December 31, 2010 and December 31, 2009, the Company had sold protection with a notional amount of $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.

F-38

---



KKR Financial Holdings LLC and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

Note 9. Derivative Financial Instruments (Continued)

The
following table shows the net realized gains on the Company's CDS for the years ended December 31 2010, 2009 and 2008 (amounts in thousands):

Year ended December 31, 2010

Year ended December 31, 2009

Year ended December 31, 2008Gross realized gains

$


$
58,967

$
9,779Gross realized losses





(996
)

(1,922
)Net realized gains

$


$
57,971

$
7,857


Commodity Derivatives

In an effort to minimize the effects of the volatility of oil and natural gas prices, the Company will from time to time, enter into
derivative instruments such as swap contracts to hedge its forecasted oil and natural gas sales. The Company does not designate these contracts as cash flow hedges and as such, the changes in fair
value of these instruments are recorded in current period earnings.

During
December 2010, the Company entered into commodity derivative contracts, consisting of oil and natural gas receive-fixed, pay-floating swaps for certain years through
2013. As the effective date of the swaps was no earlier than February 2011, the Company did not have any oil or natural gas derivatives settlements for the year ended December 31, 2010. The oil
and natural gas derivatives are settled monthly.

The
following table summarizes by derivative instrument type the effect on income from free-standing derivatives for the years ended December 31, 2010, 2009 and 2008
(amounts in thousands):

Free-Standing Derivatives:

For the year ended
December 31, 2010

For the year ended
December 31, 2009

For the year ended
December 31, 2008Interest rate swaps

$
311

$
(3,328
)
$
3,108Commodity swaps


(226
)




Credit default swaps


1,970


17,632


41,177Total rate of return swaps


1,771


45,607


(188,829
)Foreign exchange contracts


(17,296
)

(255
)

6,334Foreign exchange options


14,630





Common stock warrants


663


457


(799
)Net realized and unrealized gains (losses) on free-standing derivatives

$
1,823

$
60,113

$
(139,009
)


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 years ended December 31, 2010, 2009 and 2008, the Company recognized an immaterial amount of ineffectiveness in income on the consolidated statements of operations from its cash flow and
fair value hedges.

F-39

---



KKR Financial Holdings LLC and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

Note 10. Accumulated Other Comprehensive Income

The components of accumulated other comprehensive income were as follows (amounts in thousands):

As of
December 31, 2010

As of
December 31, 2009Net unrealized gains on available-for-sale securities

$
189,139

$
194,336Net unrealized losses on cash flow hedges


(55,543
)

(41,608
)Accumulated other comprehensive income

$
133,596

$
152,728


The
components of changes in other comprehensive income (loss) were as follows (amounts in thousands):

Year ended
December 31, 2010

Year ended
December 31, 2009

Year ended
December 31, 2008Unrealized (losses) gains on securities available-for-sale:Unrealized gains (losses) arising during period

$
77,127

$
401,441

$
(160,436
)Reclassification adjustments for (gains) losses realized in net income(1)


(82,324
)

(14,670
)

106,228Unrealized (losses) gains on securities available-for-sale


(5,197
)

386,771


(54,208
)Unrealized (losses) gains on cash flow hedges:Unrealized (losses) gains arising during period


(13,935
)

34,739


(57,329
)Unrealized (losses) gains on cash flow hedges


(13,935
)

34,739


(57,329
)Other comprehensive (loss) income

$
(19,132
)
$
421,510

$
(111,537
)


(1)Excludes
an impairment charge of $2.6 million, $43.9 million and $474.5 million for investments which were determined to be
other-than-temporary for the years ended December 31, 2010, 2009 and 2008, respectively.


Note 11. Commitments & 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 December 31, 2010 and 2009, the Company had committed to purchase corporate loans with aggregate commitments totaling
$90.9 million and $156.5 million, respectively. In addition, the Company participates in certain contingent financing arrangements, whereby the Company is committed to provide funding of
up to a

F-40

---



KKR Financial Holdings LLC and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

Note 11. Commitments & Contingencies (Continued)

specific
amount at the discretion of the borrower. As of December 31, 2010 and 2009, the Company had unfunded financing commitments totaling $31.6 million and $40.5 million,
respectively. The Company did not have any material losses as of December 31, 2010, nor does it 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
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 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.

KKR
Asset Management LLC has furnished information to the SEC in response to a request from the SEC for information in connection with its examination of certain investment
advisers in order to review trading procedures and valuation practices in the collateral pools of CLOs for which it acts as collateral manager. KKR Asset Management LLC also provided
information regarding the surrender by the Company for cancellation, without consideration, of certain notes that had been issued to the

F-41

---



KKR Financial Holdings LLC and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

Note 11. Commitments & Contingencies (Continued)

Company
by collateral pools of CLOs. KKR Asset Management LLC fully cooperated with the SEC's examination and the examination is now complete.

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 (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. On November 17,
2010, the Court granted the defendant's motion and dismissed the case with prejudice. Plaintiffs' time to take an appeal expired and the judgment was final.

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 November 17, 2010, the Court dismissed the Charter Litigation with prejudice
and that judgment was final. The plaintiff in the California Derivative Action subsequently agreed to withdraw his complaint, and a stipulated order dismissing the California Derivative Action was
entered on February 14, 2011.

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

F-42

---



KKR Financial Holdings LLC and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

Note 11. Commitments & Contingencies (Continued)

files
an answer to the Charter Litigation. On November 17, 2010, the Court dismissed the Charter Litigation with prejudice and that judgment was final. The plaintiff in the New York Derivative
Action subsequently agreed to withdraw his complaint, and a stipulated order dismissing the New York Derivative Action was entered on February 4, 2011.

Note 12. Common Shares, Restricted Shares and Share Options

On December 13, 2010, the Company completed an underwritten public offering of 18,000,000 common shares at a price of $9.04 per share, resulting in gross proceeds of
$162.7 million. The Company also granted the underwriter a 30 day option to purchase up to 2,700,000 additional common shares solely to cover over-allotments. On
December 28, 2010, the underwriter exercised its option and purchased 1,436,000 shares, resulting in an additional $13.0 million of gross proceeds.

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 December 31, 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. On August 9, 2010, the Compensation Committee of the board of directors granted 52,808
restricted common shares to the Company's directors pursuant to the 2007 Share Incentive Plan.

The
following table summarizes restricted common share transactions:

Manager

Directors

TotalUnvested shares as of January 1, 2008


625,000


72,657


697,657Issued


1,097,000


38,349


1,135,349Vested


(625,000
)

(41,885
)

(666,885
)Forfeited





(2,839
)

(2,839
)Unvested shares as of December 31, 2008


1,097,000


66,282


1,163,282Issued





220,519


220,519Vested





(31,183
)

(31,183
)Unvested shares as of December 31, 2009


1,097,000


255,618


1,352,618Issued





52,808


52,808Vested





(95,822
)

(95,822
)Unvested shares as of December 31, 2010


1,097,000


212,604


1,309,604


The
restricted common shares granted to the directors were valued using the fair value at the time of grant, which was $8.90, $2.79 and $10.43 per share, for the restricted common shares
granted in

F-43

---



KKR Financial Holdings LLC and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

Note 12. Common Shares, Restricted Shares and Share Options (Continued)

2010,
2009 and 2008, respectively. 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 $9.30, $5.80 and $1.58 per share at December 31, 2010, 2009 and 2008, respectively. There were $1.3 million, $3.0 million, and
$1.8 million of total unrecognized compensation costs related to unvested restricted common shares granted as of December 31, 2010, 2009, and 2008, respectively. These costs are expected
to be recognized over the next three years.

The
following table summarizes common share option transactions:

Number of
Options

Weighted Average
Exercise PriceOutstanding as of January 1, 2008


1,932,279

$
20.00Granted





Exercised





Forfeited





Outstanding as of December 31, 2008


1,932,279

$
20.00Granted





Exercised





Forfeited





Outstanding as of December 31, 2009


1,932,279

$
20.00Granted





Exercised





Forfeited





Outstanding as of December 31, 2010


1,932,279

$
20.00


As
of December 31, 2010, 2009 and 2008, 1,932,279 common share options were exercisable. As of December 31, 2010, the common share options were fully vested and expire in
August 2014. For the years ended December 31, 2010, 2009 and 2008, the components of share-based compensation expense are as follows (amounts in thousands):

Year ended
December 31, 2010

Year ended
December 31, 2009

Year ended
December 31, 2008Restricted shares granted to Manager

$
5,784

$
3,451

$
(463
)Restricted shares granted to certain directors


1,108


526


637Total share-based compensation expense

$
6,892

$
3,977

$
174


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

F-44

---



KKR Financial Holdings LLC and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

Note 13. Management Agreement and Related Party Transactions (Continued)

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 consolidated financial statements and determined that they are not material.

Base Management Fees and Manager Share-Based Compensation

For the year ended December 31, 2010, the Company incurred $19.1 million in base management fees. As of
December 31, 2010, the Company had $2.0 million base management fee payable to the Manager. In addition, the Company recognized share-based compensation expense related to restricted
common shares granted to the Manager of $5.8 million for the year ended December 31, 2010 (see Note 12). For the year ended December 31, 2009, the Company incurred
$14.9 million in base management fees. In addition, the Company recognized share-based compensation expense related to restricted common shares granted to the Manager of $3.5 million for
the year ended December 31, 2009 (see Note 12). For the year ended December 31, 2008, the Company incurred $32.1 million in base management fees. In addition, the Company
recognized share-based compensation expense related to restricted common shares granted to the Manager of $(0.5) million for the year ended December 31, 2008 (see Note 12).

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 consolidated statements of operations. Expenses incurred by the Manager and reimbursed by the Company are reflected in the respective 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 $8.8 million of base management fees during each of the years ended December 31, 2010, 2009 and 2008.

F-45

---



KKR Financial Holdings LLC and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

Note 13. Management Agreement and Related Party Transactions (Continued)

Incentive Fees

For the year ended December 31, 2010, the Manager earned $38.8 million of incentive fees. As of December 31, 2010,
the Company had $8.5 million incentive fee payable to the
Manager. The $38.8 million of incentive fees earned for the year ended December 31, 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 consolidated statement of operations. Incentive fees of $4.5 million and nil were earned by the Manager during the years ended December 31, 2009 and December 31, 2008,
respectively.

CLO Management Fees

An affiliate of the Manager 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. The collateral manager has the option to waive the fees it earns for providing management services for the CLOs and has done so in prior periods.

Beginning
April 2007, the collateral manager ceased waiving fees for CLO 2005-1 and beginning January 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). However, starting in July 2009, the collateral manager reinstated waiving the CLO management fees for CLO 2005-2 and CLO 2006-1 and starting in 2010, the collateral
manager reinstated waiving the CLO management fees for CLO 2007-A and CLO 2007-1. 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 fees for CLO 2009-1. As such, the CLO management fees for all CLOs, except for CLO 2005-1,
are being waived or are no longer entitled to be received as of December 31, 2010.

The
aggregate amounts waived are inversely related to the total CLO management fees recorded. Accordingly, for the years ended December 31, 2010, 2009 and 2008, the collateral
manager waived aggregate CLO management fees of $30.6 million, $5.2 million and $39.0 million, respectively, while for the years ended December 31, 2010, 2009 and 2008, the
Company recorded an expense for CLO management fees totaling $5.4 million, $21.5 million and $5.1 million, respectively.

Reimbursable General and Administrative Expenses

Beginning January 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. For the years ended December 31, 2010 and 2009, the Manager permanently waived reimbursement of allocable general
and administrative expenses totaling $2.4 million and $9.8 million, respectively. Due to the reinstatement of waived CLO management fees described above, effective June 2010, all
incremental CLO management fees received by the Manager had been fully applied to offset these reimbursable expenses. Accordingly, for the year ended December 31, 2010, the Company reimbursed
the Manager for allocable general and administrative expenses of $4.6 million, as compared to nil for the year ended December 31, 2009. For the year ended December 31, 2008, the

F-46

---



KKR Financial Holdings LLC and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

Note 13. Management Agreement and Related Party Transactions (Continued)

Company
reimbursed the Manager for allocable general and administrative and other expenses of $9.9 million.

Affiliated Investments

The Company has invested in corporate loans, debt securities, and other investments of entities that are affiliates of KKR. As of
December 31, 2010, the aggregate par amount of these affiliated investments totaled $2.4 billion, or approximately 30% of the total investment portfolio, and consisted of 27 issuers. The
total $2.4 billion in affiliated investments was comprised of $2.1 billion of corporate loans, $314.2 million of corporate debt securities
available-for-sale and $25.6 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 consolidated balance sheet).

Note 14. Income Taxes

The Company intends to continue to operate so as to qualify, for United States federal income tax purposes, as a partnership, and not as an association or publicly traded partnership
taxable as a corporation. As such, the Company generally is not subject to United States federal income tax at the entity level, but is subject to limited state income tax.

The
Company owns both REIT and domestic taxable corporate subsidiaries. The Company's REIT subsidiary is not expected to incur federal tax expense but is subject to limited state income
tax expense related to the 2010 tax year. Additionally, all domestic taxable corporate subsidiaries taxed as regular corporations under the Code are not expected to incur federal tax expense but are
subject to limited state income tax expense related to the 2010 tax year. The Company owns an interest in several foreign subsidiaries that from time to time generate income that is subject to United
States tax withholding. The Company also owns foreign investments that generate income that is subject to foreign tax withholding. The income tax provision for the years ended December 31,
2010, 2009 and 2008 consisted of the following components (amounts in thousands):

Year ended
December 31,
2010

Year ended
December 31,
2009

Year ended
December 31,
2008Current provision:Federal Income Tax

$
(79
)
$
79

$
(219
)Federal Withholding Tax


63





State Income Tax


90


205


326Foreign Withholding Tax


628





Total provision for income taxes

$
702

$
284

$
107


The
tax provision for domestic taxable corporate subsidiaries taxed as regular corporations was based on a combined federal and state income tax rate of 40.75% at December 31,
2010, 2009, and 2008. The tax rate is equivalent to the combined federal statutory income tax rate and the state

F-47

---



KKR Financial Holdings LLC and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

Note 14. Income Taxes (Continued)

statutory
income tax rate, net of federal benefit. There were no deferred tax assets or liabilities as of December 31, 2010, 2009 and 2008.

Note 15. 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 due to the short-term nature of these instruments.

F-48

---



KKR Financial Holdings LLC and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

Note 15. Fair Value of Financial Instruments (Continued)

The
table below discloses the carrying value and the estimated fair value of the Company's financial instruments as of December 31, 2010 and 2009 (amounts in thousands):

As of
December 31, 2010

As of
December 31, 2009Carrying
Amount

Estimated Fair
Value

Carrying
Amount

Estimated Fair
ValueFinancial Assets:Cash, restricted cash, and cash equivalents

$
885,254

$
885,254

$
439,792

$
439,792Securities available-for-sale


838,894


838,894


755,686


755,686Corporate loans, net of allowance for loan losses of $209,030 and $237,308 as of December 31, 2010 and 2009, respectively


5,857,816


6,060,530


5,617,925


5,459,273Corporate loans held for sale


463,628


473,681


925,718


954,350Residential mortgage-backed securities


93,929


93,929


47,572


47,572Residential mortgage loans








2,097,699


2,097,699Equity investments, at estimated fair value


99,955


99,955


120,269


120,269Interest and principal receivable


57,414


57,414


98,313


98,313Derivative assets


19,519


19,519


15,784


15,784Reverse repurchase agreements








80,250


80,250Private equity investments, at cost(1)


4,800


5,051


17,505


24,658Financial Liabilities:Collateralized loan obligation secured notes

$
5,630,272

$
5,176,052

$
5,667,716

$
4,775,364Collateralized loan obligation junior secured notes to affiliates


366,124


254,522


533,786


221,755Senior secured credit facility








175,000


175,000Asset-based borrowing facility


18,400


18,400





Convertible senior notes


344,142


425,564


275,800


259,252Junior subordinated notes


283,517


264,025


283,517


238,154Residential mortgage-backed securities issued








2,034,772


2,034,772Accounts payable, accrued expenses and other liabilities


14,193


14,193


7,240


7,240Accrued interest payable


22,846


22,846


25,297


25,297Accrued interest payable to affiliates


6,316


6,316


2,911


2,911Related party payable


12,988


12,988


3,367


3,367Securities sold, not yet purchased








77,971


77,971Derivative liabilities


76,566


76,566


45,970


45,970


(1)During
the year ended December 31, 2010, the Company recognized a loss totaling $10.3 million for private equity investments, at cost, that it
determined to be other-than-temporarily impaired based on the estimated fair value using unobservable inputs. Private equity investments, at cost are included in other assets
on the consolidated balance sheets.


F-49

---



KKR Financial Holdings LLC and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

Note 15. Fair Value of Financial Instruments (Continued)






The following table presents information about the Company's assets and liabilities (including derivatives that are presented net)
measured at fair value on a recurring basis as of December 31, 2010, and indicates the fair value hierarchy of the valuation techniques utilized by the Company to determine such fair value
(amounts in thousands):

Quoted Prices in
Active Markets
for Identical Assets
(Level 1)

Significant Other
Observable
Inputs
(Level 2)

Significant
Unobservable
Inputs
(Level 3)

Balance as of
December 31,
2010Assets:Securities available-for-sale

$
3,374

$
752,423

$
83,097

$
838,894Residential mortgage-backed securities








93,929


93,929Equity investments, at estimated fair value





15,023


84,932


99,955Credit default swapsprotection sold





492





492Total rate of return swaps








104


104Foreign exchange options, net








14,791


14,791Common stock warrants








3,453


3,453Total

$
3,374

$
767,938

$
280,306

$
1,051,618Liabilities:Cash flow interest rate swaps

$


$
(58,365
)
$


$
(58,365
)Foreign exchange forward contracts, net





(17,296
)




(17,296
)Commodities swaps, net





(226
)




(226
)$


$
(75,887
)
$


$
(75,887
)


The
following table presents information about the Company's assets measured at fair value on a non-recurring basis as of December 31, 2010, and indicates the fair
value hierarchy of the valuation techniques utilized by the Company to determine such fair value (amounts in thousands). There were no liabilities measured at fair value on a non-recurring
basis:

Quoted Prices in
Active Markets
for Identical Assets
(Level 1)

Significant Other
Observable
Inputs
(Level 2)

Significant
Unobservable
Inputs
(Level 3)

Balance as of
December 31,
2010Loans held for sale(1)

$


$
254,682

$
14,443

$
269,125Private equity investments(2)








1,800


1,800Total

$


$
254,682

$
16,243

$
270,925


(1)As
of December 31, 2010, total loans held for sale had a carrying value of $463.6 million of which $269.1 million was carried at
estimated fair value and the remaining $194.5 million carried at amortized cost. Of the $269.1 million carried at estimated fair value, $254.7 million was classified as
Level 2 given that the assets were valued using quoted prices and other observable inputs in an active market. The remaining $14.4 million was classified as Level 3 given that the
Company


F-50

---



KKR Financial Holdings LLC and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

Note 15. Fair Value of Financial Instruments (Continued)

applied
unobservable inputs based on the best available information to determine the estimated fair value. (2)Represents
private equity investments accounted for under the cost method that were classified as Level 3 when the assets were impaired and measured
at estimated fair value using unobservable inputs.


The
following table presents information about the Company's assets and liabilities (including derivatives that are presented net) measured at fair value on a recurring basis as of
December 31, 2009, and indicates the fair value hierarchy of the valuation techniques utilized by the Company to determine such fair value (amounts in thousands):

Quoted Prices in
Active Markets
for Identical Assets
(Level 1)

Significant Other
Observable Inputs
(Level 2)

Significant
Unobservable Inputs
(Level 3)

Balance as of
December 31, 2009Assets:Securities available-for-sale

$
1,277

$
673,121

$
81,288

$
755,686Residential mortgage-backed securities








47,572


47,572Residential mortgage loans








2,097,699


2,097,699Equity investments, at estimated fair value


26,483


75,497


18,289


120,269Total rate of return swaps








11,809


11,809Common stock warrants








2,471


2,471Total

$
27,760

$
748,618

$
2,259,128

$
3,035,506Liabilities:Cash flow interest rate swaps

$


$
(43,800
)
$


$
(43,800
)Free-standing derivatives interest rate swaps








(281
)

(281
)Credit default swapsprotection sold





(385
)




(385
)Residential mortgage-backed securities issued








(2,034,772
)

(2,034,772
)Securities sold, not yet purchased





(77,971
)




(77,971
)Total

$


$
(122,156
)
$
(2,035,053
)
$
(2,157,209
)


F-51

---



KKR Financial Holdings LLC and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

Note 15. Fair Value of Financial Instruments (Continued)

The following table presents information about the Company's assets measured at fair value on a non-recurring basis as of December 31, 2009, and indicates the fair
value hierarchy of the valuation techniques utilized by the Company to determine such fair value (amounts in thousands). There were no liabilities measured at fair value on a non-recurring
basis:

Quoted Prices in
Active Markets
for Identical Assets
(Level 1)

Significant Other
Observable Inputs
(Level 2)

Significant
Unobservable Inputs
(Level 3)

Balance as of
December 31, 2009Loans held for sale(1)

$


$
533,308

$


$
533,308REO








11,439


11,439Total

$


$
533,308

$
11,439

$
544,747


(1)As
of December 31, 2009, total loans held for sale had a carrying value of $925.7 million of which $533.3 million was carried at
estimated fair value and the remaining $392.4 million carried at amortized cost. The $533.3 million carried at estimated fair value was classified as Level 2 given that the assets
were valued using quoted prices and other observable inputs in an active market.


The
following table presents additional information about assets, including derivatives, that are measured at fair value on a recurring basis for which the Company has utilized
Level 3 inputs to determine fair value, for the year ended December 31, 2010 (amounts in thousands):

Securities
Available-
For-Sale

Residential
Mortgage-
Backed
Securities

Equity
Investments,
at Estimated
Fair Value

Total Rate of
Return Swaps

Common
Stock
Warrants

Foreign
Exchange
Options,
Net

Free-Standing
Derivatives
Interest Rate
SwapsBeginning balance as of January 1, 2010

$
81,288

$
47,572

$
18,289

$
11,809

$
2,471

$


$
(281
)Transfers in from deconsolidation(1)





74,366














Total gains or losses (realized and unrealized):Included in earnings(2)


9,005


(7,971
)

(11,249
)

1,771


663


14,630


311Included in other comprehensive income


10,107

















Transfers in to Level 3(3)


22,788





41,740











Purchases


41,841





38,620





2,716


161Sales


(24,460
)

(7,246
)




(13,476
)




Settlements


(57,472
)

(12,792
)

(2,468
)




(2,397
)




(30
)Ending balance as of December 31, 2010

$
83,097

$
93,929

$
84,932

$
104

$
3,453

$
14,791

$
The amount of total gains or losses for the period included in earnings attributable to the change in unrealized gains or losses relating to assets still
held at the reporting date(2)

$


$
(1,586
)
$
(11,249
)
$


$
663

$
14,630

$



(1)Represents
the subordinate tranches of the residential mortgage loan securitization trusts as a result of the Company's deconsolidation as of
January 1, 2010, computed as $11.4 million of REO plus $62.9 million, which represents the difference between the residential mortgage loans of $2.1 billion less RMBS
Issued, at estimated fair value, of $2.0 billion. See Note 2 for further discussion.


F-52

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KKR Financial Holdings LLC and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

Note 15. Fair Value of Financial Instruments (Continued)

(2)Amounts
are included in net realized and unrealized gain (loss) on investments, net realized and unrealized (loss) gain on derivatives and foreign exchange
or net realized and unrealized gain loss on residential mortgage-backed securities, residential mortgage loans, and residential mortgage-backed securities issued, carried at estimated fair value in
the consolidated statements of operations.(3)Certain
securities available-for-sale and equity investments, at estimated fair value, were transferred in to Level 3
reflecting reduced transparency of prices for these financial instruments as a result of less trading activity. There were no significant transfers out of Level 3 into Level 1 or 2.


The following table presents additional information about assets, including derivatives that are measured at fair value on a recurring basis for
which the Company has utilized Level 3 inputs to determine fair value, for the year ended December 31, 2009 (amounts in thousands):

Fair Value Measurements Using Significant Unobservable Inputs
(Level 3)Securities
Available-
For-Sale

Residential
Mortgage-
Backed
Securities

Residential
Mortgage
Loans

Equity
Investments,
at estimated
fair value

Derivatives,
net

Residential
Mortgage-
Backed
Securities
IssuedBeginning balance as of January 1, 2009

$
89,109

$
102,814

$
2,620,021

$
5,287

$
(76,950
)
$
(2,462,882
)Total gains or losses (realized and unrealized):Included in earnings


(4,904
)

(27,958
)

63,753


(2,970
)

45,297


(143,118
)Included in other comprehensive income


37,036














Net transfers in and/or out of Level 3


7,434





(646
)







Purchases, sales, other settlements and issuances, net


(47,387
)

(27,284
)

(585,429
)

15,972


45,652


571,228Ending balance as of December 31, 2009

$
81,288

$
47,572

$
2,097,699

$
18,289

$
13,999

$
(2,034,772
)The amount of total gains or losses for the period included in earnings attributable to the change in unrealized gains or losses relating to assets still
held at the reporting date(1)

$


$
(24,876
)
$
76,475

$
(2,970
)
$
45,590

$
(141,393
)


(1)Amounts
are included in net realized and unrealized (loss) gain on investments, net realized and unrealized gain (loss) on derivatives and foreign exchange
or net realized and unrealized loss on residential mortgage-backed securities, residential mortgage loans, and residential mortgage-backed securities issued, carried at estimated fair value in the
consolidated statements of operations.


F-53

---



KKR Financial Holdings LLC and Subsidiaries

Notes to Consolidated Financial Statements (Continued)




Note 16. Summary of Quarterly Information (Unaudited)

The following is a presentation of the quarterly results of operations for the years ended December 31, 2010 and December 31, 2009:

2010(amounts in thousands, except per share information)

Fourth
Quarter

Third
Quarter

Second
Quarter

First
QuarterNet investment income:Total investment income

$
141,394

$
122,249

$
122,366

$
119,350Interest expense


31,298


30,051


38,851


31,500Interest expense to affiliates


8,080


5,791


6,740


4,541Provision for loan losses


21,034


8,087





Net investment income


80,982


78,320


76,775


83,309Other income:Total other income


22,422


26,627


23,196


71,107Non-investment expenses:Related party management compensation


16,607


17,551


14,476


20,491General, administrative and directors expenses


6,389


3,561


3,216


3,350Professional services


1,996


1,041


1,230


1,064Total non-investment expenses


24,992


22,153


18,922


24,905Income before income tax expense


78,412


82,794


81,049


129,511Income tax expense


213


452


21


16Net income

$
78,199

$
82,342

$
81,028

$
129,495Net income per common share:Basic(1)Net income per share

$
0.48

$
0.52

$
0.51

$
0.82Diluted(1)Net income per share

$
0.48

$
0.52

$
0.51

$
0.82Weighted average number of common shares outstanding:Basic


160,662


157,057


156,997


156,997Diluted


163,173


157,461


157,423


156,997


(1)Summation
of the quarters' earnings per share may not equal the annual amounts due to the averaging effect of the number of shares and share equivalents
throughout the year.


F-54

---



KKR Financial Holdings LLC and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

Note 16. Summary of Quarterly Information (Unaudited) (Continued)

2009(amounts in thousands, except per share information)

Fourth
Quarter

Third
Quarter

Second
Quarter

First
QuarterNet investment income:Total investment income

$
133,513

$
135,236

$
145,303

$
158,673Interest expense


48,462


57,340


72,403


89,882Interest expense to affiliates


4,932


5,171


5,379


5,805Provision for loan losses








12,808


26,987Net investment income


80,119


72,725


54,713


35,999Other (loss) income:Total other (loss) income


(62,891
)

13,046


(16,544
)

(29,886
)Non-investment expenses:Related party management compensation


8,191


14,616


10,304


11,212General, administrative, directors expenses and loan servicing


5,320


3,464


5,031


4,539Professional services


1,468


441


2,090


3,385Total non-investment expenses


14,979


18,521


17,425


19,136Income (loss) before income tax expense (benefit)


2,249


67,250


20,744


(13,023
)Income tax expense (benefit)


133


63


135


(47
)Net income (loss)

$
2,116

$
67,187

$
20,609

$
(12,976
)Net income (loss) per common share:Basic(1)Net income (loss) per share

$
0.01

$
0.42

$
0.14

$
(0.09
)Diluted(1)Net income (loss) per share

$
0.01

$
0.42

$
0.14

$
(0.09
)Weighted average number of common shares outstanding:Basic


156,997


156,997


151,202


149,714Diluted


156,997


156,997


151,202


149,714


(1)Summation
of the quarters' earnings per share may not equal the annual amounts due to the averaging effect of the number of shares and share equivalents
throughout the year.


Note 17. Subsequent Events

On January 21, 2011, the Compensation Committee of the board of directors granted the Manager 240,845 restricted common shares subject to graded vesting over four years with the
final vesting date of March 1, 2015.

On
February 3, 2011, the Company's board of directors declared a cash distribution for the quarter ended December 31, 2010 on the Company's common shares of $0.15 per
share. The distribution is payable on March 4, 2011 to common shareholders of record as of the close of business on February 18, 2011.

F-55

---