Table ofContents

 

 

 

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

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**FORM 10-Q**

 

**(Mark One)**

 
| **x**                                                                                                                                                                                                              | ** ** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934**  |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------|
| ** **                                                                                                                                                                                                         | ** ** | ** **                                                                                                    |
| **For the quarterly period ended March 31, 2010**                                                                                                                                                             |
| ** **                                                                                                                                                                                                         | ** ** | ** **                                                                                                    |
| **or**                                                                                                                                                                                                             |
| ** **                                                                                                                                                                                                         | ** ** | ** **                                                                                                    |
| **o**                                                                                                                                                                                                              | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |
| ** **                                                                                                                                                                                                         | ** ** | ** **                                                                                                    |
| **For the transition period from                  to                ** |

 

**Commissionfile number: 001-33437**

 

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**KKR FINANCIAL HOLDINGS LLC**

(Exact name of registrant asspecified in its charter)

 

| **Delaware**                                       | ** ** | **11-3801844**      |
|----------------------------------------------------|------------|---------------------|
| (State or other jurisdiction of                    |       | (I.R.S. Employer    |
| incorporation or organization)                     |       | Identification No.) |
|                                               |       |                |
| **555 California Street, 50****th**** Floor** |       |                |
| **San Francisco, CA**                              | ** ** | **94104**           |
| (Address of principal executive offices)           |       | (Zip Code)          |

 

Registrant’s telephonenumber, including area code: **(415) 315-3620**

 

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Indicate by check mark whether the registrant (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorterperiod that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days. x Yes   o No

 

Indicate by check mark whether the registrant has submittedelectronically and posted on its corporate Web site, if any, every InteractiveData File required to be submitted and posted pursuant to Rule 405 ofRegulation S-T (§232.405 of this chapter) during the preceding 12 months (orfor such shorter period that the registrant was required to submit and postsuch files). Yes o  No o

 

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filer, a non-accelerated filer, or a smaller reportingcompany. 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 o                |   | Accelerated filer x              |
|-----------------------------------------------|--------|----------------------------------|
|                                          |   |                             |
| Non-accelerated filer o                  |   | Smaller reporting company o |
| (Do not check if a smaller reporting company) |   |                             |

 

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

 

The number of shares of the registrant’s common shares outstanding asof April 22, 2010 was 158,359,757.

 

 

 

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Table of Contents

 

**TABLE OF CONTENTS**

 
| **PART I.FINANCIAL INFORMATION** | ** **                                                                                  |
|---------------------------------------|---------------------------------------------------------------------------------------------|
| Item 1.                               | Financial Statements                                                                        | 3 |
| Item  2.                              | Management’s  Discussion and Analysis of Financial Condition and Results of Operations | 31 |
| Item  3.                              | Quantitative  and Qualitative Disclosures about Market Risk                                 | 53 |
| Item 4.                               | Controls  and Procedures                                                                    | 53 |
| **PART II.OTHER INFORMATION**    | ** **                                                                                  |
| Item 1.                               | Legal  Proceedings                                                                          | 53 |
| Item 1A.                              | Risk Factors                                                                                | 54 |
| Item 2.                               | Unregistered  Sales of Equity Securities and Use of Proceeds                                | 60 |
| Item 3.                               | Defaults Upon  Senior Securities                                                            | 60 |
| Item 4.                               | Submission of  Matters to a Vote of Security Holders                                        | 60 |
| Item 5.                               | Other Information                                                                           | 60 |
| Item 6.                               | Exhibits                                                                                    | 60 |

 

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**PART I.   FINANCIALINFORMATION**

 

**Item 1.Financial Statements**

 

**KKR Financial Holdings LLC and Subsidiaries**

**Condensed Consolidated Balance Sheets**

**(Unaudited)**

**(Amounts in thousands, except share information)**

 
| ** **                                                                                                                                                                                  | ** ** | **March 31,  2010** | ** ** | **December 31,  2009** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| **Assets**                                                                                                                                                                                  |       |                     |       |                        |       |
| Cash and cash equivalents                                                                                                                                                                   |       | $                        | 240,529    |                        | $          | 97,086 |   |
| Restricted cash and cash equivalents                                                                                                                                                        |       | 381,298                  |       | 342,706                     |       |
| Securities available-for-sale, $806,860 and  $740,949 pledged as collateral as of March 31, 2010 and December 31,  2009, respectively                                        |       | 829,691                  |       | 755,686                     |       |
| Corporate loans, net of allowance for loan losses  of $216,080 and $237,308 as of March 31, 2010 and December 31,  2009, respectively                                             |       | 5,691,751                |       | 5,617,925                   |       |
| Corporate loans held for sale                                                                                                                                                               |       | 733,072                  |       | 925,718                     |       |
| Residential mortgage-backed securities, at  estimated fair value, $114,023 and $47,572 pledged as collateral as of March 31,  2010 and December 31, 2009, respectively       |       | 114,023                  |       | 47,572                      |       |
| Residential mortgage loans, at estimated fair  value                                                                                                                                        |       | —                   |       | 2,097,699                   |       |
| Equity investments, at estimated fair value,  $44,154 and $110,812

pledged as collateral as of March 31, 2010  and December 31, 2009, respectively                               |       | 63,488                   |       | 120,269                     |       |
| Derivative assets                                                                                                                                                                           |       | 1,303                    |       | 15,784                      |       |
| Interest and principal receivable                                                                                                                                                           |       | 64,221                   |       | 98,313                      |       |
| Reverse repurchase agreements                                                                                                                                                               |       | —                   |       | 80,250                      |       |
| Other assets                                                                                                                                                                                |       | 152,613                  |       | 100,997                     |       |
| **Total assets**                                                                                                                                                                            |       | $                        | 8,271,989  |                        | $          | 10,300,005 |   |
| **Liabilities**                                                                                                                                                                             |       |                     |       |                        |       |
| Collateralized loan obligation secured notes                                                                                                                                                |       | $                        | 5,631,866  |                        | $          | 5,667,716 |   |
| Collateralized loan obligation junior secured  notes to affiliates                                                                                                                          |       | 380,343                  |       | 533,786                     |       |
| Senior secured credit facility                                                                                                                                                              |       | 150,000                  |       | 175,000                     |       |
| Convertible senior notes                                                                                                                                                                    |       | 343,303                  |       | 275,800                     |       |
| Junior subordinated notes                                                                                                                                                                   |       | 283,517                  |       | 283,517                     |       |
| Residential mortgage-backed securities issued, at  estimated fair value                                                                                                                     |       | —                   |       | 2,034,772                   |       |
| Accounts payable, accrued expenses and other  liabilities                                                                                                                                   |       | 83,768                   |       | 7,240                       |       |
| Accrued interest payable                                                                                                                                                                    |       | 16,597                   |       | 25,297                      |       |
| Accrued interest payable to affiliates                                                                                                                                                      |       | 2,150                    |       | 2,911                       |       |
| Related party payable                                                                                                                                                                       |       | 14,827                   |       | 3,367                       |       |
| Securities sold, not yet purchased                                                                                                                                                          |       | —                   |       | 77,971                      |       |
| Derivative liabilities                                                                                                                                                                      |       | 49,998                   |       | 45,970                      |       |
| **Total liabilities**                                                                                                                                                                       |       | 6,956,369                |       | 9,133,347                   |       |
| **Shareholders’ Equity**                                                                                                                                                               |       |                     |       |                        |       |
| Preferred shares, no par value, 50,000,000 shares  authorized and none issued and outstanding at March 31, 2010 and December 31,  2009                                       |       | —                   |       | —                      |       |
| Common shares, no par value, 500,000,000 shares  authorized, and 158,359,757 and 158,359,757 shares issued and outstanding at March 31,  2010 and December 31, 2009, respectively |       | —                   |       | —                      |       |
| Paid-in-capital                                                                                                                                                                             |       | 2,576,501                |       | 2,563,634                   |       |
| Accumulated other comprehensive income                                                                                                                                                      |       | 170,413                  |       | 152,728                     |       |
| Accumulated deficit                                                                                                                                                                         |       | (1,431,294               | )          | (1,549,704                  | )          |
| **Total shareholders’ equity**                                                                                                                                                         |       | 1,315,620                |       | 1,166,658                   |       |
| **Total liabilities and  shareholders’ equity**                                                                                                                                        |       | $                        | 8,271,989  |                        | $          | 10,300,005 |   |

 

See notes to condensedconsolidated financial statements.

 

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**KKRFinancial Holdings LLC and Subsidiaries**

**CondensedConsolidated Statements of Operations**

**(Unaudited)(Amounts in thousands, except per share information)**

** **
| ** **                                                                                                                                                                                   | ** ** | **For the three  months ended  March 31,  2010** | ** ** | **For the three  months ended  March 31,  2009** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| **Net investment income:**                                                                                                                                                                   | ** ** | ** **                                                           | ** ** | ** **                                                           | ** ** |
| Loan interest income                                                                                                                                                                         |       | $                                                                    | 91,996     |                                                                 | $          | 129,204 |   |
| Securities interest income                                                                                                                                                                   |       | 27,261                                                               |       | 28,852                                                               |       |
| Other interest income                                                                                                                                                                        |       | 93                                                                   |       | 617                                                                  |       |
| Total investment income                                                                                                                                                                      |       | 119,350                                                              |       | 158,673                                                              |       |
| Interest expense                                                                                                                                                                             |       | (31,500                                                              | )          | (89,882                                                              | )          |
| Interest expense to affiliates                                                                                                                                                               |       | (4,541                                                               | )          | (5,805                                                               | )          |
| Provision for loan losses                                                                                                                                                                    |       | —                                                               |       | (26,987                                                              | )          |
| Net investment income                                                                                                                                                                        |       | 83,309                                                               |       | 35,999                                                               |       |
| **Other income (loss):**                                                                                                                                                                     | ** ** | ** **                                                           | ** ** | ** **                                                           | ** ** |
| Net realized and unrealized gain (loss) on  investments                                                                                                                                      |       | 35,423                                                               |       | (60,204                                                              | )          |
| Net realized and unrealized (loss) gain on  derivatives and foreign exchange                                                                                                            |       | (1,418                                                               | )          | 12,396                                                               |       |
| Net realized and unrealized loss on residential  mortgage-backed securities, residential mortgage loans, and residential  mortgage-backed securities issued, carried at estimated fair value |       | (5,145                                                               | )          | (19,419                                                              | )          |
| Net realized and unrealized (loss) gain on  securities sold, not yet purchased                                                                                                               |       | (756                                                                 | )          | 1,437                                                                |       |
| Net gain on restructuring and extinguishment of  debt                                                                                                                                        |       | 39,999                                                               |       | 34,571                                                               |       |
| Other income                                                                                                                                                                                 |       | 3,004                                                                |       | 1,333                                                                |       |
| Total other income (loss)                                                                                                                                                                    |       | 71,107                                                               |       | (29,886                                                              | )          |
| **Non-investment expenses:**                                                                                                                                                                 | ** ** | ** **                                                           | ** ** | ** **                                                           | ** ** |
| Related party management compensation                                                                                                                                                        |       | 20,491                                                               |       | 11,212                                                               |       |
| General, administrative and directors expenses                                                                                                                                               |       | 3,350                                                                |       | 2,403                                                                |       |
| Professional services                                                                                                                                                                        |       | 1,064                                                                |       | 3,385                                                                |       |
| Loan servicing                                                                                                                                                                               |       | —                                                               |       | 2,136                                                                |       |
| Total non-investment expenses                                                                                                                                                                |       | 24,905                                                               |       | 19,136                                                               |       |
| Income (loss) before income tax expense (benefit)                                                                                                                                            |       | 129,511                                                              |       | (13,023                                                              | )          |
| Income tax expense (benefit)                                                                                                                                                                 |       | 16                                                                   |       | (47                                                                  | )          |
| Net income (loss)                                                                                                                                                                            |       | $                                                                    | 129,495    |                                                                 | $          | (12,976 | ) |
|                                                                                                                                                                                         |       |                                                                 |       |                                                                 |       |
| Net income (loss) per common share:                                                                                                                                                          |       |                                                                 |       |                                                                 |       |
| Basic                                                                                                                                                                                        |       | $                                                                    | 0.82       |                                                                 | $          | (0.09 | ) |
| Diluted                                                                                                                                                                                      |       | $                                                                    | 0.82       |                                                                 | $          | (0.09 | ) |
|                                                                                                                                                                                         |       |                                                                 |       |                                                                 |       |
| Weighted-average number of common shares  outstanding:                                                                                                                                       |       |                                                                 |       |                                                                 |       |
| Basic                                                                                                                                                                                        |       | 156,997                                                              |       | 149,714                                                              |       |
| Diluted                                                                                                                                                                                      |       | 156,997                                                              |       | 149,714                                                              |       |

 

See notes to condensedconsolidated financial statements.

 

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**KKRFinancial Holdings LLC and Subsidiaries**

**CondensedConsolidated Statement of Changes in Shareholders’ Equity**

**(Unaudited)(Amounts in thousands)**

** **
| ** **                                                            | ** ** | **Common  Shares** | ** ** | **Paid-In  Capital** | ** ** | **Accumulated Other  Comprehensive  Income** | ** ** | **Accumulated  Deficit** | ** ** | **Comprehensive  Income** | ** ** | **Total  Shareholders’  Equity** | ** ** |
|-----------------------------------------------------------------------|------------|--------------------|------------|----------------------|------------|---------------------------------------------------|------------|--------------------------|------------|---------------------------|------------|---------------------------------------|------------|
| **Balance at January 1, 2010**                                   |       | 158,360            |       | $                    | 2,563,634  |                                              | $          | 152,728                  |       | $                         | (1,549,704 | )                                     |       |   | $ | 1,166,658 |   |
| Net  income                                                           |       | —             |       | —               |       | —                                            |       | 129,495                  |       | $                         | 129,495    |                                  | 129,495    |   |
| Net  change in unrealized loss on cash flow hedges                    |       | —             |       | —               |       | (4,892                                            | )          | —                   |       | (4,892                    | )          | (4,892                                | )          |
| Net  change in unrealized gain on securities available-for-sale       |       | —             |       | —               |       | 22,577                                            |       | —                   |       | 22,577                    |       | 22,577                                |       |
| Comprehensive  income                                                 |       |               |       |                 |       |                                              |       |                     |       | $                         | 147,180    |                                  |       |   |
| Cash  distributions on common shares                                  |       | —             |       | —               |       | —                                            |       | (11,085                  | )          |                      |       | (11,085                               | )          |
| Equity  component of convertible notes issuance                       |       | —             |       | 9,973                |       | —                                            |       | —                   |       |                      |       | 9,973                                 |       |
| Share-based  compensation expense related to restricted common shares |       | —             |       | 2,894                |       | —                                            |       | —                   |       |                      |       | 2,894                                 |       |
| **Balance at March 31, 2010**                                    |       | 158,360            |       | $                    | 2,576,501  |                                              | $          | 170,413                  |       | $                         | (1,431,294 | )                                     |       |   | $ | 1,315,620 |   |

 

See notes tocondensed consolidated financial statements.

 

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**KKR Financial Holdings LLC and Subsidiaries**

**Condensed****ConsolidatedStatements of Cash Flows**

**(Unaudited)(Amounts in thousands)**

 
| ** **                                                                                                                                        | ** ** | **For the three months  ended March 31, 2010** | ** ** | **For the three months  ended March 31, 2009** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|
| **Cash flows from operating  activities:**                                                                                                        |       |                                                                         |       |                                                                         |       |
| Net income (loss)                                                                                                                                 |       | $                                                                            | 129,495    |                                                                         | $          | (12,976 | ) |
| Adjustments to reconcile net income (loss) to net  cash provided by operating activities:                                                         |       |                                                                         |       |                                                                         |       |
| Net realized and unrealized loss (gain) on  derivatives, foreign exchange, and securities sold, not yet purchased                            |       | 2,174                                                                        |       | (13,833                                                                      | )          |
| Net gain on restructuring and extinguishment of  debt                                                                                             |       | (39,999                                                                      | )          | (34,571                                                                      | )          |
| Write-off of debt issuance costs                                                                                                                  |       | 1,679                                                                        |       | —                                                                       |       |
| Lower of cost or estimated fair value adjustment on  corporate loans held for sale                                                                |       | (3,720                                                                       | )          | 14,037                                                                       |       |
| Provision for loan losses                                                                                                                         |       | —                                                                       |       | 26,987                                                                       |       |
| Impairment on securities available-for-sale                                                                                                       |       | 1,140                                                                        |       | 33,764                                                                       |       |
| Share-based compensation                                                                                                                          |       | 2,894                                                                        |       | (3                                                                           | )          |
| Net realized and unrealized loss on residential  mortgage-backed securities, residential mortgage loans, and liabilities at  estimated fair value |       | 5,145                                                                        |       | 19,419                                                                       |       |
| Net realized and unrealized (gain) loss on  investments                                                                                           |       | (32,843                                                                      | )          | 12,403                                                                       |       |
| Deferred  interest expense                                                                                                                        |       | 2,707                                                                        |       | 6,558                                                                        |       |
| Depreciation and net amortization                                                                                                                 |       | (23,623                                                                      | )          | (10,872                                                                      | )          |
| Changes in assets and liabilities:                                                                                                                |       |                                                                         |       |                                                                         |       |
| Interest receivable                                                                                                                               |       | 6,718                                                                        |       | 34,929                                                                       |       |
| Other assets                                                                                                                                      |       | (4,835                                                                       | )          | (5,232                                                                       | )          |
| Related party payable                                                                                                                             |       | 11,460                                                                       |       | 149                                                                          |       |
| Accounts payable, accrued expenses and other  liabilities                                                                                         |       | 509                                                                          |       | (27,233                                                                      | )          |
| Accrued interest payable                                                                                                                          |       | (8,700                                                                       | )          | (31,368                                                                      | )          |
| Accrued interest payable to affiliates                                                                                                            |       | (761                                                                         | )          | (880                                                                         | )          |
| Net cash provided by operating activities                                                                                                         |       | 49,440                                                                       |       | 11,278                                                                       |       |
| **Cash flows from investing  activities:**                                                                                                        |       |                                                                         |       |                                                                         |       |
| Principal payments from investments                                                                                                               |       | 554,723                                                                      |       | 248,254                                                                      |       |
| Proceeds from sale of investments                                                                                                                 |       | 482,985                                                                      |       | 320,570                                                                      |       |
| Purchases of investments                                                                                                                          |       | (881,776                                                                     | )          | (221,490                                                                     | )          |
| Net proceeds, purchases, and settlements of  derivatives                                                                                          |       | 13,748                                                                       |       | 10,336                                                                       |       |
| Net change in reverse repurchase agreements                                                                                                       |       | 80,250                                                                       |       | 8,096                                                                        |       |
| Net change to restricted cash and cash equivalents                                                                                                |       | (38,592                                                                      | )          | 854,753                                                                      |       |
| Net cash provided by investing activities                                                                                                         |       | 211,338                                                                      |       | 1,220,519                                                                    |       |
| **Cash flows from financing  activities:**                                                                                                        |       |                                                                         |       |                                                                         |       |
| Repayment of senior secured credit facility                                                                                                       |       | (25,000                                                                      | )          | (8,064                                                                       | )          |
| Repayment of residential mortgage-backed securities  issued                                                                                       |       | —                                                                       |       | (105,526                                                                     | )          |
| Retirement of collateralized loan obligation  secured notes                                                                                       |       | (102,002                                                                     | )          | (1,104,037                                                                   | )          |
| Retirement of collateralized loan obligation junior  secured notes to affiliates                                                                  |       | (51,654                                                                      | )          | —                                                                       |       |
| Proceeds from convertible senior notes                                                                                                            |       | 167,325                                                                      |       | —                                                                       |       |
| Repayment of convertible senior notes                                                                                                             |       | (93,922                                                                      | )          | —                                                                       |       |
| Distributions on common shares                                                                                                                    |       | (11,085                                                                      | )          | —                                                                       |       |
| Other capitalized costs                                                                                                                           |       | (997                                                                         | )          | (237                                                                         | )          |
| Net cash used in financing activities                                                                                                             |       | (117,335                                                                     | )          | (1,217,864                                                                   | )          |
| **Net increase in cash and cash  equivalents**                                                                                                    |       | 143,443                                                                      |       | 13,933                                                                       |       |
| **Cash and cash equivalents at  beginning of period**                                                                                             |       | 97,086                                                                       |       | 41,430                                                                       |       |
| **Cash and cash equivalents at  end of period**                                                                                                   |       | $                                                                            | 240,529    |                                                                         | $          | 55,363 |   |
| **Supplemental cash flow  information:**                                                                                                          |       |                                                                         |       |                                                                         |       |
| Cash paid for interest                                                                                                                            |       | $                                                                            | 37,387     |                                                                         | $          | 119,393 |   |
| Cash paid for income taxes                                                                                                                        |       | $                                                                            | 6          |                                                                         | $          | 227 |   |
| **Non-cash investing and  financing:**                                                                                                            |       |                                                                         |       |                                                                         |       |
| 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 7.5% convertible senior  notes                                                                                            |       | $                                                                            | 9,973      |                                                                         | $          | — |   |

 

See notes to condensed consolidated financial statements.

 

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**KKRFinancial Holdings LLC and Subsidiaries**

**Notes toCondensed Consolidated Financial Statements****(Unaudited)**

 

**Note 1.Organization**

 

KKR Financial Holdings LLC together with its subsidiaries (the “Company”or “KKR Financial”) is a specialty finance company with expertise in a range ofasset classes. The Company primarily invests in financial assets includingbelow investment grade corporate debt, including senior secured and unsecuredloans, mezzanine loans, high yield corporate bonds, distressed and stresseddebt securities, marketable equity securities, private equity and creditdefault swaps. Additionally, the Company has made or may make investments inother asset classes including natural resources and real estate. The corporateloans the Company invests in are generally referred to as syndicated bankloans, or leveraged loans, and are purchased via assignment or participation ineither the primary or secondary market. The majority of the Company’s corporatedebt investments are held in collateralized loan obligation (“CLO”)transactions that the Company uses as long term financing for theseinvestments. The Company’s CLO transactions are structured as on-balance sheetsecuritizations of corporate loans and high yield debt securities. The seniorsecured notes issued by the CLO transactions are generally owned by third partyinvestors who are unaffiliated with the Company and the Company owns the majority of thesubordinated notes in the CLO transactions. The Company executes itscore business strategy through majority-owned subsidiaries, including CLOs. 

 

KKR FinancialAdvisors LLC (the “Manager”), a wholly owned subsidiary of Kohlberg KravisRoberts & Co. (Fixed Income) LLC, manages the Companypursuant to a management agreement (the “Management Agreement”). KohlbergKravis Roberts & Co. (Fixed Income) LLC is a wholly-ownedsubsidiary of Kohlberg Kravis Roberts & Co. L.P. (“KKR”).

 

**Note 2.Summary of Significant Accounting Policies**

 

**Basis ofPresentation**

 

The accompanying condensedconsolidated financial statements have been prepared in conformity withaccounting principles generally accepted in the United States of America (“GAAP”).The condensed consolidated financial statements include the accounts of theCompany and entities established to complete secured financing transactionsthat are considered to be variable interest entities and for which the Companyis the primary beneficiary.

 

These condensed consolidatedfinancial statements should be read in conjunction with the consolidatedfinancial statements and notes thereto included in the Company’s Annual Reporton Form 10-K for the year ended December 31, 2009. The Company’sresults for any interim period are not necessarily indicative of results for afull year or any other interim period. In the opinion of management, all normalrecurring adjustments have been included for a fair statement of this interimfinancial information.

 

**Use ofEstimates**

 

The preparation of financialstatements in conformity with GAAP requires management to make estimates andassumptions that affect the amounts reported in the Company’s condensedconsolidated financial statements and accompanying notes. Actual results coulddiffer from management’s estimates.

 

**Consolidation**

 

Effective January 1, 2010, the Company adopted new guidance whichamended the accounting for the transfers of financial assets, eliminated theconcept of a qualified special purpose entity (“QSPE”) and significantlychanged the criteria by which an enterprise determines whether or not it mustconsolidate a variable interest entity (“VIE”). Under the new guidance,consolidation of a VIE requires both the power to direct the activities thatmost significantly impact the VIE’s economic performance and the obligation toabsorb losses of the VIE or the right to receive benefits of the VIE that couldpotentially be significant to the VIE.

 

As a result of the adoptionof new guidance regarding the amended consolidation model to be based on powerand economics, the Company determined that six residential mortgage loansecuritization trusts, which were previously consolidated by the Company as itwas deemed to be the primary beneficiary, were required to be deconsolidated.The Company determined that it did not have the power to direct the activitiesthat most significantly impact the economic performance of the securitizationtrusts or the performance of the securitization trusts’ underlying assets.As the Company was never theservicer of the trusts nor did it participate in any servicing activities, theCompany did not have the power to direct the activities which mostsignificantly impact the economic performance of the securitization trusts.Accordingly, the Company determined that it was no longer the primarybeneficiary of the securitization trusts under the new guidance.

 

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Effective January 1,2010, the Company deconsolidated the six residential mortgage loansecuritization trusts, which resulted in the reduction of both assets andliabilities of approximately $2.0 billion. In addition, loan interestincome, interest expense, loan servicing expense, and net unrealized andrealized gain (loss) associated with the residential mortgage loansecuritization trusts will no longer be reported on the Company’s condensedconsolidated financial statements. The deconsolidation of the six residentialmortgage loan securitization trusts had no net impact on the Company’sshareholders’ equity, results of operations and cash flows. Refer to Note 6 tothese condensed consolidated financial statements for further discussion of theCompany’s residential mortgage-backed securities (“RMBS”) and to Note 7 tothese condensed consolidated financial statements for the impact of thedeconsolidation.

 

KKR Financial CLO 2005-1, Ltd. (“CLO2005-1”), KKR Financial CLO 2005-2, Ltd. (“CLO 2005-2”), KKRFinancial CLO 2006-1, Ltd. (“CLO 2006-1”), KKR FinancialCLO 2007-1, Ltd. (“CLO 2007-1”) and KKR Financial CLO2007-A, Ltd. (“CLO 2007-A”), are entities established to completesecured financing transactions. These entities are VIEs which the Companyconsolidates as the Company has determined it has the power to direct theactivities that most significantly impact these entities’ economic performanceand the Company has both the obligation to absorb losses of these entities andthe right to receive benefits from these entities that could potentially besignificant to these entities.

 

These five CLOs, through which the Company financesthe majority of its corporate debt investments, include $7.3 billion paramount, or $6.7 billion estimated fair value of investments. The assets in eachCLO can be used only to settle the related entities’ debt which in aggregatetotal $5.6 billion of senior and junior secured notes outstanding and inaggregate total $380.3 million of junior notes outstanding that are held by anaffiliate of the Company’s manager. In CLO transactions, subordinated noteshave the first risk of loss and conversely, the residual value upside of thetransactions. As such, these CLOs are considered non-recourse leverage.

 

In addition, the Company continues to consolidateall non-VIEs in which it holds a greater than 50 percent voting interest.

 

All inter-company balancesand transactions have been eliminated in consolidation.

 

**Fair Valueof Financial Instruments**

 

Fair value is the price thatwould be received to sell an asset or paid to transfer a liability in anorderly transaction between market participants at the measurement date. Whereavailable, fair value is based on observable market prices or parameters, orderived from such prices or parameters. Where observable prices or inputs arenot available, valuation models are applied. These valuation techniques involvesome level of management estimation and judgment, the degree of which isdependent on the price transparency for the instruments or market and theinstruments’ complexity for disclosure purposes. Assets and liabilitiesrecorded at fair value in the condensed consolidated balance sheets arecategorized based upon the level of judgment associated with the inputs used tomeasure their value. Hierarchical levels, as defined under GAAP, are directlyrelated to the amount of subjectivity associated with the inputs to fair valuationsof these assets and liabilities, and are as follows:

 

Level 1: Inputs areunadjusted, quoted prices in active markets for identical assets or liabilitiesat the measurement date.

 

The types of assets carriedat level 1 fair value generally are equity securities listed in activemarkets.

 

Level 2: Inputs, otherthan quoted prices included in level 1, are observable for the asset orliability, either directly or indirectly. Level 2 inputs include quotedprices for similar instruments in active markets, and inputs other than quotedprices that are observable for the asset or liability.

 

Fair value assets andliabilities that are generally included in this category are certain corporatedebt securities, certain corporate loans held for sale, certain equity investmentsat estimated fair value, certain securities sold, not yet purchased and certainfinancial instruments classified as derivatives.

 

Level 3: Inputs areunobservable inputs for the asset or liability, and include situations wherethere is little, if any, market activity for the asset or liability. In certaincases, the inputs used to measure fair value may fall into different levels ofthe fair value hierarchy. In such cases, the level in the fair value hierarchywithin which the fair value measurement in its entirety falls has beendetermined based on the lowest level input that is significant to the fairvalue measurement in its entirety. The Company’s assessment of the significanceof a particular input to the fair value measurement in its entirety requiresjudgment and consideration of factors specific to the asset.

 

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Assets and liabilitiescarried at fair value and included in this category are certain corporate debtsecurities, certain corporate loans held for sale, certain equity investmentsat estimated fair value, RMBS, residential mortgage loans, residentialmortgage-backed securities issued (“RMBS Issued”) and certain derivatives.

 

A significant decrease in the volume and level ofactivity for the asset or liability is an indication that transactions orquoted prices may not be representative of fair value because in such marketconditions there may be increased instances of transactions that are notorderly. In those circumstances, further analysis of transactions or quotedprices is needed, and a significant adjustment to the transactions or quotedprices may be necessary to estimate fair value.

 

The availability ofobservable inputs can vary depending on the financial asset or liability and isaffected by a wide variety of factors, including, for example, the type ofproduct, whether the product is new, whether the product is traded on an activeexchange or in the secondary market, and the current market condition. To theextent that valuation is based on models or inputs that are less observable orunobservable in the market, the determination of fair value requires morejudgment. Accordingly, the degree of judgment exercised by the Company indetermining fair value is greatest for instruments categorized in level 3.In certain cases, the inputs used to measure fair value may fall into differentlevels of the fair value hierarchy. In such cases, for disclosure purposes, thelevel in the fair value hierarchy within which the fair value measurement inits entirety falls is determined based on the lowest level input that issignificant to the fair value measurement in its entirety.

 

Many financial assets andliabilities 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 topay for an asset. Ask prices represent the lowest price that the Company andothers are willing to accept for an asset. For financial assets and liabilitieswhose inputs are based on bid-ask prices, the Company does not require thatfair value always be a predetermined point in the bid-ask range. The Company’spolicy is to allow for mid-market pricing and adjusting to the point within thebid-ask range that meets the Company’s best estimate of fair value.

 

Depending on the relativeliquidity in the markets for certain assets, the Company may transfer assets tolevel 3 if it determines that observable quoted prices, obtained directlyor indirectly, are not available. The valuation techniques used for the assetsand liabilities that are valued using level 3 of the fair value hierarchy aredescribed below.

 

*ResidentialMortgage-Backed Securities, Residential Mortgage Loans, and ResidentialMortgage-Backed Securities Issued:*  Residential mortgage-backed securities,residential mortgage loans, and residential mortgage-backed securities issuedare initially valued at transaction price and are subsequently valued usingindustry recognized models (including Intex and Bloomberg) and data for similarinstruments (e.g., nationally recognized pricing services or brokerquotes). The most significant inputs to the valuation of these instruments aredefault and loss expectations and market credit spreads.

 

*CorporateDebt Securities:*  Corporatedebt securities are initially valued at transaction price and are subsequentlyvalued using market data for similar instruments (e.g., recenttransactions or broker quotes), comparisons to benchmark derivative indices orvaluation models. Valuation models are based on discounted cash flowtechniques, for which the key inputs are the amount and timing of expectedfuture cash flows, market yields for such instruments and recovery assumptions.Inputs are determined based on relative value analyses, which incorporatesimilar instruments from similar issuers.

 

*Over-the-counter(“OTC”) Derivative Contracts:*  OTC derivative contracts include forward,swap and option contracts related to interest rates, foreign currencies, creditstanding of reference entities, and equity prices. The fair value of OTCderivative products can be modeled using a series of techniques, includingclosed-form analytic formulae, such as the Black-Scholes option-pricing model,and simulation models or a combination thereof. Many pricing models do notentail material subjectivity because the methodologies employed do notnecessitate significant judgment, and the pricing inputs are observed fromactively quoted markets, as is the case for generic interest rate swap andoption contracts.

 

**Cash andCash Equivalents**

 

Cash and cash equivalentsinclude cash on hand, cash held in banks and highly liquid investments withoriginal maturities of three months or less. Interest income earned on cash andcash equivalents is recorded in other interest income.

 

**RestrictedCash and Cash Equivalents**

 

Restricted cash and cashequivalents represent amounts that are held by third parties under certain ofthe Company’s financing and derivative transactions. Interest income earned onrestricted cash and cash equivalents is recorded in other interest income.

 

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On the condensedconsolidated statement of cash flows, net additions or reductions to restrictedcash and cash equivalents are classified as an investing activity as restrictedcash and cash equivalents reflect the receipts from collections or sales ofinvestments, as well as payments made to acquire investments held by thirdparties.

 

**ResidentialMortgage-Backed Securities**

 

The Company carries its residential mortgage-backedsecurities at estimated fair value with unrealized gains and losses reported inincome. The Company elected the fair value option for itsresidential mortgage investments for the purpose of enhancing the transparencyof its financial condition as fair value is consistent with how the Companymanages the risks of its residential mortgage investments.

 

**SecuritiesAvailable-for-Sale**

 

The Company classifies itsinvestments in securities as available-for-sale as the Company may sell themprior to maturity and does not hold them principally for the purpose of sellingthem in the near term. These investments are carried at estimated fair value,with unrealized gains and losses reported in accumulated other comprehensiveincome (loss). Estimated fair values are based on quoted market prices, whenavailable, on estimates provided by independent pricing sources or dealers whomake markets in such securities, or internal valuation models when externalsources of fair value are not available. Upon the sale of a security, therealized 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-salesecurities portfolio for impairments. A loss is recognized when it isdetermined that a decline in the estimated fair value of a security below itsamortized cost is other-than-temporary. The Company considers many factors indetermining whether the impairment of a security is deemed to beother-than-temporary, including, but not limited to, the length of time thesecurity has had a decline in estimated fair value below its amortized cost andthe severity of the decline, the amount of the unrealized loss, recent eventsspecific to the issuer or industry, external credit ratings and recent changesin such ratings. In addition, for debt securities, the Company considers itsintent to sell the debt security, the Company’s estimation of whether or not itexpects to recover the debt security’s entire amortized cost if it intends tohold the debt security, and whether it is more likely than not that the Companywill be required to sell the debt security before its anticipated recovery. Forequity securities, the Company also considers its intent and ability to holdthe equity security for a period of time sufficient for a recovery in value.

 

The amount of the loss thatis recognized when it is determined that a decline in the estimated fair valueof a security below its amortized cost is other-than-temporary is dependent oncertain factors. If the security is an equity security or if the security is a debtsecurity that the Company intends to sell or estimates that it is more likelythan not that the Company will be required to sell before recovery of itsamortized cost, then the impairment amount recognized in earnings is the entiredifference between the estimated fair value of the security and its amortizedcost. For debt securities that the Company does not intend to sell or estimatesthat it is not more likely than not to be required to sell before recovery, theimpairment is separated into the estimated amount relating to credit loss andthe estimated amount relating to all other factors. Only the estimated creditloss amount is recognized in earnings, with the remainder of the loss amountrecognized in other comprehensive income (loss).

 

Unamortized premiums andunaccreted discounts on securities available-for-sale are recognized ininterest income over the contractual life, adjusted for actual prepayments, ofthe securities using the effective interest method.

 

**Equity Investments, at Estimated Fair Value**

 

The Company has elected the fair value option ofaccounting for certain marketable and private equity investments. The Companyelects the fair value option of accounting for private equity investmentsreceived through restructuring debt transactions or owned through an entity inwhich the Company has significant influence. The Company elected thefair value option for certain equity investments for the purpose of enhancingthe transparency of its financial condition as fair value is consistent with howthe Company manages the risks of these equity investments. Equity investments,at estimated fair value, are managed based on overall value and potentialreturns. Investments carried at fair value are presented separately on thecondensed consolidated balance sheets with unrealized gains and losses reportedin net realized and unrealized gains and losses on investments on the condensedconsolidated statements of operations.

 

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**Private Equity Investments, at Cost**

 

Private equity investmentsare accounted for under either the cost method or at fair value if the fairvalue option of accounting has been elected, (see “Equity Investments, atEstimated Fair Value” above). The Company evaluates its investments accountedfor under the cost method on a quarterly basis for possibleother-than-temporary impairment. The Company reduces the carrying value of theinvestment and recognizes a loss when the Company considers a decline inestimated fair value below the cost basis of the security to beother-than-temporary. Private equity investments recorded at cost are includedin other assets on the condensed consolidated balance sheets.

 

**SecuritiesSold, Not Yet Purchased**

 

Securities sold, not yetpurchased consist of equity and debt securities that the Company has soldshort. In order to facilitate a short sale, the Company borrows the securitiesfrom another party and delivers the securities to the buyer. The Company willbe required to “cover” its short sale in the future through the purchase of thesecurity in the market at the prevailing market price and deliver it to thecounterparty from which it borrowed. The Company is exposed to a loss to theextent that the security price increases during the time from when the Companyborrowed the security to when the Company purchases it in the market to coverthe short sale.

 

**CorporateLoans**

 

The Company purchasesparticipations and assignments in corporate loans in the primary and secondarymarket. Loans are held for investment and the Company initially records loansat their purchase prices. The Company subsequently accounts for loans based ontheir outstanding principal plus or minus unaccreted purchase discounts andunamortized purchase premiums. Interest income on loans includes interest atstated coupon rates adjusted for accretion of purchase discounts and theamortization of purchase premiums. Unamortized premiums and unaccreteddiscounts are recognized in interest income over the contractual life, adjustedfor actual prepayments, of the loans using the effective interest method.

 

A loan is typically placedon non-accrual status at such time as: (i) management believes thatscheduled debt service payments may not be paid when contractually due; (ii) theloan becomes 90 days delinquent; (iii) management determines theborrower is incapable of, or has ceased efforts toward, curing the cause of theimpairment; or (iv) the net realizable value of the underlying collateralsecuring the loan decreases below the Company’s carrying value of such loan. Assuch, loans placed on non-accrual status may or may not be contractually pastdue at the time of such determination. While on non-accrual status, previouslyrecognized accrued interest is reversed if it is determined that such amountsare not collectible and interest income is recognized using the cost-recoverymethod, cash-basis method or some combination of the two methods. A loan isplaced back on accrual status when the ultimate collectability of the principaland interest is not in doubt.

 

**CorporateLoans Held for Sale**

 

Corporate loans held forsale consist of loans that the Company has determined to no longer hold forinvestment. Corporate loans held for sale are stated at lower of cost orestimated fair value.

 

**Allowancefor Loan Losses**

 

The Company’s allowance for loan losses representsits estimate of probable credit losses inherent in its corporate loan portfolioheld for investment as of the balance sheet date. Estimating the Company’sallowance for loan losses involves a high degree of management judgment and isbased upon a comprehensive review of the Company’s loan portfolio that isperformed on a quarterly basis. The Company’s allowance for loan lossesconsists of two components, an allocated component and an unallocatedcomponent. The allocated component of the allowance for loan losses pertains tospecific loans that the Company has determined are impaired. The Companydetermines a loan is impaired when management estimates that it is probablethat the Company will be unable to collect all amounts due according to thecontractual terms of the loan agreement. On a quarterly basis, the Companyperforms a comprehensive review of its entire loan portfolio and identifiescertain loans that it has determined are impaired. Once a loan is identified asbeing impaired, the Company places the loan on non-accrual status, unless theloan is already on non-accrual status, and records a reserve that reflectsmanagement’s best estimate of the loss that the Company expects to recognizefrom the loan. The expected loss is estimated as being the difference betweenthe Company’s current cost basis of the loan, including accrued interestreceivable, and the loan’s estimated fair value.

 

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The unallocated component of the Company’s allowancefor loan losses reflects its estimate of probable losses inherent in the loanportfolio as of the balance sheet date where the specific loan that the loanloss relates to is indeterminable. The Company estimates the unallocatedcomponent of the allowance for loan losses through a comprehensive review ofits loan portfolio and identifies certain loans that demonstrate possibleindicators of impairment. This assessment excludes all loans that aredetermined to be impaired and as a result, an allocated reserve has beenrecorded. Such indicators include, but are not limited to, the current and/orforecasted financial performance and liquidity profile of the issuer, specificindustry or economic conditions that may impact the issuer, and the observable tradingprice of the loan if available. Loans that demonstrate possible indicators ofimpairment are aggregated on a watch list for monitoring and are sub-dividedfor categorization based on the seniority of the loan in the issuer’s capitalstructure, whether the loan is secured or unsecured, and the nature of thecollateral securing the loan, for purposes of applying possible default andloss severity ranges based on the nature of the issuer and the specific loan.The Company applies a range of default and loss severity estimates in order toestimate a range of loss outcomes upon which to base its estimate of probablelosses that results in the determination of the unallocated component of theCompany’s allowance for loan losses.

 

**LeaseholdImprovements and Equipment**

 

Leasehold improvements andequipment are carried at cost less depreciation and amortization and arereviewed for impairment whenever events or changes in circumstances indicatethat the carrying amount of the assets might not be recoverable. Equipment isdepreciated using the straight-line method over the estimated useful lives ofthe respective assets of three years. Leasehold improvements are amortized on astraight-line basis over the shorter of their estimated useful lives or leaseterms. Leasehold improvements and equipment, net of accumulated depreciationand amortization, are included in other assets.

 

**Borrowings**

 

The Company finances theacquisition of its investments, including loans, residential mortgage-backedsecurities and securities available-for-sale, primarily through the use ofsecured borrowings in the form of securitization transactions structured assecured financings and other secured and unsecured borrowings. The Companyrecognizes interest expense on all borrowings on an accrual basis.

 

**TrustPreferred Securities**

 

Trusts formed by the Companyfor the sole purpose of issuing trust preferred securities are not consolidatedby the Company as the Company has determined that it is not the primarybeneficiary of such trusts. The Company’s investment in the common securitiesof such trusts is included in other assets on the Company’s condensedconsolidated financial statements.

 

**DerivativeFinancial Instruments**

 

The Company recognizes allderivatives on the condensed consolidated balance sheet at estimated fairvalue. On the date the Company enters into a derivative contract, the Companydesignates and documents each derivative contract as one of the following atthe 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 thevariability of cash flows to be received or paid related to a recognized assetor liability (“cash flow” hedge); (iii) a hedge of a net investment in aforeign operation; or (iv) a derivative instrument not designated as ahedging instrument (“free-standing derivative”). For a fair value hedge, theCompany records changes in the estimated fair value of the derivativeinstrument and, to the extent that it is effective, changes in the fair valueof the hedged asset or liability in the current period earnings in the samefinancial statement category as the hedged item. For a cash flow hedge, theCompany records changes in the estimated fair value of the derivative to theextent that it is effective in other comprehensive (loss) income andsubsequently reclassifies these changes in estimated fair value to net incomein the same period(s) that the hedged transaction affects earnings. Theeffective portion of the cash flow hedges is recorded in the same financialstatement category as the hedged item. For free-standing derivatives, theCompany reports changes in the fair values in other (loss) income.

 

The Company formallydocuments at inception its hedge relationships, including identification of thehedging instruments and the hedged items, its risk management objectives,strategy for undertaking the hedge transaction and the Company’s evaluation ofeffectiveness of its hedged transactions. Periodically, the Company alsoformally assesses whether the derivative it designated in each hedgingrelationship is expected to be and has been highly effective in offsettingchanges in estimated fair values or cash flows of the hedged item using eitherthe dollar offset or the regression analysis method. If the Company determinesthat a derivative is not highly effective as a hedge, it discontinues hedgeaccounting.

 

**ForeignCurrency**

 

The Company makesinvestments in non-United States dollar denominated securities and loans. As aresult, the Company is subject to the risk of fluctuation in the exchange ratebetween the United States dollar and the foreign currency in which it makes aninvestment. In order to reduce the currency risk, the Company may hedge theapplicable foreign currency. All investments denominated in a foreign currencyare converted to the United States dollar using prevailing exchange rates onthe balance sheet date. Income, expenses, gains and losses on investmentsdenominated in a foreign currency are converted to the United States dollarusing the prevailing exchange rates on the dates when they are recorded.Foreign exchange gains and losses are recorded in the condensed consolidatedstatements of operations.

 

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**ManagerCompensation**

 

The Management Agreementprovides for the payment of a base management fee to the Manager, as well as anincentive fee if the Company’s financial performance exceeds certainbenchmarks. Additionally, the Management Agreement provides for the Manager tobe reimbursed for certain expenses incurred on the Company’s behalf. SeeNote 13 to these condensed consolidated financial statements foradditional discussion on the payment of the base management fee and incentivefee. The base management fee and the incentive fee are accrued and expensedduring the period for which they are earned by the Manager.

 

**Share-BasedCompensation**

 

The Company accounts forshare-based compensation issued to its directors and to its Manager using afair value based methodology prescribed.Compensation cost related torestricted commonshares issued to the Company’s directors ismeasured at its estimated fair value atthe grant date, and isamortized and expensed over thevesting period on astraight-line basis. Compensation cost relatedto restricted common sharesand commonshare options issued to the Manager is initially measured at estimated fairvalue at the grant date, and is remeasured on subsequent dates to the extenttheawards are unvested. The Company has elected to use the graded vestingattribution method to amortize compensation expense for the restricted commonshares and common share options granted to the Manager.

 

**Income Taxes**

 

The Company intends tocontinue to operate so as to qualify as a partnership, and not as anassociation or publicly traded partnership that is taxable as a corporation,for United States federal income tax purposes. Therefore, the Company is notsubject to United States federal income tax at the entity level, but is subjectto limited state income taxes. Holders of the Company’s shares will be requiredto take into account their allocable share of each item of the Company’sincome, gain, loss, deduction, and credit for the taxable year of the Companyending within or with their taxable year.

 

During 2010, the Companyowned an equity interest in KKR Financial Holdings II, LLC (“KFH II”)which elected to be taxed as a REIT under the Internal Revenue Code of 1986, asamended (the “Code”). KFH II holds certain real estate mortgage-backedsecurities. A REIT is not subject to United States federal income tax to theextent that it currently distributes its income and satisfies certain asset,income and ownership tests, and recordkeeping requirements, but it may besubject to some amount of federal, state, local and foreign taxes based on itstaxable income.

 

KKR TRS Holdings, Ltd. (“TRSLtd.”), KKR Financial Holdings, Ltd. (“KFH Ltd.”), KFH III Holdings Ltd. (“KFHIII Ltd.”), KFN PEI VII, LLC (“PEI VII”), KFH PE Holdings I LLC (“PE I”),KFH PE Holdings II LLC (“PE II”), and KKR Financial Holdings, Inc. (“KFH Inc.”)are wholly-owned subsidiaries of the Company and are taxable as corporationsfor United States federal income tax purposes and thus are not consolidatedwith the Company for United States federal income tax purposes. For financialreporting purposes, current and deferred taxes are provided for on the portionof earnings recognized by the Company with respect to its interest in PEI VII,PE I, PE II, and KFH Inc., all domestic taxable corporate subsidiaries, becauseeach is taxed as a regular corporation under the Code. Deferred income tax assetsand liabilities are computed based on temporary differences between the GAAPconsolidated financial statements and the United States federal income taxbasis of assets and liabilities as of each consolidated balance sheet date. CLO2005-1, CLO 2005-2, CLO 2006-1, CLO 2007-1, CLO 2007-A and KKR Financial CLO2009-1, Ltd. (“CLO 2009-1”) are foreign subsidiaries of the Company thatelected to be treated as disregarded entities or partnerships for United Statesfederal income tax purposes. These subsidiaries were established to facilitatesecuritization transactions, structured as secured financing transactions. TRSLtd., KFH Ltd. and KFH III Ltd. are foreign corporate subsidiaries that wereformed to make certain foreign and domestic investments from time to time. TRSLtd., KFH Ltd. and KFH III Ltd. are organized as exempted companiesincorporated with limited liability under the laws of the Cayman Islands, andare anticipated to be exempt from United States federal and state income tax atthe corporate entity level because they restrict their activities in the UnitedStates to trading in stock and securities for their own account. However, theCompany will be required to include their current taxable income in the Company’scalculation of its taxable income allocable to shareholders.

 

**EarningsPer Share**

 

The Company calculatesearnings per share (“EPS”) using the two-class method which is an earningsallocation formula that determines EPS for common shares and participatingsecurities. Unvested share-based payment awards that contain non-forfeitablerights to dividends or dividend equivalents (whether paid or unpaid) areparticipating securities and shall be included in the computation of EPS usingthe two-class method. Accordingly, all earnings (distributed and undistributed)are allocated to common shares and participating securities based on theirrespective rights to receive dividends.

 

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The Company presents bothbasic and diluted earnings (loss) per common share in its condensedconsolidated financial statements and footnotes thereto. Basic earnings (loss)per common share (“Basic EPS”) excludes dilution and is computed by dividingnet income or loss by the weighted-average number of common shares, includingvested restricted common shares, outstanding for the period. Diluted earnings(loss) per share (“Diluted EPS”) reflects the potential dilution of commonshare options and unvested restricted common shares using the treasury method,as well as the potential dilution of convertible senior notes using the numberof shares it would take to satisfy the excess conversion obligation (averageCompany share price for the period in excess of the conversion price related tothe Company’s convertible senior notes), if they are not anti-dilutive.  See Note 3 to these condensed consolidatedfinancial statements for earnings (loss) per common share computations.

 

**RecentAccounting Pronouncements**

 

*Consolidation*

 

In February 2010, the Financial AccountingStandards Board (“FASB”) issued new guidance deferring the application of theamended consolidation requirements related to VIEs for a reporting entity’sinterest in an entity that has all the attributes of an investment company orfor which it is applies measurement principles that are consistent with thosefollowed by investment companies. The guidance was expected to mostsignificantly affect reporting entities in the investment management industry.Entities including, but not limited to, securitization entities or entitieswith multiple levels of subordinated investors such as a CLO for which theprimary purpose of the capital structure of the entity is to provide creditenhancement to senior interest holders, will not qualify for the deferral.  The guidance was effective for interim andannual reporting periods beginning after November 15, 2009. The adoptiondid not have an affect on the Company’s condensed consolidated financialstatements.

 

**Note 3. Earnings per Share**

 

The following table presentsa reconciliation of basic and diluted net income per common share, as well asthe distributions declared per common share for the three months ended March 31,2010 and 2009 (amounts in thousands, except per share information):

 
| ** **                                                                        | ** ** | **Three months ended  March 31, 2010** | ** ** | **Three months ended  March 31, 2009** | ** ** |
|-----------------------------------------------------------------------------------|------------|------------------------------------------------------------|------------|------------------------------------------------------------|------------|
| Net income (loss)                                                                 |       | $                                                          | 129,495    |                                                       | $          | (12,976 | ) |
| Less: Dividends and  undistributed earnings allocated to participating securities |       | 1,106                                                      |       | (100                                                       | )          |
| Net income (loss)  applicable to common shareholders                              |       | $                                                          | 128,389    |                                                       | $          | (12,876 | ) |
| ** **                                                                        |       |                                                       |       |                                                       |       |
| **Basic:**                                                                        |       |                                                       |       |                                                       |       |
| Basic weighted-average  shares outstanding                                        |       | 156,997                                                    |       | 149,714                                                    |       |
| Net income (loss) per  share                                                      |       | $                                                          | 0.82       |                                                       | $          | (0.09 | ) |
| ** **                                                                        |       |                                                       |       |                                                       |       |
| **Diluted:**                                                                      |       |                                                       |       |                                                       |       |
| Diluted weighted-average  shares outstanding (1)                                  |       | 156,997                                                    |       | 149,714                                                    |       |
| Net income (loss) per  share                                                      |       | $                                                          | 0.82       |                                                       | $          | (0.09 | ) |
|                                                                              |       |                                                       |       |                                                       |       |
| Distributions declared per  common share                                          |       | $                                                          | 0.07       |                                                       | $          | — |   |

 

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(1)                         Potentialanti-dilutive common shares were excluded from diluted earnings per sharerelated to convertible senior notes for the three months ended March 31,2010 and 2009, as the conversion price on the convertible senior notes wasgreater than the average market price of the Company’s shares.  Potential anti-dilutive common sharesexcluded from diluted earnings per share related to common share options were1,932,279 for both the three months ended March 31, 2010 and 2009.

 

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**Note 4.Securities Available-for-Sale**

 

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

 
| ** **                 | ** ** | **March 31, 2010** | ** ** | **December 31, 2009** | ** ** |
|----------------------------|------------|------------------------------|------------|---------------------------------|------------|
| ** **                 | ** ** | **Amortized  Cost**          | ** ** | **Gross  Unrealized  Gains**    | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Fair Value** | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Fair Value** | ** ** |
| Corporate debt securities  |       | $                            | 612,778    |                            | $          | 220,418 |   | $ | (3,505 | ) | $ | 829,691 |   | $ | 560,637 |   | $ | 198,242 |   | $ | (4,470 | ) | $ | 754,409 |   |
| Common and preferred stock |       | —                       |       | —                          |       | — |   | — |   | 713 |   | 564 |   | — |   | 1,277 |   |
| Total                      |       | $                            | 612,778    |                            | $          | 220,418 |   | $ | (3,505 | ) | $ | 829,691 |   | $ | 561,350 |   | $ | 198,806 |   | $ | (4,470 | ) | $ | 755,686 |   |

 

The following table showsthe gross unrealized losses and fair value of the Company’s available-for-salesecurities, aggregated by length of time that the individual securities havebeen in a continuous unrealized loss position, as of March 31, 2010 and December 31,2009 (amounts in thousands):

 
| ** **                 | ** ** | **Less Than 12 months** | ** ** | **12 Months or More** | ** ** | **Total**                      | ** ** |
|----------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|--------------------------------|------------|
| ** **                 | ** ** | **Estimated  Fair Value**         | ** ** | **Unrealized  Losses**               | ** ** | **Estimated  Fair Value** | ** ** | **Unrealized  Losses** | ** ** | **Estimated  Fair Value** | ** ** | **Unrealized  Losses** | ** ** |
| ** **                 |       |                                   |       |                                 |       |                           |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **March 31, 2010**    |       |                                   |       |                                 |       |                           |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Corporate debt securities  |       | $                                      | 36,168     |                                 | $          | (833                           | )          | $ | 36,102 |   | $ | (2,672 | ) | $ | 72,270 |   | $ | (3,505 | ) |
|                       |       |                                   |       |                                 |       |                           |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **December 31, 2009** |       |                                   |       |                                 |       |                           |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Corporate debt securities  |       | $                                      | 8,437      |                                 | $          | (113                           | )          | $ | 70,967 |   | $ | (4,357 | ) | $ | 79,404 |   | $ | (4,470 | ) |

 

The unrealized losses in the table above areconsidered to be temporary impairments due to market factors and are notreflective of credit deterioration. The Company considers many factors whenevaluating whether an impairment is other-than-temporary. For corporate debtsecurities included in the table above, the Company does not intend to sellthem and does not believe that it is more likely than not that the Company willbe required to sell any of its corporate debt securities prior to recovery. Inaddition, based on the analyses performed by the Company on each of itscorporate debt securities, the Company believes that it is able to recover theentire amortized cost amount of the corporate debt securities included in thetable above.

 

During the three monthsended March 31, 2010, the Company recognized a loss totaling $1.1 millionfor corporate debt securities that it determined to be other-than-temporarilyimpaired based on the criteria above. During the three months ended March 31,2009, the Company recognized a loss totaling $33.8 million for corporatedebt securities that it determined to be other-than-temporarily impaired basedon the criteria above. The Company intends to sell these securities and as aresult, the entire amount is recorded through earnings in net realized andunrealized gain (loss) on investments in the condensed consolidated statementsof operations.

 

As of March 31, 2010and December 31, 2009, the Company had no corporate debt securities indefault.

 

The following table showsthe net realized gains (losses) on the sales of securities (amounts inthousands):

 
| ** **                  | ** ** | **Three months ended****March 31, 2010** | ** ** | **Three months ended****March 31, 2009** | ** ** |
|-----------------------------|------------|-----------------------------------------------|------------|-----------------------------------------------|------------|
| Gross realized gains        |       | $                                             | 7,530      |                                          | $          | 912 |   |
| Gross realized losses       |       | —                                        |       | (5,773                                        | )          |
| Net realized gains (losses) |       | $                                             | 7,530      |                                          | $          | (4,861 | ) |

 

Note 8 to these condensedconsolidated financial statements describes the Company’s borrowings underwhich the Company has pledged securities available-for-sale for borrowings. Thefollowing table summarizes the estimated fair value of securitiesavailable-for-sale pledged as collateral as of March 31, 2010 and December 31,2009 (amounts in thousands):

 
| ** **                                                                                                      | ** ** | **As of  March 31, 2010** | ** ** | **As of  December 31, 2009** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|---------------------------------------------|------------|
| Pledged as collateral for  borrowings under senior secured credit facility                                      |       | $                                        | 107,145    |                                        | $          | 107,845 |   |
| Pledged as collateral for  collateralized loan obligation secured notes and junior secured notes to  affiliates |       | 699,715                                  |       | 633,104                                     |       |
| Total                                                                                                           |       | $                                        | 806,860    |                                        | $          | 740,949 |   |

 

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**Note 5.Corporate Loans and Allowance for Loan Losses**

 

The following tablesummarizes the Company’s corporate loans as of March 31, 2010 and December 31,2009 (amounts in thousands):

 
| ** **                             | ** ** | **March 31, 2010** | ** ** | **December 31, 2009**         | ** ** |
|----------------------------------------|------------|-------------------------|------------|------------------------------------|------------|
| ** **                             | ** ** | **Corporate  Loans**    | ** ** | **Corporate Loans  Held for Sale** | ** ** | **Total Corporate  Loans** | ** ** | **Corporate  Loans** | ** ** | **Corporate Loans  Held for Sale** | ** ** | **Total Corporate  Loans** | ** ** |
| Principal(1)                           |       | $                       | 6,272,646  |                               | $          | 762,926 |   | $ | 7,035,572 |   | $ | 6,180,028 |   | $ | 1,033,383 |   | $ | 7,213,411 |   |
| Unamortized discount                   |       | (364,815                | )          | (23,783                            | )          | (388,598 | ) | (324,795 | ) | (76,028 | ) | (400,823 | ) |
| Total amortized cost                   |       | 5,907,831               |       | 739,143                            |       | 6,646,974 |   | 5,855,233 |   | 957,355 |   | 6,812,588 |   |
| Lower of cost or fair value adjustment |       | —                  |       | (6,071                             | )          | (6,071 | ) | — |   | (31,637 | ) | (31,637 | ) |
| Allowance for loan losses              |       | (216,080                | )          | —                             |       | (216,080 | ) | (237,308 | ) | — |   | (237,308 | ) |
| Net carrying value                     |       | $                       | 5,691,751  |                               | $          | 733,072 |   | $ | 6,424,823 |   | $ | 5,617,925 |   | $ | 925,718 |   | $ | 6,543,643 |   |

 

----

(1)                                 Principal amountis net of charge-offs and other adjustments totaling $99.3 million and $158.8million as of March 31, 2010 and December 31, 2009, respectively.

 

The following tablesummarizes the changes in the allowance for loan losses for the Company’scorporate loan portfolio during the three months ended March 31, 2010 and2009 (amounts in thousands):

 
| ** **                      | ** ** | **For the three  months ended  March 31, 2010** | ** ** | **For the three  months ended  March 31, 2009** | ** ** |
|---------------------------------|------------|--------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|
| Balance at beginning of  period |       | $                                                                        | 237,308    |                                                                     | $          | 480,775 |   |
| Provision for loan losses       |       | —                                                                   |       | 26,987                                                                   |       |
| Charge-offs                     |       | (21,228                                                                  | )          | —                                                                   |       |
| Balance at end of period        |       | $                                                                        | 216,080    |                                                                     | $          | 507,762 |   |

 

As of March 31, 2010 and December 31,2009, the Company recorded an allowance for loan loss of $216.1 million and$237.3 million, respectively. As described in Note 2 to these condensedconsolidated financial statements, the allowance for loan losses represents theCompany’s estimate of probable credit losses inherent in its loan portfolio asof the balance sheet date. The Company’s allowance for loan losses consists oftwo components, an allocated component and an unallocated component. Theallocated component of the allowance for loan losses consists of individualloans that are impaired. The unallocated component of the allowance for loanlosses represents the Company’s estimate of losses inherent, but notidentified, in its portfolio as of the balance sheet date.

 

As of March 31, 2010, the allocated componentof the allowance for loan losses totaled $82.4 million and relates toinvestments in loans issued by six issuers with an aggregate par amount of$216.7 million and an aggregate amortized cost amount of $118.3 million. As of December 31,2009, the allocated component of the allowance for loan losses totaled $81.7million and relates to investments in loans issued by six issuers with anaggregate par amount of $223.6 million and an aggregate amortized cost amountof $121.2 million. The unallocated component of the allowance for loan lossestotaled $133.7 million and $155.6 million as of March 31, 2010 and December 31,2009, respectively. During the three months ended March 31, 2010, theCompany recorded charge-offs totaling $21.2 million comprised primarily ofloans transferred to loans held for sale. There were no charge-offs recordedduring the three months ended March 31, 2009.

 

The Company reduced thelower of cost or market valuation allowance by $3.7 million for certain loansheld for sale during the quarter ended March 31, 2010 which had a carryingvalue of $733.1 million as of March 31, 2010. The Company recorded a$14.0 million charge to earnings during the quarter ended March 31,2009 for the lower of cost or estimated fair value adjustment for corporateloans held for sale which had a carrying value of $259.9 million as of March 31,2009.

 

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As of March 31, 2010and December 31, 2009, the Company had loans on non-accrual status with atotal carrying value of $253.3 million and $439.9 million, respectively.  The average recorded investment in theimpaired loans included in non-accrual loans during the three months ended March 31,2010 and 2009 was $346.6 million and $565.2 million, respectively. As of March 31,2010 and 2009, the allocated component of the allowance for loan lossesincluded all impaired loans for the respective periods. The amount of interestincome recognized using the cash-basis method during the time within the periodthat the loans were impaired was $5.6 million and $2.1 million for the threemonths ended March 31, 2010 and 2009, respectively.

 

As of March 31, 2010,the Company held corporate loans that were in default with a total carryingvalue of $209.7 million from four issuers. As of December 31, 2009, theCompany held loans that were in default with a total amortized cost of $392.5million from seven issuers. The majority of corporate loans in default during2010 and 2009 were included in the loans for which the allocated component ofthe Company’s allowance for losses was related to, or for which the Companydetermined were loans held for sale as of March 31, 2010 and December 31,2009, respectively.

 

Note 8 to these condensedconsolidated financial statements describes the Company’s borrowings underwhich the Company has pledged loans for borrowings. The following tablesummarizes the amortized cost of total corporate loans, including corporateloans held for sale, pledged as collateral as of March 31, 2010 and December 31,2009 (amounts in thousands):

 
| ** **                                                                                                      | ** ** | **As of  March 31, 2010** | ** ** | **As of  December 31, 2009** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|---------------------------------------------|------------|
| Pledged as collateral for  borrowings under senior secured credit facility                                      |       | $                                        | 296,987    |                                        | $          | 425,740 |   |
| Pledged as collateral for  collateralized loan obligation secured notes and junior secured notes to  affiliates |       | 6,241,305                                |       | 6,354,382                                   |       |
| Total                                                                                                           |       | $                                        | 6,538,292  |                                        | $          | 6,780,122 |   |

 

**Note 6.Residential Mortgage-Backed Securities**

 

TheCompany held RMBS with an estimated fair value of $114.0 million and $47.6million as March 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 loansecuritization trusts (see “Consolidation” under Note 2 to these condensedconsolidated financial statements). The $74.4 million represents the estimatedfair value of the Company’s RMBS which were issued by these six residentialmortgage securitization trusts.

 

Note 8 to these condensedconsolidated financial statements describes the Company’s borrowings underwhich the Company has pledged RMBS. The following table summarizes theestimated fair value of RMBS pledged as collateral as of March 31, 2010and December 31, 2009 (amounts in thousands):

 
| ** **                                                                                                      | ** ** | **As of  March 31, 2010** | ** ** | **As of  December 31, 2009** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|---------------------------------------------|------------|
| Pledged as collateral for  borrowings under senior secured credit facility                                      |       | $                                        | 109,648    |                                        | $          | 42,627 |   |
| Pledged as collateral for  collateralized loan obligation secured notes and junior secured notes to  affiliates |       | 4,375                                    |       | 4,945                                       |       |
| Total                                                                                                           |       | $                                        | 114,023    |                                        | $          | 47,572 |   |

 

**Note 7.Deconsolidation of Residential Mortgage Loan Securitization Trusts**

 

OnJanuary 1, 2010, the Company deconsolidated six residential mortgagesecuritization trusts as a result of the Company’s adoption of new guidanceregarding the consolidation model for variable interest entities. The Companyhas no exposure to loss in excess of the estimated fair value of the $74.4million RMBS which were issued by these six residential mortgage securitizationtrusts (see Note 6 to these condensed consolidated financial statements).

 

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Thefollowing information represents the assets and liabilities removed from theCompany’s condensed consolidated balance sheet as of January 1, 2010 as aresult of the deconsolidation of the six residential mortgage loansecuritization trusts (amounts in thousands):

 
| ** **                                                                                     | ** ** | **As of  January 1, 2010** | ** **      |
|------------------------------------------------------------------------------------------------|------------|---------------------------------|-----------------|
| **Assets**                                                                                     |       |                            |            |
| Residential mortgage  loans, at estimated fair value (1)                                       |       | $                               | 2,023,333       |   |
| Real estate owned  (recorded within other assets on the condensed consolidated balance sheets) |       | 11,439                          |            |
| Interest receivable                                                                            |       | 4,529                           |            |
|                                                                                           |       | $                               |  2,039,301 |   |
|                                                                                           |       |                            |            |
| **Liabilities**                                                                                |       |                            |            |
| Residential  mortgage-backed securities issued, at estimated fair value                        |       | $                               | 2,034,772       |   |
| Accrued interest payable                                                                       |       | 4,529                           |            |
|                                                                                           |       | $                               |  2,039,301 |   |

 

----

(1)                                  Excludes $74.4million which represents the estimated fair value of the Company’s RMBS whichwere issued by the six residential mortgage loan securitization trusts thatwere deconsolidated under GAAP as of January 1, 2010.

 

Asa result of the deconsolidation of the six residential mortgage loan securitizationtrusts, all references to residential mortgage loans interest income, RMBSIssued interest expense, net realized and unrealized gain (loss) on residentialmortgage loans and RMBS Issued, and loan servicing expense relate to priorperiod balances and activities.

 

*Residential mortgage loans*

 

The Company carried its residential mortgage loansat estimated fair value with unrealized gains and losses reported in income. The Companyhad elected the fair value option for its residential mortgage loans for thepurpose of enhancing the transparency of its financial condition as fair valuewas consistent with how the Company managed the risks of its residentialmortgage investments.

 

As of December 31,2009, residential mortgage loans at estimated fair value, totaled $2.1 billion,which excluded real estate owned (“REO”) as a result of foreclosure ondelinquent loans of $11.4 million as of December 31, 2009. Loans weretransferred to REO at the lower of cost or fair value. REO was recorded withinother assets on the Company’s condensed consolidated balance sheets.

 

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

 
| ** **                                                                 | ** ** | **As of  December 31, 2009** | ** ** |
|----------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| Pledged as collateral for  borrowings under senior secured credit facility |       | $                                           | 74,366     |   |
| Pledged as collateral for  residential mortgage-backed securities issued   |       | 2,023,333                                   |       |
|                                                                       |       | $                                           | 2,097,699  |   |

 

The following is areconciliation of carrying amounts of residential mortgage loans for the yearended December 31, 2009 (amounts in thousands):

 
| ** **                                                            | ** ** | **2009** | ** ** |
|-----------------------------------------------------------------------|------------|----------|------------|
| Beginning balance                                                     |       | $        | 2,620,021  |   |
| Principal payments                                                    |       | (585,429 | )          |
| Transfers in to REO                                                   |       | (646     | )          |
| Net change in unrealized  and realized gain/loss and premium/discount |       | 63,753   |       |
| Ending balance                                                        |       | $        | 2,097,699  |   |

 

The following tablesummarizes the delinquency statistics of the residential mortgage loans,excluding REOs, as of December 31, 2009 (dollar amounts in thousands):

 
| ** **                  | ** ** | **December 31, 2009** | ** ** |
|-----------------------------|------------|---------------------------------|------------|
| **Delinquency Status** | ** ** | **Number  of Loans**       | ** ** | **Principal  Amount** | ** ** |
| 30 to 59 days               |       | 84                              |       | $ | 37,261 |   |
| 60 to 89 days               |       | 47                              |       | 19,389 |   |
| 90 days or more             |       | 138                             |       | 55,697 |   |
| In foreclosure              |       | 139                             |       | 57,497 |   |
| Total                       |       | 408                             |       | $ | 169,844 |   |

 

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As of December 31,2009, 26 of the residential mortgage loans owned by the Company with anoutstanding balance of $11.4 million were REOs as a result of foreclosure ondelinquent loans. As of December 31, 2009, the Company had 277 loans thatwere either 90 days or greater past due or in foreclosure and placed onnon-accrual status.

 

As of December 31,2009, the loss exposure or uncollected principal amount related to the Company’sdelinquent residential mortgage loans in the table above exceeded their fairvalue by $20.2 million.

 

*Residential mortgage-backedsecurities issued*

 

RMBS Issued consisted of thesenior tranches of six residential mortgage loan securitization trusts that theCompany previously consolidated under GAAP and for which the Company reportedthe debt issued by these trusts that it did not hold on its condensedconsolidated balance sheets. The Company carried RMBS Issued at estimated fairvalue with unrealized gains and losses reported in income. The Company electedthe fair value option for its RMBS Issued for thepurpose of enhancing the transparency of its financial condition as fair valuewas consistent with how the Company managed the risks of its residentialmortgage portfolio.

 

As of December 31,2009, RMBS Issued had an outstanding amount of $2.6 billion and an estimatedfair value of $2.0 billion. As of December 31, 2009, the weighted averagecoupon of the RMBS Issued was 2.3% and the weighted average years to maturitywere 25.8 years.

 

**Note 8.Borrowings**

 

Certain information withrespect to the Company’s borrowings as of March 31, 2010 is summarized inthe 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                   |       | $                           | 150,000    |                                   | 4.25       | %                                                          | 589        |                                       | $          | 615,165 |   |
| CLO 2005-1 senior secured  notes                  |       | 832,772                     |       | 0.57                                   |       | 2,583                                                      |       | 890,953                                    |       |
| CLO 2005-2 senior secured notes                   |       | 800,709                     |       | 0.57                                   |       | 2,797                                                      |       | 909,252                                    |       |
| CLO 2006-1 senior secured  notes                  |       | 683,265                     |       | 0.62                                   |       | 3,069                                                      |       | 892,338                                    |       |
| CLO 2007-1 senior secured  notes                  |       | 2,075,040                   |       | 0.80                                   |       | 4,063                                                      |       | 2,311,189                                  |       |
| CLO 2007-1 junior secured  notes to affiliates(2) |       | 314,015                     |       | —                                 |       | 4,063                                                      |       | 347,936                                    |       |
| CLO 2007-1 junior  secured notes(3)          |       | 64,121                      |       | —                                 |       | 4,063                                                      |       | 71,418                                     |       |
| CLO 2007-A senior secured  notes                  |       | 1,165,099                   |       | 1.14                                   |       | 2,755                                                      |       | 1,254,168                                  |       |
| CLO 2007-A junior secured  notes to affiliates(4) |       | 66,328                      |       | —                                 |       | 2,755                                                      |       | 71,398                                     |       |
| CLO 2007-A junior  secured notes(5)          |       | 10,860                      |       | —                                 |       | 2,755                                                      |       | 11,690                                     |       |
| Convertible senior notes                          |       | 343,303                     |       | 7.24                                   |       | 1,641                                                      |       | —                                     |       |
| Junior subordinated notes                         |       | 283,517                     |       | 5.40                                   |       | 9,718                                                      |       | —                                     |       |
| Total                                             |       | $                           | 6,789,029  |                                   |       |                                                       |       |                                       | $          | 7,375,507 |   |

 

----

| (1)    |   | Collateral for borrowings consists of RMBS, securities  available-for-sale, equity investments, at estimated fair value, private  equity investments, corporate loans and common stock warrants.                                                                                                                                                             |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                         |
| (2)    |   | CLO 2007-1 junior secured notes to affiliates consist of  (x) $183.7 million of mezzanine notes with a weighted average borrowing  rate of 5.3% and (y) $130.3 million of subordinated notes that do  not have a contractual coupon rate, but instead receive a pro rata  amount of the net distributions from CLO 2007-1.          |
|   |   |                                                                                                                                                                                                                                                                                                                                                         |
| (3)    |   | CLO 2007-1  junior secured notes consist of (x) $58.3 million of mezzanine  notes with a weighted average borrowing rate of 3.6% and  (y) $5.8 million of subordinated notes that do not have a  contractual coupon rate, but instead receive a pro rata amount of the  net distributions from CLO 2007-1.                |
|   |   |                                                                                                                                                                                                                                                                                                                                                         |
| (4)    |   | CLO 2007-A junior  secured notes to affiliates consist of (x) $55.8 million of  mezzanine notes with a weighted average borrowing rate of 6.4% and  (y) $10.5 million of subordinated notes that do not have a  contractual coupon rate, but instead receive a pro rata amount of the  net distributions from CLO 2007-A. |

 

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| (5) |   | CLO 2007-A  junior secured notes consist of (x) $6.3 million of mezzanine notes  with a weighted average borrowing rate of 6.9% and (y) $4.6 million  of subordinated notes that do not have a contractual coupon rate, but instead  receive a pro rata amount of the net distributions from CLO 2007-A. |
|-----|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

*CLO Notes*

 

The indentures governing theCompany’s CLO transactions include numerous compliance tests, the majority ofwhich relate to the CLO’s portfolio profile. In the event that a portfolioprofile test is not met, the indenture places restrictions on the ability ofthe CLO’s manager to reinvest available principal proceeds generated by thecollateral in the CLOs until the specific test has been cured. In addition tothe portfolio profile tests, the indentures for the CLO transactions includeover-collateralization tests (“OC Tests”) which set the ratio of the collateralvalue of the assets in the CLO to the tranches of debt for which the test isbeing measured, as well as interest coverage tests. If a CLO is not incompliance with an OC Test or an interest coverage test, cash flows normallypayable to the holders of junior classes of notes will be used by the CLO toamortize the most senior class of notes until such point as the OC test isbrought back into compliance. Due to the failure of OC Tests during the firstquarter of 2010, CLO 2007-1 senior secured notes were paid down by$90.3 million. As of March 31, 2010, all of the Company’s CLOtransactions were in compliance with their respective OC and interest coveragetests.

 

Due to the failure of OC Tests during 2009, CLO 2005-2 seniorsecured notes were paid down by $9.0 million, CLO 2006-1 senior secured noteswere paid down by $32.1 million, CLO 2007-1 senior secured notes were paid downby $149.5 million and CLO 2007-A senior secured notes were paid down by $56.1million.

 

During the threemonths ended March 31, 2010, in an open market auction, the Companypurchased $10.3 million of mezzanine notes issued by CLO 2007-A for $5.5million and $72.7 million of mezzanine and subordinate notes issued by CLO2007-1 for $38.8 million, both of which were previously held by an affiliate ofthe Company’s manager. These transactions resulted in the Company recordingan aggregate gain on extinguishment of debt totaling $38.7 million.

 

*SeniorSecured Credit Facility*

 

In February 2010, the Company paid down $25.0 million ofborrowings outstanding under its senior secured credit facility due 2011,reducing the amount outstanding from $175.0 million as of December 31,2009 to $150.0 million as of March 31, 2010. As of March 31, 2010,the Company believes it was in compliance with the senior secured creditfacility covenant requirements.

 

*ConvertibleDebt*

 

During January and February 2010, the Company repurchased$95.2 million par amount of its 7.0% convertible senior notes maturing on July 15,2012 (the “7.0% Notes”), reducing the amount outstanding from$275.8 million as of December 31, 2009 to $180.6 million as of March 31,2010. These transactions resulted in the Company recording a gain of $1.3million, which was partially offset by a write-off of $0.6 million ofunamortized debt issuance costs during the first quarter of 2010.

 

On January 15, 2010, the Company issued $172.5 million of7.5% Convertible Senior Notes due January 15, 2017 (“7.5% Notes”). The7.5% Notes bear interest at a rate of 7.5% per annum on the principal amount,accruing from January 15, 2010. Interest is payable semiannually inarrears 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 previouslyredeemed, repurchased or converted in accordance with their terms prior to suchdate. Holders of the 7.5% Notes may convert their notes at the applicableconversion rate at any time prior to the close of business on the business dayimmediately preceding the stated maturity date subject to the Company’s rightto terminate the conversion rights of the notes. The Company may satisfy itsobligation with respect to the 7.5% Notes tendered for conversion by deliveringto the holder either cash, common shares, no par value, issued by the Companyor a combination thereof. The initial conversion rate for each $1,000 principalamount of 7.5% Notes is 122.2046 shares, which is equivalent to an initialconversion price of approximately $8.18 per share. The conversion rate may beadjusted under certain circumstances, including the occurrence of certainfundamental change transactions and the payment of a quarterly cashdistribution in excess of $0.05 per share, but will not be adjusted for accruedand unpaid interest on the 7.5% Notes. Net proceeds from the offering totaled$167.3 million, reflecting $172.5 million from the issuance less$5.2 million for underwriting fees.

 

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Inaccordance with accounting for convertible debt instruments that may settled incash upon conversion, the Company separately accounted for the liability andequity components to reflect the nonconvertible debt borrowing rate. TheCompany determined that the equity component of the 7.5% Notes totaled $10.0million and is included in paid-in-capital on the Company’s condensedconsolidated balance sheet as of March 31, 2010. The remaining liabilitycomponent of $162.7 million, included within convertible senior notes on theCompany’s condensed consolidated balance sheet as of March 31, 2010, iscomprised of the principal $172.5 million less the unamortized debt discount of$9.8 million. The total debt discount amortization recognized for the threemonths ended March 31, 2010 was $0.2 million. The debt discount willcontinue to be amortized at the effective interest rate of 8.6%. For the threemonths ended March 31, 2010, the total interest expense recognized on the7.5% Notes was $2.7 million.

 

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        |                                       | $          | 739,640 |   |
| CLO 2005-1 senior secured  notes                  |       | 832,622                     |       | 0.61                                   |       | 2,673                                                      |       | 868,291                                    |       |
| CLO 2005-2 senior secured  notes                  |       | 800,504                     |       | 0.58                                   |       | 2,887                                                      |       | 859,457                                    |       |
| CLO 2006-1 senior secured  notes                  |       | 683,266                     |       | 0.63                                   |       | 3,159                                                      |       | 858,317                                    |       |
| CLO 2007-1 senior secured  notes                  |       | 2,176,805                   |       | 0.82                                   |       | 4,153                                                      |       | 2,337,779                                  |       |
| CLO 2007-1 junior secured  notes to affiliates(3) |       | 437,730                     |       | —                                 |       | 4,153                                                      |       | 468,422                                    |       |
| CLO 2007-1 junior  secured notes(4)          |       | 14,185                      |       | —                                 |       | 4,153                                                      |       | 15,237                                     |       |
| CLO 2007-A senior secured  notes                  |       | 1,157,209                   |       | 1.16                                   |       | 2,845                                                      |       | 1,137,077                                  |       |
| CLO 2007-A junior secured  notes to affiliates(5) |       | 96,056                      |       | —                                 |       | 2,845                                                      |       | 94,505                                     |       |
| CLO 2007-A junior  secured notes(6)          |       | 3,125                       |       | —                                 |       | 2,845                                                      |       | 3,074                                      |       |
| Convertible 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.                                                                                                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                                           |
| (3)    |   | CLO 2007-1  junior secured notes to affiliates consist of (x) $256.9 million of  mezzanine notes with a weighted average borrowing rate of 5.2% and  (y) $180.8 million of subordinated notes that do not have a  contractual coupon rate, but instead receive a pro rata amount of the  net distributions from CLO 2007-1. |
|   |   |                                                                                                                                                                                                                                                                                                                                                           |
| (4)    |   | CLO 2007-1  junior secured notes consist of (x) $8.4 million of mezzanine notes  with a weighted average borrowing rate of 5.2% and (y) $5.8 million  of subordinated notes that do not have a contractual coupon rate, but instead  receive a pro rata amount of the net distributions from CLO 2007-1.                    |
|   |   |                                                                                                                                                                                                                                                                                                                                                           |
| (5)    |   | CLO 2007-A  junior secured notes to affiliates consist of (x) $81.5 million of  mezzanine notes with a weighted average borrowing rate of 6.5% and  (y) $14.6 million of subordinated notes that do not have a  contractual coupon rate, but instead receive a pro rata amount of the  net distributions from CLO 2007-A.   |
|   |   |                                                                                                                                                                                                                                                                                                                                                           |
| (6)    |   | CLO 2007-A  junior secured notes consist of (x) $2.6 million of mezzanine notes  with a weighted average borrowing rate of 6.5% and (y) $0.5 million  of subordinated notes that do not have a contractual coupon rate, but instead  receive a pro rata amount of the net distributions from CLO 2007-A.                    |

 

**Note 9.Derivative Financial Instruments**

 

The Company enters intoderivative transactions in order to hedge its interest rate risk exposure tothe effects of interest rate changes. Additionally, the Company enters intoderivative transactions in the course of its portfolio management activities.The counterparties to the Company’s derivative agreements are major financialinstitutions with which the Company and its affiliates may also have otherfinancial relationships. In the event of nonperformance by the counterparties,the Company is potentially exposed to losses. The counterparties to the Company’sderivative agreements have investment grade ratings and, as a result, theCompany does not anticipate that any of the counterparties will fail to fulfilltheir obligations.

 

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**Cash FlowHedges**

 

The Company uses interestrate derivatives consisting of swaps to hedge a portion of the interest raterisk associated with its borrowings under CLO senior secured notes. The Companydesignates these financial instruments as cash flow hedges.

 

**Free-StandingDerivatives**

 

Free-standing derivativesare derivatives that the Company has entered into in conjunction with itsinvestment and risk management activities, but for which the Company has notdesignated the derivative contract as a hedging instrument for accountingpurposes. Such derivative contracts may include credit default swaps (“CDS”),foreign exchange contracts, and interest rate derivatives. Free-standingderivatives also include investment financing arrangements (total rate ofreturn swaps) whereby the Company receives the sum of all interest, fees andany positive change in fair value amounts from a reference asset with aspecified notional amount and pays interest on such notional amount plus anynegative change in fair value amounts from such reference asset.

 

The table below summarizesthe aggregate notional amount and estimated net fair value of the derivativeinstruments as of March 31, 2010 and December 31, 2009 (amounts inthousands):

 
| ** **                                 | ** ** | **As of March 31, 2010** | ** ** | **As of December 31, 2009** | ** ** |
|--------------------------------------------|------------|----------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                 | ** ** | **Notional**                                 | ** ** | **Estimated  Fair Value**                  | ** ** | **Notional** | ** ** | **Estimated  Fair Value** | ** ** |
| **Cash Flow Hedges:**                      |       |                                         |       |                                            |       |   |   |   |   |
| Interest rate swaps                        |       | $                                            | 383,333    |                                            | $          | (48,705 | ) | $ | 383,333 |   | $ | (43,800 | ) |
| **Free-Standing Derivatives:**             |       |                                         |       |                                            |       |   |   |   |   |
| Interest rate swaps                        |       | 83,965                                       |       | (641                                            | )          | 89,246 |   | (281 | ) |
| Credit default  swaps—protection sold |       | 51,000                                       |       | 225                                             |       | 51,000 |   | (385 | ) |
| Total rate of return swaps                 |       | —                                       |       | 228                                             |       | 104,446 |   | 11,809 |   |
| Common stock warrants                      |       | —                                       |       | 198                                             |       | — |   | 2,471 |   |
| Total                                      |       | $                                            | 518,298    |                                            | $          | (48,695 | ) | $ | 628,025 |   | $ | (30,186 | ) |

 

A CDS is a contract inwhich the contract buyer pays, in the case of a short position, or receives, inthe case of long position, a periodic premium until the contract expires or acredit event occurs. In return for this premium, the contract seller receives apayment from or makes a payment to the buyer if there is a credit default orother specified credit event with respect to the issuer (also known as thereferenced entity) of the underlying credit instrument referenced in the CDS.Typical credit events include bankruptcy, dissolution or insolvency of thereferenced entity, failure to pay and restructuring of the obligations of thereferenced entity.

 

Asof March 31, 2010 and December 31, 2009, the Company had sold protection with a notionalamount of approximately $51.0 million. The Company sells protection toreplicate fixed income securities and to complement the spot market when cashsecurities of the referenced entity of a particular maturity are not availableor when the derivative alternative is less expensive compared to otherpurchasing alternatives.

 

The following table shows the net realized gains (losses) on theCompany’s CDS for the three months ended March 31, 2010 and 2009 (amountsin thousands):

 
| ** **                  | ** ** | **Three months ended  March 31, 2010** | ** ** | **Three months ended  March 31, 2009** | ** ** |
|-----------------------------|------------|---------------------------------------------|------------|---------------------------------------------|------------|
| Gross  realized gains       |       | $                                           | —     |                                        | $          | 58,922 |   |
| Gross realized losses       |       | —                                      |       | (996                                        | )          |
| Net realized gains (losses) |       | $                                           | —     |                                        | $          | 57,926 |   |

 

For all hedges where hedgeaccounting is being applied, effectiveness testing and other procedures toensure the ongoing validity of the hedges are performed at least quarterly.During the three months ended March 31, 2010 and 2009, the Companyrecognized an immaterial amount of ineffectiveness in income on the condensedconsolidated statements of operations from its cash flow hedges.

 

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Note 8 to these condensed consolidated financial statementsdescribes the Company’s borrowings under which the Company has pledged warrantsfor borrowings. The following table summarizes the estimated fair value ofwarrants pledged as collateral as of March 31, 2010 and December 31,2009 (amounts in thousands):

 
| ** **                                                                                                     | ** ** | **As of  March 31, 2010** | ** ** | **As of  December 31, 2009** | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|-----------------------------------|------------|
| Pledged as collateral for borrowings under senior  secured credit facility                                     |       | $                              | 198        |                              | $          | 1,078 |   |
| Pledged as collateral for collateralized loan  obligation secured notes and junior secured notes to affiliates |       | —                         |       | 1,393                             |       |
| Total                                                                                                          |       | $                              | 198        |                              | $          | 2,471 |   |

 

**Note 10.Accumulated Other Comprehensive Income**

 

The components of accumulatedother comprehensive income were as follows (amounts in thousands):

 
| ** **                                             | ** ** | **As of  March 31, 2010** | ** ** | **As of  December 31, 2009** | ** ** |
|--------------------------------------------------------|------------|------------------------------------------|------------|---------------------------------------------|------------|
| Net unrealized gains on  available-for-sale securities |       | $                                        | 216,913    |                                        | $          | 194,336 |   |
| Net unrealized losses on  cash flow hedges             |       | (46,500                                  | )          | (41,608                                     | )          |
| Accumulated other  comprehensive income                |       | $                                        | 170,413    |                                        | $          | 152,728 |   |

 

The components of changes inother comprehensive income were as follows (amounts in thousands):

 
| ** **                                                                 | ** ** | **Three months ended  March 31, 2010** | ** ** | **Three months ended  March 31, 2009** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------------------------------------------|------------|------------------------------------------------------------|------------|
| Unrealized gains on  securities available-for-sale:                        |       |                                                       |       |                                                       |       |
| Unrealized holding gains  arising during period                            |       | $                                                          | 30,107     |                                                       | $          | 28,946 |   |
| Reclassification  adjustments for (gains) losses realized in net income(1) |       | (7,530                                                     | )          | 4,861                                                      |       |
| Unrealized gains on  securities available-for-sale                         |       | 22,577                                                     |       | 33,807                                                     |       |
| Unrealized (losses) gains  on cash flow hedges                             |       | (4,892                                                     | )          | 9,047                                                      |       |
| Other comprehensive income                                                 |       | $                                                          | 17,685     |                                                       | $          | 42,854 |   |

 

----

| (1) |   | Excludes an impairment  charge of $1.1 million and $33.8 million for investments which were  determined to be other-than-temporary for the three months ended  March 31, 2010 and 2009, respectively. |
|-----|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

**Note 11.Commitments and Contingencies**

 

***Loan Commitments***

 

As part of its strategy of investing in corporateloans, the Company commits to purchase interests in primary market loansyndications, which obligate the Company to acquire a predetermined interest insuch loans at a specified price on a to-be-determined settlement date.Consistent with standard industry practices, once the Company has been informedof the amount of its syndication allocation in a particular loan by thesyndication agent, the Company bears the risks and benefits of changes in thefair value of the syndicated loan from that date forward. As of March 31,2010, the Company had committed to purchase corporate loans with aggregatecommitments totaling $250.8 million. In addition, the Company participates in certaincontingent financing arrangements, whereby the Company is committed to providefunding of up to a specific amount at the discretion of the borrower. As of March 31,2010, the Company had unfunded financing commitments totaling$42.0 million. The Company does not expect material losses related tothose corporate loans for which it committed to purchase and fund.

 

***Contingencies***

 

On July 10, 2009, the Company surrendered for cancellation,without consideration, approximately $64.0 million of mezzanine notesissued 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 CLO2006-1 (the “2006-1 Notes”), as well as certain other notes issued to theCompany by another CLO. The surrendered notes were cancelled by the trusteeunder the applicable indenture, and the obligations due under such surrenderednotes were deemed extinguished.

 

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Holders constituting a majority of the controlling class of seniornotes of CLO 2005-2 (the “2005-2 Noteholders”) notified the related trustee ofpurported defaults under the indentures related to the surrender of the 2005-2Notes. The Company announced on November 29, 2009 that it reached anagreement on November 23, 2009 with the 2005-2 Noteholders pursuant towhich the 2005-2 Noteholders have agreed, subject to the terms and conditionsof the agreement, not to challenge the July 2009 surrender forcancellation transaction. In exchange, the Company has agreed to certainarrangements, including, among other things, to refrain from undertaking acomparable surrender for cancellation, of any other mezzanine notes or juniornotes issued to it by CLO 2005-2. In addition, the Company has agreed with the2005-2 Noteholders that, for so long as no legal action or similar challenge isbrought to the Company’s prior surrender of notes in any of its CLOtransactions, the Company will not undertake a comparable surrender forcancellation, without consideration, of any mezzanine notes or junior notesissued to it by CLO 2005-1, CLO 2006-1, CLO 2007-1 or CLO 2007-A.

 

In addition, during the first quarter of 2010, certain holders of thesenior notes of CLO 2006-1 (the “2006-1 Noteholders”) notified the relatedtrustee of purported defaults under the indenture related to the surrender ofthe 2006-1 Notes. The Company does not believe based on discussions withcounsel that an event of default has occurred and is engaged in discussionswith the 2006-1 Noteholders to resolve this matter. Accordingly, the Companydoes not believe that this matter will have a material effect on its financialcondition.

 

The parent company of the Managerrecently furnished information to the SEC, in response to an examination lettersent to a number of investment advisers in the structured credit productsector, regarding its trading procedures and valuation practices in thecollateral pools of CLOs for which it acts as collateral manager.

 

The Company has been named as a party in various legal actions whichinclude the matters described below. It is inherently difficult to predict theultimate outcome, particularly in cases in which claimants seek substantial orunspecified damages, or where investigations or proceedings are at an earlystage and the Company cannot predict with certainty the loss or range of lossthat may be incurred. The Company has denied, or believes it has a meritoriousdefense and will deny liability in the significant cases pending against theCompany discussed below. Based on current discussion and consultation with counsel,management believes that the resolution of these matters will not have amaterial impact on the Company’s condensed consolidated financial statements.

 

On August 7, 2008, the members of the Company’s board of directorsand certain of its current and former executive officers and the Company werenamed in a putative class action complaint filed by Charter Township of ClintonPolice and Fire Retirement System in the United States District Court for theSouthern District of New York, or the Charter Litigation. On March 13,2009, the lead plaintiff filed an amended complaint, which deleted asdefendants the members of the Company’s board of directors and named asdefendants only the Company’s former chief executive officer Saturnino S.Fanlo, the Company’s former chief operating officer David A. Netjes, theCompany’s current chief financial officer Jeffrey B. Van Horn and the Company.The amended complaint alleges that the Company’s April 2, 2007registration statement and prospectus and the financial statements incorporatedtherein contained material omissions in violation of Section 11 of theSecurities Act, regarding the risks and potential losses associated with theCompany’s real estate-related assets, the Company’s ability to finance its realestate-related assets and the adequacy of the Company’s loss reserves for itsreal estate-related assets. The amended complaint further alleges that,pursuant to Section 15 of the Securities Act, Messrs. Fanlo, Netjesand Van Horn each have legal responsibility for the alleged Section 11violation. On April 27, 2009, the defendants filed a motion to dismiss theamended complaint for failure to state a claim under the Securities Act.

 

On August 15, 2008, the members of the Company’s board ofdirectors and its executive officers (collectively, the “Kostecka IndividualDefendants”) were named in a shareholder derivative action brought by RaymondW. Kostecka, a purported shareholder, in the Superior Court of California,County of San Francisco (the “California Derivative Action”). The Company wasnamed as a nominal defendant. The complaint in the California Derivative Actionasserts claims against the Kostecka Individual Defendants for breaches offiduciary duty, abuse of control, gross mismanagement, waste of corporate assets,and unjust enrichment in connection with the conduct at issue in the CharterLitigation, including the filing of the Company’s April 2, 2007registration statement with alleged material misstatements and omissions. Byorder dated January 8, 2009, the Court approved the parties’ stipulationto stay the proceedings in the California Derivative Action until the CharterLitigation is dismissed on the pleadings or the Company files an answer to theCharter Litigation.

 

On March 23, 2009, the members of the Company’sboard of directors and certain of its executive officers (collectively, the “HaleyIndividual Defendants”) were named in a shareholder derivative action broughtby Paul B. Haley, a purported shareholder, in the United States District Courtfor the Southern District of New York (the “New York Derivative Action”). TheCompany was named as a nominal defendant. The complaint in the New YorkDerivative Action asserts claims against the Haley Individual Defendants forbreaches of fiduciary duty, breaches of the duty of full disclosure, and forcontribution in connection with the conduct at issue in the Charter Litigation,including the filing of the Company’s April 2, 2007 registration statementwith alleged material misstatements and omissions. By order dated June 18,2009, the Court approved the parties’ stipulation to stay the proceedings inthe New York Derivative Action until the Charter Litigation is dismissed on thepleadings or the Company files an answer to the Charter Litigation.

 

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**Note 12. Share Options and Restricted Shares**

 

On May 4, 2007, the Company adopted an amended and restated shareincentive plan (the “2007 Share Incentive Plan”) that provides for the grant ofqualified incentive common share options that meet the requirements of Section 422of the Code, non-qualified common share options, share appreciation rights,restricted common shares and other share-based awards. The CompensationCommittee of the board of directors administers the plan. Share options andother share-based awards may be granted to the Manager, directors, officers andany key employees of the Manager and to any other individual or entityperforming services for the Company.

 

The exercise price for any share option granted under the 2007 ShareIncentive Plan may not be less than 100% of the fair market value of the commonshares at the time the common share option is granted. Each option to acquire acommon share must terminate no more than ten years from the date it is granted.As of March 31, 2010, the 2007 Share Incentive Plan authorizes a total of8,464,625 shares that may be used to satisfy awards under the 2007 Share IncentivePlan.

 

The following table summarizes restricted common share transactions:

 
| ** **                                      | ** ** | **Manager** | ** ** | **Directors** | ** ** | **Total** | ** ** |
|-------------------------------------------------|------------|-------------|------------|---------------|------------|-----------|------------|
| **Unvested shares as of January 1,  2010** |       | 1,097,000   |       | 255,618       |       | 1,352,618 |       |
| Issued                                          |       | —      |       | —        |       | —    |       |
| Vested                                          |       | —      |       | —        |       | —    |       |
| Cancelled                                       |       | —      |       | —        |       | —    |       |
| Forfeited                                       |       | —      |       | —        |       | —    |       |
| **Unvested shares as of March 31,  2010**  |       | 1,097,000   |       | 255,618       |       | 1,352,618 |       |

 

The Company is required to value any unvested restricted common sharesgranted to the Manager at the current market price. The Company valued theunvested restricted common shares granted to the Manager at $8.21 and $0.88 pershare at March 31, 2010 and March 31, 2009, respectively. There were$3.3 million and $1.0 million of total unrecognized compensation costsrelated to unvested restricted common shares granted as of March 31, 2010and 2009, respectively. These costs are expected to be recognized over threeyears from the date of grant.

 

The following table summarizes common share option transactions:

 
| ** **                                  | ** ** | **Number of  Options** | ** ** | **Weighted-Average  Exercise Price** | ** ** |
|---------------------------------------------|------------|-----------------------------|------------|-------------------------------------------|------------|
| **Outstanding as of January 1,  2010** |       | 1,932,279                   |       | $                                         | 20.00      |   |
| Granted                                     |       | —                      |       | —                                    |       |
| Exercised                                   |       | —                      |       | —                                    |       |
| Forfeited                                   |       | —                      |       | —                                    |       |
| **Outstanding as of March 31,  2010**  |       | 1,932,279                   |       | $                                         | 20.00      |   |

 

As of March 31, 2010 and December 31, 2009, 1,932,279 commonshare options were exercisable. As of March 31, 2010, the common shareoptions were fully vested and expire in August 2014. For the three monthsended March 31, 2010 and 2009, the components of share-based compensationexpense are as follows (amounts in thousands):

 
| ** **                                     | ** ** | **For the three  months ended  March 31, 2010** | ** ** | **For the three  months ended  March 31, 2009** | ** ** |
|------------------------------------------------|------------|--------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|
| Restricted shares granted to Manager           |       | $                                                                        | 2,392      |                                                                     | $          | (140 | ) |
| Restricted shares granted to certain directors |       | 502                                                                 |       | 137                                                                      |       |
| Total share-based compensation expense         |       | $                                                                        | 2,894      |                                                                     | $          | (3 | ) |

 

**Note 13. Management Agreement and Related PartyTransactions**

 

The Manager manages the Company’s day-to-day operations, subject to thedirection and oversight of the Company’s board of directors. The ManagementAgreement expires on December 31 of each year, but is automaticallyrenewed for a one-year term each December 31 unless terminated upon theaffirmative 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 commonshares, based upon (1) unsatisfactory performance by the Manager that ismaterially detrimental to the Company or (2) a determination that themanagement fee payable by the Manager is not fair, subject to the Manager’sright to prevent such a termination under this clause (2) byaccepting a mutually acceptable reduction of management fees. The Manager mustbe provided 180 days prior notice of any such termination and will be paida termination fee equal to four times the sum of the average annual basemanagement fee and the average annual incentive fee for the two 12-monthperiods immediately preceding the date of termination, calculated as of the endof the most recently completed fiscal quarter prior to the date of termination.

 

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The Management Agreement contains certain provisions requiring theCompany to indemnify the Manager with respect to all losses or damages arisingfrom acts not constituting bad faith, willful misconduct, or gross negligence.The Company has evaluated the impact of these guarantees on its condensedconsolidated financial statements and determined that they are not material.

 

For the three months ended March 31, 2010, the Company incurred$4.2 million in base management fees. In addition, the Companyrecognized share-based compensation expense related to restricted common sharesgranted to the Manager of $2.4 million for the three months ended March 31,2010 (see Note 12 to these condensed consolidated financial statements). For the threemonths ended March 31, 2009, the Company incurred $3.6 million in basemanagement fees. In addition, the Company recognized share-based compensationexpense related to restricted common shares granted to the Manager of $(0.1)million for the three months ended March 31, 2009 (see Note 12 to these condensedconsolidated financial statements).

 

Base management fees incurred and share-based compensation expenserelating to common share options and restricted common shares granted to theManager are included in related party management compensation on the condensedconsolidated statements of operations. Expenses incurred by the Manager andreimbursed by the Company are reflected in the respective condensedconsolidated statements of operations, non-investment expense category based onthe 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 sharerights offering that occurred during the third quarter of 2007 until such timeas the Company’s common share closing price on the NYSE is $20.00 or more forfive consecutive trading days. Accordingly, the Manager permanently waivedapproximately $2.2 million of base management fees during each of the threemonths ended March 31, 2010 and 2009.

 

Duringthe three months ended March 31, 2010, the Manager earned $22.2 million ofincentive fees. Of this amount, the Manager permanently waived payment of $9.7million of incentive fees that were related to the $38.7 million gainrecorded by the Company as a result of the repurchase of $83.0 million ofmezzanine and subordinate notes issued by CLO 2007-1 and CLO 2007-A during thequarter ended March 31, 2010. The remaining $12.5 million, representingthe incentive fee net of the amount waived, is included in related partymanagement compensation on the Company’s condensed consolidated statement ofoperations for the quarter ended March 31, 2010 and is due and payable tothe Manager as of that date.

 

An affiliate of the Manager has entered into separate managementagreements with the respective investment vehicles for CLO 2005-1,CLO 2005-2, CLO 2006-1, CLO 2007-1, CLO 2007-A and CLO2009-1 and is entitled to receive fees for the services performed as collateralmanager.  Previously, the collateralmanager had waived the fees it earned for providing management services for theCompany’s CLOs. Beginning April 15, 2007, the collateral manager ceasedwaiving fees for CLO 2005-1 and beginning January 1, 2009, thecollateral manager ceased waiving fees for CLO 2005-2, CLO 2006-1,CLO 2007-1, CLO 2007-A and Wayzata Funding LLC (restructured andreplaced with CLO 2009-1 on March 31, 2009). Beginning in July 2009,the collateral manager reinstated waiving the CLO management fees for CLO 2005-2and CLO 2006-1. In addition, due to CLO 2007-A and CLO 2007-1 regainingcompliance with their respective OC Tests during the first quarter of 2010, thecollateral manager also reinstated waiving the CLO management fees for CLO2007-A and CLO 2007-1. For the three months ended March 31, 2010, thecollateral manager waived an aggregate of $4.5 million for CLO 2005-2, CLO2006-1 and CLO 2007-A. In addition, due to the deleveraging of CLO 2009-1completed in July 2009 whereby all the senior notes were retired, thecollateral manager is no longer entitled to receive management fees from CLO2009-1. The Company recorded an expense for CLO management fees of$1.4 million and $7.7 million for the quarters ended March 31,2010 and 2009, respectively.

 

In addition, beginning January 1, 2009, the Manager permanentlywaived reimbursable general and administrative expenses allocable to theCompany in an amount equal to the incremental CLO management fees received bythe Manager. For the three months ended March 31, 2010 and 2009, theManager permanently waived reimbursement of $1.3 million and $2.3 millionin allocable general and administrative expenses, respectively.

 

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The Company has invested in corporate loans, debt securities and otherinvestments of entities that are affiliates of KKR. As of March 31, 2010,the aggregate par amount of these affiliated investments totaled$2.5 billion, or approximately 31% of the total investment portfolio, andconsisted of 24 issuers. The total $2.5 billion in affiliated investmentswere primarily comprised of $2.1 billion of corporate loans and $415.2 millionof corporate debt securities available-for-sale. 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, andconsisted of 21 issuers. The total $2.8 billion in investments werecomprised of $2.3 billion of corporate loans, $466.0 million ofcorporate debt securities available for sale, and $61.8 million notionalamount of total rate of return swaps referenced to corporate loans issued byaffiliates of KKR (included in derivative assets and liabilities on thecondensed consolidated balance sheet).

 

**Note 14. Fair Value of Financial Instruments**

 

**Fair Value of Financial Instruments**

 

The fair value of certain instruments including securitiesavailable-for-sale, corporate loans, derivatives, and loan commitments is basedon quoted market prices or estimates provided by independent pricing sources.The fair value of cash and cash equivalents, interest receivable, seniorsecured credit facility and interest payable, approximates cost as of March 31,2010 and December 31, 2009, due to the short-term nature of theseinstruments.

 

The table below discloses the carrying value and the estimated fairvalue of the Company’s financial instruments as of March 31, 2010 and December 31,2009 (amounts in thousands):

 
| ** **                                                                                                                                       | ** ** | **As of March 31, 2010** | ** ** | **As of December 31, 2009** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                                                                                       | ** ** | **Carrying  Amount**                         | ** ** | **Estimated Fair  Value**                  | ** ** | **Carrying  Amount** | ** ** | **Estimated Fair  Value** | ** ** |
| Financial Assets:                                                                                                                                |       |                                         |       |                                            |       |   |   |   |   |
| Cash, restricted cash, and cash equivalents                                                                                                      |       | $                                            | 621,827    |                                            | $          | 621,827 |   | $ | 439,792 |   | $ | 439,792 |   |
| Securities available-for-sale                                                                                                                    |       | 829,691                                      |       | 829,691                                         |       | 755,686 |   | 755,686 |   |
| Corporate loans, net of allowance for loan losses  of $216,080, and $237,308 as of March 31, 2010 and December 31,  2009, respectively |       | 5,691,751                                    |       | 5,743,517                                       |       | 5,617,925 |   | 5,459,273 |   |
| Corporate loans held for sale                                                                                                                    |       | 733,072                                      |       | 753,611                                         |       | 925,718 |   | 954,350 |   |
| Residential mortgage-backed securities                                                                                                           |       | 114,023                                      |       | 114,023                                         |       | 47,572 |   | 47,572 |   |
| Residential mortgage loans                                                                                                                       |       | —                                       |       | —                                          |       | 2,097,699 |   | 2,097,699 |   |
| Equity investments, at estimated fair value                                                                                                      |       | 63,488                                       |       | 63,488                                          |       | 120,269 |   | 120,269 |   |
| Interest and principal receivable                                                                                                                |       | 64,221                                       |       | 64,221                                          |       | 98,313 |   | 98,313 |   |
| Derivative assets                                                                                                                                |       | 1,303                                        |       | 1,303                                           |       | 15,784 |   | 15,784 |   |
| Reverse repurchase agreements                                                                                                                    |       | —                                       |       | —                                          |       | 80,250 |   | 80,250 |   |
| Private equity investments, at cost                                                                                                              |       | 17,505                                       |       | 24,958                                          |       | 17,505 |   | 24,658 |   |
|                                                                                                                                             |       |                                         |       |                                            |       |   |   |   |   |
| Financial Liabilities:                                                                                                                           |       |                                         |       |                                            |       |   |   |   |   |
| Collateralized loan obligation secured notes                                                                                                     |       | $                                            | 5,631,866  |                                            | $          | 5,155,656 |   | $ | 5,667,716 |   | $ | 4,775,364 |   |
| Collateralized loan obligation junior secured  notes to affiliates                                                                               |       | 380,343                                      |       | 236,007                                         |       | 533,786 |   | 221,755 |   |
| Senior secured credit facility                                                                                                                   |       | 150,000                                      |       | 150,000                                         |       | 175,000 |   | 175,000 |   |
| Convertible senior notes                                                                                                                         |       | 343,303                                      |       | 395,910                                         |       | 275,800 |   | 259,252 |   |
| Junior subordinated notes                                                                                                                        |       | 283,517                                      |       | 255,520                                         |       | 283,517 |   | 238,154 |   |
| Residential  mortgage-backed securities issued                                                                                                   |       | —                                       |       | —                                          |       | 2,034,772 |   | 2,034,772 |   |
| Accounts payable, accrued expenses and other  liabilities                                                                                        |       | 83,768                                       |       | 83,768                                          |       | 7,240 |   | 7,240 |   |
| Accrued interest payable                                                                                                                         |       | 16,597                                       |       | 16,597                                          |       | 25,297 |   | 25,297 |   |
| Accrued interest payable to affiliates                                                                                                           |       | 2,150                                        |       | 2,150                                           |       | 2,911 |   | 2,911 |   |
| Related party payable                                                                                                                            |       | 14,827                                       |       | 14,827                                          |       | 3,367 |   | 3,367 |   |
| Securities  sold, not yet purchased                                                                                                              |       | —                                       |       | —                                          |       | 77,971 |   | 77,971 |   |
| Derivative liabilities                                                                                                                           |       | 49,998                                       |       | 49,998                                          |       | 45,970 |   | 45,970 |   |

 

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**Fair Value Measurements**

 

Thefollowing table presents information about the Company’s assets and liabilities(including derivatives that are presented net) measured at fair value on arecurring basis as of March 31, 2010, and indicates the fair valuehierarchy of the valuation techniques utilized by the Company to determine suchfair 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  March 31, 2010** | ** ** |
|----------------------------------------------|------------|-----------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|-------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                                   | ** ** | ** **                                                                                          | ** ** | ** **                                                         | ** ** | ** **                                            | ** ** | ** **                                            | ** ** |
| **Assets:**                                  | ** ** | ** **                                                                                          | ** ** | ** **                                                         | ** ** | ** **                                            | ** ** | ** **                                            | ** ** |
| Securities available-for-sale                |       | $                                                                                                   | —     |                                                               | $          | 761,083                                               |       | $                                                     | 68,608     |   | $ | 829,691 |   |
| Residential mortgage-backed securities       |       | —                                                                                              |       | —                                                             |       | 114,023                                               |       | 114,023                                               |       |
| Equity investments, at estimated fair value  |       | —                                                                                              |       | 41,789                                                             |       | 21,699                                                |       | 63,488                                                |       |
| Credit default swaps —  protection sold |       | —                                                                                              |       | 225                                                                |       | —                                                |       | 225                                                   |       |
| Total rate of return swaps                   |       | —                                                                                              |       | —                                                             |       | 228                                                   |       | 228                                                   |       |
| Common stock warrants                        |       | —                                                                                              |       | —                                                             |       | 198                                                   |       | 198                                                   |       |
| Total                                        |       | $                                                                                                   | —     |                                                               | $          | 803,097                                               |       | $                                                     | 204,756    |   | $ | 1,007,853 |   |
| ** **                                   | ** ** | ** **                                                                                          | ** ** | ** **                                                         | ** ** | ** **                                            | ** ** | ** **                                            | ** ** |
| **Liabilities:**                             | ** ** | ** **                                                                                          | ** ** | ** **                                                         | ** ** | ** **                                            | ** ** | ** **                                            | ** ** |
| Cash  flow interest rate swaps               |       | $                                                                                                   | —     |                                                               | $          | (48,705                                               | )          | $                                                     | —     |   | $ | (48,705 | ) |
| Free-standing interest  rate swaps           |       | —                                                                                              |       | —                                                             |       | (641                                                  | )          | (641                                                  | )          |
| Total                                        |       | $                                                                                                   | —     |                                                               | $          | (48,705                                               | )          | $                                                     | (641       | ) | $ | (49,346 | ) |

 

There were no transfers between levels 1 and 2 during the three monthsended March 31, 2010.

 

The following table presents information about the Company’s assetsmeasured at fair value on a non-recurring basis as of March 31, 2010, andindicates the fair value hierarchy of the valuation techniques utilized by theCompany to determine such fair value (amounts in thousands). There were noliabilities 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  March 31, 2010** | ** ** |
|---------------------|------------|-----------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|-------------------------------------------------------|------------|
| Loans held for sale |       | $                                                                                                   | —     |                                                               | $          | 210,788                                                   |       | $                                                     | —     |   | $ | 210,788 |   |
|                     |            |                                                                                                     |            |                                                                    |            |                                                           |            |                                                       |            |  |  |  |  |

 

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(1)          As of March 31, 2010,total loans held for sale had a carrying value of $733.1 million of which$210.8 million was carried at estimated fair value and the remaining$522.3 million carried at amortized cost. The $210.8 million carriedat estimated fair value was classified as level 2 given that the assetswere valued using quoted prices and other observable inputs in an activemarket.

 

Thefollowing table presents information about the Company’s assets and liabilities(including derivatives that are presented net) measured at fair value on arecurring basis as of December 31, 2009, and indicates the fair valuehierarchy of the valuation techniques utilized by the Company to determine suchfair 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, 2009** | ** ** |
|-----------------------------------------------|------------|----------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|------------------------------------------------------|------------|-------------------------------------------|------------|
| **Assets:**                                   | ** ** | ** **                                                                 | ** ** | ** **                                               | ** ** | ** **                                           | ** ** | ** **                                | ** ** |
| Securities available-for-sale                 |       | $                                                                          | 1,277      |                                                     | $          | 673,121                                              |       | $                                         | 81,288     |   | $ | 755,686 |   |
| Residential mortgage-backed securities        |       | —                                                                     |       | —                                                   |       | 47,572                                               |       | 47,572                                    |       |
| Residential mortgage loans                    |       | —                                                                     |       | —                                                   |       | 2,097,699                                            |       | 2,097,699                                 |       |
| Equity investments, at estimated fair value   |       | 26,483                                                                     |       | 75,497                                                   |       | 18,289                                               |       | 120,269                                   |       |
| Total rate of return swaps                    |       | —                                                                     |       | —                                                   |       | 11,809                                               |       | 11,809                                    |       |
| Common stock warrants                         |       | —                                                                     |       | —                                                   |       | 2,471                                                |       | 2,471                                     |       |
| Total                                         |       | $                                                                          | 27,760     |                                                     | $          | 748,618                                              |       | $                                         | 2,259,128  |   | $ | 3,035,506 |   |
| **Liabilities:**                              |       |                                                                       |       |                                                     |       |                                                 |       |                                      |       |
| Cash flow interest rate swaps                 |       | $                                                                          | —     |                                                     | $          | (43,800                                              | )          | $                                         | —     |   | $ | (43,800 | ) |
| Free-standing 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 | ) |

 

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Thefollowing table presents information about the Company’s assets measured atfair value on a non-recurring basis as of December 31, 2009, and indicatesthe fair value hierarchy of the valuation techniques utilized by the Company todetermine such fair value (amounts in thousands). There were no liabilitiesmeasured at fair value on a non-recurring basis. There were no liabilitiesmeasured 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, 2009** | ** ** |
|------------------------|------------|----------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|------------------------------------------------------|------------|-------------------------------------------|------------|
| Loans held for sale(1) |       | $                                                                          | —     |                                                     | $          | 533,308                                              |       | $                                         | —     |   | $ | 533,308 |   |
| REO                    |       | —                                                                     |       | —                                                   |       | 11,439                                               |       | 11,439                                    |       |
| Total                  |       | $                                                                          | —     |                                                     | $          | 533,308                                              |       | $                                         | 11,439     |   | $ | 544,747 |   |

 

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(1)                                  As of December 31,2009, total loans held for sale had a carrying value of $925.7 million ofwhich $533.3 million was carried at estimated fair value and the remaining$392.4 million carried at amortized cost. The $533.3 million carriedat estimated fair value was classified as level 2 given that the assetswere valued using quoted prices and other observable inputs in an activemarket.

 

The following table presents additional information about assets,including derivatives that are measured at fair value on a recurring basis forwhich the Company has utilized level 3 inputs to determine fair value, forthe three months ended March 31, 2010 (amounts in thousands):

 
| ** **                                                                                                                                                                                     | ** ** | **Fair Value Measurements Using Significant Unobservable  Inputs  (Level 3)** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------|------------|
| ** **                                                                                                                                                                                     | ** ** | **Securities  Available-  For-Sale**                                          | ** ** | **Residential  Mortgage-  Backed  Securities** | ** ** | **Equity  Investments,  at estimated  fair value** | ** ** | **Total rate of  return swaps** | ** ** | **Common  stock warrants** | ** ** | **Free-standing  derivatives  interest rate  swaps** | ** ** |
| Beginning 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                                                                                                                                                                           |       | 700                                                                           |       | (4,124 | ) | (3,937 | ) | 1,743 |   | 123 |   | (360 | ) |
| Included in other comprehensive income                                                                                                                                                         |       | 5,743                                                                         |       | — |   | — |   | — |   | — |   | — |   |
| Transfers in to level 3                                                                                                                                                                   |       | 501                                                                           |       | — |   | — |   | — |   | — |   | — |   |
| Purchases, sales, other settlements and issuances,  net                                                                                                                                        |       | (19,624                                                                       | )          | (3,791 | ) | 7,347 |   | (13,324 | ) | (2,396 | ) | — |   |
| Ending balance as of March 31, 2010                                                                                                                                                       |       | $                                                                             | 68,608     |   | $ | 114,023 |   | $ | 21,699 |   | $ | 228 |   | $ | 198 |   | $ | (641 | ) |
| 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) |       | $                                                                             | —     |   | $ | (1,977 | ) | $ | (3,937 | ) | $ | — |   | $ | 123 |   | $ | (358 | ) |

 

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| (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. |
|-----|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) |   | 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 condensed consolidated  statements of operations.    |

 

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Thefollowing table presents additional information about assets, includingderivatives, that are measured at fair value on a recurring basis for which theCompany has utilized level 3 inputs to determine fair value, for the threemonths ended March 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  Issued** | ** ** |
| Beginning 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                                                                                                                                                                           |       | (6,156                                                                                                          | )          | (7,369 | ) | (252,653 | ) | — |   | 7,428 |   | 243,768 |   |
| Included in other comprehensive loss                                                                                                                                                           |       | 1,881                                                                                                           |       | — |   | — |   | — |   | — |   | — |   |
| Transfers out of level 3                                                                                                                                                                  |       | —                                                                                                          |       | — |   | (427 | ) | — |   | — |   | — |   |
| Purchases, sales, other settlements and issuances,  net                                                                                                                                        |       | (8,784                                                                                                          | )          | (7,562 | ) | (106,182 | ) | — |   | 67,291 |   | 105,527 |   |
| Ending balance as of March 31, 2009                                                                                                                                                       |       | $                                                                                                               | 76,050     |   | $ | 87,883 |   | $ | 2,260,759 |   | $ | 5,287 |   | $ | (2,231 | ) | $ | (2,113,587 | ) |
| 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) |       | $                                                                                                               | —     |   | $ | (6,800 | ) | $ | (248,213 | ) | $ | — |   | $ | 36,718 |   | $ | 244,001 |   |

 

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| (1) | Amounts are included in 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 condensed consolidated  statements of operations. |
|-----|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

**Note 15. Subsequent Events**

 

On April 29, 2010, the Company’s boardof directors declared a cash distribution for the quarter ended March 31,2010 on the Company’s common shares of $0.10 per common share. The distributionis payable on May 28, 2010 to common shareholders of record as of theclose of business on May 14, 2010.

 

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**Item 2.  Management’s Discussion andAnalysis of Financial Condition and Results of Operations**

 

*Except where otherwise expressly stated or thecontext suggests otherwise, the terms “we,” “us” and “our” refer to KKRFinancial Holdings LLC and its subsidiaries.*

 

*The following discussion and analysis of ourfinancial condition and results of operations should be read in conjunctionwith our condensed consolidated financial statements and related notes includedelsewhere in this Quarterly Report on Form 10-Q.**Certain information contained in this Quarterly Report on Form 10-Qconstitutes “forward-looking” statements within the meaning of Section 27Aof the Securities Act of 1933, as amended, or the Securities Act, and Section 21Eof the Securities Exchange Act of 1934, as amended, or the Exchange Act, thatare based on our current expectations, estimates and projections. Statementsthat are not historical facts, including statements about our beliefs andexpectations, are forward-looking statements. The words “believe,”“anticipate,” “intend,” “aim,” “expect,” “strive,” “plan,” “estimate,” and“project,” and similar words identify forward-looking statements. Suchstatements are not guarantees of future performance, events or results andinvolve potential risks and uncertainties. Accordingly, actual results and thetiming of certain events could differ materially from those addressed inforward-looking statements due to a number of factors including, but notlimited to, changes in interest rates and market values, financing and capitalavailability, changes in prepayment rates, general economic and politicalconditions and events, changes in market conditions, particularly in the globalfixed income, credit and equity markets, the impact of current, pending andfuture legislation, regulation and legal actions, and other factors notpresently identified. Other factors that may impact our actual results arediscussed under “Risk Factors” in Item 1A of the Company’s Annual Reporton Form 10-K filed with the Securities Exchange Commission on March 1,2010. We do not undertake, and specifically disclaim, any obligation topublicly release the result of any revisions that may be made to anyforward-looking statements to reflect the occurrence of anticipated orunanticipated events or circumstances after the date of such statements, exceptfor as required by federal securities laws.*

 

**Executive Overview**

 

We are a specialty finance company with expertise in a range of assetclasses. Our core business strategy is to leverage the proprietary resources ofour Manager with the objective of generating both current income and capitalappreciation. We primarily invest in financial assets including belowinvestment grade corporate debt, including senior secured and unsecured loans,mezzanine loans, high yield corporate bonds, distressed and stressed debtsecurities, marketable equity securities, private equity and credit defaultswaps. Additionally, we have made or may make investments in other assetclasses including natural resources and real estate. The corporate loans weinvest in are primarily referred to as syndicated bank loans, or leveragedloans, and are purchased via assignment or participation in either the primaryor secondary market. The majority of our corporate debt investments are held incollateralized loan obligation (“CLO”) transactions that are structured ason-balance sheet securitizations and are used as long term financing for theseinvestments. The senior secured notes issued by the CLO transactions areprimarily owned by unaffiliated third party investors and we own the majorityof the subordinated notes in the CLO transactions. Our CLO transactions consistof five cash flow CLO transactions, KKR Financial CLO 2005-1, Ltd. (“CLO 2005-1”), KKR Financial CLO 2005-2, Ltd. (“CLO2005-2”), KKR Financial CLO 2006-1, Ltd. (“CLO 2006-1”), KKR Financial CLO2007-1, 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 corebusiness strategy through majority-owned subsidiaries, including CLOs. 

 

***Significant Debt Transactions***

 

On January 15, 2010, we issued $172.5 million of 7.5%convertible senior notes due January 15, 2017 (“7.5% Notes”). Proceedsfrom the offering totaled $167.3 million, reflecting $172.5 millionfrom the issuance less $5.2 million for underwriting fees.

 

During the threemonths ended March 31, 2010, in an open market auction, we purchased $10.3million of mezzanine notes issued by CLO 2007-A for $5.5 million and $72.7million of mezzanine and subordinate notes issued by CLO 2007-1 for $38.8million, both of which were previously held by an affiliate of our manager. Thesetransactions resulted in us recording an aggregate gain on extinguishment ofdebt totaling $38.7 million.

 

During the quarter ended March 31, 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 March 31, 2010.  In addition, in February 2010,we paid down $25.0 million of our senior secured credit facility due 2011,reducing the amount outstanding from $175.0 million as of December 31,2009 to $150.0 million as of March 31, 2010.

 

***Distributions to Shareholders***

 

On April 29, 2010, our board ofdirectors declared a cash distribution for the quarter ended March 31, 2010on our common shares of $0.10 per share. The distribution is payable on May 28,2010 to common shareholders of record as of the close of business on May 14,2010.

 

Our senior secured credit facility contains negative covenants thatrestrict our ability, among other things, to pay dividends or make certainother restricted payments, including a prohibition on distributions to ourshareholders in an amount in excess of what would be required to pay allfederal, state and local income taxes arising from the taxable income and gainthat our shareholders incur in connection with the ownership of our commonshares. In addition, no dividends shall be paid if a deficiency in the requiredcollateral per the agreement exists or would exist as a result of suchdividend.

 

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***Consolidation***

 

Effective January 1, 2010, we adopted new guidance which amendedthe accounting for the transfers of financial assets, eliminated the concept ofa qualified special purpose entity (“QSPE”) and significantly changed thecriteria by which an enterprise determines whether or not it must consolidate avariable interest entity (“VIE”). Under the new guidance, consolidation of aVIE requires both the power to direct the activities that most significantlyimpact the VIE’s economic performance and the obligation to absorb losses ofthe VIE or the right to receive benefits of the VIE that could potentially besignificant to the VIE.

 

As a result of the adoptionof new guidance regarding the amended consolidation model to be based on powerand economics, we determined that six residential mortgage loan securitizationtrusts, which were previously consolidated by us as we were deemed to be theprimary beneficiary, were required to be deconsolidated. We determined that wedid not have the power to direct the activities that most significantlyimpacted the economic performance of the securitization trusts or theperformance of the securitization trusts’ underlying assets.

 

EffectiveJanuary 1, 2010, we deconsolidated the six residential mortgage loansecuritization trusts, which resulted in the reduction of both assets andliabilities of approximately $2.0 billion. In addition, loan interestincome, interest expense, loan servicing expense, and net unrealized andrealized gain (loss) associated with the residential mortgage loansecuritization trusts will no longer be reported on our condensed consolidatedfinancial statements. Our deconsolidation of the six residential mortgage loansecuritization trusts had no net impact on shareholders’ equity, results ofoperations 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 VIEswhich we consolidate as we determined we have the power to direct theactivities that most significantly impact these entities’ economic performanceand we have both the obligation to absorb losses of these entities and theright to receive benefits from these entities that could potentially besignificant to these entities.

 

As our condensed consolidated financial statements in this QuarterlyReport on Form 10-Q are presented to reflect the consolidation of the CLOswe hold investments in, the information contained in this Management’sDiscussion and Analysis of Financial Condition and Results of Operationsreflects the CLOs on a consolidated basis which is consistent with thedisclosures in our condensed consolidated financial statements.

 

***Investment Portfolio***

 

*Overview*

 

As discussed above, the majority of our investments are held throughCLO transactions that are managed by an affiliate of our Manager and for whichwe own the majority, and in some cases all, of the economic interests in thetransaction through the subordinated notes in the transaction. On anunconsolidated basis, our investment portfolio primarily consists of thefollowing as of March 31, 2010: (i) mezzanine and subordinatedtranches of CLO transactions with an aggregate par amount of $1.1 billion;(ii) corporate loans with an aggregate par amount of $582.8 millionand an estimated fair value of $452.6 million; (iii) corporate debtsecurities with an aggregate par amount of $136.8 million and an estimated fairvalue of $130.0 million; (iv) residential mortgage-backed securities (“RMBS”)with a par amount of $260.5 million and estimated fair value of$109.6 million; and (v) equity and private equity investments with anestimated fair value of $76.7 million. In addition, we hold otherinvestments including long and short credit default swap transactions andinterest rate swaps.

 

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*CorporateDebt Investments*

 

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

 

These investments have an aggregate par balance of $8.0 billion,an aggregate net amortized cost of $7.3 billion and an aggregate estimatedfair value of $7.3 billion as of March 31, 2010. Included in theseamounts is $7.3 billion par amount or $6.7 billion estimated fairvalue of investments held in our five Cash Flow CLOs through which we financethe majority of our corporate debt investments. These Cash Flow CLOs haveaggregate secured notes outstanding totaling $5.6 billion held by us andexternal parties, and an aggregate of $380.3 million of junior notesoutstanding that are held by an affiliate of our Manager. In CLO transactions,subordinated notes effectively represent the equity in such transactions asthey have the first risk of loss and conversely, the residual value upside ofthe transactions. We consolidate all five of our Cash Flow CLOs and reflect allincome and losses related to the assets in these CLOs on our condensedconsolidated statement of operations even though a minority interest in two of theseCLO transactions is held by an affiliate of our Manager.

 

*RMBSInvestments*

 

Our residential mortgage investment portfolio consists of investmentsin RMBS with an estimated fair value of $114.0 million as of March 31,2010.

 

**Critical Accounting Policies**

 

Our condensed consolidated financial statements are prepared bymanagement in conformity with GAAP. Our significant accounting policies arefundamental to understanding our financial condition and results of operationsbecause some of these policies require that we make significant estimates andassumptions that may affect the value of our assets or liabilities andfinancial results. We believe that certain of our policies are critical becausethey require us to make difficult, subjective, and complex judgments aboutmatters that are inherently uncertain. We have reviewed these criticalaccounting policies with our board of directors and our audit committee.

 

***Fair Value of Financial Instruments***

 

Fair value is the price that would be received to sell an asset or paidto transfer a liability in an orderly transaction between market participantsat the measurement date. Where available, fair value is based on observablemarket prices or parameters or derived from such prices or parameters. Whereobservable prices or inputs are not available, valuation models are applied.These valuation techniques involve some level of management estimation andjudgment, the degree of which is dependent on the price transparency for theinstruments or market and the instruments’ complexity for disclosure purposes.Assets and liabilities recorded at fair value in the condensed consolidatedbalance sheets are categorized based upon the level of judgment associated withthe inputs used to measure their value. Hierarchical levels, as defined underGAAP, are directly related to the amount of subjectivity associated with theinputs to fair valuations of these assets and liabilities, and are as follows:

 

Level 1: Inputs are unadjusted, quoted prices in active marketsfor identical assets or liabilities at the measurement date.

 

The types of assets carried at level 1 fair value are equitysecurities listed in active markets.

 

Level 2: Inputs, other than quoted prices included inlevel 1, are observable for the asset or liability, either directly orindirectly. Level 2 inputs include quoted prices for similar instrumentsin active markets, and inputs other than quoted prices that are observable forthe asset or liability.

 

Fair value assets and liabilities that are included in this categoryare certain corporate debt securities, certain corporate loans held for sale,certain equity investments at estimated fair value, certain securities sold,not yet purchased and certain financial instruments classified as derivativeswhere the fair value is based on observable market inputs.

 

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Level 3: Inputs are unobservable inputs for the asset orliability, and include situations where there is little, if any, marketactivity for the asset or liability. In certain cases, the inputs used tomeasure fair value may fall into different levels of the fair value hierarchy.In such cases, the level in the fair value hierarchy within which the fairvalue measurement in its entirety falls has been determined based on the lowestlevel input that is significant to the fair value measurement in its entirety.Our assessment of the significance of a particular input to the fair valuemeasurement in its entirety requires judgment and the consideration of factorsspecific to the asset.

 

Assets and liabilities carried at fair value and included in thiscategory are certain corporate debt securities, certain corporate loans heldfor sale, certain equity investments at estimated fair value, residentialmortgage-backed securities, residential mortgage loans, residentialmortgage-backed securities issued and certain derivatives.

 

Asignificant decrease in the volume and level of activity for the asset orliability is an indication that transactions or quoted prices may not berepresentative of fair value because in such market conditions there may beincreased instances of transactions that are not orderly. In thosecircumstances, further analysis of transactions or quoted prices is needed, anda significant adjustment to the transactions or quoted prices may be necessaryto estimate fair value.

 

Theavailability of observable inputs can vary depending on the financial asset orliability 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 tradedon an active exchange or in the secondary market, and the current marketcondition. To the extent that valuation is based on models or inputs that areless observable or unobservable in the market, the determination of fair valuerequires more judgment. Accordingly, the degree of judgment exercised by us indetermining fair value is greatest for instruments categorized in level 3.In certain cases, the inputs used to measure fair value may fall into differentlevels of the fair value hierarchy. In such cases, for disclosure purposes, thelevel in the fair value hierarchy within which the fair value measurement inits entirety falls is determined based on the lowest level input that issignificant to the fair value measurement in its entirety.

 

Many financial assets and liabilities have bid and ask prices that canbe observed in the marketplace. Bid prices reflect the highest price that weand others are willing to pay for an asset. Ask prices represent the lowestprice that we and others are willing to accept for an asset. For financialassets and liabilities whose inputs are based on bid-ask prices, we do notrequire 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 withinthe 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 quotedprices, obtained directly or indirectly, are not available. The valuationtechniques used for the assets and liabilities that are valued usinglevel 3 of the fair value hierarchy are described below.

 

*Residential Mortgage-Backed Securities, ResidentialMortgage Loans, and Residential Mortgage-Backed Securities Issued:*  Residential mortgage-backed securities,residential mortgage loans, and residential mortgage-backed securities issuedare initially valued at transaction price and are subsequently valued usingindustry recognized models (including Intex and Bloomberg) and data for similarinstruments (e.g., nationally recognized pricing services or brokerquotes). The most significant inputs to the valuation of these instruments aredefault and loss expectations and market credit spreads.

 

*Corporate Debt Securities:*  Corporate debt securities are initiallyvalued at transaction price and are subsequently valued using market data forsimilar instruments (e.g., recent transactions or broker quotes),comparisons to benchmark derivative indices or valuation models. Valuationmodels are based on discounted cash flow techniques, for which the key inputsare the amount and timing of expected future cash flows, market yields for suchinstruments and recovery assumptions. Inputs are determined based on relativevalue analyses, which incorporate similar instruments from similar issuers.

 

*Over-the-counter (“OTC”) Derivative Contracts:*  OTC derivative contracts include forward,swap and option contracts related to interest rates, foreign currencies, creditstanding of reference entities, and equity prices. The fair value of OTCderivative products can be modeled using a series of techniques, includingclosed-form analytic formulae, such as the Black-Scholes option-pricing model,and simulation models or a combination thereof. Many pricing models do notentail material subjectivity because the methodologies employed do notnecessitate significant judgment, and the pricing inputs are observed fromactively quoted markets, as is the case for generic interest rate swap andoption contracts.

 

***Share-Based Compensation***

 

We account for share-based compensation issued to members of our boardof directors and our Manager using a fair value based methodology. We do nothave any employees, although we believe that members of our board of directorsare deemed to be employees for purposes of interpreting and applying accountingprinciples relating to share-based compensation. We record as compensationcosts the restricted common shares that we issued to members of our board ofdirectors at estimated fair value as of the grant date and we amortize the costinto expense over the three-year vesting period using the straight-line method.We record compensation costs for restricted common shares and common shareoptions that we issued to our Manager at estimated fair value as of the grantdate and we remeasure the amount on subsequent reporting dates to the extent theawards have not vested. Unvested restricted common shares are valued usingobservable secondary market prices. Unvested common share options are valuedusing the Black-Scholes model and assumptions based on observable market datafor comparable companies. We amortize compensation expense related to therestricted common share and common share options that we granted to ourManager using the graded vesting attribution method.

 

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Because we remeasure the amount of compensation costs associated withthe unvested restricted common shares and unvested common share options that weissued to our Manager as of each reporting period, our share-based compensationexpense reported in our condensed consolidated financial statements will changebased on the estimated fair value of our common shares and this may result inearnings volatility. For the three months ended March 31, 2010,share-based compensation was $2.9 million. As of March 31, 2010,substantially all of the non-vested restricted common shares issued are subjectto remeasurement. As of March 31, 2010, a $1 increase in the price of ourcommon shares would have increased our future share-based compensation expenseby approximately $1.1 million and this future share-based compensationexpense would be recognized over the remaining vesting periods of ouroutstanding restricted common shares and common share options. As of March 31,2010, the common share options were fully exercised and expire in August 2014.As of March 31, 2010, future unamortized share-based compensation totaled$3.3 million, of which $2.6 million, $0.6 million, and $0.1 millionwill be recognized in 2010, 2011 and beyond, respectively.

 

***Accounting for Derivative Instruments and Hedging Activities***

 

We recognize all derivatives on our condensed consolidated balancesheets at estimated fair value. On the date we enter into a derivativecontract, we designate and document each derivative contract as one of thefollowing at the time the contract is executed: (i) a hedge of arecognized asset or liability (“fair value” hedge); (ii) a hedge of aforecasted transaction or of the variability of cash flows to be received orpaid related to a recognized asset or liability (“cash flow” hedge); (iii) ahedge of a net investment in a foreign operation; or (iv) a derivativeinstrument not designated as a hedging instrument (“free-standing derivative”).For a fair value hedge, we record changes in the estimated fair value of thederivative instrument and, to the extent that it is effective, changes in thefair value of the hedged asset or liability in the current period earnings inthe same financial statement category as the hedged item. For a cash flowhedge, we record changes in the estimated fair value of the derivative to theextent that it is effective in other comprehensive income and subsequentlyreclassify these changes in estimated fair value to net income in the sameperiod(s) that the hedged transaction affects earnings. The effectiveportion of the cash flow hedge is recorded in the same financial statementcategory as the hedged item. For free-standing derivatives, we report changesin the fair values in other (loss) income.

 

We formally document at inception our hedge relationships, includingidentification of the hedging instruments and the hedged items, our riskmanagement objectives, strategy for undertaking the hedge transaction and ourevaluation of effectiveness of our hedged transactions. Periodically, we alsoformally assess whether the derivative designated in each hedging relationshipis expected to be and has been highly effective in offsetting changes inestimated fair values or cash flows of the hedged item using either the dollaroffset or the regression analysis method. If we determine that a derivative isnot highly effective as a hedge, we discontinue hedge accounting.

 

We are not required to account for our derivative contracts using hedgeaccounting as described above. If we decide not to designate the derivativecontracts as hedges or if we fail to fulfill the criteria necessary to qualifyfor hedge accounting, then the changes in the estimated fair values of our derivativecontracts would affect periodic earnings immediately potentially resulting inthe increased volatility of our earnings. The qualification requirements forhedge accounting are complex and as a result, we must evaluate, designate, andthoroughly document each hedge transaction at inception and performineffectiveness analysis and prepare related documentation at inception and ona recurring basis thereafter. As of March 31, 2010, the estimated fairvalue of our net derivative liabilities totaled $48.7 million.

 

***Impairments***

 

Wemonitor our available-for-sale securities portfolio for impairments. A loss isrecognized when it is determined that a decline in the estimated fair value ofa security below its amortized cost is other-than-temporary. We consider manyfactors in determining whether the impairment of a security is deemed to beother-than-temporary, including, but not limited to, the length of time thesecurity has had a decline in estimated fair value below its amortized cost andthe severity of the decline, the amount of the unrealized loss, recent eventsspecific to the issuer or industry, external credit ratings and recent changesin such ratings.  In addition, for debtsecurities we consider our intent to sell the debt security, our estimation ofwhether or not we expect to recover the debt security’s entire amortized costif we intend to hold the debt security, and whether it is more likely than notthat we will be required to sell the debt security before its anticipatedrecovery. For equity securities, we also consider our intent and ability tohold the equity security for a period of time sufficient for a recovery invalue.

 

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Theamount of the loss that is recognized when it is determined that a decline inthe estimated fair value of a security below its amortized cost isother-than-temporary is dependent on certain factors.  If the security is an equity security or ifthe security is a debt security that we intend to sell or estimate that it ismore likely than not that we will be required to sell before recovery of itsamortized cost, then the impairment amount recognized in earnings is the entiredifference between the estimated fair value of the security and its amortizedcost. For debt securities that we do not intend to sell or estimate that we arenot more likely than not to be required to sell before recovery, the impairmentis separated into the estimated amount relating to credit loss and theestimated amount relating to all other factors. Only the estimated credit lossamount is recognized in earnings, with the remainder of the loss amountrecognized in other comprehensive income.

 

This process involves a considerable amount of subjective judgment byour management. As of March 31, 2010, we had aggregate unrealized losseson our securities classified as available-for-sale of approximately$3.5 million, which if not recovered may result in the recognition offuture losses. During the three months ended March 31, 2010, we recordedcharges for impairments of securities that we determined to beother-than-temporary totaling $1.1 million.

 

***Allowance for Loan Losses***

 

Ourallowance for loan losses represents our estimate of probable credit lossesinherent in our corporate loan portfolio held for investment as of the balancesheet date.  Estimating our allowance forloan losses involves a high degree of management judgment and is based upon acomprehensive review of our loan portfolio that is performed on a quarterlybasis. Our allowance for loan losses consists of two components, an allocatedcomponent and an unallocated component. The allocated component of ourallowance for loan losses pertains to specific loans that we have determinedare impaired. We determine a loan is impaired when we estimate that it isprobable that we will be unable to collect all amounts due according to thecontractual terms of the loan agreement. On a quarterly basis we perform acomprehensive review of our entire loan portfolio and identify certain loansthat we have determined are impaired. Once a loan is identified as beingimpaired we place the loan on non-accrual status, unless the loan is already onnon-accrual status, and record a reserve that reflects our best estimate of theloss that we expect to recognize from the loan. The expected loss is estimatedas being the difference between our current cost basis of the loan, includingaccrued interest receivable, and the loan’s estimated fair value.

 

Theunallocated component of our allowance for loan losses reflects our estimate ofprobable losses inherent in our loan portfolio as of the balance sheet datewhere the specific loan that the loan loss relates to is indeterminable. Weestimate the unallocated component of our allowance for loan losses through acomprehensive review of our loan portfolio and identify certain loans thatdemonstrate possible indicators of impairment. This assessment excludes allloans that are determined to be impaired and as a result, an allocated reservehas been recorded as described in the preceding paragraph. Such indicatorsinclude, but are not limited to, the current and/or forecasted financialperformance and liquidity profile of the issuer, specific industry or economicconditions that may impact the issuer, and the observable trading price of theloan if available. Loans that demonstrate possible indicators of impairment areaggregated on a watch list for monitoring and are sub-divided forcategorization based on the seniority of the loan in the issuer’s capitalstructure, whether the loan is secured or unsecured, and the nature of thecollateral securing the loan, for purposes of applying possible default andloss severity ranges based on the nature of the issuer and the specific loan.We apply a range of default and loss severity estimates in order to estimate arange of loss outcomes upon which to base our estimate of probable losses thatresults in the determination of the unallocated component of our allowance forloan losses. As of March 31, 2010, the range of outcomes used to estimatethe probability of default was between 5% and 40% and the range of lossseverity assumptions for loans that may default was between 20% and 75%. The estimatesand assumptions we use to estimate our allowance for loan losses are based onour estimated range of outcomes that are determined from industry informationproviding both historical and forecasted empirical performance of the type ofcorporate loans that we invest in, as well as from our own estimates based onthe nature of our corporate loan portfolio. These estimates and assumptions aresusceptible to change due to our corporate loan portfolio performance as wellas industry performance of the corporate loan asset class and general economicconditions. Changes in the assumptions and estimates used to estimate ourallowance for loan losses could have a material impact on our financialcondition and results of operations.

 

As of March 31, 2010, our allowance for loan losses totaled$216.1 million.

 

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**Recent Accounting Pronouncements**

 

*Consolidation*

 

In February 2010, the Financial AccountingStandards Board (“FASB”) issued new guidance deferring the application of theamended consolidation requirements related to VIEs for a reporting entity’sinterest in an entity that has all the attributes of an investment company orfor which it is applies measurement principles that are consistent with thosefollowed by investment companies. The guidance was expected to mostsignificantly affect reporting entities in the investment management industry.Entities including, but not limited to, securitization entities or entitieswith multiple levels of subordinated investors such as a CLO for which theprimary purpose of the capital structure of the entity is to provide creditenhancement to senior interest holders, will not qualify for the deferral. Theguidance was effective for interim and annual reporting periods beginning afterNovember 15, 2009. As we are not considered an investment company, theadoption did not have an affect on our condensed consolidated financial statements.

 

**Results of Operations**

 

*Summary*

 

Our net income for the three months ended March 31, 2010 totaled$129.5 million (or $0.82 per diluted common share), as compared to a net lossof $13.0 million (or $(0.09) per diluted common share) for the three monthsended March 31, 2009. The increase in net income of $142.5 million fromthe same quarter in 2009 was primarily a result of three key drivers: (i) anincrease in net realized and unrealized gains on investments of $95.6 milliondue to a significant rise in bond and loan market values, (ii) noprovision for loan losses recorded during the first quarter of 2010, resultingin an increase in net investment income of $27.0 million, and (iii) adecrease in interest expense, slightly offset by a decrease in interest incomeattributable to a decline in our total corporate debt portfolio.

 

The following table presents the components of our net investmentincome for the three months ended March 31, 2010 and 2009:

 

**Comparative Net Investment Income Components**

**(Amounts inthousands)**

 
| ** **                                                 | ** ** | **For the three  months ended  March 31, 2010** | ** ** | **For the three  months ended  March 31, 2009** | ** ** |
|------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|
| Investment Income:                                         |       |                                                                     |       |                                                                     |       |
| Corporate loans and  securities interest income            |       | $                                                                        | 86,819     |                                                                     | $          | 105,184 |   |
| Residential mortgage loans  and securities interest income |       | 7,653                                                                    |       | 39,001                                                                   |       |
| Other interest income                                      |       | 67                                                                       |       | 356                                                                      |       |
| Dividend income                                            |       | 26                                                                       |       | 261                                                                      |       |
| Net discount accretion                                     |       | 24,785                                                                   |       | 13,871                                                                   |       |
| Total investment income                                    |       | 119,350                                                                  |       | 158,673                                                                  |       |
| Interest Expense:                                          |       |                                                                     |       |                                                                     |       |
| Collateralized loan  obligation secured notes              |       | 12,582                                                                   |       | 46,415                                                                   |       |
| Senior secured credit  facility                            |       | 3,273                                                                    |       | 3,942                                                                    |       |
| Convertible senior notes                                   |       | 7,254                                                                    |       | 5,246                                                                    |       |
| Junior subordinated notes                                  |       | 3,889                                                                    |       | 4,441                                                                    |       |
| Residential  mortgage-backed securities issued             |       | —                                                                   |       | 25,859                                                                   |       |
| Interest rate swap                                         |       | 4,332                                                                    |       | 2,737                                                                    |       |
| Other interest expense                                     |       | 170                                                                      |       | 1,242                                                                    |       |
| Total interest expense                                     |       | 31,500                                                                   |       | 89,882                                                                   |       |
| Interest expense to  affiliates                            |       | 4,541                                                                    |       | 5,805                                                                    |       |
| Provision for loan losses                                  |       | —                                                                   |       | 26,987                                                                   |       |
| Net investment income                                      |       | $                                                                        | 83,309     |                                                                     | $          | 35,999 |   |

 

Due to our adoption of new guidance related to consolidation of variableinterest entities (as described above under “Executive Overview”), certainamounts for the three months ended March 31, 2009, which were related tothe six residential mortgage loan securitization trusts that we deconsolidatedeffective January 1, 2010, should be disregarded for comparative purposes.For the three months ended March 31, 2009, RBMS Issued interest expensetotaled $25.9 million and residential mortgage loans interest income totaled$28.0 million related to the six residential mortgage loan securitizationtrusts which were deconsolidated.

 

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Excluding the amounts above, the increase in net investment income fromthe three months ended March 31, 2009 to the same period in 2010 wasprimarily due to the provision for loan losses recorded in the first quarter of2009 and a reduction in total interest expense due to paydowns of ourcollateralized loan obligation secured notes during 2009 and the first quarterof 2010. In addition, during the three months ended March 31, 2010compared to the same period in 2009, paydowns of corporate debt securities andloans increased significantly, which resulted in additional acceleration ofdiscount accretion of approximately $10.6 million.

 

*Other Income (Loss)*

 

The following table presents the components of other income (loss) forthe three months ended March 31, 2010 and 2009:

 

**Comparative Other Income (Loss) Components**

**(Amounts inthousands)**

 
| ** **                                                                                                                                                                      | ** ** | **For the three  months ended  March 31, 2010** | ** ** | **For three  months ended  March 31, 2009** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| Net realized and unrealized (loss) gain on  derivatives and foreign exchange:                                                                                                   |       |                                                                     |       |                                                            |       |
| Interest rate swaps                                                                                                                                                             |       | $                                                                        | (358       | )                                                               | $          | 475 |   |
| Credit default swaps                                                                                                                                                            |       | 1,018                                                                    |       | 7,980                                                           |       |
| Total rate of return swaps                                                                                                                                                      |       | 1,743                                                                    |       | 6,953                                                           |       |
| Common stock warrants                                                                                                                                                           |       | 123                                                                      |       | —                                                          |       |
| Foreign exchange(1)                                                                                                                                                             |       | (3,944                                                                   | )          | (3,012                                                          | )          |
| Total net realized and unrealized (loss) gain on  derivatives and foreign exchange                                                                                              |       | (1,418                                                                   | )          | 12,396                                                          |       |
| Net realized loss on residential mortgage-backed  securities and residential mortgage loans, carried at estimated fair value                                                    |       | (3,168                                                                   | )          | (8,407                                                          | )          |
| Net unrealized loss on residential mortgage-backed  securities, residential mortgage loans, and residential mortgage-backed  securities issued, carried at estimated fair value |       | (1,977                                                                   | )          | (11,012                                                         | )          |
| Net realized and unrealized gain (loss) on  investments(2)                                                                                                                      |       | 36,563                                                                   |       | (26,440                                                         | )          |
| Net realized and unrealized (loss) gain on  securities sold, not yet purchased                                                                                                  |       | (756                                                                     | )          | 1,437                                                           |       |
| Impairment of securities available for sale                                                                                                                                     |       | (1,140                                                                   | )          | (33,764                                                         | )          |
| Net gain on restructuring and extinguishment of  debt                                                                                                                           |       | 39,999                                                                   |       | 34,571                                                          |       |
| Other income                                                                                                                                                                    |       | 3,004                                                                    |       | 1,333                                                           |       |
| Total other income (loss)                                                                                                                                                       |       | $                                                                        | 71,107     |                                                            | $          | (29,886 | ) |

 

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| (1) | Includes  foreign exchange contracts and foreign exchange 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. |

 

For the three months ended March 31, 2009, the aggregate realizedand unrealized gain (loss) on residential mortgage loans and residentialmortgage-backed securities issued (“RMBS Issued”) related to the sixresidential mortgage loan securitization trusts that we deconsolidatedeffective January 1, 2010. The deconsolidation had no net impact on ourresults of operations for the three months ended March 31, 2010.

 

Total other income totaled$71.1 million for the three months ended March 31, 2010 as compared toother loss of $29.9 million for the three months ended March 31, 2009.Total other income increased from the three months ended March 31, 2009 to2010 due to primarily two factors. First, net realized and unrealized gain oninvestments totaled $36.6 million for the quarter ended March 31, 2010,compared to a loss of $26.4 million for the quarter ended March 31, 2009.Second, losses due to the impairment of securities available for sale totaled$1.1 million for the quarter ended March 31, 2010 compared to $33.8million for the quarter ended March 31, 2009. The improvement with respectto both realized and unrealized losses on investments and impairment losses wasprimarily attributable to significant asset appreciation during the threemonths ended March 31, 2010 compared to the same period in 2009 as demonstratedby the increase in the weighted average market value as a percentage of facevalue of our corporate debt portfolio from approximately 61% as of March 31,2009 to 91% as of March 31, 2010.

 

During the threemonths ended March 31, 2010, in an open market auction, we purchased $83.0million of notes issued by CLO 2007-A and CLO 2007-1, both of which werepreviously held by an affiliate of our manager. These transactions resultedin us recording an aggregate gain on extinguishment of debt totaling $38.7million during the first quarter of 2010. For the three months ended March 31,2009, the $34.6 million gain on debt restructuring reflected the reduction ofthe reported amount of debt held by an affiliate of our Manager upon thereplacement of Wayzata Funding LLC (“Wayzata”) with CLO 2009-1 on March 31,2009.

 

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*Non-InvestmentExpenses*

 

The following table presents the components of non-investment expensesfor the three months ended March 31, 2010 and 2009:

 

**Comparative Non-Investment Expense Components**

**(Amounts inthousands)**

 
| ** **                             | ** ** | **For the three  months ended  March 31, 2010** | ** ** | **For the three  months ended  March 31, 2009** | ** ** |
|----------------------------------------|------------|--------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|
| Related party management compensation: |       |                                                                     |       |                                                                     |       |
| Base management fees                   |       | $                                                                        | 4,157      |                                                                     | $          | 3,625 |   |
| Incentive fees                         |       | 12,500                                                                   |       | —                                                                   |       |
| Share-based compensation               |       | 2,392                                                                    |       | (140                                                                     | )          |
| CLO management fees                    |       | 1,442                                                                    |       | 7,727                                                                    |       |
| Related party management  compensation |       | 20,491                                                                   |       | 11,212                                                                   |       |
| Professional services                  |       | 1,064                                                                    |       | 3,385                                                                    |       |
| Loan servicing                         |       | —                                                                   |       | 2,136                                                                    |       |
| Insurance                              |       | 637                                                                      |       | 303                                                                      |       |
| Directors expenses                     |       | 1,195                                                                    |       | 304                                                                      |       |
| General and administrative             |       | 1,518                                                                    |       | 1,796                                                                    |       |
| Total non-investment  expenses         |       | $                                                                        | 24,905     |                                                                     | $          | 19,136 |   |

 

For the three months ended March 31, 2009, the entire loan servicingexpense of $2.1 million was related to the six residential mortgage loansecuritization trusts which we deconsolidated effective January 1, 2010.As such, the $2.1 million balance should be disregarded for comparativepurposes.

 

As presented in the table above, our non-investment expenses increasedby approximately $5.8 million from the three months ended March 31, 2009to 2010. The significant components of non-investment expense are describedbelow.

 

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

 

The base management fee payable was calculated in accordance with theManagement Agreement and is based on an annual rate of 1.75% times our “equity”as defined in the Management Agreement. Base management fee increased by $0.5million from the three months ended March 31, 2009 to 2010. Our Manager isalso entitled to a quarterly incentive fee provided that our quarterly “netincome,” as defined in the Management Agreement, before the incentive feeexceeds a defined return hurdle. During the three months ended March 31,2010, our Manager earned $22.2 million of incentive fees.  Of this amount, our Manager permanentlywaived payment of $9.7 million of incentive fees that were related to the$38.7 million gain recorded by us as a result of the repurchase of $83.0million of mezzanine and subordinate notes issued by CLO 2007-1 and CLO 2007-Aduring the quarter ended March 31, 2010. The remaining $12.5 million,representing the incentive fee net of the amount waived, is included in relatedparty management compensation on our condensed consolidated statement ofoperations for the quarter ended March 31, 2010 and is due and payable toour Manager as of that date.

 

An affiliate of our Manager has entered into separate managementagreements with the respective investment vehicles CLO 2005-1, CLO 2005-2, CLO2006-1, CLO 2007-1, CLO 2007-A and CLO 2009-1 and is entitled to receive feesfor the services performed as collateral manager. Previously, the collateralmanager had waived the fees it earned for providing management services for ourCLOs. Beginning April 15, 2007, the collateral manager ceased waiving feesfor CLO 2005-1 and beginning January 1, 2009, the collateral managerceased 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). Beginning in July 2009, the collateral manager reinstated waivingthe CLO management fees for CLO 2005-2 and CLO 2006-1. In addition, due to CLO2007-A and CLO 2007-1 regaining compliance with their respective over-collateralizationtests (“OC Tests”) during the first quarter of 2010, the collateral manageralso reinstated waiving the CLO management fees for CLO 2007-A and CLO 2007-1.For the three months ended March 31, 2010, the collateral manager waivedan aggregate of $4.5 million for CLO 2005-2, CLO 2006-1 and CLO 2007-A. Inaddition, due to the deleveraging of CLO 2009-1 completed in July 2009whereby all the senior notes were retired, the collateral manager is no longerentitled to receive fees for CLO 2009-1. Accordingly, CLO management feesdecreased $6.3 million from the three months ended March 31, 2009 to 2010to account for all six CLOs paying CLO management fees during the there monthsended March 31, 2009.

 

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In addition, beginning January 1, 2009, our Manager permanentlywaived reimbursable general and administrative expenses allocable to us in anamount equal to the incremental CLO management fees received by the Manager.For the three months ended March 31, 2010, our Manager permanently waivedreimbursement of $1.3 million in allocable general and administrative expenses.For the three months ended March 31, 2009, the Manager permanently waivedreimbursement of $2.3 million in allocable general and administrative expenses.

 

General and administrative expenses include expenses incurred by ourManager on our behalf that are reimbursable to our Manager pursuant to theManagement Agreement. Professional services expenses consist of legal,accounting and other professional services. Directors’ expenses representshare-based compensation, as well as expenses and reimbursables due to theboard of directors for their services. Professional fees decreased $2.3 millionfrom the three months ended March 31, 2009 to 2010.

 

*Income Tax Provision*

 

We intend to continue to operate so as to qualify as a partnership, andnot as an association or publicly traded partnership that is taxable as acorporation, for United States federal income tax purposes. Therefore, wegenerally are not subject to United States federal income tax at the entitylevel, but are subject to limited state income taxes. Holders of our shares arerequired 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 withtheir taxable year.

 

During 2010, we owned an equity interest in KKR Financial HoldingsII, LLC (“KFH II”), which has elected to be taxed as a REIT under theInternal Revenue Code of 1986, as amended (the “Code”). KFH II holds certainreal estate mortgage-backed securities. A REIT is not subject to United Statesfederal income tax to the extent that it currently distributes its income andsatisfies certain asset, income and ownership tests, and recordkeeping requirements,but it may be subject to some amount of federal, state, local and foreign taxesbased on its taxable income.

 

KKR TRS Holdings, Ltd. (“TRS Ltd.”), KKR FinancialHoldings, Ltd. (“KFH Ltd.”), KFH III Holdings Ltd. (“KFH III Ltd.”),KFN PEI VII, LLC (“PEI VII”), KFH PE Holdings I LLC (“PE I”), KFH PEHoldings II LLC (“PE II”) and KKR Financial Holdings Inc. (“KFH Inc.”)are our wholly-owned subsidiaries and are not consolidated with us for UnitedStates federal income tax purposes. For financial reporting purposes, currentand deferred taxes are provided for on the portion of earnings recognized by uswith respect to our interest in PEI VII, PE I, PE II and KFH Inc., all domestictaxable corporate subsidiaries, because each is taxed as a regular corporationunder the Code. Deferred income tax assets and liabilities are computed basedon temporary differences between the GAAP consolidated financial statements andthe United States federal income tax basis of assets and liabilities as of eachconsolidated balance sheet date. CLO 2005-1, CLO 2005-2, CLO 2006-1, CLO2007-1, CLO 2007-A and CLO 2009-1 are our foreign subsidiaries that elected tobe treated as disregarded entities or partnerships for United States federalincome tax purposes. Those subsidiaries were established to facilitatesecuritization transactions, structured as secured financing transactions.TRS Ltd., KFH Ltd. and KFH III Ltd. are our foreign subsidiaries andare taxed as corporations for United States federal income tax purposes. Theseentities were formed to make certain foreign and domestic investments from timeto time. TRS Ltd., KFH Ltd. and KFH III Ltd. are organized asexempted companies incorporated with limited liability under the laws of theCayman Islands, and are anticipated to be exempt from United States federal andstate income tax at the corporate entity level because they restrict theiractivities in the United States to trading in stock and securities for theirown account. No provisions for income taxes for the quarter ended March 31,2010 were recorded for these entities; however, we are generally required toinclude their current taxable income in our calculation of taxable incomeallocable to shareholders.

 

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

 

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**InvestmentPortfolio**

 

***Corporate Investment PortfolioSummary***

 

Our corporate investment portfolio primarily consists of investments incorporate loans and debt securities. Our corporate loans primarily consist ofsenior secured, second lien and subordinate loans. The corporate loans weinvest in are primarily below investment grade and are floating rate indexed toeither one-month or three-month LIBOR. Our investments in corporate debtsecurities primarily consist of investments in below investment grade corporatebonds that are senior secured, senior unsecured and subordinated. We evaluateand monitor the asset quality of our investment portfolio by performing detailedcredit reviews and by monitoring key credit statistics and trends. The keycredit statistics and trends we monitor to evaluate the quality of ourinvestments include credit ratings of both our investments and the issuer,financial performance of the issuer including earnings trends, free cash flowsof the issuer, debt service coverage ratios of the issuer, financial leverageof the issuer, and industry trends that have or may impact the issuer’s currentor future financial performance and debt service ability.

 

*CorporateLoans*

 

Our corporate loan portfolio totaled approximately $6.6 billion as of March 31,2010 and $6.8 billion as of December 31, 2009. Our corporate loanportfolio consists of debt obligations of corporations, partnerships and otherentities in the form of senior secured loans, second lien loans and subordinateloans.

 

The following table summarizes our corporate loans portfolio stratifiedby type as of March 31, 2010 and December 31, 2009:

 

**Corporate Loans**

**(Amounts inthousands)**

 
| ** **                             | ** ** | **March 31, 2010 (1)** | ** ** | **December 31, 2009 (1)** | ** ** |
|----------------------------------------|------------|-----------------------------|------------|--------------------------------|------------|
| ** **                             | ** ** | **Carrying  Value**         | ** ** | **Amortized  Cost**            | ** ** | **Estimated  Fair Value** | ** ** | **Carrying  Value** | ** ** | **Amortized  Cost** | ** ** | **Estimated  Fair Value** | ** ** |
| Senior secured                         |       | $                           | 5,939,661  |                           | $          | 5,939,661 |   | $ | 5,814,111 |   | $ | 6,093,463 |   | $ | 6,093,463 |   | $ | 5,774,248 |   |
| Second lien                            |       | 617,706                     |       | 617,706                        |       | 578,887 |   | 638,052 |   | 638,052 |   | 560,038 |   |
| Subordinate                            |       | 89,607                      |       | 89,607                         |       | 104,130 |   | 81,073 |   | 81,073 |   | 79,337 |   |
| Subtotal                               |       | 6,646,974                   |       | 6,646,974                      |       | 6,497,128 |   | 6,812,588 |   | 6,812,588 |   | 6,413,623 |   |
| Lower of cost or fair value adjustment |       | (6,071                      | )          | —                         |       | — |   | (31,637 | ) | — |   | — |   |
| Allowance for loan losses              |       | (216,080                    | )          | —                         |       | — |   | (237,308 | ) | — |   | — |   |
| Total                                  |       | $                           | 6,424,823  |                           | $          | 6,646,974 |   | $ | 6,497,128 |   | $ | 6,543,643 |   | $ | 6,812,588 |   | $ | 6,413,623 |   |

 

----

| (1) |   | Includes  loans held for sale    |
|-----|--------|-------------------------------------------------|

 

As of March 31, 2010, $7.0 billion, or 98.8%, of our corporateloan portfolio was floating rate and $0.1 billion, or 1.2%, was fixedrate. As of December 31, 2009, $7.2 billion, or 98.3%, of ourcorporate loan portfolio was floating rate and $0.1 billion, or 1.7%, wasfixed rate. Fixed and floating amounts and percentages are based on par values.

 

All of our floating rate corporate loans have index reset frequenciesof less than twelve months with the majority resetting at least quarterly. Theweighted-average coupon on our floating rate corporate loans was 3.8% and 3.7%as of March 31, 2010 and December 31, 2009, respectively, and theweighted-average coupon spread to LIBOR of our floating rate corporate loanportfolio was 3.2% and 3.1% as of March 31, 2010 and December 31,2009, respectively. The weighted-average years to maturity of our floating ratecorporate loans was 4.3 years as of both March 31, 2010 and December 31,2009. As of March 31, 2010 and December 31, 2009, $0.8 billion paramount, or 11.6%, and $0.6 billion par amount, or 8.8%, respectively, of our floatingrate corporate loan portfolio had interest rate floors.

 

As of March 31, 2010, our fixed rate corporate loans had aweighted-average coupon of 13.1% and weighted-average years to maturity of5.1 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 pastdue at the time of such determination. When placed on non-accrual status,previously recognized accrued interest is reversed and charged against currentincome. While on non-accrual status, interest income is recognized using thecost-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 theprincipal and interest is not in doubt.

 

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As of March 31, 2010 and December 31, 2009, we had loans onnon-accrual status with total carrying value of $253.3 million and $439.9million, respectively. The average recorded investment in the impaired loansincluded in non-accrual loans during the three months ended March 31, 2010and 2009 was $346.6 million and $565.2 million, respectively. As of March 31,2010 and 2009, the allocated component of the allowance for loan lossesincluded all impaired loans for the respective periods. The amount of interestincome recognized using the cash-basis method during the time within the periodthat the loans were impaired was $5.6 million and $2.1 million for the threemonths ended March 31, 2010 and 2009, respectively.

 

As of March 31, 2010, we held corporate loans that were in defaultwith a total carrying value of $209.7 million from four issuers. As of December 31,2009, we held corporate loans that were in default with a total amortized costof $392.5 million from seven issuers. The majority of corporate loans indefault during 2010 and 2009 were included in the loans for which the allocatedcomponent of the allowance for losses was related to or in those investmentsfor which we determined were loans held for sale as of March 31, 2010 and December 31,2009, respectively.

 

The following table summarizes the changes in the allowance for loanlosses for the three months ended March 31, 2010 and 2009 (amounts inthousands):

 
| ** **                     | ** ** | **For the three  months ended  March 31, 2010** | ** ** | **For the three  months ended  March 31, 2009** | ** ** |
|--------------------------------|------------|--------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|
| Balance at beginning of period |       | $                                                                        | 237,308    |                                                                     | $          | 480,775 |   |
| Provision for loan losses      |       | —                                                                   |       | 26,987                                                                   |       |
| Charge-offs                    |       | (21,228                                                                  | )          | —                                                                   |       |
| Balance at end of period       |       | $                                                                        | 216,080    |                                                                     | $          | 507,762 |   |

 

Asof March 31, 2010 and December 31, 2009, we had an allowance for loanloss of $216.1 million and $237.3 million, respectively. As describedunder “Critical Accounting Policies”, our allowance for loan losses representsour estimate of probable credit losses inherent in our corporate loan portfolioheld for investment as of the balance sheet date. Estimating our allowance forloan losses involves a high degree of management judgment and is based upon acomprehensive review of our loan portfolio that is performed on a quarterlybasis. Our allowance for loan losses consists of two components, an allocatedcomponent and an unallocated component. The allocated component of ourallowance for loan losses pertains to specific loans that we have determinedare impaired. We determine a loan is impaired when we estimate that it isprobable that we will be unable to collect all amounts due according to thecontractual terms of the loan agreement. On a quarterly basis we perform acomprehensive review of our entire loan portfolio and identify certain loansthat we have determined are impaired. Once a loan is identified as beingimpaired we place the loan on non-accrual status, unless the loan is already onnon-accrual status, and record a reserve that reflects our best estimate of theloss that we expect to recognize from the loan. The expected loss is estimatedas being the difference between our current cost basis of the loan, includingaccrued interest receivable, and the loans’ estimated fair value.

 

Theunallocated component of our allowance for loan losses reflects our estimate ofprobable losses inherent in our loan portfolio as of the balance sheet datewhere the specific loan that the loan loss relates to is indeterminable. Weestimate the unallocated component of our allowance for loan losses through acomprehensive review of our loan portfolio and identify certain loans thatdemonstrate possible indicators of impairment. This assessment excludes allloans that are determined to be impaired and as a result, an allocated reservehas been recorded as described in the preceding paragraph. Such indicatorsinclude, but are not limited to, the current and/or forecasted financial performanceand liquidity profile of the issuer, specific industry or economic conditionsthat may impact the issuer, and the observable trading price of the loan ifavailable. Loans that demonstrate possible indicators of impairment areaggregated on a watch list for monitoring and are sub-divided forcategorization based on the seniority of the loan in the issuer’s capitalstructure, whether the loan is secured or unsecured, and the nature of thecollateral securing the loan, for purposes of applying possible default andloss severity ranges based on the nature of the issuer and the specific loan.We apply a range of default and loss severity estimates in order to estimate arange of loss outcomes upon which to base our estimate of probable losses thatresults in the determination of the unallocated component of our allowance forloan losses.

 

Asof March 31, 2010, the allocated component of our allowance for loanlosses totaled $82.4 million and relates to investments in loans issued by sixissuers with an aggregate par amount of $216.7 million and an aggregateamortized cost amount of $118.3 million. As of December 31, 2009, theallocated component of the allowance for loan losses totaled $81.7 million andrelates to investments in loans issued by six issuers with an aggregate paramount of $223.6 million and an aggregate amortized cost amount of$121.2 million. The unallocated component of our allowance for loan lossestotaled $133.7 million and $155.6 million as of March 31, 2010 and December 31,2009, respectively. During the three months ended March 31, 2010, werecorded charge-offs totaling $21.2 million comprised primarily of loanstransferred to loans held for sale. There were no charge-offs during the threemonths ended March 31, 2009.

 

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We reduced the lower of cost or market valuation allowance by $3.7million for certain loans held for sale during the quarter ended March 31,2010 which had a carrying value of $733.1 million as of March 31,2010. We recorded a $14.0 million charge to earnings during the quarter ended March 31,2009 for the lower of cost or estimated fair value adjustment for corporateloans held for sale which had a carrying value of $259.9 million as of March 31,2009.

 

The following table summarizes the par value of our corporate loanportfolio stratified by Moody’s Investors Service, Inc. (“Moody’s”) andStandard & Poor’s Ratings Services (“Standard & Poor’s”)ratings category as of March 31, 2010 and December 31, 2009:

 

**Corporate Loans**

**(Amounts inthousands)**

 
| **Ratings Category**   | ** ** | **As of  March 31, 2010** | ** ** | **As of  December 31, 2009** | ** ** |
|-----------------------------|------------|------------------------------------------|------------|---------------------------------------------|------------|
| Aaa/AAA                     |       | $                                        | —     |                                        | $          | — |   |
| Aa1/AA+ through Aa3/AA-     |       | —                                   |       | —                                      |       |
| A1/A+ through A3/A-         |       | —                                   |       | —                                      |       |
| Baa1/BBB+ through Baa3/BBB- |       | 9,249                                    |       | 22,040                                      |       |
| Ba1/BB+ through Ba3/BB-     |       | 1,453,891                                |       | 1,526,201                                   |       |
| B1/B+ through B3/B-         |       | 4,772,006                                |       | 4,610,234                                   |       |
| Caa1/CCC+ and lower         |       | 791,909                                  |       | 1,120,140                                   |       |
| Non-rated                   |       | 107,846                                  |       | 93,550                                      |       |
| Total                       |       | $                                        | 7,134,901  |                                        | $          | 7,372,165 |   |

 

*CorporateDebt Securities*

 

Our corporate debt securities portfolio totaled $829.7 million and$754.4 million as of March 31, 2010 and December 31, 2009,respectively. Our corporate debt securities portfolio consists of debtobligations of corporations, partnerships and other entities in the form ofsenior secured, senior unsecured and subordinated bonds.

 

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

 

**CorporateDebt Securities**

**(Amounts inthousands)**

 
| ** **       | ** ** | **March 31, 2010** | ** ** | **December 31, 2009** | ** ** |
|------------------|------------|------------------------------|------------|---------------------------------|------------|
| ** **       | ** ** | **Carrying Value**      | ** ** | **Amortized Cost**         | ** ** | **Estimated Fair  Value** | ** ** | **Carrying Value** | ** ** | **Amortized Cost** | ** ** | **Estimated Fair  Value** | ** ** |
| Senior secured   |       | $                            | 296,512    |                            | $          | 226,957 |   | $ | 296,512 |   | $ | 156,410 |   | $ | 99,202 |   | $ | 156,410 |   |
| Senior unsecured |       | 429,869                      |       | 310,635                         |       | 429,869 |   | 425,683 |   | 318,216 |   | 425,683 |   |
| Subordinated     |       | 103,310                      |       | 75,186                          |       | 103,310 |   | 172,316 |   | 143,219 |   | 172,316 |   |
| Total            |       | $                            | 829,691    |                            | $          | 612,778 |   | $ | 829,691 |   | $ | 754,409 |   | $ | 560,637 |   | $ | 754,409 |   |

 

As of March 31, 2010, $684.1 million, or 76.8%, of our corporatedebt securities portfolio was fixed rate and $206.2 million, or 23.2%, wasfloating rate. As of December 31, 2009, $647.4 million, or 77.6%, of ourcorporate debt securities portfolio was fixed rate and $186.7 million, or22.4%, was floating rate. Fixed and floating amounts and percentages are basedon par values.

 

As of March 31, 2010, our fixed rate corporate debt securities hada weighted-average coupon of 9.2% and weighted-average years to maturity of6.5 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 resetfrequencies of less than twelve months. The weighted-average coupon on our floatingrate corporate debt securities was 4.5% and 3.6% as of March 31, 2010 and December 31,2009, respectively, and the weighted-average coupon spread to LIBOR of ourfloating rate corporate debt securities was 4.1% and 3.4% as of March 31,2010 and December 31, 2009, respectively. The weighted-average years tomaturity of our floating rate corporate debt securities was 3.8 and4.1 years as of March 31, 2010 and December 31, 2009,respectively. As of March 31, 2010 and December 31, 2009, $10.8million par amount, or 5.2%, and nil, respectively, of our floating rate corporatedebt securities portfolio had interest rate floors.

 

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During the three months ended March 31, 2010 and 2009, we recordedimpairment losses totaling $1.1 million and $33.8 million, respectively,for corporate debt and equity securities that we determined to beother-than-temporarily impaired. These securities were determined to beother-than-temporarily impaired either due to our determination that recoveryin value is no longer likely or because we decided to sell the respectivesecurity in response to specific credit concerns regarding the issuer.

 

As of March 31, 2010 and December 31, 2009, we had nocorporate debt securities in default.

 

The following table summarizes the par value of our corporate debtsecurities portfolio stratified by Moody’s and Standard & Poor’sratings category as of March 31, 2010 and December 31, 2009:

 

**Corporate Debt Securities**

**(Amounts inthousands)**

 
| **Ratings Category**   | ** ** | **As of  March 31, 2010** | ** ** | **As of  December 31, 2009** | ** ** |
|-----------------------------|------------|------------------------------------------|------------|---------------------------------------------|------------|
| Aaa/AAA                     |       | $                                        | —     |                                        | $          | — |   |
| Aa1/AA+ through Aa3/AA-     |       | —                                   |       | —                                      |       |
| A1/A+ through A3/A-         |       | —                                   |       | 15,590                                      |       |
| Baa1/BBB+ through Baa3/BBB- |       | —                                   |       | —                                      |       |
| Ba1/BB+ through Ba3/BB-     |       | 154,268                                  |       | 35,500                                      |       |
| B1/B+ through B3/B-         |       | 288,091                                  |       | 207,162                                     |       |
| Caa1/CCC+ and lower         |       | 414,751                                  |       | 557,187                                     |       |
| Non-Rated                   |       | 33,141                                   |       | 18,691                                      |       |
| Total                       |       | $                                        | 890,251    |                                        | $          | 834,130 |   |

 

***Residential Mortgage InvestmentSummary***

 

Our residential mortgage investment portfolio consists of investmentsin RMBS with an estimated fair value of $114.0 million as of March 31,2010. The $114.0 million of RMBS is comprised of $29.2 million ofRMBS that are rated investment grade or higher and $84.8 million of RMBSthat are rated below investment grade.

 

As our condensed consolidated financial statements included in thisQuarterly Report on Form 10-Q are presented to reflect the deconsolidation ofthe aforementioned six residential mortgage securitization trusts beginning January 1,2010, the information contained in this Management’s Discussion and Analysis ofFinancial Condition and Results of Operations reflects our residential mortgageportfolio presented on a deconsolidated basis consistent with the disclosuresin our condensed consolidated financial statements. See “Executive Overview —Consolidation” for further discussion.

 

The table below summarizes the carrying value, amortized cost andestimated fair value of our residential mortgage investment portfolio as of March 31,2010 and December 31, 2009. Carrying value is the value that investmentsare recorded on our condensed consolidated balance sheets and is estimated fairvalue for RMBS and residential mortgage loans. Estimated fair values set forthin the tables below are based on dealer quotes, nationally recognized pricingservices and/or management’s judgment when relevant observable inputs do notexist.

 

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**Residential Mortgage Investment Portfolio**

**(Amounts in thousands)**

 
| ** **                             | ** ** | **March 31, 2010** | ** ** | **December 31, 2009** | ** ** |
|----------------------------------------|------------|------------------------------|------------|---------------------------------|------------|
| ** **                             | ** ** | **Carrying  Value**          | ** ** | **Amortized  Cost**             | ** ** | **Estimated  Fair Value** | ** ** | **Carrying  Value** | ** ** | **Amortized  Cost** | ** ** | **Estimated  Fair Value** | ** ** |
| Residential Mortgage Loans(1)          |       | $                            | —     |                            | $          | — |   | $ | — |   | $ | 2,097,699 |   | $ | 2,772,216 |   | $ | 2,097,699 |   |
| Residential Mortgage-Backed Securities |       | 114,023                      |       | 288,762                         |       | 114,023 |   | 47,572 |   | 95,483 |   | 47,572 |   |
| Total                                  |       | $                            | 114,023    |                            | $          | 288,762 |   | $ | 114,023 |   | $ | 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 loansowned by us with an outstanding balance of $11.4 million were REO as aresult of foreclosure on delinquent loans.

 

**Shareholders’ Equity**

 

Our shareholders’ equity at March 31, 2010 and December 31,2009 totaled $1.3 billion and $1.2 billion, respectively. Included in ourshareholders’ equity as of March 31, 2010 and December 31, 2009 isaccumulated other comprehensive income totaling $170.4 million and $152.7million, respectively.

 

Our average shareholders’ equity and return on average shareholders’equity for the three months ended March 31, 2010 were $1.2 billionand 43.1%, respectively.  Our averageshareholders’ equity and return on average shareholders’ equity for the threemonths ended March 31, 2009 were $691.5 million and (7.6)%,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 March 31, 2010 and December 31,2009 was $8.31 and $7.37, respectively, and is computed based on 158,359,757shares issued and outstanding as of both March 31, 2010 and December 31,2009.

 

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

 

**Liquidity and Capital Resources**

 

We actively manage our liquidity position with theobjective of preserving our ability to fund our operations and fulfill ourcommitments on a timely and cost-effective basis. As of March 31, 2010, wehad unrestricted cash and cash equivalents totaling $240.5 million.

 

During the first quarter of 2010, we observed signsof recovery in market value for some assets. As a result, capital markets,including debt and equity financing, that were previously frozen or availableonly on unattractive terms, show limited signs of reopening. Although webelieve our current sources of liquidity are adequate to preserve our abilityto fund our operations and fulfill our commitments, we will continue toevaluate opportunities to deploy incremental capital based on the terms ofcapital available to us. This may include taking advantage of market timing toissue equity or refinance or replace indebtedness, including the issuance ofnew debt securities and retiring debt pursuant to privately negotiatedtransactions, 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 receivedfrom our investments in the mezzanine and subordinated notes of our Cash FlowCLOs. During a portion of the quarter ended March 31, 2010, two of ourCash Flow CLOs were out of compliance with certain compliance tests (specifically,OC Tests) outlined in their respective indentures. During the period in which aCash Flow CLO is not in compliance with an OC Test, the cash flows we wouldgenerally expect to receive from our Cash Flow CLO holdings are paid to thesenior note holders of the Cash Flow CLOs. However, by March 31, 2010,both of these Cash Flow CLOs came into compliance with their OC Tests, resumingcash flows to the mezzanine and subordinate note holders, including us.

 

**Sources of Funds**

 

*Cash FlowCLO Transactions*

 

As of March 31, 2010, we had five Cash Flow CLOs outstanding. Anaffiliate of our Manager owns an interest in the junior notes of bothCLO 2007-1 and CLO 2007-A. The aggregate carrying amount of the juniornotes in CLO 2007-1 and CLO 2007-A held by the affiliate of our Manager is$380.3 million as of March 31, 2010 and is reflected ascollateralized loan obligation junior secured notes to affiliates on ourcondensed consolidated balance sheets.

 

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In accordance with GAAP, we consolidate each of these Cash Flow CLOs aswe have the power to direct the activities of these VIEs, as well as theobligation to absorb losses of the VIEs and the right to receive benefits ofthe VIEs that could potentially be significant to the VIEs. We utilize CLOs tofund our investments in corporate loans and corporate debt securities. Theindentures governing our Cash Flow CLOs include numerous compliance tests, themajority of which relate to the CLO’s portfolio profile. In the event that aportfolio profile test is not met, the indenture places restrictions on theability of the CLO’s manager to reinvest available principal proceeds generatedby the collateral in the CLOs until the specific test has been cured. Inaddition to the portfolio profile tests, the indentures for the Cash Flow CLOs includeOC Tests which set the ratio of the collateral value of the assets in the CLOto the tranches of debt for which the test is being measured, as well asinterest coverage tests. For purposes of the calculation, collateral value isthe par value of the assets unless an asset is in default, is a discountedobligation, or is a CCC-rated asset in excess of the percentage of CCC-ratedasset limit specified for each Cash Flow CLO.

 

If an asset is in default, the indenture for each Cash Flow CLOtransaction defines the value used to determine the collateral value, whichvalue is the lower of market value of the asset or the recovery valueproscribed 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 aparticular percentage of par. The discount obligation amounts are specified ineach 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 thepercentage of total assets in the CLO that can be rated CCC. All assets inexcess of the CCC threshold specified for the respective CLO are included inthe OC Tests at market value and not par.

 

Defaults of assets in Cash Flow CLOs, ratings downgrade of assets inCash Flow CLOs to CCC, price declines of CCC assets in excess of the proscribedCCC threshold amount, and price declines in assets classified as discountobligations may reduce the over-collateralization ratio such that a Cash FlowCLO is not in compliance. If a Cash Flow CLO is not in compliance with an OCTest, cash flows normally payable to the holders of junior classes of noteswill be used by the CLO to amortize the most senior class of notes until suchpoint as the OC Test is brought back into compliance. As a result of thehistoric declines in asset prices, particularly in the corporate loan and highyield securities asset classes during the fourth quarter of 2008, one or moreof our Cash Flow CLOs were out of compliance with the OC Tests for periods oftime. While being out of compliance with an OC Test would not impact ourinvestment portfolio or results of operations, it would impact our unrestrictedcash flows available for operations, new investments and dividenddistributions. During the first quarter of 2010, however, as signs of economicrecovery appeared evidenced by appreciating market values, all of our CLOtransactions came into compliance with their OC Tests. The following tablesummarizes several of the material tests and metrics for each of our Cash FlowCLOs. This information is based on the March 2010 monthly reportswhich are prepared by the independent third-party trustee for each Cash FlowCLO:

 

·                  Investments: The par valueof the investments in each CLO plus principal cash in the CLO.

 

·                  Senior interest coverage (“IC”)ratio minimum: Minimum required ratio of interest income earned on investmentsto interest expense on the senior debt issued by the CLO per the respective CLO’sindenture.

 

·                  Actual senior IC ratio: Theratio is interest income earned on the investments divided by interest expenseon the senior debt issued by the CLO.

 

·                  CCC amount: The par amountof assets rated CCC or below (excluding defaults, if any).

 

·                  CCC threshold percentage:Maximum amount of assets in portfolio that are rated CCC without being subjectto being valued at fair value for purposes of the OC Tests.

 

·                  Senior OC Test minimum:Minimum senior over-collateralization requirement per the respective CLO’sindenture.

 

·                  Actual senior OC Test:Actual senior over-collateralization amount as of the March 2010 reportdate.

 

·                  Actual cushion / (excess):Dollar amount that over-collateralization test is being passed, cushion, or failed(excess).

 

·                  Subordinated OC Testminimum: Minimum subordinated over-collateralization requirement per therespective CLO’s indenture.

 

·                  Actual subordinated OC Test:Actual subordinated over-collateralization amount as of March 2010 reportdate.

 

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·                  Subordinate cushion /(excess): Dollar amount that the OC Test is being passed, cushion, or failed(excess).

 
| **(dollar amounts in thousands)** | ** ** | **CLO 2005-1** | ** ** | **CLO 2005-2** | ** ** | **CLO 2006-1** | ** ** | **CLO 2007-1** | ** ** | **CLO 2007-A** | ** ** |
|--------------------------------------------------|------------|---------------------|------------|---------------------|------------|---------------------|------------|---------------------|------------|---------------------|------------|
| Investments                                      |       | $                   | 1,041,902  |                | $          | 1,000,240           |       | $                   | 1,039,445  |                | $          | 3,374,940 |   | $ | 1,525,981 |   |
| Senior IC ratio minimum                          |       | 115.0               | %          | 125.0               | %          | 115.0               | %          | 115.0               | %          | 120.0               | %          |
| Actual senior IC ratio                           |       | 596.7               | %          | 606.0               | %          | 420.0               | %          | 489.8               | %          | 436.0               | %          |
| CCC amount                                       |       | $                   | 61,929     |                | $          | 69,894              |       | $                   | 196,880    |                | $          | 757,186 |   | $ | 289,119 |   |
| CCC percentage of portfolio                      |       | 5.9                 | %          | 7.0                 | %          | 18.9                | %          | 22.4                | %          | 18.9                | %          |
| 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                            |       | 128.7               | %          | 134.0               | %          | 158.7               | %          | 170.5               | %          | 130.9               | %          |
| Cushion / (Excess)                               |       | $                   | 71,678     |                | $          | 81,516              |       | $                   | 94,692     |                | $          | 202,102 |   | $ | 123,094 |   |
| Subordinated OC Test minimum                     |       | 106.2               | %          | 106.9               | %          | 114.0               | %          | 120.1               | %          | 109.9               | %          |
| Actual OC Test                                   |       | 110.0               | %          | 118.9               | %          | 135.4               | %          | 117.8               | %          | 113.2               | %          |
| Cushion / (Excess)                               |       | $                   | 34,592     |                | $          | 100,650             |       | $                   | 152,713    |                | $          | (58,534 | ) | $ | 41,887 |   |

 

As reflected in the table above, each of our Cash Flow CLOs is incompliance with its respective IC ratio tests based on the March 2010 monthlyreports for the respective CLOs. In addition, all Cash Flow CLOs are also incompliance with their respective senior OC Tests and CLO 2005-1, CLO 2005-2,CLO 2006-1, and CLO 2007-A are in compliance with their respective subordinateOC Tests.

 

On January 4, 2010, CLO 2007-A was brought into compliance withits respective OC Tests. Also, on March 19, 2010, CLO 2007-1, our finalremaining 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. The table above,based on the March 2010 monthly report, was prepared using determinationdates as defined in each respective CLO indenture. The determination date forCLO 2007-1 was prior to CLO 2007-1 coming into compliance and as such, itscompliance was not reflected in the test results above. As of March 31,2010, CLO 2007-A and CLO 2007-1, both of which were previously not incompliance and were amortizing the most senior class of notes, have already orwill resume cash flows normally payable to the holders of junior classes ofnotes, including us.

 

During the threemonths ended March 31, 2010, in an open market auction, we purchased $10.3million of mezzanine notes issued by CLO 2007-A for $5.5 million and $72.7million of mezzanine and subordinate notes issued by CLO 2007-1 for $38.8million, both of which were previously held by an affiliate of our manager. Thesetransactions resulted in us recording an aggregate gain on extinguishment ofdebt totaling $38.7 million during the first quarter of 2010.

 

*SeniorSecured Credit Facility*

 

During February 2010, we paid down outstanding borrowings underour senior secured credit facility by $25.0 million, reducing the amountoutstanding from $175.0 million as of December 31, 2009 to $150.0million as of March 31, 2010.

 

*ConvertibleDebt*

 

On January 15, 2010, we issued $172.5 million of 7.5%Convertible Senior Notes due January 15, 2017. The 7.5% Notes bearinterest 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 15of 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 withtheir terms prior to such date. Holders of the 7.5% Notes may convert theirnotes at the applicable conversion rate at any time prior to the close ofbusiness on the business day immediately preceding the stated maturity datesubject to our right to terminate the conversion rights of the notes. We maysatisfy its obligation with respect to the 7.5% Notes tendered for conversionby delivering to the holder either cash, common shares, no par value, issued byus or a combination thereof. The initial conversion rate for each $1,000principal amount of 7.5% Notes is 122.2046 shares, which is equivalent to aninitial conversion price of approximately $8.18 per share. The conversion ratemay be adjusted under certain circumstances, including the occurrence ofcertain fundamental change transactions and the payment of a quarterly cashdistribution in excess of $0.05 per share, but will not be adjusted for accruedand unpaid interest on the 7.5% Notes. Net proceeds from the offering totaled$167.3 million, reflecting $172.5 million from the issuance less$5.2 million for underwriting fees.

 

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During the first quarter of 2010, we repurchased $95.2 million paramount of our 7.0% convertible senior notes due 2012, reducing the amountoutstanding from $275.8 million as of December 31, 2009 to$180.6 million as of March 31, 2010. These transactions resulted inus recording a gain of $1.3 million, which was partially offset by a write-offof $0.6 million of unamortized debt issuance costs during the first quarter of2010.

 

Asof March 31, 2010 and as of the date of filing this Quarterly Report on Form 10-Q,we believe we are in compliance with the covenants contained within ourrespective borrowing agreements.

 

*Off-Balance Sheet Commitments*

 

As of March 31, 2010, we had committed to purchase corporate loanswith aggregate commitments totaling $250.8 million. In addition, weparticipate in certain financing arrangements, including revolvers and delayeddraw facilities, whereby we are committed to provide funding at the discretionof the borrower up to a specific predetermined amount. As of March 31,2010, we had unfunded financing commitments totaling $42.0 million. We donot expect material losses related to the corporate loans for which we committo purchase and fund.

 

**Partnership Tax Matters**

 

***Non-Cash “Phantom” Taxable Income***

 

We intend to continue to operate so that we qualify, for United Statesfederal income tax purposes, as a partnership and not as an association or apublicly traded partnership taxable as a corporation. Holders of our shares aresubject to United States federal income taxation and generally other taxes,such as state, local and foreign income taxes, on their allocable share of ourtaxable income, regardless of whether or when they receive cash distributions.In addition, certain of our investments, including investments in foreigncorporate subsidiaries, CLO issuers, including those treated as partnerships ordisregarded entities for United States federal income tax purposes, and debtsecurities, may produce taxable income without corresponding distributions ofcash to us or may produce taxable income prior to or following the receipt ofcash relating to such income. Consequently, in some taxable years, holders ofour shares may recognize taxable income in excess of our cash distributions.Furthermore, even if we did not pay cash distributions with respect to ataxable year, holders of our shares may still have a tax liability attributableto their allocation of taxable income from us during such year.

 

***Qualifying Income Exception***

 

We intend to continue to operate so that we qualify as a partnership,and not as an association or a publicly traded partnership taxable as acorporation, for United States federal income tax purposes. In general, if apartnership is “publicly traded” (as defined in the Code), it will be treatedas a corporation for United States federal income purposes. A publicly tradedpartnership 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 toregister under the Investment Company Act and at least 90% of its gross incomefor each taxable year constitutes “qualifying income” within the meaning of Section 7704(d) ofthe Code. We refer to this exception as the “qualifying income exception.”Qualifying income generally includes rents, dividends, interest (to the extentsuch interest is neither derived from the “conduct of a financial or insurancebusiness” nor based, directly or indirectly, upon “income or profits” of anyperson), income and gains derived from certain activities related to mineralsand natural resources, and capital gains from the sale or other disposition ofstocks, bonds and real property. Qualifying income also includes other incomederived from the business of investing in, among other things, stocks andsecurities.

 

If we fail to satisfy the “qualifyingincome exception” described above, items of income, gain, loss, deduction andcredit would not pass through to holders of our shares and such holders wouldbe treated for United States federal (and certain state and local) income taxpurposes as shareholders in a corporation. In such case, we would be requiredto 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 onall of our income. Distributions to holders of our shares would constituteordinary dividend income taxable to such holders to the extent of our earningsand profits, and these distributions would not be deductible by us. If we weretaxable as a corporation, it could result in a material reduction in cash flowand after-tax return for holders of our shares and thus could result in asubstantial reduction in the value of our shares and any other securities wemay issue.

 

***TaxConsequences of Investments in Natural Resources***

 

As referenced above, we maymake certain investments in natural resources. When we make such investments, it is likely that the income from suchinvestments would be treated as effectively connected with the conduct of aUnited States trade or business with respect to holders of our shares that arenot “United States persons” within the meaning of Section 7701(a)(30) ofthe Code.  Furthermore, any notional principalcontracts that we enter into, if any, in connection with investments in naturalresources likely would generate income that would be treated as effectivelyconnected income with the conduct of a United States trade or business.  To the extent our income is treated aseffectively connected income, a holder who is a non-United States persongenerally would be required to (i) file a United States federalincome tax return for such year reporting its allocable share, if any, of ourincome or loss effectively connected with such trade or business and(ii) pay United States federal income tax at regular United States taxrates on any such income. Moreover, if such a holder is a corporation, it mightbe subject to a United States branch profits tax on its allocable share of oureffectively connected income. In addition, distributions to such a holder wouldbe subject to withholding at the highest applicable tax rate to the extent ofthe holder’s allocable share of our effectively connected income. Any amount sowithheld would be creditable against such holder’s United States federal incometax liability, and such holder could claim a refund to the extent that theamount withheld exceeded such person’s United States federal income tax liabilityfor the taxable year. Finally, if we are engaged in a United States trade orbusiness, a portion of any gain recognized by an investor who is a non-UnitedStates person on the sale or exchange of its shares may be treated for UnitedStates federal income tax purposes as effectively connected income, and hencesuch holder may be subject to United States federal income tax on the sale orexchange.

 

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

 

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**Our Investment Company Act Status**

 

Section 3(a)(1)(A) of the Investment Company Act defines aninvestment company as any issuer that is, holds itself out as being, orproposes to be, primarily engaged in the business of investing, reinvesting ortrading in securities and Section 3(a)(1)(C) of the InvestmentCompany Act defines an investment company as any issuer that is engaged orproposes to engage in the business of investing, reinvesting, owning, holdingor 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 U.S. governmentsecurities and cash items) on an unconsolidated basis (the “40% test”).Excluded from the term “investment securities” are, among others, securitiesissued by majority-owned subsidiaries unless the subsidiary is an investmentcompany or relies on the exceptions from the definition of an investmentcompany provided by Section 3(c)(1) or Section 3(c)(7) ofthe Investment Company Act (a “fund”). The Investment Company Act defines a “majority-ownedsubsidiary” of a person as any company 50% or more of the outstanding votingsecurities (i.e., those securities presently entitling the holder thereofto vote for the election of directors of the company) of which are owned bythat person, or by another company that is, itself, a majority owned subsidiaryof that person.

 

We are organized as a holding company. We conduct our operationsprimarily through our majority owned subsidiaries. Each of our subsidiaries is eitheroutside of the definition of an investment company in Sections 3(a)(1)(A) and3(a)(1)(C), described above, or excepted from the definition of an investmentcompany under the Investment Company Act. We believe that we are not, and thatwe 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 heldourselves out as such. We intend to continue to conduct our operations so thatwe are not required to register as an investment company under the InvestmentCompany Act.

 

We monitor our holdings regularly to confirm our continued compliancewith the 40% test. In calculating our position under the 40% test, we areresponsible for determining whether any of our subsidiaries is majority-owned.We treat subsidiaries in which we own at least 50% of the outstanding votingsecurities, including those that issue CLOs, as majority-owned for purposes of the40% test. Some of our subsidiaries may rely solely on Section 3(c)(1) orSection 3(c)(7) of the Investment Company Act. In order for us tosatisfy the 40% test, our ownership interests in those subsidiaries or any ofour subsidiaries that are not majority-owned, together with any other “investmentsecurities” that we may own, may not have a combined value in excess of 40% ofthe value of our total assets on an unconsolidated basis and exclusive of U.S.government securities and cash items. However, most of our subsidiaries eitherfall outside of the general definitions of an investment company or rely onexceptions provided by provisions of, and rules and regulationspromulgated under, the Investment Company Act (other than Section 3(c)(1) orSection 3(c)(7) of the Investment Company Act) and, therefore, arenot defined or regulated as investment companies. In order to conform to theseexceptions, these subsidiaries are limited with respect to the assets in whicheach 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 applicableexception and our freedom of action, and that of our subsidiaries, may belimited as a result. For example, our subsidiaries that issue CLOs generallyrely on Rule 3a-7 under Investment Company Act, while KKR FinancialHoldings II, LLC, or “KFH II,” our subsidiary that is taxed as a REIT forU.S. federal income tax purposes, generally relies on Section 3(c)(5)(C) ofthe Investment Company Act. Each of these exceptions requires, among otherthings that the subsidiary (i) not issue redeemable securities and (ii) engagein the business of holding certain types of assets, consistent with the termsof the exception. Similarly, any subsidiaries engaged in the ownership of oiland gas assets may, depending on the nature of the assets, be outside thedefinition of an investment company or rely on exceptions provided by Section3(c)(5)(C) or Section 3(c)(9) of the Investment Company Act.  While Section 3(c)(9) of the InvestmentCompany Act does not limit the nature of the securities issued, it does imposebusiness engagement requirements that limit the types of assets that may beheld.

 

We do not treat our interests in majority-owned subsidiaries that areoutside 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 asinvestment securities when calculating our 40% test.

 

We sometimes refer to our subsidiaries that rely on Rule 3a-7under the Investment Company Act as “CLO subsidiaries.” Rule 3a-7 underthe Investment Company Act is available to certain structured financingvehicles that are engaged in the business of holding financial assets that, bytheir terms, convert into cash within a finite time period and that issue fixedincome securities entitling holders to receive payments that depend primarilyon the cash flows from these assets, provided that, among other things, thestructured finance vehicle does not engage in certain portfolio managementpractices resembling those employed by mutual funds. Accordingly, each of theseCLO subsidiaries is subject to an indenture (or similar transaction documents)that contains specific guidelines and restrictions limiting the discretion ofthe CLO subsidiary and its collateral manager. In particular, these guidelinesand restrictions prohibit the CLO subsidiary from acquiring and disposing ofassets primarily for the purpose of recognizing gains or decreasing losses resultingfrom market value changes. Thus, a CLO subsidiary cannot acquire or dispose ofassets primarily to enhance returns to the owner of the equity in the CLOsubsidiary; however, subject to this limitation, sales and purchases of assetsmay be made so long as doing so does not violate guidelines contained in theCLO subsidiary’s relevant transaction documents. A CLO subsidiary generallycan, for example, sell an asset if the collateral manager believes that itscredit quality has declined since its acquisition or that the credit profile ofthe obligor will deteriorate and the proceeds of permitted dispositions may bereinvested in additional collateral, subject to fulfilling the requirements setforth in Rule 3a-7 under the Investment Company Act and the CLO subsidiary’srelevant transaction documents. As a result of these restrictions, our CLOsubsidiaries may suffer losses on their assets and we may suffer losses on ourinvestments in those CLO subsidiaries.

 

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We sometimes refer to KFH II, our subsidiary that relies on Section 3(c)(5)(C) ofthe Investment Company Act, as our “REIT subsidiary.” Section 3(c)(5)(C) ofthe Investment Company Act is available to companies that are primarily engagedin the business of purchasing or otherwise acquiring mortgages and other lienson and interests in real estate. While the SEC has not promulgated rules toaddress precisely what is required for a company to be considered to be “primarilyengaged in the business of purchasing or otherwise acquiring mortgages andother liens on and interests in real estate,” the SEC’s Division of InvestmentManagement, or the “Division,” has taken the position, through a series ofno-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 thecompany’s assets consist of mortgage loans, other assets that are consideredthe functional equivalent of mortgage loans and certain other interests in realproperty (collectively, “qualifying real estate assets”), and at least 25% ofthe company’s assets consist of real estate-related assets (reduced by the excessof the company’s qualifying real estate assets over the required 55%), leavingno more than 20% of the company’s assets to be invested in miscellaneousassets. The Division has also provided guidance as to the types of assets thatcan be considered qualifying real estate assets. Because the Division’sinterpretive letters are not binding except as they relate to the companies towhom they are addressed, if the Division were to change its position as to,among other things, what assets might constitute qualifying real estate assetsour REIT subsidiary might be required to change its investment strategy tocomply with the changed position. We cannot predict whether such a change wouldbe adverse.

 

Based on current guidance, our REIT subsidiary classifies investmentsin mortgage loans as qualifying real estate assets, as long as the loans are “fullysecured” by an interest in real estate on which we retain the right toforeclose. That is, if the loan-to-value ratio of the loan is equal to or lessthan 100%, then the mortgage loan is considered to be a qualifying real estateasset. Mortgage loans with loan-to-value ratios in excess of 100% areconsidered to be only real estate-related assets. Our REIT subsidiary considersagency whole pool certificates to be qualifying real estate assets. Examples ofagencies that issue whole pool certificates are the Federal National MortgageAssociation, the Federal Home Loan Mortgage Corporation and the GovernmentNational Mortgage Association. An agency whole pool certificate is acertificate issued or guaranteed as to principal and interest by the U.S.government or by a federally chartered entity, which represents the entirebeneficial interest in the underlying pool of mortgage loans. By contrast, anagency certificate that represents less than the entire beneficial interest inthe underlying mortgage loans is not considered to be a qualifying real estateasset, but is considered to be a real estate-related asset.

 

Most non-agency mortgage-backed securities do not constitute qualifyingreal estate assets because they represent less than the entire beneficialinterest in the related pool of mortgage loans; however, based on Divisionguidance, where our REIT subsidiary’s investment in non-agency mortgage- backedsecurities is the “functional equivalent” of owning the underlying mortgageloans, our REIT subsidiary may treat those securities as qualifying real estateassets. Moreover, investments in mortgage-backed securities that do notconstitute qualifying real estate assets will be classified as real estate-related assets. Therefore, based upon the specific terms and circumstancesrelated to each non-agency mortgage-backed security that our REIT subsidiaryowns, our REIT subsidiary will make a determination of whether that securityshould be classified as a qualifying real estate asset or as a real estate-related asset; and there may be instances where a security is recharacterizedfrom being a qualifying real estate asset to a real estate-related asset, orconversely, from being a real estate-related asset to being a qualifying realestate asset based upon the acquisition or disposition or redemption of relatedclasses of securities from the same securitization trust. If our REITsubsidiary acquires securities that, collectively, receive all of the principaland interest paid on the related pool of underlying mortgage loans (less fees,such as servicing and trustee fees, and expenses of the securitization), andthat subsidiary has foreclosure rights with respect to those mortgage loans,then our REIT subsidiary will consider those securities, collectively, to bequalifying real estate assets. If another entity acquires any of the securitiesthat are expected to receive cash flow from the underlying mortgage loans, thenour REIT subsidiary will consider whether it has appropriate foreclosure rightswith respect to the underlying loans and whether its investment is a first lossposition in deciding whether these securities should be classified asqualifying real estate assets. If our REIT subsidiary owns more than onesubordinate class, then, to determine the classification of subordinate classesother than the first loss class, our REIT subsidiary will consider whether suchclasses are contiguous with the first loss class (with no other classesabsorbing losses after the first loss class and before any other subordinateclasses that our REIT subsidiary owns), whether our REIT subsidiary owns theentire amount of each such class and whether our REIT subsidiary would continueto have appropriate foreclosure rights in connection with each such class ifthe more subordinate classes were no longer outstanding. If the answers to anyof these questions is no, then our REIT subsidiary would expect not to classifythat particular class, or classes senior to that class, as qualifying realestate assets.

 

We may hold oil and gas assets through one or more subsidiaries andwould refer to those subsidiaries as our “Oil and Gas Subsidiaries”.  Depending upon the nature of the oil and gasassets held by an Oil and Gas Subsidiary, such Oil and Gas Subsidiary may relyon Section 3(c)(5)(C) or Section 3(c)(9) of the Investment Company Act or mayfall outside of the general definition of an investment company.  An Oil and Gas Subsidiary that does not engageprimarily, propose to engage primarily or hold itself out as engaging primarilyin the business of investing, reinvesting or trading in securities will beoutside of the general definition of an investment company provided that itpasses the 40% test.  This may be thecase where an Oil and Gas Subsidiary holds a sufficient amount of oil and gasassets constituting real estate interests together with other assets that arenot investment securities such as equipment. Oil and Gas Subsidiaries that hold oil and gas assets that constitutereal property interests, but are unable to pass the 40% test, may rely onSection 3(c)(5)(C), subject to the requirements and restrictions describedabove.  Alternately, an Oil and GasSubsidiary may rely on Section 3(c)(9) of the Investment Company Act ifsubstantially all of its business consists of owning or holding oil, gas orother mineral royalties or leases, certain fractional interests, orcertificates of interest or participations in or investment contracts relatingto such royalties, leases or fractional interests.  These various restrictions imposed on our Oiland Gas Subsidiaries by the Investment Company Act may have the effect oflimiting our freedom of action with respect to oil and gas assets (or otherassets) that may be held or acquired by such subsidiary or the manner in whichwe may deal in such assets.

 

As noted above, if the combined values of the investment securitiesissued by our subsidiaries that must rely on Section 3(c)(1) or Section 3(c)(7) ofthe Investment Company Act, together with any other investment securities wemay own, exceeds 40% of the value of our total assets (exclusive of U.S.government securities and cash items) on an unconsolidated basis, we may bedeemed to be an investment company. If we fail to maintain an exception,exemption or other exclusion from the Investment Company Act, we could, amongother things, be required either (i) to change substantially the manner inwhich we conduct our operations to avoid being subject to the InvestmentCompany Act or (ii) to register as an investment company. Either of thesewould likely have a material adverse effect on us, our ability to service ourindebtedness and to make distributions on our shares, and on the market priceof our shares and any other securities we may issue. If we were required toregister as an investment company under the Investment Company Act, we wouldbecome subject to substantial regulation with respect to our capital structure(including our ability to use leverage), management, operations, transactionswith certain affiliated persons (within the meaning of the Investment CompanyAct), portfolio composition (including restrictions with respect todiversification and industry concentration) and other matters. Additionally,our Manager would have the right to 

 

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terminateour management agreement. Moreover, if we were required to register as aninvestment company, we would no longer be eligible to be treated as apartnership for United States federal income tax purposes. Instead, we would beclassified as a corporation for tax purposes and would be able to avoidcorporate taxation only to the extent that we were able to elect and qualify asa regulated investment company (“RIC”) under applicable tax rules. Because oureligibility for RIC status would depend on our assets and sources of income atthe time that we were required to register as an investment company, there canbe no assurance that we would be able to qualify as a RIC. If we were to losepartnership status and fail to qualify as a RIC, we would be taxed as a regularcorporation. See “Partnership Tax Matters—*QualifyingIncome Exception*”.

 

We have not requested approval or guidance from the SEC or its staffwith respect to our Investment Company Act determinations, including, inparticular: our treatment of any subsidiary as majority-owned; the complianceof any subsidiary with Section 3(c)(5)(C) or Section 3(c)(9) of, or Rule 3a-7under, the Investment Company Act, including any subsidiary’s determinationswith respect to the consistency of its assets or operations with therequirements thereof; or whether our interests in one or more subsidiariesconstitute investment securities for purposes of the 40% test. If the SEC wereto disagree with our treatment of one or more subsidiaries as being exceptedfrom 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 otherholdings 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 engageor the manner in which we hold ourselves out, we and/or one or more of oursubsidiaries would need to adjust our operating strategies or assets in orderfor 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 berequired to adjust our operating strategy and holdings, or to effect sales ofour assets in a manner that, or at a time or price at which, we would nototherwise choose, if there are changes in the laws or rules governing ourInvestment Company Act status or that of our subsidiaries, or if the SEC or itsstaff provides more specific or different guidance regarding the application ofrelevant provisions of, and rules under, the Investment Company Act. Suchguidance could provide additional flexibility, or it could further inhibit ourability, 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 wewere required, but failed, to register as an investment company in violation ofthe Investment Company Act, we would have to cease business activities, wewould breach representations and warranties and/or be in default as to certainof our contracts and obligations, civil or criminal actions could be broughtagainst us, our contracts would be unenforceable unless a court were to requireenforcement and a court could appoint a receiver to take control of us andliquidate our business, any or all of which would have a material adverseeffect on our business.

 

**Quantitative and Qualitative Disclosures About MarketRisk**

 

***ForeignCurrency Risks***

 

From time to time, we may make investments that are denominated in aforeign currency through which we may be subject to foreign currency exchangerisk.

 

***CreditSpread Exposure***

 

Our investments are subject to spread risk. Our investments in floatingrate loans and securities are valued based on a market credit spread over LIBORand for which the value is affected by changes in the market credit spreads overLIBOR. Our investments in fixed rate loans and securities are valued based on amarket credit spread over the rate payable on fixed rate United StatesTreasuries of like maturity. Increased credit spreads, or credit spreadwidening, will have an adverse impact on the value of our investments whiledecreased credit spreads, or credit spread tightening, will have a positiveimpact on the value of our investments.

 

***Interest Rate Risk***

 

Interest rate risk is defined as the sensitivity of our current andfuture earnings to interest rate volatility, variability of spreadrelationships, the difference in repricing intervals between our assets andliabilities and the effect that interest rates may have on our cash flows andthe prepayment rates experienced on our investments that have embedded borroweroptionality. The objective of interest rate risk management is to achieveearnings, preserve capital and achieve liquidity by minimizing the negativeimpacts of changing interest rates, asset and liability mix, and prepaymentactivity.

 

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We are exposed to basis risk between our investments and ourborrowings. Interest rates on our floating rate investments and our variablerate borrowings do not reset on the same day or with the same frequency and, asa result, we are exposed to basis risk with respect to index reset frequency.Our floating rate investments may reprice on indices that are different thanthe indices that are used to price our variable rate borrowings and, as aresult, we are exposed to basis risk with respect to repricing index. The basisrisks noted above, in addition to other forms of basis risk that exist betweenour investments and borrowings, may be material and could negatively impactfuture net interest margins.

 

Interest rate risk impacts our interest income, interest expense,prepayments, and the fair value of our investments, interest rate derivatives, andliabilities. We manage our interest rate risk using various techniques rangingfrom the purchase of floating rate investments to the use of interest ratederivatives. The use of interest rate derivatives is a component of ourinterest risk management strategy. The contractual notional balance of ouramortizing interest rate swaps was $383.3 million as of both March 31,2010 and December 31, 2009.

 

***DerivativeRisk***

 

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

 

Collateral posting requirements are individually negotiated betweencounterparties and there is no regulatory requirement concerning the amount ofcollateral that a counterparty must post to secure its obligations undercertain derivative instruments. Because they are unregulated, there is norequirement that parties to a contract be informed in advance when a creditdefault swap is sold. As a result, investors may have difficulty identifyingthe party responsible for payment of their claims. If a counterparty’s creditbecomes significantly impaired, multiple requests for collateral posting in ashort period of time could increase the risk that we may not receive adequatecollateral. Amounts paid by us as premiums and cash or other assets held inmargin accounts with respect to derivative instruments are not available forinvestment purposes.

 

The following table summarizes the estimated net fair value of ourderivative instruments held at March 31, 2010 and December 31, 2009(amounts in thousands):

 
| ** **                                | ** ** | **As of March 31,  2010** | ** ** | **As of December 31,  2009** | ** ** |
|-------------------------------------------|------------|--------------------------------|------------|-----------------------------------|------------|
| ** **                                | ** ** | **Notional**                   | ** ** | **Estimated  Fair Value**         | ** ** | **Notional** | ** ** | **Estimated  Fair Value** | ** ** |
| **Cash Flow Hedges:**                     |       |                           |       |                              |       |   |   |   |   |
| Interest rate swaps                       |       | $                              | 383,333    |                              | $          | (48,705 | ) | $ | 383,333 |   | $ | (43,800 | ) |
| **Free-Standing Derivatives:**            |       |                           |       |                              |       |   |   |   |   |
| Interest rate swaps                       |       | 83,965                         |       | (641                              | )          | 89,246 |   | (281 | ) |
| Credit default swaps—protection sold |       | 51,000                         |       | 225                               |       | 51,000 |   | (385 | ) |
| Total rate of return swaps                |       | —                         |       | 228                               |       | 104,446 |   | 11,809 |   |
| Common stock warrants                     |       | —                         |       | 198                               |       | — |   | 2,471 |   |
| Total                                     |       | $                              | 518,298    |                              | $          | (48,695 | ) | $ | 628,025 |   | $ | (30,186 | ) |

 

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

 
| ** **                                | ** ** | **Less than  1 year** | ** ** | **1-3 years** | ** ** | **3-5 Years** | ** ** | **More than  5 years** | ** ** | **Total** | ** ** |
|-------------------------------------------|------------|----------------------------|------------|--------------------|------------|---------------|------------|-----------------------------|------------|-----------|------------|
| **Cash Flow Hedges:**                     |       |                       |       |               |       |          |       |                        |       |      |       |
| Interest rate swaps                       |       | $                          | —     |               | $          | —        |       | $                           | —     |      | $          | (48,705 | ) | $ | (48,705 | ) |
| **Free-Standing Derivatives:**            |       |                       |       |               |       |          |       |                        |       |      |       |
| Interest rate swaps                       |       | (641                       | )          | —             |       | —        |       | —                      |       | (641      | )          |
| Credit default swaps—protection sold |       | (69                        | )          | 294                |       | —        |       | —                      |       | 225       |       |
| Total rate of return swaps                |       | 228                        |       | —             |       | —        |       | —                      |       | 228       |       |
| Total                                     |       | $                          | (482       | )                  | $          | 294           |       | $                           | —     |      | $          | (48,705 | ) | $ | (48,893 | ) |

 

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***Management Estimates***

 

The preparation of our financial statements requires management to makeestimates and assumptions that affect the amounts reported in our consolidatedfinancial statements and accompanying notes. Significant estimates, assumptionsand judgments are applied in situations including the determination of ourallowance for loan losses and the valuation of certain investments. We reviseour estimates when appropriate. However, actual results could materially differfrom management’s estimates.

 

**Item 3.  Quantitative andQualitative Disclosures about Market Risk**

 

Seediscussion of quantitative and qualitative disclosures about market risk in “Quantitativeand Qualitative Disclosures About Market Risk” section of Management’s Discussionand Analysis of Financial Condition and Results of Operations.

 

**Item 4.  Controls and Procedures**

 

TheCompany’s management evaluated, with the participation of the Company’sprincipal executive and principal financial officer, the effectiveness of theCompany’s disclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934, as amended (the “ExchangeAct”)) as of March 31, 2010. Based on their evaluation, the Company’s principalexecutive and principal financial officer concluded that the Company’sdisclosure controls and procedures as of March 31, 2010 were designed andwere functioning effectively to provide reasonable assurance that theinformation required to be disclosed by the Company in reports filed under theExchange Act is (i) recorded, processed, summarized, and reported withinthe time periods specified in the SEC’s rules and forms, and (ii) accumulatedand communicated to management, including the principal executive and principalfinancial officers, as appropriate, to allow timely decisions regardingdisclosure.

 

Therehas been no change in the Company’s internal control over financial reporting(as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act)that occurred during the three ending March 31, 2010, that has materiallyaffected, or is reasonably likely to materially affect, the Company’s internalcontrol over financial reporting.

 

**PART II.OTHER INFORMATION**

 

**Item 1. LegalProceedings**

 

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

 

On August 7, 2008, the members of our board of directors andcertain of our current and former executive officers and we were named in aputative class action complaint filed by Charter Township of Clinton Police andFire Retirement System in the United States District Court for the SouthernDistrict of New York, or the Charter Litigation. On March 13, 2009, thelead plaintiff filed an amended complaint, which deleted as defendants themembers of our board of directors and named as defendants only our former chiefexecutive officer Saturnino S. Fanlo, our former chief operating officer DavidA. Netjes, our current chief financial officer Jeffrey B. Van Horn and us. Theamended complaint alleges that our April 2, 2007 registration statementand prospectus and the financial statements incorporated therein containedmaterial omissions in violation of Section 11 of the Securities Act,regarding the risks and potential losses associated with our realestate-related assets, our ability to finance our real estate-related assetsand the adequacy of our loss reserves for our real estate-related assets. Theamended complaint further alleges that, pursuant to Section 15 of theSecurities Act, Messrs. Fanlo, Netjes and Van Horn each have legalresponsibility for the alleged Section 11 violation. On April 27,2009, the defendants filed a motion to dismiss the amended complaint forfailure to state a claim under the Securities Act.

 

On August 15, 2008, the members of our board of directors and ourexecutive officers (collectively, the “Kostecka Individual Defendants”) werenamed in a shareholder derivative action brought by Raymond W. Kostecka, apurported shareholder, in the Superior Court of California, County of SanFrancisco (the “California Derivative Action”). We are named as a nominaldefendant. The complaint in the California Derivative Action asserts claimsagainst the Kostecka Individual Defendants for breaches of fiduciary duty,abuse of control, gross mismanagement, waste of corporate assets, and unjustenrichment in connection with the conduct at issue in the Charter Litigation,including the filing of our April 2, 2007 registration statement withalleged material misstatements and omissions. By order dated January 8,2009, the Court approved the parties’ stipulation to stay the proceedings inthe California Derivative Action until the Charter Litigation is dismissed onthe pleadings or we file an answer to the Charter Litigation.

 

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On March 23, 2009, the members of our boardof directors and certain of our executive officers (collectively, the “HaleyIndividual Defendants”) were named in a shareholder derivative action broughtby Paul B. Haley, a purported shareholder, in the United States District Courtfor the Southern District of New York (the “New York Derivative Action”). Weare named as a nominal defendant. The complaint in the New York DerivativeAction asserts claims against the Haley Individual Defendants for breaches offiduciary duty, breaches of the duty of full disclosure, and for contributionin connection with the conduct at issue in the Charter Litigation, includingthe filing of our April 2, 2007 registration statement with allegedmaterial misstatements and omissions. By order dated June 18, 2009, theCourt approved the parties’ stipulation to stay the proceedings in the New YorkDerivative Action until the Charter Litigation is dismissed on the pleadings orwe file an answer to the Charter Litigation.

 

**Item 1A. Risk Factors**

 

Otherthan the risk factors set forth below, there have been no material changes inour risk factors from those disclosed in our Annual Report on Form 10-Kfor the year ended December 31, 2009.

 

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

 

Section 3(a)(1)(A) ofthe 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 businessof investing, reinvesting or trading in securities and Section 3(a)(1)(C) ofthe Investment Company Act defines an investment company as any issuer that isengaged 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 U.S. government securities and cash items) on an unconsolidatedbasis (the “40% test”). Excluded from the term “investment securities” are,among others, securities issued by majority-owned subsidiaries unless thesubsidiary is an investment company or relies on the exceptions from thedefinition of an investment company provided by Section 3(c)(1) or Section 3(c)(7) ofthe Investment Company Act (a “fund”). The Investment Company Act defines a“majority-owned subsidiary” of a person as any company 50% or more of theoutstanding voting securities (i.e., those securities presently entitlingthe holder thereof to vote for the election of directors of the company) ofwhich are owned by that person, or by another company that is, itself, amajority owned subsidiary of that person.

 

We are organized as a holding company. We conduct our operationsprimarily through our majority-owned subsidiaries. Each of our subsidiaries iseither outside of the definition of an investment company in Sections 3(a)(1)(A) and3(a)(1)(C), described above, or excepted from the definition of an investmentcompany under the Investment Company Act. We believe that we are not, and thatwe 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 heldourselves out as such. We intend to continue to conduct our operations so thatwe are not required to register as an investment company under the InvestmentCompany Act.

 

We monitor our holdings regularly to confirm our continued compliancewith the 40% test. In calculating our position under the 40% test, we areresponsible for determining whether any of our subsidiaries is majority-owned.We treat subsidiaries in which we own at least 50% of the outstanding votingsecurities, including those that issue CLOs, as majority-owned for purposes ofthe 40% test. Some of our subsidiaries may rely solely on Section 3(c)(1) orSection 3(c)(7) of the Investment Company Act. In order for us tosatisfy the 40% test, our ownership interests in those subsidiaries or any ofour subsidiaries that are not majority-owned, together with any other“investment securities” that we may own, may not have a combined value inexcess of 40% of the value of our total assets on an unconsolidated basis andexclusive of U.S. government securities and cash items. However, most of oursubsidiaries either fall outside of the general definitions of an investmentcompany or rely on exceptions provided by provisions of, and rules andregulations promulgated under, the Investment Company Act (other than Section 3(c)(1) orSection 3(c)(7) of the Investment Company Act) and, therefore, arenot defined or regulated as investment companies. In order to conform to theseexceptions, these subsidiaries are limited with respect to the assets in whicheach 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 applicableexception and our freedom of action, and that of our subsidiaries, may belimited as a result. For example, our subsidiaries that issue CLOs generallyrely on Rule 3a-7 under Investment Company Act, while KKR FinancialHoldings II, LLC, or “KFH II,” our subsidiary that is taxed as a REIT forU.S. federal income tax purposes, generally relies on Section 3(c)(5)(C) ofthe Investment Company Act. Each of these exceptions requires, among otherthings that the subsidiary (i) not issue redeemable securities and (ii) engagein the business of holding certain types of assets, consistent with the termsof the exception. Similarly, any subsidiaries engaged in the ownership of oiland gas assets may, depending on the nature of the assets, be outside 

 

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thedefinition of an investment company or rely on exceptions provided by Section 3(c)(5)(C) orSection 3(c)(9) of the Investment Company Act.  While Section 3(c)(9) of theInvestment Company Act does not limit the nature of the securities issued, itdoes impose business engagement requirements that limit the types of assetsthat may be held.

 

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

 

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

 

We sometimes refer to KFH II, our subsidiary that relies on Section 3(c)(5)(C) ofthe Investment Company Act, as our “REIT subsidiary.” Section 3(c)(5)(C) ofthe Investment Company Act is available to companies that are primarily engagedin the business of purchasing or otherwise acquiring mortgages and other lienson and interests in real estate. While the SEC has not promulgated rules toaddress precisely what is required for a company to be considered to be“primarily engaged in the business of purchasing or otherwise acquiringmortgages and other liens on and interests in real estate,” the SEC’s Divisionof Investment Management, or the “Division,” has taken the position, through aseries of no-action and interpretive letters, that a company may rely on Section 3(c)(5)(C) ofthe Investment Company Act if, among other things, at least 55% of thecompany’s assets consist of mortgage loans, other assets that are consideredthe functional equivalent of mortgage loans and certain other interests in realproperty 

 

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(collectively,“qualifying real estate assets”), and at least 25% of the company’s assetsconsist of real estate-related assets (reduced by the excess of the company’squalifying real estate assets over the required 55%), leaving no more than 20%of the company’s assets to be invested in miscellaneous assets. The Divisionhas also provided guidance as to the types of assets that can be consideredqualifying real estate assets. Because the Division’s interpretive letters arenot 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, whatassets might constitute qualifying real estate assets our REIT subsidiary mightbe required to change its investment strategy to comply with the changedposition. We cannot predict whether such a change would be adverse.

 

Based on current guidance, our REIT subsidiary classifies investmentsin 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 toforeclose. That is, if the loan-to-value ratio of the loan is equal to or lessthan 100%, then the mortgage loan is considered to be a qualifying real estateasset. Mortgage loans with loan-to-value ratios in excess of 100% areconsidered to be only real estate-related assets. Our REIT subsidiary considersagency whole pool certificates to be qualifying real estate assets. Examples ofagencies that issue whole pool certificates are the Federal National MortgageAssociation, the Federal Home Loan Mortgage Corporation and the GovernmentNational Mortgage Association. An agency whole pool certificate is acertificate issued or guaranteed as to principal and interest by the U.S.government or by a federally chartered entity, which represents the entirebeneficial interest in the underlying pool of mortgage loans. By contrast, anagency certificate that represents less than the entire beneficial interest inthe underlying mortgage loans is not considered to be a qualifying real estateasset, but is considered to be a real estate-related asset.

 

Most non-agency mortgage-backed securities do not constitute qualifyingreal estate assets because they represent less than the entire beneficialinterest in the related pool of mortgage loans; however, based on Divisionguidance, where our REIT subsidiary’s investment in non-agency mortgage- backedsecurities is the “functional equivalent” of owning the underlying mortgageloans, our REIT subsidiary may treat those securities as qualifying real estateassets. Moreover, investments in mortgage-backed securities that do notconstitute qualifying real estate assets will be classified as real estate-related assets. Therefore, based upon the specific terms and circumstancesrelated to each non-agency mortgage-backed security that our REIT subsidiaryowns, our REIT subsidiary will make a determination of whether that securityshould be classified as a qualifying real estate asset or as a real estate-related asset; and there may be instances where a security is recharacterizedfrom being a qualifying real estate asset to a real estate-related asset, orconversely, from being a real estate-related asset to being a qualifying realestate asset based upon the acquisition or disposition or redemption of relatedclasses of securities from the same securitization trust. If our REITsubsidiary acquires securities that, collectively, receive all of the principaland interest paid on the related pool of underlying mortgage loans (less fees,such as servicing and trustee fees, and expenses of the securitization), andthat subsidiary has foreclosure rights with respect to those mortgage loans,then our REIT subsidiary will consider those securities, collectively, to bequalifying real estate assets. If another entity acquires any of 

 

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thesecurities that are expected to receive cash flow from the underlying mortgageloans, then our REIT subsidiary will consider whether it has appropriateforeclosure rights with respect to the underlying loans and whether itsinvestment is a first loss position in deciding whether these securities shouldbe classified as qualifying real estate assets. If our REIT subsidiary ownsmore than one subordinate class, then, to determine the classification ofsubordinate classes other than the first loss class, our REIT subsidiary willconsider whether such classes are contiguous with the first loss class (with noother classes absorbing losses after the first loss class and before any othersubordinate classes that our REIT subsidiary owns), whether our REIT subsidiaryowns the entire amount of each such class and whether our REIT subsidiary wouldcontinue to have appropriate foreclosure rights in connection with each suchclass if the more subordinate classes were no longer outstanding. If theanswers to any of these questions is no, then our REIT subsidiary would expectnot to classify that particular class, or classes senior to that class, asqualifying real estate assets.

 

We may hold oil and gas assets through one or more subsidiaries andwould refer to those subsidiaries as our “Oil and Gas Subsidiaries”.  Depending upon the nature of the oil and gasassets held by an Oil and Gas Subsidiary, such Oil and Gas Subsidiary may relyon Section 3(c)(5)(C) or Section 3(c)(9) of the InvestmentCompany Act or may fall outside of the general definition of an investment company.  An Oil and Gas Subsidiary that does notengage primarily, propose to engage primarily or hold itself out as engagingprimarily in the business of investing, reinvesting or trading in securitieswill be outside of the general definition of an investment company providedthat it passes the 40% test.  This may bethe case where an Oil and Gas Subsidiary holds a sufficient amount of oil andgas assets constituting real estate interests together with other assets thatare not investment securities such as equipment.  Oil and Gas Subsidiaries that hold oil andgas assets that constitute real property interests, but are unable to pass the40% test, may rely on Section 3(c)(5)(C), subject to the requirements andrestrictions described above. Alternately, an Oil and Gas Subsidiary may rely on Section 3(c)(9) ofthe Investment Company Act if substantially all of its business consists ofowning or holding oil, gas or other mineral royalties or leases, certainfractional interests, or certificates of interest or participations in orinvestment contracts relating to such royalties, leases or fractionalinterests.  These various restrictionsimposed on our Oil and Gas Subsidiaries by the Investment Company Act may havethe 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 mannerin which we may deal in such assets.

 

As noted above, if the combined values of the investment securitiesissued by our subsidiaries that must rely on Section 3(c)(1) or Section 3(c)(7) ofthe Investment Company Act, together with any other investment securities wemay own, exceeds 40% of the value of our total assets (exclusive of U.S.government securities and cash items) on an unconsolidated basis, we may bedeemed to be an investment company. If we fail to maintain an exception,exemption or other exclusion from the Investment Company Act, we could, amongother things, be required either (i) to change substantially the manner inwhich we conduct our operations to avoid being subject to the InvestmentCompany Act or (ii) to register as an investment company. Either of thesewould likely have a material adverse effect on us, our ability to service ourindebtedness and to make 

 

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distributionson our shares, and on the market price of our shares and any other securitieswe may issue. If we were required to register as an investment company underthe Investment Company Act, we would become subject to substantial regulationwith respect to our capital structure (including our ability to use leverage),management, operations, transactions with certain affiliated persons (withinthe meaning of the Investment Company Act), portfolio composition (includingrestrictions with respect to diversification and industry concentration) andother matters. Additionally, our Manager would have the right to terminate ourmanagement agreement. Moreover, if we were required to register as aninvestment company, we would no longer be eligible to be treated as apartnership for United States federal income tax purposes. Instead, we would beclassified as a corporation for tax purposes and would be able to avoidcorporate taxation only to the extent that we were able to elect and qualify asa regulated investment company (“RIC”) under applicable tax rules. Because oureligibility for RIC status would depend on our assets and sources of income atthe time that we were required to register as an investment company, there canbe no assurance that we would be able to qualify as a RIC. If we were to losepartnership status and fail to qualify as a RIC, we would be taxed as a regularcorporation. See “Partnership Tax Matters—*QualifyingIncome Exception*”.

 

We have not requested approval or guidance from the SEC or its staffwith respect to our Investment Company Act determinations, including, inparticular: our treatment of any subsidiary as majority-owned; the complianceof 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’sdeterminations with respect to the consistency of its assets or operations withthe requirements thereof; or whether our interests in one or more subsidiariesconstitute investment securities for purposes of the 40% test. If the SEC wereto disagree with our treatment of one or more subsidiaries as being exceptedfrom the Investment Company Act pursuant to Rule 3a-7, Section 3(c)(5)(C) orSection 3(c)(9), with our determination that one or more of our otherholdings 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 engageor the manner in which we hold ourselves out, we and/or one or more of oursubsidiaries would need to adjust our operating strategies or assets in orderfor us to continue to pass the 40% test or register as an investment company, eitherof which could have a material adverse effect on us. Moreover, we may berequired to adjust our operating strategy and holdings, or to effect sales ofour assets in a manner that, or at a time or price at which, we would nototherwise choose, if there are changes in the laws or rules governing ourInvestment Company Act status or that of our subsidiaries, or if the SEC or itsstaff provides more specific or different guidance regarding the application ofrelevant provisions of, and rules under, the Investment Company Act. Suchguidance could provide additional flexibility, or it could further inhibit ourability, 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 wewere required, but failed, to register as an investment company in violation ofthe Investment Company Act, we would have to cease business activities, wewould breach representations and warranties and/or be in default as to certainof our contracts and obligations, civil or criminal actions could be broughtagainst us, our contracts would be unenforceable unless a court were to requireenforcement and a court could appoint a receiver to take control of us andliquidate our business, any or all of which would have a material adverseeffect on our business.

 

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***We may make investments, such as investments in naturalresources, that  would generate incomethat is treated as effectively connected with respect to holders of our commonshares that are not “United States persons.”***

 

Wemay make investments, such as investments in natural resources, the income fromwhich likely would be treated as effectively connected with the conduct of aUnited States trade or business with respect to holders of our shares that arenot “United States persons” within the meaning of Section 7701(a)(30) ofthe Code.  Furthermore, any notionalprincipal contracts that we enter into, if any, in connection with investmentsin natural resources likely would generate income that would be treated aseffectively connected income with the conduct of a United States trade orbusiness.  To the extent our income istreated as effectively connected income, a holder who is a non-United Statesperson generally would be required to (i) file a United Statesfederal 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) payUnited States federal income tax at regular United States tax rates on any suchincome. Moreover, if such a holder is a corporation, it might be subject to aUnited States branch profits tax on its allocable share of our effectivelyconnected income. In addition, distributions to such a holder would be subjectto withholding at the highest applicable tax rate to the extent of the holder’sallocable share of our effectively connected income. Any amount so withheldwould be creditable against such holder’s United States federal income taxliability, and such holder could claim a refund to the extent that the amountwithheld exceeded such person’s United States federal income tax liability forthe taxable year. Finally, if we are engaged in a United States trade orbusiness, a portion of any gain recognized by an investor who is a non-United Statesperson on the sale or exchange of its shares may be treated for United Statesfederal income tax purposes as effectively connected income, and hence suchholder may be subject to United States federal income tax on the sale orexchange.

 

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

 

In addition to United States federal income taxes, holders of ourcommon shares will likely be subject to other taxes, including foreign, stateand local taxes, unincorporated business taxes and estate, inheritance orintangible taxes that are imposed by the various jurisdictions in which weconduct business or own property.  Forexample, we will likely be treated as doing business in any foreign, state orlocal jurisdiction in which any natural resources in which we invest arelocated.  As a result, our holders willlikely be required to file foreign, state and local income tax returns and payforeign, state and local income taxes in some or all of these variousjurisdictions.  Further, holders may besubject to penalties for failure to comply with those requirements.

 

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**Item 2 *.*Unregistered Sales of Equity Securities andUse of Proceeds**

 

OnJanuary 15, 2010, our non-employee directors deferred a total of $0.1 millionin cash compensation in exchange for 9,728 shares of phantom shares pursuant tothe KKR Financial Holdings LLC Non-Employee Directors’ Deferred Compensationand Share Award Plan.  Each phantom shareis the economic equivalent of one of our common shares. The phantom sharesbecome payable, in cash or common shares, at the election of the Company, uponthe earlier of (i) the first day of January following the applicablenon-employee director’s termination of service as a director or (ii) anelection date pre-selected by the applicable non-employee director, and in anyevent in cash or common shares, at the election of the applicable non-employeedirector, upon the occurrence of a change in control of the Company.  The grants made to our non-employee directorswere exempt from the registration requirements of the Securities Act pursuantto Section 4(2) thereof.

 

**Item 3. DefaultsUpon Senior Securities**

 

None.

 

**Item 4. Submissionof Matters to a Vote of Security Holders**

 

None.

 

**Item 5. OtherInformation**

 

None.

 

**Item 6. Exhibits**

 
| **Exhibit  Number** | ** ** | **Description**                                        |
|---------------------|------------|--------------------------------------------------------|
|                |       |                                                   |
| 31.1                |       | Chief Executive Officer  Certification                 |
| 31.2                |       | Chief Financial Officer  Certification                 |
| 32                  |       | Certification Pursuant  to 18 U.S.C. Section 1350 |

 

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**SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, KKR FinancialHoldings LLC has duly caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.

 
| ** **                | ** ** | KKR Financial Holdings LLC                                            |
|---------------------------|------------|-----------------------------------------------------------------------|
| ** **                | ** ** | ** **                                                            |
| **Signature**             | ** ** | **Title**                                                             |
|                      |       |                                                                  |
|                      |       |                                                                  |
| /s/ WILLIAM C.  SONNEBORN |       | Chief Executive Officer  (Principal Executive Officer)                |
| **William  C. Sonneborn** |       |                                                                  |
|                      |       |                                                                  |
|                      |       |                                                                  |
| /s/ JEFFREY B. VAN HORN   |       | Chief Financial Officer  (Principal Financial and Accounting Officer) |
| **Jeffrey  B. Van Horn**  |       |                                                                  |

 

Date: April 29,2010

 

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