Fitch: KFN's 'BBB' IDR on Positive Watch; KKR Affirmed at 'A' Following Acquisition Announcement

NEW YORK--()--Fitch Ratings has placed the 'BBB' Issuer Default Rating (IDR) of KKR Financial Holdings LLC (KFN) on Rating Watch Positive and affirmed the 'A' long-term IDRs of KKR & Co. L.P. (KKR) and its subsidiaries, following the announced acquisition of KFN by KKR, for approximately $2.6 billion in equity. KKR's Rating Outlook is Stable. A complete list of rating actions is detailed at the end of this release.

KEY RATING DRIVERS - KKR Financial Holdings LLC

The placement of KFN's ratings on Positive Watch reflects Fitch's view that following the acquisition, the entity would be viewed as being of strategic importance to KKR, as outlined in its criteria, 'Rating FI Subsidiaries and Holding Companies'. In accordance with the criteria, a subsidiary considered to be of strategic importance is rated one to two notches below its parent. As a result, Fitch would expect to upgrade the IDR of KFN to 'A-' upon closing of the transaction, which is expected to occur in the first half of 2014, subject to shareholder approval.

KKR's non-private equity business, with $23.7 billion of fee-earning assets under management (FAUM), which is included in its public markets segment, has been growing in recent years as the firm has focused on broadening its product suite for limited partners, improving the liquidity of its investment portfolio, and generating a recurring yield from the balance sheet. This transaction serves to accelerate that strategy, to some extent, as KFN has historically invested in more liquid credit via the issuance of CLOs, which provide a contractual yield to the firm.

Also supporting the view of KFN's strategic importance to KKR is the sharing of the brand, the high level of management integration, and the fact that during the recent financial crisis KKR provided explicit financial support to KFN, by waiving management fees, backstopping an equity raise, and providing the firm with a $100 million liquidity facility. While Fitch has continued to believe that KKR would provide additional support to KFN if necessary, this acquisition strengthens that notion.

That said, Fitch believes that KFN's small size and more limited track record prevent the firm from being considered a core subsidiary, at present, which would result in equalization of the ratings. Depending on KFN's size, strategy, and relative earnings contribution to KKR, Fitch's assessment of KFN's strategic importance could evolve over time.

KEY RATING DRIVERS - KKR & Co. L.P.

The affirmation of KKR's ratings reflects the firm's strong liquidity position and modest balance sheet leverage, as measured by debt-to-tangible equity. Furthermore, while cash flow leverage is expected to be elevated as a result of consolidation of KFN debt and the loss of management fees to KKR from KFN, Fitch believes that leverage is likely to decline over time as proceeds from KKR's February 2013 debt issuance are deployed into opportunities to add to fee-related EBITDA.

The acquisition will add approximately $832.7 million of debt to KKR's consolidated balance sheet, consisting of retail notes, junior subordinated debt, and perpetual preferred securities, which receive 50% equity credit from Fitch given the cumulative nature of the distribution. Additionally, the management fees and incentive income that KKR currently receives from KFN, which aggregated $56.7 million through the first nine months of 2013, will be eliminated. However, that income will be replaced with KKR's full ownership of KFN's earnings stream, which amounted to $224.4 million through Sept. 30, 2013. Unlike management fees, however, investment income can be more volatile over time, which may introduce greater variability in KFN's contribution to KKR's overall performance.

The Stable Outlook for KKR continues to reflect Fitch's belief that its credit fundamentals will remain strong, given the locked-in nature of the majority of the fee stream, and that KKR will produce consistent investment performance to support future fundraising and FAUM expansion, operate with relatively low leverage, and retain a solid liquidity profile in order to cover operating expenses and meet co-investment commitments to funds.

RATING SENSITIVITIES - KKR & Co. L.P.

Negative rating action could result from material changes in KKR's operating strategy or leverage tolerance resulting from declines in investment performance, which adversely impacts the business franchise. A more aggressive capital structure at KFN could also impact KKR's ratings, given the interrelationship between the two companies and Fitch's consolidation of KFN debt on KKR's balance sheet. Historically, KFN's recourse leverage target, as measured by debt-to-equity, has been in a range of 0.5x-1.0x, which Fitch has deemed prudent given its strategy and asset composition. KFN's leverage was 0.36x at Sept. 30, 2013.

Meaningful FAUM and margin contraction, reduced product line diversity, impairment of the liquidity profile, and legislative risk and/or prolonged market disruptions that impact the ability to fundraise or arrange attractive fund exit opportunities could also yield negative rating momentum for KKR.

Fitch believes positive rating momentum for KKR is limited, given its current rating level and the nature and risk profile of the business, including the impact that key man events and/or reputational damage can have on the franchise and future fundraising prospects.

RATING SENSITVITIES - KKR Financial Holdings LLC

Following the close of the acquisition, the ratings of KFN will be directly linked to KKR, as Fitch considers KFN to be a strategically important subsidiary. Any change in Fitch's view on the relationship between KFN and its parent could alter the rating linkage. Absent a change in the perceived relationship between KKR and KFN, Fitch would expect KFNs ratings to move in step with any changes to KKR's ratings. Additionally, a material increase in leverage and/or significant deterioration in the operating performance of KFN could become a constraining factor for the ratings of KKR.

Fitch has affirmed the following with a Stable Outlook:

KKR & Co. L.P.

KKR Management Holdings L.P.

KKR Fund Holdings L.P.

-- Long-term IDR at 'A'.

KKR Group Finance Co. LLC

-- Long-term IDR at 'A';

-- Unsecured debt at 'A'.

KKR Group Finance Co. II LLC

-- Long-term IDR at 'A';

-- Unsecured debt at 'A'.

Fitch has placed the following on Rating Watch Positive:

KKR Financial Holdings LLC

-- Long-term (IDR of 'BBB';

-- Unsecured debt of 'BBB';

-- Preferred stock of 'BB+'.

Additional information is available at 'www.fitchratings.com.'

Applicable Criteria and Related Research:

-- 'Global Financial Institutions Rating Criteria' (August 2012);

-- 'Investment Manager and Alternative Funds Criteria' (December 2012).

Applicable Criteria and Related Research:

Global Financial Institutions Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=686181

Investment Manager and Alternative Funds Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=725057

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=812098

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Contacts

Fitch Ratings, Inc.
Primary Analyst
Meghan Neenan, CFA, +1-212-908-9121
Senior Director
Fitch Ratings, Inc.
One State Street Plaza
New York, NY 10004
or
Secondary Analyst
Mohak Rao, +1-212-908-0559
Director
or
Committee Chairperson
Joo-Yung Lee, +1-212-908-0560
Managing Director
or
Media Relations
Brian Bertsch, +1-212-908-0549
brian.bertsch@fitchratings.com

Contacts

Fitch Ratings, Inc.
Primary Analyst
Meghan Neenan, CFA, +1-212-908-9121
Senior Director
Fitch Ratings, Inc.
One State Street Plaza
New York, NY 10004
or
Secondary Analyst
Mohak Rao, +1-212-908-0559
Director
or
Committee Chairperson
Joo-Yung Lee, +1-212-908-0560
Managing Director
or
Media Relations
Brian Bertsch, +1-212-908-0549
brian.bertsch@fitchratings.com