Another day, another crisis in the credit markets. KKR Financial, which is a publicly traded investment vehicle run by Kohlberg Kravis Roberts, made headlines this morning when it asked for a restructuring of billions of dollars in short-term debt. Apparently they’ve struck a bargain with their investors to delay the repayment of the debt, which was due last Friday, until March. But reading about the story of KKR Financial is like watching the credit crunch in action.
As best we can tell, KKR Financial started out life as a publicly-traded fixed income fund that was basically a REIT. KKR made around $800 million from the 2005 IPO. Things went swimmingly for a time, and the success of KKR Financial is sometimes cited as prompting other private equity firms to consider public offerings.
We all know what happened next: the boom ran headlong into the subprime meltdown. When the mortgage market turned bloody last year, KKR had to raise $500 million in new money to rescue the fund and promptly sold off half its mortgage portfolio at a loss. It funded the remaining half of the mortgage portfolio by selling short-term commercial paper debt in two conduits—KKR Atlantic Funding Trust and KKR Pacific Funding Trust. Basically, the REIT became a SIV. This short-term/long long-term debt model was a standard SIV financing tactic before the commercial paper market seized up and investors turned their backs on SIVs.
In connection with throwing over the mortgage portfolio, in May 2007, KKR Financial transformed itself from a REIT to a limited liability company, allowing it to invest in a broader range of assets. Sometime in October, KKR threw another $38.3 million into the two conduit funds as S&P started downgrading them. It worked out a deal to extend the payment on the existing debt to February 15. And something really odd seems to have happened, KKR Financial apparently sought to dig itself out of the trouble in the mortgage market by investing in another troubled asset class—leveraged loans.
“Back in the summer KFH had more than $5bn of mortgages financed by short term commercial paper. Since then that seems to have mutated into a $7.6bn portfolio of corporate debt. (Yes, after the residential property blow up it moved into leveraged loans.)” FT Alphaville explained.
How did it “mutate?” Well, we asked some questions to KKR’s spokespeople today and they’ve promised to get back to us. Until then, we’re just taking an educated guess. Back in September, Citigroup’s then-chief executive Chuck Prince paid a visit to the office of Henry Kravis over at 9 West. No-one would talk about the meeting but a few weeks later we learned that Citi and KKR had been in talks for Citi to lend money to KKR, money which KKR then planned to use to buy leveraged loans off Citi’s books. As if this wasn’t dizzying enough, some of these loans were originally made by Citi to KKR to fund buyouts.
Is this how KKR Financial built up its huge leveraged loan portfolio? After a few initial reports that the plan was being discussed, we never learned what became of it. Some suspect that it might have died with the ouster of Chuck Prince. But there’s no real reason to assume that happened. Even if the financing to build up this leveraged loan portfolio did not come from Citigroup, it appears KKR Financial was able to raise billions in other ways. The January 28th earnings statement shows that during the fourth quarter of 2007, KKR Financial raised billions of dollars of new debt. The new debt includes a $1.5 billion structured finance deal, $1.2 billion in senior notes and a 800 million Euro facility. It also announced an additional structured finance deal that provides for the issuance of $1.6 billion of senior secured non-recourse debt.
There’s plenty of reason to think that the serial executions of Wall Street executives may have helped KKR pickup the leveraged loans on the cheap. The logic of KKR’s plan was explained to us by some loan market professionals we spoke with last fall. The banks were concerned that investor appetite for the loans would not be enough to absorb the total amount they planned to bring to market, and that a flood of new loans selling into lowered demand could put pressure on the banks to make even steeper discounts, creating even larger losses at a time when the banks are attempting to put the legacy of credit market losses behind them. The alternative—keeping the loans on the books and hoping for better days ahead—is no better for banks trying to show shareholders that they cleaned the debt mess off their books.
KKR Financial, which had recently acquired new locked-up capital from investors and found senior lenders willing to hand over billions, seems to have decided to take a longer view of the debt market. It appeared to be betting that although a lot of debt was scheduled to come to market, a drought of those loans loomed just over the horizon. The slowdown of leveraged-buyout deals last summer guaranteed that there would, eventually, be fewer loans coming to market. And this drought could hit just when investor appetite for debt is recovering. At that point, KKR would be in a great position to sell the loans at prices above the discounted price at which they bought them from the banks.
But investor appetite for leveraged loans has not recovered, and the commercial paper market remains tight. SIV funding is more or less unavailable. And all that cash KKR Financial was carrying around? Well, perhaps that was actually “cash equivalents” in the form of auction-rated securities and is locked-up right now too. We're still investigating. What seems clear is that the credit crunch has lasted far longer than KKR had planned for but its lenders seem none too eager to let it default.
Citi did not immediately return our call. But we didn't really give them much time to respond, so you can't blame them.
KKRF's 8-K [SEC.gov]
KKR arm in talks after fresh repayment delays [Financial Times]