KKR affiliate admits to mortgage-backed securities woes

A publicly-traded affiliate of the venerable buyout firm Kohlberg Kravis Roberts has announced that it might face a USD200m loss on mortgage-backed securities, as well as a further tax bill as a result of a USD5.1bn sale of residential mortgage assets and interest rates swaps that might cost the company its status as a real estate investment trust.

The troubles of KKR Financial, which raised USD800m when it floated in June 2005, are widely believed to have been a factor in the reported decision of KKR to postpone its initial public offering scheduled for September, in which it planned to raise USD1.25bn. The firm has denied the reports, saying it is continuing to work on preparations for the flotation.

On Monday KKR Financial announced that it had agreed to sell USD230m worth of new shares to funds managed by Farallon Capital Management, Fir Tree Partners, JGE Capital Management, Marsico Capital Management, Morgan Stanley, Oak Hill Advisors, and Sageview Capital, to be used for 'general corporate purposes'.

Chief executive Nino Fanlo said: 'KKR Financial will use the capital to strengthen its balance sheet and ensure it is able to operate from a position of strength in these turbulent times. We are grateful for the support of the investor group and our partners at KKR.' The firm also plans to raise a further USD270m through a rights issue to existing investors.'

The rights issue includes a backstop commitment agreement under which the principals of Kohlberg Kravis Roberts have committed to purchase up to approximately USD100m worth of KKR Financial shares at the same price per share of USD14.40 if the rights offering is not fully subscribed.

KKR Financial says that 'due to the unprecedented disruption in the residential mortgage and global commercial paper markets, [it] has initiated discussions with the investors in its asset-backed secured liquidity note facilities regarding various alternatives to resolve potential funding disruptions resulting from the current market environment.' If these efforts fail, it may take an accounting charge of up to USD200m.

In addition, the company says, the sale of nearly half of its portfolio of mortgage-related assets may result in it failing to qualify as a Reit for the 2007 tax year, which would make it liable for up to USD50m in federal, state and local corporate income tax on its income for the year.

KKR Financial converted from a Reit to a limited liability company in May this year, but invested in residential real estate assets in order to be treated as a Reit for federal income tax purposes. As a Reit, at least 75 per cent of the company's gross income had to be generated by real estate assets.

The company says that to meet this requirement, it sought to limit its exposure to both interest rate risk and credit risk by investing in floating rate and hybrid rate assets that were hedged with interest rate derivatives, and by investing in residential mortgage assets with high credit quality.

KKR Financial now intends to dispose of its existing portfolio of residential real estate assets through either a run-off of the assets through principal payments and prepayments or through a strategic alternative, including actively pursuing the sale of the common stock of its Reit subsidiary.

The recent USD5.1bn sale of its residential mortgage assets and terminated related interest rate swaps will result in a net loss of approximately USD40m, the company says, and leaves it with some USD5.8bn in mortgage loans, primarily in the form of residential mortgage-backed securities.

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